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July 29, 2003, 10:45 a.m. Conservative Drug Split Reimportation is right and good. By Edward H. Crane & Roger Pilon

he prescription-drug-reimportation bill the House passed in the wee hours last Friday morning, by a vote of 243 to 186, was widely opposed by the thoughtful Right — folks at AEI, CEI, the Heritage Foundation, the Manhattan Institute, Americans for Tax Reform, the Club for Growth, the Wall Street Journal, the Washington Times, even Cato's own Doug Bandow in last Thursday's NRO. When we saw, however, that principled members of the House like Jeff Flake (R., Ariz.) and Pat Toomey (R., Penn.) were on the other side, we thought we'd take a closer look. It turns out that this really is one of those issues that's as simple as it seems — free trade is the answer — although it's easy to be distracted by the complications that surround it. And that, unfortunately, appears to be what's happened to many of our friends and colleagues.

Nuances in the bill aside, its effect would be to allow prescription drugs — most of them developed and manufactured in America, but available far more cheaply abroad — to be reimported into this country at those much lower prices. To be sure, many in Congress who supported the bill did so on crass political or anti-corporate grounds: drugs cost too much; drug companies are gouging the public, as is evidenced by prices abroad; let's drive domestic prices down, and cut government outlays in the process, by letting Americans buy from abroad. "The issue is price," said Rep. Rosa DeLauro (D., Conn.). "It is time that this Congress stop acting as a wholly owned subsidiary of the pharmaceutical companies and step up to its responsibility to the consumers of this nation." Motives aside, that's an easy target for those who understand FDA regulations on drug research and development; the extraordinary upfront costs of R&D; the need for drug patents to encourage R&D; and socialized national medical systems abroad.

Because our drug market, burdened as it is with regulations and cost controls, is still free relative to such systems, America's drug companies, which do most of the world's drug research and development, recoup most of their costs, including R&D costs, in the domestic market, then sell abroad at prices far below true costs. Foreigners are thus classic free riders. As with defense, Americans are underwriting a good part of the health-care costs of the rest of the world. But if we allow those below-true-cost drugs to be reimported, critics say, there goes the R&D and all the wonder drugs of recent years. As AEI's John Calfee put it in a July 14 piece aptly titled "The High Price of Cheap Drugs," "reimportation would mean importing foreign price controls, which would destroy the pricing structure of the U.S. drug market and have disastrous consequences for future drug research and development."

Those are powerful arguments — until you stop to think about them, as Rep. Pat Toomey did in a July 17 "Dear Colleague" letter, one paragraph of which goes to the heart of the matter:

Specifically, dropping trade barriers and freeing U.S. consumers to purchase drugs at far lower prices overseas would significantly threaten the profit margins of the pharmaceutical companies. These companies would be forced to present the price-setting countries with an ultimatum: Either liberalize your market or we will leave. It's hard to imagine that countries in this situation will deny their citizens access to life-saving drugs. Instead, they will most likely ease their controls and increase the price they are willing to pay for their drugs.

Toomey goes on say that if free trade were not reason enough to support the bill before the House, then the destruction of price controls should be. In short, reimportation is both right and good.

REIMPORTING'S CRITICS
A brief sampling of arguments against reimportation suggests that they get to a certain point, then stop — as if the next step would reveal the flaw in the reasoning. Take one of the more thoughtful pieces, the Calfee item just noted. Calfee begins by claiming that those supporting the House bill want U.S. prices to match prices abroad, where they're government controlled. Doubtless, many supporters do. But the bill doesn't call for that. It simply allows for market pricing by "forcing" pharmaceutical companies, as Toomey says, to rethink their pricing strategies. Market segmentation and price discrimination might very well continue, but with pricing designed to discourage reimportation. Thus, reimportation isn't the end; it's simply a means — free trade — that might very well lower prices for Americans by "forcing" foreign buyers to pick up part of the costs of R&D, which American law currently shields them from bearing, at the expense of American consumers.

But Calfee continues: Foreign price controls, he says, "prevent innovative pharmaceutical firms from reaping free-market rewards anywhere but in the United States." Prevent? You'd think those controls were set in stone — and the pharmaceuticals had no options. The truth is, they have options, but under current law they have no incentives, because American consumers pick up the tab. Later in his argument Calfee seems to recognize that when he turns to speculation about what will happen under this bill. If reimportation of below-cost drugs begins, he says, companies will simply stop selling abroad at those low prices. Socialized systems would then "have to reassess their price ceilings or leave their citizens short of the best pharmaceuticals."

In that case, Calfee imagines two scenarios, one bad, the other worse. On the first, if companies refused to ship at current prices for fear of undercutting their high-priced domestic markets, due to reimportation,

… our European friends would probably have a political fit. They would face the prospect of either going without American drugs or raising their own price ceilings — and with them the costs of their fiscally strapped socialist health care systems. From their point of view, the importation plan would be a clever way to force U.S. drug prices on Europeans. They would very much want to prevent that. An international demand for drug price controls in the United States (not just in Europe) would be a centerpiece of international diplomacy. And we might cave in, pushed by the same politicians who want importation.

Anything's possible, to be sure. But pity the politician who imposed price controls at home to save socialized systems abroad. Moreover, high prices at home already drive many in Congress, oblivious to the implications, to call for price controls. Yet we don't have them. And we don't because enough members realize how disastrous controls would be. Are we to imagine that pressure from abroad — to save those corrupt systems, no less — will move such members to abandon all reason? Not likely.

Under the second scenario Calfee imagines, reimportation would proceed apace, forcing drug prices to drop here. With the collapse of the U.S. pricing structure — due to the importation, in effect, of foreign price controls — the money that supports R&D would be gone and, with it, the miracle of modern pharmacological medicine. Bleak, indeed, until you ask: Why would American companies continue for long to sell abroad at below-cost prices? Absent the implausible first scenario, Calfee has no answer to that.

Nor do we get any answer from Calfee's AEI colleagues, James Glassman and John Lott. In a July 23 piece entitled "The Drug World's Easy Riders," those two make many of the points Calfee made. They too believe that the effect of reimportation would be to import price controls. And they recognize that reimportation might force companies to demand that foreign governments pay higher prices. But their paying higher prices is "a fantasy," the authors say; "they won't. The best the world can hope for is a continuation of the current process." We search the essay in vain for why we're stuck with the status quo.

In an editorial a week ago, the Wall Street Journal weighed in with an additional point, that reimportation could end up undermining intellectual-property protections: "That's because foreign governments could take the industry's response — supply limits and higher prices — as an excuse to seize drug patents." Again, that's possible, but look at what it amounts to. It has foreign governments saying to American companies: "Sell at below cost or we'll take your product." We enter treaties protecting intellectual property precisely to guard against that kind of theft. The American government should be defending the property of American companies, not asking American consumers to pay ransom to ward off international thieves.

The most interesting case we've seen opposing reimportation comes, not surprisingly, from the University of Chicago's Richard Epstein, writing last Thursday for TechCentralStation. Recasting the issue as one of contract, Epstein argues that market segmentation and price discrimination make sense when they enable companies to expand sales in markets composed of people with differing inclinations to pay — provided they're coupled with contracts prohibiting low-cost buyers from reselling to high-cost buyers. Such a restraint "is not imposed by government," Epstein says. "It is not antithetical to free trade; it is part and parcel to free trade." But those contracts are hard to enforce, he continues, "because it is hard to trace drugs that pass through several vendors. Thus, imposing statutory restrictions on reimportation of patented products is an effective substitute for a valid, if ineffective, contractual restraint."

LEAVE IT TO THE FREE MARKET
Were we to remove the statutory ban, however, two undesirable consequences would follow, Epstein believes. Exports would be reduced, resulting in shortages abroad. And the incentive to innovate would be sapped. Just why innovation would be sapped if low-profit exports were reduced isn't made clear in Epstein's account. Nor is it clear that profits would be reduced if companies changed their pricing strategies abroad by demanding higher prices in those markets. Like other critics of reimportation, Epstein seems to assume that foreign-price controls make for price inelasticity. We'll never know, of course, unless we test that. But we'll never test it as long as drug companies can fall back on the American market while foreigners ride free.

What are we to make, however, of Epstein's enforcement argument? A first response would say that those who make unenforceable contracts should bear the risk of losses. True, the net gain from such a contract might seem to justify the statutory regime Epstein defends, but then we'd need to look at the contractual and related burdens and benefits not simply in the aggregate but from a distributional perspective as well. For purposes of the argument, assume that lower prices abroad produce sales that would otherwise not be made and hence greater profits for American drug companies. Net profits will remain high, however, only if low-price buyers keep their contractual bargain not to resell to high-price buyers. Yet notice where that obligation rests, and whose business it is to enforce it. In the case of socialized medical systems abroad, American drug companies make their low-cost-drug contracts with foreign governmental or quasi-governmental entities. Yet rather than insist that those governments police their own vendors, American companies turn to the American government, asking it to enforce contractual terms binding foreign governments by restricting the freedom of Americans, who are not parties to the contract. Something is wrong there — very wrong.

In a nutshell, if foreign governments want to pay less — and will not pay more even if it means their own citizens will go without better drugs — then let those governments police the no-resell terms that enable them to get the lower prices. Right now, not only do Americans pay higher prices because foreigners refuse to pay the actual costs of drugs, but they pay the enforcement costs of that arrangement as well, including restrictions on their freedom. And if foreign governments cannot police those discriminatory contracts — because the incentive to resell, on one side, and to buy more cheaply, on the other side, makes enforcement difficult or impossible — then let a truly free market, encumbered only by enforceable contracts in restraint of trade, set prices at whatever the market will bear. It is neither right nor good that Americans bear so great a portion of the health-care costs of the world.

— Edward H. Crane is president of the Cato Institute. Roger Pilon is Cato's vice president for legal affairs and director of its Center for Constitutional Studies.