Patents are temporary monopolies granted by governments to encourage innovation. They do so by allowing patent-holders to charge monopoly prices, which are higher than competitive prices, and thus to benefit from the innovations they have made. The promise of financial reward for successful innovation is designed to keep the stream of innovation flowing.
That solves one problem — without an articficial monopoly, it would be hard to profit from an easily-copied innovation, and thus profit-maximizing firms wouldn’t do much of it — at the expense of creating another. Monopoly pricing is inefficient because there are always some consumers who would happily buy the good at its competitive price who won’t buy it at its monopoly price, and their forgone consumers’ surpluses are pure waste.
There is no theoretically optimal solution to this problem. If a good has the central characteristic of what economists (confusingly to the rest of us) call public goods (being non-rival in consumption, which is to say that my using it doesn’t leave any less of it around for you to use), then there is no pricing rule that both provides the right amount of incentive to produce it and efficient consumer decisions about how much of the good to consume.
In the case of pharmaceuticals, the lost consumers’ surpluses are especially heart-rending, amount in some cases to lost lives. (In addition, there are utility losses from the unequal incidence of what amounts to a tax on having certain diseases.) It might be better to replace the patent/monopoly system with a system of prizes for desired innovation, but any such system poses complicated administrative problems. A single-payer system of health care finance, including pharmaceuticals, would shift the locus of policy decision and reduce the financial impact on consumers, but at the risk of either allowing drug companies to price-gouge without limit or having to introduce pricing regulation.
In Canada, where market conditions are different due to a different health-care-finance environment, drug companies typically charge lower prices than they charge for the same drugs in the United States. That creates an opportunity for consumer arbitrage: consumers either physically go to Canada to buy drugs or buy them by phone, mail, or internet from Canadian pharmacies.
That creates a policy problem for the U.S.: should such arbitrage be allowed? It’s a complicated problem. Arbitrage via cross-border purchase will reduce the value of patent-based drug monopolies, thus reducing the incentive to innovate, thus costing future lives and increasing future suffering. The U.S. market is so large compared to the Canadian market that some firms will raise their Canadian prices if arbitrage is permitted, thus making Canadians worse off without making Americans better off.
Right now, the Food and Drug Administration, using its authority to regulate drug safety, prevents most of the cross-border retail pharmaceutical trade. The safety concerns are almost entirely bogus as applied to Canada, though perhaps less so when applied to Mexico.
No doubt, the politicians who are campaigning to permit pharmaceutical arbitrage are demagoging the issue by failing to mention the impact on innovation. But at least the argument they make — that allowing arbitrage would reduce prices to consumers — is more or less correct, and actually expresses their goal. The politicians who oppose arbitrage, by contrast — including the Bush Administration — largely try to hide behind the “safety” fig-leaf. That’s an insult to the intelligence of the voters.