Aug 19, 2019

Bad Ways to Lower Drug Prices

Robert Graboyes Senior Research Fellow

My August 14 InsideSources column, Bad Bipartisan Ideas on Drug Prices, questioned the logic of two Trump Administration proposals aimed at driving down prescription drug prices: (1) allowing drug imports from Canada and (2) tying Medicare’s drug prices to an index of prices paid in other countries.

President Trump views lower drug prices in Canada and elsewhere as “global freeloading” on American ingenuity. He’s not entirely wrong; Americans do pay the lion’s share of research and development costs.

Many devout free-traders also instinctively support drug importation or the indexing idea as pathways to lower US costs. Trade in automobiles allows Toyota to drive down US prices by competing with General Motors. Why not do the same with drugs?  

Unfortunately, the automobile and pharmaceutical markets aren’t analogous. The likeliest outcomes of these two proposals would be reduced access to drugs in other countries, fewer new drugs developed, and little change in US prices.

Intellectual Property (IP) Seizure Masquerading as Free Trade

In an email exchange on this topic, my colleague and arch-free-trader Don Boudreaux captured my logic:

 [T]he issue isn't one of free trade vs. protectionism at all. Rather, it's the extent to which Uncle Sam allows private companies to control their own IP.

Toyota and General Motors are separate companies with separate bottom lines. A month’s worth of the cholesterol medication Crestor costs $40 in Canada and $300 in the US, but Americans and Canadians are purchasing the same patented product from arms of the same company—Astrazeneca.

While a pharmaceutical is under patent, its manufacturer enjoys a government-granted monopoly—permission to charge prices well above marginal cost. This temporary privilege is essential to new drug development because of the industry’s peculiar economics.

Most drugs’ current manufacturing and distribution costs are small, compared with up-front costs of research, development, and regulatory approval. Those early expenditures often exceed $2.5 billion for a single drug, mostly spent 10 to 15 years before the drug actually reaches patients. During the patent’s brief life, the company must recover those initial outlays, or the investment fails financially.

Let’s suppose some hypothetical company charges US patients $1,000 for its drug—enough to cover $950 in long-ago expenditures and $50 in present-day manufacturing and distribution costs. With this profitable investment, the company has incentive to develop, say, a new cancer or Alzheimer’s cure.

Now, Canada wishes to purchase the drug for Canadians but refuses to pay more than $300. If the company refuses, Canada may simply deny its citizens access to this drug. The drug company faces two options. (1) Accept the $300 price and incur the $50 in present-day costs, leaving a $250 profit. (2) Refuse the Canadian offer and get nothing. The $300 deal is a no-brainer—as long as Canadians cannot turn around and sell these drugs to Americans, who currently pay $1,000.

Using drug manufacturer Merck as an example, Boudreaux put it this way in our conversation:

Merck (for example) might well agree to sell drug X in Canada at a much lower price than Merck charges for drug X in the US. If the US government then permits Canadian buyers of drug X to resell drug X in the US below Merck's US price for drug X, then the issue strikes me as the US government in fact not enforcing the IP that it agreed to enforce.

Put differently, Merck should be allowed to set the terms of its sales and resales. If Merck sells in Canada only on the condition that Canadian buyers of drug X not resell it in the US, then that contractual obligation should be enforceable. And to enforce this obligation is not a violation of the principles of free trade.

Abandoning these principles demolishes the incentives for companies to develop new drugs.

Single-Price Versus Price-Discriminating Monopolists

Any Economics 101 text explains the social virtues of an unpleasant-sounding term: “price discrimination.” If a “single-price monopolist” charges the same amount to all purchasers, this generates what economists call “deadweight loss.” The monopolist reduces the quantity supplied to force the price upwards. This wastes resources and denies some customers the product.

In contrast, a “price-discriminating monopolist” charges different prices to different consumers, depending on their willingness to pay. With price discrimination, the incentive to reduce production dissipates. A hypothetical “perfectly discriminating monopolist” charges a separate price to every customer, and deadweight loss disappears altogether. The seller’s profits rise, but so do the number of customers who benefit from the product.

Consider air travel. Airlines and third-party vendors like Priceline.com are adept at gauging how much each customer is willing to pay for a seat. A wealthy person with an important business meeting in Seattle might be willing to pay $800, while the less-wealthy recreational traveler in the adjacent seat might be willing to pay only $300. By charging different prices, the airline can fill practically every seat and maximize revenues. The maximum number of people get to visit Seattle.

But this arrangement only works if seats cannot be resold. If the recreational flyer can buy a ticket for $300 and then sell it to the wealthy business traveler, present-day airline finance falls apart. Revenues plunge. Perhaps the airline can no longer afford to operate. Or perhaps they’re forced to raise their ticket prices to $800, driving away recreational flyers. Airline revenues drop, seats are empty, and would-be tourists stay home.

Allowing Canadian imports would impact the drug market in much the same way that allowing ticket resales would impact airlines. Whatever this is, it’s not free trade.

International Price Index Versus Intellectual Property

The second Trump Administration proposal would tie the price that Medicare pays for a drug to an International Price Index (IPI)—a weighted average of prices paid by a set of foreign countries. These de facto price controls would strip manufacturers of control over their IP as surely as cross-border sales.

We can use the president’s own hotel chain to illustrate the problems with this approach.

According to Expedia.com, a room at the Trump International Hotel New York costs $519. Rooms at Trump hotels in Washington, Miami, and Las Vegas cost $336, $159, and $131, respectively—reflecting different market conditions in each city. Now, imagine New York City passes a law stipulating that Trump International New York can charge no more than the average room charge for the Washington, Miami, and Las Vegas hotels: $209.

The Trump Organization would either lose a fortune on its New York location or it would have to raise its Washington, Miami, and Las Vegas prices to stanch financial losses at its New York location. Perhaps the company would have to close one or more of the locations because this price control-by-index renders the organization’s business model untenable. You can be fairly certain that the Trump Organization wouldn’t drop its New York price to $209—if at all. This is directly analogous to limiting Medicare’s drug prices to the average of, say, Canada, France, and Sweden.

Importing other countries’ price controls into the US pharmaceutical market is destructive. As Boudreaux noted, these ideas aren’t manifestations of free trade. Rather, they’re after-the-fact devaluation of patent rights. In the end, they’re unlikely to bring US drug prices down, but will likely discourage future development of new drugs to save lives and reduce suffering.

For Lower Drug Prices, Look to Supply-Side Solutions

One last point: None of this means that there is nothing we can do to bring drug prices down. As I noted in a recent piece ("When Saving a Child's Life for Free Is Bad News"), the idea that drug prices are skyrocketing without reason is somewhat overblown. More than in the past, today’s new drugs are often aimed at small populations, so the enormous up-front costs must be concentrated on relatively few patients.

That said, there‘s no doubt that public policy could reduce those up-front costs. The greatest opportunities, however, lie on the supply side—accelerating the regulatory approval process, for example—rather than on demand-side price-control schemes. But that’s another conversation for another day.

Photo by Joe Raedle/Getty Images

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