The Pharmaceutical Industry

Dr. Katherine Sauer Metropolitan State College of Denver Health Economics

I. II. III. IV. V.

Structure and Regulation Health and Substitutability Pricing and Profits R&D and Innovation Cost Containment

Drug therapies have supplemented nutrition, sanitation, and medical care in preserving health. What would health be like without pharmaceuticals? vaccines antibiotics chemotherapy Pharmaceutical firms are some of the largest and most profitable businesses in the US.

I. Structure and Regulation In 2006, spending on prescription drugs amounted to $217 billion. This is 10.3% of national health expenditures. 8.9 percent in 2000 4.7 percent in 1980

The pharmaceutical industry has always interested economists in the field of industrial organization. - high profits - patent protection - high R&D spending - intense product promotion - heavy regulation

Concentration Ratios for Selected Industries

By looking at the number of firms and concentration ratios, the pharmaceutical industry looks relatively competitive. - misleading - drugs in different therapeutic classes really arent substitutes

A. Barriers to Entry A patent is a legal barrier to entry. - Patents are vital to the pharmaceutical industry. Advertising/promotion can also create barriers to entry. - brand loyalty - familiarity - free samples to physicians - advertising in medical journals In 1997, the FDA relaxed rules governing advertising in mass media. - Direct to Consumer (DTC) marketing

The long and costly process for getting a new drug FDA approved is also a barrier to entry. About 1 out of every 5,000 to 10,000 chemical compounds screened eventually become a drug. 3 out of every 10 drugs approved eventually become profitable.

B. Regulation Pharma is one of the most heavily regulated industries. 1906 Food and Drug Act dealt with labeling 1938 Federal Food, Drug, and Cosmetic Act requirements for testing and safety 1959 Senate hearings on questionable drug industry practices 1956 1962 thalidomide tragedy in Europe 1962 FFDCA amendments give FDA more control

Process: 1. drug discovery - screen / engineer thousands of compounds 2. pre-clinical tests - lab/animal tests (3-6 years, 250 compounds enter) 3. Investigational New Drug application filed with FDA 4. clinical trials (Phase I, II, and III) - humans (5 compounds enter) 5. New Drug Application - 100,000 pages (1 compound) 6. FDA review/approval - 10-15% of applications rejected - 16.9 months to review 7. on-going studies

II. Health and Substitutability - role of prescription drugs in producing health - relationship to other health inputs Consider two inputs to health production: medical care drugs What might the isoquants look like? - perfect substitutes? - needed in fixed proportions? - too much pharmaceuticals can harm a person

A. Least-Cost Production Suppose a patient utilizes two types of health inputs: medical care (M) pharmaceutical drugs (D) The total cost of care (C) can be written: C = PDD + PMM or if M is on the vertical axis: M = C/P - (PD/PM) D
M

If a patient has no insurance, then the cost of care line is the same as their health budget line. The rational patient wants to find the combination of medical care and pharmaceuticals that will yield a certain health status, while minimizing spending.

The patient will seek to attain a certain level of health (HS), but spend as little as possible to do so. The slope of the cost line is - PD/PM

M*

HS C1 D* C2 D C3

B. What if the patient has insurance? Consider a policy that covers a constant proportion of expenses on both D and M. Ex: suppose initially PD= 50 and PM = 100 the budget line has a slope of - 1/2 suppose now insurance covers 80% of spending The out-of-pocket prices are now (0.2)(50)= 10 (0.2)(100) = 20 The price ratio is still the same, 1/2

Since the slope of the budget line has not changed, the consumers optimal combination of medical care and drugs has not changed. Since the combination of M and D has not changed, the total cost of care has not changed.

Now consider a policy that pays 80% of medical expenses but requires a $5 co-pay for prescriptions. now PD= 5 and PM = 20 slope of budget line = -1/4 - it is now flatter The patient will choose a new optimal combination of drugs and medical care - more drugs (they are cheaper) Since the patient chooses a new combination of M and D, the total cost of care also changes.

Notice that the tangency point falls outside the original cost line. The total cost of care has increased. The patient still achieves the same level of health status.
HS C D1 D2 D BL

M1 M2

C. Technological change Technological improvement means that fewer inputs can be used to produce a given health outcome. - or the same amount of inputs can generate a higher outcome

Suppose there is a technological advancement that allows HS* level of health while using the level of inputs that would previously only have yielded HS1. - use fewer inputs to achieve the same level of health - lower cost

M* M1 HS* C1 D1 D* HS1 D

M M/D 1 M/D *

Case 1:The ratio of M to D has gotten steeper - greater reduction in use of drugs relative to reduction in medical care Medical care utilization increases relative to drugs.
HS*

M* M1

C1 D1 D*

HS1 D

Technological change was in favor of drugs.

Case 2: The ratio of M to D has gotten flatter - greater reduction in use of medical care relative to reduction in drugs
M/D *

M*

care.

M/D 1

Drug utilization increases relative to medical

HS* M1 C1 D1 D* HS1 D

Technological change was in favor of medical care.

If the new optimal combination of D and M lies on the original ray (D/M), then the change in technology was neutral. [we solely did the example of using fewer inputs to achieve the same initial level of health status try on your own to use the same level of inputs and achieve a higher level of health status]

III. Pricing and Profits Many studies have found that pharmaceutical profits, as reported in financial statements, are consistently among the highest of all industries.

A. Monopoly Pricing

The gap between the market price and the marginal cost is quite large.
P*

AC* AC MC MR Q* D Q

If the drug was a breakthrough, what would the demand curve look like? If the drug was a me too drug, what would the demand curve look like?

B. Price Discrimination Third-degree price discrimination is possible for pharmaceuticals. - segment market into groups of buyers - retail pharmacies - veterinarians - countries - hospitals - managed care Charge according to elasticity of demand.

US
P P

Mexico

P* P* MC MR Q* D Q Q* MR D Q

C. Behavior other than profit-maximizing The negative publicity associated with high prices and profits may change a firms behavior. Ex: Burroughs Wellcome (now GSK) brought AZT to market - AZT was the first promising treatment for AIDS - AIDS causes almost-certain death - inelastic demand - $8000 for a years treatment BW reduced prices after receiving considerable public pressure.

D. Monopsony pricing and price controls Many foreign governments regulate prices of drugs or are monopsony buyers. E. Competition and Generic entry Once a patent expires, many firms can sell the drug. - much lower barriers to entry - dont have to re-do clinical trials, etc - dont have to advertise - dont have to do R&D

IV. R&D and Innovation The usual length of a patent is 20 years. For drugs, a patent is filed years before the drug actually makes it to market. - shortened patent life The Drug Price Competition and Patent Restoration Act of 1984 allows an extension of up to 5 years from drugs. - total effective patent life cant exceed 14 years

Investment decisions: There are roughly 3 periods of a drug patents life. 1.research, testing, and review period (m years) 2.effective period of patent protection (n years) 3.period following patent expiration (s years) m+n+s= T T is the life of the project

In the first phase, the firm incurs only costs and earns no revenue. In the second phase, the firm earns monopoly profits. In the third phase, the firm faces competition from generics.

( 0 Ct ) + t =m+ n ( Rt Ct ) + t =m+ n+ s ( Rt Ct ) NPV = +1 (1 + r ) t t =m+n+1 (1 + r ) t t t =1 (1 + r ) t =m

t =m

Riskier projects should be discounted more heavily.

R&D Spending: US 1980: $1.5billion 2007: $ 35billion Many drugs do not have a positive NPV.

Empirics: Mansfield (1986) found that 60 percent of pharmaceutical drugs between 1981 and 1983 would not have been developed without patent protection. DiMasi et al (1991) estimated total costs, computed as capitalized expected costs and discounted at 9 percent, at $231 million in 1987 dollars per new chemical entity that was marketed.

DiMasi, Hansen, and Grabowski (2003) estimated average out-of-pocket R&D costs for new chemical entities at $403 million, in year 2000 dollars. This figure reaches $802 million when capitalized at 11 percent. Grabowski and Vernon found that a product has an effective patent life of about 9 to 13 years and a market life of about 20 years. Cash flows do not become positive until the third year after launch, and sales peak in the tenth or eleventh year.

Vernon (2005) estimates that a price control policy that would lower pre-tax pharmaceutical profit margins to the average of those in non-U.S. markets would lower industry R&D investment by between 23 and 33 percent. Other studies find a consistent and substantial direct relationship between higher real drug prices and increased innovation.

V. Cost Containment The rapid growth in drug expenditures has led to great policy interest in cost containment. We will focus on three strategies: higher copayments use of generic drugs adoption of drug formularies

A. Copayments We know that the lower the out-of-pocket price, people tend to use more. What about higher co-pays? - reduce the use - substitute toward more medical care - could increase total cost of care - substitute toward generics

Motheral and Henderson (1999) examined two plans with tiered systems that increased brand-name copayments more than copayments for generics. They found little effect on total drug utilization. However, utilization of brand-name products decreased about 18 percent relative to a control group that had no price increases.

Goldman et al. (2004) found substantial decreases in utilization within the most common drug classes from a doubling of copayments. Reductions ranged from a low of 25 percent for antidiabetics to highs of 44 percent for antihistamines and 45 percent for nonsteroidal anti-inflamatory drugs.

Gibson and colleagues (2005) concluded that these arrangements generally work as intendedby encouraging generic use and limiting overuse. But their study also found reports that higher cost sharing can also disrupt treatment through lower levels of adherence, lower use of essential medicines, and, in some cases, drug discontinuation.

B. Generic Substitution About 70% of all prescriptions are written for drugs with multiple sources. The US has a much higher utilization rate of generic drugs than other nations. While therapeutically equivalent generics dont always have the exact same effects as the name-brand drug. - Ambien vs zolpidem

C. Drug Formularies Managed cares strong financial interest in cost containment has led to policies that go well beyond copayment strategies to promote generics. Many plans monitor physicians and require substitution when generics are available. Many also use pharmacy benefit managers to negotiate discounts and improve the efficiency of their claimsprocessing and pharmacy operations. - only covered for certain drugs

Discussion Questions: In 2004, Congressman Dennis Kucinich proposed the Free Market Drug Act. This legislation would have removed patent protection on drugs developed with public funds and given control over pharmaceutical R&D to the National Institutes of Health. Evaluate this type of proposal in terms of the effects on price, competition, and level of innovation.