Arbitrage Deterrence: A Theory of International Drug Pricing

Prices of patented pharmaceuticals in the United States exceed the prices that foreign governments have negotiated for the same drugs, which in turn exceed the marginal costs of production. This paper provides a tractable theoretical model that explains these stylized facts while taking account of the structure of the industry. The explanation involves arbitrage-deterrence due to oligopolistic limit-pricing: manufacturers would reject proposed foreign prices any closer to the marginal cost of production because the resulting price differentials would trigger massive arbitrage into the higher-priced U.S. market. The model is used to predict the consequences of policies proposed to reduce domestic drug prices, such as (1) ensuring that Medicare pays the price negotiated by foreign governments, (2) legalizing commercial arbitrage, and (3) promoting importation for personal use of prescription drugs from online pharmacies licensed in other high income countries. Tying Medicare prices to prices negotiated by foreign governments will allow these countries to press for even lower prices. Facilitating commercial and personal imports, on the other hand, will raise foreign prices. Therefore, when each policy is set to achieve the same reduction in the domestic retail price, the loss in manufacturer profits is greatest when Medicare’s buying power is utilized. A combination of the three policies can leave foreign prices unchanged while lowering the domestic price. Although each of these policies to lower the domestic price will depress innovation in the long run, the government can offset this side-effect. It is shown to be cheaper for the government to restore innovation by subsidizing all research to identify promising molecules once it is in midstream rather than by rewarding only research which proves successful.

Read a non-technical op-ed coauthored by Stephen W. Salant on this report in The Hill.