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In this issue.
Internet pharmacies are a threat to drug prices in Canada — both
Canadian consumers and the drug companies can win by closing them

The Study in Brief
Canada’s Internet pharmacies represent a threat to domestic drug supplies and prices, and the federalgovernment should close the business.
Drug companies charge different prices to different buyers internationally and within the U.S.
Uninsured buyers, and those in relatively small buyer groups in the U.S., pay among the highest prices inthe world. Their purchases from Canadian Internet pharmacies have until now been relatively small involume, but could grow much larger if the President signs legislation permitting retail pharmaceuticalimports. Since the prices of some drugs are relatively low in Canada, legalization of imports would likelyresult in large increases in demand on Canadian suppliers.
Drug manufacturers do not want to cannibalize the profitable U.S. market by supplying low-priced imports from Canada, so they will press for higher prices in Canada. Since Canadian federal regulationsprohibit them from increasing drug prices at a rate higher than inflation, the manufacturers’ only methodof protecting their American profits would be to restrict supply to Canada, which could lead to shortagesand eventually to higher prices.
Because the cross-border trade remains mostly illegal and the volume small, Canada has not suffered a serious shortage of drugs or big price increases. This situation could quickly change if legislation ispassed in Washington to legalize imports.
From Canada's perspective, it makes sense to act sooner rather than later. If the next President implements legislation to facilitate drug imports, it would look hostile on Canada's part to immediatelyprohibit drug exports.
Stopping exports soon would eliminate the prospect of shortages and price increases and is entirely advantageous for Canada. It would also be an act of moral leadership. Ottawa recently passed a billallowing exports of generic drugs to developing countries that issued compulsory licenses for them. Thatbill required developing-country recipients to take “reasonable measures” to prevent re-exports of thosedrugs, so that Canadian manufacturers were not undercut by shipping low-price drugs to lower-incomecountries. Canada should lead by taking reasonable measures to prevent unauthorized exports of the drugsregulated by the Patented Medicines Prices Review Board.
Aidan Hollis is Associate Professor of Economics at University of Calgary and a Research Fellow of theInstitute of Health Economics.
Aslam Anis is Associate Professor of Health Economics in the Department of Health Care andEpidemiology at the University of British Columbia and Director of Health Economics at the Centre forHealth Evaluations and Outcomes Sciences, Providence Health Care, Vancouver.
C.D. Howe Institute Commentary is a periodic analysis of, and commentary on, current public policy issues. Kevin Doyle edited themanuscript; Wendy Longsworth prepared it for publication. As with all Institute publications, the views expressed here are thoseof the author and do not necessarily reflect the opinions of the Institute’s members or Board of Directors. Quotation withappropriate credit is permissible.
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ISSN 0824-8001 (print); ISSN 1703-0765 (online) Internet pharmacies in Canada are enjoying a booming business selling prescription drugs to U.S. consumers, with sales estimated at as much as $600million (unless otherwise specified all figures are in Canadian dollars) in 2003,or approximately 3.8 percent of total retail drug sales (IMS Health Canada 2004). Do these sales threaten to increase Canadian drug prices, cause shortages,or solve the U.S. problem of high drug prices, as a number of commentators havesuggested? If they are a threat to Canada, are there any desirable remedies? Weconclude that the sales do constitute a danger and we recommend a protectivepolicy for the federal government.
As we discuss in this paper, there are two barriers to a substantial increase in Internet pharmacy exports. The first barrier is that the drug companies activelymonitor sales to eliminate supplies to pharmacies selling into the U.S. and thesecond is that the U.S. Food and Drug Act prohibits retail drug imports. There isnow a fair probability that these laws will be modified to allow drug imports fromsome Canadian sources and if that happens, there is no certainty that the drugcompanies would be successful in preventing a substantial increase in retail drugexports. Should such exports increase, it seems likely that drug companies wouldseek — and perhaps be able to obtain — higher prices in Canada. Any increases inthe price of drugs could have severe consequences on provincial health budgetswhere spending on pharmaceuticals already represents as much as 16 percent oftotal health expenditures, the second largest line item after spending oninstitutions.
One of the sticking points in the Internet pharmacy debate is the perception among the U.S. public and legislators that drug price controls in Canada accountfor the price differences between Canada and the U.S. As a result, U.S. politiciansput strenuous pressure on Canada to eliminate drug price controls.1 As we arguein this paper, eliminating Canadian price controls may not be a way out of thisproblem. On the contrary, the preponderance of evidence indicates that federalprice controls, exercised through the Patented Medicines Prices Review Board(PMPRB), have relatively little impact on drug prices in Canada.
Because this finding implies that prices in the U.S. and Canada are essentially set by drug companies in response to demand conditions, including the leverageexercised by provincial drug plans, our analysis employs the standard economicframework of price discrimination (the situation when companies charge differentprices to different buyers for the same type of good). This well-developedeconomic literature allows us to develop some helpful insights into reasons forand possible policy responses to Internet pharmacies.
We build on the standard analysis of price discrimination and parallel imports as presented in Maskus (2000), Malueg and Schwartz (1994) and Gallini and Hollis(1999). Parallel imports are imports of genuine products, produced underprotection of trademark and made available for sale in the originating country,thus — potentially — violating the trademark, patent, or copyright held by a local For example, Speaker of the House of Representatives Dennis Hastert recently complained thatCanada's “price control regime is unfair to American consumers; Americans shouldn't be forcedto subsidize the health care for the rest of the world.” (Office of Speaker Dennis Hastert web site2003).
company. This is exactly the situation of the Internet pharmacies. Typically,parallel imports arise when a company attempts to discriminate in pricingbetween markets.
Several papers have focused on drug imports. For example, Calfee (2003) examined the political economy of imports into the U.S. and argued that they willlead to “rapidly escalating pressure for pharmaceutical price controls” in the U.S.,a direction that was totally rejected in the 2003 Medicare Act (Calfee 2003). Indeed,if anything, it seems to have led to escalating pressure from the U.S. for theelimination of any form of Canadian price controls. Arfwedson (2003) examindedparallel trade in pharmaceuticals on a global scale and, while briefly discussingCanadian Internet pharmacies, chiefly explores the trade-off between preservingintellectual property rights and ensuring access to essential medicines indeveloping countries. Our analysis, in contrast, focuses explicitly on Canadian policies and options.
We offer a perspective highlighting the convergent interests of Canadians and ofdrug companies. We argue that the best policy for the Canadian government is totake steps to eliminate, or at least to reduce, Canada’s Internet pharmacy exportsto the United States, a policy that exactly matches what the drug companies want.
We also offer some cautions on the difficulty of constraining such exports.
There are two underlying reasons for the recent rise of Canada’s Internet pharmacies. For one thing, the cost of finding low-priced drugs in Canada andshipping them to the U.S. has fallen because of the Internet — which makesinstant price comparisons possible — and improved express shipping. A cross-border trade in drugs has existed for a long time, fuelled by seniors willing to takea bus to Canada to buy cheap drugs, but it is the rise of the Internet and bettershipping that has enabled drug exports to expand massively. For another, the success of the Internet pharmacies depended on prices for some drugs in Canada being lower than the prices available to some consumers inthe U.S. Not all drug prices need be lower in Canada to stimulate exports andindeed there are many products for which the price is lower in the United States.
Overall, drug prices in Canada tend to be lower than in the U.S., but Danzon andChao (2000), using 1992 data, find prices about the same when accounting forproducts available generically as well as branded products. Danzon andFurukawa (2003), using 1999 data, find prices for patented drugs in Canada to beon average about 36 percent below U.S. prices. (They say that lower relativeCanadian prices are largely explained by depreciation of the Canadian dollar.)Naturally, however, exports to the U.S. have been of those drugs that are lower-priced in Canada. It has been well documented that in the U.S., drug companies practice extensive price discrimination with uninsured consumers paying the most, largecorporations and Health Maintenance Organizations (HMOs) paying somewhatless, and the federal government paying the least. The bulk of the Internetpharmacy exports from Canada have been to uninsured consumers who face highdrug prices. Thus, all that is necessary for Internet pharmacies to have substantialcross-border sales is for at least some drugs to be priced substantially higher in theU.S. for at least some classes of consumers, a condition which is readily metbecause of the high prices faced by retail consumers in the U.S. There is an additional wrinkle in appreciating why Canadian and U.S. drug prices differ. U.S. federal legislation requires pharmaceutical manufacturers toprovide price discounts for certain types of government purchases. For example, aclause introduced under the Omnibus Budget Reconciliation Act (1990) gives “MostFavored Customer” status for all drug purchases under the Medicaid program.
Scott-Morton (1997) has shown that this lessened market competition among bothbranded and generic companies leads to a 4 percent average increase in prices.
Similarly, drug manufacturers are required to discount all drug purchases by theU.S. Department of Veterans Affairs.
The Big Picture
In the next section, we begin with a look at the current state of Canada's Internetpharmacy exports. We then briefly review the economics of price discriminationand parallel imports and offer some evidence on Canada's drug price controls,showing that for the most part they have little effect on prices. That enables us toargue that a standard analysis of price discrimination is appropriate. Then wediscuss Canada’s options and make some recommendations for responses.
High drug prices have produced alluring incentives for U.S. consumers to lookabroad to fill their prescriptions. For the United States overall, the U.S. CustomsService estimates that approximately 10 million citizens bring medications acrossland borders with Mexico and Canada each year. In addition, there are millions ofshipments by mail from Internet pharmacies in Canada, as well as approximatelytwo million packages of pharmaceuticals arriving annually by international mailfrom countries around the world (Flaherty and Gaul 2003). Most Internetpharmacy sales are made from Canada, rather than from other countries, such asMexico, because Americans generally feel more comfortable with the qualitystandards in Canada.
IMS Health Canada estimates that in 2003, sales by Internet pharmacies to U.S.
consumers were between $566 million and $605 million, more than double thelevel in the 2002. IMS estimates that, given U.S. retail prices for the productsexported, their retail value to U.S. buyers — including foot-traffic, or consumerswho personally cross the border to fill their prescriptions — was $1.4 billion. Thisimplies that the losses to drug companies may be as high as $500 million, whichexplains why pharmaceutical companies are very concerned about Internetpharmacy exports. The number of Canadian pharmacies with an active onlineexport business has risen to approximately 120 in 2003 from four in 1999, althoughonly a handful of these have substantial sales. Retail pharmacy imports to the U.S. are technically not permitted under Food and Drug Administration (FDA) regulations, except for small personal exemptionsfor travelers and for imports of certain drugs not available in the U.S. Althoughwholesalers and pharmacies in Canada fall outside the ambit of the FDA, drugscannot be freely exported into the U.S, even if they have previously been imported from there and are in fact identical to drugs sold legitimately in the U.S. However,Washington has not seriously tried to prevent actual shipments because that onlypenalizes the small number of consumers whose deliveries are blocked. Thedifficulty is compounded by the fact that when medications are intercepted, theconsumers who ordered them are upset and complain to their politicians. Indeed,there has been a continuous flow of legislation in Congress — none so farsuccessful — to legalize drug imports from Canada and elsewhere. The main reason given by the FDA for not permitting retail drug imports into theU.S. is that they may jeopardize patients’ safety. The principal problems are of twotypes. First, there are concerns about Internet pharmacies, whether they operatedomestically or internationally. These pharmacies do not see their clientspersonally or ensure that faxed-in prescriptions are used only once. There is alsoconcern about drugs being subject to unsuitable environmental conditions while intransit (for example, being subject to too much heat). These problems are relevantnot only to international Internet pharmacies. Internet pharmacies also operatedomestically in the U.S., and we do not believe that those in Canada deserve anyextra concern in this regard.2 Another safety concern is that counterfeit drugs —manufactured under unsanitary conditions and perhaps not containing the correctamount — if any — of the active ingredient, may be able to slip into the supplystream because of weak controls by a foreign country such as Canada. Clearly,then, before the U.S. government is willing to change its regulations to allow retailimports from Canada, it will have to at a minimum, provide a method of ensuringthe safety and integrity of the supply network. At present, the FDA has notdeclared itself satisfied with the patchwork of oversight that would occur if HealthCanada, the Canadian provinces, and provincial pharmacy associations werecollectively responsible for safety in Canadian Internet pharmacies (FDA 2004).
There are two business models currently used in Canada for Internet drug exports. The most common one is for a pharmacy to hire physicians in Canada toco-prescribe the medication with a U.S. physician. The Canadian signature is arequirement for the pharmacist to fill the prescription. This approach has somedrawbacks. The Canadian physician may be in breach of professional obligations.
Most of the provincial Colleges of Physicians lay down strict rules requiringphysicians to maintain extensive records and show evidence that they have fullknowledge of the patient’s conditions, including concomitant medications thatthey may be taking, before prescribing medicines to them. It is likely that these Indeed, compared to U.S. Internet pharmacies serving their customers in the U.S., it is arguablethat there is extra protection when the same customers go to a Canadian Internet pharmacybecause in the latter case their prescription will be checked by a second Canadian physician whoreviews the file and prescription of the patient's U.S. doctor, before co-signing the prescription. Arecent report by the General Accounting Office showed that in some respects, Canadian Internetpharmacies had stricter standards than those in the United States, consistently requiringphysician-written prescriptions before filling orders, and including appropriate labels,instructions, and warnings (“Few problems at Canadian Internet Pharmacies,” Washington Post,June 17, 2004).
rules are being violated, at least in spirit if not in the letter of law, and could beenforced more rigorously by taking away prescribing privileges of the offendingphysicians (the federal government has encouraged the provincial physicians’colleges to be enforce such rules). The problem, however, lies in identifyingphysicians in breach of these standards. At the same time, the co-signing physicianintroduces extra costs, typically charging a fee of $10 per prescription (Simon2003). As well, the Canadian physicians who co-prescribe without seeing thepatient may be unable to obtain liability insurance for this activity; the CanadianMedical Protective Association announced that as of February 2004, it will nolonger extend assistance to physicians facing legal actions arising from co-signingprescriptions where the physician has no recognized doctor-patient relationship(Sproule 2004).
The threat of sanctions by professional associations and the absence of liability insurance have apparently not been frightening enough to prevent doctors fromco-signing prescriptions. Provincial physicians associations appear to havepursued very few doctors who have co-signed prescriptions for Internetpharmacies. For example, in Manitoba, only one case is publicly listed of aphysician who has been reprimanded for co-signing prescriptions (College ofPhysicians and Surgeons of Manitoba 2004). In that case, the College first warnedthe physician to stop this activity. When the physician continued co-signing, hewas fined $14,190, including costs, and received a reprimand. Based on a rate of$10 for each of the 2,271 prescriptions he co-signed, it appears that he still made aprofit even after accounting for the fine.
The alternative — and relatively rarely used — business model is to function only as an exporter of pharmaceuticals. Under this approach, the pharmacy is notaccredited by its provincial pharmaceutical association, and does not useCanadian doctors to co-sign prescriptions. This solves some of the problemsalready mentioned, but is of questionable legality.3 The operation of suchpharmacies has been defended under the Canadian Food and Drugs Act, Sec. 37,which explicitly exempts drugs not sold for consumption in Canada.4 Provincialgovernments appear to have been loathe to take action against these Internetpharmacies, as long as their activities are restricted to exporting.
Canadian Internet pharmacies can offer substantial savings to some Americanconsumers, particularly those with chronic conditions — such as high bloodpressure or high cholesterol — requiring regular, predictable doses of medicineover long periods. Newspapers have been filled with reports of consumers whoclaim to have saved hundreds of dollars through buying in Canada. The State of For example, the Ontario Drug and Pharmacies Regulation Act requires all pharmacies to beaccredited by the Council of the Ontario College of Pharmacists.
This section of the Act was intended to apply to drugs manufactured in Canada, but the Internetpharmacies have tried to use it to provide a legal defence for their activities. Health Canada hasnevertheless attempted to inspect at least export-only pharmacies (Canadian Press 2004).
Wisconsin maintains a website that “gives our citizens the ability to buy certainprescriptions at significantly lower prices directly from Canadian pharmacies thatour state has visited and found to be safe, reputable, and reliable.”5 The websitecontains ordering information and prices of drugs which cost less in Canada. A quick comparison of the prices advertised there and on the official U.S.
government’s Medicare website shows substantial differences between prices formany drugs. For example, a 100-pill supply of Mobic, used to relieve osteoarthritisin adults, costs us $78.60 at a Canadian pharmacy shown on the Wisconsingovernment site, while it costs us $243.68 at the lowest-priced Medicare drug cardsite.6 On average, Canadian prices for patented single-source drugs were 64percent of U.S. prices in 1999, when weighted by consumption and adjusted fordiscounts (Danzon and Furukawa 2003); after adjusting for a 10 percent increase inthe Canadian exchange rate since 1999, the average prices currently may beextrapolated to be around 75 percent of U.S. prices. However, exports are likely tobe concentrated in individual drugs which are considerably cheaper in Canadathan in the U.S., such as Mobic.
The price differentials may be due to a variety of factors. In the next section we consider why drug prices in Canada and the U.S. are so different.
Price Discrimination, Parallel Imports
and Exclusive Territories

Price discrimination is said to exist when a firm charges different prices indifferent markets for substantially the same good.7 We commonly see price discrimination by movie theatres, where children andseniors are charged lower prices for the same product. The reason for pricedifferences of this sort is not any affection for children and seniors, but therealization that it is profitable to charge a lower price to them in order to sell moretickets. More generally, monopolists may wish to charge different prices indifferent markets if they have different characteristics. The monopoly price in eachmarket will depend on the shape of the demand curve, as well as cost conditions. In general, markets with low demand elasticity will have relatively higher prices. (In the movie example, children and seniors have high demand elasticity.)Typically, the monopoly price in poorer countries will be lower. Profitable pricediscrimination requires that a company have market power, or the ability to setprices to some extent, that it is able to distinguish between markets, and that Available from: ( According to the Globe and Mail,some 16 states and 22 municipalities have or are in the process of setting up similar websites(Zehr 2004). Available from: ( The price comparisons were made May20, 2004.
Economists call this “third-degree” price discrimination.
arbitrage or resale between markets is limited. All of these conditions havehistorically characterized drug markets, which helps to explain some of the widelyobserved variation in international drug prices. Price discrimination does notimply cross-subsidization among different consumers, as long as consumers in allmarkets are paying at least marginal costs, a condition which certainly holds indeveloped country pharmaceutical markets.
One reason that we observe very different prices charged in different countries and to different types of buyers is buyer-power, which is the bargaining leverageof purchasers to extract price concessions from sellers. Individual consumersevidently have little buyer-power, while large-scale purchasers, such as provinces,may refuse to list drugs in their formularies unless they obtain price discounts.
The exercise of buyer-power is closely related to the notion of demand elasticity:the exercise of buyer-power by large purchasers can be seen as being an indicationthat they have more elastic demand because they are better informed aboutpossible substitutes.
International price discrimination tends to induce companies and consumers to engage in cross-border resale. While within countries there are few limits onresale, between countries such resale is described as a parallel import and incertain circumstances companies may be able to obtain government support tostop the cross-border trade. Companies often use intellectual property rights —patents, copyright, and trademarks — to eliminate parallel imports. This strategycan work when the patent or trademark in a country is owned by one company,and the goods imported from another country are deemed to be infringing thelocal patent or trademark. The ability of the patent holder to prevent tradedepends on its treatment of international property rights (Maskus 2000). U.S. lawhistorically has not allowed the use of intellectual property rights to preventparallel imports when the intellectual property is owned by the same company orby affiliated companies in the exporting and importing country (Gallini and Hollis1999).8 However, in a recent case (Jazz Photo v. ITC, 264 F.3d 1094, 2001), the Courtof Appeals for the Federal Circuit has, at least partially, reversed this historicpattern. Thus, for pharmaceutical products not first sold in the U.S., patentinfringement actions may be successful in stopping parallel imports into the U.S.
(though, as we will illustrate, some proposed legislation eliminates the ability touse patent rights to stop parallel imports).
Are Price Controls Actually
Setting Prices in Canada?

An important condition for the claim that there is price discrimination betweenCanada and the U.S. is that the drug companies are in a real sense setting prices in A subtle irony here is that the reason that U.S. law permits parallel imports when the intellectualproperty rights are controlled by the same company is that the company in that case has aremedy, which is to charge the same price in both countries. This remedy is not readily availablein the case of pharmaceuticals.
both countries. Drug prices face no explicit government price controls in the U.S.
However, if the prices in Canada are controlled by government, then the claimsthat there is price discrimination may ring hollow. We therefore examine theimportance of federal price controls in the following section. Are price controls on pharmaceuticals actually effective in Canada? Ottawaappears to have a somewhat contradictory attitude toward price controls. On theone hand, the federal government operates the Patented Medicine Prices ReviewBoard (PMPRB) which, among its other functions, is widely characterized as apharmaceutical price-control agency. On the other hand, Canada’s ambassador tothe U.S. claimed that the “price review regulations play a minor role” indetermining drug prices (Kergin 2003). The PMPRB is apparently intended to curb“excessive” pricing only, and such pricing is found in a small number of drugseach year. This means that the average pricing of drugs in Canada is little affectedby the price review process. The board has ordered or obtained a voluntaryundertaking of a price reduction for only eight products in the last five years,although the threat of investigation by the PMPRB will presumably have beeneffective in pushing down prices for other products as well.9 A PMPRB restrictionon the maximum rate of annual price increases has left drug companies unable torespond to parallel trade by raising prices domestically.
Various studies have confirmed that the effect of the PMPRB on prices may not be substantial. Anis and Wen (1998), using a study based on 1992 data, show thatthe PMPRB maximum allowable price thresholds appear not to be binding.
Graham (2000) notes that historically drug companies have not taken fulladvantage of the PMPRB provisions that allow them to increase prices annuallywith the rate of inflation. The implication is that the preferred profit-maximizingprice chosen by drug manufactures in Canada is often lower than the ceilingestablished by the PMPRB. There is also evidence from other countries that pharmaceutical price controls are not a major determinant of average prices. Danzon and Furukawa (2003)examine prices of drugs in nine countries in 1999 and find that prices varysubstantially across countries, but that, after correcting for discounts and rebateson U.S. drugs, average U.S. prices are not far out of line with those of majortrading partners. In particular, they show that examining a basket of pricesincluding generics tends to reduce the price differential, and that using purchasingpower parity instead of nominal exchange rates makes the U.S. cheaper than most Surprisingly, of those eight drugs, three are classified as “Orphan Drugs” under the U.S. OrphanDrugs Act, meaning that the U.S. government provided special incentives for their developmentbecause the markets were thought to be too small to support development on a commercial basis.
The PMPRB's targeting of drugs financed in part under the Orphan Drug Act leaves Canada inthe morally tenuous situation of imposing price controls on rare-disease drugs financed by theU.S. government, while U.S. consumers pay higher prices.
other countries. They also point out that the observable differences at nominalexchange rates seem to be well explained by income differences across countries.10 One reason that drug prices may be lower in Canada than in the U.S. could be bargaining power exercised by provincial formularies and other large purchasers.
A provincial formulary listing is the key to successfully marketing a drug in eachprovince because listing ensures that the provincial drug plan will cover the costof the drug for eligible beneficiaries. In an effort to control the cost of insureddrugs, most provinces require evidence of cost-effectiveness of new drugintroductions. Anis et al. (2001) show that formularies are selective in the productsthey list, in part based on their evaluation of the cost-effectiveness of the product,and this, implies that the drug companies may be willing to offer their products atlower prices in order to obtain a listing (Borrell 2003).
Even if formularies do choose to list a product, they may assign limited-use designations to particularly expensive drugs. Such designations require extrapaperwork for both doctors and pharmacies. As a result, drug manufacturers aresomewhat constrained in their pricing if they wish to increase the chances ofobtaining an early, unrestricted listing on provincial formularies. While directbargaining between formularies and pharmaceutical companies over the price atwhich a drug will be listed is rarely observed, formularies may have passivelyexercised some discipline over pricing simply through their discretion overwhether and how to list a new product.11 So while there is a common perception that the cause of low prices in Canada is government regulation, the evidence appears to point instead to the low price inCanada being caused by profit-maximizing behavior on the part of thepharmaceutical manufacturers facing a population with lower incomes than in theU.S. and a system of health insurance that is looking for value for money.
Still, it is true that PMPRB reviews are binding on the prices of at least some drugs. And it is most likely the case that drug companies would like to increaseCanadian prices to prevent export sales into the U.S. market. Normally, if themanufacturer of a product does not want to see parallel imports flowing from alow-priced country into a higher-priced one, the company has a remedy: eitherincrease the price in the low-price country, or lower it in the higher-priced one. Inthe case of pharmaceuticals, increasing prices in Canada is not necessarily anavailable option because of PMPRB regulations. The alternative remedy ofreducing prices in the U.S. is not reasonable because the U.S. market is both largeand profitable. For example, pharmaceutical sales revenue at just one drugstorechain in the U.S., CVS Pharmacy Inc., is substantially greater than the entire retaildrug market in Canada. We discuss the implications of these facts in the followingsection.
10 This claim is weakened by a glaring exception: The two lower-income countries in their study, Brazil and Mexico, had prices that were more or less in line with the average of the higherincome countries.
11 It is true that price regulation and buyer-power may be very similar in their effect, particularly if the buyer represents a significant proportion of the market, as is the case with the Canadianprovinces. The difference is that buyer-power typically reduces prices only for a given buyer andthat price regulation is usually backed up with the threat of compulsory licensing, if the sellerrefuses to sell at the allowed price. Internet Pharmacies: A Threat to Canadian Drug Prices
If large-scale drug exports were to occur, most likely drug prices would rise inCanada to U.S. retail levels, which would eat into provincial health care budgetsand increase drug costs for most Canadians.
The Threat of a Huge Increase in Exports U.S. retail prices may be lower or higher than Canadian prices for particulardrugs, but on average, patented drugs are more expensive in the U.S. In 2002, totaldrug spending in Canada was around $18.1 billion, with $6.6 billion financed bythe public sector (Canadian Institute for Health Information 2004). As a result, aprice increase of, say, 15 percent on average, holding quantities constant, wouldcost Canada approximately $2.7 billion, with $1 billion coming from government.
This would be an unambiguously bad outcome for Canada. Most likely, however,such an increase in prices would result in some decrease in the quantitypurchased, probably leading to worse health conditions and substitution of otherforms of medical care.
Because of the difference in prices for at least some drugs between Canada and the U.S., what prevents more and more drugs being exported? The quick answer isthat there are two main obstacles to export growth. First, there are legal obstaclesto imports in the U.S that make it more expensive and less convenient to importretail drugs than it would be in the absence of the obstacles. Second, drugcompanies are restricting supply in Canada, and are trying to target pharmaciesthat are actively exporting into the U.S. We now evaluate just how muchprotection these obstacles to exports really offer.
Currently, federal regulations make the import of pharmaceuticals from Internetpharmacies illegal, but the FDA policy results in “enforcement discretion” at U.S.
Customs, which, in effect, allows most drugs through. The illegal status of drugimports from Canada leads many insurance plans — with or without co-payrequirements — to refuse to cover any drugs bought from Canadian Internetpharmacies, which severely limits the demand for Canadian drugs. As a result,most of the U.S. demand for drugs from Canada comes from consumers with noinsurance at all, or from consumers with health benefits paid for by the few citiesand states that offer coverage for purchases from Canada. If federal regulationswere to change to allow imports from Canada, then demand for Canadian drugswould increase substantially. As we will discuss, there is a fair probability thatsuch a change in federal regulations will occur within the next year or so. The response of the state and federal governments in the United States to the growth in Internet pharmacy imports from Canada has been divided. Normally,with price discrimination between countries, it is in the interest of the countrywith the higher prices to encourage arbitrage — but in the case ofpharmaceuticals, the manufacturers are also located in the high-price country.
Thus the issue of whether to allow drug imports comes down to a trade-off. The trade-off is between supporting the profitability of the pharmaceutical companiesthrough enabling continued segmentation of markets and differential prices basedon the profit-maximizing price for each market, and reducing prices for domesticconsumers (while increasing them for foreign consumers). Different politicalgroups have lined up in support of different positions. The Republicans havetypically fought against importation, while the Democrats have tended to favor it.
Meanwhile, governments of some states and cities — particularly those without asignificant pharmaceutical industry — have been pushing actively for access topharmaceuticals at Canadian prices. The result of this split in interests is that the Medicare Prescription Drug Improvement and Modernization Act of 2003 was passed with a compromise on drugimportation. The Act requires the Secretary of Health and Human Services toconduct a study of the desirability of drug imports, and then, if possible to writeappropriate regulations ensuring safety, to allow importation of medicines fromCanada only. This provision means that for the present there will be continuousobstacles to importing drugs, but that there is a fair probability of amendments tothe laws regarding imports of drugs from Canada. The FDA has consistentlyargued that drugs imported from Canada cannot be assumed to be safe, even ifthey have been approved by Health Canada.12 However, consumers, employersand city and state governments are exerting such pressure to obtain lower pricesthat the outcome of this debate in the U.S. is unpredictable. Tommy Thompson,the Secretary of the Department of Health and Human Services, recently predictedthat drug re-importation “is coming”, adding that he would not advise thePresident to veto a bill allowing drug imports from Canada under certainconditions (Boston Globe 2004).
Two bills in the Senate to facilitate imports of drugs, especially from Canada, Dorgan/Snowe (S. 2328) and Gregg (S. 2493) have received bipartisan support.
Both bills allow for imports of pharmaceutical products at retail and wholesalelevels, giving some FDA oversight for safety. The Dorgan/Snowe bill isparticularly strong because it also eliminates some other roadblocks to drugimports: It overrides the Jazz Photo decision, expressly noting that patentees in theU.S. will not have the right to block imports of legitimate, patented drugs thatwere first sold abroad and it prohibits manufacturers from discriminating insupply against companies that are exporting drugs into the U.S.13 Some state and city governments have already added coverage in their insurance plans for employees who buy prescription drugs from outside theUnited States, but so far they have not faced legal action. In addition, severalstates and cities have been investigating how drug importing would be most 12 The FDA has conducted a number of blitzes to determine what sort of medicines are being imported from Canada currently. The agency has discovered that there may be some safetyproblems, owing to the underground nature of the business. For example, they found that somelots of a given product had been recalled in Canada. The FDA suggested that U.S. buyers of theproduct might not have been informed of the recall by the Canadian Internet pharmacy (FDANews 2004).
13 There is some question as to the legal validity of the “forced trade” provisions of the Dorgan/Snowe bill, which do not allow drug manufacturers to discriminate in price or quantitywhen selling to companies that export products to the U.S. (Pilon 2004).
effective. The State of Illinois, which undertook a substantial study arguing thatCanadian drug approval, safety and control standards were equivalent to those ofthe FDA, has been active in promoting drug imports (Kamath and McKibbin2003). Similarly, the State of Wisconsin is actively promoting purchases fromCanadian Internet pharmacies. The sustained pressure from states, cities, a largenumber of members of both houses of Congress, as well as such lobbying groupsas the American Association of Retired Persons (AARP) make it likely that federallaws will be changed to allow retail drug imports from Canada.
If retail drug imports become legal in the U.S., how will the pharmaceuticalmanufacturers, individually, and acting as a group through their industryassociations, Research-Based Pharmaceutical Companies ( Rx&D) and thePharmaceutical Research and Manufacturers of America (PhRMA) react? They willhave several options. They can attempt to set prices in Canada and the UnitedStates that will not lead to arbitrage — this implies prices becoming fairly similar.
Alternatively, they can try to stop the cross-border shipments of drugs. A finalapproach is to tolerate the arbitrage while keeping prices different.
Harmonizing prices in Canada and the U.S. may seem to be the easiest choice for the drug companies because, as discussed, they charge many different prices inthe United States, depending on local markets and the situation of buyers. As aresult, any single price in Canada would not match with at least some of thoseprices. If the Canadian prices were set equal to those charged to the U.S. federalgovernment, that would be exactly the same average relationship between pricesas currently (Hollis 2004 forthcoming). Arbitrage would be prevented only ifCanadian prices were similar to the retail price for uninsured United Statesresidents. However, in that case, average U.S. prices would be much lower thanCanadian prices, a situation that would not be desirable for the pharmaceuticalcompanies. Recall that prices in the U.S. for uninsured consumers are set in orderto maximize profits.14 Since Canadians have lower incomes and the bargainingprocess includes large buyers in Canada, it is likely that for most drugs, the profit-maximizing price in Canada will be below the profit-maximizing price foruninsured retail consumers in the U.S. (Danzon and Furukawa 2003).15 Asdiscussed, it appears that the pharmaceutical companies are already charging neartheir profit-maximizing price in Canada, so raising prices to the highest U.S. levelswould likely lead to a decrease in profits. In any case, in the short term PMPRBregulations prohibit substantial price increases, and even for new drugs it seemsunlikely that the PMPRB would allow Canadian prices to be set at U.S. retail levelsbecause that would make Canada the highest-priced jurisdiction in the world.
14 Possibly they are set above the profit-maximizing level because the government requires that purchases by the VA and affiliated organizations be 24 percent below the “average wholesaleprice”, which means that the optimal price for all other buyers will be pushed above the profit-maximizing price.
15 This is not necessarily the case in every circumstance, however. Consumers who are insured may be less price-sensitive than those who are not insured.
A second approach for Rx&D would be to leave prices as they are and try to minimize cross-border shipments of drugs. This would maintain the existingstructure of price discrimination. There are a number of ways to lessen arbitrage,and it appears that Rx&D has engaged in all of them to varying extents. Amongother things, it has threatened to supply only the amount normally required forCanadian demand, so that if substantial exports occur, there will be drugshortages in Canada.16 This strategy is probably not very relevant given thecurrent level of Internet exports, though it could become binding if the volume ofexports increases substantially. The public announcements of this policy can beseen as a way of indicating that if the Internet pharmacy export business isallowed to grow unchecked, there will be some consequences for Canada.
Pharmaceutical manufacturers have attempted to limit supply to individual wholesalers that supplied pharmacies engaging in cross-border sales. For example,in February 2004, Pfizer announced that it had stopped supplying two pharmacywholesalers, based on concern that they were supplying Internet pharmacies(Agovino 2004). However, attempts to limit supply to Internet pharmacies areunder attack in U.S. and Canadian courts. The State of Minnesota started aninvestigation of GlaxoSmithKline Inc. on the basis that the company’s threats tolimit supply to Canada because of Internet pharmacies might have violated stateantitrust laws in Minnesota (State of Minnesota District Court 2003). A separateclass-action lawsuit in the U.S. alleges that the big pharmaceutical companiesconspired to eliminate cross-border sales through common means of restrictingsupply (Iverson et al. v. Pfizer et al. 2004). In Canada, four applications have beenfiled with the Competition Tribunal by pharmacies, alleging that severalmanufacturers’ refusal to supply them constitutes a refusal to deal under S. 75 ofthe Competition Act. It appears that the manufacturers blacklisted these pharmaciesbecause they were reselling some products to Internet pharmacies. The languageof S. 75 leaves scope for the application because there is nothing in the Act thatseems to contemplate cutting off supply to one retailer on the basis that it mightresell products to a second one.17 If the applicants are successful at theCompetition Tribunal, then the manufacturers will be unable to stop third-partysupply of the Internet pharmacies.
The third approach that Rx&D could adopt is to ignore the arbitrage. This policy might be attractive if it were desirable to price discriminate between retail 16 Allowing supply shortages is a risky strategy for the pharmaceutical manufacturers, since the Patent Act allows the Canadian government to issue compulsory licenses in case of non-supply.
However, the timetable required to show supply shortages, then obtain a compulsory licensefrom the Commissioner of Patents, and then to obtain supply through a compulsory licensedgeneric manufacturer makes the threat of compulsory licensing irrelevant unless the supplyshortage lasts a relatively long time.
17 The direct application to the Tribunal by the pharmacies is different from an unsuccessful attempt by Internet pharmacies to engage the Competition Bureau in 2003. The Bureau declined tosupport the Internet pharmacies, because: “The civil provisions of Canadian competition lawpertaining to refusal to supply and market restrictions generally recognize that suppliers may setthe terms and conditions of sales to businesses provided that they have reasonable businessjustification.” (News release at, last accessed June 8, 2004) S. 75 explicitly notes that the terms of trademean “terms in respect of payment, units of purchase and reasonable technical and servicingprovisions,” which does not, on the face of it, seem to include terms restricting resale.
buyers in the U.S. based on their willingness to search out low prices. However,large-scale arbitrage would almost certainly result in substantial decreases inprofits. Price discrimination based on willingness to buy drugs from Canadawould likely be ineffectual at separating out consumers based on willingness topay high prices, and most likely the drug companies would simply lose sales athigh prices in order to gain the same sales at lower prices. Because of the relativelylarge size of the U.S. market compared to the Canadian market, this would notmake sense.
This review of the possible approaches makes it clear that the second one — maintaining price discrimination while trying to minimize arbitrage — is the mostattractive strategy for the pharmaceutical companies given the current volume ofparallel trade.18 However, this strategy could become very costly for bothpharmaceutical manufacturers and Canada if the volume of parallel imports wereto increase substantially because of implementation of the Dorgan/Snowe bill. Inthat case, the limitations on supply threatened by Rx&D would likely become areality, leading to supply shortages, which in turn could only be fixed byincreasing prices beyond the limits currently imposed by the PMPRB. Possibly,Canadian buyers would have to purchase drugs from American or other foreignwholesalers to meet demand. There is, of course, only a risk that FDA regulationswill be changed to allow cross-border retail drug imports; however, if thishappens, it seems unrealistic to expect that the drug companies will be able tomanage drug supplies in Canada to meet both existing Canadian demand andvastly increased demand from the U.S.
What Should Canada Do?
Canada now faces the possibility of threats to provincial health budgets andshortages of drugs, so it seems useful to consider the available responses. In such asituation, one of the issues to consider is whether to be pro-active and eliminatethe prospect of a problem, or to wait until the problem arrives before reacting. Wefavor the former approach in this case, because drug shortages could arise quitequickly if drug exports were to increase rapidly, while legislative changes taketime to enact. Drug shortages could have serious, indeed fatal, consequences forCanadians. Moreover, a Canadian government ban on Internet sales into the U.S.
enacted immediately after the U.S. government permits imports from Canadacould be perceived as unhelpful or even hostile, so that the possible responses inthe future may be more constrained than actions taken now.
Individual provincial governments are not likely to take effective action concerning Internet pharmacy exports because they do not have the sameinterests. The provinces that have substantial Internet exports — especiallyManitoba — may have an interest in sustaining the business, which brings bothjobs and tax revenue. The Internet pharmacy business employs an estimated 1,500people in Manitoba and generates direct tax revenue of approximately $150million (Redekop 2004). Provinces without Internet pharmacies, on the other hand, 18 In an unusual turn of events, the interests of generic companies are aligned with those of the innovator firms because generic companies in the U.S. are harmed by low-priced competition inthe brand-name product coming from Canada.
may wish that the business were stopped, but cannot do anything about it. As aresult, we believe that any response to the Internet pharmacy exports must be afederal one. Ottawa could: Eliminate the price review functions of the PMPRB in order to remove therationale for action by the U.S.; Do nothing at all, or take minimal actions including the application ofexisting laws to control Internet pharmacies where there is any infraction,or, Amend legislation to stop Internet pharmacy exports.
Consider a situation where price regulation was eliminated altogether in Canada, and FDA rules changed to accommodate cross-border imports of drugsfrom Canada. Drug companies would likely increase their Canadian prices tominimize losses from resale into the high-priced U.S. market, and Canadian drugprices would more closely match U.S. retail prices. This would eliminate theprospect of shortages, though it would not be particularly good for Canadians. Itwould also not be the best outcome for drug companies, as noted, because U.S.
retail prices are generally higher than the profit-maximizing prices for Canada.
The second approach, using existing laws to inhibit cross-border pharmacy sales appears to be the strategy taken until this point by the federal government.
However, as discussed, this approach leaves Canada vulnerable to a change inU.S. regulations on pharmacy imports.19 The use of existing laws to preventInternet pharmacy exports from Canada is a reasonable first step. But it does notappear to have been particularly effective. Despite various attempts to stem theInternet business through implementation of existing laws, the public letter fromAssistant Deputy Minister of Health Diane Gorman to the provincial pharmacyassociations and others dated Oct. 27, 2003, reveals that the federal governmenthas basically no leverage to stop Internet pharmacy exports without a change inthe Food and Drugs Act. Instead, the government has relied on the provincialgovernments and pharmacy associations to limit the economic viability ofexporting. The federal government, in short, appears to lack the ability to limit theactivities of Internet pharmacies unless it takes the more serious step of enactingrestrictive legislation.
The third approach — taking substantial steps to eliminate retail pharmacy exports — is, we believe, the best choice for Canada. This would involvemodifying the Food and Drugs Act to explicitly restrict retail pharmacies fromshipping any product reviewable under PMPRB guidelines to customers outsideof Canada.20 It is not hard to justify such a restriction because the PMPRBregulations prohibit pharmaceutical manufacturers from reacting to the currentproblems of re-exportation into the U.S. by increasing their prices. While Internetpharmacy exports currently represent only a small fraction of total Canadian 19 Note that if the FDA never finds a means to assure the safety of Canadian drugs, then this strategy may be the best one, but it does depend for its optimality on U.S. legislative inaction.
20 It may be possible that the Minister of Health could eliminate retail drug exports through administrative or regulatory changes falling short of an amendment to the Act. However, such anapproach would likely be subject to court challenges and seems to us a less desirable solution.
demand, if the American market ever becomes open to parallel imports fromCanada, the demand from the U.S. could easily exceed total Canadian demand forat least some products. Unless the pharmaceutical companies were willing toaccept relatively large decreases in profit from their U.S. market, it is likely thatthey would follow through on their threats to limit supply in Canada. This wouldinevitably lead to supply shortages and price increases in Canada. BlockingInternet exports is a way of preserving a system of price discrimination, whichhappens to be favorable to Canadians and to the drug manufacturers. The federal government’s inaction on Internet pharmacy exports is also puzzling when considered alongside the recent amendment of the Patent Act toallow exports of patented medicines under compulsory licenses to developingcountries in cases of health emergencies. Those amendments reflect particularconcern to avoid re-exportation of medicines that were originally shipped to adeveloping country. Specifically, Bill C-9 does not permit compulsory licensees tosupply drugs to a country which has not implemented “reasonable measures” toprevent re-exportation of drugs supplied under the Act. The U.S. is in a somewhatcomparable situation regarding re-export from Canada. It seems hypocritical — tosay the least — for Ottawa to require developing countries to establish “reasonablemeasures” to prevent re-exportation while Canada has no measures at all toprevent re-exportation of drugs subject to price controls under the PMPRB.21 Conclusion
In this Commentary, we have argued that Canadian Internet pharmacies exist inlarge part because of the market structure of the pharmaceutical industry and notbecause of any Canadian prices or regulations. High retail pricing for drugs in theU.S. is a made-in-the-U.S. issue, and it is unlikely that relying on imports fromCanada can solve it in the long run. On the contrary, forcing Canadians to increasetheir domestic prices will hurt Canadian consumers and decrease U.S.
multinational drug companies’ profits because they will be forced to raise pricesbeyond their profit-maximizing levels.
Some readers of an earlier draft of this paper objected to the idea that the Canadian government should act to solve a problem of the drug companies(which simply wish to engage in a system of price discrimination) or to legislate asolution to a U.S. political impasse. It is a fact that Canadian drug exports to theUnited States are not, in themselves, a Canadian problem. But if, as a problem forthe U.S. and drug companies, they lead to price increases and drug shortages inCanada, then pharmaceutical exports to the U.S. become a Canadian problem.
In Canada, drugs are not like other goods: They are price-controlled, and large-scale exports of price-controlled drugs to the U.S. are not compatible with 21 The former FDA commissioner, Mark McClellan, pointed out that the Canadian government had not been altogether helpful in eliminating Internet exports: “To simply say it's not our problem,these are not the words of a helpful partner … . [W]when it comes to the health and safety of theAmerican public, we are reaching out to them in the spirit of cooperation, asking for theirassistance” (Wagner 2004).
low prices in Canada or the price-control system. Canadians are not likely to beable to enjoy low drug prices in Canada and profit from large-scale exports ofdrugs to the U.S. at the same time; Ottawa must make a choice as to which is moredesirable. Indeed, if government chooses to try to profit from re-exportation ofdrugs, Canadians are likely to find that domestic drug prices rise and exportprofits dry up.
It appears that there is a fair probability that Congress will pass laws, and the President sign them, allowing large-scale imports of drugs from Canada. Mostserious would be the Dorgan/Snowe version of drug importation legislation.
There is also a chance that the applications by four pharmacies before theCompetition Tribunal will be successful, which would hamper any manufacturers’effort to control exports into the U.S. If either of these possibilities become reality,then the pharmaceutical companies will be facing increased arbitrage betweenCanada and their retail (and perhaps wholesale) consumers in the U.S; if bothhappen, there will be large-scale arbitrage. This would likely lead the companiesto restrict supply to Canada — possibly leading to shortages — and to push forsubstantial price increases in Canada in order to protect profits in the U.S. IfCanadian drug prices were increased to match U.S. retail prices, the total impacton the health budgets of the provinces would likely be a cost increase of at least 2percent and there would be additional costs for consumers. The upside ofcontinuing to supply U.S. consumers through Canadian pharmacies is, on theother hand, relatively small. To us, this shows that finding a solution to the threatposed by pharmacy exports should be a priority.22 The effects of price increases would be pan-Canadian, rather than being restricted to those provinces where the Internet pharmacy trade operates. As aresult, there is a case for prophylactic federal — not provincial — action to preventprice increases or drug shortages. One reasonable approach would be to amendthe Food and Drug Act to specifically prohibit retail exports of any pharmaceuticalsubject to price review by the PMPRB. If the federal government does not act itcould jeopardize both provincial health care budgets and the health of Canadians.
22 A task force in Health Canada is studying whether Internet exports threaten to cause shortages.
Agovino, T. 2004. “Pfizer Cuts Supplies to Two Canadian Dealers.” Washington Post. February 26.
Anis, Aslam, H. D. Guh and X. Wang. 2001. “A Dog’s Breakfast: Prescription Drug Coverage Varies Widely Across Canada.” Medical Care 39(4):315–26.
Anis, Aslam H. and Q. Wen. 1998. “Price Regulation of Pharmaceuticals in Canada.” Journal of Health Arfwedson, Jacob. 2003. Parallel Trade in Pharmaceuticals. Brussels: Center for the New Europe.
Bill C-9, An Act to Amend the Patent Act and the Food and Drugs Act, House of Commons, First Borrell, Joan Ramon. 2003. “Drug Price Differentials Caused by Formularies and Price Caps.” International Journal of the Economics of Business 10(1):35–48.
Rowland, Christopher. 2004. “Thompson Shifts on Drug Imports.” Boston Globe. May 5.
Calfee, John E. 2003. The Grim Economics of Pharmaceutical Importation. Pamphlet. American Enterprise Canadian Institute for Health Information. 2004. Drug Expenditure in Canada 1985-2002. Available from: ( Accessed March 29,2004.
College of Physicians and Surgeons of Manitoba. 2004. Censures & Inquiry Committee Decisions Inquiry: IC03-10-04. Available from:( Accessed October 12, 2004.
Danzon, Patricia M. and L. W. Chao. 2000. “Cross-National Price Differences for Pharmaceuticals: How Large and Why?” Journal of Health Economics 19(2):159-95.
Danzon, Patricia M. and Michael F. Furukawa. 2003. “Prices and Availability of Pharmaceuticals: Evidence From Nine Countries.” Health Affairs Web Exclusives. Available from:( ). Accessed March 15, 2004.
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Recent C.D. Howe Institute Publications
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The Institute promotes the application of independent research and analysis to major economic and social issues affecting the quality of life of Canadians in all regions of thecountry. It takes a global perspective by considering the impact of international factors onCanada and bringing insights from other jurisdictions to the discussion of Canadian publicpolicy. Policy recommendations in the Institute’s publications are founded on qualityresearch conducted by leading experts and subject to rigorous peer review. The Institutecommunicates clearly the analysis and recommendations arising from its work to thegeneral public, the media, academia, experts, and policymakers.
The Institute began life in 1958 when a group of prominent business and labour leaders organized the Private Planning Association of Canada to research and promote educationalactivities on issues related to public economic and social policy. The PPAC renamed itself theC.D. Howe Research Institute in 1973 following a merger with the C.D. Howe MemorialFoundation, an organization created in 1961 to memorialize the Right Honourable ClarenceDecatur Howe. In 1981, the Institute adopted its current name after the MemorialFoundation again became a separate entity in order to focus its work more directly onmemorializing C.D. Howe. The C.D. Howe Institute will celebrate its 50th Anniversary as thegold standard for public-policy research in 2008.
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The Chairman of the Institute is Guy Savard; Jack M. Mintz is President and Chief C.D. Howe Institute


Appendix 316

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