The True Cost of Cheaper Drugs

by Brian Lee Crowley

The AARP recently launched an ad campaign urging Congress to legalize the importation of prescription drugs from Canada, where brand-name pharmaceuticals are about 5 percent below the international median. Unfortunately, legalizing importation wouldn’t make drugs cheaper for Americans.

First, prices in Canada wouldn’t remain at their current levels; instead, the two national markets would merge, and prices would equalize. And, since the U.S. market is 10 times larger, prices in America wouldn’t drop much – Canada’s prices would simply rise to U.S. levels.

If Americans truly want “Canadian” drug prices, then we must first understand the market and government forces that create the lower prices. Most people attribute Canada’s cheaper drugs to the fact that the government imposes price controls on patented medicines. In fact, they’re not the primary cause.

Canada doesn’t control the retail price of drugs – only what drug manufacturers can charge wholesalers. Wholesale and retail mark-ups are left to the market. Anyway, many drug makers don’t even charge the full price permitted under federal rules.

In fact, research shows that most of the price differential on patented pharmaceuticals can be explained by two factors other than price controls: 1) differences between each country’s standard of living and 2) legal liability issues.

While our respective standards of living used to be quite comparable, Canada’s has been steadily falling; the average Canadian’s standard of living is 20 percent to 30 percent lower than the average American’s. That affects drug prices because of what economists call “price discrimination”. When a firm sells its product in two different markets, it will calculate a profit-maximizing price for each market. Generally, it will be higher in markets where consumers are less sensitive to price and lower where consumers are more price-sensitive. That’s why Budweiser is cheaper in rural New Mexico than it is in Beverly Hills. And it’s also why drugs like Lipitor and Nexium are cheaper in Canada – because Canadians can’t afford to pay as much as their American counterparts.

The second big factor that explains cross-border price differentials is the U.S. legal system, which heavily distorts the U.S. pharmaceutical market. Like the rest of America’s health sector, drug companies are favourite targets for American trial lawyers. Although civil lawsuits exist in Canada, they are less common. Moreover, damages are almost never decided by juries – and Canadian judges are less willing to give huge awards to sympathetic plaintiffs just because drug or insurance companies have deep pockets.

As a result, the U.S. legal system effectively imposes a tax on pharmaceuticals that Canadians do not have to pay. In a representative 1997 study in the “Journal of Law and Economics,” Brigham Young professor Richard Manning determined that America’s liability costs account for a third to and a half of the U.S.-Canadian price difference.

Yes, price controls play a role. But these extreme restrictions on what drugs government will pay for, and other measures to try and hold down prices are harmful – they have completely stifled Canada’s pharmaceutical industry. Canada produces pharmaceutical inventions at half the rate of the U.S. industry. And per capita investment in pharmaceutical research and development is one of the lowest in the developed world.

If America truly wants a “Canadian-style” drug market, the steps to follow are clear. Cut living standards by a third; reform the U.S. liability laws – and impose price controls and other restrictions, thereby putting a stop to cutting-edge medicine.

For those of us who live north of the border, that sounds like an awfully bad prescription.

Brian Lee Crowley is president of the Atlantic Institute for Market Studies, a public policy think tank in Halifax, Nova Scotia.