TCS Daily

Your Brain on Drugs

By Kevin Hassett - July 18, 2003 12:00 AM

Congress is poised to pass a new law that will make it legal to import drugs from foreign nations. This "reimportation" bill has strong bipartisan support, and may well become law. If it does, the results will be disastrous.

The logic of the bill appears attractive at first glance. U.S. drug companies sell their drugs abroad at prices below those paid by domestic customers. For example, 30 tablets of Zocor cost $89.95 in a typical U.S. pharmacy, and only $41.20 in a Munich pharmacy.

This large difference in prices creates an impression that drug profiteers are gouging American customers. If they can sell to the French for less at a profit, why can't they sell it at home at the same price? Rather than specifically setting the price, the reimportation bill will allow U.S. customers to purchase drugs at these low foreign prices. Those low prices will make U.S. customers better off, won't they?

Not really. The crafters of this bill have clearly misunderstood the basic economics of drugs. Therefore, a review is in order. The U.S. is the only significant market in the world where companies are allowed to set the price for their products in the marketplace. The pricing of drugs is very complicated. At the time that a new and important drug is approved, a drug company likely has a monopoly on that specific product and can charge a very high price for the drug if it so chooses.

The monopoly can be relatively short-lived, however, since there are no significant barriers to entry, and other companies can develop competing products if a new and successful moneymaker is discovered. (One need only think about all of the different competing pain medications to understand this process).

Moreoever, after the patent period expires (usually about 10 years after a drug hits the market) generic competitors can enter and drive prices down as well. So a window exists wherein a firm can charge a price that is higher than the immediate production cost. During that period, a firm hopes to earn enough profit from the drug to cover that drug's development cost (often in the billions) and also to offset the losses for all of the other drugs that the firm investigated and dropped.

Because of these challenges, the drug industry is perhaps the only industry where a firm can currently market goods at a price significantly above the marginal cost of production and yet not be insanely profitable on balance. For example, Merck is one of the larger U.S. drug companies with many successful drugs such as the cholesterol drug Zocor, and yet its share price (about $60 per share) is exactly where it was five years ago. While that is going on at the top of the sector, the new entrants seeking to compete for Merck's profit in the biotechnology sector are famously hurting for cash, with many of them near bankruptcy. That is hardly a story of an industry with runaway profits.

U.S. firms use the profits on the winners to balance out the losses on the losers. In the U.S. they have significant room for maneuvering, but in Europe (and Canada) the story is much different. There, the U.S. firm must negotiate with government bodies that present the firm with a take-it-or-leave-it offer. If a drug costs $10 a pill to produce at the margin and is being sold in the U.S. for $20 a pill, then a European government can say "sell it to my people for $11 a pill or you can not sell it at all in my country." Since the deal gives the firm $1 profit at the margin, the U.S. firm makes the deal. The choice is not surprising since it is a very basic result in economics that "price discrimination" can help a monopolist maximize the revenue from its product.

So the marginal profit on a sale in a country with socialized medicine is lower, but the extra profit on top of that earned in the U.S. free market helps firms balance out all the other losses. The system has worked for U.S. firms, while low profits in Europe have shut off product development and innovation there. The U.S. is responsible for most new discoveries and for 15 of the top 20 drugs worldwide. The development disparity is getting larger, as U.S. firms are responsible for the lion's share of worldwide R&D.

By allowing reimportation, the new bill remove the pricing power that firms have in the "window of profitability" for new drugs and cede it to foreign governments. While the change in law may force U.S. firms to try to take a harder line with foreign governments, it is hard to be optimistic about the outcome of the debate since foreign governments can always just decide to ignore the U.S. patents and counterfeit the drug themselves. While such an action would violate treaties, it is hard to imagine that the socialists (already nearly bankrupt) would agree to commit significant new funds to drugs. So firms will have to either stop selling the drug abroad, or lower their U.S. prices. Either way they lose.

Accordingly, the bill will destroy the system that allows profits from winners to offset losses from losers, and likely destroy the economic architecture that has led the U.S. pharmaceutical industry to be the envy of the world. It will also significantly reduce the profitability of U.S. firms which will have a dramatic impact on their share prices, and the stock market as a whole. Lower profits will inevitably lead to reduced research and development, which will slow the discovery of new drugs.

This last effect puts this Congressional action in proper perspective. Congress is sacrificing future cures so that they can offer voters cheaper drugs between now and the next election. Such crass calculations have sadly become par for the course in American politics.

That said, I am not even sure that the political calculation is correct. For example, the Associated Press reported on July 16th that the FDA discovered that millions of fake Lipitor pills were slipped into the country this spring. The extent to which these fake drugs harmed consumers is not yet known, but the FDA is concerned that it will be unable to adequately monitor the quality of imported drugs if this bill becomes law. FDA commissioner Mark McClellan told the AP that "our enemies are smart, they're cunning, they're aggressive." Imagine the news coverage when U.S. patients start dying because their cheap imported drugs proved to be ineffective counterfeits. It is hard to imagine that such stories will help incumbents.

If Congress allows reimportation, it will be frittering away a crown jewel of the U.S. economy for short-term political gain that will endanger Americans. Let's hope our elected officials see the light before it is too late.

Kevin A. Hassett is Director of Economic Policy Studies at the American Enterprise Institute.

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