Economics for an Optimal Solution: Price discrimination without parallel importation

 

If manufacturers could know in advance how much each person was willing to pay for their product, they could charge each person that amount.  The manufacturer would then sell to each person willing to pay more than the cost of production, charging each the maximum that each was willing to pay.  Generally, however, manufacturers have no way to evaluate how much each potential customer is willing to pay, and so set one price for a product.  Any given price for a product will tent to be less than some people are willing to pay and more than other people are willing to pay. 

 

In the case of patent protected pharmaceuticals, as discussed here, the price charged is generally significantly higher than the cost of production, and significantly higher than it would be under conditions of competition.  This means that, in the absence of health insurance, many people to whom the product could be profitably sold do not buy the product, resulting in lost revenue to the company and many people who could benefit from the drug not doing so.[1]

 

Companies can, however, in some circumstances charge different prices for their products in different locations.  One way to lower prices in poor nations, and for a company to earn more money in those nations, would be for a company to charge a lower price in poor countries, or even a different price in every country, depending on the ability of people to pay.[2]  A company adopting such a strategy could sell more, earn a greater profit, and provide more people with access to their drug.  This is one solution that proponents of strong intellectual property rights for pharmaceuticals in developing nations offer, in order to encourage the availability of medicines at low cost in poor countries.[3]

 

Problems with the implementation of the parallel importation solution

There are two main reasons that pharmaceutical companies are reluctant to implement widely divergent pricing in different countries.  First, companies fear that customers in rich countries will resent paying prices that are many times higher that rates charged in developing countries.  Particularly in the United States, there is a large consumer movement that feels they are being overcharged for pharmaceuticals.[4]  Second, companies fear parallel importing, the practice of buying drugs in a low cost jurisdiction and exporting them for resale in a high cost jurisdiction.  Because pharmaceutical companies make most of their profits by selling patented drugs at high prices in developed nations they are generally unwilling to price discriminate if doing so will jeopardize rich country sales. 

 

Currently, parallel importation occurs between rich countries.  For example, drug prices tend to be lower in Canada than the United States due to Canadian regulations that limit prices on patent protected pharmaceuticals.  This has lead to a thriving drug export business from Canada to the U.S.  As the Canada/US prescription drug business has grown, drug companies have taken action to stop it.  Recently, Pfizer Inc., one of the world’s largest pharmaceutical companies, took action to limit supplies of their patent protected drugs in Canada, in order to discourage the parallel import of pharmaceuticals between the two countries.[5]  

 

Some parallel importation may occur between rich and poor countries, though this is less clearly documented.  There have been isolated reports of drugs donated to poor nations, or sold to poor nations at deep discounts, being diverted back into rich country markets.[6]  The European Union recently introduced legislation to help prevent the importing of pharmaceuticals from poor nations, where those drugs have been sold at a significant discount.  The European Union scheme also introduces a product labelling protocol that may help to identify drugs sold at low prices in poor nations, thus preventing the illicit resale of those drugs in rich nations.[7]

 

Other problems with parallel importation

While parallel importation and fear of alienating rich country customers are important factors limiting the practice of price discrimination, there is reason to believe that price discrimination, even in the absence of these barriers, will produce sub-optimal results.  Price discrimination, under conditions of monopoly, will not lead to the lowest possible price.[8]  It will lead to the price at which the pharmaceutical company believes it can maximize its profit.  This optimal profit price, in developed nations, is generally far higher than the cost of production.  For example AIDS drug regimens that cost $12,000 per year the United States cost less than $300 to produce.  In poor nations the optimal profit price is likely to remain well above the cost of production.  Income discrepancies between the middle class and poor in developing nations may mean that a company earns more money by pricing a drug for consumption by the middle class, well above the cost of production, even when this places the drug out of reach of the poor.

 

In developed nations, historically, prices for pharmaceuticals only drop significantly with the introduction of a large number of generic competitors.[9]  There is evidence to suggest that lowest possible prices for pharmaceuticals are never achieved in jurisdictions that offer significant patent protection, even after patent protection expires.[10]  Competition between manufacturers tends to drive down prices.  In poor countries, where consumers have limited incomes, price sensitivity can be expected to play a large role in helping to promote the use of the lowest cost alternative.  Preference for the lowest cost alternative can, in turn, be expected to drive down prices under condition of competition. 

 

Price discrimination may help to promote lower prices on poor nations, however, while patent monopolies exist, drug prices are likely to remain higher than they would be under conditions of competition.  Vigorous generic competition, on the other hand, is likely to result in lowest possible drug prices and thus widest possible drug availability in developing countries.

 

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