India's role in generic drug production and distribution

India Pharma Mfg

Many Americans have responded to the high prices on U.S. pharmaceuticals by purchasing them from other countries. Several countries have built cottage industries around shipping drugs to the United States. Initially, Canada was a favored country for this, given the reliability of drugs coming from Canada. However, price caps or not Canada still has Western prices for its pharmaceuticals, which has led to buyers searching the world for even lower-cost options, one of which is India. India's drug export market has grown at 24% per year, and now equals $14.7 billion, of which 55% goes to Western markets, the U.S. being the largest of these (Taylor, 2013). The total U.S. pharmaceutical market is $359 billion and is expected to grow to $476 billion by 2020 (PRWeb, 2013). This paper will analyze the impact that Indian pharmaceuticals are expected to have on the U.S. market. This discussion is especially salient given that the U.S. pharmaceutical market is lobbying actively to have more limitations put on Indian drug exports to the United States.

The Structure of the U.S. Drug Market

The U.S. pharmaceutical market is regulated by the Food & Drug Administration. The process has been in place since 1938 and has the objective of balancing the needs of consumers for access to safe drugs with the needs of business to provide a climate in which drugs can be developed (FDA.gov, 2014). The FDA does this by approving drugs for sale, but granting monopoly periods to approved drugs. The monopoly period allows the pharmaceutical company to recoup the cost of the drug development, which can run well over $1 billion. After the monopoly period has ended, the patent is expired and the drug can be marketed by any company. These are known as generic drugs. The structure of the generic drug market has some characteristics of perfect competition, because the product has a very low level of differentiation. It is not pure-form perfect competition because of differences in firm size and because of information asymmetry on the buyer side, but it is closer to that market form than any other because of the lack of differentiation.

Drug Imports

The market for drug imports has become increasingly robust in the past couple of decades. Regulators have wavered on their opposition to drug imports. While the FDA cautions that imported drugs may be unsafe, that is code for "we don't know what the other country's regulatory authority does with respect to safety." Consumers in the U.S. may trust drugs from developed nations like Canada more than from developing nations, but there is good reason to believe that many consumers have high price sensitivity -- possibly out of necessity -- and therefore overlook safety considerations in favor of lower prices. To that end, India has become a favored nation for drug imports. India has a large pharmaceutical industry, and it is also a competitive industry. Production costs are generally low, such that India has absolute competitive advantage over American companies with respect to drug prices. One of the results of the competitive Indian domestic market -- and the lower purchasing power of Indian consumers -- is that Indian drug makers see exports as the key to growth. Several of the top manufacturers in Indian do 80% of their business or more in exports (Taylor, 2013).

Demand for drug imports is driven primarily by high pharmaceutical costs in the U.S. The cost of developing new drugs is high. The U.S. offers a unique combination of strong patent protection for new drugs and no price caps. In many nations where the government is the main payer for drugs, price caps are in place to strike a balance between the public need for drugs and the companies' need to earn profits. In the U.S., the companies face no such restrictions on profits. Predictably, with a monopoly and a high level of information asymmetry (customers know next to nothing about the drugs), pharmaceutical prices in the U.S. are the highest in the world. The following chart shows the comparison between prices in the U.S., UK, Canada, Australia and India.

NAME OF THE DRUG

USA

UK

CANADA

AUSTRALIA

INDIA

Ciprofloxacin 500 mg

6

Gliclazide 80 mg

63.7

53.77

28.39

9.15

3.5

Ibuprofen 600 mg

2.2

0.43

6.76

6.67

0.9

Indomethacin 25 mg

3.63

4.87

9.25

10.85

1.5

Insulin 100 IU/ml

Isosorbide Mononitrate 20 mg

19.82

59.87

41.55

30.51

3.2

Ofloxacin 200 mg

4

Omeprazole 20 mg

91.54

4

Paracetamol 500 mg

12.55

4.43

2

12.98

1

Propanolol 10 ml

61.41

32.33

11.61

6.49

2

Source: Vijaya (2014)

Clearly, even taking into account shipping costs, buying drugs from India is the only logical choice for a rational buyer, or anyone with any sort of price sensitivity.

Patent Protection

Most of India's exports are for generics. India has relatively weak intellectual property rights protections, so pharmaceutical companies may avoid producing patented drugs in India. The country maintains that it has the right to set its own laws with respect to intellectual property rights protections (Baker, 2014). However, the country has come under fire from the U.S. In particular for having its own laws. U.S. industry is engaged in an active fight to gain U.S.-style monopolies around the world, and the competitive threat posed by India has made that country a specific target (Baker, 2014).

However, it should be noted that gaining some global consensus on intellectual property issues is part of several trade negotiations (Halliburton, 2009). Frameworks that have been developed seek to move major nations towards intellectual property rights laws, something that could threaten the Indian pharmaceutical industry, which has built its business model around reverse engineering (Chandran, Roy & Jain, 2005). It is likely that if there is any influence of free trade agreements or changes in regulation due to the application of external pressure, that this will result in tightening of restrictions on Indian pharmaceuticals. However, the nation would still be able to compete with generics.

There are no meaningful barriers to trade in pharmaceuticals, in particular generics. This means that for American consumers, competition is global. Nations can compete based on competitive advantage, and that has opened the door for India to export drugs to the U.S. The practice has become widespread, and there no reason to think that in the generic market in particular the regulatory environment will change. It is simply too easy to get drugs through customs even when there are limits. This competition is not perfect competition, where firms are price takers, but it is close. Firms basically only compete on price, because the product is generic. Those firms -- and nations -- that have a price advantage will win the business. In that sense, the market for generic drugs is no different than the market for plastic garbage cans or wooden spoons. For drug companies accustomed to monopoly pricing on their drugs, such competition is naturally a shock, going from one end of the competition spectrum to the other.

Economic Issues

The implication of such a shift in economic models is fairly obvious. A monopoly is characterized by the ability to increase prices as high as the market will bear. For most drugs under patent, there is very low price elasticity of demand because the benefit they convey is about health, one thing people tend not to put a price tag on. This is combined with very low information, and pharmaceutical companies leverage these information asymmetries to generate very high profits. Appendix A illustrates a typical monopoly market, compared with perfect competition. The graph shows that monopolists profit from constraining output and charging high prices. Now, with drugs demand is driven by medical need, and there is little control that the company has with respect to demand. As a consequence, profits are taken to the maximum effect for whatever the demand is.

Under conditions that approach perfect competition, the producer has no ability to earn monopoly rents on the prices. Under perfect competition, producers are effectively price takers. Because shipping drugs is easy, the market is essentially global in nature. Once the formula is understood, most drugs are relatively cheap to produce. Thus, marginal revenue is going to be quite close to marginal cost. Only a minor level of information asymmetry allows for a small degree of profit-taking among firms competing in the generics industry. American manufacturers have trouble matching production costs of developing nations like India, and therefore are at a competitive disadvantage. Trust in foreign producers is a limiting factor that will keep some demand focused on domestic suppliers, and market knowledge about foreign vendors is also a limiting factor, but these are informational problems that the Indian sellers can overcome in order to increase their market share in the United States.

The expected outcome of increased competition on U.S. producers, therefore, is that prices in the U.S. will drop. This is the normal reaction based on supply and demand. When more producers enter the market, the price of a good is expected to drop. This is especially the case where the product is a commodity, with little or no opportunity for differentiation on any factor other than price. U.S. companies will need to compete with Indian ones on price for generics, or on the mitigating factors noted above. That is one of the reasons why they are looking at legislative remedies rather than confronting Indian companies on the market. The last thing U.S. pharma companies want is to point out to more customers than India is an option, but a quieter, political approach will keep the low information consumers as low information consumers.

It is worth noting that market conditions are equal for all pharmaceutical industries players, both in the U.S. And in India. What this means is that the American pharmaceutical companies are perfectly willing to use India's advantages when it suits their needs. For example, U.S. drug makers are increasingly using India as a research center in order to lower the cost of new drug development (Sandler, 2012).

Furthermore, U.S. manufacturers are able to produce generics in India and import them, leveraging the country's low cost production in that way (Subbu, 2014). Appendix B shows a chart of major pharma companies' finished good trade from India to the U.S. Note that it has been growing rapidly over the past eight years. Where there are trade objections on the part of U.S. companies, they are not based in economics, but rather are thinly-veiled attempts to cut smaller Indian pharmaceutical companies out of the lucrative U.S. market (Subbu, 2014).

Politics

Recent moves by big pharmaceutical companies to keep Indian players out of the U.S. market gained some traction in the U.S. The U.S. International Trade Commission started public hearings in Washington DC as part of its witch hunt against Indian pharmaceutical companies. The hearings were a pretext to impose tariffs on Indian drug imports in an attempt to make them more cost competitive with U.S.-made drugs. Setting aside the ethics of such behavior the economics of this behavior are lousy. Tariffs are an example of a market distortion that creates a deadweight loss. Import duties result in a deadweight loss of about 40 cents on the dollar (Irwin, 2007), and the cost is split between Indian companies, who lose business, and the U.S. consumer.

The U.S. consumer in particular loses when markets are distorted. The monopolies created on drugs in the first place -- and the fact that profits are not regulated within the context of those monopolies -- is a system that accepts deadweight loss as a means of fostering innovation within the pharmaceutical sector. For the most part, that system is at least somewhat understandable, because the nation benefits considerably from the rapid pace of medical advances. However, the deadweight loss from the tariffs has not such positive opportunity associated with it. It is a cost for no particular reason, a wealth transfer from the American consumer to large pharmaceutical companies. Without even taking into consideration the target market for Indian pharmaceuticals, such a transfer at deadweight loss makes no economic sense. The social cost, of course, is something that would be considered at the political level -- when someone who would otherwise demand drugs no longer does so because he/she cannot afford them, the need for those drugs does not go away.

Analysis

From an economic perspective, competitive markets are preferred. They have the highest level of efficiency, meaning that demand and production are likely to be in equilibrium. Market distortions, in particular those caused by government policy, are detrimental to market efficiency. They result in deadweight loss. In particular, consumers pay more for drugs, and pharmaceutical companies produce less than they otherwise would. There is an implicit understanding in America that patent protection that seeks to foster innovation has a positive benefit, despite its obvious economic distortions.

India's trade in pharmaceuticals with the U.S. is almost entirely in generics. Some major drugmakers argue that this trade is detrimental, that Indian drugs represent unfair competition. This is not the case, but nevertheless it is possible that there will be trade barriers put into place on these drugs. This, of course, will create deadweight loss, and a transfer of wealth from consumers to the large pharmaceutical companies. Is it worth it? To answer that, we must have a sense of what these imports do to U.S. pharmaceutical companies. With any generic, there is going to be competition in the market. The trouble for U.S. manufacturers is that their factor inputs, especially labor, are far more expensive than their Indian equivalents. India has absolute competitive advantage in cost. In theory, all generics sold in the U.S. would be made in India, but this is not the case. Despite increasing importation in recent years, many consumers are not aware of the Indian option, are not allowed to buy drugs from India under their plans, or are skeptical of the quality of Indian drugs. The result is that, based on last year's figures, no more than $8 billion of the U.S. pharma market came from India (and the figure is probably quite a bit less, since that represents all of the Western world). This represents 2.2% of the total U.S. drug market.