Pfizer's (NYSE:PFE) decision to cut off drug supplies to several Canadian Internet pharmacies and shut down shipments to some Canadian wholesalers marked the newest salvos in the protracted battle over drug prices.

As The Motley Fool's Bill Mann indicated back in 2001, the issue is a major concern for pharma investors. Price controls in Canada mean pharmaceuticals are far cheaper there than in the U.S. Several Canadian Web pharmacies have done a brisk business exporting cheaper drugs back into the U.S. to consumers eager for a price break. Canadian wholesalers, meanwhile, have abetted this process, providing drugs to the Internet pharmacies. For U.S. citizens, importing drugs from abroad is illegal, but the law is rarely enforced, so the transactions have continued largely unchecked.

Pfizer evidently decided it was time to take a stand. In announcing the actions, the firm cited patient safety, evidently referring to the possibility that U.S. consumers could be buying dangerous counterfeit products from the Canadian outfits. While bogus drugs are a serious problem, Pfizer's motivation doubtless had more to do with protecting its business. The flow of cheap drugs from Canada seriously threatens the company, and the pharmaceutical industry as whole, which relies on the high profit margins from selling in the U.S., the world's largest pharmaceutical market and one of the few in which prices are unregulated. Pfizer's actions are some of the most direct to date, but its peers, including AstraZeneca (NYSE:AZN), Wyeth (NYSE:WYE), Eli Lilly (NYSE:LLY), and GlaxoSmithKline (NYSE:GSK), have all worked to closely monitor shipments to Canada, lest excess supplies end up back in the U.S.

These tactics may slow cross-border traffic for now, but they are unlikely to put an end to the controversy. Drug costs remain a hot button issue. Under heavy public pressure, federal and state leaders around the U.S. have voiced support for large-scale importation from Canada. Two senior citizens recently filed a lawsuit in U.S. federal court aimed at overturning federal laws barring the practice. If it were to occur, mass re-importation would essentially act as a de facto price control. For the pharmaceutical business, it would be a disaster.

No solutions in Medicare, biotech
The industry may get some breathing room from the new Medicare drug benefit, scheduled to go into effect in 2006. In the near term, seniors and other eligible citizens will probably willingly turn to the program rather than break the law, and drug makers will enjoy the resulting revenue. But getting in bed with the government has its risks.

Over the long term, the program may actually exacerbate pharma's problem. The new law blocks the government from negotiating with companies for discounts. If drug costs continue to grow at their current rate, the benefit will eventually consume an unacceptably large slice of the federal budget pie. Already, government officials have increased the benefit's likely price tag over 10 years to $534 billion from $395 billion. A future Congress, confronted with a large budget deficit, could be faced with the unpalatable choice of dropping the benefit (unlikely), negotiating discounts, or instituting price controls.

Although it may be tempting to seek a solution to the pricing dilemma in innovative new technologies, there does not appear to be a quick fix in the near term. In fact, the growing biotechnology industry may contribute to the problem. As Alyce Lomax noted, Genentech's (NYSE:DNA) new cancer drug, Avastin -- a biologic drug based on genetically altered human antibodies -- costs a staggering $44,000 per year, per patient.

The reason for the high price partially stems from the nature of the product. Biologics, or large-molecule drugs, often are more complex, fragile, and unstable than synthetic, or small-molecule, drugs produced by the pharmaceutical giants. According to Bio, the biotechnology industry's trade association, the cost of materials for biotech manufacturing is 20 to 100 times that of synthetic drugs. To make up for the higher cost of production, biotech companies have to charge more if they want margins comparable to large pharmaceutical companies.

Price controls inevitable?
If current trends continue, it's not hard to imagine some form of caps. Of course, the U.S. could try to convince Canada, Japan, and Europe to eliminate price controls by arguing that unfettered markets will lower costs for everyone. Europe is currently wrestling with its own drug importation issues, because, although most governments employ controls, prices vary widely from country to country. Given European governments' lack of progress in reforming their welfare states, though, a total rollback seems highly unlikely. A more probable outcome is that the U.S. would adopt a compromise position between its current system and those of other developed countries. Still, any governmental reform would probably involve some erosion in profit margins.

If they hope to stave off government interference, drug makers will have to find their own ways of slowing the growth of prices. One way to make up for lower margins from reduced pricing would be to get more drugs on the market. So far, though, the industry has not been able to appreciably increase its output of approved drugs. In fact, the number of new drugs approved by the Food and Drug Administration declined last year, and the number of totally original drugs (as opposed to new formulations of existing products) has remained essentially flat in recent years, and well below levels in the mid-to-late 1990s.

At the moment, a more feasible approach appears to be to reduce costs. Investors should keep an eye on companies making strides in this regard. Paradoxically, firms facing looming patent expirations now may have a leg up over the long term. Forced to take a hard look at operations and make deep cuts, outfits such as Merck (NYSE:MRK) are learning valuable lessons that will help them preserve margins in the future. Other companies are turning to more outsourcing, and in some cases are handing off entire business functions. For example, last year, Wyeth sealed a deal to outsource its clinical data management to Accenture (NYSE:ACN), while in 2001 AstraZeneca outsourced its IT infrastructure to IBM (NYSE: IBM).

The pharmaceutical industry almost certainly will never turn into a low-margin business like consumer electronics. In the future, though, public pressure and the threat of government meddling may force the drug segment to adopt more cost cutting measures. Years from now, success may depend as much on lean operating procedures as on good drugs.

Fool contributor Brian Gorman is a freelance writer in Chicago, Ill. He does not own shares of any companies mentioned in this article. The Motley Fool is investors writing for investors.