How to Make Medicine Safe and Cheap

By Steve H. Hanke, Alexander B. Rose, and Stephen J. K. Walter

Assuring that affordable, high-quality drug therapies are available in poor countries is a priority for policymakers, scholars, and advocacy groups around the world. However, there is little agreement over how to achieve that goal. Some see international arbitrage as a solution. Its proponents would allow firms to buy patented, trademarked, or copyrighted goods in countries where prices are low (perhaps because of local price controls or lower wholesale prices set by manufacturers) and re-sell them in higher-price countries without the permission of the owner of the intellectual property rights attached to the goods.

They argue, among other things, that such behavior enhances competition in international markets and thus improves welfare, especially for lower-income consumers.

This view alarms many scholars, especially when such “parallel trade” (meaning the goods in question sometimes travel a parallel route out of the manufacturing country and then back again) involves pharmaceuticals. They note that developing and obtaining regulatory approval for new drugs frequently involve enormous fixed costs and low marginal costs of production.

Recovering the fixed costs while maximizing the gains from exchange commonly requires not a uniform price across markets and countries but, rather, adept price discrimination. These scholars claim that “Ramsey pricing”—higher prices in affluent countries where demand for pharmaceuticals is inelastic, and much lower prices in poorer countries where demand is more elastic—would maximize welfare and be more likely to recover fixed and marginal costs. They warn that allowing parallel trade would cause prices to fall toward marginal costs everywhere, disrupting the Ramsey pricing scheme and reducing research and development investment and innovation. To avoid that, the scholars say, drug companies likely would stop giving discounts to low-income nations—or leave them unserved altogether.

As befits a topic that is both controversial and important, volumes have been written about the advisability of allowing parallel imports, but much of this work is theoretical. There have been few assessments of the actual effects of this phenomenon, especially in developing countries. In this brief case study, we contribute to this sparse empirical literature by examining the reasons for and consequences of international arbitrage of medicines in the Republic of Georgia, which encouraged the practice via regulatory reforms starting in late 2009.

We find that the regulatory environment and market conditions in a particular country will be key factors in determining whether parallel trade in pharmaceuticals (and presumably other goods for which intellectual property rights issues are important) might be welfare-enhancing. Specifically, Georgia’s experience demonstrates that the nature of institutions in a small, developing nation can lead to noncompetitive pricing in local markets, and that regulatory changes—in this case, outsourcing some key processes—that facilitate arbitrage can deliver major benefits to consumers without, apparently, disturbing manufacturers’ pricing policies or adversely affecting cost recoupment for R&D efforts. . .

Concluding Remarks

Though there are many reasons to be concerned about possible ill side-effects of expanded international arbitrage of pharmaceuticals, the regulatory reforms that enhanced such trade in Georgia must be counted as a success—at least thus far—and should be instructive for other developing countries.

Georgia did not simply jettison regulation and invite unfettered parallel imports of drugs. Rather, the country removed some regulatory barriers to competition that had, by creating and maintaining oligopoly power among its largest pharmaceutical firms, inflated domestic prices. By farming out some regulatory duties to bodies in larger, wealthier states, Georgia’s reforms quickly and significantly reduced prices of essential medicines to consumers by making market entry easier and less costly. Thus, price relief came in this case not because parallel trade disturbed an intricate international price discrimination scheme on which R&D cost recoupment and further innovation depend, but simply by enhancing domestic competition.

Of course, the efficiencies resulting from this reform should not be terribly surprising. As noted earlier, Georgia is about as populous as the Phoenix metropolitan area. If Phoenix officials decided they did not trust the U.S. Food and Drug Administration to regulate drug safety and efficacy, and the city set up its own regulatory apparatus, it would be obvious that such needless duplication would significantly increase costs for local distributors and retailers. The added (fixed) compliance costs would tilt the competitive playing field in favor of large-scale local enterprises.

There would be an immediate hue and cry to “open up the Phoenix market” to parallel trade, and doing so would likely have effects every bit as favorable as those demonstrated here for Georgia, and without adverse effects on the behavior of innovators. . .

Read the entire report at Cato . . . .

Steve H. Hanke is a professor of applied economics and co-director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise (IAEGHSBE) at the Johns Hopkins University. He is also a senior fellow at the Cato Institute. Alexander B. Rose is a research assistant at IAEGHSBE. Stephen J. K. Walters is a professor of economics at Loyola University Maryland and a fellow at IAEGHSBE

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