Pharmaceuticals and Multi-layered Government-granted Monopoly

Mylan’s price increase of the EpiPen in late August has caused consternation and a lot of debate about the reasons why Mylan has been able to increase the EpiPen price so dramatically above its production cost. Don’t forget that production cost includes the time and resources that comprise FDA compliance costs, even for generics like epinephrine when delivered using Mylan’s proprietary medical device. David Henderson and Charles Hooper wrote yesterday about how the FDA’s overly-cautious regulatory reach keeps the price of pharmaceuticals high by raising compliance costs, even for compounds that have been in existence for over a century.

In the simplest model of a competitive market, rivalry drives price to marginal cost, total surplus is maximized, the largest economical quantity of the good is produced and consumed, and there’s no waste. Producers earn inframarginal profits, although the marginal profit on the last unit sold is zero. Consumers get lots of consumer surplus if all units sell at that P=MC, although the consumer of the last unit consumed gets zero consumer surplus on that unit.

Although this simple model is a good starting point for asking the question of why Mylan can raise price above cost, the model’s usefulness ends pretty quickly once you consider the specifics of the pharmaceutical industry, the medical device industry, and the third-party payer medical care/insurance industry in combination. Then you have to add some elements to your model by asking some more questions:

  • What prevents rivalry from driving price toward cost? Are there entry barriers? Are those entry barriers cost-driven or regulation-driven? If regulation-driven, what are the associated benefits (actual, not intended) of the regulation?
  • What is the political economy of the entry barriers? For example, is the entry barrier the combination of cost-driven and regulation-driven because an incumbent firm has lobbied for a regulation that raises the costs of its rivals and deters their entry, enabling it to raise prices? Or has the firm succeeded in lobbying for a regulation that increases its sales volume?

The first, obvious entry barrier is the patent that the government granted Mylan on the EpiPen device. Given the high costs of R&D and FDA compliance, patents enable medical device developers to charge high enough prices to recoup those costs.

With those questions in mind, I read Scott Alexander’s “Drugs vs. Chairs” post last week in which he analyzed the EpiPen pricing change, in response to a Vox article advocating for more price regulation in which the claim was that the EpiPen price increase “tells us a lot about what’s wrong with American health care”. His analysis reflects the kind of economic reasoning I used above:

[W]hen was the last time that America’s chair industry hiked the price of chairs 400% and suddenly nobody in the country could afford to sit down? When was the last time that the mug industry decided to charge $300 per cup, and everyone had to drink coffee straight from the pot or face bankruptcy? When was the last time greedy shoe executives forced most Americans to go barefoot? And why do you think that is?

The problem with the pharmaceutical industry isn’t that they’re unregulated just like chairs and mugs. The problem with the pharmaceutical industry is that they’re part of a highly-regulated cronyist system that works completely differently from chairs and mugs.

If a chair company decided to charge $300 for their chairs, somebody else would set up a woodshop, sell their chairs for $250, and make a killing – and so on until chairs cost normal-chair-prices again. When Mylan decided to sell EpiPens for $300, in any normal system somebody would have made their own EpiPens and sold them for less. It wouldn’t have been hard. Its active ingredient, epinephrine, is off-patent, was being synthesized as early as 1906, and costs about ten cents per EpiPen-load.

Why don’t they? They keep trying, and the FDA keeps refusing to approve them for human use.

Regulation that raises costs, check. He then provides examples of the attempts of rivals to enter the market and the, to my mind, difficult to support FDA rejections. FDA compliance raises costs, which raises prices, and when it deters entry it dulls the natural process through which prices fall through competition.

Mylan actively seeks regulations that favor it in the market, by lobbying to defeat legislation that would allow substitution:

With ordinary medications, pharmacists are allowed to interpret prescriptions for a brand name as prescriptions for the generic unless doctors ask them not to. …

EpiPens are protected from this substitution. If a doctor writes a prescription for “EpiPen”, the pharmacist must give an EpiPen-brand EpiPen, not an Adrenaclick-brand EpiPen. This is apparently so that children who have learned how to use an EpiPen don’t have to relearn how to use an entirely different device (hint: jam the pointy end into your body). …

There are a lot of different factors, but let me focus on the most annoying one. EpiPen manufacturer Mylan Inc spends about a million dollars on lobbying per year. tells us what bills got all that money. They seem to have given the most to defeat S.214, the “Preserve Access to Affordable Generics Act”. The bill would ban pharmaceutical companies from bribing generic companies not to create generic drugs.

Did they win? Yup. In fact, various versions of this bill have apparently failed so many times that FDA Law Blog notes that “insanity is doing the same thing over and over again and expecting different result”.

Lobbying to perpetuate entry barriers, check.

Note how complicated this becomes: even if rivals can innovate around the epinephrine-delivery device patent, they are stymied by the regulations that require filling the “epipen” prescription with EpiPen.

I can’t recommend Alexander’s post (and even the comments on it) highly enough, as well as his follow-up post where he digs in to the economics literature on the effects of price regulation on innovation:

So by my count, there are eight-and-a-half studies concluding that price regulation would hurt new drug innovation, and one-half of a study concluding that it wouldn’t. I’ve tried to eliminate all the studies sponsored by the pharmaceutical industry from this list, but I might have missed some, and I am always skeptical of anything that says anything the pharmaceutical industry approves of even I can’t trace the money directly.

In both cases, as they say, do read the whole thing. So much more substance and nuance in his analysis than any excerpts can convey.

Sam Bowman from the Adam Smith Institute carries Alexander’s argument a step further by observing the extent to which price-controlling jurisdictions in Europe free ride on the R&D performed in the US:

In the short-term, things get better – drugs are cheaper. Great! But in the longer-term, things get worse. Much worse. Innovation declines and life expectancies fall in both the US and Europe.

Which makes me think that, as bad as the US system is in many ways, there’s a very important silver lining. All that money and intellectual property protection create much, much bigger incentives for healthcare innovation in the US than in Europe.

And that allows those of us in price-controlled countries to get something like the best of both worlds: cheap(er) drugs, but lots of research for new drugs, funded by our less fortunate friends in the United States. In a very important sense, it looks as if we’re free riding on American healthcare spending. …

Without Americans spending all that money on healthcare, those of us living in price-controlled European systems would be living shorter lives, too.

The American health care system is indeed a mess, and a very complicated mess at that. The layers upon layers of regulations that create market power for incumbents, whether medical device incumbents or hospital incumbents or insurance company incumbents, are “a dog’s dinner” in Sam’s words. Any suggestion that more price regulation would right what’s wrong with American healthcare is simplistic at best, but more realistically is wrong-headed, as Alexander and Bowman demonstrate.