Trade and Price Differentials for Pharmaceuticals: Policy Options

Danzon, P.

Monograph
May 1997

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Pharmaceutical prices have traditionally differed substantially across countries, reflecting differences in regulation and other factors. In recent years, governments are increasingly attempting to take advantage of lower prices abroad to control pharmaceutical expenditures under their own national health and social insurance programmes. Two policies are used to these ends. The first uses cross-national price comparisons as a benchmark for setting domestic price levels. For example, Canada and Italy use prices in a specified set of foreign countries to cap the prices permitted in their own countries. A similar approach was proposed for the US in President Clintons Health Security Act (1993), and has recently been proposed for Japan. The second strategy permits parallel importing of pharmaceuticals. Traders are granted a license to import products purchased in lower price countries, such as France, Spain or Greece, into countries with higher prices, such as Germany, the UK or the Netherlands. The European Court of Justice has upheld parallel importing, as consistent with the free movement of goods. In 1996, in Merck v. Primecrown, the free movement of goods was affirmed even though the exporting country did not grant patent protection and the practical effect was to undermine the patent value in the importing country.

Parallel trade and regulatory use of international price comparisons both have the effect of exporting low pharmaceutical prices in one country to other countries that have traditionally paid higher prices. Actual parallel trade flows were only 5 per cent of total EEC value of sales in 1992 (SNIP, 1993), but may be 20 per cent or more in traditionally higher price countries such as the UK and Germany. However, actual trade flows greatly understate the potential impact of parallel imports. For a manufacturer faced with the threat of significant parallel imports, the loss minimizing strategy is to reduce the price differentials, in order to eliminate the arbitrage opportunity. Thus the mere threat of parallel trade may suffice to make the lowest price within a trading area the effective maximum price, even in markets that would otherwise pay higher prices.

The potential for parallel importing to reduce the revenues of pharmaceutical companies has increased with the admission to the European Union of traditionally low price countries such as Spain and, in the future, the countries of Eastern Europe. In addition, since 1995 new medicines that are approved by the European Medicines Agency are automatically approved in all EU countries. The resulting harmonization of registration and labelling requirements is likely to reduce the costs of parallel importing and hence reduce the price differentials that can be sustained without inducing parallel trade. Previously, a 15-20 per cent price difference was necessary to cover the costs of complying with different regulations and other importing costs.

Trade normally increases consumer welfare and it is on this basis that the European Commission has upheld parallel imports. The economic rationale for international trade is the same as for any other exchange. Trade occurs when the value to the purchaser exceeds the marginal cost to the supplier. In well-functioning competitive markets, the supplier's marginal cost reflects the social opportunity cost of resources used in production, and the buyer's demand price reflects the marginal value to consumers. Trade occurs where marginal value exceeds marginal cost and is therefore generally welfare-enhancing. Consumers benefit through either lower prices or a wider range of products.

The purpose of this paper is to examine the welfare arguments for international price differences for pharmaceuticals and the welfare effects of policies that have the effect of eliminating such differences, in particular, parallel trade and regulation based on foreign prices.

The main conclusion is that uniform prices are generally not welfare enhancing for innovative pharmaceuticals because of their unusual cost structure, in particular, the importance of global joint costs. Joint costs are costs that jointly benefit many consumers and are the same, regardless of the number of consumers served. These costs are 'global joint costs' when the benefits accrue to consumers in different countries. R&D expenditure for innovative pharmaceuticals is largely a global joint cost. Economic theory (Ramsey pricing) implies that charging different prices to different users (in this case, different countries) is a (second best) optimal means to achieve the welfare-maximizing rate of R&D, given its 'jointness' for users worldwide who differ in income, preferences for medical care and other factors that affect price elasticity of demand.

In practice charging to cover these global joint costs of R&D and other shared functions is made more difficult because these costs are sunk at the time of price negotiation. In most countries governments have monopsony power as purchasers for national health and social insurance programmes. Each government faces the temptation to exploit this bargaining leverage, attempting to force prices down to its country-specific marginal cost, freeriding on others to pay for the joint costs. However, if every country pays only its marginal costs — either by direct regulation or by the spillover of low prices in one country to others through international price comparisons or parallel imports - then no one pays for the global joint costs of R&D. In the long run, consumers will be worse off because they will have access to fewer innovative medicines. The lower level of pharmaceutical revenues will not support the development of some innovative medicines that would have been developed, had price differentials that reflect true willingness to pay been maintained, thereby generating greater revenues.

In this paper, Section 2 describes the cost structure of the innovative pharmaceutical industry, and the role of patents and regulation in constraining pricing to cover these costs. Section 3 outlines the economic approach to determining optimal price differences in the presence of joint costs. Section 4 identifies the winners and losers from parallel trade. Sections 5 and 6 discuss policy options to minimize the adverse impact of parallel trade and regulation based on foreign prices, if these policies are to be permitted.

Section 7 sets out concluding comments.