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...

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

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.


Andrew 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...

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.