In most markets, shortages (and surpluses) are rare. Instead, prices change to keep the quantity of products supplied and the quantity demanded balanced. For example, when, because of a supply disruption, the market supply of a product declines, prices rise and consumer demand adjusts. In general, the number and severity of shortages in any sector depend on the extent to which the demand for a product and the supply of a product respond to price (the price elasticities of demand and supply). Very low price responsiveness on both the demand and supply sides for many medically necessary prescription drugs means that shortages of prescription drugs (or of upstream Active Pharmaceutical Ingredients — API) are not an unexpected phenomenon in this sector in the presence of supply or demand changes that are not fully anticipated by manufacturers.
The degree of price responsiveness for medically necessary prescription drugs is low, both in the short run and in the long run, for two reasons. First, these drugs are, by definition, medically necessary, implying that they have few substitutes and consumption cannot generally be shifted over time (for this reason, shortages of drugs for the treatment of chronic conditions are much less likely to occur). Second, consumers in the prescription drug market generally purchase services through health insurance contracts that pay providers using pre-established payment rates and guarantee to provide consumers necessary services. Final consumers’ demand for services is largely unaffected by changes in price. Although hospitals and physician offices may face increases in price, their demand for the prescription medications used to treat their patients is also not very responsive to the price paid to manufacturers for the drug.
This lack of price elasticity on the demand side is mirrored on the supply side, particularly in the short run. Costly, specialized equipment is required to produce prescription medications, production processes are complex, especially for sterile injectable products, and firms are required to adhere to Current Good Manufacturing Processes (CGMPs). Substitutions of products within a class can often be (and usually are) achieved on the same supply line, but a specific class of drugs usually requires equipment and regulatory approvals that are limited to that class. Drugs have a limited shelf life and holding excess inventory is costly meaning that drug manufacturers try to keep inventories as low as possible. Raw materials for production are frequently difficult to source, must be validated by manufacturers, and require regulatory approvals. It will generally take a long time — years — for the industry to increase capacity in response to an increase in prices. If the increase in prices is expected to be temporary (as would be expected in the case of a shortage due to a production line disruption), investments in increased capacity are unlikely to occur. In the longer run — over a period of 2-3 years, for example — supply will be much more price responsive.
This framework suggests that the development of shortages will be a function of the short run elasticity of demand and supply for a particular drug, and of unanticipated demand and supply changes that occur in that market.
It is expensive to hold capacity ready to make a drug and yet earn no sales from that capacity the vast majority of the time. In our current system this cost would fall on the generic drug firm that chose to build excess capacity or dual source; it would have high costs relative to its competitors. Clearly, in a competitive market, which the generic drug industry is, no firm will choose this route unless it receives a higher price in the market or other compensation.