Generic drug shortages cannot be blamed solely on group purchasing organizations

TThe Hatch-Waxman Act of 1984, which gave rise to the modern generic drug market, was one of the most important cost-cutting policy innovations of the last 40 years. In 2021 alone, the use of generic and biosimilar medicines saved $373 billion in healthcare costs. More than 90% of prescriptions filled that year were for generics or biosimilars, compared with just over 18% the year Hatch-Waxman was approved.

Today, however, generic drugs seem to be a victim of their success. Major categories of drugs, from antibiotics to chemotherapy and saline solutions, experience persistent shortages and inadequate quality. Because? Prices have fallen so low that manufacturers do not have the resources to produce adequate quantities of drugs or ensure compliance with quality standards. This shortage is becoming a feature of the generic pharmaceutical industry.

The dominance of a small number of group purchasing organizations (GPOs), the middlemen who buy drugs and supplies for hospitals, clinics, surgery centers and home health agencies, is often cited as a cause of the problem. GPOs, according to history, use their quasi-monopoly to drive down prices too much. The obvious solution to this problem would be to restore normal market competition, perhaps by breaking up mammoth group purchasing organizations into smaller, competing entities or by removing price caps and quality regulations that inhibit rapid responses to shortages.

In our respective roles as a health economist who studies health systems (JBR) and a management consultant who advises them (RSR), we often see the pernicious effects of excessive pricing power in the health sector. Prices for hospital services and insurance are higher than they should be, and valuable innovations are derailed by the market power of providers and payers. However, we are skeptical that the pricing power of GPOs explains the chronic shortage of generic drugs.

Let’s assume that a GPO has a large amount of pricing power, enough that it can make generic manufacturers a take-it-or-leave-it offer. What price would this GPO choose? The GPO does not want drug shortages or lower quality because they alienate their customers, the health systems and clinics whose patients need the drugs. GPOs will therefore offer a high enough price to ensure adequate supply with adequate quality. A lower price reduces supply and a higher price reduces margins. The GPO’s price-setting power alone should not lead to persistent shortages, even if it allows the GPO to force generic manufacturers to sell at low prices.

An alternative explanation for the persistent shortage highlights the incentives for group purchasing organizations to ensure adequate supply. After all, a large GPO that wants to eliminate shortages could offer drugmakers a payment contingent on building adequate production capacity or inventory for vulnerable drugs. The complication is that additional capacity or inventory resulting from these payments would also help others GPOs prevent scarcity. As the profits from GPO payments go to competitors, the incentives for GPOs to ensure supply are insufficient, leading to chronic shortages. The same dynamic weakens GPO incentives to ensure adequate drug quality. Economists call this type of market failure a common agency problem.

According to economic theory, market competition alone will not solve common agency problems. For example, splitting GPOs into smaller entities makes the overflow problem worse. Government action is needed to boost the market. This action may include subsidies to ensure the supply of drugs prone to shortages, incentives for hospitals and clinics to build reserves in case of supply chain disruptions, and improved quality control. Non-governmental actors can also play a role. The Biden administration recently proposed a plan that relies on the creation of two non-governmental organizations to monitor supply chain resilience: one for manufacturers and one for hospitals. Large enough private actors can amplify government actions. For example, a public commitment by one of the large GPOs to pay adequate prices to ensure uninterrupted supply for a certain period could help attract manufacturers to the generic market.

The example of generic drugs illustrates that market-based innovation is necessary, but not always sufficient, to make health care better and cheaper. Sometimes markets need help to do their job.

James B. Rebitzer is the Peter and Deborah Wexler Professor of Management at Boston University’s Questrom School of Business. Robert S. Rebitzer is a national advisor for Manatt Health. They are the authors of Why not better and cheaper? Health and Innovation (Oxford University Press, June 2023).