Governments in developing countries seeking to combat the rising costs of health care have increasingly focused on the pharmaceutical industry. They often set the amount they will pay for pharmaceutical prices through reference to other countries' prices when negotiating with pharmaceutical companies in an effort to control health care expenditures. This system of international reference pricing inhibits access to essential pharmaceuticals in underdeveloped countries and decreases pharmaceutical innovation and equitable research and development cost-sharing between developed countries.
This Note explores the tension between market forces in the pharmaceutical industry and promoting pharmaceutical innovation, equitable research, development cost-sharing, and access to affordable drugs in underdeveloped countries. The interaction of parallel trade and the lack of international regulation or restriction on the practice of international reference pricing causes this tension. The United States should enter into a series of free trade agreements with developed countries that utilize international reference pricing for pharmaceuticals providing for pricing principles restricting or limiting the practice of reference pricing, parallel trade, and other inhibitions on a socially optimal pharmaceutical market.
TABLE OF CONTENTS I. INTRODUCTION II. THE NATURE OF THE PHARMACEUTICAL INDUSTRY A. Indications: Research and Development B. Directions for Use: A Primer on Patents C. Side Effects and Adverse Reactions: Price Controls and Differential Pricing III. INTERNATIONAL REFERENCE PRICING A. International Reference Pricing Defined B. Reference Pricing as an Obstacle to Affordable Pharmaceuticals in Underdeveloped Countries C. Reference Pricing as an Obstacle to Equitable Joint Research and Development Costs Between Developed Countries D. The Law(lessness) of International Reference Pricing 1. The United States 2. Canada 3. New Zealand IV. PARALLEL TRADE A. Parallel Trade Defined B. The Law C. Case Studies in the United States and the European Union 1. The United States 2. The European Union D. Analysis V. THE INTERACTION OF INTERNATIONAL REFERENCE PRICING AND PARALLEL TRADE A. Economic Implications B. Legal Implications VI. THE Rx VII. CONCLUSION I. INTRODUCTION
Recently, the Swiss drug manufacturer Novartis challenged South Korea's pharmaceutical pricing policy, warning the government that it would be denied its chronic myeloid leukemia drug Gleevec/Glivec if it refused to pay a reasonable price for the product. (1) Meanwhile, due to European government cost-containment measures, the top sixteen pharmaceutical companies only launched ten new products in Europe last year, a drop for the second consecutive year. (2) Governments seeking to reduce escalating healthcare costs increasingly focus on the pharmaceutical industry. (3) A growing practice has been for developed countries' governments to set the amount they will pay for pharmaceutical prices by reference to other countries' prices in negotiations with pharmaceutical companies to control health care expenditures. (4) This system of international reference pricing has inhibited access to essential pharmaceuticals in some countries and contributed to a decrease in new pharmaceutical development.
While this trend may appear consistent with notions of free trade and freedom of contract, it is far from ideal because of the nature of the pharmaceutical industry. This industry presents two primary competing interests: ensuring incentives for pharmaceutical research and development (R&D) and providing widespread consumer access to affordable pharmaceuticals. Applied to pharmaceuticals, international reference pricing and parallel trade decrease R&D incentives, inhibit equitable R&D cost-sharing between developed countries, and decrease underdeveloped countries' access to affordable pharmaceuticals. (5)
This Note explores the tension between market forces in the pharmaceutical industry, promoting pharmaceutical R&D, equitable R&D cost-sharing between developed countries, and access to affordable drugs in underdeveloped countries. This Note focuses on how parallel trade and the lack of international regulation or restriction on the practice of international reference pricing interact to cause this tension. Part II discusses the pharmaceutical industry and how it differs from other industries. Part III discusses the concept of international reference pricing and its role as an impediment to pharmaceutical R&D, equitable R&D cost-sharing between developed countries, and affordable access to pharmaceuticals in underdeveloped countries. Part IV presents a brief overview of the concept of parallel trade as applied to the pharmaceutical industry. Part V analyzes the interaction of international reference pricing and parallel trade as applied to the pharmaceutical industry. Part VI proposes that the United States enter into a series of free trade agreements with developed countries that are utilizing international reference pricing for pharmaceuticals. These agreements would provide for pricing principles restricting or limiting the practice of reference pricing, parallel trade, and other inhibitions on a socially optimal pharmaceutical market.
THE NATURE OF THE PHARMACEUTICAL INDUSTRY
Indications: Research and Development
The pharmaceutical industry is particularly vulnerable to regulation because of its unique cost structure. (6) R&D costs are an unusually large component of total product output costs. (7) Calculated into R&D are high upfront investments, costs imposed because of product liability, relatively low variable costs of production within capacity for most non-biotech products, and required long payback period dependent on patients. (8) By the time a product is launched R&D costs, accounting for over thirty percent of total product output costs, have already been incurred. (9) The costs remaining to be incurred by the time the product is introduced into the market are marginal costs, such as processing, packing, promotion, and distribution of additional units. (10) When pharmaceuticals are introduced into the market, manufacturers must take into account both R&D and marginal costs in pricing their products. It is a widely accepted principle that industrialized countries should share R&D costs. (11) To what extent each country should contribute to these costs is disputed, generally unregulated, and highly inequitable. (12) This makes investment in pharmaceutical R&D both expensive and risky.
Directions for Use: A Primer on Patents
Despite the expense and risk associated with pharmaceutical R&D, pharmaceutical developers invest heavily in it because they expect ultimately to profit. (13) Patents ensure this. Patents preserve incentives for future R&D by limiting or delaying generic (copy product) competition. (14) The purpose of patents is to bar generic entry into the market for the term of the patent. (15) This provides the product's original innovator the opportunity to price above marginal cost and thereby recoup their R&D expense. (16)
Side Effects and Adverse Reactions: Price Controls and Differential Pricing
For most products, particularly those manufactured on a global scale, price differences from country to country are unlikely to be significant. (17) Companies would incur financial losses if they sold products at half price in developing countries. (18) The pharmaceutical industry is different. Financially, it would make sense for pharmaceutical companies to take local affordability into account when setting (profitable) price levels in each country. (19) This is impossible to do because there is no free market for pharmaceuticals in most countries. (20)
As governments tend to be the sole purchasers of pharmaceuticals for an entire state or country, they have a great deal of market power to influence price. (21) In the pharmaceutical market, the method of sale is typically between pharmaceutical companies and the government, whereby the government negotiates directly with each company to determine the price that will be paid for the products. (22) The government, or a government-sanctioned body, reviews company price applications and determines whether the company's requested price is "fair." If it is not "fair," the government may set a lower price. (23) If that price is lower than the company requested, the company typically has a right to appeal the decision. (24) In any case, the pharmaceutical company is not obligated to sell if the government they are dealing with cannot negotiate satisfactory terms. (25)
Because there is no free market for pharmaceuticals in most countries, these countries impose price controls on pharmaceuticals sold within their borders. (26) These price controls ensure more affordable drugs for their consumers but provide less profit for the pharmaceutical industry to compensate for R&D expenses, and invariably, those profits must be recouped elsewhere. (27) While price controls seemingly benefit consumers by regulating pharmaceutical profit margins, they discourage innovation and competition in the pharmaceutical industry. (28) A study examining the effects of countries' price regulations on R&D incentives revealed that no country with price controls has had innovative success in the pharmaceutical industry matching that of the United States--one of the few countries without pharmaceutical price controls. (29) From 1975 to 1989, U.S. companies produced forty-seven significant new pharmaceutical compounds, compared to fifty for the rest of the world. (30) Between 1970 and 1992, U.S. companies accounted for 42.8 percent of the world's breakthrough drugs. (31) During a similar period, Britain accounted for fourteen percent, Germany seven percent, and France three percent. (32)
Macroeconomic principles suggest that reduced profits will lead to reduced innovation. (33) The cost of capital is low when investors...