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Market forces are powerful shapers of human conduct. As Adam Smith pointed out in 1776, and the collapse of the Soviet Union in 1991 demonstrated for all the world to see, there is no adequate substitute for markets to find out what people want and to organize resources efficiently to provide people what they want. Yet even the most enthusiastic champions of markets recognize that they can operate properly only if certain background conditions are provided by government. The most obvious are physical security (it’s tough these days to be in the oil pipeline business in Iraq); definition and protection of property rights (think of copyrights, the current problems with illegal swapping of recorded music and films on the Internet, and the future of the markets for those products); and courts that will interpret honestly and promptly, and enforce contracts cost-effectively. (Street violence among drug dealers may be due not only to turf wars but also to the fact that, as participants in illegal markets, they cannot go to court to enforce their commercial contracts.) In a free-market economy, fundamentals are a start In a modern free-market economy, the role of government goes far beyond those fundamentals. Think of the roles in support of markets performed by the Federal Reserve Board, the Securities and Exchange Commission (and the New York attorney general) and the World Trade Organization. Governments manage critical aspects of the market system, and in some important cases, e.g., the Internet, create new markets. Even in free-market America, governmental influence on markets is pervasive. Market forces respond to incentives; and in virtually all markets, even the unlawful ones, the government significantly affects the incentives to which buyers and sellers respond. When the government fails to perform its market-shaping role adequately, the result can be an increase in crime and other behavior considered objectionable. To illustrate this phenomenon, I will discuss three aspects of pharmaceutical markets. Much of the conduct of pharmaceutical companies that is criticized (and sometimes prosecuted or attacked in other ways) by governmental officials, by leaders of consumers’ groups, by editorial writers and others is marketplace behavior, responses to the incentives that operate in the markets. Under long-standing legislation, the federal government has assumed responsibility for ensuring that drugs are safe and effective, neither adulterated nor misbranded, and not advertised improperly. This governmental role has contributed to the vast expansion of pharmaceuticals and pharmaceutical markets over many decades. The government has also had to devise means for reimbursement for drugs provided to beneficiaries of Medicare and Medicaid. All of these roles of government have affected, and continue to affect, the performance of pharmaceutical markets. Deficiencies in the government’s discharge of some of these responsibilities have significantly contributed to conduct considered criminal or otherwise objectionable. Each of the following examples involves carefully calculated, economically motivated-and therefore deterrable-conduct. In the second half of the 1980s, there was a sudden and widespread outbreak of fraud in applications submitted to the Food and Drug Administration (FDA) by generic drug manufacturers. The frauds were committed not by one company or a few, but by many in one sector of the industry and not in others. Why? A useful answer will not be found in the particular characteristics of particular individuals or companies in the generic sector. Rather, the answer lies in what the government had done. In 1984, it enacted the Hatch-Waxman Amendments, Pub. L. No. 98-417, 98 Stat. 1585 (1984), which codified FDA’s system for applications for approval of generic drugs. The amendments went beyond FDA’s system by creating, with respect to each brand-name drug, a large reward (six months of market exclusivity) for the generic company that filed the first substantially complete application with a certification that challenged a patent on the relevant brand-name drug. Congress thus created a series of races to the agency, with a first prize sometimes of tens or even hundreds of millions of dollars. There had been no history of fraud in applications to FDA; and FDA essentially had no defenses against such fraud. No one in Congress or FDA took care to ensure that the new and lucrative races would be run fairly. An unintended, and unnoticed, consequence of the amendments was a dramatic change in the risk-reward ratio for fraud in generic-drug applications. Where apparently very attractive opportunities for gain open up, market forces will drive competitors to exploit them, unless there are clear and strong disincentives to exploiting them. The most obvious countermeasure against improper exploitation of opportunities for gain is a clear criminal or civil prohibition effectively enforced. Where, however, the risk of detection of improper conduct or of strong enforcement action against it appears to be small, competitors will cheat, even at some risk of running afoul of laws with substantial penalties. Just as some athletes seek to use prohibited substances to gain an advantage in their competition, so some generic drug companies used fraud to gain a competitive advantage. Somewhat similar analyses would help explain the scandals in recent decades in the savings-and-loan industry and in crude-oil reselling. Fraud is a reasonably well-defined and well-understood crime. The foregoing analysis does not imply that, in general, the prosecutions for generic-drug fraud were inappropriate. The analysis does suggest, however, that there would have been less fraud if the government had identified the new incentive for fraud and had done its job properly to take precautions against it in advance. Once the problem was identified, measures against fraud were put in place that provided a basis for confidence that fraud in generic-drug applications is not continuing. A different kind of governmental inadequacy is reflected in the regulation of pharmaceutical advertising. FDA frequently sends to pharmaceutical manufacturers letters objecting that their advertising overstates the benefits or understates the risks of their products, makes comparisons unsupported by the requisite scientific data or improperly suggests uses of the products not approved by the agency. Virtually every company that advertises drugs receives such letters. In response, the companies terminate the advertising objected to, presumably after achieving some beneficial effect. Why do companies repeatedly go beyond the limits of what FDA considers acceptable? The limits, themselves, are not entirely clear, in part because the application of the First Amendment to FDA-regulated advertising has not yet been fully worked out. Also, Congress has not given FDA the resources needed to police the prescription-drug advertising market effectively. The agency also seems satisfied with writing letters that bring particular objectionable advertising claims to an end, but don’t much deter companies from making such claims until a letter from the agency arrives. And, so, market forces push companies to go beyond the limits (whatever they are). In current circumstances, companies competing in the market have to choose either to exceed the limits or suffer a competitive disadvantage. A Lanham Act case or similar private civil action is not often an adequate response to a competitor’s overly aggressive claims. Improper advertising is conduct inherently known to nonperpetrators, and almost always known to competitors. If there were a credible threat of significant governmental enforcement, the volume of objectionable advertising surely would diminish. Prohibition and strong enforcement A third example reflects effective governmental action to discourage conduct considered objectionable. The Medicare-Medicaid anti-kickback statute, 42 U.S.C. 1320a-7b, with some exemptions, broadly prohibits the giving of any “remuneration” to induce a person to arrange for the furnishing of any product or service for which reimbursement may be paid under Medicare or Medicaid. The statute thus prohibits many types of sales practices that are considered acceptable in other kinds of markets and that, in the absence of the prohibition, competitive forces would drive manufacturers of medical products and suppliers of medical services to engage in. The distinction between what is prohibited and what is permitted under the statute has been elaborated in regulations and other issuances from the Office of Inspector General of the Department of Health and Human Services; the trade association of the brand-name manufacturers has issued a code of conduct that addresses the area covered by the statute; and enforcement by the Justice Department is vigorous. The result is a strong counterforce against the pressures of market forces to engage in conduct considered objectionable in medical markets. What these examples suggest is that a pattern of criminal or otherwise objectionable conduct among firms in a particular area of economic activity is probably attributable to some governmental failure in shaping marketplace incentives. When society is dissatisfied with the behavior of multiple firms in an industry, it should not, or at least not merely, denounce particular firms or individuals as reprehensible, but should (or should also) examine the operative marketplace incentives to which those firms and individuals respond, the responsibility of government with respect to those incentives and how that responsibility has been and should be discharged. Sometimes, even objectionable conduct simply should be tolerated, without further action by government; but, if the conduct is truly intolerable, then further governmental action is likely to be needed and, if resources are applied, may successfully discourage the conduct. Richard M. Cooper is a partner at Williams & Connolly in Washington. He can be reached by e-mail at [email protected].

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