Question

U.S. pharmaceutical companies charge different prices for prescription drugs to buyers in different nations, depending on elasticity of demand and government-imposed price ceilings. Explain why these companies, for profit reasons, oppose laws allowing re-importation of drugs to the United States. LO12. 6

Short answer

Pharmaceutical companies oppose re-importation laws as they undermine pricing strategies and could reduce U.S. profits by allowing cheaper foreign drugs to compete in the domestic market.

Step-by-step solution

Understanding Price Differentials

Pharmaceutical companies charge different prices for drugs in different countries based on the elasticity of demand, which refers to how sensitive the quantity demanded is to a change in price. In countries with more elastic demand, a small price increase can lead to a significant drop in quantity demanded, prompting firms to lower prices. In addition, some countries may have government-imposed price ceilings that prevent prices from rising above a certain level.

Explaining Profit Maximization

U.S. pharmaceutical companies maximize their profits by pricing prescription drugs differently in various markets. They set lower prices in markets where demand elasticity is high or where price ceilings are enforced, while maintaining higher prices in the U.S. market where demand is more inelastic and fewer price regulations exist.

Understanding Re-importation Concerns

Re-importation refers to the practice of importing drugs that were sold in foreign markets back into the U.S. If laws were changed to permit re-importation, drugs purchased at lower prices abroad could flood the U.S. market. This would undermine the companies' pricing strategies and reduce profits from their home market, as cheaper re-imported drugs would compete with domestically priced medications.

Conclusion of Re-importation Impact

Allowing re-importation would lead to arbitrage, where individuals buy drugs cheaply in other countries and sell them for less than domestic prices in the U.S. This would force pharmaceutical companies to potentially lower U.S. prices to remain competitive, thereby reducing their overall profit margins.

Key concepts

Elasticity of Demand

Elasticity of demand is a core concept in economics that describes how sensitive the quantity demanded of a product is to changes in its price. It is critical for understanding how businesses, like pharmaceutical companies, set prices for different markets. When demand is elastic, small changes in price lead to significant changes in the quantity demanded. This is often the scenario in countries where consumers have many alternatives or when the product is considered non-essential.
In these markets, companies tend to set lower prices to maintain sales volume. In contrast, in markets with inelastic demand, consumers are less responsive to price changes. This situation often occurs when a product is essential or when there are few substitutes, allowing firms to keep prices high without a significant drop in sales. In such cases, companies can ensure higher profit margins because the decrease in sales due to a price increase is relatively small.

Re-importation

Re-importation refers to the act of bringing products that were exported to foreign markets back for sale in the domestic market. In the context of pharmaceuticals, this means importing drugs that are sold at lower prices in other countries back into the United States. This practice can be attractive for obvious economic benefits. Drugs sold at lower international prices could be brought back to the U.S. and offered at a cost less than current domestic prices, benefiting consumers by lowering their prescription drug costs. However, pharmaceutical companies often oppose re-importation, as it disrupts their international pricing strategies and reduces profit margins. By allowing cheaper foreign drugs into the domestic market, companies face competition with their own products, prompting potential price reductions in the U.S.

Price Ceilings

Price ceilings are government-imposed limits on how high a price can be charged for a product. These are typically set to protect consumers from excessively high prices, especially for necessities like medications. When a price ceiling is in place, it makes it impossible for companies to charge above a certain level, often leading to lower market prices than in countries without such regulations. For pharmaceutical companies, working with price ceilings requires strategic adjustments in pricing to ensure profitability. In countries enforcing strict price ceilings, they may charge lower prices for drugs to comply with laws and maintain market share. However, lower prices in these regions contrast with higher prices in countries without such ceilings, highlighting the economic dynamics of price discrimination. By managing these differences, firms aim to maximize profits globally, though it complicates their response to re-importation pressures.

Arbitrage

Arbitrage involves taking advantage of a price difference between two or more markets, capitalizing on the buy low-sell high principle. In pharmaceutical markets, arbitrage would occur if individuals or organizations purchase drugs in countries where they are cheaper and then sell them at a higher price point in countries like the United States. This activity can become particularly significant if re-importation is allowed. By straddling price differentials created by global strategies, arbitrageurs undercut domestic prices, undermining a company's control over its pricing structure. For pharmaceutical firms, this erodes profits because it forces them to compete against the lesser-priced reimported drugs. To counteract this, companies might need to reduce their domestic prices, aligning them closer to international levels, ultimately squeezing their profit margins.