TCS Daily


Once More Into the Breach

By Richard A. Epstein - August 18, 2003 12:00 AM

On most issues great and small the defenders of free trade stick together to oppose the fiendish array of restrictions that protectionist governments use to insulate domestic producers against foreign competition. It is therefore noteworthy when free traders divide among themselves on any issue of policy, especially one as important as the question of whether the current restrictions on parallel importation of pharmaceutical products should be kept in place. But as Edward Crane and Roger Pilon observed recently in the National Review Online, just that split has occurred within the conservative (really libertarian) movement, and even within the hallowed ranks of the Cato Institute. 


To Crane and Pilon, the issue is as "simple as it seems -- free trade is the answer." But then, as if to show that the simplicity point cannot be the clincher, they devote several tightly reasoned pages to explain why parallel importation is as American as sliced bread. They pay me of the compliment of being ingenious in error for my earlier defense of the parallel importation ban that appeared in TCS. So now it's my turn to return the compliment by saying that the right answer is a good deal more complicated than their ingenious arguments suggest.


To back up a moment, it's important to remember that the prohibition on parallel importation prohibits the resale into the United States of pharmaceutical products that were sold cheaply overseas, at prices below those which prevail in the American marketplace. To Crane and Pilon it is just a matter of good sense that we allow American citizens the benefit of the low prices that our free-riding allies obtain in Europe and in other markets, where they are protected by a friendly, often socialist, regime of local price controls. In my earlier essay on the subject, I approached the matter as one of contract between the original American companies and their overseas buyers. The point here is that a believer in freedom of contract has to respect these restrictions like any other contract term. And if so, then the only question is how these should be enforced.

To Crane and Pilon, the one party who ought not to enforce these contracts is the American government. They write in criticism of my earlier piece: 


Yet notice where that obligation rests, and whose business it is to enforce it. In the case of socialized medical systems abroad, American drug companies make their low-cost-drug contracts with foreign governmental or quasi-governmental entities. Yet rather than insist that those governments police their own vendors, American companies turn to the American government, asking it to enforce contractual terms binding foreign governments by restricting the freedom of Americans, who are not parties to the contract. Something is wrong there -- very wrong.


The situation is, however, neither as odd nor as strange as it seems. The problem in this case arises because the world is full of imperfections to which there are, alas, only imperfect responses. The first part of the difficulty comes from the necessity of having a patent system in the first place. It is a tragedy that life-saving drugs have to be priced at monopoly levels when we all wish that they could be dispensed for free; and perhaps a greater tragedy that the monopolist has to be given the right to price discriminate. But consider the alternatives; one could deny the monopoly, at which point the pricing question becomes moot (and consumer surplus tumbles to zero) because there are no drugs to sell in the first place. So against our strong libertarian instincts we create the patent monopoly as a spur to production, and in no area is the case for patent protection stronger than it is with pharmaceutical products.

 

Next step. Do we allow that monopolist to discriminate? In competitive markets we never have to worry about this nasty question, because the seller who seeks to go high with some customers will see his business dribble away to numerous rivals. But for many patented products there are no close substitutes, so that the price increases do not result in the market drying up. What next? We could say no to price discrimination, and act as if the competitive norms are best in the monopoly context. But even Crane and Pilon would (or at least should) not take this position, because the uniform price shuts low demanders out of the market, and allows high demanders to pay less than they otherwise would. With fewer dollars in the till, the total return to innovation decreases, and so too the speed and amount of innovation.


Last step. Why is it so strange to see the United States getting involved? Here the law is filled with all sorts of cases where actions are allowed against third parties because the direct remedy is blocked for some reason. Here is one case: A induces B to break his contract with C. No question that C has an action against B, but there is also no question that C has an action against the inducer, A, as well, for the loss of the arrangement. And why is that so valuable? Well, B may be insolvent, or outside the jurisdiction. Or there may be many Bs who are too numerous to sue, but only one A who has orchestrated the breach, and so on. It is for this reason that we allow owners to sue not only thieves but also the people to whom these goods are sold in some secondary market. If it is possible to kill off the resales, then the original theft or violation of trust is that much less likely to occur.


Ideally, we would like to see the local governments enforce or respect their obligations, but if they choose to violate their contracts with their own sellers, then the sellers could sue the third parties to stop the resale, which is all that happens when the sales back home are enjoined. There is nothing odd about saying that third parties, Americans all, cannot receive goods that they obtain in violation of a prior contract. It happens all the time.


All this is not to say that the arrangements are ideal. There is no question that the Americans are boiling mad that the Europeans are free riding off our low prices, and would like to share the short term gain. Our problem comes in part because we are so dominant in the research side of the business that foreign countries don't hurt their own innovators when they take after ours. My colleague Randy Picker has suggested to me that we could play tough: set the prices in the domestic market below their current levels so that drug companies could only innovate if other nations raised their prices, which they will do rather than lose the market altogether. His stomach has less acid than mine. I have no doubt on the soundness of his stripped-down game or that he is after the right outcome, as are Crane and Pilon, when they seek to get the Europeans to pay more so that we could pay less. But this is a treacherous game: there are many foreign nations, and no particular nation will raise its local prices if others do not. So we could find ourselves in the situation where no foreign country responds to the threat, which cuts off the innovation on which so many lives turn. I have zero confidence in how this bluff system will play out over the decade or more that it takes to develop new drugs. 


Still, even if some initiatives could work, there is no reason to relax the ban on parallel imports. The indirect enforcement of the original contracts of sale is proper for the American government in light of the strong national policy that allows price discrimination at home as an inducement for production. Free trade is advanced, not retarded by the extra remedies afforded sellers who cannot. I understand the motives to hit back at the Europeans and to share the gains at home, but question the wisdom of any policy whose long term effect leads us to cut off our nose to spite our face.

 

Richard A. Epstein is James Parker Hall Distinguished Service Professor of Law, the University of Chicago, and Peter and Kirstin Bedford Senior Fellow, the Hoover Institution.

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