JustMedicine is a non-profit that aims to introduce competition into the generic drug market by sponsoring generic entrants. The organization’s CEO explains why non-profit generic drug manufacturers can generate billions of dollars in savings for US consumers.

Generic pharmaceutical products have long been considered a great cost-saver in the US health care system. One recent estimate suggested that generic drugs saved US consumers $265 billion in 2017 as compared to branded drugs, with generic drugs impressively accounting for nine out of every ten prescriptions filled. These numbers sound good, but the savings patients have enjoyed pale in comparison to the savings they would have received if the generic drug industry were more competitive.

News from the last month has shown that pharmaceutical manufacturers were allegedly colluding illegally to set prices on over 300 generic drugs. In some ways, this revelation is shocking—generic drug makers are supposed to save money for patients. In other ways, this news was entirely predictable. Generic drug makers have seen consolidation leading to fewer firms and decreased entry leading to fewer firms per market over the past several years.

A conclusion that had been hiding in plain sight is now unavoidable: generic drug companies are making more money than they would make if they operated in a competitive market. The generic drug industry is not working for consumers. Fortunately, there is a market-based solution to this problem that can generate billions of dollars in savings for US consumers: non-profit generic drug manufacturers, such as my organization JustMedicine.

A functional generic pharmaceutical market is one that provides high-quality, low-priced medications to consumers. This outcome is likeliest when there is vigorous competition in the market. For purchasers—including health systems, pharmacy benefit managers (PBMs), and individual consumers—to gain the benefits of competition, generic firms entering these competitive markets must also be able to generate sufficient profits to justify their entry.

There are two reasons that competition is necessary to create these benefits. First, many pharmaceutical products have inelastic demand at the generic price, which is often much lower than the price consumers and purchasers were willing to pay for the branded product. This means that without competition, a generic manufacturer can demand a very high price. Second, generic pharmaceutical products are undifferentiated from one another, meaning products are virtually identical and purchasers have no preference among manufacturers’ products.

This lack of differentiation means that, in a competitive market, firms compete entirely on price, which in turn increases the benefit to manufacturers of limiting price competition.

From Competition to Collusion and Cooperation

For many years, the generic drugs market behaved in a way that greatly benefited consumers thanks to frequent new entrants and vigorous competition among them. The passage of the Hatch-Waxman Act of 1984 made entry into many markets profitable for the first time, encouraging firms to enter.

In the years after Hatch-Waxman, for each large-market orally administered drug, seven or more firms entered the market in the two years post patent expiry, resulting in precipitous price drops for consumers. For more complicated products such as injectables, between three and five firms entered. Typical generic prices in markets with many entrants were often 10 percent of the pre-entry branded price. The promise of Hatch-Waxman and a thriving generic marketplace was realized, and generics generated massive savings for the United States health care system.

While this equilibrium benefitted large purchasers and consumers, many generic manufacturers earned zero economic profit. Intense competition kept prices low, and as investors lost patience with protracted price wars and periods of low profit, many firms exited or participated in mergers and acquisitions that effectively consolidated the industry. As drugs created in the 1980s aged and their demand declined, some manufacturers left, leaving behind fewer firms. Further frustrating competition, since 2014, some generic manufacturers have allegedly participated in illegal collusion by allocating customers and even agreeing to price increases before implementation, with the probe now including over 300 different products.

The result is a generic market that now looks little like the robust market of the late 1990s and early 2000s, with fewer firms in the industry and less competition in each molecule-dosage market. Now a full 40 percent of generic pharmaceutical markets have a single firm producing the product, and the median number of firms per market is just two. Prices have increased as competition has dropped, in sharp contrast to trends from 1985 to 2010. As long as manufacturers are able to restrain competition, these trends are unlikely to shift course.

Persistence of the Problem

The problem of reduced competition is unlike many other problems in the pharmaceutical marketplace, such as shortages or quality issues, insofar as it is permanent and structural. Government cannot require manufacturers to enter additional markets, and for-profit firms will not consistently enter markets that decrease their profits. For manufacturers, a reduction in competition is the efficient outcome. Therefore, without some outside intervention, the expectation should be that pharmaceutical markets will remain largely uncompetitive.

The Solution: Non-Profit Generic Entry

If the generic market effectively functioned with considerable benefits to the United States health system when there was more competition, today as we face the reality of many markets with few competitors our easiest solution is to encourage market entry.

An additional entrant that produces low-cost, high-quality products will attract customers and will pressure existing firms to lower their prices to maintain their share. However, the current market structure provides little incentive for a for-profit manufacturer to do so. The fixed costs of entry, specifically scientific development and regulatory approval, total several million dollars, while post-entry competition among homogeneous products results in razor-thin margins. Furthermore, an entrant that drives down profits by competing and fails to collude may be acquired by another generic incumbent. Yet both challenges—insufficient return on initial investment and consolidation—can be overcome if the entrant is a non-profit generic manufacturer.

A non-profit generic firm focused on increasing competition has the right incentives and capacity to bring the market into an equilibrium state that benefits consumers. By entering markets that have reduced competition and charging a price above but near long-term average cost, a non-profit generic firm can earn a small profit while also putting strategic pressure on the incumbents in the market.

Upon entry of a non-profit charging a price slightly above long term average cost, the incumbent monopolist can: (a) price above the non-profit’s price and lose market share, (b) price at the non-profit’s price and earn lower profits, or (c) price below the non-profit’s price, at long-term average cost, and keep their market share but earn little to no profit. All of these responses will increase consumer benefit. Crucially, any of these responses benefits the non-profit. If it makes sales, it both earns profits and helps customers buy the drug at a lower price. If it does not make sales because the incumbent undercuts, it helps customers buy the drug at a very low price. The non-profit’s mission and organizational structure protects it from choosing to charge a monopoly price or engaging in collusion and also protects it against any acquisition attempt by incumbents.

It is clear that a non-profit entrant with a standard production cost will ultimately bring down prices not only for its customers, health systems, and large-scale purchasers, but also for the entire market, creating a tremendous benefit for all purchasers and consumers.

Methods to Overcome Barriers to Non-Profit Entry

1. Barrier: Non-Profits Struggle to Secure Financing to Enter

Despite the promise of consumer and health system benefit, non-profit entry has been largely absent due to several structural barriers. First, securing financing for these projects can be difficult. Even the simplest drugs will cost several million dollars to get an Abbreviated New Drug Application (ANDA) approved by the FDA that will allow the firm to sell into the US market. This barrier is insignificant if investors anticipate financial returns, but for a non-profit firm, offering market-rate financial benefits to investors is not only difficult but also potentially antithetical to its mission.

Philanthropic organizations are well-suited to bridge the gap between a financial barrier to entry and a positive social outcome; however, such institutions are reluctant to provide grants of this size for organizations that promise to disrupt domestic markets and compete with for-profit firms.

Further, the problem of reduced competition is not well understood. Until around 2010 the market was functioning well for consumers and did not require much intervention. Prior to this shift, the primary strategy for health systems to generate savings on pharmaceuticals was to shift consumers to generic products whenever available. It is reasonable then that the shift toward focusing on generic prices in and of themselves as a problem is new to health systems and philanthropy.

Most importantly, the largest beneficiaries of the non-profit entrant are the large purchasers of generic drugs, specifically health systems, pharmacy chains, and PBMs. These are the parties that have the most incentive to fund an entrant because they directly reap the benefit. But these groups have yet to sponsor entry in a way that addresses the root issues of competition.

The lack of action is caused by several aspects of the problem. Importantly, an entrant creates a positive impact on all buyers, leading even large buyers to feel that their investment would mainly benefit competitors. Additional reasons include general risk aversion, the long time horizons for benefits to be realized, the possibility that the incumbent lowers its price and the non-profit fails to deliver an accounting profit (though of course it would be delivering large cost savings to the buyer/investor), and the complexity of the problem and solutions.

One major risk of sponsoring entry for an investor or donor is the threat of setting off a price war. Buyers such as pharmacies, health systems, and PBMs benefit greatly from a price war. However, a price war would result in zero or negative profit for the non-profit. While the price war is a massive success on the one hand (for consumers, buyers, and the non-profit’s mission), the non-profit will earn no revenue to repay its investors or sponsor its own entry into additional markets. In that case, a price war that necessitated continued financial support might, without a committed buyer, be an effective strategy by incumbents to minimize the non-profits impact.

For this reason, the investor must also be the purchasing entity, as then the logic shifts. When the purchaser pays for the fixed costs of developing the ANDA that enables commercial production, a price war would actually lead to even greater cost savings on the product entered, allowing the health system to recoup its investment costs through a reduction in the per unit price of the product regardless of the firm from which they purchase.

2. Barrier: Free-Riding / Solution: Restrict Sales to Sponsors

If purchasers care only about absolute cost, we should expect to see purchasers funding non-profit entry. The inherent problem with this strategy is that purchasers also care about relative cost among their peer sellers of insurance or health services. Investing to lower both one’s own cost and peer costs may impede profitability by increasing costs without increasing market share.

These firms are thus rightfully concerned about free-riding. One firm having a uniquely low price for a product is a competitive advantage. If every firm has a lower price, there is no advantage. If every firm has a lower price, but only one firm invested in lowering that price, then the firm that paid is uniquely disadvantaged.

This risk of free-riding and the resulting competitive disadvantage may discourage investment in the non-profit entrant. Therefore, it is necessary that the health system investing in the non-profit entrant will, in the short-term, uniquely capture more of the value it creates for the industry as a whole than the firms that do not invest in the non-profit.

One method is for the non-profit entrant to initially restrict sales (a “subscriber model”) and initially offer the new, lower price to only those firms that fund entry. By restricting sales at favorable prices for the first several years to only those firms that are paying the entry costs, the optimal pricing decision for the incumbent shifts. Instead of competing with the entrant for every customer, a significant portion of the market continues to face a monopoly seller and the incumbent can continue to charge high prices to those customers. Under subscriber pricing, incumbent manufacturers are likely to maintain high prices over the uncontested share of the market. The subscribers will then have favorable costs relative to non-subscribers, and will be able to uniquely recoup their investment.

After a few years, the restriction on making only enough output for subscribers would end, and we would expect to see full-fledged competition between generic companies spurred by the non-profit entrant.

3. Barrier: Drug Selection / Solution: Consortium

Another barrier is the risk that a scientific discovery may decrease demand in the market the non-profit plans to enter. Purchasers can mitigate this risk by sharing the entry cost across a cooperative consortium of purchasers. By having several purchasers work together, the non-profit can produce at the quantity that allows it to be cost-competitive without requiring a single purchaser to guarantee a substantial investment for a product it may not use as often in the future.

Additionally, this consortium of drug purchasers could sponsor several drug entries to reduce the risk that any one does not earn a financial return, and to build a more robust competitive landscape. By determining a set of criteria that would lead to a guaranteed purchase quantity from the consortium, this consortium could incent even greater entry by more non-profits.

Finally, by having this consortium guarantee purchase if a set of conditions is met, the risk of entry would decrease greatly, as the revenue source would be identified and secured prior to entry. Under these circumstances, private sector capital would likely be available for these projects and would thereby lower the financial exposure and required capital commitments for the firms trying to create a better generic marketplace. Further, by having multiple firms purchase, the purchase requirements per firm are lower, decreasing risk even further.

However, it is important not to succumb to the idea that a for-profit will enter the market and provide equivalent benefits. A for-profit would have a fiduciary responsibility to charge high prices for its products, or to agree to sell the company for a favorable price.

By providing a strong probability of high rates of return, by mitigating the free-rider problem, and by minimizing the financial commitment required by purchasers, non-profit entrants can bring down generic drug prices and benefit their sponsors in a sustainable way that does not rely on ongoing donations or mission-focused capital. After several years of low contracted prices, the non-profit can then expand its production level and sell to any customer at its average cost. This expansion of sale offerings will bring the benefit of low generic prices to the entire market.

Conclusion

If the generic pharmaceutical market needs competition to function well for consumers, and if for-profit firms find competition undesirable and are able to avoid it, then it is critical that a group, or several groups, of purchasers sponsors non-profit entry. By creating a market that rewards firms for consistently producing high-quality, low-cost products, we can help make the profit-maximizing behaviors those behaviors that also align with consumer welfare.

There are many barriers to non-profit entry, but all can be overcome through thoughtful strategy. Critically, under the approach we at JustMedicine propose, no actor needs to follow a strategy against its self-interest for non-profit entry to succeed. These groups only need to do what is logically beneficial for themselves and their customers to dramatically increase consumer welfare.

Mark Rosenberg (email: mark@justmedicine.org) is the CEO of JustMedicine, a non-profit organization dedicated to making generic pharmaceutical markets work for consumers.

Disclaimer: The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.