Senate Health Committee Issues Testimony From Northwestern University Professor (Part 2 of 2)

WASHINGTON, April 21 -- The Senate Health, Education, Labor and Pensions Committee issued the following testimony by Craig Garthwaite, a professor in hospital and health services management in Kellogg School of Management at the Northwestern University, involving a hearing on March 22, 2023, entitled "Taxpayers Paid Billions for It: So Why Would Moderna Consider Quadrupling the Price of the COVID Vaccine?":

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(Continued from Part 1 of 2)

Given the economically meaningful role of the public sector in the healthcare market, the ability to maintain a competitive market inherently relies, at least in part, on government policies and regulations. Ultimately, healthcare is our nation's most meaningful public-private partnership. This has become even more apparent as the United States increasingly relies on private firms for the provision of publicly funded social insurance benefits. This includes the Medicare Advantage program, Medicaid Managed Care, and the Affordable Care Act - which I've previously noted is perhaps the most conservative, market-based approach to the provision of health insurance for such a large number of low-income individuals.29 Private firms are being used to provide these services because, at their core, they have the strong incentive to respond to consumer demand in a quest to maximize profits. These incentives allocate resources in ways that increase welfare. It is unlikely that a government entity could achieve a similar result, and therefore optimal healthcare policy harnesses market forces while maintaining no illusions about the motivations of the firms it employs to efficiently provide goods and services.

However, successfully managing these public-private partnerships requires establishing rules that enhance rather than inhibit competition. While the existing Medicare Part D program involves a large amount of price negotiation, there are still many drugs paid for by Medicare that effectively involve no direct price negotiation by a payer and instead attempt indirectly benefit from private market negotiations. These drugs are administered by providers and covered under the Medicare Part B benefit. Rather than use private firms to directly negotiate prices for these products, Medicare operates under a "buy and bill" system. Physicians purchase these drugs and then are reimbursed a fixed percentage above the average sales price (ASP) of the product - a price measure intended to account for rebates paid by manufacturers to payers. The purpose of this reimbursement system is to provide doctors with simplicity and predictability of reimbursement. These attractive features, however, come at a meaningful cost for the entire system, as the Part B procurement rules increase prices for the public and private markets while also shifting share at the margin to more expensive treatment options.

In order to understand the widespread effects of Part B, consider the motivations of a pharmaceutical manufacturer negotiating with PBMs and payers to determine its optimal price. Given that these firms are attempting to maximize profits, they set prices that are expected to earn the greatest profits. Once those profit-maximizing prices are set, higher prices will, by definition, decrease the firm's total profits. This occurs because the increased margin will not make up for the lost quantity (and related profits) that comes from a greater use of prior authorization, step therapy, increased cost sharing, or other utilization management tools.

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29 Garthwaite, Craig. 2017. "Why replacing Obamacare is so hard: It's fundamentally conservative." The Washington Post. July 10.

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By linking public and private prices, the Part B purchasing rule distorts the optimal pricing decision in the private market. Firms are willing to increase private prices, and suffer declining profits in the private market, because they know they can make up those lost profits and more from the public market. In addition, because they know that physicians earn more money from administering a higher-priced drug, they have an additional incentive related to Part B for raising prices.

The combination of these factors means that the Part B procurement rules create the incentives for firms to offer fewer discounts in the private market, resulting in a higher ASP and greater profits from the public market. As a result, the current Part B rules for purchasing physician-administered drugs result in higher prices in both the public and the private markets. These incentives increase with Medicare's market share in each drug - a larger Medicare market means the potentially higher reimbursement from the public payers is more important for determining profits than the lost sales in the private market. Given the age and disease profile of Part B enrollees, there are a large number of high-cost drugs for which Medicare has a meaningfully large market.

As we look for policy solutions to address the lack of competition created by the Part B reimbursement rules, we must confront two areas of concern. Part B can cause higher prices both because physicians have an incentive to prescribe higher priced drugs (because they earn more for administering such products) and because manufacturers have an incentive to raise private prices to influence the public market.

In attempting to address physician incentives, we must be careful not to create perverse incentives to inappropriately prescribe lower-cost drugs. We also must be careful about creating a situation where it is no longer economically viable for physicians to practice in particular areas or in particular organizational forms. For example, attempts to reform the Part B procurement rules that switch to simply paying physicians a flat fee for each administered drug ignore the fact that physicians can face meaningful inventory costs for stocking and maintaining a large volume of high-cost drugs. Many of these costs are likely a function of the acquisition cost of the product. These costs could be particularly acute for small practices, which may lack sufficient liquidity to maintain sufficient stock of medications and may make prescription choices to limit these costs. At the extreme, this could push further consolidation of the provider market.

Congress should consider policies that adopt a vendor model for the distribution of physician-administered drugs that would transform that market from the existing "buy and bill" system to one where physicians have little financial incentive to prescribe particular medications. The details of such a fundamental shift in the market are important and must be worked out. In doing so, Congress should investigate why previous attempts to establish a similar model under the Competitive Acquisition Program (CAP) did not successfully attract vendors and providers. Certainly, part of this failure results from the fact that many providers are currently dependent on the revenues they earn from the buy-and-bill system. Thus, any successful reform must figure out a way to attract those physicians and other providers into the system. In addition, such a program would need to be sufficiently attractive to vendors to attract entrants to the market. This would likely require empowering vendors with the ability to walk away from particular drugs in order to secure greater discounts. This may limit the access of Medicare patients to some products, but we must be honest and adamant that some degree of reduced access is a necessary part of any true price negotiation process.

While there are many details to work out in this area, I would strongly encourage policymakers to follow the policy lead of Part D and find ways to utilize private-sector vendors to negotiate lower prices for Part B, rather than accepting this portion of Medicare as being a price taker. Failing to do so will continue to perpetuate a policy that increases spending across the system.

III. The role of government in supporting a robust small molecule generic market

As discussed above, the access-innovation trade off involves granting firms a time-limited period of market exclusivity. At the conclusion of this period, it is in the best interest of society for products to be sold in a robust and competitive market. Our existing system of follow-on competition has largely worked well since the passage of the Hatch-Waxman Act in 1984. However, the complexity of the modern drug market has created a new set of challenges for this previously well-functioning process.

Markets for generic small molecule products are intended to have fierce price competition facilitated by the automatic substitution of prescriptions towards less-expensive generic products. In a well-functioning generic market, firms compete primarily on price and therefore profits are determined by a firm's ability to manufacture products at the lowest marginal cost. This fierce price competition means that successful entrants must be able to produce enough to reach the minimum efficient scale (MES) of their production process. Absent sufficient quantity, entrants realize they will find themselves at a perpetual cost disadvantage to incumbent firms and therefore will rationally decline to enter the market. For sufficiently small markets, there is only enough demand for a single manufacturer to reach MES - and the incumbent firm is a natural monopolist that maintains meaningful pricing power.

In recent years, several firms appear to have recognized the pricing power available to ANDA holders for generic products with sufficiently small potential markets. This was perhaps best personified by the pricing strategies of Turing Pharmaceuticals, but aspects of this strategy have been implemented by other firms and thoroughly documented in several media outlets.30 The ability for these firms to charge monopoly prices for generic products is not the result of the above-discussed tradeoff between access today and innovation tomorrow - society has long since paid for the innovation from any of these products. Instead, the high prices represent firms taking advantage of a market failure created by the small patient population. While large pharmaceutical firms were historically either unwilling to exploit this pricing power or unaware of this financial strategy, the practice of firms charging high prices without fear of entry in small generic markets is now widespread throughout the industry (albeit the strategy is typically employed by smaller firms with fewer invested assets in the industry). If Congress hopes that for-profit firms will simply avoid this pricing strategy going forward, they will be sorely mistaken. Instead, solutions to market failures for small-market generics will need to come either from firms being harmed by this practice or through government action.

For some of these products, private firms are stepping forward with market-based solutions. Specifically, a consortium of hospitals led by Intermountain Healthcare has created CivicaRx - a joint venture designed to address the high prices charged for many generics that are administered in a hospital setting.31 For products administered in the inpatient hospital setting, providers are unable to pass the increased costs along to patients or payers and have therefore decided to vertically integrate and manufacture the products themselves.

While vertical integration in this setting is an efficient response by hospitals in response to a market failure in their supplier market, CivicaRx will likely not find it valuable to undertake the manufacturing of products that are sold directly to patients through retail or specialty pharmacies or administered in an outpatient setting. Those products do not impact the financial health of the hospitals involved in the joint venture. Therefore, solutions for these other products must come from new government policies that either reduce the number of natural monopoly markets or use economic tools to more directly intervene in the natural monopoly markets that remain.

If high fixed entry costs make it difficult for multiple firms to profitably produce small-market generics, one potential policy solution is to lower these fixed costs. This would decrease the quantity required for a new entrant to reach MES and compete with the incumbent manufacturer. In recent years, the FDA has been focused on programs to accomplish this goal. For example, there have been efforts to streamline and harmonize the generic application process across developed countries.32 There have also been attempts to increase the speed and efficiency of the ANDA process, which would decrease barriers to entry and potentially increase the number of markets that could support multiple firms.33

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30 Hopkins, Jared S., and Andrew Martin. 2018. "These New Pharma Bros Are Wreaking Havoc on Prescription Drug Prices." Bloomberg. April 6. Pollack, Andrew. 2015. "Drug Goes From $13.50 a Tablet to $750, Overnight." The New York Times. September 20. Rockoff, Jonathan D., and Ed Silverman. 2015. "Pharmaceutical Companies Buy Rivals' Drugs, Then Jack Up the Prices." The Wall Street Journal. April 26.

31 Abelson, Reed, and Katie Thomas. 2018. "Fed Up With Drug Companies, Hospitals Decide to Start Their Own." The New York Times. January 18.

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I would encourage the FDA to continue to evaluate the approval process to look for additional efficiencies that would decrease entry costs. However, even the most efficient process for entering a generic market will require some expenditures to demonstrate the safety and bioequivalence of the product - and this will always represent a meaningful fixed-cost investment. Therefore, another potential solution to promote entry is to attempt to increase the size of some generic markets. While this can't be accomplished within any geographic boundary (i.e., we are unlikely to uncover more patients with these types of conditions), I would encourage Congress and regulators to consider a broader system of importation across developed countries with similar safety and regulatory systems (i.e., the countries the FDA is currently empowered to turn to in the case of drug shortages). Aggregating demand across these markets would increase total quantity and the number of products that could successfully be produced by multiple manufacturers. Some have argued the FDA could implement this strategy today by considering generic products with large price hikes to be a situation of shortage.34 However, it is likely that Congressional investigation and debate are needed before we implement such an important change to the sourcing of generic medications.

Even after efforts to decrease costs and increase market sizes, there likely will remain some markets that still cannot support multiple firms. In this case, further regulations are likely necessary to reach an efficient outcome. Senator Elizabeth Warren has previously proposed that the government step in to manufacture generic drugs when products have small market sizes and large drug price increases.35 I understand and appreciate the motivation for Senator Warren's proposal and think that it is a potentially viable policy option for addressing this particular market failure, i.e., the lack of competition in markets for generic products without sufficient size to support multiple firms.

However, I fear that a government entity will likely fail at being an efficient producer of these products - after all, this is not an enterprise in which they specialize. As a result, the marginal costs of a government producer would likely be higher than for a private firm with experience in drug production. Before the government undertakes such a new and complicated economic activity, I would propose a private-sector solution in which Congress empowers the FDA to provide a new form of market exclusivity for generic products with market sizes that do not support multiple competitors.

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32 Gottlieb, Scott. 2018. "Advancing Toward the Goal of Global Approval for Generic Drugs: FDA Proposes Critical First Steps to Harmonize the Global Scientific and Technical Standards for Generic Drugs." FDA. October 18.

33 Elvidge, Suzanne. 2018. "FDA sets another record in 2018 for generic drug approvals." BioPharma Dive. October 12.

34 Greene, Jeremy A., Gerard Anderson, and Joshua M. Sharfstein. 2016. "Role of the FDA in Affordability of Off-Patent Pharmaceuticals." JAMA 315 (5): 461-462. doi:10.1001/jama.2015.18720.

35 Warren, Elizabeth. 2018. "It's time to let the government manufacture generic drugs." The Washington Post. December 17.

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The exact specifics of such an exclusivity would need to be worked out, but a first step would be for Congress to ask the FTC to examine how many potential patients are necessary for a market to support multiple generic firms. While most generic prescriptions are likely for molecules that can support multiple competitors, there are potentially a large number of molecules with small patient populations that can't support multiple manufacturers. For example, there has been an increase in the number of exits by ANDA holders in recent years, with many firms citing a lack of profitability. The median generic market currently has only two manufacturers, and approximately 40% have a single manufacturer - which likely is the result of limited market potential for these molecules.36 That said, the current number of firms participating in the market in equilibrium does not provide sufficient information to understand whether the market could ultimately support multiple firms. After all, it is the threat of entry and not actual entry that disciplines profits. Inferring the number of firms that a particular generic market could support based on the number of current firms could be particularly problematic given the ongoing allegation of collusion in this market.37 Therefore, it is important for economists at the FTC to determine the exact market size and structure that would indicate that the market for the generic product is a natural monopoly where the incumbent firms possesses significant pricing power. Ideally this investigation would incorporate the potential market-expanding policies of decreasing entry costs and potentially increasing the market size to include some limited foreign markets.

After establishing the market characteristics likely to lead to natural monopolies, I would propose the FDA be required to undertake a request for proposal (RFP) process for those markets. Under this RFP process, any private firm could apply for the rights to be the exclusive manufacturer of a natural monopoly generic medicine at a certain fixed percentage above manufacturing costs. As part of this RFP process, firms would compete on the amount of margin they would require to serve the market. The winning firm would possess the exclusive rights to sell the drug at this regulated price for a time period sufficient to recover the fixed costs of entry. At that time, the FDA would have the option of re-auctioning off the market exclusivity. In order to ensure the efficient operation of this process, it may also be necessary for the FDA to set a maximum percentage that they will accept before they will turn to a non-profit or government supplier for the product. This will limit any ability of firms to collude to divide up the markets they choose to enter.

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36 Berndt, Ernst R., Rena M. Conti, and Stephen J. Murphy. 2017. "The Landscape of US Generic Prescription Drug Markets, 2004-2016." NBER Working Paper No. 23640.

37 Silverman, Ed. 2019. "Here's how prosecutors say generic drug makers schemed to fix prices." STAT. February 19.

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I would encourage Congress to immediately investigate solutions in the area of small-market generics, as this problem will only grow in importance. Recent scientific advances have allowed for an increasing personalization of medicine. Along with co-authors, I have documented the rising share of clinical trials involving a patient-specific biomarker to determine either efficacy or safety.38 Almost by definition, personalized medicine will involve products with limited patient populations, and for many of these products we should be worried about whether robust generic or biosimilar competition will ever emerge.39 Therefore, while the problem of small-market generics is not a dominant feature of today's market, it will only grow in importance. It will likely be far easier to address the problem now than it will be when the number of powerful interests manufacturing such products increases.

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38 Chandra, Amitabh, Craig Garthwaite, and Ariel Dora Stern. 2018. "Characterizing the Drug Development Pipeline for Precision Medicines." NBER Working Paper No. 24026.

39 The problem of competition for precision medicine will be further complicated in situations where the patented product is a biologic product.

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Original text here: https://www.help.senate.gov/imo/media/doc/Senate_Testimony_HELP_Garthwaite.pdf