The shortage of these drugs has resulted in the emergence of “gray markets” in which the drugs are exchanged repeatedly between various suppliers before they reach the end‐​user. Typically, gray markets are socially beneficial, moving goods toward consumers with the strongest demand. But in this case, prescription drug gray markets seem unsavory and will likely soon be the subject of new government regulation. However, drug makers can circumvent this intervention while, at the same time, capturing some consumer surplus that they currently lose to distributors.

The shortage / The FDA historically has defined a “drug shortage” as “a situation in which the total supply of all clinically interchangeable versions of an FDA‐​regulated drug is inadequate to meet the current or projected demand at the patient level.” That definition is probably not satisfactory to economists, but we can appreciate its meaning: there’s a sudden and dramatic decrease in supply at the drug’s customary price.

These shortages affect less than 1 percent of the approximately 40,000 ethical drugs on the market. Interestingly, the vast majority of the affected drugs are generic versions. This seems counterintuitive; one would expect that once a patent has expired and generic makers can begin production, there would be ample supply at the customary price.

The two independent sources for the shortage data are the University of Utah’s Drug Information Service (DIS), which manages the American Society of Health‐​System Pharmacies (ASHP), and the FDA Center for Drug Evaluation and Research’s Drug Shortage Program. The FDA data report lower numbers than the DIS, which is in part a product of how the two organizations define a “drug shortage.” But the difference is also partly attributable to the sources that the two agencies use for their data: DIS’s information comes from care providers who judge whether a drug is in shortage, whereas the FDA uses drug manufacturers’ data.

As shown in Table 1, both data sets exhibit the same general pattern over the past 10 years: the annual number of new shortages increased steadily in the latter 2000s, then eased in the early 2010s. However, according to the DIS data, the number of shortages remains troublingly elevated as compared to the mid 2000s, while the FDA data show a dramatically lower number of shortages in recent years.

A trend worth special attention is the percentage of drugs in shortage that are “sterile injectables.” These often are older, off‐​patent drugs produced by generic manufacturers. They include cancer drugs, anesthetics for surgery, drugs for emergency medicine, and electrolytes for intravenous feeding. As a percentage of new ethical drug shortages, sterile injectables have remained in the 70 to 80 percent range from 2010 through 2013, with 2014 being the first year to drop below 70 percent (at 68.2 percent).

Elasticities and investment / In most markets, the volume and seriousness of product shortages depend on the extent to which demand and supply of the product respond to changes in price. In microeconomic theory, these responses are referred to as price elasticities; products that experience sharp changes in supply or demand as a result of a price change are price‐​elastic; products that don’t experience much change are price‐​inelastic.

Understandably, the demand for prescription drugs is fairly inelastic. These goods are typically “medically necessary” and in many cases there are few effective substitutes. Besides, most patients have health care insurance, hence consumer demand for these drugs (and most health care services and products) is largely unaffected by price changes. Furthermore, hospitals and physicians generally prescribe medication based on its effectiveness for the patient, which is unrelated to the price paid for the drug.

On the supply side, there is also a lack of responsiveness to changes in price, at least in the short run. Pharmaceutical production often requires expensive, specialized equipment for specific drugs, and manufacturers are required to adhere to “current good manufacturing processes” that require time to implement because they are complex. Sometimes a manufacturing line can be reconfigured relatively quickly to produce a different drug that’s in the same class—say, transitioning from one type of ACE inhibitor to another. But that’s not the case if the reconfiguration involves two different drug classes—say, shifting from an antibiotic to an anesthetic. Moreover, pharmaceutical raw materials are not always readily available and require validation by manufacturers and FDA regulatory approvals. Furthermore, prescription drugs have a limited shelf life; as a result, manufacturers’ inventories are often kept low, reflecting more of a just‐​in‐​time manufacturing philosophy.

Temporary shifts in supply or demand, which often are what cause these shortages, will not generate capital investment to increase production capacity. Evidence of increased demand in the longer term (greater than two years), however, will result in supply being increasingly price responsive.

Gray markets / Because ethical drug shortages typically are a function of short‐​run (less than two years) inelasticity of demand and supply, those shortages have led to the development of gray markets for these drugs. A gray market, in this sense, is an alteration in the drugs’ normal distribution channels.

The drug distribution chain typically works as follows: drug makers sell their wares to wholesalers and repackagers, who then sell to pharmacies and hospitals, or else to “secondary” wholesalers (who then sell to pharmacies and hospitals, or perhaps to a tertiary wholesaler). During a shortage, this distribution chain becomes extended as the goods seek the highest demand and highest price. Wholesalers and repackagers will sell more of the drug to other wholesalers and repackagers than to hospitals and pharmacies, and pharmacies may resell the drugs “back up” the distribution chain to secondary wholesalers and repackagers. The secondary distributors may not even take physical custody of the drug, instead simply routing the drugs to other customers and settling accounts much like buyers and sellers of financial derivatives. In some cases, these distributors are “shell pharmacies” that spring up in moments of shortage to stockpile the scarce drug.

As a result, the final price on gray market–traded drugs may be as much as hundreds of times higher than the price that the manufacturer originally received for the product. Also, as the drugs bounce along the extended supply chain, they may be improperly repackaged, re‐​labeled, and possibly stored under unsuitable conditions, as well as replaced by counterfeits, compromising their integrity and safety.

In theory and in most cases, such reselling can benefit general welfare: it helps to deliver the goods to those consumers who most want them. But in health care, this gray market has two problems: First, many people are morally troubled by the dramatic increase in price that prescription drug gray markets produce. Though people generally appreciate the problem of scarcity and the importance of market forces to nurture supply and innovation, they are much less sanguine about wringing consumer surplus out of a “medically necessary” good. Second (and not unrelatedly), the profits from the repeated “handoffs” in the supply chain go to the distributors and repackagers instead of the drug makers, which doesn’t incentivize greater supply in the long term.

Concern about these facets of the prescription drug gray market has been raised by the drug‐​making industry’s own trade association, the Pharmaceutical Research and Manufacturers of America (PhRMA). On its website, PhRMA states:

When a drug shortage happens or one is anticipated, a “gray market” may spring up, with the potential for price gouging. The practice of price gouging by secondary wholesalers, which largely comprise the “gray market, is unacceptable and presents serious concerns for patient safety, as it cannot be assured that the products have been handled in a way that maintains their integrity.

FDA steps in / As a result of the then‐​burgeoning shortages, President Obama issued Executive Order 13588 (“Reducing Prescription Drug Shortages”) on October 31, 2011. In the order, he directed the FDA to take administrative steps to help prevent and reduce current and future disruptions in the supply of lifesaving and life‐​enhancing pharmaceuticals. Among those steps:

• Drug makers are required to provide adequate advance notice of manufacturing discontinuances of specific pharmaceuticals.
• They also are required to report supply disruptions six months in advance, if possible, or as soon as possible.
• The FDA is to expand its efforts to expedite the regulatory review of new drug suppliers, manufacturing sites, and manufacturing processes, whenever such expedited reviews would help avoid or mitigate existing or potential drug shortages.
• The FDA is to coordinate with the U.S. Department of Justice on any findings that such drug shortages have led market participants to stockpile drugs and sell them at higher prices, with the DOJ investigating whether that wholesaler behavior is consistent with applicable law.

From a federal regulatory perspective, the FDA does not have the regulatory authority to require a pharmaceutical company to start or increase production of a drug, nor to manage drug prices or distribution. Nonetheless, the agency has taken steps in accordance with EO 13588 that seemingly have reduced the incidence of drug shortage.

As noted previously, according to FDA data, the number of new shortages in a year has plunged dramatically from 251 in 2011 to just 44 in both 2013 and 2014, an 82.5 percent drop. The FDA reports that it has actively worked with pharmaceutical manufacturers to address problems with production and quality, helped to determine if pharmaceutical manufacturers have unused capacity they can employ to alleviate shortages, and even assisted pharmaceutical manufacturers with importing products into the U.S. marketplace.

So the FDA data seem to show great success by the government in reducing drug shortages. But the University of Utah’s DIS numbers are less encouraging, suggesting that in the view of care providers (who supply the DIS data) shortages are still common. This is putting pressure on the Obama administration and the FDA to do more about drug shortages and the gray markets.

The higher prices and rents extracted by the gray market represent revenue forgone by drug makers that, on the margin, could produce increased supply.

What can be done?/ So far, those complaints have not resulted in specific federal or state “price gouging” laws against distributors, and no enforcement actions have come from the Justice Department pursuant to EO 13588. However, such action seems possible in the near future.

But it’s possible that drug makers could act before the FDA in tamping down on the gray markets, motivated by both political and economic interests. The higher prices and rents extracted by the gray market represent revenue forgone by drug makers that, on the margin, could produce increased supply.

PhRMA, together with the FDA, could change this by encouraging drug makers to adopt an industry‐​wide policy that encourages both brand‐​name and generic manufacturers to actively include contractual obligations pursuant to “authorized distributors of record” agreements. These would restrict the wholesale distributors’ freedom to buy directly (only from the manufacturers) and to sell the manufacturer’s ethical drugs to only end‐​users (pharmacies and hospitals), especially in cases where there is real potential for an ethical drug shortage. This contractual, self‐​regulatory response to gray markets would ensure that ethical drugs in short supply are not price “churned” through the gray market distribution chain, but instead result in higher revenues for the manufacturers while ensuring the integrity and safety of the ethical drug supply chain and avoiding fallout from “price gouging” accusations against the gray markets.

As part of these contracts, pharmacies and hospitals could only purchase drugs that have a proper “drug pedigree.” Pedigree documents consist of a record of the distribution route a drug has traveled since it left the manufacturer and are usually required of distributors by either federal or state law. By requiring pedigree documents, hospitals and pharmacies will be better able to track where the ethical drugs have previously been in the wholesale distribution chain, thus ensuring integrity and safety, and discouraging the establishment of “shell” pharmacies. Other appropriate industry associations can provide the public support and institute industry best “standards of purchasing practices” for pharmacies and hospitals to follow.

Too often the first reaction to a persistent industry problem is heavy government intervention. The FDA needs to pursue market‐​based, self‐​regulatory solutions with stakeholders, such as industry associations, to take the next step in mitigating the issue of drug gray markets. This market‐​based approach may further mitigate a potentially life‐​threatening circumstance for human beings in desperate need of life‐​sustaining pharmaceuticals.