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Financing

Improving Vaccine Supply And Development: Who Needs What?

Abstract

 
Payment for vaccines appears, from recent shortages, to have been inadequate. This paper addresses the roles of various stakeholders in influencing current payment and affecting possible increases. It is argued that the recent problems may have stemmed from undervaluation by government payer-negotiators, by private insurers, and ultimately by consumers themselves. On the supply side, the high profits available to other kinds of drug-firm investments may have inhibited allocation of resources to development of new vaccines, and the low profitability and near-monopoly status of current products may have produced insufficient incentives for producers to protect supply against accidents.

It is therefore surprising and puzzling that these highly valuable and socially concerning interventions are also among the few medications or treatments in U.S. health care that have experienced temporary but crucial interruptions in supply once they have been on the market, and allegations of slow or no progress to market when they have been in development. The proximate causes of shortages have varied: sometimes (as in the current influenza vaccine shortfall) by problems in production, sometimes by underestimate of demand by producers, and sometimes by unexpected regulatory or legal restrictions. At the same time, the number of firms making these vaccines for the U.S. market has fallen dramatically during the past three decades, from twenty-five to five.² Some observers believe that despite the introduction of a modest set of new vaccines in recent years, the number of firms interested in developing new vaccines is falling far short of the need and of the potential for useful products.

In this paper I offer some perspective on this puzzle by outlining the gains and risks to various stakeholders in the process of developing new vaccines and protecting the supply for existing ones. Despite the large social gains from vaccines, it is tautological but apparently true that the returns (in a broad sense) from investing in new products or protecting the current production processes have not been sufficient to bring forth adequate supplies. Who is not getting enough to do what they should, and why is this happening? Where are the crucial bottlenecks or choke points, and why do they exist? My goal here, however, is not to provide a complete analysis of the sources of and solutions to failure in this market; rather, I have the more limited objective of identifying which stakeholders are important and what the potential problems are in dealing with their interests.

For the moment, I assume that the current U.S. system of almost complete private production (there is one state government that produces a small amount of some pediatric vaccines) and private development of new vaccines (although potentially using the results of government-funded research) will persist. Later I consider more far-reaching changes.

Supply-Side Stakeholders

Top Supply-Side Stakeholders Demand-Side Stakeholders An Alternative To Private... NOTES

 
Supplying capital. In the United States, the bulk of capital for the development of new vaccines and virtually all of the capital for production of current vaccines comes from the private sector. Some of this capital is furnished by and through existing pharmaceutical firms, who pay for research on potential products and production facilities to produce the products (a tiny fraction of those that are explored for development) that actually enter the market.

Existing drug firms have very simple needs: They are willing to furnish capital as long as they can expect to make enough money. To be an ideal incentive, this return should be high enough, free of risk, and predictable. But, as we are told by industry insiders, existing drug firms have high targets for how much of a return is enough; the return on any new investment has to be at least close to what the firm could earn by investing in highly profitable other drugs. The best financing, from the firm manager’s perspective, comes from profits on existing products; this internal capital is supplied in a less demanding way than profits from the external capital market would be. External capital comes not from existing major drug firms but from start-ups and (initially) small new firms; the venture capitalists who fund such firms require large returns for successful investments.

Even without identifying the problems in detail, it is easy to see that there are seeds of conflict here: Investors would rather get more, but buyers would rather pay less. This conflict partly manifests itself as investors’ strategies to seek market power—the power to earn higher returns—which buyers strive to avoid paying. At the policy level, it shows up as arguments of the "is so, is not" variety concerning the adequacy of profits when they are realized.

Do suppliers of capital for vaccines have reasonable expectations of profits, and are these expectations (reasonable or not) realized in actual markets? One theoretically correct way to answer this, which would be hopeless in practice, is to calculate the expected profit rate for potential new vaccines or for investments to protect the supply of current vaccines, and then compare it with a normal or "fair" (risk-adjusted) return. This is hopeless because the data on costs for hypothetical products either are proprietary or do not exist (because returns would have to be measured and averaged across successes and failures), and because there is no unique definition of a fair rate of return (to which the checkered history of now-abandoned public utility regulation attests).

A more feasible and more useful approach builds on the commonsense observation that above-normal profits in a line of business will draw firms into that business and below-normal profits will cause them to exit. As already noted, the production of existing vaccines has been characterized by major exit of firms and shortage of investment (relative to other drugs). Absent a conspiracy among firms to limit supply, this is circumstantial evidence that returns on investment are below normal.

For developing new vaccines the picture is less clear, because there is some investment and some entry. To the extent that returns for new vaccines are linked in investors’ minds to the low returns on old vaccine investments, there is also likely to be a problem here. The somewhat irrational practice in which large drug companies are said to avoid investing in vaccine development does not yield a return as high as investment in their other products, even if the return is well above the cost of new capital, would reinforce this bottleneck. (It might not be a coincidence that vaccine supply problems became most acute when profits from new drugs recently spiked upward.) Finally, the prospect for litigation or just bad press for a vaccine that might in the future be alleged to be harmful (no matter how "junk" the science), or that cannot be supplied when needed, adds to firms’ perceptions of low returns.

Supplying scientific knowledge. Financial capital is not the only input to the development of vaccines; scientific knowledge is required as well. Here drug firms supply some of the input with the capital investment just described, but much of it is also furnished by government through its support of the public good of basic research. The older pediatric and adult vaccines were largely developed by government alone (not by drug companies), but the newer ones have been more of a joint product. The extent to which government should support applied knowledge and development (as opposed to basic research) remains contentious. The issue of whether profit-seeking firms should be given free (no-royalty) access to the public good of knowledge is settled enough in theory—public goods with zero marginal cost of use should have a zero price—but is argued in practice. However, in the case of vaccines, there does not seem to be a strong belief that key scientific investigations have been starved for support. Still, more support would probably do more good but would have to compete with other government-supported research areas.

Supplying vaccines. Other inputs have to be supplied to produce and distribute vaccines that have been invented and recommended. As in the case of financial capital, there is strong evidence that these inputs have been undersupplied. While each vaccine shortage has its own special "accidental" cause, the recent regularity of these accidents suggests that firms are underspending on the quantity and quality of labor needed to avoid errors and the systems that can help prevent them.

Supplying vaccinations. Finally, a supporting role in supply is played by physicians who usually (although not necessarily) administer vaccines. Especially for pediatric vaccines, it is thought desirable from the viewpoint of companies and commentators to have the pediatrician immunize children as part of well-child care. (Apparently there is less need for primary care physician inputs for adult influenza vaccines, which can be given by a nurse or, in some forms, self-administered.) Here again, pediatricians complain of being underpaid for the administration of vaccines (even if they are covered for the materials). The substitute for private-practice physicians is a public clinic, which is thought to be less desirable in terms of convenience, amenities, or coordination, and therefore may contribute to noncompliance.

Demand-Side Stakeholders

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Financing public-sector demand. Governments at several levels play a large, changeable, and varied role in financing the demand for vaccines. The basis for this role presumably is in the external benefit–contagious disease nexus that gives rise to public health concern, although governments also finance vaccinations for noncontagious illnesses such as tetanus. State and local governments are nominally charged with managing public health services, and they also cofinance pediatric vaccines with the federal government in the Section 317 and Vaccines for Children (VFC) programs. States also purchase some pediatric vaccines in their own programs.

Federal price negotiations. The federal government plays a role in pediatric vaccines that multiplies its influence beyond its share of financing because it negotiates prices for both the fully federally funded VFC program and the partially state-local government–funded Section 317 program. In aggregate, the federal government negotiates the purchase and financing of more than 50 percent of pediatric vaccines.³ Congress sets statutory price caps on some childhood vaccines. The U.S. Centers for Disease Control and Prevention (CDC) specifically plays a major role in funding and managing grants to lower levels of government. The Advisory Committee on Immunization Practices (ACIP) specifies which vaccines are to be recommended; in the case of pediatric vaccines, these recommendations are virtual mandates for public health programs and for those private insurers that cover immunizations.

It appears that federal negotiators did what they perceived to be their job quite well; they negotiated much lower prices for federal purchases. Congress also responded to a perception that its tax-paying constituents wanted to pay less. While the discounts from "average wholesale price" (AWP) varied by product and were generally smaller in percentage terms for those newer products whose patent protection gave the sellers strong bargaining power with the government, discounts to the CDC ranged from 24 percent to 65 percent.⁴

Since the maximum quantity of scheduled pediatric vaccines is determined by the population of eligible children, the level of the price determines the amount of profit a producer will lose if supply cannot be maintained. If that level of profit is low, it will not pay the profit-seeking producer to invest in costly protections, including setting up multiple production lines so that contamination is confined. Moreover, if the producer has a monopoly and the vaccine is required (for example, to enter school), most of a temporary loss in production will be made up later (even though the delays could have public health consequences). Thus, low prices can have, and appear to have had, negative side effects.

State budgets. State and local government programs have had financing problems. Budgets for public health programs are often quite limited, and these programs frequently experience cuts or freezes when the overall government budgetary picture darkens. Some believe that this type of expenditure tends to be at the end of the queue, with priority taken by nonhealth spending or other state health spending, such as long-term care, which yields much less health benefit than does public health in general and vaccines in particular. The development of new, effective, but relatively costly recommended vaccines causes problems because, poverty-stricken state and local governments say, their vaccine or public health budgets are limited. Federal spending has been subject to similar externally caused fluctuations (especially the Section 317 grants).

Impact of public demand. Public demand could increase the market for a product like a vaccine, but constrained public demand combined with low price is likely to inhibit development. There are three sources of tension in this area.

First, as noted, there are reasons to believe that aggressive and successful price negotiations may have negative side effects. But to the public officials doing the negotiating, the lower prices are tangible and certain, while the supply interruptions are uncertain, with multiple proximate causes and no self-evident direct connection to lower prices. So the goal of lower prices tends to predominate.

Second, the concept of a fixed government budget for vaccines is surely disingenuous. If higher public priority were placed on spending for vaccines, taxes could be raised or other government spending displaced. The real limit on state and local spending on vaccines is the willingness of decision makers, and ultimately taxpayers, to set a high-enough priority on this type of service by being willing to pay the price of expanding it. That higher priorities will cost more money is inevitable; what is discretionary is the trade-off between costs and benefits that the public sector is willing to make.

The reason why taxpayers should be willing to pay for vaccines is presumably the externality argument, but that argument is inconsistent with the fluctuating public demand that has actually occurred. Real governments appear once again to be failing to do what the welfare economics textbooks advise is ideal. Not only is this fluctuation of concern to providers and manufacturers (making "public-private partnership" an aspiration rather than a fact), it also makes private insurers highly skeptical of proposals that they be used as the channel for government funding. Insurers and vaccine manufacturers have expressed concern that subsidies will be turned into obligations when government cuts back, and funded mandates will become burdens when the budget dries up.⁵ The alternative—full government displacement of private insurance coverage for vaccines—is variously seen as relief of a burdensome obligation or as a stalking horse for governmental assumption of complete insurance financing for nonpoor families. The status quo seems much safer, even if it may not be sustainable over time, as new and more costly but effective products strain even currently unthreatened budgets.

Influenza vaccine for adults is a somewhat different case from pediatric vaccines. Although there is substantial federal government payment for flu vaccines for Medicare beneficiaries, that payment level is set at the AWP and is not generally negotiated by government. So the source of any problems here is not public-sector discounting policies per se; the source is equally located outside of government and in private insurers’ and consumers’ decisions.

Third, the stakeholders at different levels of government are naturally interested in understanding what roles they are supposed to play in vaccine financing and concerned about protecting the roles they do play. The checkerboard patterns of financing and control, which do not even match, make these stakeholders apprehensive about change as well.

Financing private-sector demand. Recommended vaccines are potentially covered by private insurance (once any cost sharing is paid), at payment rates set by the private insurer. But for a large minority of the population under age sixty-five, insurance either does not cover immunizations or is lacking entirely; in these cases, the ultimate stakeholder is the individual consumer. Private insurers are surely the proximate stakeholders for those who are insured, and in the short run there is a trade-off for fully risk-bearing insurers between more generous payment for existing vaccines, promises of quicker extensions of coverage for new vaccines, and insurers’ profit. Insurers’ resistance to coverage at generous prices can impede demand and cast a shadow over the prospects for new products in development.

Employers. It is misleading to pay much attention to this conflict. Risk-bearing insurers can always raise premiums to cover new services and still preserve profits; the resistance to coverage then comes not from insurers but from those who purchase insurance. The great bulk of these purchasers are employers. The longer-run source of resistance is then employers that either do not value vaccines or value cost containment more than anything else. Moreover, most large employers self-insure but often use an insurer to administer the coverage. So in reality insurers will cover anything the employer-buyer is willing to pay for. Thus, the real conflict is between employers’ desires to hold down insurance premiums and yet offer benefits that still attract employees.

Consumers. Consumers who pay out of pocket are important stakeholders in the financing policy debate. Their importance may well exceed their relative proportions, since it could be only the uninsured population’s resistance to higher prices that constrains private prices. Consumers who might obtain vaccines are subject to the usual budget constraints; if they obtain a vaccine or pay a high price for it, they will have less to spend on other things.

Of course, not all consumers attach the same value to an immunization for themselves or their children. The worth of a flu shot depends on an adult’s risk level; the value of a pediatric immunization depends on how prevalent the disease is. In addition, if the consumer is insured for all costs of the illness that might result, at the margin there will be less-than-ideal incentives for consumers to undergo both the cost and the bother of the preventive activity.⁶ This will especially be the case if the cost offset is large and the consumer’s decision on vaccine purchase is highly responsive to its user price.

The most serious issue posed by consumers’ behavior is, indeed, related to consumers’ responsiveness to immunization prices. The profitability or profit margin a firm will earn on a product produced by one or a small number of firms will be higher the less elastic or responsive to price is the demand for the product. If almost all consumers continued to buy a product at prices above costs, profits would be high; if they deserted the product in large numbers when prices rose above costs, profits would be low. Paradoxically (given the value of immunizations), it appears that vaccine demand is more responsive to price than is the case with other medical products. Their profit margins are lower, and people shy away from higher-price products or sources. Many people may well stop buying at higher prices both because they do not as typically have insurance to cushion the price increase, and because they would be willing to take a chance and go without. Even if (as is surely the case for the flu vaccine) some people place very high value on the product and will obtain it almost no matter what, the value of the demand-responsiveness of the marginal consumer (the one who may or may not get around to getting the shot) will determine the market price. This discussion of price responsiveness is, it should be admitted, based on partial and circumstantial evidence; further investigation of demand elasticity would be helpful.

For vaccines, it appears so far that this asymptomatic healthy consumer does not find the product to be essential. The low rate of use of the flu vaccine even by high-risk adults (where the use rate when the vaccine is generally available at its relatively low market price is only about 40 percent) is indicative of this high responsiveness, although there are many reasons other than price for consumers to fail to obtain vaccines for themselves and their children.

For public purchases of pediatric vaccines, it is the seller’s perception of the government buyer’s response to higher prices that drives down profits. For influenza vaccine, where there is little direct government buying, it is the low value that uninsured consumers attach to this product that constrains the profit margin. Whatever the cause, the result is the same: low investment by firms in protecting the supply chain of existing products, and low incentives to invest in the development of new products that are expected to face the same kind of elastic demand. A new vaccine that was indispensable and sold in heavily insured markets might not suffer this fate, but a firm investing in development of vaccines today would need to bet that it would be that lucky.

An Alternative To Private Markets

Top Supply-Side Stakeholders Demand-Side Stakeholders An Alternative To Private... NOTES

 
Up to this point I have been discussing stakeholders and policies in the context of the current U.S. market in which virtually all development and production of vaccines occurs in the private sector and in which government financing works through the private sector. Given the externalities and the high marginal social and private values of vaccines, this reliance on private markets and private incentives may seem anomalous. During the recent U.S. flu vaccine shortage, questions were raised about whether the government should play a larger role in production, allocating supply, and the development of new products.

Government production. Some of the early pediatric vaccines were produced in state government laboratories, and there is no intrinsic reason why production of vaccines needs to be private. Government-owned firms could in theory obtain capital (using public borrowing), hire workers, and sell their products. The key questions here are imponderable: What incentives would these organizations face, how would they set prices, and how would they organize production? There are wide differences of opinion about the relative efficiency of government production. Although a publicly managed firm might take greater care in protecting supply, "Murphy’s Law" is not repealed by the fact of public ownership. Although the public firm might choose to incur higher cost in order to invest in protecting supply (for example, by having smaller, more costly, but less vulnerable production facilities), there might be criticism of the higher price that would be needed to cover that cost or of the drawing down of the government’s limited capital supply in times of overall government financial constraint.

There is no a priori reasoning that can settle the matter. The fact that states that formerly produced vaccines have been getting out of the business, even as the number of private suppliers shrinks, suggests that public production is not an automatically available alternative in the current environment. If (as seems likely) the production of new biotech vaccines will be more complex and require more initial capital than the early pediatric vaccines, the future for public production becomes even more questionable. But the question of "why not government?" will continue to be asked.

Government R&D and other alternatives. Instead of using the patent system to reward private-sector inventors with monopoly profits, it would be possible to carry on the basic research and development (R&D) of new products within a government entity, although even that entity (somewhat like the National Aeronautics and Space Administration) would be likely to contract out much of its work to private organizations, both for-profit and nonprofit. Here again, the key issue is how to get the incentives right; at this point, all one can say is that incentives for successful development of useful new vaccines would be different for government scientists than for private firms.

A compromise might be for the government to prospectively reward successful research by private firms with a prize and then to license the intellectual property for use in production of products that would be sold at their marginal cost. This approach is especially useful for new products whose prices will be fully or nearly fully covered by insurance. The Institute of Medicine (IOM) did recommend that the government develop a pricing mechanism whereby both the price and quantity of a hypothetical new vaccine would be specified in advance, with the price dependent on a calculation of a monetary measure of the benefit from having the product available.⁷

Government short-run allocation. In the absence of large-scale shortages, the allocation of a supply of vaccine is generally handled through the market. Different providers search among the sellers (if there are multiple sellers) and try to negotiate the best price and delivery terms that they can. Sometimes a buyer will pay slightly more than the lowest possible price, to have quicker delivery or to avoid any immediate problems of supply.

This system apparently works tolerably well in most circumstances; however, the recent flu vaccine crisis indicates that society appears to be unwilling to let prices allocate a restricted supply. Even those buyers who had contracted with the surviving producer of vaccines were not permitted to take delivery and allocate as they saw fit; government rules were used to direct vaccines toward higher-risk users regardless of the precaution they or their providers had taken to secure a supply in advance.

It is easy to see what the problem is here. The cautious and risk-averse buyer, whether individual or institutional, might well seek to pay somewhat more than average to secure a guaranteed supply before an emergency develops. And this higher price will induce vaccine producers to invest in efforts to prevent the interruption of supply so that the emergency is less likely to occur. But if these private arrangements are to be overridden by public allocation of vaccines when accidents happen, there is no remaining incentive to enter into such contracts. A supply that is guaranteed by a higher price is not secure if the vaccine can be diverted by public authorities. Paradoxically, public health efforts to engage in fair and effective allocation of a limited stock of vaccines in the case of an accident seriously diminish buyers’ and producers’ efforts to avoid accidents or to protect against their consequences. If government is expected to step in, there is no private system of pricing and protecting supply that is sustainable: Why pay in advance for protection of something that can be taken away precisely when the event being protected against occurs?

No foolproof method for securing financing for vaccine production or development has yet been developed. It does seem clear that recent problems have been serious and common enough to suggest that possibilities for improvements should be explored. The usual fork in the policy road then appears to be, If the current public-private hybrid is unsatisfactory, does the situation need more market or more government to improve? The choice is not always so mutually exclusive: Shifting to more public provision of demand-side financing can be combined with greater reliance on markets to invent, produce, and distribute vaccines, as the IOM report suggested.⁸ But any movement through this ideological minefield is likely to be challenging. The high potential gains from good planning suggest that the status quo should not serve as a safe refuge; rather, serious discussion of alternatives should continue.

Editor's Notes

 
Mark Pauly (pauly{at}wharton.upenn.edu) is the Bendheim Professor in the Department of Health Care Systems at the Wharton School of the University of Pennsylvania, in Philadelphia.

NOTES

Top Supply-Side Stakeholders Demand-Side Stakeholders An Alternative To Private... NOTES

 

1. Institute of Medicine, Calling the Shots: Immunization Finance Policies and Practices (Washington: National Academies Press, 2000).
2. IOM, Financing Vaccines in the Twenty-first Century: Assuring Access and Availability (Washington: National Academies Press, 2004). The bulk of this decline occurred in the late 1970s and early 1980s; the reduction in suppliers has been slower but continuous since then.
3. Ibid., 4.
4. Ibid., 130–131.
5. B. Kaye, "Manufacturers’ Perspective," in Vaccine Financing Stakeholders’ Forum: NVPO Responds to the IOM Report, Washington, D.C., 28 June 2004, www.os.dhhs.gov/nvpo/meetings/jun2004/vaccinefinancing.html (22 March 2005).
6. M.V. Pauly and P.J. Held, "Benign Moral Hazard and the Cost-Effectiveness Analysis of Insurance Coverage," Journal of Health Economics 9, no. 4 (1990): 447.[CrossRef][ISI][Medline]
7. IOM, Financing Vaccines; and M. Kremer, "Creating Markets for New Vaccines," NBER Working Paper no. 7716 (Cambridge, Mass.: National Bureau of Economic Research, 2000).
8. IOM, Financing Vaccines, 16–18.

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