This article considers the House of Commons health select committee report into generic drug prices along with the recent short-term proposals by the Government to control prices. The article focuses on the reimbursement system for pharmacists as the main factor in the steep price rises and their sustained high levels. The challenge for the Government will be to design a reimbursement system that avoids the perverse incentives of the current system and encourages the regular supply of cost-effective generic medicines
Since the early 1990s numerous attempts have been made to increase the rate
of the prescribing of non-proprietary, generic drugs in National Health Service
general practice. Although substantial savings were generated through increased
generic substitution during the early and mid 1990s, a rapid growth in the prices
of many non-proprietary products during the last 18 months of the decade has
threatened to add £200m to the annual NHS drugs bill.1 In response, the
House of Commons Select Committee on Health undertook an inquiry into the price
of generic drugs.1 
This
confirmed that prices of some generic drugs had increased by over 500 per cent
over the year to September, 1999 (Table 1).2
The select committee reported in December, 1999, that increases in generic prices
had been caused by problems related to (i) the supply of generic products associated
with the closure of one manufacturer and the relocation abroad of two others,
(ii) the switch from bulk supply of drugs to individual patient packs as required
by European regulations, and (iii) operation of the drug reimbursement system.
The committee concluded that “it would be extremely unfortunate if the
success of the PCG [primary care group] initiative was undermined by sharp and
unpredictable rises in drugs budgets”.
In April, 2000, the Government announced a set of proposals to control prices
in the main generic drugs markets. This article will discuss those proposals
in light of the evidence of the operation of the markets for generics provided
in the select committee report. In particular, the article highlights the trade-off
in public policy towards generics between encouraging price competition to reduce
average prices and promoting price stability for the purposes of PCG budget
setting.
The markets for generics
Under current NHS regulations, when a generic drug is prescribed, a pharmacist
may dispense any licensed version of the preparation requested, as long as it
meets the requirements specified by the prescriber. As a result, cost savings
may be generated at the point of dispensing, because pharmacists may decide
to dispense the cheapest version of each product requested. In order to promote
such savings and to ensure that they primarily accrue to the Exchequer, the
Department of Health operates a reimbursement system based upon the Drug Tariff,
which reimburses pharmacists at the average price charged for the drug by a
“basket”of two major wholesalers and three major manufacturers.
Before publication of the select committee’s report, the Department of
Health argued that its reimbursement system for generic drugs encouraged competition,
as it created a “virtuous circle” in which wholesalers and manufacturers
dropped their prices below the reimbursed amount in order to win business. The
incentive for a pharmacist is to purchase only when the price offered is less
than or equal to the reimbursement price, otherwise he or she loses money. However,
despite this mechanism to stimulate price reductions, the select committee stated
that, prior to its report, the market for generics had been characterised by
“market manipulation, hoarding and collusion” and that the pricing
mechanism “not only failed under the pressure of events, but also actively
contributed to the problems”.
An important confusion in the select committee report and subsequent commentary
is the discussion of the market for generics. A market is a situation where
consumers can readily substitute one product for another.3
This is clearly not the case for prescribed drugs. Instead there are a series
of distinct markets for different generic drugs. This is an important point
in considering the market situation and competitive conditions in the supply
of the generic drugs which have seen the largest price increases in the last
18 months of the 1990s.
The shortage of generic drugs
Initially, the select committee considered whether the “supply shock”
caused by the closure in December, 1998, of the largest manufacturer of generic
drugs, Regent GM, led to the rapid growth in market prices. Although there was
evidence to suggest that the resulting reduction in supply may have caused a
short-term increase in some prices, the committee concluded that the company’s
closure was not the main source of higher price levels. Instead, it was suggested
that the shift to patient packs, the actions of short-line wholesalers (which
only supply a limited number of products) and the manipulation of the Category
D system (which reimburses pharmacists at the actual price of products in short
supply) had a large part in the problem.
Because of EC regulations, generic manufacturers throughout Europe were required
to introduce patient packs (each of which had to contain a course of medication
in ready-to-dispense form and an explanatory leaflet) for all medicines by January,
1999. As a result, many UK generics manufacturers had to invest heavily in new
production facilities, which ultimately increased the cost of the products that
they supplied. After hearing evidence from this group, the select committee
concluded that the absence of an agreed government policy for the transition
period left many manufacturers in a position in which they could manipulate
market prices.
The select committee also concluded that the actions of short-line wholesalers
had led to increases in prices, as they often entered markets for generics to
buy up large quantity of stocks creating shortages and higher prices from which
they could benefit. To add to this problem, the committee found that an increasing
number of wholesalers and manufacturers reported less than four weeks’
supply of particular products triggering Category D status, with the result
that pharmacists were no longer forced to seek out the lowest cost products.
In support of the hypothesis that this emergency system had been used to manipulate
generics prices, the select committee heard that Category D drugs had been subject
to the largest price increases and that, over the previous year, the proportion
of the products in the category rose from 1 to 16 per cent.
When a drug is listed as Category D, all parts of the supply chain earn higher
profits. Economic theory suggests that the generic price will converge to the
branded equivalent price4 and the evidence provided by the
British Generic Manufacturers Association (BGMA) to the select committee supports
this. At the higher price, manufacturers and wholesalers earn greater revenues
and can offer pharmacists greater discounts on the reimbursement price. There
exists little incentive for a manufacturer of a Category D drug to increase
production and move their product off the list.
Discussion
In response to the pricing crisis, the Office of Fair Trading (OFT) has begun
an inquiry into evidence of anticompetitive behaviour in the market for generic
drugs (it is due to be published in the autumn). The present article examines
the select committee’s assertion that the observed increases in prices
were the result of the actions of generics suppliers and inadequacies in the
Government’s regulatory mechanism.
Focus on price rises The select committee cited the rapid growth
in the price of some generic products as evidence of market manipulation and
a failure of the existing regulatory mechanism. For three main reasons, price
rises alone, however dramatic, should not be taken as evidence of the inefficient
operation of any market. First, price rises should be seen as an appropriate
response to shortages in any market and should not be taken (without further
investigation) as evidence of anticompetitive behaviour. Second, increases in
the costs of manufacturing should be expected to lead to proportionate increases
in prices. Finally, economic theory suggests that market prices will fluctuate
until the price at which particular goods may be bought equals the amount that
consumers are willing to pay.2
Price competition is a dynamic process that requires that manufacturing firms
are able to enter easily and exit the different markets for generics. The BGMA
and the British Association of Pharmaceutical Wholesalers (BAPW) claimed that
the markets in generics were commodity markets, prone to fluctuations in price
according to demand and availability. For example, agricultural commodity markets
often see short-term price rises in response to the relative scarcity of a particular
commodity.
The very large price increases for generics have occurred in the most concentrated
markets, where one or two manufacturers dominate supply. For example, Regent
GM was a monopoly supplier of certain generics. However, providing a manufacturer
holds a product licence, it is relatively easy to switch production between
different drugs (about two to three months). Most manufacturers hold a portfolio
of licences, so, even if they do not produce a particular drug at any one time,
they should, in theory, provide a strong competitive constraint as potential
entrants to the market. This is the crucial question for the OFT investigation:
why have the high profits of a Category D drug or a high price generally not
attracted entrants to that market thereby increasing supply and driving prices
down?
The main point of this article is that the recent rapid rises in the price of
some generics can be best understood by focusing on the interactions between
the reimbursement system and price competition in the market. The system creates
perverse incentives for rational individual firms (manufacturers, wholesalers
and pharmacies) to exploit. For example, the incentive for all firms in the
supply chain to have a drug listed as Category D but without, it seems, providing
incentives for rival firms to enter that market and increase supply. Further,
the reimbursement rates set out in the Drug Tariff for Category A drugs follow
the market price and act as a ceiling on the level of NHS reimbursement; they
are not designed to lead the market and set the price. However, if the price
of a generic drug starts to increase, the incentive is for pharmacists to stop
buying the product (because the actual price he or she pays is above the reimbursed
price) therefore creating shortages of that generic drug.
Regulation of the market Within economics, the failure of any mechanism to encourage economic agents to behave in the ways expected of them has been called “incentive incompatibility.”5 In this context, the reimbursement mechanism for generic drugs could be labelled “incentive incompatible” because it eventually failed to encourage suppliers to meet the Government’s objective of the secure and continual supply of cost-effective drugs. As it failed to stop market manipulation, the mechanism was not what economists call “strategy proof”. In other words, a weakness in the regulatory system allowed sellers to act strategically and to find ways of increasing their prices. Although this behaviour led to rapid increases in prices, many economists would expect suppliers to behave in this way and would not blame the resulting problems on them, but on the inadequacies of the Government’s regulatory system. In consequence, the OFT should not be investigating the strategic behaviour of generic manufacturers and wholesalers. Instead, efforts should be concentrated on examining how weaknesses in the government’s regulatory mechanism may be addressed.6
Government’s proposals In April, 2000, the Government proposed
a statutory price ceiling for the main generic medicines, corresponding to the
average prices in the Drug Tariff for November, 1998, to January, 1999. Lord
Hunt (Under-Secretary of State for Health) stated: “I am determined that
the NHS will not be ripped off. I am taking action today to cut the price of
generic drugs.” He added that “there is no adequate explanation for
the steep price rises we have seen — nor for prices remaining high for
so long”. These maximum prices would be reviewed after 15 months. At the
same time, the Government proposed changes to the reimbursement arrangements
for pharmacists and dispensing doctors. In particular, this included the abolition
of the Category D arrangement in the Drug Tariff. These proposals were put out
to consultation in May and June.
The main problem with imposing a price ceiling on any market is that if the
actual market price is above the ceiling, then in basic demand and supply terms,
the supply of that commodity will fall. Norton Healthcare, the UK’s biggest
manufacturer of generic drugs, threatened to cease production of a number of
generics if the ceilings were implemented on the grounds that they would make
production uneconomic.7 In response to this threat, the Government
issued a revised list of proposed maximum prices, some increased by as much
as 500 per cent, for a one-week consultation. After further negotiations, in
which some maximum prices were increased, Norton Healthcare’s sales and
marketing director stated that the company would not now “be forced to
discontinue 23 generic lines” (Health Service Journal, July 13, 2000).
The maximum prices came into force in August’s Drug Tariff.
The rationale for the introduction of the Category D system in the mid 1990s
was to ensure the continuity of supplies of medicines to patients (even if this
increased the drugs bill of the NHS). Under the Government’s initial proposals,
this safeguard did not exist to ensure the supply of medicines in the event
of price caps creating shortages. Pharmacists would have lost money if they
sourced branded drugs for a generic prescription because, without the Category
D system, they will only be reimbursed the average basket price of the generic
version between November, 1998, and January, 1999. At the beginning of September,
the PSNC negotiated a replacement for Category D of the Drug Tariff with the
NHS Executive. In instances when there is a shortage of a generic drug, as agreed
between the PSNC, the PPA and the NHSE, contractors will still be able to dispense
a branded product and be reimbursed appropriately. Contractors will be advised
of shortages as and when they occur, but they will not be listed in the Drug
Tariff.
The NHSE has set out certain conditions:
This system is designed to avoid a situation where the only way for general practitioners to be confident that medicines will be dispensed is to prescribe the branded drug.
Conclusions
The reimbursement mechanism for generic drugs is designed to promote competition
between suppliers and to secure lower prices. The mechanism had the desired
effect for a number of years, but there was an absence of effective checks on
the rapid increase in generic prices during the late-1990s. There were a number
of genuine “market” reasons for this; however, the health select committee
concluded that the major part of the explanation of the rapid escalation and
sustained high levels of generic drugs prices was in the perverse incentives
provided by the reimbursement system to all parts of the generics industry.
In the long term, therefore, primary care expenditure on these products may
not depend solely on the competitiveness of the market, but on the Government’s
ability to design a regulatory mechanism that cannot be manipulated by the suppliers
of non-proprietary drugs. However, such a design will face the trade-off between
trying to ensure stable prices to help PCG budget control and trying to encourage
price competition to reduce average drugs price but at the cost of introducing
price volatility.
In the short term, the Government’s proposals for price ceilings might
produce shortages of certain generic drugs and the abolition of the Category
D status will remove pharmacists’ incentive to search for all available
supplies of a drug in short supply.
Dr Kay is lecturer in economics at the University of Glamorgan business school. Dr Baines is senior lecturer in health economics at the University of Birmingham health services management centre. Correspondence to Dr Kay at Business School, University of Glamorgan, Pontypridd, CF37 1DL (e-mail akay@glam.ac.uk)
Listening Friends Scheme
The Listening Friends Scheme exists to offer free confidential help to pharmacists
suffering from stress.
The scheme has been set up by the Royal Pharmaceutical Society but operates
independently so that help can be sought in complete confidence. The service
allows any pharmacist under stress to talk to a fellow pharmacist who has insight
into the particular pressures that apply in pharmacy. The service is not, however,
restricted to work-related problems, but offers help with all causes of stress,
such as family problems, illness and bereavement.
The service is run by a team of volunteer pharmacists, all of whom are mature
and experienced in their field of practice. All have been trained in listening
skills and many have counselling training and experience. They are also able
to direct pharmacists under stress to sources of specialist help where needed.
Contact with the Listening Friends is made initially by telephoning the scheme’s
automatic answering service on 020 7820 3387. Callers will be given brief details
of the service and asked to leave their name, the area in which they live, a
contact telephone number and a convenient time to call. A Listening Friend will
then call back to discuss the details of the pharmacist’s problem in complete
confidence. Further contacts are usually by telephone.
Information about the scheme and how it operates is available in the form of
a leaflet. This can be obtained by contacting the help-line number. Funding
for the scheme is provided by the Society’s Benevolent Fund.