Dealing with Drug Free-Riders

I got to thinking more about Megan McArdle's post, in which she points out the problems with dealing with regulated drug markets:

And we cannot forbid pharmaceutical companies to sell into those nations at discount prices, because those countries can break the patents and license generic manufacturers to manufacture the drugs. All we would end up doing is removing a small source of profit from the pharma company's books.

I posted a comment similar to what's below:

First, a question: Does anybody know what percentage of profit is actually coming from regulated markets? And a related question: What percentage of the actual drugs is going to those markets in unit terms? Seems you can't really estimate the effect of any trade action without knowing those two variables.

Having said that, we should make sure that there aren't ways to force regulated markets to de-regulate with appropriate trade policies. After all, this is basically the same as busting a union, a skill with which Americans have no small amount of experience. The fact that the Union is European is merely a matter of scale.

The issue of whether these countries would break our patents is key. Also note that, as was pointed out in the comments to Megan's post, trade secrets won't work--drugs are easy to reverse-engineer. However, I'm having a hard time imagining the EU or any other regulated market starting a trade war over this. The consequences of destroying the international intellectual property framework are too terrible to imagine. Call me a cockeyed optimist--I don't think it would happen.

Given that, how would your proceed to destroy the regulated markets, or at least make them buy at closer to fair market value? Some ideas (none of them without serious flaws):

1. You can massively reimport. This will induce shortages in the regulated markets, forcing them either to raise their prices or do without. Two problems with this: First, the pharma companies have to be willing to take the hit on domestic profits for as long as it takes to make the shortages critical. Second, it's easy for the regulated market to make exporting the drugs illegal.



2. Subsidize domestic pharma companies to reduce or withold supply from the regulated markets. Again, shortages mean higher prices. Beside the obvious domestic political problems with this, I suspect that this would run afoul of WTO treaty obligations, but you could cause an awful lot of trouble before the legal process took its course.



3. Simply embargo drugs to regulated markets. The obvious problem with this is that's its pretty close to an act of war and would certainly result in breaking the patents.



4. Negotiate. The regulated markets have as much or more to lose than we do. Maybe if you get them to import at no less that x% of US fair market value, you can dramtically reduce the problem. As shown above, we have a certain number of sticks to bring to such a negotiation. Finding a few carrots shouldn't be very hard.



5. This is a half-baked idea: It occurs to me that the real problem here is that drugs are effectively pure intellectual property. They cost very little to manufacture but their R&D costs are huge. I wonder if there's a way to set up royalty pools for drug export. We do this all the time for other forms of technology. In effect, you get a license under which you agree to pay a certain cost per unit into the pool for the intellectual property and you have the right to manufacture as much as you want. Seems to me that you could, per treaty, come up with a formula where pharma companies could establish a royalty pool to generate an appropriate return on investment and then license the manufacturing of their products in the regulated markets. As I said, this is half-baked at best, but it certainly would change the paradigm. At the very least, it exposes the true cost of bringing the drug to market.

As I said at the beginning of this post, a lot of what you can do is dependent on how big the regulated markets really are. But you ultimately can't have a market with some free-riders and some market consumers--it's unstable.

This is a really scary problem because, as Megan has pointed out, you only have to change the economics a little bit to make the return on investment unattractive and stifle all innovation. And once you've done that, un-stifling it is very difficult. Once the R&D apparatus is disassembled, it's hard to but Humpty-Dumpty together again.