Capacity shortages, regulation, and firm incentives in the generic drugs industry

Drug shortages are becoming more frequent and severe in the United States, especially for generic drugs. A lack of economic incentives has been cited as a root cause. Only few firms choose to produce a such drugs, and, if they do, these firms do not allocate large levels of capacity. Hence, total industry supply is limited, increasing the odds of shortages. We develop and analyze a stylized game‐theoretic model of a generic drug market to understand the impact of various governmental interventions on the total industry equilibrium supply. We explicitly consider firm market entry and exit decisions and the participating firms' incentives to allocate productive capacity to the focal drug market. We first characterize sustainable numbers of active drug manufacturers and their equilibrium capacity allocation decisions for a given regulatory environment. We then analyze the effects of different possible policy interventions on these equilibrium decisions and total industry capacity. Finally, we consider the impact of combinations of different interventions and, importantly, the sequence in which such combined interventions are introduced. A key result of our analysis is that the sequence of policy interventions may have an important effect on the resulting equilibrium industry capacity. When changing the regulatory environment, policymakers should be careful never to lead a sequence of changes with an adjustment that adversely affects pharmaceutical firms' incentives to allocate capacity to the focal drug market; we show that starting with capacity‐supporting interventions always is a dominant strategy when aiming to increase total industry capacity.