On July 25, the House passed a bill, H.R. 2427, that allows the importation of price-controlled prescription drugs from 25 other nations, with no certification of their safety. The legislation became part of the Medicare bill passed by the House, which has been sent to a conference committee for reconciliation with a Senate bill that also allows importation.

The bills continue a trend of increased access to price-controlled drugs. Bus trips to Canada, internet purchases from foreign countries, and state laws granting Medicaid prices to non-beneficiaries are fueling this trend. Consumers haven’t seen any reason to complain. To many, it seems unfair that citizens of other countries pay less. Others correctly see the encroachment of price controls as bad for our health. A recent award-winning film can illuminate the problem.

In 2002, A Beautiful Mind was awarded four Oscars, including Best Picture and Best Director. Fans will recall that protagonist John Nash stumbles through Princeton University in the 1940s searching for an original idea that will elevate him to prominence, while succumbing to the onset of schizophrenia. Nash would eventually recover and receive the 1994 Nobel Prize in economics for his contributions to “game theory.”

His original insight was that, in situations where a small number of decision makers have interdependent outcomes, the isolated pursuit of self-interest could bring about unfavorable results. He formulated a solution, now known as the “Nash equilibrium,” under which decision makers cooperatively bargain to achieve the best possible outcome for all parties. A popular illustration of this is the “prisoner’s dilemma.”

Two crime suspects, Bonnie and Clyde, are put into separate jail cells, unable to communicate, and are presented with their options. If Bonnie and Clyde both confess to the crime, they will each be sentenced to five years in prison. If one of the suspects confesses and implicates the other who decides not to confess, the confessor will be sentenced to one year in prison, while the other will receive 10 years. If neither Bonnie nor Clyde confesses, they will be convicted on a lesser charge and each will receive two years in prison.

Since they are kept from communicating, they each must look at their options assuming the other has made a decision. Bonnie sees that, whichever choice Clyde makes, the decision to confess “dominates.” That is, if Clyde confesses, Bonnie will get five years if she confesses and ten years if she doesn’t. If Clyde doesn’t confess, Bonnie will get one year if she confesses and two years if she doesn’t. In either case, Bonnie will get less prison time if she confesses. Clyde faces the same circumstances. As a result, both choose to confess and each is sentenced to five years in prison.

Had they been allowed to communicate, Bonnie and Clyde could have cooperated by agreeing not to confess and each would have received only two years. That’s clearly better for both of them, although it is not the best possible result (a one-year prison sentence) that either of them might have achieved by confessing. Game theory is now being applied to many fields, such as labor relations and international trade. How about the international market for prescription drugs?

Drug manufacturers spend a tremendous amount of money on research and development, including the clinical testing of new drugs for safety and efficacy. The Tufts Center for the Study of Drug Development estimates these fixed costs average $897 million per drug. Once developed, the marginal cost of manufacturing a chemical compound tends to be quite small. So drug companies operate with very high fixed costs but low marginal costs of production. This presents its own dilemma.

Drug companies need to be able to charge prices significantly above the marginal cost of production to recoup their fixed costs and earn a competitive rate of return. Purchasers of drugs, on the other hand, want low prices. In particular, foreign governments that operate nationalized health systems are willing to impose price controls to get below-market prices. Thus, the international market for prescription drugs can be viewed using game theory. To simplify things, let’s say there are only two decision makers, the United States and the Rest of the World, deciding whether to impose price controls on drugs.

They’ve already made initial choices – the rest of the world has chosen price controls, the U.S. has not – but those decisions can be revised. If the U.S. acts unilaterally to adopt price controls, either by imposing or importing them, drug companies will become unprofitable, and research and development on future drugs will be severely compromised. For the rest of the world, especially Europe whose once thriving pharmaceutical sector has been slowly decimated under price controls (but kept alive by the U.S. market), this would mean the end of their free ride and the destruction of their remaining drug industry.

The U.S. has even more to lose. We are the home of most pharmaceutical research and the jobs that come with it. Importing price controls might give us marginally lower prices in the short run, but it would damage the economy, destroy jobs, and wreak havoc with the retirement savings of many Americans. Not least, price controls would bring a halt to the remarkable progress in disease treatment that innovative drugs have provided. For Americans, who expect and demand state-of-the-art drugs for their illnesses, this represents the worst-case scenario.

Today Mr. Nash has access to drugs far more advanced than the ones he took in the 1950s. For instance, Eli Lilly’s Zyprexa, introduced in 1996, is considered a breakthrough drug for schizophrenia. Sales of Zyprexa were $3.7 billion in 2002, fully one-third of Eli Lilly’s $11.1 billion in total revenue for the year. Zyprexa exemplifies the virtuous cycle of the research drug industry: patients are helped by a new and improved drug whose revenues finance research on tomorrow’s drugs.

Price controls represent the biggest threat to that cycle. Clearly, everyone could gain from cooperative behavior. As the controversy over importation demonstrates, the prescription drug market has increasingly come under the umbrella of international trade. Rather than importing international price controls, U.S. trade negotiators should embrace Mr. Nash’s work to find a better equilibrium.

Chris Middleton is the Senior Policy Analyst for Health Care Studies at the Pacific Research Institute in San Francisco. He can be reached via email at cmiddleton@pacificresearch.org