It’s a pleasure to be back in Chicago. I got my training down the coast a couple of miles at the University of Chicago. I feel like I’m bringing coals to Newcastle. What I’m about to say is really based on fundamental price theory, the sort you’d pick up in any textbook, and a little bit of corporate finance tossed in.
I’m not making it up. If you want to pick up one of the textbooks, you’ll see the same sort of analysis. I’m just trying to apply it to a part of government policy where very frequently the budget people are involved or the social people are involved, but sometimes the economists aren’t consulted. So this is a plea for a little bit of economic input into a difficult issue.
This is basically what we do at the Institute for Research on the Economics of Taxation, although usually at the federal level. We advise members of Congress and their staffs on complex issues, and I do a lot in federal budget work and federal taxation, as well as industrial policy.
We’re talking today about a specific problem with the reimportation—or more accurately, the importation—of prescription drugs from abroad. Not all drug importation. As you know, we get some of our drugs from American subsidiaries abroad and from major foreign drug companies, made in plants inspected by the FDA. These drugs are imported under the companies’ auspices in the normal course of their business, carefully controlled and distributed here in their normal manner at the normal U.S. prices.
The issue we are talking about today is the importation of cut-rate drugs produced outside of this system, some of which are indeed real drugs and some of which are not. I’m going to focus on what we should be thinking about as people are talking about cut-rate imports of real drugs. Even if we are getting safe and effective products, would this be a good policy?
Bringing drugs in from abroad at cut-rate prices would certainly seem to save current drug users money and seem to reduce benefit costs for this state’s employee health plan. But if it worked, and if it spread to other states, and was copied by the general public, it would have a devastating side effect. It would cripple research into new medicines which are very expensive and risky to develop. It would cut off new and improved treatments to tens of millions of future patients, resulting in earlier death and reduced quality of life compared to what these patients could expect if the rules laid out by current law were followed. If governments want to help the poor or trim their payroll costs, importing price controls for pharmaceuticals is not the way to go about it.
Let’s put the issue into perspective. New developments in biology and chemistry have opened up amazing opportunities for progress against heart disease, cancer, Alzheimer’s, and viral diseases of all sorts, including AIDS. The human genome has been deciphered. Scientists are learning how to tailor a drug to the specific genetic makeup of a cancer patient’s tumor. We know more today about cell chemistry than ever before.
You’d think that society would be urging the research community to take full advantage of these scientific advances by turning them into pills and treatments as fast as possible. Instead, the public and the politicians are obsessed with the cost and affordability of existing medicines and existing treatments. Their knee-jerk reaction is to impose price controls or to let people import drugs from abroad where other governments have set low prices, or to demand discounts for patients in their states or in specific federal programs. The direct result of ratcheting down the returns on drug development will be to slow the rate of scientific advance and to delay the introduction of new medicines and treatments made possible by the new science.
Access to Drugs for the Poor
The ability of poor Americans to afford medication is a legitimate concern, but drug affordability is a welfare issue arising because some people have low incomes. It is not a problem with the price of the drugs. The right reaction is to leave the drug prices alone and to give the poor the wherewithal to purchase the medicines they need like everyone else. We should treat them with respect to their medical needs the way we treat them when they need to buy food: we give them food stamps; or when they need to buy housing: we give them housing vouchers. We don’t put price controls on the food industry, nor do we routinely impose rent controls, except in a few cities with absolutely disastrous results.
What do you think would happen if we tried to help the poor buy food by telling the grocery stores they would have to sell everything at 30 percent off; or if we told the farmers they would get only half of what they now get for corn and wheat and soybeans? Many farmers would go broke. Many grocery stores would shut down. The food supply would shrink until there was enough of a shortage to drive the prices up so that, even with the discount, there would be as high a return to the suppliers as before the intervention to justify production.
So instead of price controls on food, we give people food stamps and let them go to the grocery store like everyone else. We fix the income problem without disrupting the price signals that make the market work. Similarly, if the state, or a company, has negotiated a health insurance package as part of its labor contract, it should honor that contract without trying to distort market prices. The employees and employers should take account of the costs when workers ask for health care benefits as part of their compensation rather than cash, and both sides should pony up and pay the market price. They should not gang up on the suppliers when they get the bill.
In a normal market, the prices of goods and services cover the costs of producing them. When you buy a loaf of bread, you’re paying for the seed and the farmer’s time, for the shipment of the wheat to the silo and from the silo to the mill. You are paying the wages of the people who work in the mill, of the people who bake the bread, and of the people who transport it and put it on the grocery store shelves. You’re paying all of the costs of producing the bread.
The same thing is true for drug research. Consumers pay for what they get and get what they pay for. If we are not willing to make the patients pay for the cost of their medicine, including the necessary R&D and testing that make possible the pills they consume, then some other way of letting the drug innovators recover their costs will have to be found or the research will stop. You might have to have the government come in and start subsidizing all the research, in which case either the politicians or the bureaucrats would probably start picking and choosing which pills to work on.
I don’t think the result would be a good market outcome. The taxpayer would have to cough up the shortfall in drug revenues, or we would not get the research done; we would not get the scientists trained and hired, or the lab equipment and chemicals purchased for the research and the production of the medicines.
Why the Drug Industry Is Different
In most industries, competition sets the price of an extra unit of the product at the marginal cost of production. And in most industries it costs more to produce more units, so that the marginal cost is rising and exceeds the average cost by enough that the resulting price covers all the fixed costs.
In a few cases—and pharmaceuticals and software are two good examples—the competitive market price doesn’t cover the research costs because the cost of an additional unit is very low and flat. The product can easily be reproduced without straining resources. With that cost structure, there are high fixed costs and flat or low marginal costs, and the normal market outcome—price equal to marginal cost—does not work well for these industries or for their consumers.
It may take a billion dollars of research to test thousands of potential chemicals for use against a disorder. One must find the few good candidates for development, test them for efficacy and safety, settle on the best, and develop a reliable and efficient manufacturing process to turn it into a marketable medication. Once the drug is perfected, however, it may cost only a few pennies to churn out an additional pill.
In this situation, the marginal cost will not cover the R&D costs. The product will be developed only if the discoverer can obtain a patent or a license giving it the exclusive rights of production for a time. The firm can then charge enough for a while to recover its development costs for that drug, including all the dead ends it had to explore before it could find the right route to the solution.
If, instead, other companies are allowed to come right in and copy and sell the product at the cost of an additional pill without any of the development costs, then the cost of the original research is much harder to recover, research is discouraged, and it will not be undertaken at a socially optimal rate. It was precisely to deal with such cases that patent protections were instituted by civilized governments around the world.
The Importance of Patents
Patents allow innovators to charge enough to recover development costs and to earn a normal return on the investment. Then when the patent expires, the good is opened to competition and the price is driven down to the competitive level. Innovation is fostered, but the consumer is protected longer term by the expiration of the patent. The drug reimportation bill that was introduced into Congress a while back, and these other schemes to get around normal pricing structures, would effectively cripple patent protection and would violate the intellectual property rights of the innovators.
The patent process involves striking a balance. Longer patents would increase the incentive to innovate, which helps future consumers by creating new and better products, but it would increase the cost to current consumers. Shorter patents, or patents rendered ineffective by reimportation, would hurt innovation and the consumers who would benefit from it, but help current consumers in the short run. Patents, therefore, have a clear economic purpose. If the politicians and the public think they don’t, that they are the result of some bizarre political clout and that they can be dispensed without consequences, they’re wrong.
If drug companies have to charge enough to cover R&D, why do they sell drugs so cheaply abroad? You can find this in the textbooks too. The drug companies sell abroad at the reduced prices set by foreign governments because those governments set the prices just above the marginal costs of making additional doses. The resulting little bit of net revenue is better than none, so the companies will sell them product. The skimpy foreign profit margins, however, are not enough to contribute meaningfully to covering the fixed costs of the R&D or of setting up the production lines. The same is true when the companies sell for just over marginal costs in poor countries where a higher price would put the drugs out of the consumers’ reach.
Consumers in rich developed countries with socialized medicine and price controls are shirking their responsibility to help fund medical research. They are free riders on the strength of the U.S. market. The United States is the only country where the companies earn enough to pay for the fundamental science, the dead ends, the testing of the compounds that do not pan out, and the tests for safety and efficacy demanded by the FDA. As irritating as that is for American consumers and for the politicians who have promised drugs for the poor, and are now faced with having to pay for them, the alternative is not to have the drugs at all.
If some states try to mimic the foreign freeloaders and arrange for their state governments and residents to duck their share of the nation’s drug costs, then those costs will have to be picked up by other states and other U.S. consumers, or by the federal taxpayers, or the drugs will not be developed. If some states get away with being free riders, others will follow. And if everyone wants to be a free rider and no one picks up the slack, then there will be no new drugs.
Today we’re talking only about Illinois and only about Illinois’s public employees health benefit plan as the starting point. But the ultimate objective of most of the people supporting free importation is to drive down the cost of drugs throughout the country, so this discussion is part of a bigger issue. But let’s look at Illinois just for a minute.
Suppose millions of Americans try to buy cheaper drugs from Canada. Canada’s population is about 11 percent as large as the U.S. population, but its GDP is only about 7 percent of total U.S. income, and Canada spends less than 5 percent of what we do on drugs.
Suppose even 5 to 10 percent of U.S. customers started buying medicine from Canada in a particular case where the drug price happened to be lower in Canada. The U.S. demand would easily gobble up the whole supply of the drug that the company normally ships to Canada or produces there. There would be none left for the Canadians.
If you think that Illinois is only a small part of the United States and therefore only a small part of the problem, think again. The population of Illinois is about 4.4 percent that of the U.S., but it’s equal to 40 percent of the population of Canada. Illinois’s GDP is about 4.7 percent of U.S. GDP, but it’s about 67 percent of Canada’s. And given the higher rate of spending on drugs in the United States, the Illinois drug market is about 90 percent of the Canadian drug market. Even if the governor’s importation proposal for the state employees’ health plan covers only the state employees’ share of the state population, it would still absorb between 1.5 and 2 percent of the Canadian drug supply.
If all the states did that for their employees, you’d take almost 50 percent of the Canadian drug supply. Or if the practice spread to the rest of the Illinois population, to the seniors, to the local government employees, to the teachers and so forth, you can see there would be a significant impact. And if the other states followed suit, it would be even greater.
Markets Won’t Allow It
Would the U.S. drug companies be willing to increase their shipments to Canada to cover the extra drugs being brought back to the U.S.? I don’t think so. It would make no sense for them to do that. So there would be no medication left in Canada. Some Canadian newspapers are already catching on to that problem. Of course, Canadians wouldn’t just sit there and let the drugs leave the country, and I don’t think they are going to want to have to buy their drugs from Bangladesh and Iran. So they would have to start policing the border.
It would not be rational for a U.S. drug company to expand its foreign sales to make up for drugs imported to the United States at cut-rate prices, thereby pulling the rug out from under their own feet. They’d be much more likely to simply note that the foreign markets are not that big, and it would be better just to give them up, rather than to sell to them and destroy their pricing structure in the huge U.S. market. Therefore, these importation schemes really can’t work. One way or another, the market is going to say, “This doesn’t make sense, and it can’t happen.” And if it can’t happen, we shouldn’t do it.
Sooner or later we have to find a way to make other customers step up to the plate and do their part for medical research. Other nations need to do a better job than they are of supporting scientific advances. But until then, let’s not destroy the work that is being done to fight disease and to improve the quality and length of life.
The bottom line: If we were to import price controls from Canada or Europe, we’d shut off the pipeline of new drugs. We’d be surrendering millions of American lives to ancient biological enemies that we can now defeat. We would be snatching disease from the jaws of victory.
Everyone knows the old saying about economics being the dismal science. Actually, economics is not the dismal science if you have a morbid sense of humor. But I would suggest to you that when basic principles that you can find in any textbook are routinely ignored in the political debate, it isn’t economics that is the dismal science. It is political science that is the dismal science. And I hope we can shed a little sunshine on it before it gets really bad. Thank you.
Stephen J. Entin is president and executive director of the Institute for Research on the Economics of Taxation (IRET). Entin was deputy assistant secretary for economic policy at the Treasury Department in the Reagan administration. His email address is [email protected].