Some generics are too cheap for own good

More than 90% of prescriptions in the U.S. are filled with generic drugs.

These cheaper alternatives to branded medications have expanded access to care for millions of Americans while saving the health system hundreds of billions of dollars a year. While the prices of branded drugs have skyrocketed in recent years, generics prices have been falling steadily.

For patients, this sounds like unqualified good news.

Yet there's a downside if prices fall too low: In recent months, major manufacturers have declared bankruptcy and scaled back production. Hundreds of generic drugs are now in shortage, including lifesaving cancer treatments and medicines for premature babies.

How can prices for in-demand products fall too low? As ever when it comes to the U.S. health care market, the answer isn't straightforward.

The Hatch-Waxman Act, passed in 1984, laid the groundwork for the modern generics industry. One of its greatest achievements was establishing a regulatory regime in which generic drugs are considered the same as each other and their branded counterparts. Today, more than 80% of drugs have generic versions. But with little to distinguish between products, manufacturers compete solely on price, not quality. Drugmakers have diminishing leverage as sellers in an increasingly consolidated supply chain.

Medications typically move from manufacturing facilities to pharmacy shelves via wholesale distributors. In recent years, the largest retail pharmacies and other drug middlemen have teamed up with the biggest wholesalers to form discount buying groups for generic drugs. These intermediaries — four little-known joint ventures that represent hundreds of billions of dollars in cumulative market capitalization — have become the ultimate gatekeepers of distribution and sales in the retail market.

Buying groups use their outsized power to set onerous contract terms that push prices lower and fatten their margins. They get away with this “take it or leave it” approach because manufacturers would struggle to sell their products otherwise. The discounts they negotiate, meanwhile, are rarely passed to consumers at the pharmacy counter. Most continue to shell out steady and, in some cases, increasing co-pays despite falling net prices to manufacturers.

Buying groups have also started developing their own private-label products that compete directly with the generics for which they negotiate discounts. While in-house labels aren't unusual in other industries — say, grocery chains — those products typically go head-to-head on quality and consumers buy them directly. By wedging themselves between patients and drugmakers, middlemen have sapped consumers' power to determine prices.

Bankruptcies and production stoppages due to quality problems have made the supply chain brittle and exacerbated shortages — all at great risk to patients.

These problems are often compounded by policy decisions that disadvantage generics and lead to underpriced drugs. Medicaid, for example, requires drugmakers to pay a rebate when average prices rise faster than inflation. Other drug discount programs impose steep price cuts despite ample competition among suppliers. Such policies are better suited to branded products, where suppliers have no direct rivals and more leverage to set prices.

The prescription drug market is thus caught between two extremes: prices that are simultaneously too high for branded drugs and too low for generics. Both artificially restrict access to needed medications. Additional scrutiny of supply-chain middlemen, to include retail buying groups, should be a priority for competition authorities. Mark Cuban's Cost Plus Drug Co. — which buys certain generics directly from manufacturers and sells them at a flat markup, cutting out the middlemen — shows that progress is possible.