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.