Amputating the invisible hand

How To Create Shortages In An Abundant World

By B. Frezza

An old cold war joke asks a Russian, a Pole, an Israeli, and an American the following man-on-the-street question. “Excuse me, what is your opinion of the meat shortage?” Each reply reveals the essence of that country’s political economy at the time. The American’s answer was, “What’s a shortage?”

As we abandon the economic system that made this joke funny (other replies below*), Americans are beginning to experience the sting of shortages firsthand.

Exhibit number one is the crisis faced by many hospitals that can’t get their hands on a growing list of both routine and life-saving drugs. Doctors have resorted to rationing, forcing patients to either go without or use inferior substitutes. Clinical trials are being interrupted, wreaking havoc on the approval of new and more effective drugs. Shady black markets have emerged to fill the gap – a worrying trend given the importance of purity and proper handling. The whole thing has a certain third-world feel to it.

The FDA’s own drug shortage page indicates that 2010 was a record year, and 2011 is on track to be even worse. According to the Drug Shortage Research Center, the number of critical drug shortages, mostly of clinical injectables, has nearly tripled since 2006. The FDA maintains an ever growing list of drugs – including anesthetics, antibiotics, nutritional supplements, and chemotherapy agents – that have all become scarce for reasons that basically boil down to “supply does not meet demand.”

What is going on here?

Congress has held hearings to determine what additional authority should be given to the FDA or other federal agencies, in order to give them more power over manufacturers. The paucity of attempts to understand the root cause of the problem reveals the intellectual bankruptcy of that approach. Dr. Howard Koh, Assistant Secretary for Health at the U.S. Department of Health and Human Services, testified that, “industry consolidation, shortages of underlying raw materials, changes to inventory and distribution practices, difficulty in producing a given drug, quality and manufacturing problems, production, discontinuations for business reasons, and unanticipated increased demand” have all come together in a perfect storm.

Funny, but those sorts of challenges occur every day in a wide variety of industries without causing chronic shortages. None of them require a czar in Washington to make their market work. What makes these drugs so special?

No, these are not high priced biologics. They are largely generic drugs. Many have been produced for years, even decades, without any issues. The problem doesn’t seem to be occurring in retail pharmacies, just in hospitals. In fact, shortages are getting worse every year as more drugs come off patent and are replaced by generics.

Don’t look now, but in the world of drug distribution someone amputated the invisible hand.

Supply and demand achieve balance in every other industry, over time and across disparate locations, by adjusting the price. High prices call forth more supply as vendors chase profit opportunities. Excess supply motivates price cuts to clear inventory. Hard-to-service customers in challenging locations pay more to ensure a steady supply. Large volume users command top discounts. The most complex multi-vendor distribution networks operate in a completely distributed, self organizing fashion, products flowing in one direction with information flowing in the other as prices reflect changing conditions. When was the last time you saw a Web page for tracking shortages of wide screen TVs?

Fix prices by government fiat by specifying a certain level of Medicare reimbursement (which also sets a benchmark for private insurers), and the reverse information flow is destroyed. Remove the ability to raise prices when demand exceeds supply and shortages will follow as sure as night follows day. Policies that keep prices too low for too long incentivize suppliers to exit the business. Consolidation follows, making the supply chain more prone to disruptions. And disruptions become more likely, as prices can’t rise to encourage survivors to invest in updating and maintaining their manufacturing systems.

If you want to see the future of our pharmaceutical industry operating under such a regime, look at some old photos of the South Bronx during the heyday of rent control.

There is no magic here. You don’t need a Ph.D. in economics to understand. Adam Smith explained it all back in 1776, the same year thirteen colonies embarked on a unique experiment in freedom coupled with responsibility.

That American experiment is not failing in the health care industry. Rather, it has been abandoned, with worse to come when, and if, Obamacare kicks in. Doctor shortages. Insurance shortages. And now drug shortages. This is the price we are paying as we continue to federalize one sixth of our national economy.

* The Russian man-on-the-street answered, “What’s an opinion?” The Pole, “What’s meat?” And the Israeli, “What’s excuse me?”