1 Scherer, Frederic M., The Pharmaceutical Industry: Prices and Progress, 351 NEW ENGL. J. MED, 927, 929 (2004)CrossRefGoogle ScholarPubMed; Milton Friedman, Nobel Laureate, Panel Discussion at Border Wars: The Prescription Drug Battle with Canada (Jan. 29, 2004) (transcript available at http://www.pacificresearch.org/press/rel/2004/ma04-01-27/transcript.pdf).

2 See, e.g., Alan Sager & Deborah Socolar, Do Drug Makers Lose Money on Canadian Imports? April 15, 2004 (unpublished manuscript, available at http://www.house.gov/apps/list/press/il05_emanuel/bu_rx_study.pdf).

3 Pharmaceutical Market Access and Drug Safety Act of 2005, S. 334 109th Cong. (2005).

4 As will become apparent later in this paper, a sharp distinction is drawn between the regulatory environment in U.S. market for prescription drugs and all other, ex-U.S. regulatory environments for prescription drugs. Specifically, the assertion that price regulation exists in one market (the “ex-U.S. market”) but not the other (the U.S. market) is made. This is indeed an oversimplification. For one, the regulatory environments outside the U.S. are quite heterogeneous, and the degrees to which prescription drug prices are controlled vary greatly. Also, to say that in the U.S. there are no mechanisms by which prescription drug prices are regulated would be inaccurate. Nonetheless, it is a generally accepted fact that there is far less regulation of prescription drug prices in the U.S. relative to other countries. Therefore, this oversimplification—which imposes a binarytype classification for prescription drug price controls—still makes a good deal of sense from a modeling perspective.

5 Patricia M. Danzon, Making Sense of Drug Prices, REGULATION 2000 at 56, 56.

6 Id.

7 Cf. id.; PHARMACEUTICAL RESEARCH AND MANUFACTURERS OF AMERICA [hereinafter PhRMA], PHARMACEUTICAL INDUSTRY PROFILE 2005, at 1-14 (PhRMA, 2005), available at http://international.phrma.org/publications/publications//2005-03-17.1143.pdf.

8 Vernon, John A., Drug Research and Price Controls: What Would Happen if the United States Adapted Other Countries’ Drug Price Regulations?, 25 REGULATION 22, 25 (Winter 2002-2003)Google Scholar [hereinafter Vernon 2003a] (noting that “pharmaceutical price regulation is very complex and quite heterogenous across countries[,]” and concluding: “New price regulation in the United States could impose a very high cost in terms of foregone medical innovation.”).

9 E.g., id., at 23 tb1.1. See Danzon, supra note 5, at 57,58 (warning that unweighted averages “likely…result in an inaccurate measure of the relative costs of drugs[,]” and referring to British Colombia's reference pricing system).

10 See, e.g., Vernon, supra note 8, at 23 tb1.1 (correlating countries with “means of regulating prescription drug prices”).

11 Cf. id. at 8; Danzon, supra note 5.

12 See H.P.S. Chawla, Nalin Diwan & Keertiman Joshi, Emerging Trends in the World Pharmaceutical Market – A Review 3 in TOUCH BRIEFINGS, BUS. BRIEFING: PHARMATECH 2004, at 2 (2004) (noting that “[t]he total global pharmaceutical sales for 2002 is estimated to be about US$430 billion with North America, Europe and Japan contributing about 81.95% of it“), available at http://www.touchbriefings.com/pdf/790/8-chawla.pdf.

13 Vernon, REGULATION 25(4), 22-25.

14 Vernon, supra note 8.

15 Danzon, supra note 5; Vernon, supra note 8.

16 Modigliani, Franco & Miller, Merlon H., The Cost of Capital, Corporation Finance and the Theory of Investment, 48 AM, ECON. REV. 261, 297 (1958)Google Scholar; Vernon, John A., Examining the Link Between Price Regulation and Pharmaceutical R&D Investment, 14 HEALTH ECON. 1, 17 (2005)CrossRefGoogle ScholarPubMed [hereinafter Vernon 2005a].

17 Id.

18 Vernon, supra note 16; Giaccotto, Carmello, Santerre, Rexford, & Vernon, John A., Drug Prices and Research and Development Investment Behavior in the Pharmaceutical Industry, 48 J.L. & ECON. 195, 214 (2005)CrossRefGoogle Scholar; Grabowski, Henry G. & Vernon, John M., The Determinants of Pharmaceutical Research and Development Expenditures, 10 J. EVOLUTIONARY ECON. 201, 215 (2000)CrossRefGoogle Scholar.

19 See Modigliani & Miller, supra note 16; Vernon, supra note 15, at 2.

20 See Modigliani & Miller, supra note 16; Vernon, supra note 15, at 2.

21 See Vernon, supra note 16.

22 See Hall, Bronwyn H., Investment and Research and Development at the Firm Level: Does the Source of Financing Matter? 193–225 (Nat’l Bureau of Econ. Research, Working Paper, No. 4096, 1992)CrossRefGoogle Scholar; See Hubbard, Glenn R., Capital Market Imperfections and Investment, 36 J. ECON. LIT. 193 (1998)Google Scholar.

23 See Vernon, supra note 16; Grabowski & Vernon, supra note 18.

24 Vernon, John A., Pharmaceutical R&D Investment and Cash Flows: An Instrumental Variables Approach to Testing for Capital Market Imperfections, 13 J. PHARMACEUTICAL FINANCE, ECONOMICS AND POLICY 3, 8-10 (2005)CrossRefGoogle Scholar [hereinafter Vernon 2005b].

25 Indeed, this is the primary argument put forth by most opponents to the regulation of prescription drug prices in the U.S. The standard argument maintains that the unregulated U.S. pharmaceutical market (with respect to prices) supports industry-wide R&D incentives, and is thus largely responsible for keeping innovation from stagnating. See, e.g., Green, David G., Is Price Regulation Necessary: A Summary of Arguments, 14 PHARMACOECONOMICS, 137, 139 (1998)CrossRefGoogle ScholarPubMed.

26 Technically speaking, for price regulation to exert a negative influence on the profit incentives for firms conducting pharmaceutical R&D, it would need to be the case that lower prices from regulation will not be offset by higher quantities of drugs sold, holding constant everything else of course. That is, the elasticity of total revenues would have to be less than unity—i.e., inelastic. Empirical economic research has consistently found this to be the case (see, e.g., Giaccotto et al., supra note 18). Furthermore, specifically regarding the likely impact of pharmaceutical price regulation in the U.S., recent studies by Muse and Lewin VHI Inc. have concluded this would indeed be the case. They found that revenue gains from universal prescription drug coverage would be outweighed by revenue losses resulting from Medicare rebates, increased use of generic substitutes, and increased price competition from managed-care options (see Grabowski & Vernon, supra note 18). While this pertains to potential price regulation in the U.S. market, and not regulation in other countries, similarities do exist. It thus seems plausible that pharmaceutical price regulation should reduce firm profitability. In fact, as Vernon (2003b) has demonstrated, pharmaceutical profit margins in the largely unregulated U.S. market are approximately four times that of non-U.S. profit margins. Vernon, John A., The Relationship Between Price Regulation and Pharmaceutical Profit Margins, 10 APPLIED ECONOMICS LETTERS, 467 (2003)CrossRefGoogle Scholar [hereinafter Vernon 2003b]. Of course, this says nothing about total profitability, which is what's relevant here, but such a large differential does nonetheless suggest that total profits are likely to be higher in unregulated markets. Moreover, there exist other important ways price regulation may reduce profitability: through delayed product launches. Danzon, Patricia, Wang, Richard & Wang, Liang, The Impact of Price Regulation on the Launch Delay of New Drugs – Evidence from Twenty-Five Major Markets in the 1990’s, 14 HEALTH ECON. 269 (2005)CrossRefGoogle Scholar. This is discussed shortly.

27 See Danzon, supra note 5; Vernon, supra note 8; Vernon, supra note 16; PhRMA, supra note 7.

28 Danzon et al., supra note 26, at 286-289.

29 See id.

30 Vernon, supra note 16, at 9.

31 An assumption is made that the degree of price regulation a firm faces is, to a certain extent exogenous, especially in the short run; and that a firm forms expectations regarding its future exposure to price regulation based on current (and near-term future) levels of exposure. This assumption seems reasonable; the extent to which firms control the composition of their market makeup is sufficiently limited. Significant barriers to entry exist, for example, in penetrating the U.S. market (see Vernon, 2005a, for a discussion), and there exists remarkable stability over time with respect to firms’ sales distributions across U.S. and non-U.S. markets. See Vernon, supra note 16 at 3.

32 Vernon, supra note 26, at 468-470.

33 See e.g., Lichtenberg, Frank R., Probing the Link Between Gross Profitability and R&D Spending, 20(5) HEALTH AFFAIRS 221 ( 2001)CrossRefGoogle Scholar.

34 Id.

35 See e.g., Sager & Socolar, supra note 2 (disclaiming the widely accepted belief that importing prescription drugs from Canada would damage drug makers’ profits and capacity to finance research).

36 Vernon, supra note 24, at 14.

37 See Importation of Prescription Drugs: Before the Senate Committee on Health, Education, Labor, and Pensions, 108th Cong. 23-24 (2005), available at http://frwebgate.access.gpo.gov/cgibin/getdoc.cgi?dbname=108_senate_hearings&docid=f:93889.pdf.

38 See Frontline: The Other Drug War, Join the Discussion, http://www.pbs.org/wgbh/pages/frontline/shows/other/talk/.

39 Danzon, supra note 5, at 61; Modigliani & Miller, supra note 16; Vernon, supra note 8; Vernon, supra note 16.

40 Danzon, supra note 5, at 62; Vernon, supra note 16, at 3; see also Green, supra 25, at 140.

41 Vernon, supra note 24; Sager & Socolar, supra note 2, at 4.

42 ADAM SMITH, THE WEALTH OF NATIONS (Canaan, Edwin ed., The Modern Library 1937) (1776).Google Scholar

43 Danzon, supra note 5, at 56-58.

44 Senate Committee on Health, Education, Labor, and Pensions, supra note 37.

45 Vernon, supra note 8; Drug Reimportation: Hearing Before the Comm. on Health, Education, Labor, and Pensions, 106th Cong. (2004) (testimony of James Vernon, PhD), available at http://www.kaisernetwork.org/health_cast/uploaded_files/052004_Senate_Reimportation.pdf.

46 Id. at 68.

47 If prices in foreign markets were not government regulated (directly or indirectly), then legalized importation would tend to move pharmaceutical prices to a single, global price (one that would be higher in foreign markets and lower in the U.S. relative to currently observed prices). Danzon and Towse (2003) discuss why this would be socially suboptimal compared to differential pricing. See Danzon, Patricia M. & Towse, Adrian, Differential Pricing for Pharmaceuticals: Reconciling Access, R&D and Patents, 3 INT’L J. HEALTH CARE FIN. & ECON. 183 (2003)CrossRefGoogle Scholar.

48 See Vernon, supra note 24.

49 International & Academic Perspectives Stakeholder Meeting: Presentation to Dept. of Health and Human Services Task Force on Drug Importation, (Apr. 27, 2004) (statement of Iain Cockburn, Boston University).

50 Vernon, supra note 16.

51 Grabowski & Vernon, supra note 18.

52 See Danzon, supra note 5; see Modigliani & Miller, supra note 19; see Vernon, supra note 15; see Vernon, supra note 8.

53 See Vernon, supra note 16 (discussing price regulation in greater detail).

54 Grabowski and Vernon, supra note 18; See Vernon 2005a, supra note 16.

55 Id.; see also supra, note 4.

56 There is an implicit assumption made here that the geographical distribution of a firm's pharmaceutical sales are exogenous. Two facts support this contention. First, there is little variability over time with respect to a firm's geographical distribution of pharmaceutical sales. For example, a firm whose primary pharmaceutical market is Europe over time will keep Europe as its primary market. Its distribution of pharmaceutical sales remains relatively constant over time. Secondly, as Vernon (2003a) discusses, using similar data over a longer time period, Granger-causality tests reveal that exposure to price regulation influences R&D investment and not the other way around. Therefore, it seems reasonable to maintain that firms have different expectations about the degree of price regulation that they will be exposed to in the future. Theoretical arguments for the observed persistency in sales distributions are discussed in Vernon (2005a) and are based on barriers to entry and firm specific capabilities. It might be nice to find a good instrument for ƛ , and also estimate models using two-stage least squares (2SLS), but using a weak instrument is often a worse empirical strategy than OLS if one suspects endogeneiety bias (Bound, John, Jaeger, David A. & Baker, Regina M., On Potential Problems with Instrumental Variables Estimation when the Correlation Between the Instruments and the Endogenous Explanatory Variable is Weak, 90 J. OF THE AM. STAT. ASS’N 443, 450 (1995)Google Scholar). For results using the other model specification, see Vernon, supra note 16.

57 Vernon, supra note 16.

58 Id.

59 See Vernon 2005a, supra note 16.

60 Danzon, supra note 5; Modigliani & Miller, supra note 16; Vernon, supra note 16; Vernon, supra note 8.

61 A Hausman test indicated this was the preferred specification.

62 Joseph Golec, Shantaram Hegde, & John Vernon, Pharmaceutical Stock Price Reactions to Price Constraint Threats and Firm-Level R&D Spending, J. OF FIN. (2005).

63 Pharmaceutical Market Access and Drug Safety Act of 2005, supra note 3.

64 Modigliani & Miller, supra note 16, at 262; Vernon supra note 15, at 2-3.

65 Pharmaceutical Market Access and Drug Safety Act of 2005, supra note 3.

66 PhRMA-member firms have the most detailed and publicly available data. These firms also represent virtually all the largest pharmaceutical companies in the industry. Analyses using these data, therefore, seem most appropriate because the intention is to understand how the major firms will respond to the forced-sale provision in the Dorgan bill. It is worth noting, too, that the distribution of pharmaceutical sales reported by PhRMA-member firms is significantly different from the distribution in our sample of 14 firms used in our regression analyses. This occurs because of the vastly different samples of firms and the different time periods considered. Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 2005, at 40, available at http://international.phrma.org/publications/publications/2005-03-17.1143.pdf.

67 Id.

68 Id.

69 Vernon, supra note 16, at 7; Pharmaceutical Market Access and Drug Safety Act of 2005, supra note 3.

70 By conservative we mean using the lowest estimate of profit margin in the U.S. and the highest estimate of profit margin abroad. This produces the narrowest range and errs on the side of making the profit margins in these two broadly defined markets closer together.

71 Because there are important considerations regarding the structure of costs assumed in Vernon's published estimates of pharmaceutical profit margins, one may wish to assume marginal costs are zero. While this is clearly an erroneous assumption, it nevertheless establishes a lower bound on regional profit distributions. In this extreme (and unrealistic) scenario the profit distribution is, by definition, identical to the sales distribution (every $1 in sales is $1 in profits because marginal costs are zero), and the U.S. market accounts for 67.7% of global pharmaceutical profits.

72 Pharmaceutical Market Access and Drug Safety Act of 2005, supra note 3.

73 See Kevin M. Murphy & Robert H. Topel, The Economic Value of Medical Research, in MEASURING THE GAINS FROM MEDICAL RESEARCH: AN ECONOMIC APPROACH (Kevin M. Murphy & Robert H. Topel eds., 2003).; see also Frank R. Lichtenberg, The Effect of Pharmaceutical Utilisation and Innovation on Hospitalisation and Mortality, in PRODUCTIVITY, TECHNOLOGY, AND ECONOMIC GROWTH, (Bart van Ark, Simon K. Kuipers & Gerard H. Kuper eds., 2000); see also Lichtenberg, Frank R., Sources of U.S. Longevity Increase 1960-1997 (Nat’l Bureau of Econ. Research, Working Paper No. 8755, 2002)CrossRefGoogle Scholar.