Leveraging Pharma to Lower Premiums: Medical Loss Ratio Regulation in the Pharmaceutical Industry

BYU Law Review BYU Law Review

Volume 2018 Issue 1 Article 8

Fall 8-31-2018

Leveraging Pharma to Lower Premiums: Medical Loss Ratio Leveraging Pharma to Lower Premiums: Medical Loss Ratio

Regulation in the Pharmaceutical Industry Regulation in the Pharmaceutical Industry

Cami R. Schiel

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Cami R. Schiel,

Leveraging Pharma to Lower Premiums: Medical Loss Ratio Regulation in the

Pharmaceutical Industry

, 2018 BYU L. Rev. 205 (2018).

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Leveraging Pharma to Lower Premiums:

Medical Loss Ratio Regulation

in the Pharmaceutical Industry

Many recognize escalating drug prices as a significant dilemma

related to America’s rising healthcare costs. Yet few can agree on what to

do about them. Unaffordable drug prices are a result of many complex

forces. One theory to address this problem is to reduce all government

intervention and let normal market forces act as they usually do to bring

the goods’ prices down to consumer-friendly ranges. However, the pre-

scription drug market is not, and perhaps never can be, a normal market.

Reasons for this include (1) a lack of price transparency, (2) information

and control asymmetries between patients and physicians, (3) third-party

payors, (4) demand that remains constant irrespective of any exorbitant

price increases (i.e., market inelasticity), and (5) patent-ensured mono-

polies. These factors disrupt the normal market forces that usually

maintain prices at levels amenable to the general public (i.e., price equi-

librium). Left unchecked, Big Pharma increase their prices partly to pay

for elevated marketing and other expenses and partly to recoup greater

earnings. Consequently, they rake in substantial profits—at an average

greater than any other industry. Thus, rising drug prices burden not only

those who need them but also those who are expected to help pay for them.

To right this abnormal market, this Note suggests an alternative

theory: that Congress should apply a medical loss ratio framework to the

pharmaceutical drug industry, similar to the ratio framework applied to

reform the health insurance industry. This framework seeks to balance

corporate profits with consumer benefits by separating profits and “other”

less value-adding expenses from those that add greater value to the

consumer (i.e., “medical loss”). In the health insurance industry’s 80:20

ratio framework, if the less value-adding expenses (e.g., profits, sales and

marketing) cross the ratio threshold (20%), then the companies must

reimburse the excess back to the consumer. This measure has eased some

insurance premium increases. Similar reform is needed in the pharma-

ceutical industry, as currently the industry averages 21% profit—

significantly above that of other industries—while also spending around

23% on sales and marketing and around 30% on manufacturing.

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Therefore, the average medical loss ratio is roughly 30:70 (30% on medical

loss and 70% on less value-adding areas). Imposing a stricter ratio

threshold, such as 40:60, would provide some much-needed incentives for

drug companies to reduce their lesser-value-adding expenses and, as a

result, reduce drug prices. If Big Pharma failed to meet the 40% threshold,

then the excess would be returned to the consumer. Imposing a medical

loss ratio regulation in the pharmaceutical industry is a promising solu-

tion to one of our nation’s greatest healthcare cost concerns.

CONTENTS

I. INTRODUCTION .......................................................................................... 207

A. MLR Regulation Corrects Market Failure

in the Insurance Industry ................................................................. 209

B. MLR Regulation Returns Billions to Consumers................................. 210

C. Extend the MLR Regulation to the Pharmaceutical Industry............. 212

II. ABNORMAL MARKET FORCES IN THE HEALTHCARE INDUSTRY RESULT

IN MARKET FAILURE .......................................................................... 214

A. Lack of Transparency in the Pharmaceutical Industry

Contributes to Market Failure .......................................................... 215

1. Information and control asymmetries between physicians

and patients hamper consumer power ..................................... 215

2. Transparent drug pricing is often impractical, and the

resultant lack of price information further limits

buyer power ............................................................................... 218

3. Healthcare is a highly inelastic market ........................................ 221

B. Third-Party Payors Further Frustrate Aspects

of a Normal Market .......................................................................... 223

1. The frequent need for health insurance burdens consumers

more so than other insurance types .......................................... 224

2. Third-party payor costs contribute to elevated drug prices ....... 227

C. Monopolistic Features Increase Drug Prices ....................................... 228

D. Without Normal Market Forces, Basic Supply and Demand Fail

to Establish Price Equilibrium .......................................................... 229

1. In general, supply and demand in normal markets result in

all-around satisfactory prices .................................................... 230

2. Long-term conditions ensure demand, further distorting

price equilibrium ........................................................................ 231

E. Summary: The Pharmaceutical Industry Cannot Be

a Normal Market .............................................................................. 234

III. PRONOUNCED PROFIT-TAKING EXISTS

IN THE PHARMACEUTICAL INDUSTRY .................................................. 235

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A. The Pharmaceutical Industry Reaps Mammoth Profits ..................... 235

B. Big Pharma’s Expenses Spur Their Profits .......................................... 238

C. High Prices and Low Returns Lead to Inaccessibility Problems ........ 241

IV. PROPOSAL: APPLY A MODIFIED MLR REGULATION

TO THE PHARMACEUTICAL INDUSTRY ................................................. 242

A. Profits Are “Other” .............................................................................. 245

B. Manufacturing and Distribution Are “Other” .................................... 245

1. Big Pharma exercises significant control over manufacturing

and distribution costs ................................................................. 247

2. Manufacturing and distribution costs are susceptible to

abuse by Big Pharma, and thus, these costs would benefit

from being grouped in the “other”category ............................. 249

3. Alternative options to align incentives ........................................ 252

4. Manufacturing and distribution expenses should be

classified as “other”.................................................................... 254

C. Lawsuits Are “Medical Loss” .............................................................. 255

D. Research and Development Is “Medical Loss” ................................... 256

E. Taxes, Fees, and Depreciation Are “Medical Loss”............................. 258

F. Marketing Is “Other” ............................................................................ 258

1. Promoting awareness of medications is valuable........................ 259

2. Marketing should be classified as “other” to align incentives .... 260

G. Community Benefit Expenditures Are “Medical Loss” ..................... 261

H. Salaries and Agent Commissions Are “Other” .................................. 261

I. Administrative Expenses Are “Other” ................................................. 262

J. Exceptions to Consider .......................................................................... 262

K. Ratio Should Be 40:60 ........................................................................... 262

V. CONCLUSION: REDUCED TAXPAYER BURDEN, INCREASED AFFORDABILITY ... 263

I. INTRODUCTION

Healthcare spending in America is growing at an alarming rate.

In 2015 healthcare spending totaled $3.2 trillion, or $9990 per

person.

This spending is projected to grow at an average of 5.8%

between 2015 and 2025—approximately 1.3% faster than the GDP.

With healthcare costs rising every year, controlling this growth has

. National Health Expenditures 2016 Highlights, CTRS. FOR MEDICARE & MEDICAID SERVS.,

https://www.cms.gov/research-statistics-data-and-systems/statistics-trends-and-reports

/NationalHealthExpendData/Downloads/highlights.pdf (last visited Nov. 7, 2017).

. Sean P. Keehan et al., National Expenditure Projections, 2015–2025: Economy, Prices,

and Aging Expected to Shape Spending and Enrollment, 35 HEALTH AFF. 1522, 1522–31 (2016).

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become a national priority.

One area with noticeably rising costs is

the pharmaceutical industry. Americans spent $323 billion (rough-

ly 10% of total healthcare expenditures) on prescription medica-

tions in 2016—and that is after rebates and discounts.

For those

under age sixty-five, drug prices are expected to jump 11.6% in

2017.

As a comparison, wages are expected to rise only 2.5% in

2017.

Perhaps unsurprisingly, when comparing industries’ net

profits and percent growth, biotech companies consistently rank

higher than almost any other industry.

It is these sky-high cor-

porate profits that account for a remarkable portion of rising

medication prices.

While some individuals have recently proposed

ways to rein in drug prices—such as foreign importation—more

overarching reform is needed.

To counter the pharmaceutical in-

dustry’s abnormal market forces and to control unsustainable costs,

Congress should enact a pharmaceutical Medical Loss Ratio (MLR)

. Zeke Emanuel et al., State Options to Control Health Care Costs and Improve Quality,

HEALTH AFF. (Apr. 28, 2016), http://healthaffairs.org/blog/2016/04/28/state-options-to

-control-health-care-costs-and-improve-quality/; Steven M. Lieberman & Paul B. Ginsburg,

Would Price Transparency for Generic Drugs Lower Costs for Payers and Patients?, BROOKINGS

INST. (2017), https://www.brookings.edu/wp-content/uploads/2017/06/es_20170613_ge

nericdrugpricing.pdf (outlining that every one percent in an average generic prescription

reimbursement would cut $1 billion from the nation’s healthcare spending).

. U.S. Prescription Drug Spending as High as $610 Billion by 2021: Report, CNBC:

HEALTH CARE (May 4, 2017, 6:12 AM), https://www.cnbc.com/2017/05/04/us-prescription

-drug-spending-as-high-as-610-billion-by-2021-report.html (“U.S. spending on prescription

medicines in 2016 increased by 5.8 percent over 2015 levels to $450 billion based on list prices,

and by 4.8 percent to $323 billion when adjusted for discounts and rebates.”).

. For older Americans, price hikes will be a little lower at 9.9%. Aimee Picchi,

Prognosis for Rx in 2017: More Painful Drug-Price Hikes, CBS NEWS: MONEYWATCH (Dec. 30,

2016, 12:32 PM), https://www.cbsnews.com/news/drug-prices-to-rise-12-percent-in-2017/.

. Id.

. Keith Speights, 12 Big Pharma Stats That Will Blow You Away, MOTLEY FOOL (July

31, 2016, 2:04 PM), https://www.fool.com/investing/2016/07/31/12-big-pharma-stats

-that-will-blow-you-away.aspx; see also Sean Williams, 7 Facts You Probably Don’t Know About

Big Pharma, MOTLEY FOOL (July 19, 2015, 9:06 AM), https://www.fool.com/investing

/value/2015/07/19/7-facts-you-probably-dont-know-about-big-pharma.aspx (explaining

the finances of pharmaceutical companies).

. Melody Petersen, How 4 Drug Companies Rapidly Raised Prices on Life-Saving Drugs,

L.A. TIMES (Dec. 21, 2016, 3:35 PM), http://www.latimes.com/business/la-fi-senate-drug

-price-study-20161221-story.html (“The companies raised prices—not to fund research to

discover new drugs—but to boost profits for executives and investors.”).

. Rachel Bluth, Should the U.S. Make It Easier to Import Prescription Drugs?, PBS (Mar.

22, 2017, 10:33 AM), https://www.pbs.org/newshour/health/u-s-make-easier-import-pre

scription-drugs.

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regulation, similar to that imposed by the Affordable Care Act

(ACA) for health insurance companies.

A. MLR Regulation Corrects Market Failure in the Insurance Industry

Imposing an MLR regulation would assist in managing the

market failures in the pharmaceutical industry, as it has for the

health insurance industry. Market failure occurs when, for a variety

of reasons, a market fails to function like a normal free market by

not allocating resources efficiently or achieving price equilibrium.

One type of market failure is inequality, in which transactions

concentrate rewards in the hands of a few.

In the health insurance

industry, inequality is exemplified when the free market economy

fails to provide reasonable safeguards to prevent insurers from

raising premiums—well beyond what a consumer would willingly

spend—simply in order to concentrate wealth for the insurance

executives.

Given the non-transparent and third-party payor

natures of health insurance, normal market forces are often

inadequate to achieve price equilibrium in this industry. The

ACA’s insurance MLR regulation attempts to normalize resource

allocation in this market by putting guidelines around how much

revenue may be kept as profit or used for other administra-

tive expenses.

In general, an MLR distinguishes the dollars spent on “other”

expenses, such as administrative expenses and profits, from

“medical loss.”

“Medical loss” is defined as care-related and

improvement expenditures like treatment, providers’ salaries, and

. Types of Market Failure, ECON. ONLINE, http://www.economicsonline.co.uk

/Market_failures/Types_of_market_failure.html (last visited Dec. 27, 2017).

. Id.

. See Wendell Potter, Why Big Insurance Adores the American Health Care Act, MOYERS

& CO. (Mar. 23, 2017), http://billmoyers.com/story/why-big-insurance-adores-the-am

erican-health-care-act/; see also Fighting Unreasonable Health Insurance Premium Increases, CTR.

FOR MEDICARE & MEDICAID SERV., https://www.cms.gov/CCIIO/Resources/Fact-Sheets

-and-FAQs/ratereview05192011a.html (last updated Nov. 16, 2011) (laying out the unex-

plained rapidly rising health insurance premiums and other health insurance trends pre-

ACA that supported the need for the insurance MLR regulation).

. See generally 45 C.F.R. § 158 (2017).

. Medical Loss Ratio, HEALTHCARE.GOV, https://www.healthcare.gov/glossary/med

ical-loss-ratio-MLR/ (last visited Feb. 22, 2017).

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research and development (R&D) costs.

“Other” expenses include

those providing relatively less value directly to the consumer, such

as overhead, marketing, C-suite salaries, and profits.

The ACA’s

MLR regulation requires health insurance companies that keep

more than 15% of their income from large employer plans for these

“other” expenses (or 20% from small employer and individual

plans) to rebate the excess back to the consumer.

The regulation

establishes an 85:15 or 80:20 ratio: Insurers must spend 85% or 80%

of their revenues directly on “medical loss.” In doing so, the MLR

regulation ensures that health insurers provide a reasonable

amount of value to the consumer, in effect moderating their

premium hikes.

Consequently, the MLR regulation incentivizes

insurers to invest in value-promoting care and improvements,

while refining efficiencies in less value-adding areas—particularly

by reducing administrative waste and outlandish profits. In an

industry where normal free market forces are inadequate, the

ACA’s MLR regulation has successfully pared down insurers’

“other” costs, including profits.

B. MLR Regulation Returns Billions to Consumers

Since the enactment of the health insurance MLR regulation,

health insurance companies have returned billions of dollars that

were previously kept for profits and other administrative costs in

. Medical Loss Ratio, supra note 14; Louise Norris, Billions in ACA Rebates Show 80/20

Rule’s Impact, HEALTHINSURANCE.ORG (Jan. 18, 2018), https://www.healthinsurance.org

/affordable-care-act/medical-loss-ratio-returns-nearly-2b-to-consumers/; Rate Review & the

80/20 Rule, HEALTHCARE.GOV, https://www.healthcare.gov/health-care-law-protections/rate

-review/ (last visited Feb. 22, 2017).

. Medical Loss Ratio, supra note 14.

. Id.; Norris, supra note 15; Rate Review & the 80/20 Rule, supra note 15. By law,

insurance companies cannot base the price of health premiums on health, medical history,

or gender. They can only account for five things when setting premium prices: age, location,

tobacco use, individual versus family enrollment, or plan category. How Insurance Companies

Set Health Premiums, HEALTHCARE.GOV, https://www.healthcare.gov/how-plans-set-your

-premiums/ (last visited Nov. 7, 2017).

. U.S. GOV’T ACCOUNTABILITY OFF., GAO-14-580, PRIVATE HEALTH INSURANCE:

EARLY EFFECTS OF MEDICAL LOSS RATIO REQUIREMENTS AND REBATES ON INSURERS AND

ENROLLEES 1 (2014) [hereinafter PRIVATE HEALTH INSURANCE].

. See Norris, supra note 15.

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the form of rebates for employers and consumers.

For example,

seventy-five percent of the money returned was originally used to

pay brokers and agents, but since brokers’ and agents’ pay fell on

the “other” side of the MLR ratio, insurers had to rebate the excess

funds so as to meet the ratio threshold.

Insurers are further adjust-

ing payments to agents and brokers, some reporting the MLR

regulation thresholds as the primary motivator.

Most remarkably,

insurers’ underwriting gain (i.e., profits) diminished markedly

from $8.8 to $3.7 billion, from 2012 to 2014.

Specifically, insurers

returned $1.1 billion in rebates to consumers in 2012, $504 million

in 2013, down to $333 million in 2014, up to $469 million in 2015,

and $397 million in 2016.

The ACA’s MLR regulation did its job.

Insurers are right-sizing their premiums and rebating billions of

dollars back to employers and individuals.

While tightening their

belts and squeezing out less value-adding costs, these companies

still recoup healthy profits.

Importantly, the MLR ratio is not arbitrary or impractical. Be-

fore the ACA’s MLR regulation was enacted, most insurers (77% of

insurers in the large employer market and 70% in the small market)

. Specifically, insurers returned $1.1 billion in rebates in 2012, $504 million for 2013,

down to $333 million in 2014, up to $469 million in 2015, and $397 million in 2016. Norris,

supra note 15.

. PRIVATE HEALTH INSURANCE, supra note 18, at 18.

. Furthermore, administrative costs for the 2014 individual market decreased de-

spite an increase in premium revenue. This indicates insurers are expanding coverage to

more individuals while maintaining efficient administrative expenses. See id. at 21; see also

Mark A. Hall & Michael J. McCue, Realizing Health Reform’s Potential: How Has the Affordable

Care Act Affected Health Insurers’ Financial Performance?, COMMONWEALTH FUND (July 2016),

http://www.commonwealthfund.org/~/media/files/publications/issue-brief/2016/jul

/1886_hall_insurers_financial_performance_aca_rb_revised_07_26_2016.pdf.

. Hall, supra note 22, at 4–5. To note, in 2017 insurers reported markedly increased

underwriting gain and net income all while remaining within the ratio requirements. This

merits further investigation, including into the effects of the recent repeal of the health

insurer tax. Perhaps the influx of subsidy money means the resulting ratio of “other” should

be smaller. See Bob Herman, Blue Cross Blue Shield Insurers Are Still Doing Well, AXIOS (Nov.

7, 2017), https://www.axios.com/the-blue-cross-blue-shield-insurers-are-still-doing-well-

2507217868.html. One possible explanation is diversification of portfolios. For example,

UnitedHealth Group has cut back their participation in the “money-losing” individual

market from thirty-four states to three and diversified into various other profitable areas,

such as data management, outpatient clinics, and surgical services. Jeff Sommer, Gripes About

Obamacare Aside, Health Insurers Are in a Profit Spiral, N.Y. TIMES (Mar. 18, 2017), https://

www.nytimes.com/2017/03/18/business/health-insurers-profit.html.

. Norris, supra note 15.

. Id.

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already met these standards.

Furthermore, the legislation permits

the Secretary of Health and Human Services “to adjust the MLR

standard for the individual market in a State if requiring issuers to

meet that standard may destabilize the individual market.”

The

ratio’s purpose is not to impinge on financial viability; instead, it is

to provide a check on insurer’s expenses when the free market

alone has failed to do so. Ultimately, the MLR regulation acts as a

value guardrail. While market instability and an influx of costs

have pushed health insurance premiums upward, the MLR regu-

lation has provided a much-needed check on profits and other

expenses to ensure a certain level of consumer value. Otherwise, this

value would be sacrificed for profits and shareholder dividends in

this abnormal market.

C. Extend the MLR Regulation to the Pharmaceutical Industry

This Note proposes applying a similar MLR regulation to the

pharmaceutical industry, another industry characterized by market

failure. Similar to its effect on the health insurance industry, this

ratio regulation would provide a much-needed check on excessive

profits in the pharmaceutical industry. It would also ensure a cer-

tain level of value for consumers. Instead of impinging on financial

viability, it would simply erect guardrails to stabilize this abnormal

pharmaceutical market. Doing so could also incentivize drug com-

panies to right-size their drug prices. Although the MLR ratio

varies considerably by company, the ratio for the pharmaceutical

industry, and specifically for Big Pharma, currently hovers some-

where around 30% “medical loss” and 70% “other” expenses.

Specifically, the pharmaceutical industry on average spends 70% of

revenue on its “other” expenses: 23% of its revenues on marketing,

30% on manufacturing, and 21% on profits.

The “medical loss”

. Still, less than half of the individual market insurers (43%) met the standard.

Explaining Health Care Reform: Medical Loss Ratio (MLR), KAISER FAMILY FOUND. (Feb. 29, 2012),

http://kff.org/health-reform/fact-sheet/explaining-health-care-reform-medical-loss-ratio-mlr/.

. 45 C.F.R. § 158.101 (2017).

. See infra notes 29 and 30.

. In 2013, the profit margin for pharmaceutical companies ranged from 10% to 42%,

with an average of 18%. Pfizer was at the top of the profit list, and four other companies

(Hoffman-La Roche, AbbVie, GlaxoSmithKline, and Eli Lilly) had profit margins of more

than 20%. Richard Anderson, Pharmaceutical Industry Gets High on Fat Profits, BBC NEWS

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makes up about 30%, including 17% on R&D.

Due to differences

between the two industries, this proposal acknowledges that the in-

surance industry’s 80:20 ratio may not be practical here.

There-

fore, this proposal recommends a ratio of 40:60 for the pharmaceu-

tical industry and, if necessary, a profit cap around 12% (down

from the current 21%).

Part II discusses how the healthcare market’s abnormal nature

results in market failure in the pharmaceutical market. Part III

enumerates the resultant disproportionate profit garnering in the

pharmaceutical industry. Part IV proposes the application of an

MLR regulation to the pharmaceutical industry to right this market,

laying out ratio details, the incentives that result from assigning

various expense categories to different sides of the ratio, and other

related reasoning. Furthermore, it argues that applying the MLR

regulation to the pharmaceutical industry provides a promising,

(Nov. 6, 2014), http://www.bbc.com/news/business-28212223. “[Twenty-one percent] is

the 2015 profit margin that Forbes estimated for the healthcare technology industry, making

it by far the most profitable industry of all, with major and generic pharmaceutical

companies leading the way. The company really setting the pace is Gilead Sciences

(NASDAQ:GILD), which has a profit margin of nearly 53% over the last 12 months.”

Speights, supra note 7. As a point of reference, the profit margin of pharmaceutical companies

was essentially the same as that of banks (19%), but the banks’ range of profit was lower,

from 5% to 29%. SUZANNE M. KIRCHHOFF, CONG. RESEARCH SERV., R42735, MEDICAL LOSS

RATIO REQUIREMENTS UNDER THE PATIENT PROTECTION AND AFFORDABLE CARE ACT (ACA):

ISSUES FOR CONGRESS (2014); Prabir Basu et al., Analysis of Manufacturing Costs in Pharma-

ceutical Companies, 3 J. OF PHARMACEUTICAL INNOVATION 30, 30 (2008) (“In the pharma-

ceutical industry, costs attributed to manufacturing are a major part of a company’s total

expenses.”), available at https://www.researchgate.net/publication/225466494_Analysis_of

_Manufacturing_Costs_in_Pharmaceutical_Companies (accessed Mar. 13, 2018). “Manufac-

turing costs are a substantial part of their total cost structure. According to some estimates,

these costs can be as high as 27–30% of sales for manufacturers of brand-name pharma-

ceuticals, more than double the share of costs for research and Development.” Id.; Catherine

D. Deangelis, Big Pharma Profits and the Public Loses, 94 MILBANK Q. 30, 30–33 (2016); ROCHE

GROUP, FINANCE REPORT 2015, at 4 (2016), http://www.roche.com/dam/jcr:74af99eb-b51a

-4f13-88b2-aacaf9f53c0c/en/fb15e.pdf (Pfizer, Hoffmann-La Roche, AbbVie, GlaxoSmith-

Kline, and Eli Lilly).

. See also Ben Adams, The Top 10 Pharma R&D Budgets in 2016, FIERCEBIOTECH (Apr.

26, 2017), http://www.fiercebiotech.com/special-report/top-10-pharma-r-d-budgets-2016

(“On average last year, the top 10 Big Pharmas spent just over 17% of their top line on

research, with GlaxoSmithKline spending the second least in percentage terms at 12.9%, and

the least in absolute numbers at £3.62 billion ($4.49 billion).”).

. See supra note 15.

. See Deangelis, supra note 29, at 30; Anderson, supra note 32.

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collaborative solution to one of the nation’s most pressing health-

care cost conundrums. Part V concludes.

II. ABNORMAL MARKET FORCES IN THE HEALTHCARE INDUSTRY

RESULT IN MARKET FAILURE

Normal market forces usually curb a good’s price to a market

equilibrium—a price amenable to both buyer and seller.

However, the unique arrangements in the American healthcare

industry effectuate a market that lacks these steadying forces.

Normal market forces include buyers who are reasonably well

informed, make purchases independent of third-party payors (e.g.,

insurance companies), and have multiple choices among sup-

pliers.

These and other forces combine with basic supply and

demand principles to create price equilibrium.

Admittedly, there

are areas in healthcare that could be categorized as “normal”

markets where healthcare is clearly a “product” for sale, such as

elective eye surgeries, Fitbits, and over-the-counter Tylenol. But the

market for prescription medication is anything but normal. In large

part, this is due to the fact that it lacks many of these normal

factors—quality and price transparency, independent buyers using

their own money, and multiple options of goods from which to

choose.

Without the normal “free market” forces, the laws of

. Robert J. Graham, How to Determine Price: Find Economic Equilibrium Between

Supply and Demand, DUMMIES, http://www.dummies.com/education/economics/how-to

-determine-price-find-economic-equilibrium-between-supply-and-demand (last visited Jan.

24, 2018); Fiona M. Scott Morton, The Problems of Price Controls, 24 REGULATION 50, 50 (2001)

(“The determining of market prices through the dynamic interaction of supply and demand

is the basic building block of economics. . . . This dynamic interaction produces an equi-

librium market price; when buyers and sellers transact freely, the price that results causes

the quantity demanded by consumers to exactly equal the supply produced by sellers.”).

. See Chris Ladd, There Is Never a ‘Free Market’ in Health Care, FORBES (Mar. 7, 2017,

10:00 AM), https://www.forbes.com/sites/chrisladd/2017/03/07/there-is-never-a-free-mar

ket-in-health-care/#2427c6b71147.

. Alain C. Enthoven, Market Forces and Efficient Health Care Systems, 23 HEALTH AFF.

25, 25 (2004).

. Id.

. Shelby Livingston, Is the Price Right? Solving Healthcare’s Transparency Problem,

MOD. HEALTHCARE, http://www.modernhealthcare.com/reports/achieving-transparency

-in-healthcare/#!/ (“[T]he industry undoubtedly remains one of the nation’s most opaque.

The scarcity of price and quality information is often blamed for the high cost of care.”) (last

visited Dec. 20, 2017).

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supply and demand do not balance each other in a way that leads

to affordable pricing.

A. Lack of Transparency in the Pharmaceutical Industry

Contributes to Market Failure

In a normal market, consumers are well informed about their

needs and choices.

For example, individuals know their shoe size

and preferred shoe styles, and they can research the prices and

quality of various shoes online or in stores.

This information

empowers them to decide which shoes meet their needs, weigh the

price and quality options, and make reasoned decisions regarding

which shoes to buy. However, in the pharmaceutical industry

similar transparency is much more difficult due to information and

control asymmetries between patient and provider, a lack of

transparent pricing, and healthcare’s highly inelastic market.

1. Information and control asymmetries between physicians and patients

hamper consumer power

Prescription drug consumers consistently lack information that

is normally available to consumers in other markets. This partly

stems from power and information asymmetries between pre-

scribers and their patients.

Unlike shoe purchasers, ordinary

prescription drug consumers do not have the necessary training to

identify their health needs or the remedying medications.

Rather,

. See Enthoven, supra note 35, at 25.

. Perfect Competition, ECONOMICS ONLINE, http://www.economicsonline.co.uk/Busi

ness_economics/Perfect_competition.html (last visited Feb. 12, 2018); see also Consumer Pro-

tection, ENCYCLOPEDIA.COM, http://www.encyclopedia.com/social-sciences-and-law/law

/law/consumer-product-safety-act (last visited Feb. 12, 2018) (discussing what information

consumers should reasonably be able to expect).

. “The information asymmetry experienced by consumers, providers, and payers

shield these critical stakeholders from the information they need to make decisions about

what works best for them.” INST. OF MEDICINE, THE HEALTHCARE IMPERATIVE: LOWERING

COSTS AND IMPROVING OUTCOMES 335 (Pierre L. Yong, Robert S. Saunders & LeighAnne

Olson eds., 2010), https://www.ncbi.nlm.nih.gov/books/NBK53921/. “As a rule the doctor

has relevant information that the patient lacks.” Stephen Shmanske, Information Asymmetries

in Health Services: The Market Can Cope, 1 INDEP. REV. 191, 197 (1996).

. Ariel Katz, Pharmaceutical Lemons: Innovation and Regulation in the Drug Industry,

14 MICH. TELECOMM. & TECH. L. REV. 1, 14 (2007).

Even more difficult for most consumers is knowing and evaluating the

expected long-term effects of the drug, the possible complications, or the reactions

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drug consumers are usually unaware of either the existence of or

the differences between prescription drugs like Prilosec and

Protonix, or Perjeta and Pegintron. And drugs are arguably more

complex than shoes and other commodities and require a certain

level of training to know which is appropriate for which medical

need. In fact, the reasons patients even go to doctors in the first

place include their extensive medical expertise and prescription

pads, both of which patients lack.

They turn to the experts whose

years of training enable them to identify health needs, weigh

options, and then sign that pad—because without a prescriber’s

signature, patients cannot obtain prescription medication, even if

the information about the medical need or the prescribed medi-

cation were more transparent.

The same is not true for shoes or

houses. Not even car or computer repairs require a graduate-level

licensed provider. In fact, with only a little training, consumers can

buy and change their own engine oil or tires. But with prescription

drugs the capacity to understand sufficiently the medical nuances

and to consider the choices, as well as the power to access the

prescription medication, lies with prescribers.

Sometimes only the

with other substances. Moreover, even if they were affluent enough to do so,

because combining different drugs may be ineffective, or even lethal, consumers

cannot simply try every drug and every cure until they find the one that works.

They need to know before they commit to a specific drug that it is likely to work.

Id. (internal citations omitted).

. See Shmanske, supra note 40, at 191 (“[O]ne type of asymmetric information occurs

because the doctor typically has knowledge the patient does not—that’s why the patient sees

the doctor in the first place.”).

. “A drug intended for human use . . . shall be dispensed only (i) upon a written

prescription of a practitioner licensed by law to administer such drug . . . .” 21 U.S.C.

§ 353(b)(1)(B) (2012) (“The act of dispensing a drug contrary to the provisions of this paragraph

shall be deemed to be an act which results in the drug being misbranded while held for sale.”).

. Katz supra, note 41.

Perhaps more importantly, however dramatic the effect of a drug on one

person may be, since the effect of drugs may vary from person to person,

meaningful information on drugs’ quality can be obtained only by looking at large

samples and carefully applying statistical methods. Not only is this type of

epidemiological research beyond the reach of consumers, it is also beyond the

reach of most practicing physicians. Therefore, if sellers (drug companies) have

better information about the efficacy and safety of their products, severe

asymmetry of information about the quality of drugs (their efficacy and safety)

may occur.

Id. at 14 (internal citations omitted).

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drug companies themselves have the information.

Overall, the

information and power imbalances in the prescription drug indus-

try place incredible power into the hands of healthcare providers,

beyond the reach of the average drug consumer.

As such, the

consumer loses much of the ability to directly choose cheaper

products and thus coax prices down to reasonable levels. Further-

more, the cost of meeting with a provider for the prescription

further adds to the rising cost of drug distribution and other

healthcare costs.

Some argue that these asymmetries are inconsequential since

other markets with both information and power asymmetries, such

as car repairs and housing markets, have coped and achieved some

level of market equilibrium.

However, both cars and houses are

some of our most expensive commodities, in part due to the poten-

tial for danger and resultant care we take to ensure our safety.

Furthermore, the potential inconvenience or additional cost re-

sulting from a mistake in car repairs or a housing purchase is very

different than the potential bodily harm or even death resulting

from misguided medication prescription. Certainly, harm done to

a car or house can be costly. But it is much less personal.

Moreover, with individual differences in symptoms and ana-

tomy, it is even harder for prescribers to know at the outset of a

. The pharmaceutical companies have done the extensive chemical and epide-

miological research on their products and are then responsible to disseminate that

information out to prescribers. Id. “Therefore, if sellers (drug companies) have better

information about the efficacy and safety of their products, severe asymmetry of information

about the quality of drugs (their efficacy and safety) may occur.” Id. at 14 n.65.

. Charles Ornstein, Ryann Grochowski Jones & Mike Tigas, Drug-Company Payments

Mirror Doctors’ Brand-Name Prescribing, NPR (Mar. 17, 2016, 5:00 AM), http://www.npr

.org/sections/health-shots/2016/03/17/470679452/drug-company-payments-mirror-doc

tors-brand-name-prescribing (“A ProPublica analysis has found that doctors who receive

payments from the medical industry do indeed prescribe drugs differently on average than

their colleagues who don’t.”); Shmanske, supra note 40, at 198 (“[P]atients still have no

guarantee that competent, licensed doctors will not use their informational advantage for

personal gain.”).

. See Shmanske, supra note 40, at 197.

The information asymmetry in the doctor-patient relationship is simply

another case of scarcity with which the market can cope. . . . Getting a second

opinion in health-care markets is comparable with comparison shopping in other

markets, yet no one claims that markets fail because prudent buyers of clothing

expend time, effort, and resources shopping or because would-be homebuyers

order termite inspections.

Id.

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medical encounter which medication is appropriate and how much

of it to prescribe.

When someone walks into a hospital, the

provider cannot run a manufacturer-guided diagnostic or look up

the make and model to find the appropriate repair part like a car

mechanic can when changing engine oil or spark plugs. Finding the

right antibiotic, chemotherapy treatment, or more notably, the right

psychiatric medication, often requires time and periods of trial and

error, even for extensively trained physicians. This uncertainty

characterizes the healthcare market more so than other markets.

This is why it is called a medical “practice.” Putting these decisions

into the hands of untrained buyers is almost unconscionable—

similar to handing car keys to a six-year-old. Consenting to the

information asymmetry is essentially an imperative to engage in

this market. Yet, at the same time, this asymmetry weakens buyer

power, and thus the forces to lower prices are insufficient to achieve

true price equilibrium.

2. Transparent drug pricing is often impractical, and the resultant lack

of price information further limits buyer power

Buyer power is also limited due to costs that are often opaque—

even less transparent than the need for or the fit of a specific

medication.

Unlike shoes, prescription drugs are not price tagged,

nor do hospitals list drug prices on a sign above the welcome desk

like oil changes at a car repair shop.

Prescribers don’t hand over a

priced menu during their hospital rounds when they ask, “Do you

prefer Zofran or Phenergan? Percocet or Norco?” In fact, doctors,

on average, discuss drug costs with only 2.6 out of 10 patients.

. Anna D. Sinaiko & Meredith B. Rosenthal, Increased Price Transparency in Health

Care—Challenges and Potential Effects, 364 NEW ENG. J. MED. 891, 891–93 (2011).

. See Paul K.J. Han, William M.P. Klein & Neeraj K. Arora, Varieties of Uncertainty in

Health Care: A Conceptual Taxonomy, 31 MED. DECISION MAKING 828, 828–38 (2011).

. Livingston, supra note 37 (“[T]he industry undoubtedly remains one of the nation’s

most opaque. The scarcity of price and quality information is often blamed for the high cost

of care.”) (last visited Dec. 20, 2017).

. Cf. Featured Auto Services, WALMART, https://www.walmart.com/cp/auto-ser

vices/1087266 (last visited Dec. 27, 2017).

. Doctors and Rx Prices: Ending the Silence, CONSUMER REP. (June 21, 2016), https://

www.consumerreports.org/drugs/doctors-and-rx-prices-ending-the-silence/ (“[Six] percent

of people currently taking a prescription drug found out about the cost of their new medi-

cation during a doctor’s visit, when the prescription was being written.”).

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times, this is because even the physicians are unaware of drug costs,

further limiting patients’ access to price information.

Once the

medication is prescribed, nurses administering the ordered medi-

cation to the patients usually do not discuss the cost.

Not only are

they similarly unaware of the price, but some would even consider

that type of discussion unethical.

Drug prices are complicated. While consumers are usually

aware of their drug copay, the ultimate drug price is often obscured

by insurance rebates or discounts mandated to government payors

(e.g., Medicaid).

This leads to elevated, ever-fluctuating list prices

that determine the consumers’ portion to be paid.

Complex “drug

formularies” from the insurance companies further complicate

drug prices because consumers will pay vastly different amounts

depending on the drug status (e.g., cheaper “preferred drugs” or

generics, or expensive specialty and brand drugs).

Even calling to

get a price estimate can be a fruitless endeavor. “It depends on your

insurance,” is a far-too-common response. Overall, drug prices are

. See Livingston, supra note 37 (“[C]linicians often don’t know the price tag of the

medical services they provide.”).

. See Lieberman & Ginsburg, supra note 3, at 1 (“The U.S. system for selling

prescription medicines involves multiple parties, differs markedly for generic and brand

drugs, has complex, nontransparent financial arrangements, and limits available information

in assymetric ways that disadvantage third-party payers and patients.”).

. In my experience, nurses make efforts to save patients money in simple ways. But

when a patient is seriously ill the priority becomes the patient’s care and comfort. Price dis-

cussions become superfluous and insensitive.

. “[T]he complex charges for prescription drugs often range from co-payments of

$15–$100 for ’preferred‘ drugs to 45% or more of the cost of specialty or non-preferred

drugs.” Grace-Marie Turner, Price Transparency Is Critical to Drug Pricing Solutions, FORBES

(July 11, 2017, 4:59 PM), https://www.forbes.com/sites/gracemarieturner/2017/07/11/price

-transparency-is-critical-to-drug-pricing-solutions/#1193fda5204a. “A huge system of drug

rebates and discounts happens behind the scenes in the pharmaceutical supply chain, further

distorting the market and confusing consumers about the actual price of a drug. Only a

trickle of these discounts and rebates actually reaches the consumer.” Id.

. “Even though rebates paid by biopharmaceutical companies can substantially

reduce the prices insurers and pharmacy benefit managers (PBMs) pay for brand medicines,

insurers use list prices—rather than discounted prices—to determine how much to charge

patients when they pay their share, further increasing what consumers pay.” Id.

. Insurance companies generally create complex “drug formularies” in which

their insured patients pay less for “preferred” drugs, especially generics, but can pay much

more for expensive brand and specialty drugs. Laurie Toich, Drug Rebates: Do Patients Really

Benefit?, AM. J. PHARMACY BENEFITS (Apr. 26, 2017), http://www.ajpb.com/news/drug

-rebates-do-patients-really-benefit; see also Turner, supra note 56.

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much less transparent than the prices of other products.

Many

suppliers refuse even to disclose how they set prices.

And even

when price transparency is not an issue, there is little patients can

do to shop around for the best price if they are locked in to an

insurance plan with a set drug copay. A copay that is always a set

amount irrespective of the drug prescribed further removes the

consumer from the cost information and reduces buyer power.

Furthermore, the urgent nature of healthcare itself differen-

tiates it from other industries. Few persons would stop emergency

medical services in an ambulance or in the intensive care unit to

price-compare drugs or obtain approval from the consumer. Nor

does it do much good to explain to a patient undergoing surgery

the price of all the medicines the hospital has contracted to use for

anesthesia and preventive antibiotics. It is also unreasonable to

explain to sick, hospitalized patients (or their families) all of the

drugs that are being used in the patient’s care. These examples

demonstrate that pushing for drug price transparency to reduce the

cost of these particularly expensive areas in healthcare is impracti-

cal. Since consumers’ access to this information—and thus their

ability to compare quality and price—is severely limited, or even at

times impossible, buyer power rests mainly outside their control.

Instead, the buyer power lies dominantly in the hands of providers

and insurers.

Admittedly, prescribers and patients have some increasing

access to the price of medications, as well as increased incentive to

pay attention.

A price comparison may be accessible to patients

. See Livingston, supra note 37 (“For the most part, consumers remain in the dark

about what they will be asked to pay after visiting a primary-care doctor or undergoing an

inpatient procedure. In that way, healthcare is unlike every other aspect of the consumer

experience in America. It would be unimaginable to leave a broken-down car with a mechan-

ic before getting a cost estimate, for example. But in healthcare, ‘everyone’s flying blind.’”).

. Id.

. See, e.g., Patrick McGreevy, More Transparency Proposed for Prescription Drug Price

Increases Under Bill Passed by California Senate, L.A. TIMES (May 30, 2017, 4:33 PM), http://

www.latimes.com/politics/essential/la-pol-ca-essential-politics-updates-more-sunlight-pro

posed-for-prescription-1496186778-htmlstory.html (“Alarmed by skyrocketing prices for

some prescription drugs, the California Senate on Tuesday approved a measure aimed at

increasing pressure to hold down costs to consumers by requiring more public reporting of

price hikes.”); see also Livingston, supra note 37 (“[M]any other healthcare organizations,

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via a call to a local pharmacy or by visiting certain websites.

The

majority of health plans (self-insured employers in particular) offer

cost-estimating tools for healthcare prices.

And some insurance

companies list drug prices per drug tier.

Yet sources indicate few

patients (three percent) actually compare costs of care among pro-

viders—often because they are unaware of the above-mentioned

tools.

And frequently drug copays are set by the insurer or de-

pend on the pharmacy, so price comparison at the time of prescrib-

ing would be practically useless.

3. Healthcare is a highly inelastic market

Most importantly, unlike a physical body, commodities like

shoes and cars can be replaced. In commodities markets, the repair,

maintenance, or inspection costs are all controlled by normal mar-

ket forces, regardless of the information and power imbalances

inherent in the service. When shoes wear out, the consumer throws

them away and buys a new pair at a normal market rate. If the

repair costs for a damaged car outweigh replacement costs, the car

is “totaled.” The consumer compares the price and quality of new

models and uses what equity is left on the “totaled” car to purchase

a new one—again at a normal market rate.

Healthcare offers consumers no such alternatives. There is no

market-controlled replacement model available if cancer metasta-

sizes throughout a body or when heart-failure-induced fluid build-

up makes it difficult to breathe. Grandma isn’t “totaled” when her

urinary tract infections become resistant to normal antibiotics, nor

is mom when her cancer pain becomes unbearable. It is hard to cut

off funds for chronic pain or a failing body because, unlike a car,

from providers to insurers, are working to increase price transparency for the services they

provide, to varying degrees of success.”).

. See, e.g., PHARMACYCHECKER.COM, https://www.pharmacychecker.com (last vi-

sited Jan. 19, 2017); SCRIPTSAVE WELLRX, https://www.wellrx.com/prescriptions (last visit-

ed Jan. 19, 2017).

. See Livingston, supra note 37 (“Nearly all major health plans offer a cost-estimator

tool or contract with a third-party vendor to provide one so that commercially insured

patients can search for a common clinical service and obtain a cost estimate.”).

. How Do Drug Tiers Work?, BLUE CROSS BLUE SHIELD BLUE CARE NETWORK OF

MICHIGAN, http://www.bcbsm.com/medicare/help/understanding-plans/pharmacy-pre

scription-drugs/tiers.html (last updated Oct. 2, 2017).

. See Livingston, supra note 37.

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mom is irreplaceable. There is no “going market rate” for the price

of a loved one. Consumers cannot refuse to participate in this

market, so the medical bills pile up. In other words, this market is

highly inelastic; no matter how high prices rise, the demand for life-

saving drugs stays constant. As such, the costs of life-saving or

quality-of-life-enhancing prescription drugs from profit-maximiz-

ing companies know few market bounds. To illustrate, the biggest

cash cow for the pharmaceutical industry is oncology (worth

$78.9 billion).

Pharmacyclics’ cancer drug Ibrutinib alone raked in

revenue over 67 times the R&D investment.

Clearly, consumers’

usual qualms over paying astronomical prices were absent for this

product. Either they didn’t care what it cost, or they didn’t know—

probably both. In general, when cancer, or any other debilitating

mental or physical illness, rears its ugly head buyers have priorities

other than deal-shopping. In a way, it is a collective sense of hu-

manity—an unwillingness to begrudge the funds needed in order

to save a life or prolong suffering—that throws normal market

forces out the window. The normal market is not designed for life-

or-death situations. Drugs are.

Combined together, the information imbalance between patient

and prescriber, opaque pricing information, and the strong sense of

empathy intrinsic to human nature all render the prescription drug

market uniquely inelastic. Consequently, with so much power out-

side consumer control, this market’s asymmetries of information

and control cripple the patient-buyer’s typical ability to compare

options, match them to their needs, and pick those options that are

simultaneously effective and affordable.

. Bryan Mc Govern, Why Consider Investing in Pharmaceutical Stocks?, INVESTING

NEWS (Jan. 1, 2018), https://investingnews.com/daily/life-science-investing/pharmaceut

ical-investing/investing-in-pharmaceutical-stocks/ (“The 2015 report from Statista also

reveals some of the biggest cash cows for the sector, with oncology pharma taking the lead

on an indicated value in sales of $78.9 billion.”).

. Vinay Prasad & Sham Mailankody, Research and Development Spending to Bring a

Single Cancer Drug to Market and Revenues After Approval, 177 J. AM. MED. ASS’N INTERNAL

MED. 1569, 1572 (2017).

. Ironically, even if we did have price transparency, it is not guaranteed to lower

costs. One Harvard Medical School study actually concluded that offering price estimators

did not necessarily lower costs; it often raised them, as people equated higher cost with

higher quality. See Livingston, supra note 37 (“[A] 2016 Harvard Medical School study . . .

found that offering employees a price-estimator tool (in the study’s case, the Truven calcu-

lator) did not lower healthcare spending. In fact, employees who used the tool ended up

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B. Third-Party Payors Further Frustrate Aspects of a Normal Market

The third-party payor role of health insurance is unlike other

types of insurance and further complicates this market. Consumers

in most commodity markets control their money when they trans-

fer it directly to sellers in exchange for goods.

For example, when

one buys groceries or a cell phone, the known amount of cash

transfers directly to the seller at the time the customer acquires the

goods. Even when the immediate exchange between buyer and

seller is obscured by an independent middleman, such as a credit

card company, the customer is usually aware of and responsible for

the whole price of the purchased item. Yet the middleman role

played by health insurers obscures the amount paid and insulates

the consumer from the loss.

A middleman is one who facilitates transactions between a

buyer and seller for a fee, often resulting in price increases.

Insurers are a specific type of middleman. Unlike retailers or other

types of middlemen, insurers collect scheduled payments, or

premiums, from customers in exchange for a guarantee of some

compensation in the event of an expensive loss—such as an earth-

quake or hospital visit.

In the event of such a loss, the customer

pays a portion as a deductible or out-of-pocket maximum, while

the insurer pays the rest.

In essence, insurance transfers risk “from

an individual to a company,” pooling it with other individuals so

as to mitigate the losses felt by any one individual.

Health insurers

thus use pooled resources to insulate the financial losses of

spending more than those who didn’t. The researchers suggested consumers could spend

more if they equate high cost with high quality.”). The Livingston article also quotes Alan

Sager, a Boston University professor of health law, policy, and management, offering his

opinion: “Asking patients to become informed about price and quality, and make

decisions about diagnosis and treatment in light of information about price and quality, I

think that’s largely a waste of time; and worse, it imposes radically unfair burdens on

many patients.” Id.

. See Consumer Spending, INVESTOPEDIA, https://www.investopedia.com/terms/c

/consumer-spending.asp (last visited Feb. 12, 2018).

. Middleman, INVESTOPEDIA, http://www.investopedia.com/terms/m/middleman

.asp (last visited Jan. 15, 2018).

. CATHY PARETO, Introduction to Insurance, INVESTOPEDIA (2010), http://elibrary

.vssdcollege.ac.in/web/data/books-com-sc/bcom-3/Introduction%20To%20insurance.pdf.

. Id.

. Glossary of Insurance Terms, NAT’L ASS’N OF INS. COMMISSIONERS, http://www

.naic.org/consumer_glossary.htm (last visited Jan. 15, 2018).

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prescription drug (and other) costs felt by any one consumer. By its

very design, health insurance is meant to limit a consumer’s

exposure to healthcare costs. For some types of insurance (e.g., fire

or earthquake insurance) this design may not pose a substantial

cost burden. However, because health insurance is used much

more frequently than other types of insurance, costs escalate with

corresponding frequency.

1. The frequent need for health insurance burdens consumers more so

than other insurance types

Health insurance plays a much larger role in a person’s habitual

finances than other insurance types. For commodities like cars and

houses, an insurer’s role is largely limited to rarer catastrophic

situations like a car crash or fire.

Yet health insurance pays for

much more than just catastrophes. While brake repairs or oil

changes are not covered by car insurance, preventive health screen-

ings and other checkups are often covered by health insurance.

While car insurance does not pay for the gas needed to run the

engine, health insurance often covers drugs that must be taken on

a daily basis. While many may not need these daily medications

when they are young and healthy, few escape the infirmities of old

age. Additionally, one may have ailing dependents requiring

significant resources. Eventually, everyone needs health insurance.

In other words, unlike other insurance types, health insurance is

constantly necessary to help defray healthcare costs for a significant

number of people.

This unusually large role played by insurers in the pharma-

ceutical industry reduces consumers’ access to information and,

therefore, their ability to price discriminate between products.

Specifically, predetermined provider networks frustrate the impact

that price comparisons and second opinions have on promoting

competitive pricing the way they do in other markets.

Usually

. Mandated Car Insurance vs. Mandated Health Insurance: What’s the Difference?,

UNITED POLICYHOLDERS, http://www.uphelp.org/news/mandated-car-insurance-vs-man

dated-health-insurance-what%E2%80%99s-difference/2012-10-31 (last visited Jan. 15, 2018)

(“While health insurance covers preventive measures, including checkups and screenings,

as well as catastrophic events, such as cancer treatments, heart surgery or intensive care, auto

insurance doesn’t cover preventive measures such as oil changes and brake checks.”).

. Preferred Provider Organization (PPO), HEALTHCARE.GOV, https://www.health

care.gov/glossary/preferred-provider-organization-PPO/ (last visited Jan. 15, 2018).

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insurance companies charge the same copay at any pharmacy in

their preferred network; seeing different providers within the

network doesn’t change that. And leaving the insurer’s preferred

network means paying more, which further limits patients’ choices.

This is vastly different than other types of insurance; for example,

car insurers don’t stipulate which mechanics to see or at what

dealer to shop. And changing health insurance companies in order

to find a cheaper provider usually isn’t an option because health

insurers are either chosen by an employer or changed once a year

on the Affordable Care Act’s individual marketplace. Thus, insur-

ers play a more continuous and invasive role in healthcare than in

other markets—a role that proportionately limits drug consumers’

buyer power.

Over the years, the health insurer’s role has continued to

expand as the pharmaceutical cost burden has shifted from in-

dividuals to third-party payors. Between 1960 and 1988, direct out-

of-pocket expenditures fell 28%, while public financing increased

17.6% and private financing increased 10%.

Even now, third

parties continue to shield costs. In 2015, 49% of Americans’ health

insurance was provided through an employer.

In addition, almost

85% of those enrolled in the ACA exchanges received healthcare

subsidies from the government.

In reality, only about ten cents on

every healthcare dollar are contributed directly from the patient.

The remaining cost is negotiated by insurers and the government.

One ironic result of this cost shielding is that the insured end

up paying more than they otherwise would, since normal pressures

. Patricia M. Danzon, Health Care Industry, CONCISE ENCYCLOPEDIA OF ECONS.

(1993), http://www.econlib.org/library/Enc1/HealthCareIndustry.html.

. Health Insurance Coverage of the Total Population, KAISER FAM. FOUND., https://

www.kff.org/other/state-indicator/total-population/?currentTimeframe=0&sortModel=%

7B%22colId%22:%22Location%22,%22sort%22:%22asc%22%7D (last visited Jan. 15, 2018)

(webpage allows the user to examine the health care coverage of the population using a

variety of filters).

. See Louise Norris, Will You Receive an Obamacare Premium Subsidy?,

HEALTHINSURANCE.ORG (Jan. 1, 2017), https://www.healthinsurance.org/affordable-care-act

/will-you-receive-an-obamacare-premium-subsidy/.

. John Graham, Opinion, Surprise Medical Bills: A Growing Problem Requiring Price

Transparency, FORBES (Dec. 1, 2016, 10:14 AM), https://www.forbes.com/sites/theapothecary

/2016/12/01/surprise-medical-bills-a-growing-problem-requiring-price-transparency/#38

9daf3b7d27.

. Id.

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to prevent costs from rising do not exist. In the first two years of the

ACA’s enactment, out-of-pocket spending plunged 21.4% for the

poorest Americans.

Yet, for the average American household,

premiums rose 12%, which computes to an even larger dollar

amount.

Healthcare costs that were avoided by some were

compensated for by others. In essence, because health consumers

have historically been shielded from the true cost of healthcare,

without adequate government or normal market forces to rein in

expenses, healthcare costs have risen stiflingly high. For many, the

ACA has started to reverse the cost shielding trend by passing on

these inflated costs as higher premiums and deductibles. Yet for the

poorest, the cost shielding trend continues, and when consumers

are so heavily insulated from the price, price becomes a non-issue—

partly because it can’t be an issue. Insurers and other third parties

are necessary to aggregate the funds needed to cover elevated drug

prices and thus mitigate the financial loss felt by consumers. The

minimum-wage earner and the chronically sick could never afford

the prices necessary to recoup the millions or billions of dollars

required for a drug’s development, prescribers’ salaries, or other

costs.

Free market advocates insist that eliminating the insurer

would bring costs down. But again, this is not a normal market.

Those most in need of the expensive care provided in this market

(such as nursing homes, intensive care units, and cancer drugs) are

often the least able to work to pay for it. Consequently, third parties

must continue to shield consumers from some expensive prescrip-

tion drug costs.

. Dan Mangan, Out-Of-Pocket Health Spending Dropped by Nearly 12 Percent—But

Premiums Rose After Obamacare Rolled Out, CNBC: HEALTH CARE (Jan 22, 2018, 2:31 PM),

https://www.cnbc.com/2018/01/22/out-of-pocket-health-spending-dropped-after-obama

care-rolled-out.html.

. Id.

. Cost to Develop and Win Marketing Approval for a New Drug is $2.6 Billion, TUFTS CTR.

FOR STUDY DRUG DEV. (Nov. 18, 2014), https://www.outsourcing-pharma.com/Article

/2016/03/14/Tufts-examines-2.87bn-drug-development-cost (“Developing a new prescrip-

tion medicine that gains marketing approval, a process often lasting longer than a decade, is

estimated to cost $2,558 million . . . .”).

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2. Third-party payor costs contribute to elevated drug prices

Coordination among the various players in the healthcare

industry carries additional hidden costs.

The overhead required

for the negotiating middlemen (e.g., insurance company employees

and executives, pharmacy benefit managers, pharmacists, drug

reps) continues to drive up prices.

One notable example is phar-

macy benefit managers (PBMs), on whom health plans depend for

negotiating reimbursement terms with retail pharmacies.

These

negotiations derive revenues from a combination of fees from the

drug companies, as well as shared savings from the maintenance of

pharmacy networks.

Ultimately, this unusually significant and disconnected third-

party payor system both isolates consumers from financial loss and

escalates costs in the pharmaceutical industry—indeed, in the

whole healthcare system.

With removed consumers and profit-

maximizing middlemen, drug prices can rise unfettered.

. See Danzon, supra note 77.

. See Jayne O’Donnell, Do Drug Benefit Managers Reduce Health Costs?, USA TODAY

(Mar. 3, 2014, 2:30 PM), https://www.usatoday.com/story/money/personalfinance/2014

/03/03/pharmacy-benefit-managers-healthcare-costs-savings/5495317/ (“As more people

become insured under the Affordable Care Act, PBMs will become both more profitable and

powerful, which could thwart efforts to keep drug costs down, some critics say. Express

Scripts, for example, is ranked 24th on the Fortune 500, thanks in part to its $29 billion deal

to buy Medco last year. Last month, the company said it expects to have 10% to 20% growth

in earnings per share for the next several years, thanks to ‘health care trends, industry

positioning and the overall environment.’”); Rob Sawicki, How Insurance Companies Drive Up

the Cost of Life-Saving Drugs for Patients, HUFFINGTON POST (Dec. 4, 2015, 12:37 PM),

http://www.huffingtonpost.com/rob-sawicki/how-insurance-companies-d_b_8710216.html;

Turner, supra note 56 (“Caterpillar moved away from its PBM, suspecting that a quarter of

the manufacturer’s $150 million annual drug bill was being wasted.”).

. See Lieberman & Ginsburg, supra note 3, at 1 (“Health plans rely heavily on

contracted pharmacy benefit managers (PBMs) to negotiate reimbursement terms on their

behalf with retail pharmacies. However, PBMs also operate mail-order pharmacies, giving

them knowledge of actual generic drug costs. . . . This disincentive to keep generic drug

reimbursement low for their health plan client poses an apparent conflict of interest for PBMs

and increases health plan spending to the extent that a lack of information about actual

generic drug costs leads to excessive reimbursement.”).

. Pharmacy Benefit Managers, HEALTH AFFAIRS 1, 2 (2017), https://www.healthaffairs

.org/do/10.1377/hpb20171409.000178/full/healthpolicybrief_178.pdf.

. See Lieberman & Ginsburg, supra note 3, at 1; see also Danzon, supra note 77.

. See Paul Fronstin & Jack VanDerhei, Savings Medicare Beneficiaries Need for Health

Expenses: Some Couples Could Need as Much as $350,000, 38 EMP. BENEFIT RES. INST. NOTES 1, 7

(2017), https://www.ebri.org/pdf/notespdf/EBRI_Notes_Hlth-Svgs.v38no1_31Jan17.pdf;

see also Norris, supra note 79.

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C. Monopolistic Features Increase Drug Prices

Normal markets provide consumers with options.

A market

composed of multiple players prevents one seller from elevating a

product’s prices out of control, since buyers can buy the lower-

priced option.

Alternatively, a monopolized market lacks the ri-

valry between players that manages price and quality.

This dearth

of competition concentrates selling power in the hands of a single

player.

That player then has total control to raise prices.

In most

markets, antitrust laws, such as the Federal Trade Commission Act,

prevent monopolies and promote cost-curbing conditions.

However, the American pharmaceutical industry actually facil-

itates monopolies.

In some cases, medication and treatment op-

tions are limited because science hasn’t advanced and few cures

exist.

However, in many cases patents restrict choices by blocking

innovation of new or improved products.

As defined by statute, a

patent is “the right to exclude others from making, using, offering

for sale, or selling . . . or importing the invention.”

100

While patents

. See Enthoven, supra note 35, at 25–27.

. Perfect Competition, supra note 39.

. Monopoly, INVESTOPEDIA, http://www.investopedia.com/terms/m/monopoly.asp

(last visited Jan. 15, 2018).

A monopoly is characterized by the absence of competition, which can lead

to high costs for consumers, inferior products and services, and corrupt behav-

ior. A company that dominates a business sector or industry can use that

dominance to its advantage, and at the expense of others. It can create artificial

scarcities, fix prices, and otherwise circumvent natural laws of supply and

demand. It can impede new entrants into the field, discriminate, and inhibit

experimentation or new product development, while the public—robbed of the

recourse of using a competitor—is at its mercy. A monopolized market often

becomes an unequal, and even inefficient, one.

Id.

. Id.

. The Antitrust Laws, FED. TRADE COMMISSION, https://www.ftc.gov/tips-advice

/competition-guidance/guide-antitrust-laws/antitrust-laws (last visited Dec. 28, 2017).

. See Aaron S. Kesselheim, Jerry Avorn & Ameet Sarpatwari, The High Cost of Pre-

scription Drugs in the United States: Origins and Prospects for Reform, 316 J. AM. MED. ASS’N 858,

859 (2016).

. 8 Diseases for Which We Still Haven’t Found a Cure, EMGN.COM, http://emgn

.com/entertainment/8-diseases-still-havent-found-cure/ (last visited Dec. 28, 2017).

. “[T]he current system is not working well . . . the most notable current feature of

pharmaceutical innovation is the huge ‘drought’ in the development of new products.”

Michele Boldrin & David K. Levine, The Case Against Patents, 27 J. ECON. PERSP. 3, 13 (2013).

100

. 35 U.S.C. § 154(a)(1) (2012).

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help drug makers recoup R&D costs, they also restrict the choices

available to consumers.

101

These market exclusivity rights bypass

normal market safeguards and create an ideal environment for

single-product domination.

102

As to be expected, this monopoliza-

tion pushes up prices. In fact, the 2013 per capita spending for

drugs in America was $858—over twice the $400 average of

nineteen other industrialized nations (many with government-

mandated drug price controls).

103

Further exacerbating rising prices

is the requirement imposed on the majority of U.S. government

drug payment plans (e.g., Medicare Part D) to cover nearly all drug

products.

104

Under this requirement, drug companies can charge

whatever they like, and insurers must pay for products if

prescribed. Admittedly, prior authorizations and other tools do

serve as a check on prices.

105

Yet as a whole, these pharmaceutical

monopolies are a substantial factor in unrestricted prescription

drug prices. It is true that patents provide the incentives for drug

companies to take on the lengthy and risky process of developing

new drugs. Thus, the solution may not be to get rid of the patent

system. Instead, there may be a way to alter the market structure as

a whole to allow for both patents and some restraint on drug prices.

D. Without Normal Market Forces, Basic Supply and Demand

Fail to Establish Price Equilibrium

The tension between supply and demand normally keeps a

good’s price within a manageable range.

106

Yet as explained in

subsections A through C, this is not a normal market. The demand

is almost constant for healthcare services, especially for long-term

conditions, and thus buyer power is significantly weaker than in

101

. See Kesselheim et al., supra note 97.

102

. See id.

103

. Id.

104

. See id.

105

. “Prior authorization is a requirement from your insurance company to your

physician. The physician has to get specific medications (or operations) approved by the

insurance company before the insurance company will provide full (or any) coverage for

them.” Prior Authorization for Prescription Drugs: All You Need to Know, HEALTH MARKETS

(Mar. 17, 2016), https://www.healthmarkets.com/resources/health-insurance/prior-author

ization-for-prescription-drugs/.

106

. Adam Hayes, Economics Basics: Supply and Demand, INVESTOPEDIA, http://www

.investopedia.com/university/economics/economics3.asp (last visited Dec. 28, 2017).

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other normal markets. Without the buyer power to counteract the

massive patent-enhanced seller power, a balanced price equilibri-

um is near impossible.

1. In general, supply and demand in normal markets result in all-around

satisfactory prices

As demand rises, sellers can raise the price of a good without

fear of alienating buyers.

107

For example, if a substantial number

of buyers desire a Tesla sports car, producers can raise prices and

still sell plenty of cars.

108

But when a good’s price rises higher than

the buyer’s ability or desire to pay, demand drops.

109

For example,

some demand for the Tesla is lost because of its exorbitant price. On

the other hand, when demand decreases too low—like for a United

Airlines flight after a scandal—so does the price.

110

In order to

maximize profits, sellers will attempt to produce and advertise

more of the higher-priced merchandise (e.g., a Tesla car or the latest

edition iPhone) over a cheaper model because the return on

investment is much higher.

111

Together, supply and demand bal-

ance each other to reach a price equilibrium—an attractive price for

both buyers and sellers.

112

107

. See Pricing Products, LUMEN LEARNING, https://www.boundless.com/business

/textbooks/boundless-business-textbook/product-and-pricing-strategies-15/pricing-products

-96/impacts-of-supply-and-demand-on-pricing-449-1939/ (last visited Dec. 28, 2017) (“If

demand increases and supply is unchanged, then it leads to a higher equilibrium price and

higher quantity. If demand decreases and supply is unchanged, then it leads to a lower

equilibrium price and lower quantity.”).

108

. See Zachary Shahan, Tesla’s 2016 Deliveries = 76,230+ Vehicles, Production = 83,922

Vehicles, CLEAN TECHNICA (Jan. 3, 2017), https://cleantechnica.com/2017/01/03/teslas

-2016-deliveries-production/.

109

. See Irena Asmundson, Supply and Demand: Why Markets Tick, INT’L MONETARY

FUND, http://www.imf.org/external/pubs/ft/fandd/basics/suppdem.htm (last updated

July 29, 2017).

110

. Law of Supply and Demand, INVESTOPEDIA, http://www.investopedia.com/terms/l

/law-of-supply-demand.asp (last visited Dec. 28, 2017); see also Marquita Harris, United Is

Offering “Apology Fares” That Include Cheap Flights to Europe, REFINERY29 (Apr. 26, 2017,

6:00 PM), http://www.refinery29.com/2017/04/151846/united-airlines-apology-fares-cheap

-flights (“Prices have dropped significantly in less than two weeks. Those hefty discounts

include: ‘round-trip flights to Trinidad and Tobago for as little as $274 (typically $550); flights

to Paris for $433 (typically $800); and round-trip fares to Mexico City for less than $200

(typically $500),’ as noted by the site.”).

111

. See Asmundson, supra note 109 (“The higher the price, the more suppliers are

likely to produce.”).

112

. Graham supra, note 33.

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Yet without normal market forces, the pharmaceutical industry

cannot establish this price equilibrium. Without the usual access to

prices or the needed expertise to understand their needs and options,

uninformed consumers cannot make informed choices between

products. Nor are they always aware of increasing drug prices,

especially when third-party payors veil the costs.

113

Likewise, when

a rare, life-changing drug has a monopoly on the market, the

(inelastic) demand for this drug remains elevated—like that of the

latest iPhone—but without any incentive to reduce and normalize

the price for those waiting for the price reduction. In fact, per the

principles of supply and demand, drug companies will spend

billions of dollars on aggressive marketing strategies to promote

more of their high-margin prescription drugs (like the Teslas and

iPhones) and thus achieve higher profits.

114

With profits feeding

marketing expenses and further profits, and buyer power severely

diminished, price equilibrium is nearly impossible to achieve.

2. Long-term conditions ensure demand, further distorting

price equilibrium

Long-term conditions further weaken buyer power.

115

Those

with chronic health conditions, such as diabetes, congestive heart

failure, and Parkinson’s disease, depend on medications to manage

symptoms.

116

Additionally, one in twenty-five adults is living with

113

. See Ginger Skinner, To Get the Lowest Drug Prices It Pays to Shop Around, CONSUMER

REP. (Dec. 14, 2017), https://www.consumerreports.org/drug-prices/why-drug-costs-keep

-rising-what-you-can-do-about-it/.

114

. See Peterson, supra note 8 (“The companies raised prices—not to fund research to

discover new drugs—but to boost profits for executives and investors.”).

115

. David Ferguson, Most Healthcare Providers Unprepared for Longitudinal Care,

FIERCEHEALTHCARE (Dec. 2, 2015, 11:01 AM), http://www.fiercehealthcare.com/healthcare

/most-healthcare-providers-unprepared-for-longitudinal-care.

116

. See, e.g., Diabetes: Symptoms and Causes, MAYO CLINIC (July 31, 2014), http://

www.mayoclinic.org/diseases-conditions/diabetes/basics/complications/con-20033091;

Understand Heart Failure, AM. HEART ASS’N, http://www.heart.org/HEARTORG/Condi

tions/HeartFailure/Heart-Failure_UCM_002019_SubHomePage.jsp (last visited Dec. 30,

2017) (“Although it can be difficult to live with a chronic condition like heart failure, you can

learn to manage the symptoms and live a full and enjoyable life.”); Understanding Parkinson’s,

PARKINSON’S FOUND., http://www.pdf.org/about_pd (last visited Dec. 30, 2017). Wellbutrin

(an antipsychotic) and diltiazem (for heart rhythm problems) must be taken daily—

sometimes up to four times a day. Diltiazem (Oral Route), MAYO CLINIC, http://www

.mayoclinic.org/drugs-supplements/diltiazem-oral-route/proper-use/DRG-20071775

(“For oral dosage form (tablets): Adults—At first, 30 milligrams (mg) four times a day before

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a debilitating mental illness—including bipolar disorder and long-

term recurring major depression.

117

In fact, one in six Americans

takes psychiatric medication, and eight out of ten of those report

long-term use.

118

While much controversy surrounds the use of

psychotropic medications, they can often both improve symptoms

and increase the effectiveness of other treatments, like psycho-

therapy.

119

Overall, this guaranteed demand removes these con-

sumers’ ability to choose to forego the drug product, tipping the

meals and at bedtime. Your doctor may increase your dose if needed.”); Medications for

Arrhythmia, AM. HEART ASS’N, http://www.heart.org/HEARTORG/Conditions/Arrhyth

mia/PreventionTreatmentofArrhythmia/Medications-for-Arrhythmia_UCM_301990_Arti

cle.jsp#.WdlBMbpFzIU; Lisa Rapaport, Many Patients Skip Prescribed Drugs After a Heart

Attack, REUTERS (June 3, 2015), https://www.reuters.com/article/us-heart-medication/ma

ny-patients-skip-prescribed-drugs-after-a-heartattackidUSKBN0OJ2M720150603; Wellbutrin

SR, RXLIST, http://www.rxlist.com/wellbutrin-sr-drug.htm (“The usual adult target dose

for WELLBUTRIN SR is 300 mg per day, given as 150 mg twice daily.”); Lisa Rapaport, Many

Patients Skip Prescribed Drugs After MI, REUTERS (June 2, 2015), https://uk.reuters.com

/article/us-heart-medication/many-patients-skip-prescribed-drugs-after-mi-idUKKBN0OI2

KU20150602.

117

. E.g., Shaunak A. Ajinkya, Pradeep R. Jadhav & Shruti Rajamani, Which Is A More

Debilitating Disorder Schizophrenia or Dysthymia?—A Comparative Study, 9 J. CLINICAL &

DIAGNOSTIC RES. 1, 1 (2015) (“Schizophrenia and Dysthymia are debilitating disorders that

affect general health and functioning.”); Living with a Mental Health Condition, NAT’L

ALLIANCE ON MENTAL ILLNESS, https://www.nami.org/Find-Support/Living-with-a-Men

tal-Health-Condition (last visited Dec. 30, 2017) (“[A]cross the population, 1 in every 25

adults is living with a serious mental health condition such as schizophrenia, bipolar

disorder or long-term recurring major depression.”); ’Monkey Mind’: When Debilitating

Anxiety Takes Over, NPR (July 3, 2012, 1:30 PM), http://www.npr.org/2012/07/03/156

200170/monkey-mind-when-debilitating-anxiety-takes-over (“For some, anxiety can be

much more than just sweaty palms and quivering hands. It can be a debilitating condition

with severe physical and mental effects.”).

118

. Thomas J. Moore & Donald R. Mattison, Adult Utilization of Psychiatric Drugs and

Differences by Sex, Age, and Race, 177 J. AM. MED. ASS’N INTERNAL MED. 274, 274 (2017) (“[An

estimated] 11.5% of adults reported taking prescription medication for ‘problems with

emotions, nerves, or mental health’ in 2011.”); Sara G. Miller, 1 in 6 Americans Takes a Psych-

iatric Drug, SCI. AM. (Dec. 13, 2016), https://www.scientificamerican.com/article/1-in-6

-americans-takes-a-psychiatric-drug/ (“[M]ore than eight in 10 adults who were taking

psychiatric drugs reported long-term use . . . .”).

119

. Laura Weiss Roberts & Shaili Jain, Ethical Issues in Pharmacology, PSYCHIATRIC

TIMES (May 7, 2011), http://www.psychiatrictimes.com/articles/ethical-issues-psycho

pharmacology (“There are also concerns about the widespread application (some would say

overprescription) of psychotropics—a controversy that is further fueled by the fact that

nonpsychiatric providers are the source of most psychotropic prescriptions in the United

States.”); see also Mental Illness: Diagnosis & Treatment, MAYO CLINIC, http://www.mayo

clinic.org/diseases-conditions/mental-illness/basics/treatment/con-20033813 (last visited

Dec. 30, 2017) (“Although psychiatric medications don’t cure mental illness, they can often

significantly improve symptoms. Psychiatric medications can also help make other treat-

ments, such as psychotherapy, more effective.”).

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power heavily in favor of the drug producer.

120

For some, medi-

cation and other mental health services mean the difference

between holding down a steady job or complete dependence on

disability programs.

121

Interestingly, providing access to psycho-

tropic medication saves the U.S. healthcare system around $25

billion annually in reduced admissions to mental institutions.

122

The inverse has also been demonstrated. “[S]tudies have shown

that when patients’ access to psychotropic drugs is arbitrarily

restricted by insurers, patients use hospital care at a cost to those

insurers that greatly exceeds the drug cost savings they foolishly

attained.”

123

This is because regular adherence to costly medica-

tions is critical to a stable health condition and, thus, to being a

productive member of society.

124

Unlike in normal markets for

Teslas or iPhones, the poor cannot always wait for the rich to buy

enough of the prescription medication so that prices deflate

enough. Deciding to forego the latest iPhone or Tesla does not

carry the same consequences as foregoing psychiatric or heart

medication. Producers of drugs for chronic health conditions are

practically guaranteed a constant, long-term demand of a mostly

inelastic market. In fact, eighty-six percent of all healthcare

120

. See Rapaport, supra note 116 (“‘Ultimately, regardless of the reason, patient non-

adherence to medications after a heart attack has been associated with poor outcomes—these

can include repeat hospitalization, progression of their underlying disease, or even reduced

survival,’ said Mathews, a researcher at Duke University Medical Center in Durham,

North Carolina.”).

121

. Robert E. Drake, Jonathan S. Skinner, Gary R. Bond & Howard H. Goldman, Social

Security and Mental Illness: Reducing Disability with Supported Employment, 28 HEALTH AFF.

761, 761 (2009) (suggesting that providing supported employment along with “mental health

care would improve financial security” of people with serious mental illnesses and “could

even save the government money”).

122

. J.D. Kleinke, The Price of Progress: Prescription Drugs in the Health Care Market, 20

HEALTH AFF. 43, 47 (2001) (“According to a study by Lichtenberg, ‘Drug treatments have

saved the cost of keeping about 400,000 patients in mental institutions about $25 bil-

lion annually.’”).

123

. Id.

124

. See, e.g., Kimberly Holland & Valencia Higuera, The Dangers of Abruptly Stopping

Antidepressants, HEALTHLINE (Apr. 3, 2017), https://www.healthline.com/health/depression

/dangers-of-stopping-antidepressants (“Quitting without consulting your doctor can be life-

threatening.”); see also Rapaport, supra note 116 (“‘Ultimately, regardless of the reason,

patient non-adherence to medications after a heart attack has been associated with poor

outcomes—these can include repeat hospitalization, progression of their underlying disease,

or even reduced survival,’ said Mathews, a researcher at Duke University Medical Center in

Durham, North Carolina.”).

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spending is for patients with one or more chronic conditions.

125

this way, the pharmaceutical industry is unlike any other, not

subject to normal market forces and consumer pressures. In other

words, prices cannot reach equilibrium because buyers cannot

refuse to buy, leaving sellers with little reason to cut prices.

E. Summary: The Pharmaceutical Industry Cannot Be a Normal Market

Consumers are relatively powerless to rein in drug companies’

prices. Near-constant demand and little buyer power tips the

balance of power heavily in the hands of the drug companies.

Without typical market forces to provide balance, the industry

cannot achieve price equilibrium. Around the world, governments

usually step in to help manage prices from getting out of control.

126

Yet American lawmakers have imposed relatively few price

constraints on prescription drugs.

127

Instead, Americans have

chosen to depend on normal market forces and public opinion in

order to curb these prices, with only minimal impact.

128

Again,

without aspects of normal markets like quality and price trans-

parency, independent buyers dealing directly with sellers, and

monopolistic safeguards in the prescription drug market, basic

supply and demand principles operate such that drug producers

are free to set exorbitant prices.

129

Only as more consumers feel the

painful monetary losses through insurance premium hikes will this

“price gouging” garner enough public attention to effectuate

lower prices.

130

125

. DEP’T OF HEALTH & HUM. SERVICES, AGENCY FOR HEALTHCARE RES. & QUALITY,

AHRQ PUB. NO. 14-0038, MULTIPLE CHRONIC CONDITIONS CHARTBOOK 7 (2014), https://

www.ahrq.gov/sites/default/files/wysiwyg/professionals/prevention-chronic-care/deci

sion/mcc/mccchartbook.pdf (“[Eighty-six percent] of healthcare spending is for patients

with one or more chronic conditions.”).

126

. See Asmundson, supra note 109 (“As a result, governments usually regulate such

monopolies to ensure that they do not abuse their market power by setting prices too high.”).

127

. Erin Fox, How Pharma Companies Game the System to Keep Drugs Expensive, HARV.

BUS. REV. (Apr. 6, 2017), https://hbr.org/2017/04/how-pharma-companies-game-the-system

-to-keep-drugs-expensive.

128

. Jay Hancock, Everyone Wants to Reduce Drug Prices. So Why Can’t We Do It?, N.Y.

TIMES (Sept. 23, 2017), https://www.nytimes.com/2017/09/23/sunday-review/prescription

-drugs-prices.html.

129

. See Kesselheim et al., supra note 97.

130

. Is There a Cure for High Drug Prices?, CONSUMER REP., https://www.consumer

reports.org/drugs/cure-for-high-drug-prices (last updated July 29, 2016).

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With the healthcare industry hanging in the balance, this

unrestrained market has ceded significant price control to profit-

amplifying corporations in the pharmaceutical industry.

131

One

physician remarked that the prices of cancer drugs have soared so

high “that we are getting into areas that are almost unimaginable

economically.”

132

In the insurance industry, the ACA has begun to

bring insurers’ margins to a reasonable level by enforcing the health

insurance MLR regulation—with undeniable success at reducing

waste.

133

Yet the pharmaceutical industry has thus far eluded any

such value mandate, despite similarities in market abnormalities

and even starker shareholder manipulation than the insurance

industry.

134

Consequently, the abnormal market conditions, com-

bined with a lack of moderating regulations, have led to pronounc-

ed profit-taking in the pharmaceutical industry.

III. PRONOUNCED PROFIT-TAKING EXISTS

IN THE PHARMACEUTICAL INDUSTRY

Without normalizing market forces at play, pharmaceutical

companies are left unchecked to reap skyrocketing profits. As they

recoup their profits, these companies simultaneously neglect devel-

opment of some less profitable, albeit much-needed, drugs.

A. The Pharmaceutical Industry Reaps Mammoth Profits

The priority of for-profit corporations is to maximize the return

on shareholders’ investments. The landmark case of Dodge v. Ford

Motor Co. noted explicitly that a business’s primary purpose is to

amplify the “profit of the stockholders.”

135

Although more obser-

vation than a binding rule, this “shareholder primacy norm”

theory both captures and strengthens the widespread approach of

131

. See Fox, supra note 127.

132

. Gina Kolata, What Does It Cost to Create a Cancer Drug? Less Than You’d Think, N.Y.

TIMES (Sept. 11, 2017), https://www.nytimes.com/2017/09/11/health/cancer-drug-costs.html.

133

. See PRIVATE HEALTH INSURANCE, supra note 18.

134

. See, e.g., Andrew Pollack, Martin Shkreli Resigns from Turing Pharmaceuticals, N.Y.

TIMES (Dec. 18, 2015), https://www.nytimes.com/2015/12/19/business/martin-shkreli-re

signs-turing-drug-company.html.

135

. Dodge v. Ford Motor Co., 170 N.W. 668, 684 (Mich. 1919); Marshall M. Magaro,

Note, Two Birds, One Stone: Achieving Corporate Social Responsibility Through the Shareholder-

Primacy Norm, 85 IND. L.J. 1149, 1153 (2010) (discussing shareholder wealth maximization).

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pharmaceutical companies. Unlike other developed countries, the

United States grants drug companies free rein to charge “whatever

they want.”

136

Medicare isn’t even allowed to negotiate drug

prices.

137

So, unhindered by normal market forces, the pharma-

ceutical industry has magnified this Dodge charge to amplify

stockholder profit.

The major drug companies’ profits are substantial. Generally

included in the term “Big Pharma” are fifteen pharmaceutical

giants, notably Johnson & Johnson ($276 billion market value),

Novartis ($273 billion), and Roche ($248 billion).

138

They enjoy

significant yearly shareholder yields and profit margins.

139

While

the S&P 500 companies realize a median of 2% shareholder yields

(or payouts to stockholders), those of Big Pharma are well above that;

Pfizer’s shareholder yields, for example, were over 6% in 2015.

140

for average profit margins, the pharmaceutical industry was at the

top of a 2013 Forbes study, right next to the banking industry, at a

19% profit margin.

141

Five of the Big Pharma companies made profit

margins of 20% or higher.

142

In comparison, the industries with the

next-highest average profit margins were the media, 12%; oil and

136

. Deangelis, supra note 29, at 30–31 (“What has accounted for the pharmaceutical

companies’ very large profit margins? For one thing, the United States, unlike other devel-

oped countries, allows pharmaceutical companies to charge whatever they want as long as

they do not collude with one another in setting the prices. In other words, these companies

can charge whatever the market will bear. For example, Solvadi, Gilead’s hepatitis C drug,

costs $1,000 for each pill, which amounted to sales of $3.5 billion between April and June

of 2015.”).

137

. Id. at 31 (“Making matters worse, the US Congress, influenced by pharmaceutical

lobbyists, has not allowed Medicare to negotiate drug prices, as do most health care systems,

HMOs, and some insurance companies. In those countries that negotiate the prices of their

national insurance plans with Big Pharma, most drugs sell for much less. Obviously,

lobbyists for the pharmaceutical industry in the United States have been very successful.”).

138

. Compare Williams, supra note 7 (identifying market values of pharmaceutical

companies), with Dan Caplinger, How Much Is the Coca-Cola Company Worth?, MOTLEY FOOL

(Sept. 6, 2016, 12:16 PM), https://www.fool.com/investing/2016/09/06/how-much-is-the

-coca-cola-company-worth.aspx (identifying Coca-Cola’s net worth at $188–213 billion).

139

. See generally Jeremy Jones, Calculating Shareholder Yield, YOUNG RES. & PUB.,

INC. (Apr. 27, 2017), https://www.youngresearch.com/authors/jeremyjones/calculating

-shareholder-yield (showing that shareholder yields are returned capital divided by

market capitalization).

140

. Williams, supra note 7.

141

. Id.

142

. See Anderson, supra note 32 (identifying the companies as Pfizer, Hoffmann-La

Roche, AbbVie, GlaxoSmithKline, and Eli Lilly).

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gas, 8%; and car manufacturers, 6%.

143

Big Pharma’s profits are

almost twice those of the next-highest industry. This trend doesn’t

seem to be changing any time soon, considering that another Forbes

study in 2015 found the average profit margin of healthcare

technology companies was now 21%.

144

The 2015 profit margins for

Johnson & Johnson were 22%; Roche, 20%; and Novartis, 36% (when

comparing profits over sales).

145

But the company Forbes found to be

setting the pace was Gilead Sciences, with a profit margin nearly 53%

over a one-year period.

146

With margins sometimes three-fold those

of other profitable industries, it’s no wonder these companies

attract investors.

147

Maintaining these returns necessitates consistently elevating

pharmaceutical prices. Despite the recent upsurge in the proportion

of cheaper generic versions used to fill prescriptions (82% in 2016,

compared to 66% in 2010), brand versions have maintained their

roughly 78% market share of overall profits.

148

To maintain those

profits, the drug companies implemented 17% annual price hikes, at

a time when general inflation averaged 1.62%.

149

In recent years, the

news has exposed instances of price gouging and opportunistic

profit-taking. For example, Europe and Canada sold the generic

drug deflazacort, a steroid used to treat children with Duchenne

143

. See id.

144

. See supra note 7.

145

. JOHNSON & JOHNSON CO., ANNUAL REPORT (FORM 10-K) (Jan. 3, 2016); NOVARTIS,

NOVARTIS ANNUAL REPORT 2015 (2015), https://www.novartis.com/sites/www.novartis

.com/files/novartis-annual-report-2015-en.pdf (last visited Jan. 25, 2018); ROCHE GROUP,

FINANCE REPORT 2015 (2015), http://www.roche.com/dam/jcr:74af99eb-b51a-4f13-88b2

-aacaf9f53c0c/en/fb15e.pdf.

146

. See supra note 7.

147

. Hugh Dive, Investing in Biotech and Pharma, AURORA FUNDS MGMT., http://www

.aurorafunds.com.au/investing-in-biotech-and-pharma (last visited Apr. 7, 2018) (“Biotech-

nology and pharmaceuticals are probably the most seductive and exciting sectors of the

market to invest in. Not only can investors have the warm and fuzzy feeling that they are

helping humanity (an emotion not readily generated by buying shares in Westpac or BHP), but

when drugs or devices are developed and successfully adopted, it can be very profitable.”).

148

. BLUE CROSS BLUE SHIELD ASS’N, HEALTH OF AMERICA REPORT, RISING COSTS FOR

PATENTED DRUGS DRIVE GROWTH OF PHARMACEUTICAL SPENDING IN THE U.S. (May 3, 2017),

https://www.bcbs.com/sites/default/files/file-attachments/health-of-america-report/BC

BS.HealthOfAmericaReport.RisingCostsPatentedDrugs_1.pdf.

149

. Id; see also Historical Inflation Rates 1914-2018, US INFLATION CALCULATOR, http://

www.usinflationcalculator.com/inflation/historical-inflation-rates (last visited Apr. 7, 2018).

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muscular dystrophy, at a price between $1000 to $2000 per year.

150

Yet the U.S. Food and Drug Administration (FDA) has approved

Marathon Pharmaceuticals to sell the same drug in the United

States for $89,000 (a 6000% price increase) under the brand name

Emflaza.

151

Other notable examples include Turing Pharma-

ceuticals’ Daraprim ($750 per pill, as increased from $13.50), and

AMAG Pharmaceuticals’ Makena ($1500 per pill, while a different

but similar drug was sold for $20).

152

Although Turing Pharma-

ceuticals’ former CEO Martin Shkreli was recently convicted for

fraud, the conviction was for securities and conspiracy but had

nothing to do with Daraprim price hikes.

153

Altogether, there seem

to be few checks on these price hikes—especially when there are

such profits to be made!

B. Big Pharma’s Expenses Spur Their Profits

The cost of moving a drug to the profit-making stage is signi-

ficant. It takes ten to fifteen years to research and develop one

drug

154

at an average cost between $648 million to $2.65 billion.

155

Many drugs fail at various steps along the way, resulting in mil-

lions of dollars of lost funds.

156

Estimates suggest only one out of

every 5000 to 10,000 drugs makes it to clinical trials.

157

From there,

only three out of ten are profitable, and only one of these three

becomes a blockbuster drug grossing at least $1 billion per year.

158

Patents compensate for these risks and protect a company from

competition, maximizing a drug’s return. Yet over the last few

150

. Matthew Herper, Why Did That Drug Price Increase 6,000%? It’s the Law, FORBES

(Feb. 10, 2017, 1:52 PM), https://www.forbes.com/sites/matthewherper/2017/02/10/a-6000

-price-hike-should-give-drug-companies-a-disgusting-sense-of-deja-vu/#348085ca71f5.

151

. Id.

152

. See id.; see also Pollack, supra note 134.

153

. Aaron Smith, Martin Shkreli Sentenced to 7 Years in Prison for Fraud, CNN MONEY

(Mar. 9, 2018, 5:25 PM), http://money.cnn.com/2018/03/09/news/martin-shkreli-sentencing

/index.html.

154

. Paula Tironi, Pharmaceutical Pricing: A Review of Proposals to Improve Access and

Affordability of Prescription Drugs, 19 ANNALS HEALTH L. 311, 324 (2010).

155

. See Cost to Develop and Win Marketing Approval for a New Drug is $2.6 Billion, supra

note 84 (“Developing a new prescription medicine that gains marketing approval, a process

often lasting longer than a decade, is estimated to cost $2,558 million.”).

156

. See Tironi, supra note 154.

157

. Id.

158

. Anderson, supra note 32.

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years, several prominent patents have expired, allowing increased

competition and falling profits.

159

These patent expiries will cost the

industry an unprecedented $240 billion in the decade between 2010

and 2020.

160

To offset costs and maximize profits, the pharmaceutical

industry promotes sales by spending a staggering amount of

money on advertising. Nine Big Pharma companies spend sub-

stantially more on sales and marketing than on R&D (Johnson &

Johnson, Novartis, Pfizer, Sanofi, Merck, GlaxoSmithKline, Astra-

Zeneca, Eli Lilly, and AbbVie).

161

While most other industries spend

an average of 10% of revenue on marketing, these Big Pharma

companies averaged over twice that with 23% in 2013.

162

While

different business models call for varying proportions of marketing

expenditures, only the consumer packaged goods industry ap-

proaches this proportion.

163

Spending a quarter of some of the most

substantial profits in the world on marketing is significant. By com-

parison, Big Pharma R&D expenditures averaged only 16% of

revenue.

164

To note, Johnson & Johnson spent over twice as much

on marketing ($17.5 billion) as R&D ($8.2 billion).

165

It is true that it

159

. See id.

160

. Richard Anderson, Pharmaceuticals Industry Facing Fundamental Change, BBC News

(Nov. 7, 2014), http://www.bbc.com/news/business-29659537.

161

. Id.; see also Elizabeth Whitman, How the US Subsidizes Cheap Drugs for Europe, INT’L

BUS. TIMES (Sept. 24, 2015, 1:52 PM), http://www.ibtimes.com/how-us-subsidizes-cheap

-drugs-europe-2112662 (referencing Makovsky Instagram tweet indicating pharmaceutical

companies spend more on marketing than research).

162

. See Anderson, supra note 32 (featuring data from which to calculate marketing

budget as a percent of revenue: Johnson & Johnson 25%, Novartis 25%, Pfizer 22%, Roche

18%, Sanofi 20%, Merck 22%, GSK 24%, AstraZeneca 28%, Eli Lilly 25%, AbbVie 23%); Sarah

Brady, What Percent of Revenue Do Publicly Traded Companies Spend on Marketing and Sales?,

VITAL, https://vtldesign.com/digital-marketing/content-marketing-strategy/percent-of-re

venue-spent-on-marketing-sales/ (last visited Apr. 7, 2018); Christine Moorman, Who Has

the Biggest Marketing Budgets?, FORBES (Mar. 5, 2014, 11:41 AM), https://www.forbes

.com/sites/christinemoorman/2014/03/05/who-has-the-biggest-marketing-budgets/#18a

8dc6a24 (“To put these figures in perspective, The CMO Survey reports that marketing

budgets represent approximately 10.9% of overall firm budgets.”).

163

. Marketing Budgets Vary by Industry, WALL STREET J.: DELOITTE, http://deloitte

.wsj.com/cmo/2017/01/24/who-has-the-biggest-marketing-budgets.

164

. See Anderson, supra note 32 (featuring data from which to calculate R&D budget

as a percent of revenue: Johnson & Johnson 12%, Novartis 17%, Pfizer 13%, Roche 18%,

Sanofi 14%, Merck 17%, GSK 13%, AstraZeneca 17%, Eli Lilly 24%, AbbVie 15%).

165

. Id.; see also Kim T. Gordon, Defining Sales and Marketing, ENTREPRENEUR, https://

www.entrepreneur.com/article/46086 (last visited Apr. 7, 2018) (indicating sales and mar-

keting expenses can include networking activities and advertisements).

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markets and sells more than just pharmaceuticals (medical devices,

household supplies, etc.). But considering that pharmaceutical-

specific advertising has grown more than any other advertising

category in the last four years, it is reasonable to assume Johnson &

Johnson has similarly focused its advertising expenses on its phar-

maceutics.

166

Last year the pharmaceutical industry spent $6 billion

in advertisements alone, mostly via television.

167

This advertising may be not only exorbitant but also wasteful.

Notably, the United States and New Zealand are the only two

countries in the world to permit this type of product claims adver-

tising.

168

In 2015 the American Medical Association (AMA) called

for an outright ban of this direct-to-consumer advertising.

169

The

organization argued that it “inflates demand” because inquisitive

patients, armed with a brand name and a sunny testimonial, arrive

at their prescriber appointments asking why they can’t have access

to these brand drugs.

170

Yet, per the AMA, this deceptive consumer-

targeted advertising cannot correct the information asymmetries

inherent in the physician-patient relationship. As discussed in

section II.A.1, patients still lack the extensive medical training that

guides physicians’ prescription decisions. A quick television ad-

vertisement with “glossed-over” side effects cannot effectively

educate patients enough about price, quality, or alternative options

to make them truly informed consumers.

171

Yet those prescribers

who do have the requisite education often feel pressured to pre-

scribe the higher-priced drugs to please these patients, irrespective

of true need.

172

Thus, they prescribe more of these medications than

is necessary. By providing just enough information to slightly offset

166

. Bruce Horovitz & Julie Appleby, Prescription Drug Costs Are on the Rise; So Are

the TV Ads Promoting Them, KAISER HEALTH NEWS (Mar. 20, 2017), http://khn.org/news

/prescription-drug-costs-are-on-the-rise-so-are-the-tv-ads-promoting-them; INT’L TRADE

ADMIN., 2016 TOP MARKETS REPORT: MEDICAL DEVICES 2 (2016), http://www.trade.gov

/topmarkets/pdf/Medical_Devices_Executive_Summary.pdf (“The major U.S. medical

device companies include . . . Johnson & Johnson.”).

167

. Horovitz & Appleby, supra note 166.

168

. C. Lee Ventola, Direct-to-Consumer Pharmaceutical Advertising: Therapeutic or Toxic?,

36 PHARMACY & THERAPEUTICS 669, 669 (2011).

169

. Horovitz & Appleby, supra note 166.

170

. Id.

171

. Id.

172

. Id.

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these information asymmetries, the advertising confuses the pre-

scriber’s role in the patient-consumer’s decision. In the end, there is

little evidence to show that direct-to-consumer marketing provides

any real benefit to the patient.

173

In all fairness, the required R&D expenditures are substantial in

this industry and provide many jobs that help the economy.

However, it is clear that Big Pharma’s investing in advertising and

promotion of the most expensive brand name drugs ultimately

drives up pharmaceutical sales and, thus, profits for the stock-

holders.

174

And there may not be as many benefits to this adver-

tising as the drug industry would like to claim.

C. High Prices and Low Returns Lead to Inaccessibility Problems

The skewed drug market often renders much-needed drugs

inaccessible. A 2010 article reports that twenty-nine percent of

adults reported neglecting to fill a prescription in the last two years

due to its impractical price.

175

Twenty-three percent reported

cutting pills in half or skipping doses so their medications would

last longer.

176

This type of behavior increased the rate of hos-

pitalizations and ER visits.

177

The prohibitive prices frustrate the

most cost-efficient care and result in wasted resources and unsafe

physical conditions.

At the same time, development of much-needed drugs is

ignored. Drug companies lack the incentives to spend resources

developing products that, while unprofitable, would treat neglected

conditions (Chagas disease, filarial disease, leishmaniasis, etc.)—

173

. See S. Gilbody, P. Wilson & I. Watt, Benefits and Harms of Direct-to-Consumer

Advertising: A Systematic Review, 14 QUALITY & SAFETY HEALTH CARE 246, 246 (2005) (“Direct

to consumer advertising is associated with increased prescription of advertised products and

there is substantial impact on patients’ request for specific drugs and physicians’ confidence

in prescribing. No additional benefits in terms of health outcomes were demonstrated.”).

174

. Id.

175

. Tironi, supra note 154, at 317; see also Turner, supra note 56 (Kaiser Family

Foundation reports this number at 8% from 2004 to 2014); see also Cynthia Cox & Bradley

Sawyer, How Does Cost Affect Access to Care?, PETERSON-KAISER HEALTH SYS. TRACKER (Jan.

17, 2018), https://www.healthsystemtracker.org/chart-collection/cost-affect-access-care (re-

porting that in 2016 nineteen percent of adults in worse health decided to delay or forego

filling prescription drugs).

176

. Tironi, supra note 154, at 317.

177

. See id. at 322.

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both in the developing world and in the United States.

178

The devel-

opment of cures for any one of these diseases would not provide

the “blockbuster” dividend payouts that have become the specialty

of this industry.

179

And public pressure to address these health

conditions is, alone, insufficient to override the entrenched profit-

maximizing mindset.

180

Consequently, drug companies have few

incentives to dedicate the funds needed for this R&D, leaving these

drugs undeveloped and the related health conditions untreated.

181

In summary, without the normal, steadying free-market forces

in place, the mandate to maximize wealth leads to unfettered price

increases and mammoth profit-taking. While R&D expenses are

admittedly substantial, they do not justify the excessive profits

taken or marketing expenditures spent by drug companies.

182

Ultimately, desperately needed drugs become impossibly expen-

sive or otherwise inaccessible. Some form of regulation is needed

to manage the out-of-control gains and drug inaccessibility.

IV. PROPOSAL: APPLY A MODIFIED MLR REGULATION

TO THE PHARMACEUTICAL INDUSTRY

To help right this abnormal market and curb unnecessary price

increases, the government should enact a value-focused pharma-

ceutical MLR regulation—patterned after the health insurance

MLR regulation. As explained in Part I, this regulation requires

insurers to rebate funds if they spend less than the designated

amount on value-enhancing activities, such as medical care.

If this regulation were to be applied to the pharmaceutical

industry, many of the same effects that have already been observed

in the insurance industry would also be observed here. First, it

would help right the abnormal market. Admittedly, this regulation

alone would not fix the information and control asymmetries in this

market, nor render transparent pricing more practical in every

situation. Neither would it turn the highly inelastic market more

elastic (by more closely linking demand to price). However, it

178

. See Anderson, supra note 160. See generally DRUGS FOR NEGLECTED DISEASES

INITIATIVE, https://www.dndi.org/ (last visited Apr. 7, 2018).

179

. See Anderson, supra note 29.

180

. See id.

181

. See id.

182

. See Kolata, supra note 132.

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would likely improve transparency by compelling disclosure of the

aggregate amount spent in certain cost categories to demonstrate

compliance with the imposed ratio. And even if transparency is not

improved, this regulation would fill the role usually played by

price transparency in normal markets by providing a counter-

weight to the drug companies’ selling power by limiting their

potential profits and, thus, their prices. Even if elasticity—the link

between price and demand—is not improved, prices would be

constrained by this normalizing force (instead of rising unre-

strainedly). Big Pharma would no longer charge “whatever they

want.” If Big Pharma did not reduce prices themselves to keep their

profits below the threshold, they would be compelled to rebate

the excess.

Second, this regulation would also address some of the chal-

lenges posed by the third-party insurer. Even though consumers

would still be shielded from the true costs of healthcare, the

regulation would put some limitation on sellers from implement-

ing unchecked price hikes simply to maximize their own profits. In

this way, insurance companies could still play a continuous role

in mitigating the financial losses felt by any one individual, includ-

ing those least able to pay, while also reducing the tension be-

tween supplier and buyer power so that it would not be as skewed

toward suppliers.

Third, this regulation could relieve some of the monopolistic

features of this industry. Patents could still provide some insurance

against the financial risk of research and development, but the

financial returns from the patents would have some type of a check.

Prices and profits could even normalize. Furthermore, this regu-

lation might accomplish the goals of proposed government price

negotiations by, again, restraining seller power and checking

prices. The overall effect would be to improve the balance between

supplier and buyer power, thereby establishing price equilibrium.

While this market may never achieve normalcy, this measure could

correct it substantially.

Similar to the health insurance industry, MLR regulation would

provide some check on unlimited, exorbitant profits—currently an

impossible feat considering the heavy-handed seller power. Even-

tually, Big Pharma might stop placing so much emphasis on

unneeded expenditures, like wasteful advertising, since it wouldn’t

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be allowed to keep more than a certain percentage of the returns.

Also, similar to the health insurance industry, this regulation

would incentivize players to invest in value-promoting research

and development, and other improvements; it would also refine

efficiencies in less value-adding areas, like pharmacy benefit mana-

ger costs and profits. And finally, like in the insurance industry,

MLR regulation has the potential to cut billions of dollars in

American healthcare costs, potentially even shifting some of the

cost burden away from American taxpayers.

The adopted pharmaceutical ratio could mirror the health

insurance’s 80:20 ratio (80% medical loss and 20% other). But as

discussed above, expenditure ratios within the pharmaceutical

industry are dissimilar to any other industry (17% R&D, 23% sales

and marketing (S&M), 30% manufacturing, and 21% profits).

183

Expecting a blanket 80:20 ratio in the drug industry therefore seems

unreasonable, if not drastic. Again, the purpose of the MLR regula-

tion is not to impinge on financial viability but to impose guardrails

around expenditures to ensure a certain level of value for the

consumer. Erecting these guardrails requires designating each cost

category as either value-contributing or lesser-value-contributing;

analogizable to separating out the fat (or “other”) from the meat (or

medical loss). Under the ACA’s regulation, the insurance compa-

ny’s value-contributing expenditures—denoted as medical loss—

include medical claims, quality improvement activities, taxes, and

licensing fees.

184

Profits, administrative fees, marketing, agent

commissions, and community benefit expenditures constitute the

lesser-value-contributing, or “other,” category.

185

183

. See Deangelis, supra note 29, at 30 (“In 2013 the profit margin for pharmaceutical

companies ranged from 10% to 42%, with an average of 18%. Pfizer was at the top of the

profit list, and 4 other companies (Hoffman-La Roche, AbbVie, GlaxoSmithKline, and Eli

Lilly) had profit margins of more than 20%. As a point of reference, the profit margin of

pharmaceutical companies was essentially the same as that of banks, but the banks’ range of

profit was lower, from 5% to 29%.”); Adams, supra note 30 (“On average last year, the top 10

Big Pharmas spent just over 17% of their top line on research, with GlaxoSmithKline spend-

ing the second least in percentage terms at 12.9%, and the least in absolute numbers at £3.62

billion ($4.49 billion).”); Williams, supra note 7 (explaining pharmaceutical companies had

average profit margins of 19%).

184

. See Explaining Health Care Reform: Medical Loss Ratio (MLR), supra note 26.

185

. See PRIVATE HEALTH INSURANCE, supra note 18, at 4–5; Medical Loss Ratio,

HEALTHCARE.GOV, https://www.healthcare.gov/glossary/medical-loss-ratio-MLR/ (last

visited Apr. 7, 2018).

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In order to implement a similar regulation in the pharma-

ceutical industry, this industry’s major cost categories should be

evaluated for their value contribution, the inherent incentives

already at play, and the effect of this regulation on these incentives.

The rest of Part IV will examine each of the pharmaceutical

companies’ major cost categories for current incentives to limit or

increase expenditures. Each section will conclude with a recom-

mendation regarding which side of the ratio (medical loss or

“other”) to assign each cost category. Ultimately, this Note recom-

mends a 40:60 ratio for the pharmaceutical industry.

A. Profits Are “Other”

The pharmaceutical industry’s substantial profits can comfort-

ably be assigned to the “other” category.

186

Importantly, this does

not mean that drug companies should be bereft of profits. Profits

and incentives play an important role in the economy. The MLR

regulation simply puts guidelines around expenses to avoid unfair

extremes in profits and other administrative costs while requiring

value for consumers’ ever-increasing healthcare dollars.

187

Value

returned to the consumer is the ultimate line between medical loss

and other expenses.

188

Corporate profits provide relatively less, if

any, value to the consumer; consequently, they fall on the “other”

side of the MLR ratio.

B. Manufacturing and Distribution Are “Other”

Manufacturing and distribution costs, at times between 27% to

30% of Big Pharma’s revenue, make up the bulk of the value, or

“medical loss,” that is provided to drug consumers.

189

The drugs

that are manufactured and distributed to consumers save lives, ease

suffering, and improve health. Considering that this constitutes the

186

. See supra Part III.

187

. “The 80/20 rule is ensuring that insurance companies provide consumers value

for their premium dollars.” The 80/20 Rule: Providing Value and Rebates to Millions of Customers,

CTRS. FOR MEDICARE & MEDICAID SERVS., https://www.cms.gov/CCIIO/Resources/Forms

-Reports-and-Other-Resources/mlr-rebates06212012a.html (last visited Apr. 7, 2018).

188

. See id.

189

. KIRCHHOFF, supra note 29; Basu et al., supra note 29, at 30 (“In the pharmaceutical

industry, costs attributed to manufacturing are a major part of a company’s total expenses.”).

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major value that Big Pharma provides, it might naturally fall on the

“medical loss” side of the ratio, similar to the insurance companies’

medical claims expense category. But this comparison is mostly

surface-level. Health insurance companies are mainly responsible

for the financial coverage of medical expenses—essentially a

transfer of funds.

190

But they are not involved in the actual delivery

of the medical care. In contrast, pharmaceutical companies are

responsible for the payment and the actual manufacturing and

distribution of the drugs themselves. Considering that there are

significantly more steps along the pharmaceutical supply chain

than for the payout of medical claims, and that drug companies

control more aspects of these expenses than do insurance

companies, these costs are more susceptible to potential abuse.

191

And because the “medical loss” side determines the amount of

profits a Big Pharma company could keep, assigning manufactur-

ing and distribution expenses to the “medical loss” side would

incentivize Big Pharma to inflate each step they controlled so as to

be able to keep additional profits.

In order to determine whether pharmaceutical manufacturing

and distribution costs should be considered “medical loss” or

“other,” this subsection will analyze (1) the significant control that

the drug industry has over this cost category, (2) the potential for

abuse of this power and the result of misaligning the incentives by

assigning manufacturing costs to the “medical loss” side of the

MLR ratio, and (3) possible solutions to correct this misalignment.

Analyzing these factors highlights the differences between the

insurance industry’s medical claims payouts and Big Pharma’s

manufacturing and distribution costs. The differences in control

and thus the potential for abuse of this cost category indicate that

manufacturing and distribution expenses should not be grouped

on the medical loss side of the ratio, since this could inflate that side

of the ratio and by extension inflate the “other” side of the ratio,

including profits. The analysis will conclude that this industry’s

190

. What Is Health Insurance?, MED. NEWS TODAY, https://www.medicalnewstoday

.com/info/health-insurance (last updated Jan. 5, 2016).

191

. Allen Jacques, 2017 Trends & Transformations in the Pharma Supply Chain, PHARMA-

CEUTICAL PROCESSING (Dec. 29, 2016, 8:30 AM), https://www.pharmpro.com/article/2016

/12/2017-trends-transformations-pharma-supply-chain (“The pharmaceutical supply chain

is one of the most complex supply chains in the world.”).

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manufacturing and distribution costs should be categorized as

“other” to maintain the incentive to not inflate these costs in order

to keep more profits, but instead, run these processes efficiently.

1. Big Pharma exercises significant control over manufacturing and

distribution costs

Supply chains in the pharmaceutical industry are some of the

most complex in the world.

192

For instance, drug production can

start overseas with ingredients arriving from various locations.

193

For drugs entering the United States, the facilities and procedures

must meet the strict standards of both U.S. and international

regulators.

194

In addition to regulatory complexity, the physical

process of getting drugs to consumers is itself no small feat. Once a

drug is manufactured, it is transported to numerous countries;

stored in warehouses; processed by distributors; and delivered to

retailers, hospitals, pharmacies, clinics, and so on until it eventually

arrives in the hands of the consumer.

195

These supply chains are fur-

ther complicated by sophisticated international contracts, intricate

distribution channels, business-to-business price negotiations, im-

portation tariffs, labor regulations, equipment maintenance, phar-

macy benefit managers, etc.

196

There are many ways that Big

Pharma could manipulate their expenses so as to inflate their costs

and thus inflate the profit side of the ratio.

Although, emphasizing the pharmaceutical industry’s logistical

challenges is not meant to oversimplify the insurance industry.

192

. Id.

193

. See Basu et al., supra note 29, at 30–31.

194

. Mike Benson, Pharmaceutical Industry Regulations, MKT. REALIST (Jan. 22, 2015,

11:06 AM), http://marketrealist.com/2015/01/pharmaceutical-industry-regulations.

195

. Id.; see also THE HENRY J. KAISER FAM. FOUND., FOLLOW THE PILL: UNDERSTANDING

THE U.S. COMMERCIAL PHARMACEUTICAL SUPPLY CHAIN (2005), http://avalere.com/research

/docs/Follow_the_Pill.pdf.

196

. IMS INST. FOR HEALTHCARE INFORMATICS, UNDERSTANDING THE PHARMACEUTICAL

VALUE CHAIN (2014), https://www.scribd.com/document/271050319/Understanding-Phar

maceutical-Value-Chain-pdf; Elaine M. Whittington, Types of Contracts, INST. FOR SUPPLY

MGMT. (1994), https://www.instituteforsupplymanagement.org/pubs/Proceedings/conf

proceedingsdetail.cfm?ItemNumber=5238&SSO=1; see Drafting Commercial Contracts for the

Pharmaceutical Industry, FALCONBURY, https://falconbury.co.uk/product/details/234/draft

ing-commercial-contracts-for-the-pharmaceutical-industry (last visited Apr. 7, 2018) (“In such

a highly regulated industry, understanding the key challenges of negotiation and drafting

an effective and watertight contract on an international level is a complex topic.”).

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Insurers’ hospital reimbursements are based predominantly on per

diem amounts or fee-for-service schedules, which must be nego-

tiated annually between each hospital and insurer with their indi-

vidual bargaining powers.

197

Furthermore, insurance actuaries

must navigate market regulation and draw on historical experience

when developing rates.

198

Insurance is complex to be sure.

However, the ability to inflate this expense category is different

in the pharmaceutical industry. While an insurer may dictate which

hospital or doctor is available to its enrollees, the insurer is not

on the hospitals’ administration team negotiating supply contracts,

running the nursing units, or managing doctors. Insurers are a

step removed from the management decision process.

199

Drug

companies, however, exert significantly more control over their

major expenses. They directly oversee most of their products—

from negotiating research and development contracts, to running

manufacturing plants.

200

Phrases like “integrate out global opera-

tions” or “reduce manufacturing costs” make good business sense

to the pharmaceutical industry but sound out of place when

applied to the insurance industry’s control over hospitals or

pharmacies.

201

Insurance companies do not develop restructuring

plans for clinics or merge unprofitable hospitals. The differences in

each industry’s ability to control the largest portion of its costs has

critical ramifications—and deserves thoughtful consideration. Ulti-

mately, this area is much more susceptible to abuse than the

regulated insurance claims payouts.

197

. Uwe E. Reinhardt, How Do Hospitals Get Paid? A Primer, N.Y. TIMES (Jan. 23, 2009,

6:40 AM), https://economix.blogs.nytimes.com/2009/01/23/how-do-hospitals-get-paid

-a-primer.

198

. Kurt Wrobel, Opinion, On Individual Health Insurance Reform, Actuarial Details

Matter, FORBES (Jan. 24, 2017, 12:19 PM), https://www.forbes.com/sites/realspin/2017/01

/24/on-individual-health-insurance-reform-actuarial-details-matter/#1945846e62b1.

199

. Sandhya Somashekhar & Ariana Eunjung Cha, Insurers Restricting Choice of Doctors

and Hospitals to Keep Costs Down, WASH. POST (Nov. 20, 2013), http://wapo.st/17rq8bF?tid=

ss_mail&utm_term=.8d7e47dbc3a7 (“[I]nsurers are restricting their choice of doctors and

hospitals in order to keep costs low, and . . . many of the plans exclude top-rated hospitals. . . .

In most cases, the decision was about the cost of care.”).

200

. Merck Closing 8 Plants, 8 Research Sites, CBS NEWS (July 8, 2010, 9:10 AM), https://

www.cbsnews.com/news/merck-closing-8-plants-8-research-sites.

201

. Id.

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2. Manufacturing and distribution costs are susceptible to abuse by Big

Pharma, and thus, these costs would benefit from being grouped in the

“other”category

Because Big Pharma controls so much of the manufacturing and

distribution expenses, there is much more room for abuse. As such,

this cost category should be on the same side of the ratio as the

profits (the “other” side). This way, these expenses would cut into

the profit allowance, as they do now. If these expenses were on the

“other” side, the incentive would continue to be to run an efficient

supply chain, thus minimizing expenditures instead of building

them up.

202

Currently, companies cut manufacturing expenditures

because it saves them money.

203

Profit maximization—and few

other strong forces—usually impose maximum limits on labor

costs, ingredients, or other manufacturing expenses.

204

Therefore, it

is possible that assigning this category to the medical loss side of

the ratio would eliminate the only incentive to run an efficient

supply chain.

Assigning manufacturing and distribution expenses to the

medical loss side will, in fact, weaken or remove the companies’

incentive to minimize these expenses. Again, the MLR regulation

would require a company to limit its profits and “other” expenses

to a certain ratio based on the “medical loss.” If the “other”

expenses, including profits, exceeded an amount that was pro-

portionate to the “medical loss” or value provided to the consumer,

then the company would be required to refund the excess back to

the consumer. Therefore, a Big Pharma CEO seeking to increase her

allowable profits could simply increase her medical loss side, such

as workers’ salaries or the amount of ingredients purchased. That

way, as the value (“medical loss”) side of the ratio grows, so does

the lesser-value (“other”) side, including profits. And considering

202

. Tuan Nguyen, 6 Ways to Get Smart and Cut Manufacturing Costs, MANUFACTURING

TRANSFORMATION (Jan. 21, 2014), http://www.apriso.com/blog/2014/01/6-ways-to-get

-smart-and-cut-manufacturing-costs (suggesting that manufacturing intelligence solutions

“can help executives better manage their manufacturing assets in a way that meets customer

demand and might actually also help a company to save some money”).

203

. See Merck Closing 8 Plants, 8 Research Sites, supra note 200 (“Those cuts are intended

to save the Whitehouse Station, N.J., company about $3.5 billion a year starting in 2012.

Merck said Thursday the restructuring plans announced so far will bring savings of about

$2.7 billion to $3.1 billion in 2012, most of its target.”).

204

. See Nguyen, supra note 202.

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all the control that drug companies have over distribution, and all

the middlemen and contracts in this supply chain, there is ample

opportunity to drive manufacturing and distribution costs up—an

opportunity largely unavailable to health insurers whose medical

claims payouts are heavily regulated. This heavy claim regulation

limits what hospitals and doctors can collect and, therefore, limits

the medical claims paid out by insurance companies, which there-

fore limits the insurance companies’ eligible profits. However,

there is little regulation to limit what drug companies can pay out

for the ingredients or labor required to manufacture and distribute

medication. And if drug companies voluntarily shrink their manu-

facturing and distribution costs, they also shrink their allowable

profits. Thus, by assigning this cost category to the “medical loss”

side, pharmaceutical companies would lose the incentive to run

factories and supply chains efficiently.

The reality of this problem is readily illustrated by analogy to

the current U.S. healthcare spending crisis, which was caused in

large part by the way hospitals were historically paid: the cost-plus

payment model.

205

The cost-plus payment structure reimbursed

hospitals for the cost of care they provided plus a certain percentage

on top.

206

As a result, by 1980 hospitals had lost the incentive to

minimize costs.

207

Hospital management groups, looking to earn

bigger profits, manipulated reimbursements by simply inflating

their expenditures.

208

Drug companies could easily make parallel

moves if such a system were adopted. For instance, if manufac-

turing and distribution costs are counted as medical loss, then

wasting batches of medications and charging excessive fees by

205

. Elizabeth Teisberg, Michael E. Porter & Gregory B. Brown, Making Competition

Work in Healthcare, HARV. BUS. REV. (July–Aug. 1994), https://hbr.org/1994/07/making

-competition-in-health-care-work (“Beginning in the post-World War II period, hospitals were

reimbursed on a cost-plus basis, which in turn produced rapidly escalating hospital costs.”).

206

. RICHARD E. MCDERMOTT & KEVIN D. STOCKS, CODE BLUE 61 (3d ed. 2002) (“Before

1984, most insurance plans paid hospitals their billed charges less a nominal discount.

Medicare and many Medicaid plans paid cost-plus. Hospitals were reimbursed actual costs,

plus a markup for profit.”).

207

. LINDA GORMAN, THE HISTORY OF HEALTH CARE COSTS AND HEALTH INSURANCE 9

(2006), https://www.westandfirm.org/docs/Gorman-01.pdf (“The three reimbursement

methods used by the [Blue Cross Organizations] did not create normal business incentives.

They assumed that all hospital costs should be paid whether or not they were generated by

an inefficient organization. For the nonprofit [Blue Cross Organizations], a reduction in costs

reduced the amount of revenue collected.”).

208

. See id.

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pharmacy benefit management companies could become real

investment strategies for the pharmaceutical industry—especially

if such budget increases could justify expansion of the marketing

budget to sell more drugs and make more profits.

However, the analogy to the cost-plus payment model is imper-

fect, and any problems created by categorizing manufacturing and

distribution costs as medical loss may be offset by potential

benefits. Indeed, creating incentives to inflate costs might result in

pharmaceutical cost-increasing measures that are actually pro-

competitive. Hypothetically, drug production could immigrate to

more expensive areas like the United States, resulting in job

creation and economic stimulation. If this MLR regulation ends up

mirroring the cost-plus payment model by placing this cost

category on the “medical loss” side and thus flipping the current

incentive to cut costs and maximize profits, it would drive up

manufacturing costs—in effect robbing the consumer of the very

value the MLR regulation tries to ensure.

One of the biggest differences between enacting an MLR

regulation and the cost-plus payment model is that, unlike the

blank check of “plus” returns that the government promised

hospitals, pharmaceutical companies would not be guaranteed a

“plus” or margin. In other words, they would not get a guaranteed

check for every expense; rather, this MLR regulation proposal

guarantees only that drug companies could keep a limited amount

of their profits that they have garnered themselves, in proportion

with their medical loss expenses. Consequently, pharmaceutical

companies would still have to organize their expenses to remain

financially solvent. Similarly, health insurers under the MLR

regulation have not received a blank check for all their expenses.

Like the health insurers who fled the “money-losing” individual

marketplace for more profitable services, Big Pharma would likely

shed any money-draining manufacturing and distribution pro-

cesses in favor of the ones that can turn a profit.

209

They would

never choose to spend so much in manufacturing and distribution

that they would lose money overall. But at the same time, these

companies could still spend a little extra on one supply contract,

pay their distributors a little more in one area, and everything

209

. See Sommer, supra note 23.

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would add up to increase their expenses (and thus their allowable

profits) without draining their coffers. Again, drug companies exert

much more control over this expense category, and there is ample

room to drive up costs enough to balloon their profits right where

they want them.

In sum, the decision of which side to assign manufacturing and

distribution costs comes down to how much power drug compa-

nies have over their costs and reimbursement rates and, therefore,

the potential for abuse. The drug companies’ control over costs de-

serves additional study. Although, given reported 17% annual

price hikes, it seems drug companies exert at least some significant

control over their reimbursements. But outside forces also play a

role in influencing rates. Exactly what the balance is between all

these forces remains to be determined, but it is clear that Big

Pharma has significant control over this cost category, and any new

incentives should limit the probable abuse. Regardless, categor-

izing manufacturing and distribution expenses as “medical loss”

does nothing to reduce the country’s overall healthcare costs—a

main goal of this proposal.

3. Alternative options to align incentives

If manufacturing and distribution costs are categorized as

medical loss, other regulatory measures could help to keep drug

prices within a manageable range. That is, some value-enhancing

measures could limit the drug companies’ ability to increase

manufacturing costs for the sole purpose of growing the medical

loss side of the equation and, by extension, profit eligibility.

Clearly, infusing price transparency and other free market forces

into this industry to manage drug prices should be a priority. But

for the reasons enumerated above, this is not always possible.

210

Incentivizing reduction of manufacturing and distributions costs

would help correct the market where price transparency and other

normal market forces could not be achieved.

210

. See supra Section II.A.2.

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Price regulation is one proven method of controlling costs.

211

This type of regulation could prevent the unnecessary ratcheting

up of manufacturing and supply-chain costs. Moreover, if an MLR

regulation were enacted, it is likely that companies would be less

inclined to fight against such price controls since profits would be

more constricted regardless. Price controls or other guidelines sur-

rounding production expenses could allow manufacturing and

distribution costs to stay on the medical loss side of the ratio while

still ensuring value. And evidence suggests that a reduction in

production costs will increase expenses in R&D—a potential

double win.

212

There are, however, potential issues with adopting traditional

price controls. These include (1) pushing prices so far below nat-

ural levels that talent and investor capital leave the market, (2) the

inability of fixed prices to respond to changes in markets or costs,

(3) the risk that lengthy political discussions or formulas adjusted

per the bias of an agency would cause implementation delays of the

set prices, (4) possible excess supply or demand that the market

itself cannot correct, and (5) perverse incentives such as quality

reduction by those looking to cut costs.

213

Given these issues,

traditional price controls are probably not the answer to preventing

abuse in the manufacturing cost category.

Alternative options could counteract some of these cost-raising

incentives. One option is to borrow again from the ACA’s MLR

regulation and mandate public reporting of cost hikes of ten

percent or more in this category.

214

Setting a cap for these hikes is

211

. France has seen the growth in its medication costs slow (2.1% in 2008, 2% in 2009,

1.1% in 2010) due to reduced reimbursements and regulated price reductions. Annie Fenina

et al., Les Comptes Nationaux de la Santé en 2010, ÉTUDES ET RESULTATS, Sept. 2011, at 1,

http://drees.social-sante.gouv.fr/IMG/pdf/er773-2.pdf.

212

. See Basu et al., supra note 29.

213

. Fiona M. Scott Morton, The Problems of Price Controls, 24 REGULATION 50, 50–

51 (2001).

214

. See PRIVATE HEALTH INSURANCE, supra note 18 (indicating an insurance carrier

must publicly explain premium rate increases at rates of 10% or more through rate review);

Fighting Unreasonable Health Insurance Premium Increases, CTRS. FOR MEDICAID & MEDICARE

SERVS., https://www.cms.gov/CCIIO/Resources/Fact-Sheets-and-FAQs/ratereview05192

011 a.html (last visited Apr. 7, 2018) (“Under the final regulation: Starting September 1, 2011,

insurers seeking rate increases of 10 percent or more for non-grandfathered plans in the

individual and small group markets are required to publicly disclose the proposed increases

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another option. Alternatively, government oversight could be in-

creased to ensure fair valuation. Capping aggregated reimburse-

ments (think capitated payments) would mean that intentional

waste (e.g., batches of faulty medicine, unnecessary contract raises)

would still cut into a pharmaceutical company’s profits and hope-

fully minimize this unwanted behavior. It is also possible that

competing players could provide the needed competition to keep

pharmaceutical manufacturers running lean, such as Intermoun-

tain Healthcare’s upcoming nonprofit generic drug company.

215

Yet

it is unlikely that even this type of competition would help reduce

prices of patented, brand-name drugs.

216

Moving manufacturing and distribution expenses to the

“other” side of the MLR ratio might be the best way to incentivize

reducing waste. If manufacturing were to be lumped with “other”

expenses, then those costs would cut into profits—and Big

Pharma’s incentives would be aligned with reducing waste—just

like they do currently. Big Pharma CEOs would squeeze everything

on that side of the ratio to expand the profits section as much as

possible. It would encourage efficiency in manufacturing, as do

current market forces. This would also eliminate much of the

arbitrariness associated with traditional price controls while still

restricting prices to accentuate value. Instead of depending on price

regulation based on lagging or even random data, prices could

fluctuate naturally with expenses and innovation while still leaving

a reasonable profit margin. Logically, the “other” section should be

expanded to include manufacturing expenses.

4. Manufacturing and distribution expenses should be classified

as “other”

Manufacturing and distribution expenses should be on the

“other” side of the Medical Loss Ratio. Admittedly, this category

and the justification for them. Such increases will be reviewed by either State or Federal

experts to determine whether they are unreasonable.”).

215

. Reed Abelson & Katie Thomas, Fed Up with Drug Companies, Hospitals Decide to

Start Their Own, N.Y. TIMES (Jan. 18, 2018), https://www.nytimes.com/2018/01/18/health

/drug-prices-hospitals.html.

216

. Beth Jones Sanborn, Intermountain-Led Generic Drug Venture Faces Big Hurdles,

Could Forge New Regulatory and Political Ground, HEALTHCARE FINANCE (Mar. 15, 2018),

http://www.healthcarefinancenews.com/news/intermountain-led-generic-drug-venture

-faces-big-hurdles-could-forge-new-regulatory-and.

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provides value to the consumer in that this category actually

produces and delivers the life-changing or life-enhancing drugs to

the consumer. And the costs are substantial—like insurance

payouts. But assigning manufacturing and distribution expenses to

the “other” side would be the best insurance against abuse and

provide the most value to the consumer. Furthermore, like the

health insurance industry, Big Pharma does not have a guaranteed

“cost-plus” profit in proportion to manufacturing expenditures.

The reimbursements would not be automatic the way they were for

hospitals under the cost-plus payment model. As a final note, when

calculating the rebates, it will be important to exclude any

manufacturing expenses from Big Pharma’s non-pharmaceutical

areas (household goods, information management arms, etc.) from

the manufacturing and distribution directly related to drugs. In

conclusion, the manufacturing and distribution category is

valuable medical loss. Yet, given the incentives that would result if

this were assigned to the “medical loss” side of the ratio, more

value is preserved if this category is assigned to the “other” side of

the ratio. Further inquiry and careful analysis in this area are

strongly urged.

C. Lawsuits Are “Medical Loss”

Under the insurance MLR regulation, the medical loss side is

adjusted by certain funds set aside as reserves.

217

One allotment of

reserve money is specifically for potential future lawsuits.

218

These

funds are counted as part of the medical loss, per the National Asso-

ciation of Insurance Commissioners’ (NAIC) and Department of

Health and Human Services’ (HHS) recommendations.

219

Although

this “value” designation could incentivize Big Pharma to open

themselves up for lawsuits, lawsuit reserves should be allocated to

the medical loss side, given the realities of this industry and

pending different recommendations from HHS.

217

. See KIRCHHOFF, supra note 29.

218

. See id.

219

. See id.

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D. Research and Development Is “Medical Loss”

Drug companies’ constant refrain is, essentially, “only an attrac-

tive return on investment will entice the capital necessary to fund

world-changing breakthroughs.”

220

Indeed, capital is funneled into

the drug industry, at least in part, because of the substantial

financial returns.

221

And to be sure, pharmaceutical breakthroughs

are medical loss. Developments in this area mean people live longer

and healthier lives, sometimes with fewer medical costs.

222

In fact,

the resulting discoveries from all that American capital differ-

entiate this country’s drug innovation from that of others.

223

American pharmaceutical innovation is second to none. If R&D

were further incentivized under an MLR regulation, Big Pharma

might even turn additional attention to unprofitable, but badly

needed, neglected drugs. Thus, promoting the value inherent in

this category is vital.

Yet theoretically, there is still room for abuse. Drug companies

could certainly throw money into research for the sake of increasing

this side of the ratio without any real advancements. Currently,

annual projected Big Pharma R&D returns on investment are down

220

. See Lydia Ramsey, Pharma Companies’ No. 1 Justification for High Drug Prices Is

Bogus, BUS. INSIDER (Dec. 9, 2015, 12:53 PM), http://www.businessinsider.com/research

-and-development-costs-might-not-factor-into-drug-pricing-2015-12 (“Pharmaceutical com-

panies often cite the cost of researching and developing new compounds as the reason for

their high drug prices.”); Williams, supra note 7.

221

. See Williams, supra note 7.

222

. The Value of Medical Innovation: An Overview, HEALTHCARE INST. N.J. (last updated

Aug. 29, 2017), http://hinj.org/value-of-medical-innovation (“Globally, between 1960 and

1997, new therapies accounted for 45 percent of the increase in life expectancy in 30

developing and high-income countries. . . . New therapies have contributed to a nearly

22 percent decline in cancer deaths since the 1990s. U.S. cancer survivorship alone has more

than tripled since 1970, with nearly 14.5 million cancer survivors alive in the country last

year. . . . The HIV/AIDS death rate has dropped nearly 85 percent since the introduction of

highly active antiretroviral treatment (HAART) in 1995.”).

223

. Elizabeth Whitman, How the U.S. Subsidizes Cheap Drugs for Europe, INT’L BUS.

TIMES (Sept. 24, 2015, 1:52 PM), http://www.ibtimes.com/how-us-subsidizes-cheap-drugs

-europe-2112662 (“The U.S. accounted for 46 percent of global life sciences research and

development—the vast majority of which is in biopharmaceuticals—according to the

December 2013 issue of R&D Magazine. ‘The U.S. is the global leader in biomedical

innovation,’ Mark Grayson, a spokesman for PhRMA, a pharmaceutical industry trade

group that represents many of the world’s biggest drug companies, said in an email.”).

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to 3.2%.

224

An MLR regulation might, in practice, encourage waste

in research funds. Big Pharma could find a myriad of ways to prop

up these expenses. For example, more drugs might begin to

perform overlapping functions without real differentiated value

from each other—with their development costs all ascribed to

“R&D.” Production costs might shift even more to the expensive

American labor force.

225

Big Pharma could push for greater FDA

scrutiny to rack up costs in this category. And drug companies

could purposefully keep drugs in the development stage longer.

For these reasons R&D, like manufacturing costs, might belong on

the “other” side.

However, R&D ultimately belongs with the medical loss.

Again, unlike in the cost-plus payment model, there would be a

check on these expenditures—the need to maintain a profit. Not all

research leads to substantial discoveries, so there is no guaranteed

return in this investment area. Furthermore, a drug cannot begin to

return a profit until it has passed the FDA gate.

226

Thus, drug

companies would still push for minimal, not more, costly FDA

intervention. Stockholder considerations, pressure for substantial

breakthroughs, and public perception would all encourage efficient

R&D. And importantly, this might incentivize development of ne-

glected drugs that otherwise would not return a profit. With the

value and controls inherent in this category, R&D should ultimate-

ly stay on the medical loss side.

224

. A New Future for R&D? Measuring the Return from Pharmaceutical Innovation 2017,

DELOITTE, https://www2.deloitte.com/uk/en/pages/life-sciences-and-healthcare/articles

/measuring-return-from-pharmaceutical-innovation.html (last visited Apr. 7, 2018).

225

. Vanessa Fuhrmans & Scott Hensley, Drug Makers Are More Vocal Against Europe’s

Price Controls, WALL STREET J. (Dec. 13, 2001), https://www.wsj.com/articles/SB1008191144

635615520.

226

. See Development & Approval Process (Drugs), U.S. FOOD & DRUG ADMIN., https://

www.fda.gov/drugs/developmentapprovalprocess/ (last updated Jan. 16, 2018) (“American

consumers benefit from having access to the safest and most advanced pharmaceutical

system in the world. The main consumer watchdog in this system is FDA’s Center for Drug

Evaluation and Research (CDER). The center’s best-known job is to evaluate new drugs

before they can be sold. CDER’s evaluation not only prevents quackery, but also provides

doctors and patients the information they need to use medicines wisely. The center ensures

that drugs, both brand-name and generic, work correctly and that their health benefits

outweigh their known risks.”).

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E. Taxes, Fees, and Depreciation Are “Medical Loss”

In insurance MLR regulation, taxes, as well as regulatory or

licensing fees, are considered medical loss.

227

However, federal

income taxes on investment income and capital gains (profit from

a sale or investment) are not.

228

Here, taxes and fees are similarly

set by outside forces, such as government regulations.

229

As a result,

penalizing companies for paying these costs does not make sense.

Furthermore, it is unlikely that Big Pharma will advocate for an

increased tax rate. The incentives are already sufficient to keep

these costs low; no artificial incentives are required. Depreciation

of property and other assets can be calculated using various

methods.

230

Some uniform way of measuring this should be esta-

blished to prevent one drug company from obtaining an unfair

advantage over the others. These categories can all be grouped

similarly to their counterparts in the insurance industry on the

medical loss side.

F. Marketing Is “Other”

This subsection argues that although advertising drug infor-

mation does result in valuable informed consumerism, assigning

marketing to the medical loss side of the MLR ratio creates perverse

incentives for drug companies. In general, the staggering financial

returns from marketing investment are too high for drug com-

panies not to want to flood this category with cash. The incentives

would be especially counterproductive because the greater their

profit allowance grows, the more they would spend on advertising.

Instead, marketing should be categorized as “other,” thereby incen-

tivizing drug companies to minimize marketing expenses.

227

. See Explaining Health Care Reform: Medical Loss Ratio (MLR), supra note 26.

228

. See id.

229

. Topic Number: 409—Capital Gains and Losses, IRS, https://www.irs.gov/taxtopics

/tc409 (last updated Mar. 13, 2018).

230

. Ben McClure, An Introduction to Depreciation, INVESTOPEDIA, https://www.invest

opedia.com/articles/fundamental/04/090804.asp (last visited Apr. 7, 2018).

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1. Promoting awareness of medications is valuable

Valid arguments suggest that marketing should be categorized

as medical loss. In an era of increased transparency, consumers

want to be empowered and educated about drugs.

231

They want to

sit down with their physicians and have informed conversations.

232

But if physicians are unaware of a particular drug, they will not

prescribe it and patients cannot gain access to it. Thus, promoting

awareness of beneficial treatments through marketing is val-

uable.

233

Furthermore, there is merit to the drug makers’ claim that

unless they see attractive profits, investments in R&D will drop.

And the best way to turn a profit is to advertise the product.

234

Moreover, informal controls play a minimal role in reducing

marketing expenses, supporting the position that they should be

considered medical loss. Consumers along both party lines advo-

cate for reductions in drug prices, while the media publicizes the

excesses.

235

Additionally, the pot of revenue is somewhat finite, and

marketing funds have to come from somewhere. Furthermore, if

the MLR regulation is enacted and profits are limited to a reason-

able rate, there may not be the same pressure to engage in profit-

231

. NAT’L CTR. FOR BIOTECHNOLOGY INFO., THE HEALTHCARE IMPERATIVE: LOWERING

COSTS AND IMPROVING OUTCOMES: WORKSHOP SERIES SUMMARY (2010), https://www.ncbi

.nlm.nih.gov/books/NBK53921.

232

. See Horovitz & Appleby, supra note 166 (“Reis said her mother did take the Lyrica

‘and it’s helped.’ That’s a good thing, says the brand guru who takes pride in looking out for

her mom. ‘The ad spurred the conversation.’”).

233

. Russell Huebsch, What Are the Benefits of Direct-to-Consumer Advertising?, HEARST

NEWSPAPERS, http://smallbusiness.chron.com/benefits-direct-to-consumer-advertising-3587

.html (last visited Apr. 7, 2018) (“The 2004 study showed that DTCA ads were especially

helpful in getting low-income families to seek medical care. Low-income individuals and fa-

milies are typically the hardest demographic to reach for any public awareness campaign.”).

234

. Robert Pear, Marketing Tied to Increase in Prescription Drug Sales, N.Y. TIMES (Sept.

20, 2000), https://www.nytimes.com/2000/09/20/us/marketing-tied-to-increase-in-prescrip

tion-drug-sales.html (‘‘Sales of these drugs contributed powerfully to the steep increase in

prescription drug spending in 1999.’’).

235

. Mary Ellen McIntire, Republicans Eye Boosting Competition to Help Trump Lower

Drug Prices, MORNING CONSULT (Dec. 9, 2016), https://morningconsult.com/2016/12/09

/republicans-eye-boosting-competition-help-trump-lower-drug-prices (“President-elect

Donald Trump says he wants to lower drug prices, an idea that’s been pushed primarily by

Democrats but has support from some key GOP senators.”); Petersen, supra note 8 (“The

companies raised prices—not to fund research to discover new drugs—but to boost profits

for executives and investors.”); Ransdell Pierson & Bill Berkrot, Democrats Take Aim at Drug

Prices, Prompting Sharp Drops in Biotech Stocks, REUTERS (Sept. 28, 2015, 6:30 PM), http://

www.reuters.com/article/us-valeant-pharms-congress/democrats-take-aim-at-drug-prices

-prompting-sharp-drops-in-biotech-stocks-idUSKCN0RS28N20150929.

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maximizing marketing. Enacting the MLR regulation could nat-

urally reduce these expenses. However, despite these potential

benefits, other concerns suggest marketing should be assigned to

the “other” side.

2. Marketing should be classified as “other” to align incentives

Linking increased marketing expenses to increased profits by

putting marketing on the medical loss side of the ratio would only

exacerbate current problems. A Big Pharma CEO faced with man-

aging huge profit cuts would start looking at her levers. The last

thing she would do is pull the lever that shrinks the “other” side of

the ratio—her allowed profits—any more than she absolutely must.

If her marketing expenditures are considered medical loss, then she

would be prone to ratchet them up. Unlike the individual market-

place, advertising is not “money losing.” The return on advertising

investment is substantial. If these expenditures started producing

profits that exceeded the imposed ratio threshold, the CEO would

find a legitimate channel for those extra funds. Most likely she

would move them into R&D. But it is highly improbable that she

would voluntarily reduce any medical-loss-qualifying expendi-

tures because that would cut her overall allowable profit amount—

which she’s already losing. Instead, she would likely continue to

channel funds into potentially wasteful marketing expenses that

would continue to dwarf the R&D expenditures, effectively rob-

bing value from consumers. The effects would be almost identical

to the effects of the cost-plus payment model: The more the CEO

spends on marketing, the more profits she is guaranteed. Overall,

drug prices would not drop as desired if marketing expenses were

considered to be medical loss.

Instead, categorizing marketing costs as “other” would incen-

tivize minimizing advertising expenditures while still spending

enough to attract a profit. This Note does not propose slashing

marketing to cram it with profits into a twenty percent limit. How-

ever, categorizing marketing as “other” effectively incentivizes

waste reduction in this area. It could significantly reduce direct-to-

consumer advertising without outright banning it. This type of

advertising could drop to a reasonable level, which would result in

less pressure on physicians from advertisement-prepped patients

to prescribe unnecessary treatment. Since there is such an influ-

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ential return on marketing investment, the only genuine outside

force on marketing expenditures is its detraction from profits.

236

Removing this link would seriously frustrate the effort to reduce

unnecessary marketing and its associated waste. It is therefore im-

perative that these expenditures be condensed. Marketing belongs

on the “other” side of the MLR ratio.

G. Community Benefit Expenditures Are “Medical Loss”

In some ways, public health education campaigns and other

community benefit expenditures are like marketing. They increase

awareness of a product and promote sales.

237

Consequently, some

might argue that such expenditures are no better than advertising;

they are just pharmaceutical propaganda for drugs. However, the

material can provide substantial value to the public—similar to the

value noted above in the marketing section (IV.F).

238

Given the

material’s similar nature to advertising, it would make sense to

combine this with marketing. But as long as community benefit

expenditures are defined narrowly as educational initiatives—as

they are in the health insurance ratio regulation—and exclude

purely promotional initiatives, this can be medical loss.

H. Salaries and Agent Commissions Are “Other”

The purpose of a for-profit business is to make a profit.

239

Larger

profits thus equate to more success. Competitive salespersons’ and

agents’ salaries, along with attractive commissions, are critical to

effectively managing resources and creating this profit.

240

236

. See Pear, supra note 234.

237

. See Public Health Campaigns that Change Minds, MILKEN INST. SCH. PUB. HEALTH

(Nov. 8, 2016), https://publichealthonline.gwu.edu/blog/health-communication-campaigns/

(“How do you motivate an individual to quit smoking? Persuade a community to vaccinate

their children? Incentivize a whole nation to eat better? These types of questions are at the

heart of every health communication campaign, which aim to change how people think

about their health and simultaneously provide them with the resources and incentives to

improve it.”).

238

. See id.

239

. See Dodge v. Ford Motor Co., 70 N.W. 668, 684 (Mich. 1919) (discussing the

shareholder primacy norm).

240

. DAVID A. BJORK, HEALTHCARE EXECUTIVE COMPENSATION: A GUIDE FOR LEADERS

AND TRUSTEES 3 (2012) (“Hospitals may be tax-exempt charities serving the public good, but

they are still big, complicated businesses with narrow profit margins, and they need talented

executives to keep them strong. Tax exemption and public funding for Medicare and

Medicaid have no bearing on what it costs to recruit and retain executives.”).

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general, salary incentives produce results. Thus, both outside and

inside forces urge maximizing this category. Ultimately, salaries,

including those of pharmacy benefit managers, should be expan-

sive enough to attract talent but contained enough to encourage

efficiency (while avoiding extreme profit-taking). Salaries should

fall on the “other” side.

I. Administrative Expenses Are “Other”

The administrative expenses category contemplates office

expenses such as rent, utilities, supplies, and administrative per-

sonnel. These expenses provide relatively little value to the drug

consumer. Therefore, encouraging efficiency, quality, and thrift is

important here. In order to minimize waste in this area, admini-

strative costs should be categorized as “other” and left out of the

medical loss category.

J. Exceptions to Consider

There are exceptions to the 80:20 rule in the health insurance

industry for a reason.

241

Similarly, some pharmaceutical companies

do not follow the standard Big Pharma model. Some companies

lack the funds or infrastructure for major R&D.

242

Others require

only a modest marketing budget. Exceptions should be made per

the various business models. There should be room for some

reasonable flexibility.

K. Ratio Should Be 40:60

Imposing an overall MLR ratio, like the 80:20 ratio in the

insurance industry, could reduce drug prices while reserving to

pharmaceutical companies control over pricing and budget details.

With a similar overall ratio, these companies would have the

flexibility to choose to spend more on advertising and keep less for

241

. See Explaining Health Care Reform: Medical Loss Ratio (MLR), supra note 26. For other

insurance designs, the ratio is flexible so as to facilitate financial viability. See id. For example,

Special Circumstances Adjustments apply to newer plans, min-med plans, and expatriate

plans to address individual insurance situations. Low-enrollment insurers are similarly held

to different ratios to adjust for less predictability in claims expenses. Alternatively, if em-

ployers wish to self-insure and avoid paying the “non-value” margins to an insurance

company, they are not subject to the MLR regulation requirement. See id.

242

. See id.

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profits, or vice versa. However, as described above, pharmaceutical

companies have greater power to increase the costs of production.

Thus, a mixed ratio might better achieve the main goal of targeting

value. A specific profit percentage cap, such as 12% (the next high-

est industry’s average profits), combined with an overall medical

loss ratio like 70:30, could provide a helpful general framework,

leaving Big Pharma flexibility over the details.

Again, Big Pharma currently averages 21% in profits.

243

A 12%

profit margin seems reasonable and competitive. After adding sales

and marketing (currently 23%; ideally, it should match other in-

dustries’ 10% average), manufacturing and distribution costs (30%),

as well as administrative costs, salaries and commissions, etc., the

“other” portion of the ratio could approach 60%, which would

leave 40% for medical loss. Similar to what has happened to the

insurance industry, Big Pharma has the potential to rebate billions

of dollars back to Americans, easing the increases in prescription

prices.

244

Players in the pharmaceutical industry might even tighten

their belts and squeeze out costs that don’t add value to con-

sumers—all while making a reasonable margin of profit—just like

insurers. Admittedly, this ratio would benefit from a more detailed

economic analysis that could arrive at a more calculated ratio,

adjustable as the market fluctuates.

V. CONCLUSION: REDUCED TAXPAYER BURDEN,

INCREASED AFFORDABILITY

Where should the refunds go when pharmaceutical profits

exceed the 12% cap, or if the “other” category oversteps 60%? The

health insurance industry rebates their excess to individuals and

corporations.

245

Yet for pharmaceutical companies without easily

accessible means to rebate consumers, issuing rebates to indivi-

duals and corporations likely would be too complicated and

burdensome. However, there is another potential way to channel

these funds to lower insurance premiums (which is perhaps a more

243

. See Williams, supra note 7.

244

. See PRIVATE HEALTH INSURANCE, supra note 18.

245

. See The 80/20 Rule: Providing Value and Rebates to Millions of Customers, supra note

187 (“The 80/20 rule is ensuring that insurance companies provide consumers value for their

premium dollars.”).

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widespread pain point worth addressing). At first, the government

could collect and distribute this money to reimburse the still-

unfunded ACA risk corridors that were intended to be operational

in the initial years of the ACA’s implementation.

246

This would

relieve taxpayers of their $8 billion debt still owed to insurance

companies.

247

After that bill is paid, the funds could then be

distributed evenly to insurers on an ongoing basis in a way that

extends the ACA’s reinsurance payments and spreads out savings

to the consumers.

248

Since insurance companies have their own

value-driving MLR, premium price growth could slow and—dare

we hope—slightly reverse. This type of regulation could defray

individual and family healthcare expenditures, increasing afford-

ability for all. If this result is unpalatable then these funds could be

channeled toward other worthwhile endeavors—such as funding

nursing or doctor scholarships or helping provide insurance for

those with disabilities.

This proposal might have other advantages as well. Big Pharma

might move drug production jobs to the United States in an attempt

to lever up production costs and thus their profit eligibility. Drug

companies might finally shift the R&D cost burden from the United

States by lowering prices in America while keeping prices abroad

fixed.

249

Some may argue that markets eventually find ways around

246

. See Livingston, supra note 37.

247

. See id.

248

. See Cynthia Cox, Ashley Semanskee, Gary Claxton & Larry Levitt, Explaining

Health Care Reform: Risk Adjustment, Reinsurance, and Risk Corridors, HENRY J. KAISER FAM.

FOUND. 6 (2016), http://www.kff.org/health-reform/issue-brief/explaining-health-care-re

form-risk-adjustment-reinsurance-and-risk-corridors (“Reinsurance differs from risk adjust-

ment in that reinsurance is meant to stabilize premiums by reducing the incentive for

insurers to charge higher premiums due to concerns about higher-risk people enrolling early

in the program, whereas risk adjustment is meant to stabilize premiums by mitigating the

effects of risk selection across plans. Thus, reinsurance payments are only made to individual

market plans that are subject to new market rules (e.g., guaranteed issue), whereas risk

adjustment payments are made to both individual and small group plans. Additionally,

reinsurance payments are based on actual costs, whereas risk adjustment payments are

based on expected costs. As reinsurance is based on actual rather than predicted costs,

reinsurance payments will also account for low-risk individuals who may have unexpectedly

high costs (such as costs incurred due to an accident or sudden onset of an illness). . . .

[R]einsurance payments represent a net flow of dollars into the individual market, in effect

subsidizing premiums in that market.”).

249

. See Mc Govern, supra note 67 (“[T]he European Federation of Pharmaceutical

Industries and Associations released a report on the pharmaceutical industry. In this report,

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this type of price regulation with reduced efficiencies and

quality.

250

But perhaps reduced efficiency is precisely what we

want—at least in the realm of stockholder return-on-investment

efficiency. While neglected drug R&D provides relatively little

financial reward to an investor, if drug companies were somehow

incentivized to raise their R&D expenditures, then perhaps much-

needed (albeit unprofitable) drugs might become more available to

non-financial stakeholders such as patients and their families.

Ironically, this type of inefficiency could result in value for patients,

who are the ones really in need. And any measures drug companies

might take to reduce quality can be managed by the FDA.

251

In conclusion, an MLR regulation could provide much-needed

value to the pharmaceutical industry in ways that the current

market structure fails to do. Ultimately, however, more thorough

analysis is needed to identify the optimal ratio and category

classification for each expense category. But in the current push to

expedite healthcare affordability and access, a pharmaceutical MLR

regulation could provide the much-needed guardrail to facilitate

maximum value for American healthcare consumers.

Cami R. Schiel

it was revealed Europe accounted for 22.2 percent of all pharmaceutical sales of 2015, while

the US took 48.7 percent of the margin.”).

250

. See Morton, supra note 33 (“[P]rice controls, in combination with government

requisitioning and corruption, created chaos in the French economy. Merchants responded

by reducing the quality of their goods and the black market blossomed, Bourne noted. ‘It

was the honest merchant who became the victim of the law.’”).

251

. See Development & Approval Process (Drugs), supra note 226 (“American consumers

benefit from having access to the safest and most advanced pharmaceutical system in the

world. The main consumer watchdog in this system is FDA’s Center for Drug Evaluation

and Research (CDER). The center’s best-known job is to evaluate new drugs before they can

be sold. CDER’s evaluation not only prevents quackery, but also provides doctors and

patients the information they need to use medicines wisely. The center ensures that drugs,

both brand-name and generic, work correctly and that their health benefits outweigh their

known risks.”).

* J.D., December 2017, J. Reuben Clark Law School at Brigham Young University;

M.B.A., December 2017, Marriot School of Business, Brigham Young University; B.S. in

Nursing, April 2012, Brigham Young University. Schiel, a registered nurse, has worked at

Provo Rehabilitation and Nursing, the Utah State Hospital, and Utah Valley Hospital. She

thanks her family for the constant laughs and love, her professors for their patience and

encouragement, and expresses a huge thank-you to Brent for all of his help with this Note.

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