The US does not have a free market in pharmaceuticals* by mattsteinglass
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Essay question: The US’s drug market is at least as artificial and overregulated as the European one. But in the US, the regulations create higher drug prices, while in Europe they create lower ones. Discuss.

Here’s the deal. In European countries, national drug price regulating bodies set the maximum price at which pharmaceuticals can be sold. They do so based on the average price at which the drug sells in other European countries. (For new drugs, the regulations are looser and based on cost-benefit analyses, to promote innovation.) Is this some kind of Soviet-style non-capitalist system? Of course not. There are still lots of different buyers of drugs; it’s just that these buyers have all banded together into cooperatives at the country level to leverage their purchasing power. And they all insist that they get the same price the other cooperatives (countries) get. That’s the same thing you do at the supermarket when you assume that you’ll pay the same price for a tube of toothpaste as the next guy in line, rather than have the cashier look you over and say “You look richer than him — for you, the price is ten bucks.” There are lots of markets in which the only buyers are a few large cooperative organizations. Iron ore, say. And the steel companies that buy iron ore presumably negotiate pretty hard to ensure they pay the same price as the other steel companies, without anybody accusing them of restricting the actions of the free market. The European market for pharmaceuticals is basically the same thing, but at the level of countries. It’s not an unfree market; it’s a free market with 25 large, powerful buyers (the EU countries) who each insist they get roughly the same price as the others.

Now, an iron ore miner could look at one steel company and say, wait, we’re not going to sell you ore at that price. You had much higher profits than the other guys last year, so we’re going to charge you more because we know you can afford it. But this obviously wouldn’t work. The steel company could just turn around and buy the iron ore from a middleman, another steel company perhaps, at a tiny markup from their low price. Similarly, if the cashier at the supermarket told you they were going to charge you $10 for a tube of toothpaste, you’d just ask somebody else in line to buy one for you for $1.50. And so you’d figure it would be impossible for pharmaceutical companies to charge Country A more than Country B — Country A would just start buying its drugs from Country B.

So how is it possible that pharmaceutical companies can charge more for their drugs in the US than they can in Canada, or France, or Germany? We all know the answer: because the US bars retailers or health care providers by law from reimporting drugs from other countries. That is a completely artificial market restriction that wildly distorts the prices of drugs in the US. No other commodity or manufactured good is restricted in this fashion in the US — it would be illegal under WTO rules. And the effect is to artificially jack up drug prices in the US, at the expense of US consumers and taxpayers, by allowing pharmaceuticals companies to price-discriminate against Americans.

Many people (not just Megan McArdle) argue that only the US still has a free market for pharmaceuticals, which is why pharmaceuticals companies can make such high profits here, and that the US market is thus underwriting all the R+D in new medicines. Whether the US actually is underwriting all the R+D is still something of a debatable question, but it’s absolutely false that the US has a free market in pharmaceuticals. The US prohibits anyone from buying drugs at low world prices. Meanwhile it pumps government money into buying drugs in the US, through Medicare (which is not allowed to negotiate for lower drug prices with manufacturers) and through the employer health insurance tax exclusion. The natural effect is to drive up drug prices in the US at consumer and taxpayer expense. It may be true that Americans are subsidizing R+D in the pharmaceuticals industry. But that’s because the government forces Americans to pay artificially high drug prices. If you believe free markets are the answer to high health care costs, you have to, at a minimum, allow US retailers to reimport equivalent drugs and medical equipment from Canada and Europe, where prices are lower. Then we can talk.

*Add: Megan points out in comments that this is the way it works for all IP. And she’s right. Good point. I should probably not think up posts on a Sunday while swimming laps. The market in pharmaceuticals isn’t as free as the market in, oh, apples, but it’s as free as the market in DVDs. This is in fact an unavoidable feature of an IP market and if the US went for David Vitter’s proposal to allow reimportation of drugs from Canada, you’d probably just end up with a lot of companies putting clauses in their distribution contracts with Canadian distributors that they’re not allowed to resell back into the US.

I remain somewhat baffled as to why large American drug purchasers are unable to negotiate prices at levels close to those in Europe. Kaiser Permanente says it has over 8 million members. That’s larger than the populations of Belgium or Denmark. Maybe drug manufacturers figure a decision by Kaiser not to buy their drugs would result in Kaiser clients switching to other insurers, which means Kaiser has less bargaining power than Denmark, whose citizens are unlikely to move to Germany just because a few drugs are unavailable. Also, while Kaiser actually might get good prices because it’s an integrated HMO, I would imagine that more traditional insurers would have the problem of separation between the docs who are prescribing the medication and the insurance company deciding whether or not to reimburse it; the insurer, who would be most interested in negotiating the low price, would not actually be the one purchasing the medicine, and that mean there’s no one bargaining agent who has both the client numbers and the strong interest in bargaining down the price.

7 Comments so far
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The “dirty little secret” the GOP has buried in all the Big Pharma legislation is to prohibit negotiation of prices in this country. Excellent analysis Matt!

Comment by fleetlee

This is how all IP works in the US. You cannot import material that is in violation of US law. It is illegal to view Project Gutenberg works that are still in copyright here (people do, but servers don’t host them), and you aren’t technically allowed to ship them, either. You can’t sell Chinese counterfeit DVDs. Etc. Do we not have a “free market” in books and movies? In some sense, but most non-libertarians would consider it trivial, and it seems to me better than the alternative, which is to undermine an IP law that does a lot of good. Now, our copyright laws are far, far too long. But that’s a different issue.

Comment by mmcardle

Did I miss something? Does Matt’s post advocate allowing counterfeit drugs to be imported into the US? I don’t think so. Rather than compare the importation of drugs from Canada to fake Chinese DVDs, I’d say it’s more like letting me buy legal DVDs coded for Europe because I happen to own a DVD player that plays them. Do IP laws prevent that?

Comment by markbolton

Megan – partially true. It is true that you cannot import IP that violates US laws- however the IP in question, the drug formulas, do not necessarily violate US law. It is the act of importation that violate certain US laws. But this is only relevant if you buy into the argument that it is the prohibition on imports that keeps the prices artificially high. If interested, have a look at my comment here on the original post. Importation of books or other typical IP are not barred by copyright, or any other laws. Typically, important is barred as a matter of license agreement between the IP owner and territorial licensees/distributors. An English book company will seek to stop a British distributor from shipping books into the USA because it violates the exclusivity (if there is one and there usually is) of the publisher’s distribution agreement with the American distributor. So this is not a federal law issue so much as a contractual matter.

Comment by Rick Ungar

Opps. Please replace the word ‘important’ with “importation’ in the sentence “Typically, important is barred as a matter of license agreement between the IP owner and territorial licensees/distributors.”
What can I say? It’s Sunday.

Comment by Rick Ungar

Really interesting analysis but I may have to disagree with you on this one.

1. Your piece appears to presume that European nations simply buy drugs from distributors in other countries at will. Not necessarily. While you are absolutely right that (a) the European nations are not handcuffed when it comes to effectively negotiating lower prices, and that governments don’t bar importation, the drug company license agreements with distributors in a particularly country do. If I license the right to sell my drug to you as the distributor in France, there is highly likely to be a clause which prohibits you from “trans-shipping” into England because that would make my English distributor very unhappy indeed.

2. R&D is largely financed in the USA, and, as you suggest, it is the result of government’s unwillingness to use its bargaining clout to reduce the price of drugs (in most cases – Medicaid is still permitted to do so.) Some of this is the result of direct, government protection of Big Pharma (as is the case in Part D of Medicare which specifically reserves the program to privates, none of whom are large enough to negotiate substantial discounts with drug cos.), some of this is done under the guise of FDA protections (The FDA argues that Canadian drugs have not undergone the “rigorous” FDA testing we require and, therefore, it is unsafe for their drugs to come into the country because who knows where they were manufactured, and (3) laws that specifically bar personal importation from Canada.

However, I’m not sure I agree with your theory due to the matter I bring up in the first paragraph – Canada shipping into the USA violates the contractual agreements between drug company and their Canadian distributors which prohibit trans-shipping into someone else’s territory.

The drug companies are not the only ones to have provisions like this in their agreement. Virtually every product that sells around the world does the same in order to protect licensees and distributors who have national rights to sell a given product.

If we want to lower the price of drugs in America we can. Take the handcuffs off Medicare, one of the largest distributors, and let them negotiate. That will lower the price to a huge percentage of the population who uses prescription drugs.

Comment by Rick Ungar

IP grants the right-holder the power to block import/export in most jurisdictions. This does not mean that import/export of that product is ‘illegal’ per se (unless it contravenes anti-piracy criminal statute), it means it is actionable by the rights holder.

Since the EU is now a single market with its own competition law authority (the European Commission), restrictive distribution agreements and the use of IP to eliminate competition may be challenged under certain circumstances as anti-competitive. Discriminatory pricing is once of those circumstances. Hence if a British producer offers a product for sale in Portugal for much less that than in the UK and uses IP to block parallel imports (i.e., the re-importation of an exported product), then this may be subject to action by the Competition authorities if it is of a large enough scale.

Why do Americans pay more for drugs? My guess is that it is for the same reason that you pay £10 for a genuine CD in the UK but only about 20 RMB (£1.20) in China – because you’re prepared to pay more. The pharmaceutical company is only interested in maximising profit, the insurer passes all costs onto the customers who have no alternatives as everyone charges about the same, the customer’s insurance covers the expense, the medical service providers pass their costs onto the insurer. In fact, this would suggest that perhaps the anti-trust authorities in the US might want to take a leaf out of the European Commission’s book and launch an investigation into the pharmaceuticals sector.

The Commission gave a talk on the progress of their investigation (which was launched last year) which was, to say the least, scathing about the use of IP portfolios to eliminate competition and monopolise markets, as well as blatantly anti-competitive practices. AstraZeneca’s abuse of IP rights to extend protection over Losec (AKA Prilosec, AKA Omeprazole) way past the monopoly period granted under patent and allied rights (i.e., 20 years plus the time needed to get the medicine to market) was a prime example. Likewise the use of trade-marks to eliminate competition from generics in the the Gaviscon case – likewise the result of pharma playing fast-and-loose with its consumers. How often do you hear about these kind of cases in the USA? Not very often, and this is, I think, a reason to be concerned about how closely the anti-trust authorities there are watching the pharmaceuticals industry.

Comment by foarp

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