Free Market Frenzy

From the archives:

(13 March 2006) If sellers are allowed to compete freely without any regulations, market forces will inevitably drive down prices and improve the quality of services so that everyone wins, even the consumer--or so the dogma goes. Life is rarely so simple, and markets don't always behave so predictably. In the case of energy, in fact, deregulation has had the opposite effect, catalyzing massive price increases.

Although this is not a new phenomenon, Sunday's Washington Post details some of the more recent problems consumers have faced after buying into deregulation programs that promised to drive down energy costs:

Maryland and District consumers angry at the record electric bills they will receive this summer might want to recall the promises made by proponents of deregulation seven years ago. If they do, they'll be even angrier.

At the time, in 1999, evangelists for deregulation described a competitive, efficient and lower-priced system of energy delivery that, for the most part, remains a fantasy in the Mid-Atlantic region and other parts of the country today, according to industry experts.

The District, Maryland and Virginia, along with much of the nation, are wrestling with the ramifications of deregulation at the same time that the cost of producing electricity is skyrocketing. But as energy prices have soared, electricity rates have gone up more in deregulated states than in regulated ones....

Residential customers -- especially those in Maryland facing an average $743 yearly increase in their BGE bills -- are left wondering what deregulation was for, if not to reduce prices.

The basis of the argument for deregulation depended on price competition between power suppliers, but due to a lack of real competition in most areas, prices have only gone up. In fact, deregulation was sold as a silver bullet that would address a variety of issues beyond just lowering prices, including encouraging infrastructure updates and modernization. However, in real life...

Another promise was that suppliers, freed from state regulation, would sell their power to the highest bidder, creating market incentives for increased efficiency and investment in new technologies. But since 1999, older, less-efficient plants have remained profitable, discouraging investment in new plants. The Mid-Atlantic region still has a shortage of capacity, and during much of the year must import energy from outside the area, often at high prices.

Deregulation was also supposed to encourage development of a national grid system. Utilities and their would-be competitors could buy from the lowest-cost producer, no matter where the producer resided. Pepco could, in theory, buy power from a plant in Oklahoma using cheap natural gas. But the national grid hasn't been improved because power producers -- the most logical source of capital to improve the system -- don't want the competition a robust national grid would allow. Today it is nearly impossible to move large amounts of electricity over long distances.

So, energy deregulation was based more on fantasy than fact, and hopefully state legislatures will have learned their lessons after this fiasco and find a more reasonable solution that won't subject their constituents to such wild price increases. Putting that aside, though, there was something else about the Washington Post article that really caught my eye:

Under the old system, the price of electricity was strictly based on what it cost the power company to produce it. Now, prices are based on what several hundred highly sophisticated power suppliers and traders believe the market will bear, prices that can have only nominal relation to cost.

This sounds surprisingly similar to what's happening in the pharmaceutical industry right now. Although drug companies have traditionally argued that high prices were justified based on the large investment in research, development, and testing required to bring a drug to the market, many examples are coming to light where the price of a drug has little to do with these costs. An article in Sunday's New York Times discusses a few examples of this disturbing recent trend:

The medicine, also known as Mustargen, was developed more than 60 years ago and is among the oldest chemotherapy drugs. For decades, it has been blended into an ointment by pharmacists and used as a topical treatment for a cancer called cutaneous T-cell lymphoma, a form of cancer that mainly affects the skin.

Last August, Merck, which makes Mustargen, sold the rights to manufacture and market it and Cosmegen, another cancer drug, to Ovation Pharmaceuticals, a six-year-old company in Deerfield, Ill., that buys slow-selling medicines from big pharmaceutical companies.

The two drugs are used by fewer than 5,000 patients a year and had combined sales of about $1 million in 2004.

Now Ovation has raised the wholesale price of Mustargen roughly tenfold and that of Cosmegen even more, according to several pharmacists and patients.

Sean Nolan, vice president of commercial development for Ovation, said that the price increases were needed to invest in manufacturing facilities for the drugs. He said the company was petitioning insurers to obtain coverage for patients.

The increase has stunned doctors, who say it starkly illustrates two trends in the pharmaceutical industry: the soaring price of cancer medicines and the tendency for those prices to have little relation to the cost of developing or making the drugs.

Genentech, for example, has indicated it will effectively double the price of its colon cancer drug Avastin, to about $100,000, when Avastin's use is expanded to breast and lung cancer patients. As with Avastin, nothing about nitrogen mustard is changing but the price....

And once a company sets a price, government agencies, private insurers and patients have little choice but to pay it. The Food & Drug Administration does not regulate prices, and Medicare is banned from considering price in deciding whether to cover treatments.

I have written previously about Avastin and its producer Genentech, which openly acknowledges that its pricing of Avastin had little to do with the cost of producing the drug. The current Times article gives another example of this from Pfizer:

But people who analyze drug pricing say they see the Mustargen situation as emblematic of an industry trend of basing drug prices on something other than the underlying costs. After years of defending high prices as necessary to cover the cost of research or production, industry executives increasingly point to the intrinsic value of their medicines as justification for prices.

Last year, in his book "A Call to Action," Henry A. McKinnell, the chairman of Pfizer, the world's largest drug company, wrote that drug prices were not driven by research spending or production costs.

"A number of factors go into the mix" of pricing, he wrote. "Those factors consider cost of business, competition, patent status, anticipated volume, and, most important, our estimation of the income generated by sales of the product."

The idea that the income generated from a drug is the most important factor at play here seems surprisingly cynical coming from an industry purported to have the humanitarian goal of alleviating human suffering from disease. Although I have already written at length about this, I should reiterate that the drug industry is indirectly, but heavily, subsidized through federal funding of biomedical research. I'm pretty sure that voters support this funding for the promise of medical breakthroughs and new medications, not to give big pharmaceutical companies new vehicles for making bundles of money.

Although there are plenty of differences between the energy and pharmaceutical industries, the drug companies' previous use of research and development costs as justification for high prices isn't that different from energy companies preaching the benefits of deregulation. As the logic of both of these arguments begins to break down, it appears that the lessons learned in one may have some relevance to the other. Regardless, based on how things have gone in these industries, the idea of paying a price for a good or service based on what it actually costs to deliver doesn't sound all that unreasonable anymore.

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I don't think deregulation is the problem, it's regulating deregulation. Here in CA they deregulated because people wanted it ... but then went and regulated that the power companies couldn't sign long-term contracts or buy lines. Regulation is doomed to fail that way and it did when power consumption spiked and electrity was suddenly 10x as expensive. So what did the governor ( since recalled ) do? He signed a long-term contract at 10x the usual price so when prices dropped back down, we were stuck paying for it.

Deregulation works, as the airline industry and the phone industry have shown. Regulated deregulation, like power and cable, does not.

That's an interesting idea, but I don't see any evidence that "regulated" deregulation was at play in the examples I discussed in the post.

As an employee of a big pharma, I was surprised (and appalled) by what you wrote - I went around the lab fact checking, and yes, it turns out that in fact MOST drugs are sold at a fantasy price that is set at what the market can bear, and not what effectively is necessary to cover the production cost (usually marginal), research and trial. Even accounting for re-investment in new projects, with high failure probability, it is clear that there's overpricing.

I've also been told though that some decades ago the situation was even worse. at least now a new drug must be demonstrably more cost-efficient than the one it's substituting - although this leaves the door open to tweaking and biasing costs on the side of pharma...

I know for sure I'm not poaching large amounts of that money - at least, not us scientists. But I do see senior managers with Porsches around here *cough*... just kidding. (actually, some big head here semi-seriously proposed during an interview to "give" a BMW to every scientist to up their social status and convince more people to take the career - more than happy to receive one, myself)

I can offer no real solutions, but I wonder whether the state of the things may be caused by the need to post high revenues to keep the shareholders happy. May be, the pharmna business, like the energy business, is particular and would need to be kept in check by government? I don't mean nationalize it, but make sure that it follows long-term plans and not short terms.

just my 2 cents...