TCS Daily

A Risky Shot In the Dark

By Kevin Hassett - July 22, 2003 12:00 AM

The latest word is that the bill to permit reimportation of drugs mentioned in my previous piece is very close to having enough votes to pass. The reason the bill is so close to becoming law is that a number of traditionally free-market Republicans have rallied behind it. Why would they do that? Apparently, members have grown tired of watching foreign governments pay far less for U.S. drugs than U.S. citizens pay. Exasperated that the Canadians and French (and others) are free-riding off of our drug discoveries, members have decided to force the drug companies to charge the Canadians the same price they charge Americans. The hope is that this will raise the price faced abroad and lower the price here.

My first response to this is to note that this complicated world system has helped the U.S. drug industry become the envy of the world, so why are you messing with it? But a more detailed response is warranted as well.

The problem with this analysis is that the hope is misplaced. Recall how prices are set when a U.S. firm attempts to sell a drug abroad. It must negotiate a price with a government monopolist that can give the firm a take-it-or-leave-it offer. U.S. firms today want to extract as much profit as they can in these negotiations, and the result is the relatively low prices that we see abroad.

How is it that foreign governments can extract such healthy price concessions? There are two answers. First, if the U.S. firm decides to refuse to offer a government any drugs at the offered price then the government could well decide to ignore the patent and encourage a domestic producer to supply a generic version of the drug. It might even claim to do so for humanitarian reasons. Second, it is relatively unusual for a firm to have a product that has an entire market to itself. A pain medication, for example, has many competitors. Foreign governments can play one supplier off against the other, since Johnson and Johnson can rush in where Merck decides to exit.

If reimportation is allowed, then U.S. firms will be more willing to fight these lower prices, but it is hard to imagine that this will have much of an impact on the dynamics of price negotiation. This is especially true because the governments that firms will be negotiating with are already out of cash. It is impossible to use economics to say exactly how this process will work out, but it is a lock that a new single price for all countries that makes U.S. consumers better off and leaves drug revenues unscathed will not prevail. The first move will undoubtedly be a rejection of the demand for a higher price. The second move might be a search for informal side agreements that offset the new law. For example, a firm might sell at a lower price only on the condition that a country discourages exports of that drug. A black market will likely emerge to get around these deals. This is probably the most likely outcome. The bill creates a costly mess abroad, does little to prices at home, and crushes only the drug companies.

Alternatively, U.S. firms could play a game of chicken with foreign governments and refuse to offer drugs at low prices any longer. I am a little doubtful that this would happen since firms could play chicken now and don't, but exploring the possibility is instructive anyway.

In this scenario, there would likely be different outcomes for different types of drugs. For drugs with slightly inferior off-patent substitutes, foreign governments will likely just do without the superior product. For drugs -- like those that lower cholesterol -- that have long-run benefits but do not necessarily have an immediate and visible effect on mortality sales could disappear as well. Only for unique drugs (cancer, high-end antibiotics etc.) that immediately affect mortality, would I expect the U.S. firm to possibly be able to extract a higher price, but only if foreign nations continue to respect U.S. patents -- a rather iffy proposition.

But follow this scenario further. Suppose that a cancer drug manufacturer is able to significantly increase revenue from France for its drug. The French do not have the budget to significantly increase spending on drugs across the board, so they clearly will offset the concession to the U.S. cancer drug manufacturer by taking a harder line against other U.S. manufacturers either by demanding a lower price or by reducing the use of their product. On balance, U.S. firms will not likely extract new resources from abroad.

At home, the firms that concede the lower price abroad will face competition from imports of their own product at home. The powerful firms with highly unique drugs will not. This might provide some near-term relief for drug prices, but that relief will likely pale in comparison to the losses that will emerge in the pharmaceutical industry. It is hard to imagine that drug discovery will be aided by this dynamic. Don't forget that the firms that pull out of foreign markets will take an enormous profit hit.

Staying in this scenario a bit longer, it is also important to make a theoretical point. Drug firms need to maximize their profit from their winners in order to offset the losses for all of their losers. That is how we encourage them to swing for the fences and try new things. Price discrimination is a pretty efficient way to allow them to do this. Recall where the demand curve from Econ 1 comes from. Think of there being a continuum of individuals willing to purchase your widget. If you charge $10 then only David is willing to buy it. If you charge $9, David and Tiger are willing to buy it. If you charge $8, then David, Tiger, and James are all willing to buy it. If you have to charge them all the same price ($8), then David is very happy, since the widget is worth at least $10 to him. A firm can maximize its revenue for a given product by charging each customer a different price, by charging David $10. Reimportation takes this strategy away from firms, and it must make them worse off.

But will U.S. consumers be better off? They might be in the short run in the unlikely case that a new single world price emerges that is somewhere between the U.S. and foreign price. But even in that case, the net drag on profits will significantly reduce drug discovery.

Thus, while there are a number of paths that could be taken, in every scenario drug profits and research are lower. This hurts folks who hope for future cures, and it harms investors as well. It is exasperating that foreign governments extract such huge concessions from our firms, but this bill is a risky shot in the dark at the problem.

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