The Pharmaceutical Industry

Chapter25
THE PHARMACEUTICAL INDUSTRY*
F.M. SCHERER
HarvardUniversity
Contents
Abstract 1298
1. Introduction 1299
2. Distinguishing characteristics 1300
3. Pharmaceutical industry structure 1303
4. Research, development, and the discovery of new drugs 1305
5. Government regulation of new drug introductions 1308
6. Patents and pharmaceutical innovation 1316
6.1. The unusual importance of drug patents 1317
6.2. Consequences of the Uruguay Round agreement 1318
7. Pricing 1319
7.1. Pricing branded drugs 1320
7.2. Tort liability risks and prices 1320
7.3. Generic drug competition 1321
7.4. Branded vs. generic drug price competition 1322
7.5. Stimulating generic substitution 1324
7.6. New institutions; New power relationships 1325
8. Profits and price controls 1328
9. Conclusion 1331
References 1332
*The author thanks Ernst Berndt, Randall Ellis, and Joseph Newhouse for helpful comments.
Handbook of Health Economics, Volume 1, Edited by A.J. Culyer and J.P Newhouse
© 2000 Elsevier Science B. V All rights reserved
1298 EM. Scherer
Abstract
This Handbook chapter surveys the extensive body of research on the economics of
the pharmaceutical industry (with peripheral attention paid also to regulated medical
devices). Pharmaceuticals is one of the world's most research-intensive industries, gen-
erating a continuing steam of new products that save lives and raise the quality of life.
The discovery of new drugs has evolved over time from a decidedly empirical process
to one based to a considerable degree upon fundamental scientific knowledge. Rich
linkages have emerged between profit-seeking manufacturers and basic research per-
formers such as universities and national laboratories. The safety and efficacy of new
pharmaceutical products are stringently regulated in most industrialized nations, adding
to clinical testing costs. Because of high expenditures on research, development, and
clinical testing and because new products, once proven, might be imitated easily, patent
protection is unusually important. The extension of patent protection to third-world na-
tions under Uruguay Round Treaty mandates has precipitated vigorous policy debates.
Patents, first-mover advantages, and the lack of good substitutes for significant new
drugs often give rise to substantial monopoly power, against which many national gov-
ernments have counterpoised a diverse panoply of price control mechanisms. When
patents expire, however, generic substitutes often introduce vigorous price competition.
The extent to which generics capture market share from the branded original drugs de-
pends upon government regulatory policies, the reimbursement strategies of health care
insurers, and the organization of health care provider institutions.
JEL classification:Ill, L5, L65, 031, 034

Ch. 25: The PharmaceuticalIndustry 1299
1. Introduction
This chapter analyzes the supply of important inputs into the provision of health care -
notably, medicines, vaccines, and other drugs, which will be called "pharmaceuticals"
here. Because their supply is affected in analogous ways by regulatory institutions and
changes in technology, passing attention will also be devoted to medical devices such
as pacemakers, arterial grafts, prosthetics, and the like.
Pharmaceutical products account for sizeable but widely varying proportions of to-
tal expenditures on health care in the world's industrialized nations. In 1993 or 1994,
for instance, their share of total health care spending was 8.3 percent in the United
States, 15.4 percent in France, 18.5 percent in Germany, and approximately 29 per-
cent in Japan [PhRMA (1997, p. 48) and Neary (1995, p. 22)]. Some reasons for the
observed differences will emerge as our analysis proceeds. Variations in income levels
and national health care institutions lead to even larger differences in average annual ex-
penditures per capita on pharmaceutical products among the world's principal regions,
as the following United Nations staff estimates for 1990 (calculated in 1980 U.S. dollars
at prevailing exchange rates) indicate1:
North America $123.90
European Community 102.90
Other Western Europe 85.70
Japan 276.60
South and East Asia 5.00
China 4.80
Latin America 20.30
Sub-Saharan Africa 3.30
The boundaries delineating the pharmaceuticals industry, as it will be analyzed here,

are imprecise. An indication of the principal components is provided by U.S. Bureau of
the Census data (1997) on the sales (in millions of dollars) of domestic manufacturers
in diverse categories for 1995:
Finished pharmaceutical preparations
for human use 48,066
Vaccines and other biological products
for human use 4,986
Blood and blood derivatives for human use 1,624
Diagnostic products (used in vivo and in vitro) 8,271
Pharmaceutical and biological preparations
for veterinary and industrial use 2,601
Bulk medicinal and botanical products
(many used as inputs to other sectors) 7,111
The source is Ballance et al. (1992, pp. 30-31). Herbal and other naturally occurring traditional medicines
are excluded from the estimates. For 1995 estimates based upon purchasing power parity rather than prevailing
exchange rates, and showing France in the lead followed by the United States and Japan, see PhRMA (1998,
p. 75).
1300 FM. Scherer
The first category will be emphasized here, although peripheral attention will be de-
voted to analogous products. Manufactured products other than pharmaceuticals and
biologicals used primarily in health care had the following U.S. sales at wholesale (in
millions of dollars) during 1995:
Surgical, orthopedic, prosthetic, and therapeutic
appliances and supplies 10,566
Other surgical appliances and supplies 964
Electronic hearing aids 476
Surgical and medical instruments and apparatus 14,285
Dental equipment and supplies 2,117
Electromedical diagnostic and therapeutic equipment 6,852
Ophthalmic goods (including eyeglasses) 2,715
2. Distinguishing characteristics
The pharmaceuticals industry has a number of characteristics differentiating it from

most industries serving demands outside the health sector.
For one, pharmaceutical products can often be obtained legally only when the con-
sumer presents a prescription from a physician. Consumers in effect cede an important
decision-making role to physicians, who include in their decision calculus professional
responsibilities and malpractice liability risks and who, usually incurring no obligation
to pay for the consumer's purchase, may serve as imperfect agents for the consumer.
The prescription system is much more prevalent in industrialized nations than in de-
veloping nations [see Peltzman (1987)]. Its mandatory extension in the United States
to a wide range of new pharmaceutical products occurred through regulatory agency
action in 1938 without a clearly focused Congressional debate [Temin (1979a)]. Un-
der U.S. regulations, paralleled by those of many other nations, a distinction is made
between prescription drugs, which require a physician's intervention and which can be
purchased for out-patient use only from licensed pharmacists, and "over the counter" or
"proprietary" drugs, which can be obtained without prescription from a broader array
of retail outlets. In the United States, prescriptions are normally required for new drugs,
but chemical entities shown by substantial experience to have minimal toxicity risks and
whose use (often at less intense dosage levels) does not require the advice of a physician
can be accorded over-the-counter status. See Schachtel (1994) and Weintraub (1994).
Since 1972, many drugs such as acetaminophen, ibuprofen, numerous antihistamines,
the four leading anti-ulcer agents (Tagamet, Zantac, Pepcid, and Axid) and diverse top-
ical antibiotics and steroids have been shifted to OTC status in the United States. The
share of OTC drugs in sales of all U.S. pharmaceutical entities for 1988 was estimated
to be 23 percent [Ballance et al. (1992, p. 35)]. Comparable estimates for twelve other
nations ranged from six percent (for Italy) to 42 percent (for Saudi Arabia), with an
unweighted mean of 18 percent.
Second, consumers' purchases of prescription drugs, like their purchases of health
care services, are often reimbursed in whole or in part by insurance. As other contri-
butions in this volume analyze more fully, with insurance a wedge intrudes between
the demand curve derived from consumers' income and the full price paid and the
(higher) demand curve reflecting quantities consumed at prices net of insurance pay-
ments. This divergence of demand functions leads to reduced demand elasticity and
increased purchase of the insured item. See, e.g., Leibowitz et al. (1985) and Newhouse
(1993, pp. 165-171). Western European nations have tended to provide more generous
insurance coverage of pharmaceutical product purchases than the United States. How-
ever, convergence has been occurring. In the U.S., the share of outpatient drug costs
paid for out-of-pocket by consumers fell from 82.4 percent in 1970 to 33.9 percent in
1995, largely as a result of expanded private health insurance coverage. See PhRMA
(1998, p. 51) and U.S. Office of Technology Assessment (1993, pp. 238-263). Mean-
while consumers' payment shares have been rising in Europe as government health
authorities struggled to combat ever-rising costs by requiring substantially increased
co-payments. Gone, it is fair to say, are the days the author experienced in Germany
during the early 1970s when most consumers obtained prescriptions even for common
aspirin so that their health insurance would bear the cost.
Even if their outlays are not reimbursed by insurance, consumers, and especially
affluent consumers in industrialized nations, are willing to pay a considerable price to
combat a painful and debilitating infection, reduce the risk of a heart attack, alleviate the
pain of arthritis and muscle tears, or soothe the tensions of a neurotic world. What this
means, and especially when decision-making by physicians (which constricts substitu-
tion opportunities) and reimbursement by insurers are factored in, is that the demand for
many drug products is fairly inelastic up to rather high price levels before income effects
begin imparting appreciable elasticity. For instance, Berndt et al. (1995) estimated the
demand elasticity for H2 -antagonist anti-ulcer drugs as a group at -0.69 and for indi-
vidual molecular variants in the range of -0.74 to -1.03. See also (on cephalosporins)
Ellison et al. (1997).
These demand-side characteristics interact with the presence of monopoly power on
the supply side to support prices that commonly exceed drug production costs by a sub-
stantial margin. The newest ethical drugs are covered in many nations by patents, which
may limit the supply alternatives for a given chemical entity to a single firm. Even
when multiple alternatives exist, consumers' limited knowledge of efficacious substi-
tutes and insulation of decision-making physicians from the need to pay for the drugs
they prescribe can lead to the persistence of high prices for well-established pharmaceu-
tical products. Where MC is marginal cost, P the product price, and ep is the absolute
value of the price elasticity of demand, a monopolist will maximize its profits by set-
ting a price such that the price-cost margin (P - MC)/P = 1/ep. Thus, prices will be
raised until demand becomes price-elastic. This condition is inconsistent with evidence
of price elasticities below unity, but can be readily reconciled with low observed elas-
ticities if the producers of substitute drugs engage in price-eroding oligopolistic rivalry,
or if they exercise restraint to deter rival entry or avoid possibly adverse public rela-
tions repercussions from high prices. See Scherer and Ross (1990, pp. 227-229 and
Chapter 10).
1302 EM. Scherer
Using Census data, one can approximate the price-cost margins industries realize by
computing
sales - materials purchase costs - in-plant payroll costs

sales
See Scherer and Ross (1990, pp. 418-419). Such estimates are probably downward-
biased, since some payroll costs may be fixed and hence not part of true marginal cost.
Among 459 four-digit manufacturing industries covered by the U.S. Census in 1987,
pharmaceuticals (SIC 2834) had the sixth-highest price/cost margin at 61.4 percent; the
average for all manufacturing industries was 30.5 percent. 2 Public perception that drug
prices are set monopolistically has triggered numerous governmental interventions into
price-setting and other aspects of pharmaceutical marketing. See Comanor (1986) and
U.S. Office of Technology Assessment (1993). This is a subject to which we return later.
Patents are significant in part because the pharmaceutical industry is extraordinar-
ily dynamic technologically. Among the roughly 230 narrowly-defined U.S. industries
for which comparable data have been collected, pharmaceuticals has for at least two
decades devoted the largest fraction of its sales receipts to research and development
[U.S. Federal Trade Commission (1985, p. 31)]. The intensity with which it pursues
research has been rising over time. In 1975, companies with membership in the Phar-
maceutical Research and Manufacturers of America association had a weighted average
R&D/sales ratio of 11.6 percent in their ethical drug divisions; by 1995, the comparable
average was 19.4 percent [PhRlMIA (1997, p. 12)].3
From the industry's R&D efforts has emerged a stream of new pharmaceutical prod-
ucts, some of which have made significant contributions to the quality of health care.
Many afflictions that once were untreatable or even fatal can now be combatted with
routine success through drug therapy. From an analysis of matched U.S. prescription and
hospitalization records for the years 1980 and 1992, Frank Lichtenberg (1996) found
that a $1 increase on the purchase of pharmaceuticals was associated on average with
a $3.65 reduction in hospitalization expenditures. Innovative drugs had a particularly
marked impact in reducing hospitalization costs. A subsequent statistical investigation
by Lichtenberg (1998) revealed significant life-extending effects from the introduction
of important new drugs.
Product differentiation, which affects the drug makers' discretion in setting prices,
has been enhanced by vigorous marketing efforts. Under the so-called Dorfman-Steiner
2 Industries with higher PCMs than pharmaceuticals were cigarettes (67.6 percent), breakfast cereals, soft
drinks, cosmetics and toilet preparations, and chewing and smoking tobacco.
3 Company divisions selling over-the-counter drugs are much less R&D-intensive. In 1977, the latest year
for which comprehensive disaggregated data are available, among companies providing breakdowns for the
Federal Trade Commission's Line of Business reporting program (1985, p. 31), the average R&D/sales ratio
for prescription drug operations was 10.2 percent, but only 2.9 percent for over-the-counter drug operations. In
the surgical and medical instruments category, 1977 R&D outlays were 3.8 percent of sales. The median ratio
for 230 reporting lines of business spanning virtually all of the U.S. manufacturing sector was 1.0 percent.
theorem [Dorfman and Steiner (1954)], a profit-maximizing firm will seek a ratio
of advertising (or other promotional activity) to sales that satisfies the relationship
(A/S) = ea[(P - MC)/P], where A is the amount of advertising, S is sales volume,
(P - MC)/P is the price-cost margin explained earlier, and ea is the advertising elas-
ticity of demand. 4 Because price-cost margins are relatively high in pharmaceuticals
and because physicians and consumers are responsive to promotional activity, 5 appre-
ciable resources are devoted to it. Nevertheless, one finds here striking differences be-
tween prescription and over-the-counter drug sales and also among nations. Tradition-
ally, prescription drugs were sold in the United States primarily through "detailing"
- that is, through one-on-one encounters between drug makers' field sales representa-
tives and individual physicians. Advertising was confined largely to medical profession
journals. However, during the 1990s, and especially after regulatory changes in 1997,
companies attempted to cultivate end-consumer demand for their prescription products
through advertising in general readership publications. Such direct-to-consumer adver-
tising, which in the United States reached $1 billion during 1998, is prohibited by law in
most European nations.6 For over-the-counter drugs, the emphasis both in Europe and
the United States is strongly on advertising, and especially (in recent decades) on televi-
sion advertising. In 1977, OTC sellers in the United States devoted 20.2 percent of their
sales receipts to media advertising - the highest such ratio recorded in 225 reporting
industries [U.S. Federal Trade Commission (1985, p. 31)]. The corresponding media
advertising figure for prescription drug vendors was 4.0 percent (28th in rank among
225 industries). Combining outlays on media advertising and other forms of sales pro-
motion (including detailing, distribution of free samples, and in-store displays), total
selling costs in 1977 were 35.6 percent of sales for over-the-counter drug providers and
19.4 percent of sales in prescription drug operations. Total prescription drug advertising
and promotion outlays in the U.S. market during 1997 were estimated to be $12 billion,
or 18 percent of ethical drug sales [Zuger (1997)].
3. Pharmaceutical industry structure
The term "pharmaceutical industry" as used here will refer to the collection of com-
panies that manufacture ethical and over-the-counter drugs. Still one must recognize
that other actors are involved in significant ways - notably, the retail pharmacies from
which consumers purchase drugs taken outside health care institutions, the health care
4 That is, the percentage by which the quantity demanded shifts for a given percentage change in advertising
(or other promotional activity).
5 For estimates of elasticities for "detailing" and two kinds of advertising, see Berndt et al. (1995, p. 103).
Price elasticities may in turn be reduced by advertising. See Rizzo (1997).
6 See "Pill pushers", The Economist, August 9, 1997, pp. 58-59, and "Go on, it's good for you", The
Economist, August 8, 1998, pp. 51-52.
1304 EM. Scherer
institutions administering in-patient medications, and the wholesalers linking manufac-

turers with "downstream" outlets. In 1995, members of the Pharmaceutical Research
and Manufacturers of America made 78.9 percent of their ethical drug sales in the first
instance to wholesalers, 12.1 percent directly to retailers, 4.8 percent to hospitals (who
dispensed 14.3 percent of total prescription drugs by dollar value, securing the balance
of their supplies from wholesalers), and 4.2 percent to other institutions [PhRMA (1997,
pp. 30-31)]. Traditionally, retailers in the United States realized a 40 percent gross mar-
gin on the prescription drugs they sold to consumers, which meant that of the average
dollar spent by a consumer in 1966, 40 cents went to the retail pharmacist to cover op-
erating costs and profit, nine cents to wholesalers, and 51 cents to manufacturers. Task
Force on Prescription Drugs (1968, pp. 54-55). To defend their margins, retail pharma-
cists were among the strongest supporters of resale price maintenance - i.e., the fixing
by manufacturers of minimum prices below which their retailers could not sell. 7 See
Scherer (1997). Partly because the support in U.S. law for resale price maintenance was
eliminated in 1975, but even more because of events analyzed in a later section, these
relationships changed dramatically during the 1980s and 1990s, squeezing the relative
gross margins of retailers and wholesalers. Over the same period, chain outlets displaced
approximately 15,000 independent retail pharmacies.
The manufacturers of drugs, both ethical and OTC, are a diverse lot. The U.S. Census
Bureau (1992) reported 640 companies to be operating in the "pharmaceutical prepa-
rations" industry (SIC 2834) during 1987. The leading eight companies accounted for
36 percent of total industry sales; the leading 20 companies for 65 percent. Since the
early 1980s the U.S. industry has been augmented by hundreds of companies formed to
pursue opportunities opened up by the advance of biological science. By the mid-1990s,
only a dozen or so of these drug-oriented biotechnology companies had progressed to
the point of marketing profitable products.
Most of the U.S. pharmaceutical manufacturing leaders are multinational enterprises
(MNEs), operating not only in the United States but in many other nations. Incentives
to take advantage of unique and exclusive product franchises by making sales through-
out the world are so strong that pharmaceuticals is one of the most multinational of
industries. Markets outside a pharmaceutical maker's home territory are penetrated by
exporting, through the establishment of production facilities overseas, or through li-
censing of products to companies with already-existing sales channels and regulatory
relationships. According to United Nations estimates, pharmaceutical imports averaged
8.2 percent of domestic consumption during 1989 in developed nations and 19.8 per-
cent in less-developed nations [Ballance et al. (1992, p. 52)]. In 1980, approximately
27 percent of the world's pharmaceutical demand was satisfied through local production
by foreign-owned companies [Ballance et al. (1992, pp. 68-78)]. The extent of MNE
7 In some continental European nations, retail pharmacies are effectively cartelized, among other things
enjoying governmental protection against the formation of retail drug chains or the entry of nearby competing
pharmacies unless specified population density thresholds are exceeded.
operation is believed to have increased since then. In 1995, members of the Pharma-
ceutical Research and Manufacturers of America recorded ethical drug sales of $65 bil-
lion within the United States and $37 billion outside the United States [PhRMA (1998,
p. 100)].
The multinationality of leading pharmaceutical manufacturers increased during the
1980s and 1990s in part through mergers. Among the mergers that joined sizeable com-
panies with disparate national home bases were the following (with the acquiring firm
listed first):
Beecham (U.K.) - SmithKline Beckman (U.S.) 1989
Rhone-Poulenc (France) - Rorer (U.S.) 1990
Hoffmann LaRoche (Switzerland) - tGenentech (U.S.) 1990
Hoechst (Germany) - Copley (U.S.) 1993
Hoffmann LaRoche (Switzerland) - Syntex (U.S.) 1994
Bayer (Germany) - Sterling Drug (part) (U.S.) 1994
Hoechst-Roussel (Germany) - Marion Merrell Dow (U.S.) 1995
Pharmacia (Sweden) - Upjohn (U.S.) 1995
Hoffmann LaRoche (Switzerland) - Boehringer Mannheim (Germany) 1997
Other mergers linked companies of considerable scale with home bases in the same
nation. These included the fusion of two leading Swiss firms, Ciba-Geigy and Sandoz,
to form Novartis in 1996; the merger of two leading British companies, Glaxo and Bur-
roughs Wellcome, in 1996; and, in the United States, the 1989 merger of Bristol-Myers
with Squibb, and the 1994 acquisition of American Cyanamid by American Home Prod-
ucts. Altogether, pharmaceutical company acquisitions valued at well over $200 billion
occurred between 1989 and 1998. In wholesaling too, a merger wave shrank the number
of companies until the leading four firms accounted for 80 percent of U.S. wholesaling
activity. Attempts by the four leading wholesalers to merge down to two entities were
blocked in 1998 by antitrust action. 8 A significant motive for the merger wave among
drug manufacturers was the desire of companies to pool their research and development
project portfolios, yielding cross-fertilization of specialized know-how and hoped-for
risk hedging. On the former, see Henderson and Cockburn (1996).
4. Research, development, and the discovery of new drugs9

Research and the development of new and improved products play a central role in the
activities of modem pharmaceutical enterprises. This was not always so. There have
been several revolutions in the way new drug products are created. See, e.g., Schwartz-
man (1976, Chapter 2), Cooper (1970), and Temin (1979b).
As late as the 1930s, the use of scientific methods to develop new medications was
rare. Millennia of experience had identified naturally occurring substances with ther-
apeutic properties. Co-existing with genuinely efficacious medicines were numerous
8 "Judge rejects two separate drug mergers", New York Times, August 1,1998, p. B1.
9 Substantial parts of this section are adapted from Scherer (1996, pp. 343-346).
1306 FM.Scherer
quack medicines. Retail pharmacies' shelves were lined with bottles containing organic
and inorganic chemicals compounded on the spot to satisfy physicians' prescriptions or
patients' pleas for the druggist's own preferred recipe. Until 1938, prescriptions were
required in the United States only to obtain narcotic substances.
The synthesis of aspirin marked one of the first breakthroughs in the use of modem
chemistry for medicinal purposes. See Mann and Plummer (1991). A substance from the
bark of the white willow tree had long been used to relieve fever and pain. By the 1830s
German and French chemists had extracted its active ingredient and derived from it
salicylic acid. But salicylic acid caused ulcers and other gastric problems. Seeking new
markets for by-products of the synthetic organic dyes upon which its growth was based,
the Bayer company of Germany established in 1896 a laboratory devoted to creating
and testing dyestuff derivatives for medicinal effects. Early work led to the synthesis of
acetylsalicylic acid, which it named "Aspirin" (a trademark that even a century later can
be used in Germany only by Bayer) and sold with great success.
In the early years of the 20th Century a German professor, Paul Ehrlich, formulated a
conception of how small organic molecules interacted with proteins in the human body
as keys do with locks. Ehrlich found many new chemicals with useful therapeutic ef-
fects, including Salvarsan, the first drug effective against previously incurable syphilis.
Later research at the laboratory of Bayer's merged successor, I.G. Farben, led in 1935
to the discovery of a red dye derivative, sulfanilamide, that combatted lethal streptococ-
cal infections. Numerous sulfa drug variants were subsequently synthesized and tested,
leading to safer anti-infectives and the discovery of drugs with diuretic (blood pressure-
reducing) properties.
The antibacterial properties of a naturally occurring mold, penicillium notatum, were
first observed accidentally in 1929 by Alexander Fleming in England. Fleming failed to
follow through, but penicillin's therapeutic properties were identified by Howard Florey
and Emest Chain at Oxford University in time for that first antibiotic to play a life-
saving role in treating World War II casualties. Mass production methods using corn
steep liquor as a fennentation medium were devised at a U.S. Department of Agricul-
ture laboratory. Twenty U.S. companies participated in the top-priority wartime peni-
cillin production program. When the war ended, intense price competition among those
companies drove the wholesale price of penicillin in 300,000-unit doses from $3 in 1945
to $1 in 1948 and 10 cents in 1953. See U.S. Federal Trade Commission (1958).
The therapeutic success of penicillin suggested to Selman Waksman of Rutgers Uni-
versity that other naturally occurring spores might have antibiotic effects. By screening
and testing numerous soil samples during the early 1940s, he made two important dis-
coveries: a specific new antibiotic, streptomycin, and even more important, a systematic
method for finding new medicinal substances. Waksman insisted that the patent he ob-
tained on his purified form of streptomycin be licensed to all interested parties, and as
a result, the penicillin price competition experience was repeated, leaving the average
producer with negative profits.
Nevertheless, traditional pharmaceutical companies found in Waksman's methodol-
ogy a potent means of discovering new therapeutic entities on which they might obtain
exclusive patent rights. Several new broad-spectrum antibiotics - Aureomycin (chlor-

tetracycline), Chloromycetin (chloramphenicol), oxytetracycline, and tetracycline - fol-
lowed between 1948 and 1953. Each was patented, each was sold at prices high in rela-
tion to its production costs, and each proved to be very profitable for its suppliers. The
lure of high profits in turn induced many other firms to try their hand at the game. U.S.
pharmaceutical company R&D outlays (at constant 1990 price levels) rose from roughly
$263 million in 1951 to $1.7 billion in 1967, $3.1 billion in 1980, and $8 billion in 1990.
With few exceptions, the industry's approach to research and development during
this period entailed testing for therapeutic effects large numbers of newly synthesized
molecules (following the Ehrlich model) or naturally occurring substances (the Waks-
man model). In 1970 alone, U.S. pharmaceutical manufacturers are said to have con-
ducted more than 700,000 laboratory culture and animal screening tests, out of which
only a thousand chemical entities emerged with sufficiently interesting results to be car-
ried into higher animal and human tests [Schwartzman (1976, p. 60)]. To the extent that
this process was guided by systematic theory, it stemmed from prior discoveries that
certain molecules had recognized therapeutic effects, so chemists synthesized "me too"
variants of those molecules to see whether they might work better or at least circumvent
rival firms' patents.
As scientific knowledge has advanced, the industry has moved gradually from more
or less random screening to methods called "rational drug design". Extending the early
insights of Paul Ehrlich, it is known that each of the countless proteins in the human
body has specific functions, and that the functioning or malfunctioning of those pro-
teins is sensitive to the addition of chemicals at key receptor surfaces. The properties
of receptors can be gleaned through various analytic techniques, and molecules can be
designed to fit the receptors. Breakthroughs in genetic research and techniques for cre-
ating and multiplying new life forms have made it possible to manufacture proteins and
other substances that replace defective proteins in the body or modify their functioning.
Although much more highly focused than the "try every bottle on the shelf" methods
of the 1950s and 1960s, these modern techniques are more like shotgun blasts than rifle
shots. Considerable trial and error, including animal and then human tests, are required
to isolate among many possibilities new molecules or proteins that actually work with-
out serious adverse side effects. Failure is still more frequent than success. I
The science base upon which pharmaceutical manufacturers build in discovering new
drugs owes its growth in part to private research investments. Among the 24 U.S. indus-
try groups on which detailed survey statistics are published, pharmaceuticals devoted
the highest fraction - 16.6 percent - of its total 1992 R&D outlays to basic research
[U.S. National Science Foundation (1996, p. 44)]. For all other industries, the compa-
rable average was 5.3 percent. Even more important, however, is the role of govern-
ment, e.g., in the United States, the National Institutes of Health (NIH), which perform
10 On the extent to which scientific research can reduce drug development uncertainties, compare Gam-
bardella (1995) with Schwartzman (1997).
1308 F.M. Scherer
basic research and some applied work (including testing cancer drugs) intra-murally
and award grants supporting much of the relevant research at universities and medical
schools. In 1991, NIH research spending and grants totalled $7.7 billion, of which as
much as $4.8 billion was in fields germane to pharmaceuticals [Scherer (1995, p. 27)].
This work was supplemented by $260 million of National Science Foundation grants in
the biological sciences along with appreciable additional sums from other federal agen-
cies. Knowledge flows from basic research institutions to companies not only through
the medium of publications, but also through direct collaboration. Rich scientific paper
co-authorship interactions between drug company research staff on one hand and aca-
demic and governmental basic researchers on the other have been traced by Cockburn
and Henderson ( 19 9 8 ).l l
Edwin Mansfield (1995) questioned a panel of U.S. industrial R&D decision-makers
concerning the relevance of academic research to the development of specific new prod-
ucts. For the pharmaceutical industry, he learned that 27 percent of the new products
sampled could not have been developed absent underlying academic research, and an
additional 29 percent of the products were "significantly facilitated" by academic re-
search. Academic research was found by Mansfield to be more important to the emer-
gence of new products in pharmaceuticals than in the computer, instruments, electrical
equipment, and metals industries. An econometric study by Toole (1997) suggests that
17 years elapsed on average between basic biomedical research and the introduction of
commercial products building upon that research. See also (on oral contraceptives) IIT
Research Institute (1968, pp. 58-73).
Government agencies also provide important support for pharmaceutical research and
development through educational grants for prospective scientists. In 1989, the U.S.
National Institutes of Health had training grants of roughly $327 million outstanding,
supporting some 7,800 pre-doctoral candidates and 6,600 post-doctoral researchers in
the life sciences [U.S. Office of Technology Assessment (1993, p. 205)]. Many of the
researchers trained in this way subsequently accept positions with pharmaceutical and
biotechnology firms, carrying both the skills they have honed and the knowledge of
technological opportunities they have acquired into commercial research and develop-
ment activities.
5. Government regulation of new drug introductions
Most of the industrialized nations have created regulatory institutions to ensure that de-
sired safety and efficacy standards are met by new and existing drugs (and also by cer-
tain medical devices). The severity of regulatory control varies widely among national
11 Analyses of citations in published scientific articles to other work reveal that knowledge flows are interna-
tional, but with appreciable own-nation biases. See U.S. National Science Board (1998, p. A-327).
jurisdictions, with the United States leading chronologically in the implementation of

tough standards. We focus therefore initially on the U.S. experience. 12
Systematic regulation began in the United States with the Pure Food and Drug Act
of 1906, which prohibited adulteration, imposed labelling mandates, and required that
drugs sold in interstate commerce conform to U.S. Pharmacopeia standards. After some
hundred deaths occurred when a drug maker dissolved sulfanilamide in toxic diethylene
glycol, the 1938 Food, Drug, and Cosmetic Act was passed, giving the Food and Drug
Administration (the FDA, established in 1930) power to bar the interstate sale of new
drugs unless they were found to be safe. However, if the FDA did not act upon applica-
tions for new drug approvals (NDAs) within 180 days, the drug's maker was authorized
to begin commercial sales without regulatory permission. Despite the FDA's weak posi-
tion, an FDA staff member successfully delayed in 1961 the transition of a new tranquil-
izer, thalidomide, from clinical tests into full-scale commercial marketing. It became
clear shortly thereafter that sales of the drug in Europe, where thalidomide was ap-
proved and used widely to combat morning sickness, had led to the birth of some 8,000
malformed babies. Thalidomide became a cause celebre, leading the U.S. Congress to
reorient an ongoing investigation of drug prices and profits toward legislation strength-
ening regulatory controls. The Kefauver-Harris Act of 1962 eliminated the 180-day
loophole, required the FDA to certify that new drugs were not only safe, but also effica-
cious, and gave the FDA substantial new powers over drug testing and marketing.
Under regulations subsequently articulated by the FDA, an organization seeking to
test a new chemical entity in human beings must first obtain from the FDA an "Inves-
tigation of New Drug" (IND) authorization. IND applicants must submit evidence of
non-toxicity at anticipated dosage levels from tests in animals such as dogs or mon-
keys and describe in detail their contemplated experimental design, including controls
that will ensure statistical validity. The FDA has 30 days from the IND application's
submission to raise objections. When clinical testing begins, it is typically arrayed over
the following three-phase sequence, with median time spans and attrition rates (condi-
tional upon passing through the prior phase) estimated from 93 clinical trials conducted
between 1970 and 1982:13
Months Attrition
(median) rate
Phase I: Administration to a small number of healthy volunteers to test for absorp- 15.5 25%
tion, metabolism, and (at varying dosages) toxicity.
Phase n: Administration to a few and then dozens of patients with the disease to be 24.3 52%
treated.
Phase III: The drug is administered in double-blind tests to at least two large sam- 36.0 36%
ples of patients with the disease. Long-term toxicity tests are conducted in parallel.
12 The next several paragraphs are drawn in part from Scherer (1996, pp. 346-350).
13 The source is DiMasi et al. (1991). The times and attrition rates ignore possible overlaps between stages.
1310 EM. Scherer
If the drug clears all of these hurdles successfully, its sponsor applies to the FDA for
a new drug approval (NDA). The FDA often requests additional tests and information
before making its decision. On average, for the 93 clinical trials summarized above, 23
percent of the chemical entities that entered Phase I testing emerged with FDA approval.
The median lag for that sample from NDA application (following Phase III) to FDA
approval or disapproval was 30 months. Adjusting for overlapping phases, the median
time span from the start of clinical testing to NDA issuance was 98.9 months, or slightly
more than eight years. The total amount of time required for successful drugs to pass
through these testing and regulatory hurdles has tended to increase in successive decades
since the Kefauver-Harris Act was passed - e.g., from 4.7 years on average in the 1960s,
6.7 years in the 1970s, 8.5 years in the 1980s, and 9.1 years in the mid-1990s [DiMasi
et al. (1994) and Kaitin (1997)].
The increase in clinical testing mandates and the time needed to satisfy them led to
striking increases in the average cost of clinical trials. A study by Mansfield (1970) of
17 new drug development projects before the 1962 law took effect found an average suc-
cess rate of 37 percent. The average development and testing cost per successful NDA,
including the pro-rated costs of failed chemical entities, was $1.05 million (in current
dollars, equivalent to roughly $4 million in 1987 dollars). For the 93 projects studied by
DiMasi et al. (1991) whose histories are summarized above, the average clinical devel-
opment cost per NDA had escalated to $48 million (in 1987 dollars).' 4 Correcting for
general price inflation, the increase in testing costs between the late 1950s and the late
1970s was roughly ten-fold. Grabowski et al. (1978) took advantage of a difference be-
tween U.S. and British testing regulations to illuminate the reasons for increasing costs.
U.K. regulations were strengthened in 1971 from reviewing safety only, as had been
FDA practice up to 1962, to requiring proof of efficacy also. Between 1960-1961 and
1966-1970, average inflation-adjusted drug development costs in Great Britain rose by
a factor of three, while those in the United States increased sixfold. This suggested that
more stringent regulation in the United States was responsible for a twofold increase,
while influences common to both regulatory jurisdictions explained the remaining three-
fold increase. Among those other influences were the recognition by drug companies
that extensive testing was required to avoid repeating the thalidomide disaster, which
imposed huge tort liability losses on European firms; the need to accumulate evidence
used in persuading physicians to favor new drugs over tried-and-true older formulations;
and perhaps also increasing difficulty in finding superior new drugs following the first
wave of successes experienced during the 1940s and 1950s.
14 This estimate is for out-of-pocket clinical testing period costs only. Costs incurred in the pre-clinical dis-
covery phases, when pro-rated over successful NDAs, approximately double the total R&D cost of a marketed
NDA. It has become customary in the literature to take into account the opportunity cost of invested funds by
capitalizing phased R&D costs to the time of market approval, which raises even more the relative weight of
pre-clinical work, farthest in time from the date of a new product's introduction. Capitalized R&D costs as
high as $200 million per successful NCE are commonly reported.
/U i I I I i
0
QA)
cL
60
..... ... .......2....2....!... ......... :
w 50 I--- I .
.......+ All NCEs .
E .... Important
....... _ ......... .............
..........
m 40
0
(a Ju
o
C 20
E
Z 10n
. . .. *. C. ·
n I I -l ,
1940 1950 1960 1970 1980 1990

Year
Figure 1.Trends in U.S. new drug approvals, 1940-1990.
Despite rapidly rising aggregate drug R&D expenditures, the number of new drugs
approved for marketing in the United States declined markedly. This is shown by Fig-
ure 1.15 The solid line, counting the number of new chemical entity approvals, reveals
NDAs rising erratically and then peaking at 65 in 1959, only to plummet and hover
around an average of 18 per year following enactment of the Kefauver-Harris law in
1962.
The Food and Drug Administration was criticized for the drop in new drug appear-
ances and later for "drug lag" - the slow approval of even those drugs that ultimately
did reach the market, causing the United States to fall behind other nations in making
the most up-to-date therapies available to its consumers. See, e.g., Peltzman (1973),
Wardell and Lasagna (1975), and U.S. House of Representatives (1980). Peltzman laid
out inter alia a theoretical schema for FDA regulation, whose principal benefit, he ar-
gued, is to eliminate what might otherwise be information failures in the marketplace. It
is illustrated in Figure 2. Suppose the demand curve reflecting some combination of pa-
tient and prescribing physician preferences without testing information required by the
FDA is BDUNc. With no FDA intervention, consumers will consume OXu units of the
drug per year at a price (assumed fixed over all cases) of OP. If, however, the true full-
information demand curve DT1 lies much more to the left because FDA-mandated test-
ing reveals adverse side effects, consumers with full information would consume only
15 It is drawn from Scherer (1996, p. 351), tapping a variety of sources.

1312 EM. Scherer
0)
au
0
0
CL
IlUlIIULI Ul rIl : .sll4LlUl4 l
Figure 2. Welfare consequences of uncertainly reduction through clinical testing.
OXI units. Over-consumption due to imperfect information causes a consumers' sur-

plus loss measured by near triangle GFDT1, offset to a modest extent by the sacrifice of
consumers' surplus EGP during the period when the drug is not available to consumers
because of FDA-mandated testing. If on the other hand FDA-mandated tests show the
drug to be better than poorly-informed decision-makers' beliefs, the full-information
demand curve will shift to ADT2 and consumption will increase to OX 2, adding con-
sumers' surplus triangle KCF. However, if the tests are so costly that companies choose
not to develop the new drug, consumers will lose trapezoidal surplus AKFP as a result
of FDA intervention. From a statistical analysis of the decline in drug approvals, and
making the key assumption that the decrease evident as early as 1960 would in time
have been reversed, as earlier declines were, Peltzman concludes that the 1962 drug law
caused a substantial loss of consumer benefits.
In response to its critics, the FDA insisted that at least part of the sharp drop in NDAs
was intentional. What it had done by requiring more rigorous and costly testing, its of-
ficials said, was mainly to discourage "me too" variants adding little or nothing to the
therapeutic benefits of already existing drugs. It supported this argument by pointing
to its internal ratings of newly approved drugs according to their therapeutic novelty.
The dotted line in Figure 1 tracks the appearance of drugs considered by the FDA to
offer important therapeutic gains. In the 1950s, there was a surge of important drug
discoveries as the drug-finding revolution took hold, but then, long before 1962, the ap-
pearance of important new chemical entities stabilized in the range of zero to six NDAs
Ch. 25: The PhannaceuticalIndustry 1313
4 n. .... .. ... . ... . . .........................

I UV - - ... - - - --------I --
---, - ---. ........ · .I ...... ....... ... -- ... '' - - - I
v#
a0
90
cn
- -. -. 1111... I - - - - ...
Ca 80
0
o- 70
o 0
.... ........... -
2) 60
a0 50
L
Ca 40
13,
30
(n
........- .....
x~3 3
uJ,
a 10n~2
USA Switzerland France Sweden Japan

Germany UK Italy Netherlands
Nation
Figure 3. Percent of multinational drug company sales outside home market. Source: Thomas (1996).
per year, with a mean of 3.6. What had been weeded out, the FDA continued, were
mainly the drugs yielding little or no therapeutic gain. Critics questioned the accuracy
of the FDA's drug importance evaluations. Industry spokesmen acknowledged that they
had refocused their R&D efforts away from "me-too" drugs and toward the goal, not
always achieved, of developing only therapeutically important molecules.
A retrospective analysis by L.G. Thomas (1996) injects surprising new insights into
this debate. For a while, the United States had the most stringent drug testing require-
ments in the world. The United Kingdom and Germany were the next major nations to
follow the U.S. lead. By setting high standards for new drugs, Thomas argues, the reg-
ulatory agencies in those nations forced their domestic drug firms to target their R&D
on drugs of superior therapeutic efficacy, and when success was attained, the resulting
drugs sold well not only at home but also in foreign markets. The data Thomas com-
piled in support of his argument are summarized in Figure 3, which shows the fraction of
the 1985 sales of companies at home in nine leading drug-developing nations realized
outside the firms' home markets. The smaller a nation's home market, the larger was
the fraction of sales realized away from home. This plus the fact that all three nations
have excellent university systems explains the relatively high external sales ratios for
Switzerland, Sweden, and the Netherlands. Taking into account this population effect,
the stronger the home regulatory regime, the larger companies' sales were outside their
home markets. France, Italy, and Japan, with populations as large as those of (West) Ger-
many and the United Kingdom, had unusually weak domestic testing standards, which
1314 FEM. Scherer
are reflected in poor external market performance. The United States, Germany, and the
United Kingdom, with tough standards, all do well. 1 6
Despite this inadvertent mercantilist policy success, the U.S. Congress continued to
be alarmed over "drug lag" claims and especially the long decision-making lags ex-
perienced when applications for a New Drug Approval reached the FDA. A new law
passed in 1992 and amended in 1997 permitted the FDA to collect fees on new drug
approval filings and also annually from drug-producing plants and from drugs approved
after being in the FDA's review "pipeline" by September 1992 or later. See Shulman
and Kaitin (1996). The proceeds of these fees, totalling roughly $325 million between
1993 and 1997, were used to augment the FDA's technical staff, as a consequence of
which the FDA agreed to a time-phased program of reaching an increasing fraction of
its decisions within one year on conventional NDA applications and even more quickly
for high-priority drugs. An appreciable reduction in decision-making intervals in fact
resulted, from an average of 31 months over 1987-1991 to 16 months in 1997 [PhRMA
(1998, p. 24)]. It and several highly publicized withdrawals of approved products from
the market precipitated criticism that FDA approval standards may have been reduced
in the bargain. The acceleration of decision-making and clearing out of backlogs also
led to 53 new drug approvals in 1996, compared to an average of 23 in 1987-1991.
Regulatory reforms also occurred in other industrialized nations. The most impor-
tant change was the creation, beginning in January 1995, of the European Medicinal
Products Evaluation Agency (EMEA), which provided a uniform forum for regulating
new drug introductions in all member nations of the European common market. See
Heppell (1996). Initially, only medicines developed using new biotechnology methods
were placed within the sole jurisdiction of EMEA. For other products, manufacturers
retained the option of seeking approval either before EMEA or with national regula-
tory authorities, whose decisions would be mutually recognized in all European Union
nations. It is unclear whether this procedure led to convergence of national authorities'
standards - e.g., whether greater stringency was introduced into what critics called the
"French impressionist school of safety regulation" [Thomas (1996, p. 116)]. Beginning
in January 1998, the mutual recognition approach was to be phased out and manufac-
turers seeking to market new products in more than one European nation were required
to have their test results reviewed by EMEA. There has been too little experience with
EMEA's decisions to ascertain whether they differ substantively from those of the more
stringent national jurisdictions. 17
Differences between regulatory regimes point to several more fundamental philo-
sophical questions. Granting or denying permission for full-scale marketing of a new
drug is an exercise in decision-making under uncertainty. Clinical test insights can
16 See also PhRMA (1998, p. 71).

17 In a 1995 seminar at Harvard University, an EMEA official said that his agency was likely to slant its
tradeoffs somewhat differently from those of the U.S. FDA, placing relatively more emphasis on speed of
new product availability and relatively less on conclusive proof of efficacy and safety.
be sharpened through the use of appropriate statistical methodologies, but they can-
not eliminate uncertainty, especially for adverse side effects of very low incidence. 18
Decision-makers must weigh the risk of Type I errors - approving a drug when it is
not truly safe or effective - against the risk of Type II errors - withholding from the
market entities that are truly effective and safe. See, e.g., Scherer (1996, pp. 353-355).
In governmental agencies, there is a natural tendency toward placing more weight on
avoiding Type I errors, since officials who have approved a product that leads to cancer
or malformed babies will be singled out for castigation in public fora. The tradeoff can
be narrowed by increasing the size of clinical trial samples, but that solution increases
costs, possibly discouraging the development of some drugs, and it is likely also to delay
the availability of new drugs.
Several further questions follow. If uncertainty is high but the possibility of life-
saving benefits is also substantial, shouldn't a regulatory agency illuminate the prob-
lematic tradeoff and let individual physicians and/or patients make their own risk-taking
decisions, rather than being restrained by the choice of a bureaucracy? Stung by crit-
icism that its decision-making was denying potentially vital therapies to patients with
life-threatening diseases, the U.S. FDA began during the 1980s to make increasing use
of "compassionate NDA" procedures under which experimental drugs that have not yet
been approved formally are made available to physicians. For HIV drugs, it also waived
the requirement that double-blind tests be conducted, for to assign a patient randomly
to the placebo group could be tantamount to imposing a death sentence.
Recognizing such exceptions, one must ask the further question, why should a reg-
ulatory agency be the ultimate decision-maker on whether any new drug can be used?
To be sure, absent regulatory requirements, drug manufacturers might perform too little
clinical testing to ascertain whether a drug is superior to existing alternatives. Meager
testing was the norm in the pre-thalidomide era. An information market failure may
need correction. But why doesn't the regulator merely require appropriate testing and
disclosure of test data, letting physicians decide from the data whether the drug is safe
and efficacious? If there is an argument for regulation of whether new drugs may be
marketed, it must lie in a further information market failure - e.g., from the possibility
that most physicians are too busy to make well-informed independent decisions.
Carrying the debate one step farther, why should prescriptionsbe required to obtain
drugs? They are not required for over-the-counter drugs or, in many less-developed na-
tions, for any available drug. The prescription system implies that patients are unable
to make well-informed decisions about their own welfare, so physicians must act in
loco parentis. That may be true, but obtaining a prescription imposes costs, and Sam
Peltzman's (1987) statistical analysis suggests that there is no clear indication of higher
18 Withdrawal of approved drugs because of safety problems is fairly rare. Three to four percent of the drugs
approved for marketing between 1974 and 1993 in the United States, the United Kingdom, and Spain were
subsequently withdrawn for safety reasons. The number of withdrawals was 10 in the United States, 16 in
Spain, and 20 in the U.K. [Bakke et al. (1995)].
1316 EM. Scherer
poisoning or mortality rates in middle-income nations where prescriptions are not re-
quired.
Similar perplexities are encountered in the regulation of medical devices. We fo-
cus only on the U.S. experience. Reacting to numerous deaths and maladies attributed
to faulty artificial heart valves, cardiac pacemakers, and intrauterine devices, the U.S.
Congress in 1976 increased the FDA's regulatory authority over the marketing of medi-
cal devices and therapeutic apparatus. See U.S. Office of Technology Assessment (1984,
Chapter 5). All such devices were to be classified by the FDA into three categories,
depending upon safety and effectiveness risks. Devices already on the market were re-
viewed by FDA panels, and those assigned to the highest-risk Class III were required
to submit safety and efficacy data to the FDA, with forced cessation of marketing re-
sulting for devices found to be unsafe. Newly-developed Class III devices must run a
gamut of tests similar to those for new drug chemical entities before receiving mar-
keting approval from the FDA. Lower-risk class devices are subject to manufacturing
and performance standards published by the FDA. As in the history of drug regulation,
there were complaints that FDA test and approval procedures impose excessive costs,
discourage innovation, and delay the availability of potentially beneficial devices. In
1997 an unsuccessful attempt was made in the U.S. Congress to privatize significant
elements of the FDA's device certification functions.
6. Patents and pharmaceutical innovation
Owing to a combination of regulatory mandates and intrinsic difficulty whose exact

weights remain unknown, developing new drug products is a costly, high-stakes game.
It is also a risky game. The risks are shown in part through evidence assembled by
Grabowski and Vernon (1990, 1994), summarized here in Figure 4. They compiled data
on the domestic and foreign sales of 100 new drug chemical entities (NCEs) developed
by U.S. companies and introduced into the U.S. market (following FDA approval) dur-
ing the 1970s. Using standard ratios, they subtracted estimated production, distribution,
and marketing costs and plant investments from product sales, leaving estimates of the
"contribution margin" or Marshallian quasi-rents left to repay research and development
investments and provide a profit. The 100 products' discounted quasi-rents (assuming
1986 price levels) were arrayed into deciles in descending order of absolute magnitude.
What emerges is a highly skew distribution shown by Scherer (1998) to approximate log
normality and to resemble the payoff distributions in other high-technology fields. The
most lucrative ten NCEs contributed 55 percent of total quasi-rents. Products in seven
of the ten deciles did not even repay their capitalized research and development invest-
ments (including the pro-rated cost of projects yielding no marketable product), whose
average value was found to be $81 million per NCE.19 Products in the third decile came
19 A positive but statistically insignificant correlation was found between the magnitude of quasi-rents and
individual product R&D costs.
--
) )UU
n
400
0
z
0 300
0)
r 200
e)
- 100 Average R&D Cost

F- _ ................ I.................................................
o
0
UW
A1
Y v
1 2 3 4 5 6 7 8 9 10
Decile
Figure 4. Distribution of 1970s drug NCE quasi-rents. Source: Grabowski and Vernon (1990).
close to break-even, while those in the second decile provided returns roughly twice av-
erage R&D investments. Summed over 100 new products, the discounted present value
of quasi-rents exceeded the sum of R&D costs by only three percent. Thus, a relatively
few "winners", and especially the "blockbusters" in the first decile, had to repay the
losses on the majority of low-payoff products.
6.1. The unusual importance of drugpatents
Although altruistic motives undoubtedly enter, profit is the principal lure leading drug
makers to invest large sums toward the discovery and development of new drugs. Specif-
ically, company leaders hope to develop products sufficiently important, and sufficiently
well insulated from competition, to repay or more than repay their R&D investments.
Patent protection on marketed new chemical entities is a significant component of their
profit-earning expectations. Indeed, surveys asking research and development managers
what factors permit them to reap the profit benefits from their innovations - including
the competitive advantages of being first on the market with a new product, superior
sales and service efforts, secrecy and complexity of product and production process
technology, and patents - consistently show the pharmaceuticals industry to be one in
which the greatest stress is placed on patent protection [Levin et al. (1987); Cohen et al.
1318 EM. Scherer
(1997)].20 In most industries, imitators must duplicate much or all of the R&D to field a
product competitive with the original innovation, and this plus a head start and the abil-
ity to build brand loyalty in the interim are often sufficient to make R&D investments
profitable. 21 But in pharmaceuticals, much of the R&D investment is incurred to dis-
cover which molecules have medically interesting properties and to test their efficacy in
humans. Absent patent protection or some equivalent barrier,22 imitators could free-ride
on the information created by the innovator's hundred-million-dollar R&D and testing
investment, spend a few hundred thousand dollars on process engineering, and begin
competing with the innovator, eroding its quasi-rents. 2 3 At the same time, drug product
patents, unlike the patents in many other fields of technology, protect a clearly identi-
fied chemical molecule around which the marketing of substitute variants is impossible
without undergoing a complete new array of FDA clinical trials.
The development of significant new drugs is concentrated largely in the nine highly
industrialized nations covered by Figure 3 [Ballance et al. (1992, pp. 86-88)]. Many
other nations, and especially the less-developed countries, have traditionally denied
patent protection to medical and (frequently) food products. In this way, they are able
to avoid the monopoly prices and drain of scarce foreign exchange that would occur
if patent protection were granted and the patented drugs were imported (1992). Even
Switzerland, home to three of the world's leading pharmaceutical companies, provided
no drug product patent protection until 1977. A few nations allowing no drug product
patents - notably, during the 1960s and 1970s, Italy, and more recently, India - evolved
domestic pharmaceutical industries adept at "knocking off" new drugs still patented
in industrialized nations and selling them at bargain prices both at home and (through
exports) in other patent-denying nations. See, e.g., Lanjouw (1997).
6.2. Consequences of the Uruguay Round agreement
Even though the half of the world's population living in underdeveloped nations ac-
count for less than 20 percent of world pharmaceutical consumption, the patent policies
of LDCs were viewed as a thorn in the sides of multinational pharmaceutical produc-
ers. During the 1980s the United States government, urged on by a lobby organized
by pharmaceutical executives, began threatening such nations with international trade
20 The only industry in the second [Cohen et al. (1997)] survey placing more stress on patents than the
pharmaceutical industry was medical equipment.
21 On brand loyalty as a barrier to imitation of innovative drug products, see Bond and Lean (1977).
22 On new drug approval as a regulatory barrier to imitation see Kitch (1973). In the Orphan Drug Act of
1983, the U.S. Congress ordained a seven-year period of exclusivity following FDA approval of drugs treating
symptoms affecting fewer than 200,000 persons, whether or not patent protection co-exists. This orphan drug
privilege serves as a surrogate patent. Between 1983 and 1998, 140 drugs were approved by the FDA under
orphan drug rules.
23 There are exceptions. Some drugs are very difficult to produce. An example is the cephalosporin antibiotic
cefaclor, whose production entails ten complex steps and on which competitive imitation was retarded even
after a product patent and several key process patents expired during the early 1990s.
sanctions under Section 301 of the U.S. trade law unless they conformed to U.S. intellec-
tual property standards. See Santoro (1992) and Ryan (1998). Several nations changed
their laws to comply, and to pave the way for a bilateral trade treaty, Canada amended
its laws in 1987 to end compulsory licensing of drug product patents at quite mod-
est royalties, which had led to relatively low new drug product prices in Canada. See
McFetridge (1997). U.S. pharmaceutical industry leaders extended their lobbying cam-
paign to include compatriots in Europe and Japan and also attracted the collaboration of
motion picture, musical recording, and software interests. Their governments responded
by making harmonization of intellectual property standards a high-priority item on the
agenda of the Uruguay Round trade negotiations. The effort was successful. The re-
sulting Treaty of Marrakech, ratified in April 1994, requires inter alia that all signatory
nations provide full patent protection for pharmaceutical products - for industrialized
nations, by 1999, and for less-developed nations, by the year 2004.
These measures continued to be controversial even after the Marrakech Treaty was
signed. The parliaments of some LDCs balked at enacting the required law changes. For
their nations, the benefits from a modest increase in the number of new drugs likely to be
forthcoming as a result of broader international patent coverage were plausibly believed
to be outweighed by the loss of consumers' and producers' surpluses from having to
import at elevated prices the most up-to-date drugs from multinational companies. See
Deardorff (1992). The balance might change if granting drug product patents led to
the emergence of a local pharmaceutical industry skilled at discovering and developing
innovative new drugs for local production and export. However, the experience of Italy,
whose Supreme Court ordered in 1978 that the government begin issuing drug product
patents, undermining a foundation of Italy's strong "knock-off" industry, suggests that
making the transition from imitative to innovative industry is at least time-consuming
and perhaps even unlikely [Scherer and Weisburst (1995)]. Canada's experience after
it strengthened drug patent rights was more favorable because it was able to extract
from the multinational companies a pledge to move a substantial fraction of their R&D
activity to Canada and because Canada had a surplus of well-trained life scientists upon
which that shift could build. See McFetridge (1997).
7. Pricing
Although companies selling new drug chemical entities commonly enjoy patent pro-
tection for a number of years after their product is introduced, more often than not
they must face competition from chemically differentiated molecules that might be pre-
scribed to treat the same symptoms. The pharmacy benefit management company PAID
published a formulary for 1993 that can be subdivided, applying some judgment, into
141 specific symptom groups. 2 4 The number of drugs per symptom group ranged from
24 PAID Prescriptions Inc. (1993), The PAID National Formulary (Montrale, NJ). Some sub-categories were
combined where it was clear that the same symptoms were being treated in the same general mode.
1320 EM. Scherer
one to 50, with a median of five drugs and mean of 6.04. Thus, the typical market
structure for first-line drugs is differentiated oligopoly. How are prices set under those
circumstances?
7.1. Pricingbranded drugs
The most thorough relevant study is by Lu and Comanor (1998), who analyzed the pric-
ing of 148 new branded chemical entities introduced into the U.S. market between 1978
and 1987.25 All but 13 had at least one fairly close substitute in their principal therapeu-
tic indications. The average number of substitutes was 1.86. The authors distinguished
among other things between drugs that offered an important therapeutic gain, as evalu-
ated by the FDA (10 percent of the sample); those providing modest gains (37 percent);
and those offering little or no gain relative to substances already on the market. Lu and
Comanor found that drugs contributing important therapeutic gains were introduced at
prices 3.2 times the level of substitute products in equivalent dosages; those offering
modest gains were priced at 2.17 times the average for substitutes; those making little
or no gain were priced at roughly the same level as pre-existing substitutes. During the
four years after introduction, prices of the important new drugs (adjusted for general
inflation) tended to decline by about 13 percent on average, while the prices of drugs
making little or no therapeutic contribution rose on average by 22 percent. Introduc-
tory prices tended to be lower by 8 to 10 percent, all else equal, for each additional
competing differentiated substitute available at the time of initial marketing.
7.2. Tort liability risks andprices
Prices are also influenced by the amount of tort liability risk borne by drug manufac-
turers. Such risks vary both with drugs' inherent chemical properties and with national
or state legal rules. Controlling for these two variables with a matched sample of drugs
sold both in Canada and the United States, Manning (1997) found that roughly half the
difference between the prices of identical drugs in those two nations was attributable
to drug-specific tort liability risk, which was generally higher under U.S. legal prece-
dents. Because they inject modified actual disease vectors into the human body, vac-
cines pose particularly high risks of unfavorable outcomes 2 6 - so much so that public
health authorities in the United States experienced difficulty during the early 1980s in
obtaining supplies for immunization programs. See U.S. Office of Technology Assess-
ment (1993, pp. 176-182), Garber (1993), and Manning (1994). As a consequence, the
U.S. Congress passed in 1986 the National Childhood Vaccine Injury Act, which re-
duced companies' risk exposure by adopting a no-fault compensation scheme designed
25 See also Schwartzman (1976, Chapter 12). This paragraph is drawn with minor changes from Scherer
(1996, p. 369).
26 The author's bunk mate died, and the author came close to death, as a result of defective vaccines admin-
istered at a U.S. Army basic training camp in 1954.
to minimize the frequency of large damages awards based upon traditional negligence
theories.
7.3. Generic drug competition
Once patents expire, a new form of competition may emerge - competition from generic
drugs, that is, products with the same active chemical ingredient(s) as the original pio-
neer drug, and which are normally sold with little or no advertising or field sales promo-
tion. The extent to which generic drugs are substituted for original branded drugs and
their impact on prices varies widely from nation to nation and also across therapeutic
categories. A survey by Ballance et al. (1992, p. 210) reports little use of generic drugs
in Belgium, France, and Spain during the early 1990s, but extensive and rising use in
the United States, Denmark, Germany, and the United Kingdom. See also Perry (1996).
We focus initially on the U.S. experience.
As the post-World War II drug revolution gained force, most states in the United
States had laws limiting the ability of pharmacists to dispense anything other than the
specific brand prescribed by a physician. Since physicians typically prescribed by brand
name rather than by (less memorable) chemical name, this precluded the substitution of
a generic for a prescribed branded drug, and generic use was modest. During the 1970s
and early 1980s all states with such anti-substitution laws repealed them and passed
new laws permitting (with wide variation from state to state) some generic substitution.
But significant barriers to substitution remained. As of 1980, generics were dispensed
on only one fourth of the prescriptions for which substitution was feasible [Masson and
Steiner (1985, p. 26)].
There were two main limitations on generic use. For one, remaining legal hurdles, in-
cluding obstacles as trivial as the design of the physician's Rx form, interacted with
weak patient or pharmacist incentives as impediments to substitution [Masson and
Steiner (1985, Chapters 4 and 5)]. These will be explored in a different context shortly.
Second, FDA and judicial interpretations of the 1962 Kefauver-Harris Act required
would-be generic drug producers seeking approval from the FDA after an innovative
drug's patent expired to carry out tests nearly as extensive and costly as those associated
with a new chemical entity. Since the generic products would sell at much lower prices
than the original branded drug and might secure only modest market shares, generic
suppliers were often deterred from undertaking the required effort.
A grand compromise embodied in the Waxman-Hatch Act of 1984 remedied this
problem along with one troubling the research-oriented drug manufacturers. Under the
new law, generic suppliers were obliged only to demonstrate before the FDA that their
drug had the same active ingredient(s), that their formulation was absorbed into the
blood stream at a rate within plus-or-minus 20 percent of the original drug's norm (usu-
ally shown through tests on 24 human subjects), and that they adhered to good man-
ufacturing practices. Moreover, they were allowed to manufacture test samples before
the original drug's patents expired so that tests could be conducted and documenta-
tion submitted to the FDA in advance of patent expiration. Thus, they could hit the
1322 EM. Scherer
ground running - perhaps even on the day of patent expiration. As a quid pro quo for
the branded drug makers, Congress authorized an extension of the patent protection pe-
riod to compensate for the delays caused by FDA-required clinical testing regulations. 2 7
Typically, patents were obtained on promising new molecules at about the time when
clinical testing began, so if the tests and FDA decision-making took eight years, only
17 - 8 = 9 years of patent life remained. 2 8 Under Waxman-Hatch, the period of exclu-
sive protection could be extended by as much as five years, e.g., in the illustration here,
to 14 years. 29 Thus, drug developers would be given a longer period of exclusive sales,
but would have to face tougher competition once the period of exclusivity ended. Both
features strengthened incentives for vigorous new drug development.
7.4. Branded vs. generic drug price competition
The new legal mandates spurred a wave of entry into generic drug manufacturing, saving
U.S. consumers (or their insurers) an estimated $8 to 10 billion in 1994 [U.S. Congres-
sional Budget Office (1998, p. 31)]. Generics' share (by countable units, e.g., tablets) of
U.S. prescription drug sales rose from 18.6 percent in 1984 to 32.9 percent in 1990 and
44.3 percent in 1998 [PhRMA (1998, p. 57)]. Their share of dollar sales at retail was
much lower, e.g., 17.3 percent (vs. 36 percent by number of prescriptions) in 1994,3 ° in
part because the newest and highest-priced drugs were still covered by patent protection
and because, when generic entry began, the price regime for the typical drug bifurcated.
Generics tended to enter the market at whole sale prices 40 to 70 percent of those pre-
vailing before the original drug's patent expired. As additional generic competitors en-
tered a product category, the generic price fell, e.g., to 29 percent of the pre-competition
price with 10 generic rivals and 17 percent with 20 rivals [Caves et. al (1991, p. 118)].
Meanwhile, prices of the original branded drug remained essentially stable, according
to the analysis of Caves et al. (1991) or even rose, according to Grabowski and Vernon
(1992) and Frank and Salkever (1997).
Figure 5 illustrates the not atypical history of pricing after the product patent covering
the cephalosporin antibiotic cephalexin (sold as Keflex by the original patent holder, Eli
Lilly) expired in April 1987. 3 1 Two price trajectories for generic entrants are shown,
one averaging the wholesale prices charged by R&D-oriented firms (dotted line) for
100 250-mg capsules and one (dashed line) the comparable prices of generic specialists.
27 Japan enacted a similar law effective in January 1988, and in June 1992, European Community regulation
1768/92 authorized "supplementary protection certificates" with similar effect. See Ager (1997).
28 At the time, the normal life of a U.S. invention patent was 17 years from the time the patent was issued. As
a consequence of the Marrakech Treaty, the law was changed in 1994 to make the patent life 20 years from
the time an initial application is filed. The average time from application to issue was two to three years, but
with considerable variation about the mean.
29 The average actual extension was 2.3 years [Tufts University (1997)].
30 See U.S. Congressional Budget Office (1998, p. 15).
31 It is drawn from Griliches and Cockburn (1993, Figure 1).
^^
YU
80
Branded Keflex
o, 70
.,.,.,.,,,,,. -- /,....................
-7 "............................. ..........
70
0 60
.......... ............. ......... ..........................
Generics
.........
. . o
1o50
n I i I q I I i I i I i I
19 85 86 87 88 89 90 91
Year
Figure 5. Trends in cephalexin prices with generic entry.
Initial generic entry occurred at prices slightly less than half the branded product's price.
As additional firms began generic sales (ultimately, more than 20), the average generic
price was competed down to as little as 15 percent of the (rising) branded product price.
The reason for this bifurcated pricing behavior is that some physicians retained strong
preferences for the original brand and chose not to permit substitution. Branded drug
manufacturers in effect confronted two markets - one consisting of price-insensitive
consumers willing to pay high prices for the security of a brand name, and another
(growing in relative size as the 1980s gave way to the 1990s) consisting of price-
sensitive consumers willing to shift to generics. See Frank and Salkever (1992) and
Scherer (1996, pp. 376-378). The branded drug suppliers found it more profitable to
serve a minority fraction of their molecule's market (by 1992, 28 percent on average
of total unit sales 3 2) at high prices than to reduce their prices to the low levels required
to match generic competition. Some branded drug manufacturers practiced price dis-
crimination in an attempt to serve both market segments. Price-insensitive consumers
were sold the original brand, but to capture price-sensitive consumers, the patent holder
introduced shortly before patent expiration a "branded generic" - i.e., the same drug
under a different label, priced at lower levels than the original brand but higher than
32 See Grabowski and Vernon (1996, p. 114).

1324 EM. Scherer
no-name generics. In this way they gained a "first mover advantage" in the generic mar-
ket, 33 secured the leading share of generic sales, and perhaps thereby discouraged some
would-be generic suppliers from entering and driving prices even lower. However, most
companies feared adopting such a strategy because it could accelerate the shift from
their high-price branded products to low-priced generics. According to a U.S. Congres-
sional Budget Office study (1998, p. 34), among 112 drugs with generic competition,
the original brand holder sold its own generic product and gained a retail market share
of more than 10 percent in only 13 cases.
Not all of the savings from generic drug price reductions at wholesale are passed on
to consumers in the form of lower retail prices. On average, retail pharmacies retain
higher dollar margins, and hence much higher percentage margins, on the generic drugs
they dispense than on the equivalent, higher-priced, branded drugs. See Masson and
Steiner (1985, p. 36) and Grabowski and Vernon (1996, p. 117). Higher dollar margins
are realized on generics in part to defray inventory holding costs. A more important
reason, however, is that pharmacists must stock the leading branded product, but have
some choice in determining which of several possible generics to stock and dispense.
This appears to be a special case of a more general phenomenon described as the Steiner
effect: retail margins tend to be lower on products with strong consumer pull, e.g., those
that are heavily advertised, than on less-advertised items. See Steiner (1993). Kopp and
Sheffet (1997) report a substantial relative decline in retailers' margins for drugs receiv-
ing direct-to-consumer advertising support between 1988 and 1991. Viagra, the drug
product with perhaps the strongest early consumer awareness in history, was merchan-
dised by retail drug discounters at near-zero margins as a means of attracting patronage
more generally. 3 4
7.5. Stimulating generic substitution
The extent of generic substitution depends upon several variables in addition to the
number and identity of generic suppliers. Generics have been particularly unsuccessful
in replacing branded drugs for which attaining precise diffusion rates within the body
is crucial to effective therapy, e.g., in heart rhythm regulation and the administration
of anticoagulants after a heart attack. Passing over such relatively rare cases, generic
substitution was encouraged during the 1980s and 1990s in the United States by three
phenomena: rapidly rising affiliation of physicians with cost-conscious health care or-
ganizations enforcing strong pro-generic policies; "maximum allowable cost" (MAC)
reimbursement rules under which state Medicaid authorities reimbursed only the cost
33 On first-mover advantages more generally, see Bond and Lean (1977) and Robinson et al. (1994). The race
to be a first mover led some generic producers to falsify test results and bribe FDA employees. See Morton
(1997b).
34 "Kmart, Wal-Mart Compete with Teeny Viagra Prices", Reuters dispatch (obtained on Yahoo Finance),
May 21, 1998.
Ch. 25: The PharnaceuticalIndustry 1325
of the lowest-cost qualified generic substitute for a drug;3 5 and lower co-payments under
private health insurance plans when patients accepted generic as compared to branded
drugs.
The experience of Canada sheds further light on variables affecting generic substitu-
tion. See Gorecki (1986) and McRae and Tapon (1985). Generics were available early
in branded drug life cycles during the 1970s and 1980s as a result of compulsory drug
patent licensing policies. The various Canadian provinces had widely differing rules
with respect to generic substitution, and substitution rates varied as a result in iden-
tifiable ways. Quebec, New Brunswick, and Nova Scotia had especially low substitu-
tion rates because they reimbursed the full cost of any drugs dispensed under Canada's
lower-income and above-65 health insurance programs, whereas provinces with high
substitution rates reimbursed only the cost of the least expensive generic. Designation
of specific generic drugs as interchangeable with branded counterparts on provincial
formularies markedly increased substitution rates. In Quebec, unlike other provinces,
pharmacists were not absolved of malpractice liability in dispensing formulary gener-
ics. This, like Quebec's requirement that pharmacists acquire the patient's consent be-
fore substituting, reduced generic drug usage.
7.6. New institutions;New power relationships
During the 1980s and 1990s, new forces emerged in the United States to countervail
and weaken manufacturers' power to maintain high prices on patented drugs. Crucial
to these changes was the rapid growth of health maintenance organizations (HMOs)
and pharmacy benefit management firms (PBMs). Glied (2000) shows in more detail,
health maintenance organizations affiliate substantial numbers of physicians to provide
comprehensive health care on a prepaid insurance basis. Patient enrollment in HMOs
increased from 9.1 million in 1980 to 33.6 million in 1990 and 46 million in 1995 [U.
S. Bureau of the Census (1996, p. 121)]. An even newer phenomenon was the emer-
gence of PBMs to manage the payment paperwork on out-patient prescription drug in-
surance claims for HMOs, companies with large employee health care insurance plans,
and conventional insurance carriers. By 1993, the six largest PBMs were managing an
estimated 36 percent of all U.S. retail prescriptions [U.S. Congressional Budget Office
(1996, p. 21)1.
To control the rising costs of prescription drugs, many HMOs and traditional hospi-
tals began establishing formularies listing the drugs suitable for use against particular
illnesses. When appropriate generic drugs existed, formularies strongly encouraged af-
filiated HMO or hospital staff to use them in place of higher-priced branded drugs. But
even when no generic substitutes were available, formulary committees began selecting
from the menu of alternative patented drugs those deemed most cost-effective. Physi-
cians were motivated to comply with formulary guidelines by persuasion, paperwork
35 Since reimbursement is to the pharmacist, the pharmacist dispensing a high-priced drug absorbs the cost
difference.
1326 FM. Scherer
burdens justifying non-compliance, and in some cases financial penalties. As the use
of formularies gained acceptance, health care organization drug procurement personnel
realized that they could use the threat of a drug's exclusion from their formulary as a
lever to elicit discounts from pharmaceutical manufacturers. Manufacturers of substi-
tutable patented, branded drugs were played off against each other, and to an increasing
degree they conceded substantial off-list discounts. By the early 1990s, HMOs were
receiving discounts averaging 20 to 25 percent off the average wholesale prices paid by
retail pharmacies [Boston Consulting Group (1993, Figure 1-3)]. A government study
revealed that in 1991, the "best price" offered by a manufacturer to some customer -
usually an HMO or similarly bargaining hospital - carried a discount of 50 percent or
more off the wholesale list price for 32 percent of all single-source (i.e., patented) drugs
[U.S. Congressional Budget Office (1996, p. 28)].
For drugs dispensed on an inpatient basis within an HMO or hospital, there were
several ways the negotiated discount could be realized. The organization could take de-
livery of the drug directly from the manufacturer and pay only the discounted price.
But more frequently, health care organizations preferred to obtain their drug supplies
from local wholesalers, who assumed the burden of maintaining inventories and assured
same-day delivery of orders. In those instances, the wholesaler could bill the HMO at its
standard wholesale price, after which the manufacturer would issue a rebate check to the
HMO for the amount of the negotiated discount. Alternatively, the manufacturer could
notify its wholesalers of its discount arrangements with individual HMOs, whereupon
the wholesaler would deliver drugs to an HMO at the discounted price plus a negoti-
ated wholesaling fee, receiving from the manufacturer a "chargeback" payment to cover
the difference between the discounted price and the price at which the wholesaler had
acquired its inventory from the manufacturer.
PBMs entered the picture for the much larger volume of drugs obtained by patients
from retail pharmacies. HMOs contracted with PBMs to reimburse retailers for insured
prescriptions written by their affiliated physicians. When the HMO negotiated a dis-
count with a manufacturer, the PBM would reimburse the retailer for its drug acquisition
cost plus a negotiated dispensing fee, obtaining from the manufacturer a rebate (passed
on the HMO) to cover the discount negotiated between the HMO and the manufacturer.
(The negotiation of dispensing fees also imposed downward pressure on retail pharma-
cists' traditional 40 percent gross margins. 3 6 ) In addition, PBMs contracted to manage
the retail pharmacy payment paperwork for companies with large numbers of employ-
ees whose health insurance included prescription drugs. To save money for their clients,
36 According to one account, retailers' margins on the sale of ethical drugs had been driven down by 1998
from 40 to 20 percent. "Why drugstore chains are in good health", Business Week, May 4, 1998, p. 170.
See also Scherer (1997, pp. 245-246). In the late 1990s, PBMs and HMOs began concluding contracts under
which pharmacy chains agreed to bill the PBM a fixed total price per prescription, regardless of the cost of the
drug dispensed - an arrangement under which the pharmacies in effect bore the risk of dispensing unusually
many high-cost drugs. Smaller retail pharmacies were wary of accepting such contracts because of the risks,
and therefore lost HMO sales. See "Wrong Rx for their needs", Boston Globe, March 22, 1998, p. C1.
PBMs established their own formularies, negotiated discounts with manufacturers for
formulary inclusion, and assigned staff members to call physicians, urging them to pre-
scribe lower-priced formulary drugs for covered patients when appropriate substitutes
were available.
These hard-ball tactics introduced new and powerful elements of competition into
the pricing of patented drugs. A key lever used in negotiating discounts - exclusion of
non-discounting drugs from formularies - may also have had more subtle adverse side
effects. Before the tactic was widely adopted by HMOs, U.S. state government agencies
frequently excluded new and high-priced drugs from formularies listing drugs available
for Medicaid reimbursement. Statistical analyses reveal that expenditures on drugs were
in fact reduced by such policies, but that hospital admission and similar costs may have
increased by a more than offsetting amount as a consequence of using less effective
drugs. See, e.g., Dranove (1989), Moore and Newman (1993), and, concerning flat limits
on the number of reimbursable prescriptions per patient, Soumerai et al. (1991).
The transfer of substantial control over prescription drug choices from individual
physicians to formulary committees also elicited changes in pharmaceutical manufac-
turers' marketing strategies. Dispatching hordes of "detail persons" to make regular
sales calls on individual physicians became less cost-effective, and so detailing budgets
were cut sharply. To instigate patient pressure on physicians and from them on formu-
lary committees, manufacturers in the United States began devoting substantial sums to
newspaper and television advertising aimed directly at end consumers.
Another unanticipated consequence of the manufacturer - HMO bargaining was an
antitrust law suit that eventually pitted more than 25,000 retail pharmacists against 25
leading U.S. branded drug manufacturers. 3 7 The pharmacists alleged that by granting
discounts to the HMOs who could threaten them with market share losses but not to the
retail pharmacists, the drug manufacturers engaged in illegal price discrimination. They
alleged also that discounts were withheld from the retailers through an illegal conspir-
acy, inferred inter alia from the cooperation between manufacturers and wholesalers to
create a uniform computerized system for keeping wholesalers informed of negotiated
discounts and paying chargebacks to the wholesalers who delivered discounted drugs to
HMOs. Most of the plaintiffs and 13 drug companies agreed in 1996 to a settlement un-
der which the manufacturers would pay damages of $351 million and offer discounts to
retail pharmacy buying groups that could demonstrate "an ability to affect market share"
through their own formulary and physician contact activities. 38 Four other companies
settled for a total of $345 million in July 1998. In December 1998, the presiding judge
37 Inre Brand Name Prescription Drugs Antitrust Litigation, MDL-997, Master file no. 94 C 897 (consoli-
dated before the U.S. Federal Court for the Northern District of Illinois). A symposium in the International
Journal of the Economics of Business, Vol. 4 (November 1997), joins the issues inarticles by eight economists
who had consulted with either plaintiffs or respondents in the litigation.
38 Memorandum opinion of Judge Charles P. Kocoras, MDL-997, June 21, 1996. See also the Seventh Circuit
Court of Appeals decision of August 15, 1997, which rejected many of Judge Kocoras' findings but did not
overturn the settlement.
1328 FM. Scherer
dismissed the remaining conspiracy claims as "far fetched, improbable, and unreason-
able".
A U.S. government initiative seeking to reduce Medicaid drug costs had still another
unanticipated consequence, restricting the size of the discounts manufacturers were
willing to cede to hard-bargaining HMOs and other health care organizations. Under
laws enacted in 1990 and extended thereafter, manufacturers were required to give the
government agencies reimbursing Medicaid prescription drug purchases discounts equal
to the best discount offered any non-governmental purchaser on any given product, but
not less than 15.1 percent. As a consequence, manufacturers confronted with demands
for deep discounts from a strong HMO realized that if they yielded to the HMO, they
would also have to increase their discounts on Medicaid sales, which in 1995 amounted
to 17.6 percent of all out-patient prescription drug sales [PhRMA (1997, p. 35)]. Two
statistical studies have shown that the perverse most-favored customer incentives gen-
erated by the Medicaid discount law substantially reduced the discounts received by
other health care organizations [U.S. Congressional Budget Office (1996, pp. 27-44),
and Morton (1997a)].
8. Profits and price controls

Pharmaceuticals are sold under classic monopolistic competition conditions. Patents
and product differentiation lead to prices that are well above production costs. But com-
panies strive for partial monopoly positions and high margins by introducing new drugs.
To do so, they incur substantial R&D costs and marketing costs, reducing bottom-line
profits. When superior new products emerge from drug R&D, consumers and producers
alike benefit. Whether high expenditures on sales promotion are in the net socially bene-
ficial is more heatedly debated. On one hand, information is disseminated to physicians
and (more recently) consumers, speeding the entry of new drugs into medical practice.
On the other hand, as a governmental commission concluded, "It is doubtful ... that
... detail men ... give invariably unprejudiced and objective advice". [Task Force on
Prescription Drugs (1969, pp. 9-10)]. Compare also Schwartzman (1976, Chapter 9),
Comanor (1986, pp. 1196-1199), Beales (1996), and Kopp and Sheffet (1997).
In the United States, the pharmaceutical industry has for decades appeared at or near
the top of industry rankings by after-tax profit returns on stockholders' equity [Scherer
(1996, p. 342)]. However, profit reports prepared following conventional accounting
practices, including current-year writeoff of research and development expenditures,
tend to overstate true economic profitability, given the growth rates experienced by
pharmaceutical firms. When drug makers' R&D outlays were capitalized and amortized
at plausible rates, the industry's overall rate of return on invested capital in the 1970s
and 1980s was found to exceed all-industry averages by only two to three percentage
points [U.S. Office of Technology Assessment (1993, Chapter 4)].
The perception, correct or incorrect, that pharmaceutical prices and profits have been
excessive, the taxpayer burdens from rising public health care costs, and the belief,
especially in smaller nations, that reducing drug prices and profits will at best have
a minor impact on R&D expenditures by companies oriented toward serving world-

wide markets, have led many governments to impose more or less thoroughgoing price
controls on pharmaceutical products. Among 56 nations whose governmental policies
toward the pharmaceutical industry were surveyed by Ballance et al. (1992, pp. 140-
145 and 166-171), 30 nations (12 industrialized and 18 developing) were characterized
as having "substantial" price controls and 20 (11 industrialized and nine developing) as
having "limited" controls. Only six (all in the developing category) were said to have
no controls.
There are countless variations in the ways governments regulate drug prices. These
can be compacted into five broad groupings - reference pricing, item-by-item negoti-
ation and control, formula pricing, profit or rate of return regulation, and capping or
budgetary constraint controls. See Danzon (1997), Shulman and Lasagna (1994), and
U.S. Office of Technology Assessment (1993, pp. 250-262), on which the next seven
paragraphs are based. Many nations' policies entail a mix of the various methods, with
the mix changing over time, so what follows can provide only selective snapshots.
Under reference pricing, more-or-less comparable drugs are placed into a reference
group, and reimbursement is provided under national or regional health insurance plans
only at the lowest price within the reference group. The U.S. maximum allowable cost
approach to Medicaid drug reimbursement is a relatively innocuous version, placing
generics and branded drugs with identical active ingredients in the same group. A more
drastic approach was taken by Germany beginning in 1989 and Sweden beginning in
1993. Different chemical entities treating the same illness are placed in the same refer-
ence group. The broader the reference group and the more it includes new formulations
along with older drugs, the more likely it is to discourage investments in discovering
and developing superior new drugs.
In France and (until 1993) Italy, the prices of individual outpatient drugs seeking
reimbursement under national' health insurance plans were set in administrative pro-
ceedings taking into account a wide array of criteria, including therapeutic novelty and
contribution to the economy. Drugs produced and developed locally tended to receive
higher prices than imported drugs, which created incentives for local firms to develop
and introduce numerous new drugs of insufficient therapeutic novelty to achieve signif-
icant sales outside the home market. This, along with the low standards imposed by the
agencies regulating new drug introductions, helps explain the relatively modest external
sales of French and Italian drug manufacturers, as shown in Figure 3.
Under the health care reforms proposed in 1993 by U.S. President Clinton but re-
jected by the Congress, a different form of ad hoc regulation was contemplated. An Ad-
visory Council on Breakthrough Drugs was to be charged with reviewing the prices of
new drugs and, in cases where they were considered excessive, implementing measures
ranging from public suasion or "jawboning" to making the drugs ineligible for health
insurance reimbursement. The drugs most likely to be singled out for this regulation
were the "blockbusters" in the first decile of Figure 4. The difficulty with this approach,
obvious from Figure 4, is that curbing significantly the prices and profits of blockbuster
drugs could make it difficult for companies to recover their research and development
1330 EM. Scherer
investments on less successful drugs - i.e., in the fourth through tenth deciles. Severe
impairment of R&D incentives could result.
Many nations, including Italy since 1993 [Fattore (1996)] and Canada since 1987,
relate the reimbursable prices of relatively new drugs to the prices of the same drugs in
other nations. When nations (such as Spain) characterized by generally low prices are
included in the comparison group, this creates incentives for multinational drug manu-
facturers to set prices higher in the comparison group jurisdiction than those they would
otherwise be inclined to charge. 3 9 Or in the case of India, where both low incomes
and regulation limit sustainable prices, multinationals are said sometimes not to market
drugs at all until late in their life cycle so that low prices in India cannot be cited to
reduce prices in other nations making international comparisons. See Lanjouw (1997).
In Japan, the vast majority of drugs are dispensed directly by physicians, who are
then reimbursed by government health authorities on a formula basis for the drugs. New
drugs receive relatively high prices, and after that, their prices are reduced downward
systematically with the drug's age. This system has two important incentive effects. For
one, to encourage the use of their drugs, manufacturers set prices that allow physicians
generous margins between the physician's acquisition cost and the reimbursed price,
leading to the extraordinarily high prescribing rates observed in Japan. Second, because
new drugs command the highest prices, manufacturers have strong incentives, as in
France and Italy, to introduce many new drugs, whether or not they make significant
therapeutic contributions. This in turn is partly responsible for the poor external market
performance of Japanese drug manufacturers evident in Figure 3. See Thomas (1996)
and Ikegami et al. (1998).
The United Kingdom is the only nation known to have a rate of return regulation
system analogous to the way electrical and telephone utilities were regulated in the
United States for many decades. In an annual determination, the assets of individual
companies, including the capitalized value of research and development outlays, are
measured. Each company negotiates with the regulatory authority an allowed before-
tax rate of return on its assets, usually in the range of 17 to 21 percent. Prescription drug
sales revenues are set (or adjusted after-the-fact) so that, after operating, R&D, and
sales promotion costs are deducted, the company is left with profit sufficient to yield the
agreed-upon rate of return on assets. In the cost calculations, promotional expenditures
can be deducted only up to a limit of approximately 9 percent of sales. The U.K. "Price
Regulation Scheme" would appear to reward investments in research and development
39 Wide differences in drug price levels among the member nations of the European Union led to further
complications. Wholesalers in low-price nations such as Spain attempted to ship drugs imported from, e.g.,
Germany back to Germany to arbitrage the higher prices there. When manufacturers sought to curb such
"parallel imports", the Common Market authorities intervened, charging illegal restraint of competition. See
the Commission decision In re Adalat, Case IV/34.279/F3, 1995. For diverse views on policy toward parallel
imports and arguments favoring inter-national price discrimination as a "second best" Ramsey pricing solution
to the problem of recovering fixed R&D costs, see Yarrow (1995), Danzon (1997, Chapter 7), Bangemann
(1997), and Anis and Wen (1998).
Ch. 25: The PhannaceuticalIndustry 1331
and hence to avoid the negative incentive problems in many other nations' regulatory
approaches. However, there is a paradox. If the scheme is implemented mechanically,
large companies with R&D portfolios containing many projects tend to realize substan-
tially higher returns on investment than small companies with few projects. See Scherer
(1995, pp. 36-38). Given the high skewness of drug development project outcomes re-
vealed by Figure 4, companies with many projects can include the substantial R&D
investment from numerous "losers" as well from (the few) blockbusters in their R&D
asset base, and the large investment base will allow the companies to realize most, if
not all, of the profit potential from blockbusters. If a small company is lucky enough
to develop a blockbuster, it will by its very smallness have few losers in its investment
base, so the revenues it is allowed to realize on the blockbuster will be severely lim-
ited by regulation. If on the other hand (with appreciable probability) it achieves no
blockbuster, its returns will be severely limited by market competition.
Germany illustrates the use of aggregate budget constraints and roll-backs. In an at-
tempt to control escalating health care costs, the Federal Health Ministry beginning in
1993 set a tight overall drug budget, requiring inter alia a roll-back from previous spend-
ing levels. The first DM 280 million of spending above that target was to be deducted
from the incomes of physicians. If the budget was exceeded by DM 281-360 million,
the excess was to be deducted from reimbursements to drug manufacturers.4 0 Between
1995 and 1997, German drug budgets were decentralized regionally out to the level
of individual physicians (as is also done in the United Kingdom). An apparent conse-
quence of individual physician spending constraints was that primary care physicians
referred increased numbers of patients to specialists and hospitals, who were subject to
different individual constraints [Sch6ffski (1996)]. In 1998, cost containment empha-
sis in Germany shifted away from drug budget constraints toward increased individual
patient co-payments.
In sum, efforts by national authorities to curb pharmaceutical costs and offset the
demand-increasing effects of generous health care insurance by imposing drug price
controls are found throughout the industrialized and less-developed world. These some-
times succeed in their proximate goal, but cause bulges in other parts of the health
care balloon, bias new drug research and development incentives, and distort interna-
tional trade and investment patterns. Although one may share the underlying cost con-
trol goals, a review of the consequences suggests that the aversion of most economists
to price controls is well-founded.
9. Conclusion
The pharmaceutical industry has made enormous contributions to health care in the half
century since World War II as the drug research and development revolution gained
40 France introduced manufacturer-specific budget targets in 1994.

1332 EM. Scherer
momentum. Progress in biological science and molecular engineering is likely to pro-

vide the basis for further dramatic therapeutic advances in the future. But the conditions
that create strong incentives for investment in pharmaceutical R&D also arouse public
concern over monopoly positions, high prices, and the introduction of products of un-
certain efficacy or safety. From that concern flow regulatory interventions into clinical
testing protocols and pricing that could retard future technological progress. The prob-
lem is complicated by the fact that individual nation states can rationally behave as free
riders or, more accurately, cheap riders, ignoring the consequences of their policies on
drug R&D decisions in other parts of a complex multinational industry. Achieving the
right tradeoff between progress, affordability, and optimal provision of test information
remains an elusive goal.
References
Ager, B. (1997), "Patents, pharmaceuticals and generics", Eurohealth 2:35-36.

Anis, A.H., and Q. Wen (1998), "Price regulation of pharmaceuticals in Canada", Journal of Health Eco-
nomics 17:21-38.
Bakke, O.M., M. Manochia, F. de Abajo, K.I. Kaitin and L. Lasagna (1995), "Drug safety discontinuations in
the United Kingdom, the United States, and Spain from 1974 through 1993", Clinical Pharmacology and
Therapeutics, 58:108-117.
Ballance, R., J. Pogany and H. Forstner (1992), The World's Pharmaceutical Industries: An International Per-
spective on Innovation, Competition and Policy (Edward Elgar for United Nations Industrial Development
Organization, Hants, UK).
Bangemann, M. (1997), "Completing the single pharmaceutical market", Eurohealth 3(1):22-23.
Beales, J.J. (1996), "New uses for old drugs", in: R.B. Helms, ed., Competitive Strategies in the Pharmaceu-
tical Industry (AEI Press, Washington) 281-305.
Berndt, E.R., L. Bui, D.R. Reiley and G.L. Urban (1995), "Information, marketing, and pricing in the U.S.
antiulcer drug market", American Economic Review 85(2):100-105.
Bond, R.S., and D.F. Lean (1977), Sales, Promotion, and Product Differentiation in Two Prescription Drug
Markets (Federal Trade Commission, Washington).
Boston Consulting Group (1993), The Changing Environment for U.S. Pharmaceuticals (Boston).
Caves, R.E., M. Whinston and M. Hurwitz (1991), "Patent expiration, entry, and competition in the U.S.
pharmaceutical industry", Brookings Papers on Economic Activity: Microeconomics 1991:1-48.
Cockbum, I., and R. Henderson (1998), "Absorptive capacity, coauthoring behavior, and the organization of
research in drug discovery", Journal of Industrial Economics 46:157-182.
Cohen, W.M., R.R. Nelson and J. Walsh (1997), "Appropriability conditions and why firms patent and why
they do not in the American manufacturing sector", Working Paper (Carnegie-Mellon University, Pitts-
burgh).
Comanor, W.S. (1986), "The political economy of the pharmaceutical industry", Journal of Economic Liter-
ature 24:1178-1217.
Cooper, J.D. (1970), "The sources of innovation", in: J.D. Cooper, ed., The Economics of Drug Innovation
(American University, Washington) 41-62.
Danzon, P.M. (1997), Pharmaceutical Price Regulation (AEI Press, Washington).
Deardorff, A.V. (1992), "Welfare effects of global patent protection", Economica 59:35-51.
DiMasi, J.A., R.W. Hansen, H.G. Grabowski and L. Lasagna (1991), "Cost of innovation in the pharmaceuti-
cal industry", Journal of Health Economics 10:107-142.
DiMasi, J.A., M. Seibring and L. Lasagna (1994), "New drug development in the United States from 1963 to
1992", Clinical Pharmacology and Therapeutics 55:609-622.
Dorfman, R., and P.O. Steiner (1954), "Optimal advertising and optimal quality", American Economic Review
44:826-836.
Dranove, D. (1989), "Medicaid drug formulary restrictions", Journal of Law and Economics 32:143-162.
Ellison, S.F., I. Cockburn, Z. Griliches and J. Hausman (1997), "Characteristics of demand for pharmaceutical
products: An examination of four cephalosporins", RAND Journal of Economics 28:427-446.
Fattore, G. (1996), "Pharmaceutical policy in Italy 1992-1995", Eurohealth 2:34-35.
Frank, R.G., and D.S. Salkever (1992), "Pricing, patent loss and the market for pharmaceuticals", Southern
Economic Journal 59:165-179.
Frank, R.G., and D.S. Salkever (1997), "Generic entry and the pricing of pharmaceuticals", Journal of Eco-
nomics and Management Strategy 6:75-90.
Gambardella, A. (1995), Science and Innovation: The US Pharmaceutical Industry During the 1980s (Cam-
bridge University Press, Cambridge, UK).
Garber, S. (1993), "Product liability and the economics of pharmaceuticals and medical devices", RAND
Corporation Report R-4285-ICJ (Santa Monica, CA).
Glied, S. (2000), "Managed care", in: A.J. Culyer and J.P. Newhouse, eds., Handbook of Health Economics
(Elsevier, Amsterdam) Chapter 13.
Gorecki, P.K. (1986), "The importance of being first: The case of prescription drugs in Canada", International
Journal of Industrial Organization 4:371-396.
Grabowski, H.G. (1976), Drug Regulation and Innovation (American Enterprise Institute, Washington).
Grabowski, H.G., and J.M. Vernon (1983), The Regulation of Pharmaceuticals (American Enterprise Institute,
Washington).
Grabowski, H.G., and J.M. Vernon (1990), "A new look at the returns and risks to pharmaceutical R&D",
Management Science 36:804-821.
Grabowski, H.G., and J.M. Vernon (1992) "Brand loyalty, entry, and price competition in pharmaceuticals
after the 1984 drug act", Journal of Law and Economics 35:331-350.
Grabowski, H.G., and J.M. Vernon (1994), "Returns on new drug introductions in the 1980s", Journal of
Health Economics 13:383-406.
Grabowski, H.G., and J.M. Vernon (1996), "Longer patents for increased generic competition in the US",
PharmacoEconomics 10(Supplement 2): 110-123.
Grabowski, H.G., J.M. Vernon and L.G. Thomas (1978), "Estimating the effects of regulation on innovation:
An international comparative analysis", Journal of Law and Economics 21:133-163.
Griliches, Z., and I. Cockburn (1993), "Generics and new goods in pharmaceutical price indexes", Working
Paper No. 4272 (National Bureau of Economic Research).
Henderson, R., and I. Cockburn (1996), "Scale, scope, and spillovers: The determinants of research produc-
tivity in drug discovery", RAND Journal of Economics 27:32-59.
Heppell, S. (1996), "The new European system for regulating medicinal products", Eurohealth 2:28-29.
Holmes, J., and J. Dunning (1995), "Factors influencing the location of multinational investment in the phar-
maceutical industry", in: A. Towse, ed., Industrial Policy and the Pharmaceutical Industry (Office of Health
Economics, London) 92-105.
UT Research Institute (1968), Technology in Retrospect and Critical Events in Science (Illinois Institute of
Technology, Chicago).
Ikegami, N., S. Ikeda and H. Kawai (1998), "Why medical care costs in Japan have increased despite declining
prices of pharmaceuticals", PharmacoEconomics 14(Supplement 1):97-105.
Kaitin, K.I. (1997), "The new drug approvals of 1993, 1994, and 1995", American Journal of Therapeutics
4:46-54.
Kitch, E.W. (1973), "The patent system and the new drug application", in: R.L. Landau, ed., Regulating New
Drugs (University of Chicago Center for Policy Study) 81-108.
Kopp, S.W., and M.J. Sheffer (1997), "The effect of direct-to-consumer advertising of prescription drugs on
retail gross margins", Journal of Public Policy and Marketing 16:270-276.
Lanjouw, J.O. (1997), "The introduction of pharmaceutical product patents in India", Discussion Paper
No. 775 (Yale University Economic Growth Center).
1334 FM. Scherer
Leibowitz, A., W.G. Manning and J.P. Newhouse (1985), "The demand for prescription drugs as a function
of cost sharing", Social Science Medicine 21:251-277.
Levin, R.C., A.K. Klevorick, R.R. Nelson and S.G. Winter (1987), "Appropriating the returns from industrial
research and development", Brookings Papers on Economic Activity 3:783-821.
Lichtenberg, FR. (1996), "The effect of pharmaceutical utilization and innovation on hospitalization and
mortality", Working Paper No. 5418 (National Bureau of Economic Research, Cambridge, MA).
Lichtenberg, F.R. (1998), "Pharmaceutical innovation, mortality reduction, and economic growth", Working
Paper No. 6569 (National Bureau of Economic Research, Cambridge, MA).
Lu, .L., and W.S. Comanor (1998), "Strategic pricing of new pharmaceuticals", Review of Economics and
Statistics 80:108-118.
Mann, C.C., and M.L. Plummer (1991), The Aspirin Wars (Harvard Business School Press, Boston).
Manning, R.L. (1994), "Changing rules in tort law and the market for childhood vaccines", Journal of Law
and Economics 37:247-275.
Manning, R.L. (1997), "Products liability and prescription drug prices in Canada and the United States",
Journal of Law and Economics 49:203-244.
Mansfield, E. (1970), "Comment", in: J.D. Cooper, ed., The Economics of Drug Innovation (American Uni-
versity, Washington) 149-154.
Mansfield, E. (1995), "Academic research underlying industrial innovations", Review of Economics and
Statistics 77:55-65.
Masson, A., and R.L. Steiner (1985), "Generic substitution and prescription drug prices", Staff Report (Fed-
eral Trade Commission, Washington).
McFetridge, D.G. (1997), "Intellectual property rights and the location of innovative activity: The Canadian
experience", Working Paper (Carleton University, Ottawa).
McRae, J.J., and F. Tapon (1985), "Some empirical evidence on post-patent barriers to entry in the Canadian
pharmaceutical industry", Journal of Health Economics 4:43-61.
Moore, W.J., and R. Newman (1993), "Drug formulary restrictions as a cost-containment policy in Medicaid
programs", Journal of Law and Economics 36:71-114.
Morton, F.S. (1997a), "The strategic response by pharmaceutical firms to the Medicaid most-favored-
customer rules", RAND Journal of Economics 28:269-290.
Morton, F.S. (1997b), "The objectives of the FDA's Office of Generic Drugs", Working Paper No. 6143
(National Bureau of Economic Research).
Neary, I. (1995), "Japanese industrial policy and the pharmaceutical industry", in: A. Towse, ed., Industrial
Policy and the Pharmaceutical Industry (Office of Health Economics, London) 12-25.
Newhouse, J.P., and the Insurance Experiment Group (1993), Free for All? Lessons from the RAND Health
Insurance Experiment (Harvard University Press, Cambridge).
Peltzman, S. (1973), "An evaluation of consumer protection legislation: The 1962 drug amendments", Journal
of Political Economy 81:1049-1091.
Peltzman, S. (1987), "The health effects of mandatory prescriptions", Journal of Law and Economics 30:207-
238.
Perry, G. (1996), "Generic medicines: How to ensure their effective contribution to health care", Eurohealth
2:32-34.
PhRMA (1997), Industry Profile: 1997 (Pharmaceutical Research and Manufacturers of America, Washing-
ton).
PhRMA (1998), Industry Profile: 1998 (Pharmaceutical Research and Manufacturers of America, Washing-
ton).
Rizzo, J.A. (1997), "Advertising and competition in the ethical pharmaceutical industry: The case of antihy-
pertensive drugs", Working Paper (Yale University).
Robinson, W.T., G. Kalyanaram and G. Urban (1994), "First-mover advantages from pioneering new markets:
A survey of the empirical evidence", Review of Industrial Organization 9:1-24.
Ryan, M.P. (1998), Knowledge Diplomacy: Global Competition and the Politics of Intellectual Property
(Brookings, Washington).
Santoro, M. (1992), "Pfizer: Protecting intellectual property in a global marketplace", Case Study N9-392-072
(Harvard Business School, Boston).
Schachtel, B.P. (1994), "Sensible and sensitive clinical trials in the evaluation of over-the-counter drugs", in:
S.R. Shulman, ed., Moving Prescription Drugs to the Over-the-Counter Market (Tufts University Human
Nutrition Center, Boston).
Scherer, EM. (1995), "US industrial Policy in the pharmaceutical industry", in: A. Towse, ed., Industrial
Policy and the Pharmaceutical Industry (Office of Health Economics, London) 26-39.
Scherer, F.M. (1996), Industry Structure, Strategy, and Public Policy (Harper-Collins, New York).
Scherer, EM. (1997), "How U.S. antitrust can go astray", International Journal of the Economics of Business
4:239-256.
Scherer, EM. (1998), "The size distribution of profits from innovation", Annales d'Economie et de Statistique
49/50:496-516.
Scherer, EM., and D.R. Ross (1990), Industrial Market Structure and Economic Performance, 3rd edn.
(Houghton-Mifflin, Boston).
Scherer, EM., and S. Weisburst (1995), "Economic effects of strengthening pharmaceutical patent protection
in Italy", International Review of Industrial Property and Copyright Law 26:1009-1024.
Sch6ffski, 0. (1996), "Consequences of implementing a drug budget for office-based physicians in Germany",
PharmacoEconomics 10(Supplement 2):37-47.
Schwartzman, D. (1976), Innovation in the Pharmaceutical Industry (Johns Hopkins University Press, Balti-
more).
Schwartzman, D. (1997), "Has pharmaceutical research become more scientific?", Review of Industrial Or-
ganization 11:841-851.
Shulman, S.R., and K.I. Kaitin (1996), "The prescription drug user fee act of 1992", PharmacoEconomics
9(2):121-133.
Shulman, S.R., and L. Lasagna, eds. (1994), Pricing and Reimbursement of Pharmaceuticals: An Evaluation
of Cost-Containment Strategies, Symposium proceedings, PharmacoEconomics 6(Supplement 1).
Soumerai, S.B., D. Ross-Degnan, J. Ahom, T.J. McLaughlin and I. Choodnovskiy (1991), "Effects of Medic-
aid drug-payment limits on admission to hospitals and nursing homes", New England Journal of Medicine
325:1072-1077.
Steiner, R.L. (1993), 'The inverse association between the margins of manufacturers and retailers", Review
of Industrial Organization 8:717-740.
Task Force on Prescription Drugs (1968), The Drug Makers and the Drug Distributors (US Department of
Health, Education and Welfare, Washington).
Task Force on Prescription Drugs (1969), Final Report (US Department of Health, Education and Welfare,
Washington).
Temin, P. (1979a), "The origin of compulsory drug prescriptions", Journal of Law and Economics 22:91-105.
Temin, P. (1979b), "Technology, regulation, and market structure in the modem pharmaceutical industry",
Bell Journal of Economics 10:429-446.
Thomas, L.G. (1996), "Industrial policy and international competitiveness in the pharmaceutical industry", in:
R.B. Helms, ed., Competitive Strategies in the Pharmaceutical Industry (AEI Press, Washington) 107-129.
Toole, A.A. (1997), "The impact of federally funded basic research on industrial innovation: Evidence from
the pharmaceutical industry", Working Paper (Christensen Associates, Madison, WI).
Tufts University Center for the Study of Drug Development (1997), "Tufts CSDD testifies before Canadian
Parliamentary Committee about U.S. experience with patent extension", Tufts CSDD Newsletter 22:1-2.
US Bureau of the Census (1992), 1987 Census of Manufactures, Concentration Ratios in Manufacturing,
MC87-S-6 (USGPO, Washington).
US Bureau of the Census (1996), Statistical Abstract of the United States: 1996 (USGPO, Washington).
US Bureau of the Census (1997), 1995 Annual Survey of Manufactures, Value of Product Shipments,
M95(AS)-2 (USGPO, Washington).
US Congressional Budget Office (1996), How the Medicaid Rebate on Prescription Drugs Affects Pricing in
the Pharmaceutical Industry (CBO Papers, Washington).
1336 EM. Scherer
US Congressional Budget Office (1998), How Increased Competition from Generic Drugs Has Affected
Prices and Returns in the Pharmaceutical Industry (Washington).
US Federal Trade Commission (1958), Economic Report on Antibiotics Manufacture (USGPO, Washington).
US Federal Trade Commission (1985), Statistical Report: Annual Line of Business Report: 1977 (Washing-
ton).
US House of Representatives, Committee on Science and Technology (1980), Report, The Food and Drug
Administration's Process for Approving New Drugs (USGPO, Washington).
US National Science Board (1998), Science and Engineering Indicators: 1998 (USGPO, Washington).
US National Science Foundation (1996), Research and Development in Industry: 1993, NSF 96-304 (Wash-
ington).
US Office of Technology Assessment (1984), Federal Policies and the Medical Devices Industry (USGPO,
Washington).
US Office of Technology Assessment (1993), Pharmaceutical R&D: Costs, Risks and Rewards (USGPO,
Washington).
Wardell, W., and L. Lasagna (1975), Regulation and Drug Development (American Enterprise Institute, Wash-
ington).
Weintraub, M. (1994), "OTC drugs: Definitional and methodologic aspects", in: S.R. Shulman, ed., Moving
Prescription Drugs to the Over-the-Counter Market (Tufts University Human Nutrition Research Center,
Boston).
Yarrow, G. (1995), "CED and EC member state industrial policy and the pharmaceutical industry", in:
A. Towse, ed., Industrial Policy and the Pharmaceutical Industry (Office of Health Economics, London).
Zuger, A. (1997), "Drug companies' sales pitch: Ask your doctor", New York Times, August 5, p. C1.

The Pharmaceutical Industry

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Pharmaceutical Industry

Uploaded by

Copyright:

Available Formats

Chapter25

THE PHARMACEUTICAL INDUSTRY*

JEL classification:Ill, L5, L65, 031, 034

The boundaries delineating the pharmaceuticals industry, as it will be analyzed here,

The pharmaceuticals industry has a number of characteristics differentiating it from

sales - materials purchase costs - in-plant payroll costs

3. Pharmaceutical industry structure

institutions administering in-patient medications, and the wholesalers linking manufac-

4. Research, development, and the discovery of new drugs9

exclusive patent rights. Several new broad-spectrum antibiotics - Aureomycin (chlor-

5. Government regulation of new drug introductions

jurisdictions, with the United States leading chronologically in the implementation of

1940 1950 1960 1970 1980 1990

15 It is drawn from Scherer (1996, p. 351), tapping a variety of sources.

IlUlIIULI Ul rIl : .sll4LlUl4 l

Figure 2. Welfare consequences of uncertainly reduction through clinical testing.

OXI units. Over-consumption due to imperfect information causes a consumers' sur-

4 n. .... .. ... . ... . . .........................

USA Switzerland France Sweden Japan

16 See also PhRMA (1998, p. 71).

6. Patents and pharmaceutical innovation

Owing to a combination of regulatory mandates and intrinsic difficulty whose exact

- 100 Average R&D Cost

6.1. The unusual importance of drugpatents

6.2. Consequences of the Uruguay Round agreement

7.1. Pricingbranded drugs

7.2. Tort liability risks andprices

7.3. Generic drug competition

7.4. Branded vs. generic drug price competition

32 See Grabowski and Vernon (1996, p. 114).

7.5. Stimulating generic substitution

7.6. New institutions;New power relationships

8. Profits and price controls

a minor impact on R&D expenditures by companies oriented toward serving world-

40 France introduced manufacturer-specific budget targets in 1994.

momentum. Progress in biological science and molecular engineering is likely to pro-

Ager, B. (1997), "Patents, pharmaceuticals and generics", Eurohealth 2:35-36.

You might also like