The recent kerfuffle about Turing Pharmaceuticals having jacked up (and then maybe jacked down) the price of the anti-parasitic drug Daraprim should provide an opportunity to do some serious old-fashioned industrial organization (i.e. pre-game theory) teaching, if only because of the way it highlights just how complex the IO of the pharmaceutical sector is.
First, you've got the division between on-patent (or brand name) drugs and off-patent generics. The usual notion is that generics should be cheaper than brand name drugs because the generic companies don't have to put their products through clinical trials, they just have to demonstrate bioequivalence with a brand name drug whose patent has expired. The Daraprim incident shows that the only thing which will keep prices down is competition. Alex Tabarrok had a post on Marginal Revolution a little while ago dealing with the competition issue in this case - the FDA's regulations set the bar for entry into the US market by foreign (or for that matter any new) producers so high that once a number of existing producers drop out, it's not uncommon for the remaining producers to find themselves in a monopoly/duopoly position. Daraprim isn't the only recent example, it's just the most dramatic.
The basic IO story here's pretty simple. The actual physical manufacture of drugs is pretty close to being a constant marginal cost industry. For brand name drugs the research costs are fixed costs; generics don't have those. For a while, the generic drug sector was very profitable, but nobody noticed because of the halo effect of the notion of generics. New producers entered and the price was continually driven down, at least in the US. In Canada, provincial drug plans regulated generic prices by tying them to the prices of brand name drugs and, as so often happens, what was supposed to be a price ceiling turned into a price floor and we would up paying considerably more than the Americans did for generics. More on that in a later post.
Anyway, in the US the profitability of the generics sector attracted entry, and prices and profits were competed down, causing some producers to leave the market. Getting back in's a lot harder than getting out (the reverse lobster trap effect) so the ones which stayed found themselves with market power, which they started to take advantage of by raising their prices significantly, but not catastrophically from the payer's point of view. (Is that like raising the temperature in a pot of water containing a frog?)
Bottom line on generics: standard economic theory works. Price regulation will hold prices down for a little while but only competition will keep them down long run. For a while it looked as if Indian generic manufacturers were going to fill the competitive niche, but quality control problems knocked some of the biggest of them out of the American market. If the Trans Pacific Trade Partnership negotiators want to do something useful, they should agree on a new reciprocal production quality regime and encourage free trade in generics among TPP members. Canada's got an exporting generic industry - bets that that could be significantly expanded under the right trade rules?