Econ 101 is often dismissed as too simplistic. Yet recent events suggest that Econ 101 is underrated. Take the tariff debate: understanding that a tariff is a tax, that prices represent opportunity costs, that a bilateral trade deficit is largely meaningless, that a so-called trade “deficit” is equally a goods surplus or an investment surplus—these are Econ 101 ideas. Simple but important.
Today’s example is Trump’s Executive Order on pharmaceutical pricing. It builds on the Biden Administration’s Inflation Reduction Act, which I’ve criticized as failing the marshmallow test. Now Trump is trying to go further—threatening antitrust action and even drug delistings unless pharmaceutical firms equalize prices globally. Tyler and I explored exactly this type of policy in our Econ 101 textbook, Modern Principles of Economics.
In our chapter on price discrimination, we first show that pharmaceutical firms will want to charge different prices in different markets depending on the elasticity of demand. In order to do so, they must prevent arbitrage. Hence the opening to that chapter:
After months of investigation, police from Interpol swooped down on an international drug syndicate operating out of Antwerp, Belgium. The syndicate had been smuggling drugs from Kenya, Uganda, and Tanzania into the port of Antwerp for distribution throughout Europe. Smuggling had netted the syndicate millions of dollars in profit. The drug being smuggled? Heroin? Cocaine? No, something more valuable: Combivir. Why was Combivir, the anti-AIDS drug we introduced in Chapter 13 , being illegally smuggled from Africa to Europe when Combivir was manufactured in Europe and could be bought there legally?
The answer is that Combivir was priced at $12.50 per pill in Europe and, much closer to cost, about 50 cents per pill in Africa. Smugglers who bought Combivir in Africa and sold it in Europe could make approximately $12 per pill, and they were smuggling millions of pills. But this raises another question. Why was GlaxoSmithKline (GSK) selling Combivir at a much lower price in Africa than in Europe? Remember from Chapter 13 that GSK owned the patent on Combivir and thus has some market power over pricing. In part, GSK reduced the price of Combivir in Africa for humanitarian reasons, but lowering prices in poor countries can also increase profit. In this chapter, we explain how a firm with market power can use price discrimination—selling the same product at different prices to different customers—to increase profit.
Later in the Thinking and Problem Solving section we ask:
As we saw in this chapter, drug companies often charge much more for the same drug in the United States than in other countries. Congress often considers passing laws to make it easier to import drugs from these low-price countries (it also considers passing laws to make it illegal to import these drugs, but that’s another story).
If one of these laws passes, and it becomes effortless to buy AIDS drugs from Africa or antibiotics from Latin America—drugs that are made by the same companies and have essentially the same quality controls as the drugs here in the United States—how will drug companies change the prices they charge in Latin America and Africa? Why?
That, in essence, is the Trump policy. So what’s the likely outcome? Prices will fall in the U.S. and rise in poorer countries—but not equally. AIDS drugs, for example, save lives in Africa but generate little profit. If firms can’t prevent arbitrage, they’ll raise African prices closer to U.S. levels and lower U.S. prices only modestly.
The result is that Trump’s policy will end up hurting patients in low-income countries while delivering minimal gains to Americans. Worse, by reducing pharmaceutical profits overall, it weakens incentives to develop new drugs. In fact, in the long-run U.S. consumers are better off when poorer countries pay lower prices—just as airline price discrimination makes more routes viable for both economy and first-class passengers.
The reference pricing envisaged in Trump’s EO involves more than poor countries but Dubois, Gandhi and Vasserman run the numbers in a fully-specified model and reach similar conclusions:
Using our estimates of consumer preferences, marginal costs, and bargaining parameters, we assess the impact of a counterfactual in which US pharmaceutical prices are subject to international reference pricing with respect to Canada or an average of several similar countries….Our results suggest that international reference pricing on its own is unlikely to produce dramatic savings to US consumers. Overall, reference pricing induces a substantial increase in the prices charged in reference countries but only a modest decrease in the prices charged in the US.
It’s also the case that countries that pay less for pharmaceuticals get them later than countries that pay more. Most importantly, such launch delays (and here) tend to reduce life expectancy.
Thus, Econ 101 provides a critical foundation for understanding current debates.
Beyond Econ 101, it’s worth highlighting how internally inconsistent Trump’s policies are. At the same time, as the administration is raising tariffs worldwide, it wants to greatly reduce restrictions on importing pharmaceuticals! The most charitable interpretation (steel-manning) is that the ultimate goal of the Trump approach is to boost industry profits and incentivize R&D by raising prices in other countries. But it’s hard to square that with reducing prices here. Either the investment is worth it or not. Instead of focusing on investment or efficiency, Trump frames everything as grievance and redistribution: other countries are “ripping us off,” so they must be made to pay. But the pie shrinks when you fixate on dividing it instead of growing it. Moreover, Trump’s belligerent approach is unlikely to succeed because, as with tariffs, it invites retaliation. Instead, we should be pursuing IP protections for pharmaceuticals as part of an overall free trade agreement. We did precisely this, for example, in the Australia–United States Free Trade Agreement (AUSFTA) in 2005. That type of bilateralism and negotiation is anathema to Trump, however, who sees the world in zero-sum terms. As a result, the Biden-Trump policies are likely to lead future Americans to have less access to life-saving and life-improving pharmaceuticals.
Addendum: See also many previous MR posts on pharmaceutical regulation including The US has Low Prices for Most Pharmaceuticals, Pharmaceutical Price Controls and the Marshmallow Test, Update on the supervillains and Frank Lichtenberg and the cost of saving lives through pharmaceuticals as well as many others.
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