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COPYRIGHT 2004 C.D. Howe Research Institute
The Study in Brief
Canada's Internet pharmacies represent a threat to domestic drug supplies and prices, and the federal government should close the business.
Drug companies charge different prices to different buyers internationally and within the U.S. Uninsured buyers, and those in relatively small buyer groups in the U.S. pay among the highest prices in the world. Their purchases from Canadian Internet pharmacies have until now been relatively small in volume, but could grow much larger if the President signs legislation permitting retail pharmaceutical imports. Since the prices of some drugs are relatively low in Canada, legalization of imports would likely result in large increases in demand on Canadian suppliers.
Drug manufacturers do not want to cannibalize the profitable U.S. market by supplying low-priced imports from Canada, so they will press for higher prices in Canada. Since Canadian federal regulations prohibit them from increasing drug prices at a rate higher than inflation, the manufacturers' only method of protecting their American profits would be to restrict supply to Canada, which could lead to shortages and eventually to higher prices.
Because the cross-border trade remains mostly illegal and the volume small, Canada has not suffered a serious shortage of drugs or big price increases. This situation could quickly change if legislation is passed in Washington to legalize imports.
From Canada's perspective, it makes sense to act sooner rather than later. If the next President implements legislation to facilitate drug imports, it would look hostile on Canada's part to immediately prohibit drug exports.
Stopping exports soon would eliminate the prospect of shortages and price increases and is entirely advantageous for Canada. It would also be an act of moral leadership. Ottawa recently passed a bill allowing exports of generic drugs to developing countries that issued compulsory licenses for them. That bill required developing-country recipients to take "reasonable measures" to prevent re-exports of those drugs, so that Canadian manufacturers were not undercut by shipping low-price drugs to lower-income countries. Canada should lead by taking reasonable measures to prevent unauthorized exports of the drugs regulated by the Patented Medicines Prices Review Board.
Internet pharmacies in Canada are enjoying a booming business selling prescription drugs to U.S. consumers, with sales estimated at as much as $600 million (unless otherwise specified all figures are in Canadian dollars) in 2003, or approximately 3.8 percent of total retail drug sales (IMS Health Canada 2004). Do these sales threaten to increase Canadian drug prices, cause shortages, or solve the U.S. problem of high drug prices, as a number of commentators have suggested? If they are a threat to Canada, are there any desirable remedies? We conclude that the sales do constitute a danger and we recommend a protective policy for the federal government.
As we discuss in this paper, there are two barriers to a substantial increase in Internet pharmacy exports. The first barrier is that the drug companies actively monitor sales to eliminate supplies to pharmacies selling into the U.S. and the second is that the U.S. Food and Drug Act prohibits retail drug imports. There is now a fair probability that these laws will be modified to allow drug imports from some Canadian sources and if that happens, there is no certainty that the drug companies would be successful in preventing a substantial increase in retail drug exports. Should such exports increase, it seems likely that drug companies would seek--and perhaps be able to obtain--higher prices in Canada. Any increases in the price of drugs could have severe consequences on provincial health budgets where spending on pharmaceuticals already represents as much as 16 percent of total health expenditures, the second largest line item after spending on institutions.
One of the sticking points in the Internet pharmacy debate is the perception among the U.S. public and legislators that drug price controls in Canada account for the price differences between Canada and the U.S. As a result, U.S. politicians put strenuous pressure on Canada to eliminate drug price controls. (1) As we argue in this paper, eliminating Canadian price controls may not be a way out of this problem. On the contrary, the preponderance of evidence indicates that federal price controls, exercised through the Patented Medicines Prices Review Board (PMPRB), have relatively little impact on drug prices in Canada.
Because this finding implies that prices in the U.S. and Canada are essentially set by drug companies in response to demand conditions, including the leverage exercised by provincial drug plans, our analysis employs the standard economic framework of price discrimination (the situation when companies charge different prices to different buyers for the same type of good). This well-developed economic literature allows us to develop some helpful insights into reasons for and possible policy responses to Internet pharmacies.
We build on the standard analysis of price discrimination and parallel imports as presented in Maskus (2000), Malueg and Schwartz (1994) and Gallini and Hollis (1999). Parallel imports are imports of genuine products, produced under protection of trademark and made available for sale in the originating country, thus--potentially--violating the trademark, patent, or copyright held by a local company. This is exactly the situation of the Internet pharmacies. Typically, parallel imports arise when a company attempts to discriminate in pricing between markets.
Several papers have focused on drug imports. For example, Calfee (2003) examined the political economy of imports into the U.S. and argued that they will lead to "rapidly escalating pressure for pharmaceutical price controls" in the U.S., a direction that was totally rejected in the 2003 Medicare Act (Calfee 2003). Indeed, if anything, it seems to have led to escalating pressure from the U.S. for the elimination of any form of Canadian price controls. Arfwedson (2003) examinded parallel trade in pharmaceuticals on a global scale and, while briefly discussing Canadian Internet pharmacies, chiefly explores the trade-off between preserving intellectual property rights and ensuring access to essential medicines in developing countries.
Our analysis, in contrast, focuses explicitly on Canadian policies and options. We offer a perspective highlighting the convergent interests of Canadians and of drug companies. We argue that the best policy for the Canadian government is to take steps to eliminate, or at least to reduce, Canada's Internet pharmacy exports to the United States, a policy that exactly matches what the drug companies want. We also offer some cautions on the difficulty of constraining such exports.
There are two underlying reasons for the recent rise of Canada's Internet pharmacies. For one thing, the cost of finding low-priced drugs in Canada and shipping them to the U.S. has fallen because of the Internet--which makes instant price comparisons possible--and improved express shipping. A cross-border trade in drugs has existed for a long time, fuelled by seniors willing to take a bus to Canada to buy cheap drugs, but it is the rise of the Internet and better shipping that has enabled drug exports to expand massively.
For another, the success of the Internet pharmacies depended on prices for some drugs in Canada being lower than the prices available to some consumers in the U.S. Not all drug prices need be lower in Canada to stimulate exports and indeed there are many products for which the price is lower in the United States. Overall, drug prices in Canada tend to be lower than in the U.S., but Danzon and Chao (2000), using 1992 data, find prices about the same when accounting for products available generically as well as branded products. Danzon and Furukawa (2003), using 1999 data, find prices for patented drugs in Canada to be on average about 36 percent below U.S. prices. (They say that lower relative Canadian prices are largely explained by depreciation of the Canadian dollar.) Naturally, however, exports to the U.S. have been of those drugs that are lower-priced in Canada.
It has been well documented that in the U.S., drug companies practice extensive price discrimination with uninsured consumers paying the most, large corporations and Health Maintenance Organizations (HMOs) paying somewhat less, and the federal government paying the least. The bulk of the Internet pharmacy exports from Canada have been to uninsured consumers who face high drug prices. Thus, all that is necessary for Internet pharmacies to have substantial cross-border sales is for at least some drugs to be priced substantially higher in the U.S. for at least some classes of consumers, a condition which is readily met because of the high prices faced by retail consumers in the U.S.
There is an additional wrinkle in appreciating why Canadian and U.S. drug prices differ. U.S. federal legislation requires pharmaceutical manufacturers to provide price discounts for certain types of government purchases. For example, a clause introduced under the Omnibus Budget Reconciliation Act (1990) gives "Most Favored Customer" status for all drug purchases under the Medicaid program. Scott-Morton (1997) has shown that this lessened market competition among both branded and generic companies leads to a 4 percent average increase in prices. Similarly, drug manufacturers are required to discount all drug purchases by the U.S....
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