Glaxo undoubtedly earns profits from selling its drugs at Canadian prices, or it wouldn't sell in Canada. It can sell at lower prices in Canada because manufacturing and distribution costs of a patented drug are a small fraction of its price. Most of the cost is sunk in research and development. If Glaxo's prevailing American price for a pill is $1, and it costs a dime to manufacture, there's no reason for Glaxo not to sell it for a quarter to those who cannot pay a dollar for it.

Glaxo recently teamed up with some of its competitors to offer a card that provides discounts of up to 40% to Americans who earn less than $28,000. Unfortunately, since 1990, U.S. law has demanded that drugmakers treat Medicaid as a most-favored-customer, which means that no buyer can get a better price than the government. Glaxo and Bristol-Myers Squibb, a partner in the discount card program, reduced discounts to low income buyers last October because they feared the government might use those prices as a pretext to demand bigger discounts for itself.

That's not likely to happen any time soon. In the meantime, U.S. laws that encourage buying drugs via Canada, or demand the same price in the U.S. as Canada, will cause the opposite of what they intend. As Glaxo's action forebodes, the single price will be a high price, not a low price.

Copyright Dow Jones & Company Inc Feb 28, 2003

GlaxoSmithKline, the world's second largest pharmaceutical manufacturer, has announced that it is cutting off supplies to Canadian pharmacies that deliver to American patients. This has angered seniors groups in the U.S. because buying via Canada -- where pharmaceutical companies price many patented drugs significantly lower than in the U.S. -- has become their preferred way to get prescriptions filled.

These well-funded gray panthers have launched a boycott against the company's over-the-counter drugs, called "Tums Down" -- a play on the name of the company's popular antacid. Not surprisingly, politicians on both sides of the border have jumped into the fray. MaryAnn Mihychuck, Industry Minister for Manitoba province, where the leading mail order pharmacies are based, figures that Glaxo's action violates the North American Free Trade Agreement.

Senator Mark Dayton of Minnesota, who encourages his constituents to buy drugs from Canada, has also attacked Glaxo's action. Rep. Bernard Sanders of Vermont accuses Glaxo of cutting off medicines for needy Americans.

This is good, solid populism but it doesn't get at the problem. To do that, politicians would have to acknowledge that their own initiatives have worsened the prescription drug pricing mess by interfering with the natural economics of the pharmaceutical industry. Restoring free market prices would do more for needy patients than political grandstanding will.

Ms. Mihychuck's argument is easily dismissed. Free trade is about reducing governments' ability to prevent voluntary international exchanges. It is not about giving governments power to destroy distribution channels and forcing a manufacturer to compete with itself when it ships goods across borders.

The American politicians appear to have a better case. What can justify squelching this market that satisfies U.S. patients who cannot afford to pay south-of-the-border prices?

Glaxo undoubtedly earns profits from selling its drugs at Canadian prices, or it wouldn't sell in Canada. It can sell at lower prices in Canada because manufacturing and distribution costs of a patented drug are a small fraction of its price. Most of the cost is sunk in research and development. If Glaxo's prevailing American price for a pill is $1, and it costs a dime to manufacture, there's no reason for Glaxo not to sell it for a quarter to those who cannot pay a dollar for it.

There should be no reason for the company not to sell to needy Americans at lower prices, too, as long as it can separate them from the majority who can pay prevailing U.S. prices. Glaxo's decision is really driven by an inability to make that distinction. Extrapolating the current trends, companies fear that American consumers, regardless of income levels will find it increasingly easy to purchase drugs in the gray market via Canada. If that were to happen, profit margins and research budgets would be squeezed.

Differential pricing is a win-win and could be practiced in both countries if drug markets were free. Drugmakers would gladly charge lower prices to patients of lesser means, rather than lose those sales altogether. However, they must be able to enforce this market segmentation and price as they see fit. One way to do that in the U.S. through a proprietary discount card program. While these programs exist they do not operate unencumbered from the U.S. government. As a result drug prices for those least able to afford them remain stubbornly high.

Glaxo recently teamed up with some of its competitors to offer a card that provides discounts of up to 40% to Americans who earn less than $28,000. Unfortunately, since 1990, U.S. law has demanded that drugmakers treat Medicaid as a most-favored-customer, which means that no buyer can get a better price than the government. Glaxo and Bristol-Myers Squibb, a partner in the discount card program, reduced discounts to low income buyers last October because they feared the government might use those prices as a pretext to demand bigger discounts for itself.

Although Washington gave the drug companies assurances that it would not do so (on a technicality), the drugmakers have legitimate concerns that further political intervention will prevent selective discounting based on patients' means and increase activity in cross-border buying. In Maine and Ohio, state legislators who are designing state drug-benefit programs are calling for "Canadian" drug prices for all of their residents, whether or not they receive public assistance.

Canadians are less wealthy than Americans today and drug companies have responded to this market segmentation by pricing lower in the poorer country. But it is also true that Canadian politicians could make everyone better off by freeing Canadian prices and letting companies segment there as well. That way rich Canadians would pay their fare share of research instead of free-riding.

But that's not likely to happen any time soon. In the meantime, U.S. laws that encourage buying drugs via Canada, or demand the same price in the U.S. as Canada, will cause the opposite of what they intend. As Glaxo's action forebodes, the single price will be a high price, not a low price.

Drugmakers will not allow uncontrolled shipments from Canada's prescription drug market, which is 5% percent of the size of the U.S. market, to erode its American margins. Nor will they allow American politicians to use international price comparisons to fix U.S. prices. To do so would have catastrophic consequences for their profits, and ability to continue research. If forced to protect their most lucrative market, they are more likely to raise prices north of the border, or stop supplying Canada, (especially with newer drugs), in order to deal with the problem.

Glaxo's pre-emptive strike against abusive buying practices invites lawmakers to reconsider their actions. Instead, politicians on both sides of the border should stop interfering in the market for prescription drugs, and allow manufacturers to set differentiated prices that allow them to satisfy the needs of all patients.

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Mr. Graham is director of pharmaceutical policy research at the Fraser Institute in Vancouver.