February 2002
Uniform Global Prices mean Higher Prices for Drugs
by Herbert Grubel
A few years ago, American seniors discovered that Canadian prices for some pharmaceuticals were lower than those charged in the United States. Some seniors traveled to Canada to buy the cheaper drugs. Ralph Nader, amongst others, lobbied the US Congress to force drug companies to charge the same, low Canadian prices in the United States.
Such legislation has much political appeal in the United States. It plays to the widespread popular notion that drug companies are powerful and rich monopolies that prey on the sick. Health insurance providers faced with rising costs and resistance to higher premiums also support the seniors' lobby efforts in the expectation that its success will lower drug costs.
Unfortunately, however, if Congress were to pass legislation requiring the same prices in Canada and the United States, drug prices in Canada would rise to the higher US level, and the rate of introduction of new drugs in the world would slow to the detriment of all of humanity. This counter-intuitive result is very important since if the legislation were made to apply globally, as some have suggested it should, higher drug prices in poorer countries of the world would cause much suffering and many avoidable premature deaths.
The preceding, counter-intuitive conclusion stems from the peculiar nature of the economics of the drug industry, which involve very high costs in the development, testing, and approval of new drugs on the one hand, and a relatively low cost of production of the medication used by patients on the other.
Given the low cost of producing approved drugs, the companies have some freedom to set prices. As private, profit-maximizing companies, they want to set prices at the highest level the market will bear. In reality, they are constrained by the ability of consumers to switch to competing drugs performing similar functions and by their purchasing power measured in terms of disposable income. In many instances, the companies' freedom to set prices is limited by governmental or private insurance providers willing and able to exploit their monopsony power.
Competition among drug companies assures that on average, prices are set at levels that bring profits just high enough to attract and keep capital operating in a high-risk business where there is an ever-present threat of severe losses or bankruptcy from damage suits and awards. The cases of the thalidomide drug and silicone breast implants are the most widely-known instances of such producers forced into bankruptcy.
The present system faces many critics but it is important to remember that, while far from perfect, it has served humanity well. Modern drugs, developed at a rapid pace, have helped to increase life expectancies and the quality of life. Many once fatal diseases can be treated, if not cured. Drugs reduce the need for surgery and hospitalization for the benefit of both patients' health and finances.
The most fundamental criticism launched against the present system is its reliance on patent laws to prevent competitors from bringing lower-cost products to market during the 20 years when the patent is in force. This criticism clearly ignores the fact that drug companies need to recover their costs of development, testing, and approval. The simple fact is that if they cannot recover these costs, the rate of drug innovation will stall. The replacement of private with government-operated drug development organizations is unattractive, given the poor record of public enterprises. While critics of the patent system periodically attract the attention of the media and some populist politicians, most economists reject the criticism, and no responsible governments have considered seriously ending the provision of patents.
However, the episode of American seniors buying cheaper drugs in Canada has resulted in a new attack on the system, which needs to be taken seriously because it plays on basic views of justice and, therefore, has much popular appeal. Intercountry differences in the wholesale prices for the same drug basically are the result of different demand conditions noted above. The higher the purchasing power of a country's consumers, the higher is the price charged. The price is higher the fewer substitute drugs there are, and the availability of those, in turn, is determined by the ease with which governments approve new drugs.
Why do consumers or their agents permit these price differences to exist? Why do they not purchase drugs in the low- cost country and resell them in the high- cost country until this arbitrage eliminates all price differences? One explanation is found in national legislation designed to protect consumers from harmful drugs through detailed and strict rules about dosages, labeling, packaging, and the enclosure of informational material. These rules differ between countries. Therefore, drugs bought in one nation do not meet the regulatory requirements of others. It is ironic that the US seniors who bought drugs in Canada for use in the United States in effect broke the rules that the government had passed for their own protection.
As well, a recent flurry of studies has shown that many highly-standardized products such as cans of Coca-Cola and automobiles sell at surprisingly different retail prices among European countries (Moulson, 2002; Franklin, 2002). Retail drug prices differ widely among local regions inside Canada and the United States (Graham, 2001). There are many explanations for these differences, the most important of which are taxation, location of the retail outlet, and tied-in services.
These findings suggest that even if all countries world-wide required drug companies to charge the same prices everywhere for the same drug, international differences in retail prices would not disappear. There would be an equalization of the wholesale prices for drugs, but taxes, structural differences in the distribution system (in Germany, aspirin can only be bought at registered pharmacies), and consumer demand for drugs would assure that retail prices would not be equalized.
Nevertheless, there is the question of whether the international equalization of wholesale drug prices is desirable. Such a policy would certainly meet most peoples' standards of fairness, and American seniors would (erroneously) expect to be able to buy their drugs at lower prices at home. Unfortunately, the mandated equalization of drug prices in the two countries would have some highly undesirable effects. Drug prices in Canada would rise to the US level. The profits of drug companies would fall, and the rate of drug innovation would be slowed, reducing the improvements in health care that new drugs have historically brought about.
The negative effects of legislatively-mandated, internationally uniform drug prices arise from the fact that presently, the different prices charged in Canada and the United States maximize profits in each country. If the drug companies lowered their prices in the US to match Canadian prices, US profits would be reduced, and profits in Canada would remain unchanged. If the drug companies raised prices in Canada to the US level, profits in Canada would decline, but those in the US would remain unchanged. Obviously drug companies would sacrifice the smaller profits from Canadian sales in order to retain the maximum profits from US sales. Prices in Canada would rise to the US level.
However, the story does not end there. The lower profits in Canada would reduce the drug companies' total profits. Given that a certain amount of profit is necessary to amortize the cost of launching the drug and keeping capital in the industry, the loss would have to be made up in some way. To do this, the drug companies would probably reduce their current investment in the development of new drugs, which would reduce their costs and restore profits. Such a policy would delay the introduction of new, welfare-enhancing drugs and thus cause many unnecessarily premature deaths and suffering.
A related lobbying effort by developing countries involves demands for even lower drug prices than exist in those countries at present. According to a report from the World Health Organization (2001), several manufacturers offer "heavily discounted prices and donations to certain poor countries for selected drugs." Obviously these voluntary concessions are not enough, and lobbyists are demanding more. However, if the demand for ultra-low prices were met, drug companies would suffer lower global profits, which in turn would induce lower investment in drug innovation with predictable, negative consequences for all humanity.
Many people do not have a problem with the citizens of rich countries suffering a little more in the future if mandated lower prices for drugs in developing countries could offer immediate help to the great numbers of sick people there. However, this position is morally questionable. In effect, such a policy forces sick people in industrial countries to subsidize sick people in developing countries. Morally superior strategies for helping the sick in developing countries involve subsidies for drug purchases financed out of general tax revenues or provided by private charities and philanthropists in the industrial countries. However, in most industrial countries, the public opposes higher taxes for foreign aid. On the other hand, the implicit tax on the sick that would result if drug companies were made to charge lower prices in developing countries is well hidden.
The economic theory of public choice suggests how our political systems will handle the two challenges to the current, relatively free market for pharmaceuticals. US lawmakers will give in to the demand for uniform prices in high-income countries because the policy will gain them votes from seniors. Future generations of Americans or citizens of other high-income countries will not be able to cast votes against them. It is ironic that these politicians will also support the policy that would force pharmaceutical companies to sell drugs in developing countries at much lower prices, expecting votes from those who believe in the moral imperative to help the poor in the developing countries. These politicians know that there is no political punishment from future generations damaged by the reduced rate of drug innovation. That's unfortunate for those who will suffer and die unnecessarily in the future.
Sometimes rational economic analysis helps in the formation of political pressure groups that are able to impress lawmakers with the need to put the welfare of the public in the longer run above their narrow, short-run self-interests. Let us hope that this will be the response to the present, misguided demands for uniform drug prices on the one hand, and compulsory, unsustainably low drug prices in developing countries, on the other.
References
Franklin, Daniel (2002). "Single Currency, Many Prices." The Economist—The World in 2002. Special issue, p. 99.
Graham, John (2001). Prescription Drug Prices in Canada and the United States—Part 3: Retail Price Distribution. Public Policy Source No. 50. Vancouver: BC: The Fraser Institute.
Moulson, Geir (2002). "Bank Boss Dismisses Concerns about Euro Gouging." The Vancouver Sun (Sept. 4), p. F3.
World Health Organization (WHO) (2001). Report of the Workshop on Differential Pricing and Financing of Essential Drugs. Available at www.who.int/medicines/docs/equitable_pricing.doc.
Herbert Grubel(herbg@fraserinstitute.ca) is the David Somerville Chair in Taxation and Finance at The Fraser Institute and Professor Emeritus of Economics at Simon Fraser University. He is also a former Reform Party Finance Critic.
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