The latest article in the Kaiser Health News/NPR “Bill of the Month” series tells the story of Shereese Hickson, a 39-year-old disabled Medicare Advantage enrollee whose hospital charged $123,019 for two infusions of a multiple sclerosis drug:

Even in a world of soaring drug prices, multiple sclerosis medicines stand out. Over two decades ending in 2013, costs for MS medicines rose at annual rates five to seven times higher than those for prescription drugs generally, found a study by researchers at Oregon Health & Science University.

“There was no competition on price that was occurring,” said Daniel Hartung, the OHSU and Oregon State University professor who led the study. “It appeared to be the opposite. As newer drugs were brought to market, it promoted increased escalation in drug prices.”

That’s not how it’s supposed to work. New market entrants should bring more competition on price. Drug manufacturers have an incentive to capture market share by reducing their prices. But that seems to be the exception, not the rule. 

In the new Cato Institute book Overcharged: Why Americans Pay Too Much for Health Care, law professors Charles Silver and David Hyman (M.D.) show that this phenomenon occurs because government interference has eliminated incentives for pharmaceutal companies to compete on price:

Why does competition exert less influence in drug markets than it does elsewhere? One likely explanation is “parallel pricing,” which occurs when supposed competitors maintain or raise prices in lockstep. We call it “erectile pricing,” rather than parallel pricing, because we observed it when studying Viagra and other erectile dysfunction (ED) drugs…

Erectile pricing occurs with other medicines too. Insulin is a drug used by millions of Americans afflicted with diabetes. It is off-patent and made by three companies, so it should be reasonably priced. It is not. The past two decades have seen stunning price increases. Short-acting insulin, which cost about $21 in 1996, went for about $275 in 2017. And, just as with ED drugs, the prices went up in lockstep, even though there were two companies making short-acting insulin. Prices for long-acting insulins, which also had two makers, rose in tandem too.

Why does erectile pricing happen in drug markets? Many medicines are made by only a few companies, all of which are repeat players in pricing games and have learned to employ a strategy known as “tit for tat.” Whatever one company does, the others do in turn. When one raises prices, the others follow suit, knowing that if they play follow the leader, they will all get rich. The incentive to steal the market by charging less disappears because every manufacturer knows that other makers will cut their prices too, if it does. An outbreak of price competition would leave all manufacturers poorer—so they all raise prices instead of reducing them.

Ideally, tit-for-tat pricing would be unsustainable, and efforts to keep prices high would collapse, because individual producers could increase their profits by reducing their prices and stealing market share from their competitors. That appears to happen in the pharmaceutical market sector less often than it should.

Third-party payment contributes to this failure of competition. Heavily insured patients who fork over the same copays regardless of which drugs they use will not respond to rising prices by switching to lower-cost alternatives. They will buy what their doctors recommend, and their doctors will not care much about price, knowing that their patients are insured. Third-party payment may weaken drug makers’ incentive to compete for market share.

To purchase Overcharged, click here.