When Minnesota Governor Tim Pawlenty, as much a doctrinaire conservative as there is in the gubernatorial position of any state in the union, unveiled his plan for reimportation of prescription drugs from Canada, he immediately found himself obliged by his purported friends to defend his position. Friendly, but thinly veiled, skepticism he encountered ranged from his being criticized by blog commentaries for anti-business actions, to being questioned skeptically by Hugh Hewitt (who has since backed down) to being pilloried by True Believers who seem to believe that any talking points ever faxed in by any large business anywhere must be gospel. On the other side were such commentators as Minneapolis StarTribune editorialist Lori Sturdevant, who applauded Pawlenty for a shrewd political populist gambit to drown out the cries of misery that are following his evil tax-freezing, expenditure-cutting budget. Sturdevant sees a Minnesota version of the triangulating “Sister Drug-ya” moment.

There have been millions of words written by both sides promoting their respective points of view, often espoused by some strange political bedfellows: picture Sen. Mark Dayton’s Canada bus runs departing, with Pawlenty and Rep. Gutenecht wishing the seniors Godspeed as they head North, while Democratic pundit Morton Kondracke urges the White House to hold firm and veto any legislation that enables pharmaceutical free markets to operate. At the moment we are hearing political sound-bites based on the self-interests of the various parties- but, what are the real issues to this idea? Are the battle lines as simple as to obviously brand Pawlenty as an apostate, or is he actually the real free-market conservative in this debate?

There are two distinct non-political motivations that might drive one to promote the idea of re-importing prescription drugs. First, it is obvious that one can embrace the idea simply to save money by acquiring drugs at lower foreign prices. This has a short-term effect of mitigating costs, but it does nothing about the cause of the high prices. The second approach is that of the Minnesota governor: importing drugs is a necessary means of eliminating artificial barriers, barriers that are set up and maintained by government regulators. This is not a simple case of “regulation-good, big pharma-evil”; neither is it absolution for the drug companies. And it is important that such market distortions, abetted by government, be removed before the only answer is government in the form of execrable single-payer socialization plans and the rationing that has inevitably followed wherever they have been implemented. Pawlenty is telling the free-market apologists to clean out their closets before the accumulated dreck blows up the system.

There are three major objections to prescription drug reimportation that are most often cited: 1) Safety concern- imported drugs are not manufactured in FDA-blessed facilities, so they could kill us; 2) Interference with free enterprise- bringing in prescription drugs from Canada is “importing price controls”; and 3) Reimportation would lead to a loss of drug company profits that are needed to support future development of new drugs.

There are sensible responses to each of these objections. Let’s look at them, one at a time.

First: Reimporting drugs would not be safe! The FDA won’t be able to “certify the safety” of drugs sold outside of the US :

OK, let me get this straight. They are saying that the same companies that sell safe and pure pills, made in the US, would casually change all of their production and quality processes and procedures when they sell those same drugs to Canada or Brazil? Um, for those of you who have never encountered a factory or a government regulation process, I have a secret for you: the FDA can’t certify the safety of ANY of the drugs made and sold in the US either, even at several times the foreign price. People, get real. This excuse is a con; the FDA doesn’t have labs all over the US where they test the drug production lots coming out of the pharma phactories. They do things the only practical way that they can- the drug manufacturers set up procedures that match the FDA Good Manufacturing Processes (GMP) regulation, they establish process controls, and they sample the production lots. The processes are periodically inspected by outsiders to ensure that the company follows its own rules. Then the information- the data on all of this- is made available to the FDA. To believe that the safety issue is a major concern, one would have to believe that the drug manufacturers don’t care about product liability or the circling sharks of the trial lawyers bar (ATLA) who can’t wait for an easy shot at a major pharma.

The best and most enthusiastic enforcers of drug safety are not US government bureaucrats, they are the drug companies themselves. At least, that is the premise of the argument used by free market conservatives in every other area when they are not trying hard to justify protecting the current FDA-enabled monopolistic pricing power of drug companies. Imagine even that some smuggler obtained a supply of black market medication with labels that proclaimed the drugs to be The Real Thing. Whether the stuff worked as advertised OR made people sicker, who would be the most likely candidates to track down the bad guys and stop them? Good guess. If the FDA were not playing cop, you can bet the pharm that Pfizer, Merck, Bristol-Myers, and GlaxoSmithKline would have their own detectives on the beat and making citizens’ arrests at a dizzying pace.

The objection that drug safety would decline dramatically due to re-importation is simply nonsense. It is the rough equivalent of saying that a 10% cut in the city budget will lead to firing all the police and firefighters- it only happens that way if the city decisionmakers are incompetent.

Second: You’re Interfering with free enterprise by importing the price controls of foreign countries like Canada!

For those of us who believe in free markets, this is a troubling accusation; based on the universal evidence of history, we know that when we try to control prices by capping them, we only succeed in reducing the supply. That generalization doesn’t very neatly fit the pharmaceuticals’ situation, however, because the common examples deal with commodities where the per-unit variable cost margin is very tight. If there is any description that doesn’t fit prescription pharmaceuticals, it is “tight per-unit variable cost margins”. The real case is more like “a penny a pill variable cost, selling price a buck”. Not, as Seinfeld said, that there’s anything wrong with that…… However, unlike the case of natural gas, which is a standard commodity in a tight supply situation, the availability of pills is unlikely to be directly affected by any realistic price caps, not that I am suggesting that real live price caps ought to be implemented. In fact, I am arguing that the actual situation is not one of price caps, but of the rational responses of monopolists to the offers of very large, high leverage customers, to buy. Here we have monopolist sellers complaining about monopsonist buyers (think “monopolist single customers”), the rough equivalent, to quote James Bovard on another topic, of two drunks lying in the gutter, each complaining that the other is ruining the neighborhood.

Back in our first half-semester of classical theoretical microeconomics, we learned about “price discrimination”, a pricing system that is feasible only under conditions of monopoly. The fundamental principle is that any rational business enterprise will charge the particular customer highest price possible for the product. In a monopolist’s best case, there is no reason whatever to charge everyone the same amount for the same product- in fact, in the best of all possible worlds, there is a different price for each individual consumer, based on ability to pay and the degree of power wielded by the seller over that hapless captive customer. The term “price discrimination” has no moral component; it simply means that the seller will differentiate among his various customers and go to each with the highest price he can get away with charging.

We see this all the time in the real world. A common and easily recognizable example is the concession stand in the stadium or the movie theater. The market price of popcorn at home may be a quarter for a huge bowl, using Orville’s best in the old air popper. But, because the theater’s security people stand at the door to make sure that you are not smuggling in any contraband popcorn, your only alternative is for them to happily sell you an oily tub for five dollars.

The large international pharmaceutical companies have honed this art to near-perfection. The major issue faced by any seller- that is, how to prevent competitors from entering “their” market and undercutting the established prices- is solved and enforced for Big Pharma by Your Government. Our elected leaders stop all competition through a combination of patents and regulatory barriers to prop up prices, and then they vote for big spending programs to save us from the consequences of overregulation. That is not to say that patents and FDA drug regulation should be eliminated; clearly they should not, though some reform of certain abuses of drug patents is in order (i.e., one patent per basic chemical formulation), and something needs to be done to manage the costs of the clinical approval process in a safe manner.

But. The last time I heard sentiments similar to the current fear-mongering by the drug gangs was in my first job out of college working for a trucking company, right at the time that the over-the-road trucking industry was fighting against the horrors of decontrol. They had a long list of reasons why the republic would be destroyed if interstate trucking were deregulated. The real reason was that they didn’t want to lose business to individual entrepreneur, truck-owner-operators. Notice that the wordl didn’t end then, either- the trucking firms that were flexible sold most of their fleets and switched to a contract hauler model and the weak sisters fell by the wayside. The roads aren’t any worse than they were before, and goods still get moved. The trucking firms were wrong- and the airline and telecommunications industries, equally terrified of the pricing disruptions of competition, were also wrong.

Forty years ago, the sainted Nobel laureate Milton Friedman noted that the biggest supporters of regulated industries are the regulators and regulated of those industries. He cited the incestuous and self-serving nature of virtually any such relationship, from the old Minnesota Railroad and Warehouse Commission to the ICC and its trucks, and the cozy way that the FCC takes care of the old guard telephone companies. What makes us think things work much differently with regard to the US Food and Drug Administration, particularly when the power of the agency rests in its ability to control the US drug market?

Kevin Hassett of the conservative think tank American Enterprise Institute recently bemoaned the way the TRIPS agreement messes up Big Pharma’s pricing power overseas by permitting foreign governments to violate drug patents on a humanitarian basis if they are being charged “excessive prices”. This is actually a sensible provision of any patent structure, including the US system; the US government also has “march-in rights” to exploit technologies that are improperly being withheld from the public for anti-competitive reasons. The entire basis of US patent law is that such protection from competition is provided as a means of ensuring deployment of technology, not preventing competition. As a moral issue, I don’t know anyone who would seriously propose that all of Africa be allowed to die so that Glaxo can prop up its developed country drug pricing structure. TRIPS is an attempt to balance competing interests and needs to exist, yet be administered in a balanced way. The most recent domestic example of a Big Pharma trying to play games with this was when HHS Secretary Tommy Thompson was trying to get reasonable price quotes for CIPRO in the wake of the 2001 anthrax scare, and Bayer Pharmaceuticals did their best to stick it to the US. Only a threat by Thompson to invoke the emergency powers ended the problem. (And we then did the smart consumer thing anyway- switched to generic doxycycline. Served them right.)

What actually happens in Canada, as Gov. Pawlenty observes, is not price control, but two parties, a buyer and a seller in each transaction, negotiating to get the optimal exchange based on the leverage each holds. Big customers have a lot of clout- Best Buy and WalMart tell their suppliers what products and how many units they are willing to buy- and they negotiate very hard on price- BUT THEY ARE NOT IMPLEMENTING PRICE CONTROLS- they are using their leverage as dominant customers. The seller does not have to take the deal, as Super Valu wisely illustrated a few years ago when K Mart tried to squeeze them too hard in lining up a primary supplier for their grocery shelves. Best Buy and Wal-Mart essentially dictate their purchase cost by squeezing every nickel of extra margin from the producer.

In the same way, if the dominant customer is a country, Canada (or South Lichtenstein- the specific country is not important) decides what price it is willing to pay for 100,000 units of drug X. It makes an offer to the pharma manufacturer to buy drug X from them for the price it has determined to be appropriate for its needs. The pharma determines whether it is willing to sell 100,000 units of drug X at that price, based on all relevant factors- unit variable cost of production (labor, materials, tooling, energy) and ability to protect the higher selling price of, say, two dollars per pill in other markets. If each pill costs a penny to produce and the selling price in other markets will not be driven down by accepting a Canadian or Peruvian offer of ten cents per pill, it is advantageous to take the deal. In this case, the US FDA is determined to continue to pay two dollars per pill, so Big Pharma eagerly sells cheap to Canada and most of even that selling price is profit.

But then: suppose the US started to import drug X from Canada for fifty cents per pill, Big Pharma has two choices: let it happen and see revenues drop by $1.50 per pill ($2.00 less $.50), times the total sold in the US, or stop selling to Canada at the low price. Either way, total dollar sales change. Eventually, they either bite the bullet and stop discriminating against the United States consumers, or they persuade Canada to pay more. Pawlenty and other true free-trade enthusiasts are betting that the “rest of the world” price will rise a bit and the US price will fall a bit, so that, eventually, the US pays market-established prices that are similar to those paid by everyone else rather than artificially-propped-up prices enabled by government regulation. That is not “importing price controls”, it is advancing free trade.

Which brings us to the third issue.

Third objection- Reducing US prices would lead cripple future development of new drugs. Well, would it? Rational analysis suggests that it would not affect new drug discovery R&D much at all- and the changes would merely accelerate the drug development changes that are already in progress- due to biotechnology and molecular chemical design. The largest impact would be on the approval testing process, the clinical trials where most of the expenses and risk are encountered. Those effects can be mitigated somewhat, not completely, by regulatory reform (though the risk of discovering previously unknown side effects will always be with us). But we already have “Orphan Drug” laws because the drug suppliers don’t willingly pursue less sexy or less lucrative treatments. The reason that these drug qualifications cost so much is a combination of liability and the intolerance of the US public to assuming any risk for unknown-unknowns. Bush and Frist are right to promote medical tort reform.

The fundamental claim currently shopped by the defenders of the regulatory-barriers-enabled status quo is that, without the high profit margins currently enjoyed only in the US, drug producers will be unable to create new therapies and we will all be less healthy as a consequence. If you believe that, you believe that a drug firm will voluntarily cut its own throat by eagerly emptying its pipeline of future products.

Anyone who watches television knows what Big Pharma does with large portions of its money- folks, it isn’t going to dedicated lab rats to find revolutionary treatments for rare and deadly diseases. The big bucks are spent on promotion and advertising, described in the R&D budget as “public education”, to try to persuade patients to demand that their doctors switch their antihistamine prescriptions over to the enhanced extended release Clarinex before the patent on Claritin runs out. That is, all the money not spent on Viagra commercials.

Investment goes where the money is- big markets, chronic diseases (where the patient needs to take the stuff daily for years, a la baby-boomer arthritis), and low-risk incremental variations of compounds where there is already some level of market share, brand-name identity (Bayer Low-Dose Aspirin) and barrier to competitor entry. If there is less cash available for new R&D, will the budget cuts come in finding new products or TV advertising? These sorts of decisions give gray hair to CEOs; fine- let them earn those bonuses.

The frequently-cited allegation that it costs $802 million, on average, to bring a new drug to market, is not necessarily a number that any analyst would agree with; the sample of 68 drugs was culled to massage the numbers and the R&D expense figure used was subject to some creative interpretation. We like firms to make profits in our free market, but Big Pharma’s rate of return is enormously higher than for most other industries, and that profit is AFTER writing off the R&D investment. There’s enough cash there to put some back into new drug approvals if it is necessary to do so. We don’t want to regulate drug finances, we just want them to live in the market a little bit more.

That real story is the primary reason that Big Pharma is resisting changes in the marketplace: in the same manner as every other relatively comfortable business, they hate disruption. In the world of technology investing, every history survey features story after story of “disruptive technologies”- the effects of internal combustion engines on the horseshoe and buggy whip industries, how General Electric threw the growth business plans of the whale oil producers for a collective loop, the need for IBM to adapt in major ways as mainframe computers were replaced by very low cost personal computers, the current woes of the Baby Bells as wireless telephony intrudes on their previously inviolate turf, and the anguished cries of network news organizations and old-line newspapers as the public places increasing reliance on satellite TV and internet bloggers than on ABC and the New York Times.

Big Pharma, like every large entity, wants to control its own fate and be internally integrated. They want to identify drug candidates internally, do the development in-house, control key suppliers on an exclusive basis, and so on. With other consumer products, such as with the automotive industry, outside competition (from imports) forced them to become less inbred and to open up both design ideation and subsystem manufacture to outside sources. Even the fabled creativity mills at 3M have seen the in-house research centers have to compete directly with external concepts, which are acquired by the corporation through intellectual property licensing, equity investment, mergers and acquisitions, and joint ventures.

The drug companies are making their first reluctant, halting steps on these uncertain paths. They have customs and processes for doing things. Several major firms, such as Schering Plough, also have their new drug pipelines drying up. But we need to speak the unspeakable: there is no reason whatsoever that today’s Big Pharma firms need to be protected so that in 2020 Pfizer and Glaxo are still dominant players, any more than back in our history we should have protected the Union Pacific railroad, Cray Research, Pan American airlines, and Northern States Power Company’s Reddy Kilowatt. Forbes magazine recently discussed the emerging elephantine issue- that the days of large blockbuster drugs and broad general drug markets are going the way of TV network broadcasting when cable and satellite came to be. “Business Week” described “Reinventing Corporate R&D” back in September 2003, and they were largeyl correct.

The emerging sciences of individual genomic characterization combined with biometric information databases will lead us to “individual designer drugs”, meaning that there will be far fewer medications that can be marketed to most everyone. The sooner Big Pharma gets over its marketing myopia, stops quivering against the reality of fundamental changes in their world, and gets on with shaping themselves to compete in the “narrow-casting” world, the better.

To believe that Big Pharma will abandon their life’s blood R&D because of marketplace changes is to believe that businesses give up completely when things are not perfect. No- they adapt, but when the market forces them to. We should stop enabling their denial. Faced with the continuous imperative to fill their product pipelines, they will eventually adapt in any way necessary to stay afloat. Reducing the margins of some products will force them to accept the fact that we will no longer tolerate them selling Allegra over-the-counter in foreign markets, while saying that US consumers are too stupid to use the product safely in the US until the magic infusion of wisdom the day after the patent expires. This sort of nonsense might impress one group of politicians, but before long the majority of Congress will join the majority in the House of Representatives in saying “Enough! We can’t cover for you any longer!”

The current revolution in drug discovery mirrors the changes in R&D in other industries. For years, a lot of drug discovery has originated in the National Institutes of Health (NIH) university research system, where federal grants for basic science have been followed by drug companies licensing the discoveries to take them to market, or new spin-off businesses coming out of the universities and research institutions to exploit such inventions. Research by universities and very small business startups is accomplished at lower cost, and is often also more likely to be carried to a meaningful pursuit decision based on both financial and medical necessity criteria than if buried in the Bristol-Myers corporate structure. Suggesting that failing to feed the current corporate pharmaceutical development model as it currently operates means that beneficial new therapies will be lost is nonsense, and ignores current reality.

To be sure, there are already abuses by Big Pharma that need to be addressed- for example, if a non-profit research center utilizes proprietary material from a pharmaceutical manufacturer for a new project, the pharm routinely demands that all new discoveries tied to the use of the material in any way be given back to the firm. If they are providing the ideas and funding research, that makes sense; but if NIH is funding the research of an independently creative scientist, there should be legal provisions for equitable shares of the proceeds of the research to flow back to the researcher and his company or organization. In some cases at present, pharma companies do no more than provide non-unique research tools, not formulations or materials, and still demand ownership of all the research discoveries in exchange. That obviously has to stop. But these are manageable implementation issues, not dead ends.

Now what?

So, how do we make sure that drug innovation doesn’t die when (not “if”) the current wildly unbalanced, country-specific discriminatory pricing system inevitably collapses? Well, most importantly, we do not turn this into a government program, but we do enable the researchers receiving NIH support to work even more toward practical applications when appropriate, whether through new start companies or licensing to industry. We encourage industry to look to these new start companies to fill their product pipelines. We can retain promising new formulations in the research setting for longer periods to answer more of the safety and efficacy questions, thus reducing the cost burdens of the clinical trial stage that can only be completed by Big Pharma. We can provide tax incentives for both individuals and pharmaceutical firms to invest in the new start companies working on new drug formulations. We can strengthen the “orphan drug” laws to encourage firms to think less about marginal analgesics and more about life-threatening conditions. Perhaps most important, we can stop the ambulance chasers from chilling the risk climate, but in a way that protects customers. It works for Underwriters Lab and electricity.

The policy prescriptions are endless, and deserve debate- but to say that there is no way to protect new medication R&D other than to pay monopolistic prices only in the US suggests that the wrong people are in charge.

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