Why Hospitals Haven't Been in the Drug Business

That's not the only reason that drug prices spike; there can also be manufacturing problems that temporarily shut down one or more manufacturers in a multi-firm market, causing supply to crater and prices to soar. Or shortages of key inputs to the manufacturing process. Or the FDA can pull a competitive product off of the market, handing new market power to a longtime manufacturer (this is one of the things that happened with the Epi-Pen).

It's understandable if hospitals and patients don't really care why the prices are going up. But it does matter, because the reasons for the price increase tell us a lot about how successful this hospital-led effort is apt to be.

Take Epi-Pens. Given that every other kid these days seems to have some sort of terrible allergy, that's a pretty large, robust market; I wouldn't expect Mylan's pricing power to last for all that long. But by that token, it's unlikely that a hospital-owned manufacturer is going to do much good. There's no reason to think that they'll be any faster at creating their own Epi-Pen competitor than some company that has long experience in pharmaceutical manufacture and medical device development — and indeed, there are a lot of reasons to think that the hospital-owned maker would be slower. Manufacturing is hard, and doing it well takes a specific set of skills, and a managerial focus, that hospitals don't have.

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Or consider IV fluids, which have also been in short supply because of Hurricane Maria, which devastated Puerto Rico's large pharmaceutical and medical device industry. This new manufacturer is unlikely to be much help with these kinds of problems; it will not itself be somehow magically immune from acts of God that destroy its facilities, and it will not be able to tool up production to respond to supply shocks any faster than a normal manufacturer.

On the other hand, look at Daraprim, the drug that made Shkreli famous. In 2015, Turing Pharmaceuticals hiked the price from $13.50 a pill to $750 a pill; outside of the U.S., it often costs as little as one or two dollars. And last time I looked, it was still absurdly expensive. That's the sort of abuse that a hospital-owned company might actually be able to fix. Not quickly, but eventually. And the existence of a company that can step in and take away all of your ungodly profits may deter firms from adopting this strategy in the first place.

But even so, they'll also need to think hard about the costs of vertical integration. One obvious cost is … the costs. Developing a manufacturing competency will be expensive, in terms of both management expertise and capital expenditures. They will have to devote some of their own precious management time to the project, and to the inevitable arguments over exactly which drugs their new firm should make. There's a good chance that they will turn out to be worse at manufacturing drugs than the existing manufacturers (just look at the sad fate of the insurance co-ops created by the Affordable Care Act), and will end up as a drain on hospital budgets rather than a gain.

But another cost is what vertical integration does to corporate decision-making. Once you have an expensive facility set up to do something, you start making bad downstream decisions. An airline buys an oil refinery to hedge against rising oil costs — then decides to use the oil to fly planes, even though the company would make more money selling that oil on the open market.  A clothing manufacturer buys a textile mill to gain a pricing advantage in the production of fashionable double-knit clothing — then keeps making double-knits long after they've gone out of style, because what else are you going to do with that mill? A maker of small consumer electronics sets up a chip manufacturer to control their biggest input cost — then discovers that the minimum profitable scale of chip manufacturer is much larger than that of their products, and they either have to find some way to offload the extra chips, or sell a bunch of alarm clocks at a loss.

In the health care context, that's more likely to look like "Well, there's this new drug that does a better job, but we've got a huge investment in making this generic, and it would cost a bunch more money to do the approvals and the retooling to make something else, plus, we get this one cheap. So let's stick with the drug we make in-house." Or too-frequent retoolings to satisfy hospital needs, keeping the drug manufacturer running at a loss and draining hospital budgets.

That's not to say that vertical integration never works. But it should always be approached with great caution. Beware of its side effects.

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