Uwe Reinhardt offers an interesting discussion of recently proposed drug reimportation amendments that members of the Senate have recently rejected in their attempts to pass health care legislation.
It costs roughly $1 billion to bring a drug to market; this is a fixed and sunk cost. The marginal cost of producing each individual pill is very small, many on the order of a few pennies. It makes no sense for a pharmaceutical company to market its product at a price less than its marginal cost to produce it, and it must earn enough total revenue to cover its fixed costs, including the research and development for drugs that failed to make it to market. But any price above marginal cost helps the company offset its fixed costs. Therefore, if a pill costs, say, 10¢, then any price it receives above 10¢ allows the company to cover its variable costs of production and use the rest to offset its fixed costs.
Price discrimination offers an effective means of distributing the fixed costs of new drugs onto those who value those drugs most and onto those who can best afford to cover these high fixed costs. It's no different than an airline charging a business person seeking to close a multimillion dollar business deal ten times more to fly from New York to Los Angeles than a family making the same trip to visit Disneyland.
The problem is, in order to effectively price discriminate a firm has to prevent arbitrage - selling the drug to a low valued user at, say, 20¢ per pill, who then sells it to a high valued user for, say, $1. If the firm cannot prevent arbitrage then price discrimination is not a profit maximizing strategy and it will stop. This means that individuals with lower incomes and who value the product less will be excluded from the market given the higher price the firm must charge to cover its average total cost. This is why you don't observe price discrimination for cereal (other than some limited use of coupons), milk or gasoline.
The question, then, is what's in it for Canadian pharmacies to reimport drugs back into the United States? Nothing really. Yes, they earn some profit from the arbitrage, but the pharmaceutical companies will eventually respond by raising prices to Canadian pharmacies. If you cannot stop the Canadian pharmacies from buying low and selling high, cut them off. The pharmacies will either cease arbitraging drugs or stop selling them.
If Canadians don't want to pay the higher prices then they can do without the drug, and oftentimes they do. Much like a first-run movie that restricts viewings to movie theaters before going to DVD, pharmaceutical companies restrict sales of some of their newest drugs to United States markets. It's only after some time, sufficient to enable the pharmaceutical companies to recoup some of their fixed costs, do these companies export these restricted drugs to other countries, including Canada.
A discussion of price discrimination, especially when it concerns pharmaceuticals, inevitably devolves to an issue of fairness. Fairness with regard to price discrimination however, especially when it concerns drugs, is vacuous. First, although U.S. residents do pay more for drugs, they have many advantages, including having drugs available to them that are not available to others around the world and are usually able to obtain some drugs before others around the world. Second, it's not an issue of fairness, it's about consequences.
Consider two families, one in Mexico with an annual household income of $4,000, and one in the United States with an annual household income of $80,000. It's meaningless to say that it's not fair if a U.S. resident pays ten times more for a slate of drugs than what the Mexican resident would pay for the same slate of drugs, especially given that the U.S. resident's household income is twenty times that of the Mexican resident.
But what's important, and indeed ethical to consider, is that without the ability to price discriminate, in order to cover its total costs for a drug the pharmaceutical company must charge the same price in Mexico that it charges in the U.S. Consequently, the average Mexican resident finds himself unable to afford a new drug needed to prolong his life or increase the quality of life when its priced at average total cost as opposed to something less. For example, for a U.S. resident to afford an annual slate of some new drug that would prolong his life or improve its quality through pain management, he might have to forgo his annual subscription to HBO, give up one restaurant meal per month, substitute two home-cooked steak meals per month with chicken or hamburger, and enjoy only a seven-day beach vacation rather than his normal fourteen. By comparison, at the higher price of average total cost the Mexican resident might have to give up his modest home for a lean-to, forgo health care for his children, suspend food for his family one or two days each week, make no new clothes purchases for the family, and/or give up the car needed for both work and family trips. He would prefer to live with his own pain or live a shorter life than live with the alternative. It's the consequences that result from not being able to price discriminate that matter, not some nebulous concept of fairness when it comes to price discrimination.
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