Two big problems with generic-drug substitution

A New York court recently reaffirmed an injunction against Actavis that requires the pharmaceutical company to continue promoting and selling Namenda, an old medication used for treating Alzheimer's disease. Actavis wanted to downscale its support of the drug to focus on its new-and-improved version, Namenda XR. The court's decision is a landmark ruling because it will force a company to manufacture, market, and distribute a product it no longer wishes to support. We need a better system that has less potential to dampen competition and innovation.

Why would the court do this? To make generic drugs more available. There is a widespread belief that generics are always better for consumers, and, in most states, pharmacists are allowed to automatically substitute a generic drug for a patient's branded prescription. But this is a naïve and dangerous assumption. At a minimum, patients should be informed of the differences between their prescription and the generic, and asked if they want the substitution, just as we would expect in any other consumer transaction. Ideally, we would find an alternative to automatic substitution that does not derail innovation and competition.

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There are two big problems with the current automatic substitution system. First, generics are not identical to the branded drug. Generic drugs only have to meet the standard of 80 percent to 125 percent of the bioavailability of the referenced drug — a large range. For drugs with a narrow therapeutic dosage band, this kind of variation can be problematic — even dangerous. Furthermore, generic drugs are not required to have the same inactive ingredients, meaning that binders, flavors, dyes, and preservatives can be different, posing problems for people with sensitivities, and creating more variance in quality control. The FDA does not (and cannot) closely monitor the myriad factors that influence the safety and efficacy of a drug: How was the quality of ingredients purchased from suppliers tested? How was manufacturing and transportation controlled? How old is it?

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Most of this monitoring is achieved by self-regulation by the companies themselves, and this is where the key value of brand comes in. Companies like Johnson & Johnson, Pfizer, Merck, and Abbott Laboratories have invested billions of dollars in building their brands. A problem with a drug can result in a tremendous loss of consumer faith and stock market value. Accordingly, branded pharmaceutical firms invest heavily in quality standards and processes to protect their brands, and this diligent monitoring is probably the most powerful source of protection consumers have to ensure that their drugs are safe and of high quality. When patients give up the brand, they give up a billion-dollar incentive a company has in protecting them.

The second problem with automatic substitution is that it forces branded companies to subsidize generics, undermining competition and innovation. Generics already have a huge cost advantage over brands because they sidestep nearly all of the research and development and clinical testing expenses of developing new drugs. And thanks to automatic substitution, the brand's marketing efforts benefit generic drugs instead of their own. You do not have to be a rocket scientist to recognize the disaster lurking in that kind of system. Companies will be under-incentivized to develop new drugs — it's a classic "tragedy of the commons" problem.

Many people wrongly assume that having generic drugs compete with branded drugs makes the market more efficient. First, the pharmaceutical industry is already extremely competitive and not especially profitable. Studies suggest that the overall cost of developing a drug and getting it approved in the U.S. is between $500 million and $2 billion and most efforts fail. Furthermore, by the time a drug is approved by the FDA, it only has, on average, between seven and 12 years left on its patent clock to try to recoup that cost while competing against other branded drugs in the same class. Giving generics an advantage might increase price competition, but does so at the expense of multidimensional competition where firms simultaneously compete on price, quality, innovation, and more. In nearly every industry, it is this multidimensional competition that has led to innovation, and the higher standards of living we enjoy today.

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Automatic substitution is both a public-policy and a consumer issue. Consumers should not tolerate having their prescriptions swapped out for generics without informed consent. As a society, we should not tolerate a system that undermines the incentives for branded pharmaceuticals to develop innovative drugs.

The key thing that makes the pharmaceutical industry different from other industries is that it is regulated. The bulk of that $2 billion price tag in developing a drug is spent in clinical trials to ensure drugs are safe and effective. Forcing branded companies to subsidize generics doesn't solve the problem that testing is expensive, it just distorts market competition. We should instead be looking for ways to make clinical testing more efficient, and generally lowering the entry barriers to competition among branded pharmaceutical companies.

Commentary by Melissa A. Schilling, a professor of management and organizations at NYU Stern School of Business. She has also worked as an expert witness on legal cases involving pharmaceuticals and authored an Amicus Brief on behalf of business school professors regarding the Forest Laboratories' Namenda case. Follow her on Twitter at @mschilli1.