The Reimportation Blues

Roger Pilon, October 11, 2004
Mr. Pilon is vice president for legal affairs at the Cato Institute

It seems the issue of drug reimportation is finally ready for prime time. In Friday night's debate, John Kerry reaffirmed his support for drug reimportation while President Bush said he would consider supporting it if he could be certain it was "done in a safe way." A bill lifting the federal ban on reimporting prescription drugs passed the House last year, overwhelmingly. Three such bills now sit in the Senate. Several state and local officials, defying federal law, have begun their own reimportation programs.

If this is the direction of things, it's time to look seriously at the issue, because it's not as simple as many seem to think. Right now the issue is being staged as a morality play. Greedy drug companies are gouging seniors, only to sell drugs cheaply abroad. If they can make a profit there, at lower prices, they can do it here, critics say. Let's lift the ban and buy drugs at foreign prices. If it were that simple, the deed would have been done long ago. Yes, the federal ban should be lifted, but then the market should be allowed to work. If a bipartisan Senate bill succeeds, however, that second step won't happen.

International price comparisons are difficult to make. Still, Canada's review board recently reported that Americans pay on average 67% more than Canadians for patented drugs. The European differential is also substantial. To average Americans, however, what matters is the price of their drugs. They go online or they board buses to Canada and they're shocked by the difference. So they ask why.

Here's why, in a nutshell. Modern "miracle drugs" don't come cheaply. Given onerous FDA safety and efficacy standards, it takes on average 12 to 15 years and $800 million before a company can bring a new drug to market. Before the first dollar of profit comes back, those R&D costs have to be recovered, of course. But a company looks at the world and sees essentially one free market, America. Socialized medical systems abroad impose price controls. Seeing that, companies charge market prices here (half the world market) and take what they're offered abroad. Foreigners are classic "free riders" as Americans pay most of the R&D costs.

That part of the story portrays Americans and companies alike as victims of foreign price controls. There's another part, however: the economic rationale that puts companies in the driver's seat. When they look at the world, companies see different levels of demand. To maximize profits, therefore, they segment markets and price differentially. Nothing's wrong with that: airlines and theaters do it. Pricing too high excludes too many buyers. Pricing below what buyers are willing to pay yields too little profit.

Probably both scenarios are in play, but on either, companies have to guard against "parallel markets" -- drugs being resold by local vendors from low-price to high-price markets. If they don't, all their drugs will eventually go to the low-price markets, where companies don't recover true costs, only to be resold to high-price markets, thus undercutting the companies' profit-making venues.

Companies have two basic ways to preserve market segmentation: no-resale contracts, and supply limits. Both are consistent with free market principles. Back in 1987, however, drug companies took a short cut: they asked Congress to ban drug reimports. They won a statutory, public law solution to a private law problem, and therein lie difficulties.

In effect, third-party Americans were told they couldn't buy from willing foreign sellers. (In fact, Canadian provincial officials are actually encouraging local pharmacies to resell to Americans.) Thus, by opposing reimportation, the administration comes off as anti-free trade. Americans resent the price differences and the interference -- especially those who understand the free-rider issue.

What's to be done, then? Clearly, the situation today is politically unsustainable, as events are proving. The ban should be lifted, therefore, not to encourage reimportation, which isn't likely to happen, but simply to allow market practices to surface. Today, with their high-profit American market protected, companies don't have to bargain hard abroad. The ban shields them, allowing them to claim they have to accept foreign price controls. Practically, Americans are subsidizing socialized medical systems abroad.

But with the ban lifted, and the threat of underpriced drugs flooding the American market, companies would be "forced" to adjust. They could still try to maximize profits by segmenting markets. But they'd have to guard against parallel markets the right way, through no-resale contracts or supply limits. They could offer a country lower prices, but the country would have to police its exports, since America would no longer be policing imports. That places the incentive where it belongs, on the country benefiting from the bargain. And if that failed, companies could limit supplies, as they're doing now with Canada.

In Europe, however, no-resale contracts are illegal -- from a mistaken belief that they're anti-free trade. That's why there's a thriving parallel market there. If that's the way Europeans want it, companies will have no choice but to limit supplies or raise prices. That's how markets work. Companies should be free to segment markets. But if it doesn't work, international prices will move toward equality. And if that happens -- as is likely, given enforcement difficulties -- there'll be no reimportation, which moots the safety issue as well.

With the ban lifted, no one knows whether prices will rise abroad and fall here, or just rise abroad. That's for markets to decide. The last thing we want, however, is the bipartisan Dorgan-Snowe Senate bill, which would lift the ban and then prohibit companies from "gaming the system" -- limiting supplies or raising prices abroad. In effect, the sponsors want to freeze the current situation, then import below-cost drugs from abroad -- at those prices. The sponsors seem not to appreciate that the only reason a company can sell a drug for $20 in Germany is because it's sold for $100 in America. The bill would actually import foreign price controls, and that would be the end of future R&D and the miracle drugs it produces.

Opponents of lifting the ban say that if we "forced" market practices on the world, countries would balk at paying those prices and would steal American patents. But a close reading of the WTO Trips Agreement, protecting intellectual property, should allay those fears. The administration needs to watch the issue, however; and in treaty negotiations it should encourage a clear separation of commercial and charitable undertakings. In particular, the "compulsory licensing" arrangements designed to help poor countries with their drug needs should be scrapped in favor of a more market-oriented approach to this problem.

Drug reimportation is thus more complex than at first it seems, but as with so many other issues on the public's plate today, a healthy dose of market principles is the right prescription.