Can We Build a Better Prescription Drug Market?

Politically, this is a popular move. According to polls, Americans from across the political spectrum support the government’s plan, which Democrats have proposed in various forms for more than twenty years. The Congressional Budget Office says the program, enabled by last year’s Inflation Reduction Act, will save taxpayers $98 billion over the course of the next decade.

Less enthusiastic are the pharmaceutical companies, who face extremely hefty fines or the loss of a huge customer base if they choose not to participate in negotiations with Medicare. (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 investments in innovation and lead to fewer groundbreaking drugs. Six of them have already filed lawsuits to block the plan.

Given that most Americans have a sketchy view—at best—of how drug pricing actually works, the debate is easily caricatured. On one side, you have corporate greed. On the other, government overreach.

But according to Kellogg’s Amanda Starc, this story is too simplistic—and even potentially harmful, since it ignores the basic trade-off at the heart of the drug industry.

“High prices are not always a product of corporate greed,” says Starc, an associate professor of strategy. “They result from a number of complicated dynamics in a market, and some of the more advanced drugs are expensive for a reason.”

While it may sound great in the short term, Biden’s plan does not address these complicated dynamics. Nor does it really acknowledge the long-term cost of dictating prices.

“The goal should be to increase value, not just lower prices,” Starc says.

And while government does have a role to play, Starc recommends policies that encourage competition and transparency in the market as a better long-term strategy than strong-arming the drug companies to offer prices the government wants.

“There’s always a trade-off,” Starc says. “Under the current plan, consumers are probably better off in the short run and worse off in the long run. It might be a trade-off the government is willing to accept, but pretending the trade-off doesn’t exist is a little 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. (Steel yourself: it’s complicated.)

In most markets, “prices play an important role,” Starc says. “They reflect the cost of production, what the customer might be willing to pay, and they signal to investors where their money should be going.”

But in the pharmaceutical market, the signals sent by prices are muddled, to say the least.

For one, the market is unique in that most purchasers of drugs are insured customers. This weakens the classic relationship between supply and demand because, if some of the money isn’t coming directly out of customers’ pockets, they are a lot less sensitive to price.

Even what is meant by “price” is ambiguous. Whenever an insured customer buys their meds from a Walgreens or a CVS, that out-of-pocket price (which is determined by their insurance plan) is often greatly reduced from the “net price” (the price the insurance company or Medicare pays to access the drug), which is often itself reduced from the “list price” chosen by the drug’s manufacturer. (The list price is analogous to the sticker price at a car dealership—it’s there as a useful reference point, but almost nobody pays it.)

And that’s not all. Even among insurance companies, 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 discount (or “rebate”) from the manufacturer in exchange for prime placement on a list of drugs the insurance company will cover, which boosts sales.

Also confusing is the fact that although Medicare is a federal government agency, it has relied on private insurers such as Aetna and Humana to negotiate with pharmaceutical 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 negotiating directly over the prices of those drugs—a provision the pharmaceutical companies lobbied for successfully.

A new approach to drug pricing

Today, almost 50 million Americans get prescription drugs through Medicare Part D. And in the 20 years since the program’s inception, drugs have gotten more advanced—and more expensive. This is why the government is pressuring pharmaceuticals to lower the price of popular drugs.

But lower prices will inevitably lead to lower profits for drug manufacturers. Indeed, the CBO estimates the policy will reduce industry revenues by 7 percent. This is a problem if it means the industry attracts fewer investors—and possibly makes fewer advancements.

“We don’t want pharmaceuticals to simply mark up prices without providing any benefit. But we also want to incentivize firms to make big investments in research and clinical trials, improving the drugs they’ve already made, and we want venture-capital firms to fund biotech startups. Otherwise, we’ll get more apps and scooters instead of cancer drugs.”

This is why, instead of simply mandating a lower price, Starc emphasizes the need for more transparency on how prices are negotiated by various parties so they can actually act as a meaningful signal of value.

“We need to lift the veil on some of these secret negotiations in order to help consumers better understand what they’re getting,” Starc says. “This is probably a case where sunlight is the best disinfectant.”

A “healthier” drug market

Increased transparency is just one of the reforms that Starc calls for in a new paper (with her Kellogg colleague Craig Garthwaite) that offers policy suggestions for improving the drug market—and in particular, for thwarting forces that drive prices up without adding any value to the customer or society.

Starc also wants to see a lot more competition in the industry. Three pharmaceutical 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. There are very few independents left with any market power.

And then there is the shadowy world of the pharmacy benefit manger—the middleman who negotiates “rebates” off the WAC, or wholesale acquisition cost—whose position on the value chain has come in for some scrutiny. Here, too, the trend has been towards greater concentration. The three largest PBMs—Caremark, Express Scripts, and OptumRx—have 80 percent of market share and are owned by large insurance firms (CVS, Cigna, and UnitedHealth, respectively). PBMs have been around since the 1960s, but this vertical integration is relatively new.

For Starc and Garthwaite, a wise policy would encourage more robust competition among firms at every stage of the value chain. One solution might be to encourage the adoption of preferred pharmacy networks. In other words, PBMs could be encouraged to play the same role lower down on the value chain, by negotiating with pharmacies as they do with manufacturers. “They could say, ‘if you offer me a competitive price, I’m going to 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.

When it comes to pharmaceuticals, they recommend that the FDA speed up the approval process for “bioequivalent” generic drugs—drugs that are chemically identical to their branded predecessors—making it easier for more firms to enter this crucial market. The lack of competition in small-market generics is what led to Martin Shkreli’s famous price-gouging episode. High prices for generics without competition likely reflect a market failure.

Reforms that increase competition and those that boost transparency will feed off each other, she explains.

“The more competitive the market is, the more it will generate those price signals,” Starc says. “And creating more transparency around price and discount contracts might help increase competition among these pharmacy benefit managers.