**Remarks before the Task Force on Drug Importation**

**April 27, 2004**

**Iain M. Cockburn**

My name is Iain Cockburn. I am a Professor of Finance and Economics in
the School of Management at Boston University, and a Research Associate
of the National Bureau of Economic Research. Prior to joining the
faculty of Boston University, I was a professor in the Faculty of
Commerce at the University of British Columbia in Canada. Much of my
research over the past 15 years has focused on competition, pricing, and
innovation in the pharmaceutical industry. I am pleased to appear before
you today to offer background testimony on the economic impact of
importation of prescription drugs into the United States. This is a
challenging and important topic, and I applaud the leadership of the
Task Force on Drug Importation in addressing this issue.

In my opinion, permitting large scale importation of prescription drugs
into the United States from countries such as Canada is likely to have a
number of serious negative effects on Americans, as well as on citizens
of other countries.

The first and most worrying effect of large scale importation of drug
products into the US is that it would put downward pressure on drug
prices and drug company revenues in the US, and more generally limit the
ability of drug companies to maximize revenues from global sales of
their products. Access to drugs at the lower prices charged in some
countries may give an immediate economic benefit to some US purchasers
in the short run, most obviously by cash payers for on-patent branded
products. But large scale importation will likely seriously damage the
interests of all consumers of drugs by weakening incentives for
pharmaceutical companies worldwide to invest in R&D to develop new
products. Members of the Task Force are no doubt well aware that
pharmaceutical R&D is an unusually costly, risky, and lengthy process.
After taking into account failed projects and development programs
stretching out for as long as a decade, the cost per approved drug
appears to be well in excess of \$500MM, and may approach \$1BN in the
near future. These huge investments in R&D in the past have certainly
paid off: innovative drugs are responsible for substantial improvements
in health. New opportunities opened up by advances in basic science have
spurred R&D spending to record levels: worldwide R&D expenditures by
pharmaceutical and biotechnology companies now likely exceed \$70
billion per year, over \$35 billion in the US alone. But this has to be
paid for, and paid for on a prospective basis. Historically drug
companies have relied on the prospect of patent-protected market
exclusivity (and above-marginal-cost pricing) to generate economic
returns that justify these investments on an *ex ante* basis. It is
important to note in the context of the importation debate that these
economic returns have been generated by companies pricing differentially
across countries, based on national differences in ability to pay.
Reducing the ability of companies to charge different prices in
different countries will surely lower total worldwide sales of any given
product, and negatively effect expectations of economic returns to
innovation.

Like most economists, I believe that if research-based companies foresee
lower revenues from selling patented products they will cut back on R&D
spending. I acknowledge that direct evidence on this point is limited.
R&D spending by pharmaceutical companies has been shown to be
statistically associated with their current profitability, but it is
difficult to predict the impact of prospectively lower prices and sales
on R&D. We do know that government actions to weaken or abolish patent
rights (for example through compulsory licensing) or to lower prices
through more stringent regulation have been quite effective in
redistributing R&D geographically. Canada's compulsory licensing regime
for drugs certainly succeeded in lowering the amount of pharmaceutical
R&D spending in Canada. Likewise, studies have identified "unfriendly"
price regulation and government purchasing schemes in Europe as one of
the forces driving relocation of R&D effort out of Europe and into the
US.

One of the reasons it has been difficult to conclusively identify and
characterize the sensitivity of R&D spending to price controls is that
the US is such a large share of total world drug consumption that its
(historically unregulated) market conditions play a dominant role in
expectations about future revenues from developing innovative products.
Notwithstanding local differences in product approvals and payment
schemes, pharmaceuticals is a global industry and investment in research
responds largely to expectations about worldwide sales revenues -- which
to a great extent are shaped by US market conditions. Nothing can be
inferred therefore from the lack of any significant impact on global R&D
spending of actions taken in the past by small countries such as Canada
or Italy. Conversely, we should be very concerned about the impact of
lowering or regulating prices in the industry's "safe haven."

I further note that we should be concerned not just about the level of
R&D spending, but also about its allocation. We know from the experience
of the past 30 years that market-based incentives -- pricing based on
what the market will bear during the limited period of patent protection
-- have induced R&D investment decisions that are responsible for major
economic and health benefits. As a large market in which price-setting
has been large unconstrained by government regulation, the US has played
a very important role in sending price signals to R&D decision-makers. A
fundamental principle of economics is that decision-makers respond to
marginal or incremental incentives. To the extent that these are set by
US market conditions, US prices play a critical role in determining both
the level and composition of global R&D spending. Importation has the
effect of substituting (foreign) price regulators' relative valuation of
different drugs for that determined by market forces, and I believe that
we should therefore be very concerned about its long run impact on R&D
decisions.

The second serious effect of reducing pharmaceutical companies' ability
to price differentially across countries is that while lowering prices
somewhat in the wealthiest markets, it will place upward pressure on
prices in the poorest countries. From a global perspective, differential
pricing is a good thing since it increases total consumption of drugs.
In the extreme, if arbitrage through importation and reimportation moves
the world towards a single price, this will result in a tendency for
lower-income countries and lower-income consumers to become effectively
priced out of the market. In my view this is neither ethically
appropriate, nor is it in the pragmatic interests of the United States.
Rightly or wrongly, efforts by US to lower domestic drug prices at the
expense of countries who are the least able to afford it will surely be
perceived abroad as a case of "can pay, won't pay" -- weakening support
for the US in the broader international arena at a time when it can ill
afford it.

Of course, as a practical matter, we are unlikely to see an
arbitrage-driven uniform worldwide market price for most drugs. Neither
foreign governments nor drug companies are likely to remain passive if
large amounts of drugs start being imported into the US. Indeed efforts
to lower US prices through large scale importation are likely to provoke
unpalatable and costly responses. Consider first the reaction of foreign
governments. Much of the current debate has focused on price differences
between the US and Canada. Opening the US-Canada border to trade in
drugs in large quantities will quickly result in severe supply shortages
in Canada as arbitrageurs divert Canadian supply to the US.
Manufacturers are unlikely to voluntarily ship large amounts of their
product to Canada (or to increase any Canadian production) in excess of
its domestic consumption requirements. This leaves the Canadian
government with a number of options: (1) allow prices to rise, (2) shut
down arbitrage by banning exports of drugs and/or closely monitoring
imports, (3) allow imports of drugs from other countries with equal or
lower prices, or (4) take away the manufacturer's patent rights in
Canada to allow domestic generic production.

In my opinion it is highly unlikely that Canada (or any other country)
would allow its prices to rise significantly: in Canada as in many other
countries there is a regulatory agency explicitly charged with limiting
the rate of inflation of drug prices. We should not infer from Canada's
current public obliviousness to this question that Canada would not take
action to respond to drug shortages and upward pressure on prices. The
most likely, and in my view, most damaging, outcome is some combination
of options (3) and (4), with supply flowing into Canada from third
countries ("passing the buck" further down the income ladder), and/or a
return by Canada to compulsory licensing. How should or would the US, in
turn, respond? If Canada bans exports of drugs to the US, and the US is
determined to lower its prices, the US government could presumably exert
diplomatic pressure or invoke trade agreements to try to force Canada to
allow exports, though previous attempts before the WTO to characterize
export restraints as "countervailable subsidies" have not been
successful. The US could turn to other countries as a source of imports,
but they would presumably behave just like Canada, resulting in a
"contagion" of compulsory licensing and export restraints. This would
damage decades long efforts by the US and other countries to harmonize
and strengthen intellectual property rights (e.g. under TRIPs) and to
remove barriers to trade. In my view, extensive compulsory licensing of
pharmaceuticals in the world's relatively wealthy countries would have a
disastrous impact on R&D incentives. The pharmaceutical and
biotechnology industries depend to an exceptional degree on strong
patent rights. Surveys of R&D managers have persistently reported that
most companies in these industries would dramatically reduce R&D
spending if patent rights are significantly weakened or taken away.

Now consider the likely response of drug manufacturers and patent
holders to large scale importation. They could simply acquiesce, and
divert large amounts of US-destined production to other countries, or
simply lower US prices to the point at which there is no longer an
incentive for importation. This is unlikely, since it would surely
result in lower profits, though presumably there is some level of
threats by the US and foreign governments that could force manufacturers
into lowering US prices -- and making concomitant adjustments to R&D
spending and other business decisions consistent with lower
profitability -- rather than face compulsory licensing or other
sanctions. (As an aside I note that some commentators on this issue
apparently believe that the management of these companies are stupid;
claiming that profits could actually be increased by lowering prices
from their present levels. If that were the case, companies would have
already done this.) Rather than accommodate arbitrage, companies will
respond, as they already have in Europe and to some extent in Canada, by
refusing to supply "low price" countries in amounts above their domestic
consumption requirements. Over the long run, we should also expect the
industry to engage in socially wasteful efforts to re-segment the world
market by "localizing" drug products, for example by varying the
formulation or appearance of products or by seeking approval of minor
chemical variants of a "core" molecule in different markets. Ultimately
we might see the industry moving to entirely different business models,
for example by vertically integrating into direct contracts with
individual patients to supply drugs on an annual fixed-fee insurance
basis. The consequences of such dramatic changes in the ways drug are
priced and distributed for health care costs and outcomes are very
difficult to anticipate.

As a final comment, I note that economics teaches us that in many
arbitrage-driven situations, significant portions of the economic gains
associated with removing price differences end up being captured by
arbitrageurs and middle men rather by than end users. The Task Force may
want to give careful consideration to the question of where in
distribution chain potential gains from large scale importation will
actually be realized.

In summary, it is my opinion that permitting large scale importation of
drugs into the US may have potentially very serious costs, firstly in
terms of a significant deleterious impact on R&D incentives, and
secondly by generating counterproductive and damaging responses by
foreign governments and by drug companies. These costs are not confined
to the US, and I believe that as a matter of principle as well as on
purely pragmatic grounds, casting this question as one of narrow concern
to US consumers is short sighted and inappropriate. I therefore urge the
Task Force to be very cautious in recommending steps that would permit
large scale importation. Expenditures on pharmaceuticals in the US can
surely be restrained through more economically efficient mechanisms,
such as encouraging and empowering end-users to respond to price
incentives. There are very persuasive arguments against price regulation
of pharmaceutical products, but if the US decides to go this route --
which permitting large-scale importation is tantamount to doing -- then
I believe that this should be done directly and transparently, rather
than through the disruptive, costly, and inequitable mechanism of
extensive importation rights.