Drug Importation and Price Discrimination
Wow. Today, I get to disagree with InstaPundit
AND Andrew Sullivan
. Both of them seem to think that having drug companies sell their products at lower prices in other countries introduces some kind of 'free rider' problem that is anti-competitive. Here's the real scoop, but first I need to get into a tiny bit of economic theory (See? Banning me from talking about Boy Bands has its price):
How Prices are Set
A company sets the price of a product to maximize its profit. Seems clear enough. So how do you maximize profit? Well, you set the price of your product such that each sale is profitable, and the total aggregate sales return the greatest total profit.
But customers differ in how much they are willing to pay for things, and you generally have to set one price. That means that some of your customers are going to get a bargain, and some who would otherwise buy your product at a lower but still-profitable price won't buy it at all. Set your price too low, and you lose the extra revenue from the people who would have paid more. Set it too high, and you lose revenue from lost sales. So setting the price of a product is a compromise.
The most efficient pricing system would involve a magic device that determined exactly how much a customer was willing to pay, and set the price accordingly. If George Lucas could do that, he could charge the Star Wars fanatics $50 to see "Attack of the Cute CGI Animals on the Star Wars Universe". On the other hand, he'd probably be happy to let me in for a buck and a promise not to throw something at the screen. But he can't do that. So the movie is $8, and the hard-core fans get a screaming deal and guys like me don't see the movie at all. Lucas loses the buck I might have paid, and he loses the extra $42 the fans would have paid.
To get around the inefficiency of uniform pricing, manufacturers go to all kinds of lengths to set up ways in which they can charge different people different prices for essentially the same product. For example, an electronics manufacturer might have a 'bargain', 'regular', and 'premium' line of electronics, all of which are essentially the same, or with very slight differences between them. Clothing manufacturers make 'upscale' lines endorsed by celebrities, while selling essentially the same product in no-name versions for the discount crowd. Car companies have upscale lines of cars that are very similar to their main car lines, but with improved finishes and higher prices. You'd be surprised to find out how many different products are made on the same assembly line, but with different labels and wildly different prices. That's price discrimination in action.
It should be pointed out that there is nothing wrong with this, despite the fact that the word 'discrimination' has a nice knee-jerk quality about it. It's simply a reflection of the fact that demand for a product is not uniform, so the most efficient pricing system will not be uniform.
Price Discrimination and Product Exporting
Exportation is the saviour of price discrimination. The economic boundaries between countries allow companies to finally set up pricing systems that are a little more efficient. If a new market for jeans opens up, but the market can only bear to pay $12, then without price discrimination a company could not sell $20 jeans in that country. But if the Jeans only cost $8 to make, the company is losing opportunity by not lowering their prices. Allow them to discriminate, and the jeans will sell for $12 in country A, and $20 in country B. Without the price discrimination, they might wind up not selling at all in country A (leaving a need unfulfilled), and selling for $25 in country B (the additional market in country A would allow them to amortize their costs over a larger market and lower the price in country B). Note that both
countries are losers in this case.
So there you go. Price discrimination can be a good thing, and lead to a more efficient market.
Which brings us to...
The New Wellstone Drug Re-Importation Bill
Drug companies were using price discrimination to sell drugs at a lower price in Canada. Obviously they feel that they would not make as much profit from Canada at a higher price. This is not a 'free rider' problem. Yes, Canadians are benefiting from a wealthy American market that is absorbing much of the R&D cost. But on the other hand, Americans are benefiting from the additional Canadian market, which helps offset some of their costs and thus lower the price of American drugs.
However, if Americans begin re-importing Canadian drugs, they are essentially skirting the drug company's attempt to price discriminate. The net result of that will be lower revenue to the drug companies (they lose sales at the higher American prices, and increase them at the lower Canadian prices). Now, if you're a knee-jerk anti-business liberal, you'll say, "Damned good thing - why should drug companies profit at the expense of Americans?” So it's a good thing that there aren't any knee-jerk liberals around here, because that opinion is wrong. Reduction in drug company profits will mean that two things will happen: The first is that the price of Canadian drugs will increase. That means overall Canadian revenue will decrease. Less revenue to the drug companies throughout the drug market means that they will raise their prices on American drugs to make up the revenue shortfall.
How much of an impact this has on drug prices and drug policy remains to be seen. That depends on factors such as a the price differential, and the number of Americans who re-import the drugs. One outcome is guaranteed: The price of drugs in the United States will NOT drop as the result of this bill. They will either stay roughly the same, or they will increase, or the drug companies will either stop selling to Canada or raise the Canadian price enough that it's not worth importing the drugs.