Wednesday, October 06, 2004

Prescription Drug Re-importation

Yesterday, Professor Brad DeLong linked to his op-ed in the L.A. Times today about prescription drug re-importation from Canada or Europe. We spent quite a while thinking about this issue at CEA, and so it seems like a good topic on which to post. Some of this thinking, but certainly not all, made it into the Economic Report of the President 2004 (see Chapter 10 and Box 10-1, in particular).

Prescription drug prices are lower in other countries, primarily because these countries impose price caps that are lower than the market (patent protected) prices that the drug companies can charge in the United States. The American public--whether individually, through health insurance plans, or through state governments--is searching for ways to buy the drugs at the cheaper prices in other countries like Canada. The impetus for Brad's op-ed is that the Administration is currently claiming that it would be unsafe to allow prescription drugs to be re-imported.

Brad correctly points out that the Administration's arguments about safety concerns are untenable--the FDA monitors the importation of many items that, if manufactured improperly, would pose a health risk. There is no reason why it could not effectively monitor the safety of prescription drugs--particularly re-imported prescription drugs. The costs for monitoring would be paid by the consumers of the re-imported items.

Prescription drugs are an example of a product with high fixed costs of producing the first unit, given the R&D and testing they require, but much lower or near-zero marginal costs of producing the second and all subsequent units. Static efficiency at a point in time requires that the price of each incremental unit equal the marginal cost of that unit--the low number. But dynamic efficiency over time requires that the manufacturer be able to charge enough to recover the fixed costs--a higher number.

The typical way this tension between static and dynamic efficiency is resolved is through a patent with a fixed expiration date. The patent allows the producer a period of time to charge a monopoly price above the marginal cost of production. When the patent expires, the competing producers can enter the market at lower prices that more closely approximate the marginal cost of production. The optimal patent length gives the producer just enough time to recoup the fixed costs of R&D and testing (on all products, not just those that make it to market).

It should be clear that it is not the presence of Canada and Europe that is forcing our drug prices to be high. If Canada and Europe did not exist, our drug prices would not be any lower. Instead, the price disparities across countries are ultimately due to a refusal of foreign countries to honor the patent in the same way that the United States does. If they did, then it would be possible to shorten the patent period that applies in the United States, thereby lowering the average price of prescription drugs that U.S. consumers face at any point in time, without lessening the drug companies' profits (which are their incentive to develop the drugs in the first place).

The top priority for U.S. policy makers on this issue should therefore be to start these negotiations in earnest. It may very well be that other countries have less of a demand for innovative drug therapies. In that case, as part of the outcome of this negotiation, we would expect that, beyond the reduction in the number of years of patent protection allowed by a more equitable sharing of the burden of the fixed costs, the number of years of patent protection would be even further reduced. We would have fewer innovative therapies and now lower drug company profits, but the equilibrium would better reflect the desires of everyone participating (now equally) in the market.


Anonymous said...

Clearly the safety concerns are ridiculous. However, I think there are compelling arguments that U.S. patent law grants pharmaceutical companies market power far in excess of what is necessary to recoup R&D costs.

Folks have made a variety of points in the comments of the original op-ed. Widespread abuse of the patent system (patenting very similar compounds when patent protection is due to run out and what Claudia Dreifus called "me-too drugs") seems worrying. We can argue about the best theoretical way to handle knowledge goods all day, but I was struck by the median profit to drug companies — apparently 17 percent of sales compared to 3 percent for other Fortune 500 companies in 2002. Sustained profits that high seem irregular for a competitive firm.

Your thoughts?

- Anonymous Bosch

Jake said...

Another reason drug prices are lower is that Canada limits pain and suffering awards in lawsuits to $250,000.

In the US, drug companies face unlimited liability on each lawsuit.

Anonymous said...

Anonymous Bosch: If the drug companies are so profitable, then why don't we see a lot of new pharma firms? Why wouldn't a small firm with a new product decide to go it alone, rather than sell out to an established firm? I suspect the reason is that after adjusting for risk that pharma isn't so outlandishly profitable as people seem to think. If you have a better explanation, I'd be interested to hear it.


Anonymous said...


My knee-jerk response would be very high barriers to entry:

"In the pharmaceutical industry, a new entrant may be faced with various hurdles erected by established businesses, such as:

- economies of scale - manufacturing, R&D, marketing, sales,
- distribution product differentiation - established products, brands and relationships
- capital requirements and financial resources
- access to distribution channels: preferred arrangements
- regulatory policy: patents, regulatory standards
- switching costs - employee retraining, new equipment, technical assistance

If the barriers are high and/or the newcomer expects sharp retaliation from entrenched competitors, then the threat of entry is low. In the pharmaceutical industry, the barriers to entry are high. Companies have significant manufacturing capabilities that are hard to replicate; they have patents to protect their products and they invariably have big marketing budgets designed to protect their brands."


In the preceding, I would note that existing businesses certainly don't erect "the various hurdles" themselves, but they are much better prepared to deal with them. It seems as if there might be an especially serious economy of scale in dealing with the FDA approval process (with its high costs and long delays in licensing new drugs), but I don't know everything about the pharmaceutical industry.

- Anonymous Bosch

Anonymous said...

Anonymous Bosch: Yes, but...

In a industry shaped by patents, it would seem that the threat of retaliation by incumbents is much less of a problem than in the typical IO story--it doesn't strike me that pharma firms have nearly the leverage to go after rivals as say, the airline industry. Although an incumbent firm can (and I think does) lower price upon entry of a “me-too” drug, such drugs will be somewhat differentiated (chemical compound, dosage form, etc), and effectiveness in the market will depend heavily on prescribing patterns of physicians and less so on any direct pricing action taken by the pharma firm. It seems unlikely that if Paul Allen thought he could make more money in pharma than he could in building a commercial space vehicle that he would be deterred by worries about how Pfizer would retaliate.

This leaves various versions of economies of scale/scope as the primary alternative explanation. I don't find these very compelling either. For efficiency reasons we want firms to be operating at the bottom of the average cost curve; we only get nervous when that means there will be only one firm.

But pharma is a global market and we observe a lot of firms, both big and small. There doesn't seem to be a lot of evidence to support an ever-decreasing marginal cost curve for the industry as a whole. As suggested by the boeing/airbus spat, it doesn’t require a lot of competitors to lead to near-competitive outcomes (zero marginal economic profits).

I don’t think I’ve come across a model that carefully examines the interaction in an industry with patents _and_ economies of scale so maybe I’m missing an important interaction; but based on what little I know about the industry it seems pretty risky. Witness the nearly 1/3 drop in stock price of Merck since the announcement of the shelving of Vioxx. Merck is one of the largest pharma firms and also one of the best diversified as far as product line, but the loss of one product has had a huge impact.

So, if I’m left to decide between the competing explanations of pharma being ridiculously profitable, but not sufficiently profitable to induce new entry, and the alternative that after adjusting for risk pharma’s return is in line with alternative investments, I’ll pick the latter. (Hedging: I checked the beta for pharma firms: it’s about 1.08. In comparison, software is 1.18 and telecom equipment is 1.72. I’m not sure how to think about those facts.)

Even if the industry were operating with supra-normal profits, what then? I would be very nervous of anything mimicking nationalization of the industry. Abolishing patents seems foolish. Likewise is seems silly to grant a firm a patent, but then dictate the price to them post-patent; the political process would likely lead to marginal cost pricing. Shortening patent life is a simple remedy, as is the legalization of reimportation. But with reimportation firms ought to be allowed to do what they will concerning supplies to other countries.

Thanks for the post.

Anonymous said...

Anonymous Bosch,

I think your barrier to entry post is correct.

Here in Raleigh-Durham, there are lots of fledgling drug companies poping up in business parks all the time. Most are started by people coming out of the Burroughs-Welcome-Glaxo-Smith-Kline-Beecham-Bayer Big Pharma super centers. Most do initial drug or device development but need to parter with one of the long names to either: test, qualify, or distribute the new product. Shortly after the partnership agreement is in place they are bought out by the name and re-incorporated into the fold.

Anonymous Holmes

ed said...

Anonymous Bosch: "U.S. patent law grants pharmaceutical companies market power far in excess of what is necessary to recoup R&D costs."

I don't get you mean that the patent length is too long? Don't you think a firm's willingness to pursue risky research would be reduced if we shorten the patent length? Or are you suggesting some other way of reducing firm's market power? And what does free entry have to do with this...the whole idea of the patent is to create a (temporary) monopoly.

Didn't Michael Kremer have a paper a while ago proposing a scheme where the government would buy patents and put them in the public domain, based on a valuation from an auction, with a randomization to see whether the patent is sold to the winner or to the government? That seems like a promising idea.

Anonymous said...

Hi, off topic:

I'm using Galeon (a Mozilla-based linux browser, think of it as Firefox as far as rendering is concerned), and the background image that makes the text readable stops after about two lines of your top post. Testing with Firefox on Windows confirms it's happening with other Mozilla based browsers. Can this get some attention, please, as I'm looking forward to reading your posts.


William said...

Hi Andrew,

I think your argument about patents is a red herring. If foreign countries were experiencing lower prices because they were using generic versions of patented drugs, then you'd be right. But as it is, the countries are honoring the patent by buying from the manufacturer. The issue is the price at which they're buying.

The reason why American drug costs are so high is simply because American insurance companies are willing to pay that price. The reason why foreign drug costs are lower is that drug companies are willing to sell at that price. If American drug buyers were slightly tougher at home, or drug companies were slightly tougher abroad, the disparity would disappear.

Ronald said...

Hello --

FYI, you're blog template is unreadable using Mozilla Firefox browser. It's only viewable with Internet Explorer. And given the security concerns with using IE, and that people are increasingly turning to Mozilla instead, probably many of your readers are having the same problem.


Anonymous said...

I would like to see the study that shows what the amount of price difference between US and Canadian drugs are due to Canadian price caps/government negotiation and what amount is due to price discrimination.

Of course, let's not forget that Medicaid and other US government health systems also have coercive negotiations on price as well, sometimes based on a percentage of the "free market" price.

And if we want to talk about risk vs. reward in the pharma industry, look at Merk who just lost $2.5 billion a year in Vioxx sales. Not to mention expected thousands of lawsuits, which may end up costing much more!

My wife has a rare gastrointestinal condition, which only the drug domperidone is effective in treating. Domperidone went through FDA phase I trials, but failed in phase II trials because those trials must speficially obtain a particular pre=determined effect. It turns out that domperidone did help patients, but in a slightly different way than was expected.

Shortly after the first failed phase II trial, the manufacturer experienced the US FDA forcing them to end marketing Propulsid (cisapride), whose negative effects were due to doctors ignoring package warnings about giving it to people with certain heart defects. The rest of the world's FDA equivalents also forced them to pull Propulsid, and they decided they rather not take any more chances with getting domperidone through US FDA phase II tests, lest they lose another worldwide market. Domeperidone sales in the US would not make it worth the risk.

Fortunately, thanks to the Internet and personal connections in other countries, my wife can obtain the only drug that allows her to function like a normal human, here in the "most free" country in the world.

Anonymous said...

The main barrier to entry is the length of time it takes to research, develop, test and gain FDA approval of a new drug. Even if the drug is successful, you are looking at five to ten years of costs before you see any revenue. Big pharma can afford this. Start ups often cannot.

One way around this has been to start your research at a university, then go private if and when you are reasonably sure you have a good drug candidate. If you succeed, the university gets a piece of the action through patent royalties. If the research falls short, both you and the university get the benefit of the general knowledge gained.

This, along with other public funding sources such as the NIH, brings up the question of how much Pharma benefits from public research and how this should be factored into patent life and/or drug pricing.

Anonymous said...

Surprisingly, the likely actual current and future main cause of high drug prices is the existence of all kinds of drug discount plans. As drug plan providers increasingly dominate the market for specific drugs, list or retail prices can be raised by the manufacturer, increasing net profits and revenues as increased revenues from drugs purchased at discount outweigh the decreased units and revenues from drugs purchased at the higher list prices which reduce demand.

This has the result that list drug prices will be higher than they would be in even a free monopoly supplier market.

This can be demonstrated by the retail pricing of glucose test strips which are highly competitive but still list for about 80 cents apiece even though it is highly likely that discount plan providers pay less than 25 cents, maybe much less. When pricing contracts are based on discount percentages, there is no effective limit provided by the self interest of the supplier on the level of the list price.

Regards, Don Lloyd

Anonymous said...

William -
the differences in pricing likely have nothing to do with the drug companies being 'tougher' on one set of buyers than another. In poorer countries the revenue-maximizing price will simply turn out to be lower than in wealthier ones. The question is whether the government should support differential pricing systems by disallowing resale/arbitrage of drugs back to a country where the market price is higher.

Anonymous said...

It's not clear that the various posters know why drugs are cheaper in some other countries than they are here in the US. I can speak only about Canada with any certainty; perhaps posters will know about other countries. In Canada, a national commission or board twice a year examines the prices charged for patented drugs in seven countries, including Italy, Switzerland, the US, etc. The manufacturers of the patented drugs cannot charge in Canada more than the median of the prices in the seven foreign countries. Individual provinces, which in Canada administer their drug plans as well as the single-payer Canadian Medicare system, can negotiate with the drug companies to charge less than the median, but cannot charge more.

There are a few additional restrictions: Copycat drugs are not allowed; a drug must show some benefits, and some others I don't recall. Drugs are sometimes up to a year late in going on sale in Canada, compared witht he US. I am told that this is to allow for additional testing by the Canadian equivalent of the FDA to ensure efficacy and safety.

As I understand it, in some European countries the government simply tells the drug company: This is what you are allowed to charge for drug X. If you don't like it, sell it elsewhere. I don't know if this is really as cut and dried as I have described, but the situation in Canada is as I have described. I have personal experience of the system in Ontario where I occasionally picked up prescriptions for an elderly sister. Anyone over 65 pays $6.11(Canadian dollars) dispensing fee for a prescription - I'm not sure whether for one month or 90 days, but it hardly matters. The drug store then bills the Ontario provincial health department to get paid. If you are really poor, then the price is reduced to one or two dollars, or zero in hardship cases. Very simple, and I am sure, very expensive. How it compares per capita with the expected US per capita costs for the new drug benefit, I have not seen reported, although one would think it has been studied. The other provinces have similar, though more complicated price structures in some cases, but nothing like the mess here. I don't know how a person who is not to some extent computer literate, but also not used to doing cost analyses, can make his way through the mess. By the way, generics, which are not controlled in price as are patent drugs, are uniformly much more expensive than generics here in the US.

Lily said...

There's a great prescription discount card at Low membership fees. Drug prices posted.