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Can Free Market Principles Work With Pharmaceutical Price Controls?

Benjamin Zycher, Ph.D.
March 3, 2005

As the costs of drug development are enormous, the prices for many pharmaceuticals are high. And so spending on drugs is substantial. Accordingly, everyone would like cheaper medicines; and because politics is the art of wealth redistribution, the issue of pharmaceutical pricing has reemerged front and center with the new Congress now in session.

Those high R&D costs are borne largely by Americans because most other western governments have imposed price controls on drugs, knowing that because actual production costs are small, the drug producers will sell to them at the low controlled prices. Unsurprisingly, Americans too would like to pay those low prices, but the importation of drugs from overseas markets has been proscribed since 1987. And so the political drive to allow the importation of "cheap" - that is, price-controlled - pharmaceuticals is in high gear. The latest twist in the debate is the argument from some staunch supporters of free markets that importation of price-controlled drugs actually would strengthen the free market in pharmaceuticals.

The argument goes as follows: 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. And the safety problem inherent in widespread drug importation would be solved by market (preservation of the name brand) and legal (litigation avoidance) incentives.

To say that this position is na´ve is an understatement. Most foreign governments under their patent laws reserve the right to engage in compulsory licensing - essentially, theft of patents - under various conditions, one of which is a "failure to work the patent." What does that mean? That 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 pharmaceutical pricing is a political problem in the U.S. and overseas; foreigners will not be happy to pay more. And so the implicit assumption 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, is less than wholly convincing.

Compulsory licensing already has been used. It makes price negotiations and trade environments highly vulnerable even to implicit threats of patent theft. The response of the "free market" importation advocates is that some international trade agreements could be interpreted as proscribing such behavior. This is extremely unlikely, to say the least.

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? After all, even U.S. courts do not respect contracts as much as we would like. Such uncertainties inevitably will force the producers to sign agreements eroding their ability to recover R&D costs or to protect their intellectual property.

However powerful the incentives of producers to enforce safety standards, the problem of counterfeit and adulterated drugs will remain important because the profit incentive to engage in such "commerce" is enormous. The proper free market answer is: Let the buyer beware. But that is highly problematic: Apart from the problem of contagious diseases, the litigation environment upon which the "free market" importation advocates base their safety claims may yield highly perverse outcomes. Is it really so obvious that pharmaceutical producers will be held blameless, by juries in unfavorable jurisdictions, for injuries caused by adulterated or counterfeit drugs? Witness the asbestos litigation monster, which has driven wholly blameless firms into bankruptcy, with massive monetary judgments for many "victims" who cannot show even that they are ill.

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, there is little that can be done to stop a government utterly intent on doing so. What is needed instead are U.S. government policies 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 a measure of the poverty of our politics.

Benjamin Zycher is a senior fellow at the Pacific Research Institute. Email:

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