The war on drug prices

In Slate today, Judy Chevalier comments on moves to increase the prices of pharmaceuticals paid to US pharmaceutical companies. She points out that it is unclear that the current system of regulation in the US or drugs coming in from Canada seriously impact on incentives to innovate. However, she goes too far in this statement:

Drug makers are willing to sell their product cheaply in the regulated Canadian market only because very few of the drugs leak back into the United States. If drug companies were forced to sell to American consumers at whatever price they charged in Canada, to preserve U.S. profits they would raise prices in Canada, or, if that was not feasible, cut the Canadians off. That might not be entirely bad. Right now, the Canadians are freeloading off American consumers who foot the bills for pharmaceutical innovations.

The idea that Canadians are ‘freeloading’ is way too strong. An accepted means of funding drug discovery is the use of price discrimination. Effectively, that is what is going on here because the Canadians have a public health system and with it a lower willingness to pay for drugs than those in the US. Pricing low to them is optimal otherwise the pharmaceutical companies would simply not do it. Therefore, they must be getting more profits from Canada than their opportunity cost. This is the very definition of a rent that goes to fund innovation.

Indeed, as I have pointed out before, regulated price schemes for drugs are likely to be socially optimal and can be done in such a way that encourages innovation. By regulating prices to a lower level while guaranteeing sufficient volume to give innovators what they would earn with simple monopoly pricing, we can have our cake and eat it too. This is the logic behind the Australian pharmaceutical benefits scheme (click here).

The only issue with those schemes is that the government has bargaining power. If new drugs are substitutes for one another, then the government might potentially use that fact to reduce pharmaceutical prices too far. I say might because the alternative is that those drugs compete in the marketplace — also a recipe for lower profits. However, this does not mean regulation is bad. It just means that governments need to be sensitive to innovation incentives when setting regulated prices. That sensitivity requires a trade-off. However, in contrast to Chevalier’s argument, it is not a trade-off between poorer people today wanting low cost treatment and others wanting a greater variety of treatments. Instead, it is a trade-off between richer taxpayers today paying more taxes versus a greater variety of treatments. This is a trade-off based on efficiency far more than distribution.

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