Reducing Drug Prices Without Depressing Innovation

Stephen W. Salant (University of Maryland, University of Michigan)

Abstract: Prices of biopharmaceuticals in the United States exceed the prices of the same drugs negotiated by foreign governments which, in turn, exceed their marginal costs of production. The 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 marginal cost because the resulting price differentials would trigger massive arbitrage into the higher price US market. The model is used to predict the consequences of four policies proposed to reduce domestic drug prices: (1) facilitating drug imports from the European Union and Canada; (2) requiring that Medicare pay the same prices for drugs as foreign governments; (3) lowering entry barriers in the downstream channel; and (4) financing the services of downstream players (wholesalers and pharmacies) from manufacturer profits from domestic sales instead of from markups over manufacturer prices. These price-reducing policies would eventually depress drug innovation. Finally, I identify the least expensive complementary policy the government can utilize to maintain the lower domestic price while restoring innovation to its previous level.