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Pharmaceutical Importation, Price Controls, Federal Price Negotiations, and the Interests of Consumers

Medical Progress Today
May 4, 2007

Well–known principles of economic analysis and existing bodies of data not subject to serious challenge yield several conclusions on the prospective adverse effects of the importation of price–controlled pharmaceuticals into the U.S.

First, the true economic cost of pharmaceuticals cannot be reduced without improvements in the economic and regulatory environment; the importation of drugs subject to foreign price controls by necessity would import those price controls into the U.S. Second, to the extent that lower prices for consumers result, that would not represent a true reduction in "costs"; instead it would be a wealth transfer from pharmaceutical producers and possibly from foreign consumers to U.S. consumers in the short run, with long run adverse effects for U.S. consumers in the form of lost pharmaceutical innovation.

The more likely short run outcome for U.S. consumers, depending on market conditions, would be little or no price reductions but instead price increases for various market participants (intermediaries) in the supply chain, since the importation of price-controlled pharmaceuticals would not affect conditions of either market demand or market supply.

Since ultimately it is anticipated consumer demands—for cures, for disease alleviation, for better health, and for reduced suffering—that drive the research and development choices of profit–seeking firms, lower anticipated prices will reduce research and development investment and thus the future flow of new drugs. The adverse future effects in terms of fewer cures and greater suffering will be real economic costs attendant upon the importation of foreign price controls; but such costs will not appear directly in government budgets or private balance sheets, except to the (significant) extent that more–costly hospitalizations and other substitute medical procedures will be used in place of the drugs that will have failed to have been developed due to the long term effects of price controls.

Based upon the recent experience in the non–U.S. OECD and upon simulation exercises and other analyses, the magnitude of this projected adverse research and development effect varies somewhat, although it is never predicted to be small. All of these estimates are biased downward because they fail to take into account the fact that the imposition of price controls, whether direct or indirect, introduces an asymmetry into the statistical distribution of future returns to research and development, in that the price controls have the effect of limiting (truncating) upside potential while leaving downside risk unaffected. This is an effect separate from the price reduction itself, the implication of which is that the long term effects of price controls in terms of a reduced flow of new and improved drugs is likely to prove larger rather than smaller.

Some observers have argued that there can be an inefficiently large amount of pharmaceutical research and development investment, so that a reduced amount still may be efficient. High purported "profits" (either undefined or defined poorly) then are used to infer that current investment is too high. But if "profits" are (uncompetitively) high—adjusting for investment risk—we would expect to see significant entry into the market by new firms. We do not.

More generally, the current emphasis by some commentators on total revenues or total profits as predictors of research and development incentives is incorrect. It is the expected economic return for a particular research and development effort that is relevant. Consider, for example, a firm earning enormous profits, however defined; would it sink dollars into a project that it knows will not yield adequate returns (however broadly defined)? Regardless of overall revenues or profitability, firms have powerful incentives to make only efficient investments, that is, investments expected to yield at least normal rates of return with some allowance for risk. Price controls cannot further that outcome; and competitive capital markets will enforce such discipline.

Finally, an accounting of the true cost of imported drugs subject to price controls must include some consideration of the safety problem, important socially in particular in the context of contagious diseases. Moreover, adulterated and counterfeit drugs are likely to erode the value of the brand names of the pharmaceutical firms, an economic cost unlikely to prove trivial. That solutions to the safety problem are likely to prove highly elusive is evidenced by the fact that some legislative proposals for drug importation either shunt the issue aside completely, or apparently bestow an "FDA–approved" imprimatur upon foreign plants not actually approved by the FDA.

The basic cost economics for most pharmaceuticals are somewhat unique, in that large fixed costs (for research, development, and production facilities) are accompanied by small marginal production costs. The large fixed costs—about $1 billion per drug—yield a body of knowledge, which itself is a classic collective (or "public") good in that those who can find ways to avoid paying their "fair" share thus obtain a free ride on the efforts of others to finance the research and development investment. Foreign price controls on drugs have the effect of yielding for foreign consumers just such a free ride at the expense of U.S. consumers.

Some have argued that policies designed to increase foreign prices would not yield benefits for U.S. consumers because "drug companies are under no obligation to lower US prices as [foreign] prices increase."

That argument is incorrect, regardless of the assumption one makes about the competitiveness of the U.S. pharmaceutical market. From the viewpoint of U.S. pharmaceutical producers, an increase in foreign prices analytically is equivalent to an increase in foreign demand; total perceived worldwide demand would increase, yielding an increase in research and development investment, and so a long run increase in the flow of new drugs. But U.S. demand would not change, so that the increased long run supply of drugs would put downward pressure on U.S. prices. In the short run, it is unclear whether U.S. prices would fall; demand and cost conditions would not change, but producers might have incentives to cut prices in the expectation of increased competition over the longer term.

Some prominent supporters of free markets have argued recently in favor of the importation of price–controlled drugs. The argument in summary is that an end to the import ban would force pharmaceutical producers to negotiate more stringently with foreign governments over the prices for drugs, because the prospect of "cheap" foreign drugs flooding the U.S. market would make it difficult to preserve U.S. prices sufficient to cover high R&D costs. The producers also could insist upon "no foreign resale" provisions in contracts, which could be enforced by limiting sales to the foreign governments.

This argument is fundamentally flawed. Most foreign governments under their patent laws reserve the right to engage in compulsory licensing under various conditions, one of which is a "failure to work the patent." The precise meaning of that phrase is unclear, but to foreign officials it might mean a failure to sell all that is demanded at the controlled price. What is clear is that foreigners will not be happy to pay more for medicine. And so it is unlikely that foreigners faced with substantial increases in their drug costs would be fastidious in their adherence to the rule of patent or international trade law, as interpreted by U.S. drug producers and some U.S. officials. Indeed, compulsory licensing already has been used, so that price negotiations and trade environments are highly vulnerable even to implicit threats of patent theft.

Moreover, under some prominent interpretations of patent law, producers control their patents but not the resale of their patented products. Would contracts to limit resale of price-controlled drugs, even if they could be negotiated and enforced, survive challenge under this interpretation? Such uncertainties inevitably will force the producers to sign agreements eroding their ability to recover R&D costs or to protect their intellectual property.

The basic problem with the "free market" position in support of drug importation is that it tries to reconcile free markets domestically with price controls overseas. That is a circle that cannot be squared as long as foreign governments can steal patents; and in the final analysis, it is likely to be difficult and time–consuming to stop a government intent on doing so. What is needed instead are U.S. government efforts, perhaps in the context of trade policy, designed to end the free ride that many foreigners now obtain at the expense of U.S. consumers. That many U.S. officials now attack drug producers—whose investments have saved millions of lives—rather than the foreign theft of U.S. intellectual property is unlikely to prove salutary.

The interests of consumers are served by a pharmaceutical sector offering medicines both affordable and available. Policies that bestow benefits upon one set of consumers at the expense of others, perhaps in the future, are inconsistent with that goal; in particular, price controls are fundamentally incompatible with the operation of free or competitive markets, with the institutions of free trade, and with the interests of consumers. It is incontrovertible that the importation of pharmaceuticals subject to foreign price controls will have the effect of importing the price controls themselves, with clear and substantial adverse effects over the long term in terms of research and development incentives and the flow of new and improved medicines.

Benjamin Zycher is a senior fellow at the Manhattan Institute for Policy Research. Email: This article is adapted from testimony delivered to the U.S. Senate Committee on Health, Education, Labor, and Pensions on February 17, 2005

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