Friday, October 08, 2004

The Consequences of Drug Reimportation

What will happen if it becomes U.S. policy to allow the reimportation of drugs from Canada? A recent paper in the Quarterly Journal of Economics, by Daron Acemoglu and Joshua Linn, tells the tale. Here's the bottom line, according to Alex Tabarrok at Marginal Revolution:
Acemoglu and Linn's paper is formally about a different issue [than reimportation]; the effect of market size on innovation. What they find is that a 1 percent increase in the potential market size for a drug leads to an approximately 4 percent increase in the growth rate of new drugs in that category. In other words, if you are sick it is better to be sick with a common disease because the larger the potential market the more pharmaceutical firms will be willing to invest in research and development. Misery loves company.

Although they don't mention it, this finding has implications for price controls. In the pharmaceutical market the major costs are all fixed costs (they don't vary much with market size) so profit =P*Q-F. Acemoglu and Linn look at changes in Q but a 1% change in P has exactly the same effects on profits, and thus presumably on R&D, as a 1% change in Q.

We can expect, therefore, that a 1% reduction in price will reduce the growth rate of new drug entries by 4% and a 10% reduction in price will reduce new drug entries by 40%. That is a huge effect. I suspect that the authors have overestimated the effect but even if it were one-half the size would you be willing to trade a 10% reduction in price for a 20% reduction in the growth rate of new drugs? No one who understands what these numbers mean would think that is a good deal.
What the numbers mean is that allowing large-scale reimportation of drugs from Canada (where prices are controlled) will cut into drug companies' profits. Now, before you send up a loud cheer because you've been raised to believe that "profit" is a dirty word, consider what will happen after that. The reduction in profits will have a chilling effect on R&D and, therefore, on the introduction of new, life-enhancing drugs.

The logic of the issue is that simple, but it's probably lost on consumers and politicians, who will focus on what we pay for today's drugs and ignore the dire, long-term consequences of reimportation.

It's just another case where consumers will suffer because economic illiteracy leads to wrong-headed government intervention in markets.