The pharmaceutical Industry is extraordinary not only in its research intensity, but also for the amount of monopoly power held by the sellers of important new products. New drug products are typically covered by strong patents. Demand is relatively price-inelastic because of the debility-easing or even life-saving benefits unique drugs provide, because drug outlays are often covered at least in part by insurance, and because many physicians place little weight on price and much on good past therapeutic experiences in their prescribing decisions. In the United States, where the government has characteristically pursued a laissez faire approach toward drug makers' pricing decisions, the pharmaceutical Industry has for decades sustained supra-normal accounting profitability (SCHERER, 1993, pp. 97-115). Presidential candidate Estes Kefauver railed against high drug prices and profits in the 1950s, as did presidential candidate Bill Clinton in 1992. Mr. Clinton's health care reform proposal, rejected on other grounds by Congress in 1994, included a scheme to control the prices of particularly expensive drugs. Other nations have been less reticent. Drug prices and/or profits have been subjected to systematic and often pervasive public regulation in France, Italy, the United Kingdom, Japan, Australia, Belgium, and Canada, among others (REDWOOD, 1994, pp. 3-10; U.S. OFFICE OF TECHNOLOGY ASSESSMENT, 1993, pp. 250-262).

Governmental efforts in the United States thus far have been devoted to ensuring that once patents have expired, patients with Federal Medicaid prescription drug insurance (a program covering only the poor) are given strong incentives to choose generic rather than higher-priced branded drugs. This is done through «maximum allowable cost» measures that reimburse only the price of the least expensive generic substitute. Most hospitals in the United States maintain formularies that stress cheaper generics when they are available. This pattern has been adopted more recently by newer forms of health maintenance organizations (HMOs). In 1984, Federal legislation made it relatively easy for competing firms to enter the production of generic substitutes once patents have expired. Generic competition proliferated, so that by 1989 an estimated 30 per cent of all prescriptions were filled generically.

Until moving to a more directly regulatory approach in 1987, Canada had a particularly aggressive approach to encouraging generic substitution (SCHERER, 1996). From 1969 to 1987, generic suppliers could under Canadian law obtain licenses to import and/or produce drugs still covered by patents, paying a modest (4 per cent) royalty for the privilege. The law had two rationales: the desire to reduce expenditures under Canada's public medical insurance programs, leavened by evidence that ethical drugs were more expensive in Canada than in the United States; and the recognition that there was virtually no Industry developing original drugs within Canada. Rejecting drug makers' request for higher royalties to motivate new drug development, the Exchequer Court stated¹³: «It would ... be unrealistic to think that the returns from the Canadian market have any important bearing on whether research on an international scale will go on or not».

¹³Merck &. Co. Inc. v. Sherman & Ulster Ltd., 65 C.R.R.99, 108-109 (1971).

Thus, as a nation with less than 1 per cent of the world's population, Canada chose to be a free rider (or more precisely, cheap rider) on foreign nations' pharmaceutical R&D. By 1976, prices in Canada for a sample of 43 patented drugs were 21 per cent lower on average than in the United States (U.S. OFFICE OF TECHNOLOGY ASSESSMENT, 1993, p. 253).

Regulations governing the substitution of licensed generic drugs for branded drugs varied widely among the Canadian provinces, providing a natural experiment to discern the conditions under which generic use is most likely (GORECKI, 1986, pp. 371-396; MCRAE and TAPON, 1985, pp. 43-61). All provinces permitted substitution, but in Quebec, only with the patient's explicit consent. Some provinces gave the pharmacist discretion in the matter, but Ontario and New Brunswick required that the lowest-cost substitute be dispensed when reimbursement from public funds would occur - notably, for persons older than 65 years and welfare recipients. In most provinces, pharmacists were freed from malpractice liability when they dispensed generic drugs listed on the province formulary, but in Quebec, no waiver was conferred. Some provinces, including Quebec, reimbursed the full cost of the drug dispensed, whereas others, including Saskatchewan and Ontario, reimbursed only the price of the lowest-cost generic or the price set in an annual competition.

For 21 drugs with multiple sources, the average shares of reimbursed purchases won during 1980 by generic drugs in three provinces analyzed by McRae and Tapon were as follows:

Quebec, with very weak pro-substitution rules, had by far the lowest generic share. Both Saskatchewan and Ontario had strong pro-substitution rules. Saskatchewan's generic share was lower, partly because unusually many physicians exercised their mandate to prohibit generic use and perhaps also because pharmacies in small prairie towns enjoyed too little patronage to stock both branded drugs and generic substitutes. A key variable in the equation was revealed in 1982, when Quebec shifted from paying the full price of the drug dispensed to paying only the median price of available substitutes. The average generic share in seven important categories jumped in a year's time from 18.7 to 54.7 per cent.

Newfoundland and Saskatchewan both had choice and cost reimbursement rules strongly favouring substitution in 1983. Both published formularies listing generic drugs considered by expert panels to be biologically equivalent. But the formularies differed between provinces, with a marked impact on generic choices, as a tabulation of reimbursed generic shares by Paul Gorecki shows:

Not being listed on the formulary appears to have had a strongly negative effect on the three Newfoundland drugs. Gorecki repeated his formulary analysis for New Brunswick and Nova Scotia, where pharmacists were not required to substitute the lowest-priced brands and the costs of high-priced brands were reimbursed. The generic drugs' reimbursed market shares were:

Although a formulary effect appears - what is most striking is the low share for all generics - the result of fully reimbursing branded drug prices and other weak substitution mandates.

Compulsory licensing of drug patents, as practiced in Canada until 1987, and the denial of full patent protection to new drug products in many less-developed nations, were viewed by pharmaceutical manufacturers as «piracy»¹⁴. U.S. drug, computer software, and record makers banded together with their European and Japanese counterparts to lobby for unification of world patent and copyright standards through the Uruguay Round of GATT negotiations (SANTORO, 1992). The campaign was successful, and all GATT signatories will be obliged to grant full drug product patent protection within five or (for less-developed nations) ten years from 1994.

¹⁴ For an economic analysis of small or less-developed nations' incentives, see DEARDORFF (1992, pp. 35-51) or, for a less technical version, DEARDORFF (1990, pp. 497-507).

In the United States, competition among drugs still covered by patents has been stimulated by some health maintenance organizations and pharmaceutical insurance benefit providers by threatening the manufacturers with exclusion of their products from formularies unless discounts below the normal wholesale price are offered. Substantial discounts have been achieved in this manner, leading «inter alia» to a massive antitrust suit brought by thousands of retail pharmacists against more than 30 pharmaceutical manufacturers and wholesalers, alleging price discrimination and a conspiracy to deprive retailers of equivalent discounts¹⁵.

¹⁵In re Brand Name Prescription Drug Antitrust Litigation, Multi-district Litigation no. 997 (consolidated in the U.S. Federal District Court for the Northern District of Illinois). Parts of the suit were settled in January 1996 with a payment of roughly $400 million by manufacturers to plaintiff pharmacists, but other parts remain pending.

In sum, sometimes through the cultivation of generic competition, sometimes by playing one branded drug maker off against others to elicit discounts, and in still other cases, through direct governmental regulation of prices and profits, increasing pressure has been brought to bear on the prices and profits of pharmaceutical manufacturers throughout the world. The changes in the United States during the past decade have been so rapid that it is fair to say a new, much more competitive, era is beginning to materialize. Its exact contours and long-run consequences are difficult to predict.