Legalizing Prescription Drug Importation

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My name is Roger Pilon. I am vice president for legal affairs atthe Cato Institute and director of Cato's Center for ConstitutionalStudies. I want to thank the committee for inviting me to appeartoday to discuss legalizing prescription drug importation. In thisstatement I will simply summarize points I made in greater detailin my August 4 Cato Policy Analysis No. 521, "DrugReimportation: The Free Market Solution," a copy of which isattached (available at https://www.cato.org/pubs/pas/pa521.pdf).Attached also is a copy of my October 11 Wall StreetJournal op-ed, "The Reimportation Blues" (available athttps://www.cato.org/cgi-bin/scripts/printtech.cgi/research/articles/pilon-041011.html)and a biographical sketch.

Let me begin by stating clearly that I am not here to urgeCongress to pursue a policy of drug reimportation, as thatidea has come to be called. However attractive such a course mightinitially seem, reimportation is not the answer to the problem, ifit is a problem, of high prescription drug prices in America.Rather, I am here to argue mainly for lifting the currentstatutory ban on reimportation. That will better enable marketprinciples and practices to surface, which alone can sort out thecompeting claims that arise in the drug reimportation debate. I'llnow develop those points a bit more fully and conclude with a fewadditional points that do need Congress's attention.

The reimportation debate is before us, of course, because inrecent years, owing in part to the rise of the Internet, Americansin increasing numbers have discovered that the patentedprescription drugs they're using cost considerably less abroad. Butthey've also learned that American law, except under limitedcircumstances, prohibits them from buying those lower priced drugs.Thus, they're pressing Congress to lift the ban in the hope oflowering their medical bills. But in the meantime, they and manystate and local officials are simply ignoring the ban andpurchasing drugs abroad.

Why then do drugs cost so much? And why is there such adisparity between domestic and foreign prices? The answer to thefirst question points to the regulatory regime we've established inthis country to ensure drug safety and efficacy. Rather than relyon common law principles to allocate the risks of unsafe orinefficacious drugs, early in the last century we established theFood and Drug Administration (FDA) and asked it to regulate theinvention, manufacture, and distribution of drugs by privateprofit-making companies. Today, to win FDA approval for a new drug,a company must invest on average between 12 and 15 years and $800million in research and development (R&D) before the drugreaches the market. In few industries is the ratio of R&D coststo those of manufacturing and marketing greater. The first pill isenormously expensive; the second costs almost nothing toproduce.

In a moment I'll show how that first-pill/second-pill costdisparity is tied to the international price disparity, but first Iwant to note that the costly FDA approval process reflects theextremely risk-averse posture that we've taken. That posture is notcost-free, however, for in guarding so heavily against the risk ofan unsafe or inefficacious drug, we've discounted the risk incurredby a drug's being unavailable, because not yet approved, or toocostly. Suffice it to say that a more flexible FDA approvalprocess, one that allowed for greater individual assumption ofrisk, would better balance those competing risks.

Given those extraordinary up-front costs, however, companiesmust charge prices sufficient not only to recover their investmentbut also to ensure future investment in drug R&D, or they'llnot be long in business. And they've got only a limited time to dothat because the 20-year clock on patents starts ticking from thetime the company first applies for FDA approval, which means thatdrug patents run about half as long as other patents. Once thepatent ends, others can produce the drug as a generic.

We come then to the second question: Why such a disparitybetween domestic and foreign drug prices? Some question whetherthere is a disparity, so let me grant first that for a number ofreasons-including, most recently, the falling value of thedollar-international price comparisons are not easy to make.Nevertheless, domestic prices tend generally to be well above thoseabroad. In 2002, for example, patented drug prices here were 67percent higher on average than in Canada, according to thatcountry's Patented Medicine Prices Review Board. For the averageAmerican, however, what matters is the disparity in the prices ofthe drugs he uses, and that's what's driving the debate. So whatexplains the disparity?

There are two main reasons. First, when drug companies look atthe world they see essentially one free market-America. Here theycan set prices at levels that aim at maximizing profits. In therest of the world, companies tell us, socialized medical systemsset prices: "monopsony" buyers make take-it-or-leave-it offers.Because a company's marginal cost for the second pill is so low, asnoted earlier, it can accept those offers and still come out ahead.But it can do so only because it has America-half the worldmarket-to fall back on. In effect, the rest of the world ridesfree-or at least at well below cost-while American citizens pick upthe tab for drug R&D. And that, too, is driving thisdebate.

Given that scenario, it's no surprise that companies opposelifting the importation ban. For if we imported drugs at thosecontrolled prices we'd undercut the profits they make in the largeAmerican market, thereby rendering them unable to attract thecapital they need for future R&D. And that would be bad foreveryone, Americans and foreigners alike. In effect, as thecompanies rightly say, we'd be importing foreign price controls. Ifthat's the case, why not simply impose the price controls ourselvesand forgo the added costs of reimportation? We don't do that, ofcourse, because in this country, at least, we understand the follyof price controls-even as the rest of the world enjoys them at ourleave.

But the scenario the companies describe, which renders them andus hapless victims of foreign price controls, is not the wholestory. And so we come to the second, equally important reason forinternational price disparities-an explanation that puts companiesmore in the driver's seat. Recognizing different levels of demandin different countries, companies try to maximize profits bysegmenting markets and pricing differentially. Selling too high inlow demand markets excludes too many potential buyers, whileselling too low in high demand markets excludes too many buyerswilling to pay more. Market segmentation is a perfectly legitimatemarketing strategy, but it invites parallel trading-buyers in lowprice markets reselling to high price markets, outside the controlof the companies. When that happens, the advantages of marketsegmentation are lost. In fact, that's what drug reimportationwould amount to, which is another reason companies oppose it.

Consistent with market principles, companies that segmentmarkets and price differentially have two ways to try to frustrateparallel trading-no-resale contracts and supply limits. A statutoryreimportation ban of the kind now in place, however, isinconsistent with market principles because (a), absent no-resalecontracts, such a ban interferes with free trade, and (b), withno-resale contracts in place, a ban restricts the wrong party-theAmerican buyer, who is no party to the contract. There are properand improper ways to enforce market segmentation. We've chosen theimproper way.

Actions to enforce no-resale contracts should be brought by thecompanies against breaching parties. If enforcement actions shouldfail, however, the proper response is for companies to limitsupplies, as they're doing now in the case of Canada. Companiesshould never have run to Congress, as they did in 1987, seeking aban on importing drugs; and Congress should never have granted sucha request, which amounts to a passive subsidy to the companies. Ifthey want to sell drugs to foreign governments at below "truecost," they need to say to those governments, "We'll sell to you atbelow cost, but you'll have to police your exports. It's not up tothe American government to police imports." That gets theincentives right, putting the enforcement burden where it belongs,on the party receiving the benefit of the bargain. Today, however,not only do Americans pay the bulk of drug R&D costs; they alsopay the costs of enforcing the ban that enables the rest of theworld to escape those costs.

Thus, if the reimportation ban were lifted, and marketprinciples and practices were to take its place, it would notfollow necessarily that domestic drug prices would drop or that thefree-rider problem would abate. In a free market, sellers andbuyers are free to strike whatever bargains they wish. Americansmight thus continue to face high prices if foreigners wereunwilling to resell their limited supplies to them. But as pricedifferentials increase, incentives on both sides to breach themarket barriers only grow, as we are seeing today, even with astatutory ban in place. Thus, in a world of large differentials,multiple vendors, and ready information, it's not likely thatno-resale contracts and supply limits would long stanch thecross-border flow of drugs. Companies in that case would have nochoice but to adjust prices, raising them abroad and/or loweringthem here sufficiently to discourage parallel trading.

Yet insofar as the reimportation ban is effective in restrictingcross-border trade, companies to that extent are disinclined totake such measures-and disinclined, in particular, to do the hardbargaining that would "force" foreign governments to take on agreater share of the true costs of drug R&D. Today, we have noway of knowing whether foreign governments would be able or willingto pay more for drugs because companies, able to fall back on theAmerican free market, have limited incentive to press the issue.The reimportation ban, in short, skews the incentives againstAmerican citizens, forcing them in effect and in fact to subsidizesocialized medical systems abroad. It is a wholly un-Americanarrangement that should be ended immediately.

Congress does not need to exercise itself, therefore, withdrafting extraordinarily complex measures of the kind we've seen,all to try to ensure that reimported drugs will be safe. Justlifting the ban will do. Companies already have more thanenough market and legal incentives to ensure that their drugs,domestic or reimported, are safe. More to the point, the merelifting of the ban should suffice to address the safety issue, bydefault, because with the ban lifted, companies will resort tono-resale contracts or supply limits or both; and if those shouldfail they will resort to price adjustments, all of which means thatthere will be little or no reimportation-which makes no sense tobegin with-and that will render the safety issue moot.Indeed, it is the mere threat of reimportation that willbring equilibrium about. And so, as with so much else in life, thisissue turns out to be simpler than at first it seems-once we getthe principles right.

Nevertheless, there are related issues that Congress shouldaddress, which I discuss more fully in my August 4 study. Let mesimply outline a few here.

Most important, in whatever measures Congress enacts,"anti-gaming" provisions of the kind that are found in theDorgan-Snowe bill (S. 2328) of the last session of Congress must beavoided. Designed generally to prohibit companies from raisingprices or limiting supplies abroad, such measures are likelyunconstitutional; and if not, they truly would amount to importingforeign price controls. If that's what we want, then apply controlsdirectly, as noted earlier. But of course that would mark the endof the market incentives now in place that have given us themiracle drugs that have so changed modern medicine-and no one wantsthat.

The Judd Gregg bill (S. 2493) does not contain such provisions.Its problem, rather, is in trying to micromanage reimportation, asif it would happen, by implementing a program for Canada to start ayear after enactment, and then waiting two more years beforestarting reimportation from Europe and a few other developedcountries. Were that course to be followed, companies probablycould "game" the tiny Canadian market (about five percent of theAmerican market), which is too small in any event to satisfyAmerican demand. With companies limiting supplies, Canadianwholesalers would have incentives to seek supplies from the rest ofthe world, which would open the door to substandard drugs producedunder compulsory licensing in third-world countries (see below).For those and other reasons, the two-year "experiment" in limitedreimportation would likely fail before the large European marketkicked in, and we'd be back to reimposing the reimportation ban.No, the ban should be lifted all at once. Then let the market sortthe issues out.

On another matter, the Dorgan-Snowe bill, to its credit, doesseem to address the complex patent law issues that have arisensince the U.S. Court of Appeals for the Federal Circuit handed downits Jazz Photo decision in 2001 (Jazz Photo Corp v.United States International Trade Commission, 264 F.3d 1094(Fed. Cir. 2001)). This is a confused area of the law today, withexperts on all sides unsure about what the law is. In a nutshell,when a patent owner sells a product, he is said to have exhaustedcontrol over subsequent sales (not over the invention). But patentlaw is country specific, so we have two rules: the internationalexhaustion rule says that a sale anywhere exhausts the owner'ssubsequent control of sales; the territorial exhaustion rule saysthat a sale abroad exhausts control only in that country, whichmeans that the owner retains the right to control reselling toother countries. The effect of the Jazz Photo court'shaving upheld the territorial rule seems to be that drug companiescan invoke patent law to blockreimportation-i.e., they can use arguably overextendedproperty law to try to accomplish what should be accomplishedthrough contract law. The Dorgan-Snowe bill addresses that issue byenacting, in effect, an international exhaustion rule.

But this issue is further complicated by recent treaties-inparticular, the free-trade agreements that were signed and ratifiedlast year with Australia, Singapore, and Morocco, all of whichappear to have established the territorial exhaustion rule betweenthe parties. Here too, however, the issue is unclear, the languagedense; but it has all the marks of an effort to frustratereimportation in anticipation of the direct ban's being lifted.

Finally, there is the larger patent issue that is said to arisewhen drug companies threaten to raise prices in a foreign countryand are met with the counter-threat that, if they do, the countrywill invoke the compulsory licensing provisions of the WTO TRIPSAgreement and will license a local company to reverse engineer thedrug, manufacturing it as a generic. Compulsory licensing amountsto stealing the patent, of course, and companies are rightlyconcerned about such threats, if they exist. Unfortunately, thelanguage of the TRIPS Agreement allowing compulsory licensing isnot as tight as it might be. But the 2001 Doha Declaration and theAugust 2003 follow-up agreement, together with surroundingdocuments, suggest that compulsory licensing is to be used only bypoor countries under limited conditions, not by developed countriesin bargaining over prices. In fact, some 41 countries have agreednot to so use those provisions. Nevertheless, this is an area inwhich Congress and the executive branch need to be vigilant,because the integrity of the international patent system isessential to the continued health of the American pharmaceuticalindustry, which in turn is essential to the health of thenation.

Roger Pilon

Special Committee on Aging
United States Senate