If you suffer from acid reflux, your doctor may prescribe Nexium. But at $9 a pill, the price is enough to give you a worse case of heartburn.
That’s the lowest price in the U.S. If you live in Canada, though, you can get the drug for less than a $1 a pill.
This price disparity leads many politicians to think the solution is obvious: Americans should just buy drugs from Canada or other countries where they are cheaper.
Its plan supported by economic liberals like President Trump and Bernie Sanders. Several years ago Sen. Amy Klobuchar (D-Minn.) and John McCain (R-Az.) twice introduced legislation to allow Americans to order up to a 90-day supply of medicines from a licensed Canadian pharmacy. The Democratic Party even made it a part of their party platform in 2016.
If this seems too easy, it’s because it’s an economically ignorant idea. Writing in the Harvard Business Review a few years ago, Rafi Mohammed explained why this strategy won’t work:
The reason why pharmaceutical prices are relatively high in the U.S. is that drug companies employ a common strategy called differential pricing. This strategy targets specific segments with different prices. So instead of having the same price for everyone, the goal is to tailor the “right” price to various segments. Movie theaters, for instance, use differential pricing by offering lower prices to students and seniors. The assumption is students and seniors are sensitive to price, so offering targeted discounts to them is profitable. As a result, moviegoers seated next to each other often have paid different prices.
For differential pricing to be profitable, targeted segments have to be easily identifiable, and, most importantly, arbitrage cannot occur. By arbitrage, I mean those who receive discounts don’t resell to customers who are currently paying more. This strategy works well at cinemas: it’s easy to identify seniors/students, and since tickets are sold individually at the door, enterprising seniors/students typically aren’t reselling discounted tickets for a profit.
Why are drug prices so much higher in the U.S.? The answer is straightforward: most countries regulate prices or have a single-payer health care system, in which the government pays for citizens’ health care costs. In a single-payer system, the government buys all a country’s pharmaceuticals, and it has leverage in “take it or leave it” negotiations with pharma companies.
Mohammed’s explanation is helpful, but it’s also incomplete. What he doesn’t mention is the reason why the price differential for drugs can work: because expensive medicines in the U.S. subsidize the creation of drugs for the entire world.
According to the pharmaceutical giant Eli Lilly, the average cost to discover and develop a new drug is between $800 million to $1.2 billion, and the average length of time from discovery to patient is 10 to 15 years.
If a product costs $1 billion to produce and bring to market, that is the initial fixed cost. Think of it this way: the initial cost to produce the very first Nexium pill is roughly $1 billion. But once that first pill is created, the cost to produce the second, third, fourth, . . . hundred thousandth pill is very low. But if the initial fixed cost cannot be recovered, then no company will lay out the money and spend a decade or more creating the product. New medications will simply not exist.
This point should be obvious—and yet it is widely overlooked and ignored. People see a drug, like Nexium, and forget that it only exists because a pharmaceutical company believed it could recoup the cost of research and development and make a profit by selling the medicine. But how is the company able to earn back the initial billion dollar fixed costs? By charging some buyer—whether a government, HMO, insurance company or individual—a price that will cover the initial fixed costs.
Once that fixed costs of creating the drug is covered, though, the price can be reduced since the remaining variable costs (e.g., the cost to produce each individual pill) tend to be relatively low. And this brings us to why you, as an American, pay a higher price for a drug that Canadians and Europeans get much cheaper.
To make it easier to understand, let’s imagine that a medicine is created to cure a single disease in three patients living in America, Canada, and France. Now let’s say that the patient in America pays all of the fixed cost ($1 billion), plus the variable cost for one pill (50 cents), plus 50 cents in profit for the company. In total, the American ends up paying $1,000,000,001 for a single pill.
The pharmaceutical company is happy because they recouped their costs and made a profit (50 cents). Canada and France say that they too want to buy the drug, but they will pay only $1. The drug company agrees to sell the pill for $1 to both Canada and France because an additional $1 profit is better than $0 in additional profit. Everyone is happy.
Well, maybe not everyone. The American may say that it wasn’t fair for them to pay all the fixed costs —and they’d be right. In our example, Canada and France are free riders that are able to take advantage of the lower costs only because the Americans have already paid the exorbitant fixed costs. The American subsidized the cost of the drug for the patients in the other countries.
This is exactly what happens with most drugs. Very few new medicines are produced in countries that have government restrictions on drug prices. And almost no new drugs would be produced if all countries had government restrictions on drug prices. Without the willingness of the United States to pay the higher prices, the drugs would never even come into existence. Countries like Canada and France are like roommates who let you pay full price for a pizza but expect you to give them a slice in exchange for a few pennies they found in the couch.
Which brings us back to the “reimport the drugs” strategy. The reason this approach won’t work is because once Americans stop subsidizing the drugs for the rest of the world, pharmaceutical companies will not be able to recoup their costs for R&D. Pharma companies simply won’t be able to afford to create innovative new medicines. That makes everyone worse off than before.
Ultimately, socialized medicine—in the form of government-imposed drug pricing—doesn’t work for the same reason Margaret Thatcher said socialist governments don’t work: “They always run out of other people’s money.”