Politically, this is a popular move. According polls, Americans across the political spectrum support the administration’s plan, which Democrats have proposed in various forms for more than two decades. The Congressional Budget Office says the program, triggered by last year’s Inflation Reduction Act, will save taxpayers $98 billion over the next decade.
Less enthusiastic are pharmaceutical companies, which face extremely heavy fines or the loss of a huge customer base if they choose not to participate in the Medicare negotiations. (After private health insurance, Medicare is the second-largest buyer of pharmaceuticals, accounting for 30 percent of sales.) These companies say the government’s move will freeze investment in innovation and lead to fewer breakthrough drugs. Six of them have already filed lawsuits to block the plan.
Since most Americans have a sketchy view—at best—of how drug pricing actually works, the debate is easily caricatured. On the one hand, you have corporate greed. On the other hand, government exaggeration.
But according to Kellogg’s Amanda Starkthis story is too simplistic—and even potentially harmful, as it ignores the basic exchange at the heart of the drug industry.
“High prices are not always the product of corporate greed,” says Starc, an associate professor of strategy. “They arise from a series of complex dynamics in a market, and some of the most advanced drugs are expensive for a reason.”
While it may sound great in the short term, Biden’s plan doesn’t address these complex dynamics. Nor does it really recognize the long-term costs of price-fixing.
“The aim should be to increase value, not just reduce prices,” says Starc.
And while the government has a role to play, Starc recommends policies that encourage competition and market transparency as a better long-term strategy than strong-arming drug companies into offering prices the government wants.
“There’s always a trade-off,” says Starc. “Under the current plan, consumers are probably better off in the short term and worse off in the long term. It may be a compromise the government is willing to accept, but to pretend the compromise doesn’t exist is a bit disingenuous.”
Why are drug prices so confusing?
To better understand the nature of this trade-off, it helps to understand how drug pricing currently works. (Brace yourself: it’s complicated.)
In most markets, “prices play an important role,” says Starc. “They reflect the cost of production, what the customer might be willing to pay and signal to investors where their money should go.”
But in the pharmaceutical market, the messages that prices send are mixed, to say the least.
First, the market is unique in that most drug purchasers are insured customers. This weakens the classic relationship between supply and demand because if some of the money is not coming directly out of customers’ pockets, they are much less price sensitive.
Even what “price” means is ambiguous. Whenever an insured customer buys their drugs at a Walgreens or a CVS, that out-of-pocket price (determined by the insurance plan) is often significantly reduced from the “net price” (the price paid by the insurance company or Medicare on access to the drug), which is often reduced by the “list price” chosen by the drug manufacturer. (The list price is analogous to the sticker price at a car dealership—it’s there as a useful reference point, but hardly anyone pays it.)
And that’s not all. Even among insurance companies, the prices paid for the same drug can vary widely. The “net price” is negotiated by a pharmacy benefit manager, who essentially plays matchmaker, offering the plan provider a rebate (or “discount”) from the manufacturer in exchange for initial placement on a drug list that will be covered by the insurance company, the which boosts sales.
Also confusing is the fact that, although Medicare is a federal government agency, it has relied on private insurers like Aetna and Humana to negotiate with drug companies on its behalf since 2003. That year, President Bush signed into law Medicare Part D, which allowed Medicare to cover prescription drugs for the first time. But the law included a “non-interference” provision that barred the agency from directly negotiating the prices of those drugs — a provision that drug companies successfully lobbied for.
A new approach to drug pricing
Today, nearly 50 million Americans get prescription drugs through Medicare Part D. And in the 20 years since the program began, the drugs have gotten more advanced — and more expensive. This is why the government is pushing pharmaceuticals to lower the price of popular drugs.
But lower prices will inevitably lead to lower profits for drugmakers. Indeed, CBO estimates that the policy will reduce industry revenue by 7 percent. That’s a problem if it means the industry attracts fewer investors – and possibly makes less progress.
“We don’t want pharmaceuticals to just drive up prices without providing any benefit. But we also want to incentivize companies to invest heavily in research and clinical trials, improving the drugs they already make, and we want venture capital firms to finance biotech start-ups. Otherwise, we’ll have more apps and scooters instead of cancer drugs.”
This is why, rather than simply charging a lower price, Starc emphasizes the need for more transparency about how prices are negotiated by various parties so that they can truly act as a meaningful signal of value.
“We need to lift the veil on some of these secret negotiations to help consumers better understand what they’re getting,” says Starc. “This is probably a case where sunlight is the best disinfectant.”
A “healthier” drug market
Increased transparency is just one of the reforms Starc is calling for in a new newspaper (with her colleague Kellogg Craig Garthwaite) that offers policy suggestions for improving the drug market — and in particular, for preventing forces that drive up prices without adding value to the customer or society.
Starc also wants to see a lot more competition in the industry. Three drug wholesalers—McKesson, Amerisource Bergen and Cardinal—account for 90 percent of all prescription drug purchases. The same is true in the pharmacy market: CVS Health, Walgreens, Cigna, UnitedHealth and Walmart account for 64 percent of sales. Few independents are left with market power.
And then there’s the shadowy world of the pharmacy benefit manger—the middleman who negotiates “discounts” from WAC, or wholesale acquisition cost—whose place in the value chain has come for some check up. Here too, the trend was toward greater concentration. The three largest PBMs—Caremark, Express Scripts, and OptumRx—have 80% of the market share and are owned by large insurance companies (CVS, Cigna, and UnitedHealth, respectively). PBMs have been around since the 1960s, but this vertical integration it is relatively new.
For Starc and Garthwaite, a wise policy would encourage stronger competition between firms at every stage of the value chain. One solution could be to encourage the adoption of preferred pharmacy networks. In other words, PBMs could be encouraged to play the same role lower down the value chain, negotiating with pharmacies as they do with manufacturers. “They could say, ‘if you give me a competitive price, I’ll send all my customers to Walgreens.’
Another would be to increase the size of the drug market overall by allowing more imported drugs and spending more on regulatory agencies like the FDA to ensure drug quality.
For pharmaceuticals, they recommend that the FDA speed up the approval process for “bioequivalent” generic drugs—drugs that are chemically identical to their brand-name predecessors—making it easier for more companies to enter this critical market. The lack of competition in small market generic products is what led to The famous price episode of Martin Shkreli. High prices for generics without competition probably reflect a market failure.
Reforms that increase competition and those that enhance transparency will feed off each other, he explains.
“The more competitive the market is, the more it will generate these price signals,” says Starc. “And creating more transparency around pricing and rebate agreements can help increase competition among these pharmacy benefit managers.
