Pharmaceutical Industry
Pharmaceutical Industry
RESEARCH AND DEVELOPMENT (R&D)
The modern pharmaceutical industry in the United States originated during the 1818 to 1822 period when less than a dozen fine chemical manufacturers constructed factories in Philadelphia. History records Robert Shoemaker, producer of glycerin, as the first large-scale manufacturer in the period from 1818 to 1840. Medicines were previously manufactured in the laboratories of pharmacies where doctors and pharmacists compounded and administered drugs to patients and observed drug reactions. The Food and Drug Administration (FDA), which originated in 1902 by an act of U.S. Congress, regulates the modern pharmaceutical industry. (The agency is also a scientific and public health agency with oversight for the safety of most food products, radiation-emitting consumer products, cosmetics, and animal feed.)
Pharmaceutical firms are engaged in the discovery, manufacturing, and marketing of legal drugs, biologics (viruses, toxins, serums, and analogous products), vaccines, and medical devices such as pacemakers and prosthetics. Products are made for both humans and animals. Pharmaceutical products, both prescription and over the counter (OTC), account for a large share of the aggregate health care spending and represent major account items in international trade transactions of developed countries.
Pharmaceuticals as a percentage of total health care spending during 2002 comprised 12.8 percent in the United States, 14.5 percent in Germany, 15.8 percent in the United Kingdom, and 22.4 percent in Italy. Pharmaceutical spending in the United States grew at an average annual rate of 11 percent between 1970 and 2005. The industry is global and led all other industries in rent-seeking activities by spending nearly $1 billion from 1998 to 2004 on lobbying. Profit-seeking firms engage in strategic lobbying, a special case of rent seeking. Rent seeking is a selfishly motivated effort of one party (pharmaceutical firms) targeted at influencing another party’s (government regulators) decision. Economic agents will decide to invest in rent-seeking activities, such as lobbying, if the expected net present value of the effort is profitable at the margin. Global pharmaceutical trade grew at an average annual rate of 23 percent from 2000 to 2003 and was valued at $200 billion in 2002. More than 80 percent of pharmaceutical production and consumption occurs in North America, Western Europe, and Japan.
GENERAL CHARACTERISTICS
Several characteristics distinguish the pharmaceutical industry from other industries. A newly released pharmaceutical agent is usually available only by physician prescription. Patients in effect transfer decision-making authority on the appropriateness of medications for their ailments to the gate-keeping physicians (or pharmacists and nurses in some countries). Generally, a prescription may become available OTC (i.e., without physician prescription) for a non-chronic condition that is relatively easy to self-diagnose and has low potential for harm from self-medication under conditions of widespread availability.
Another important industry characteristic is the availability of health insurance coverage for prescribed medications. Most often, private insurers or government entities subsidize retail drug purchases. Consumers make a co-payment (a fixed sum for each prescription regardless of the full price) or pay a coinsurance (a fixed percentage of the full price) that is less than the full market price. Co-payments tend to vary depending on the drug classification. Consumer payment of far less than full cost of prescriptions creates the familiar “moral hazard” (excessive use) problem.
INDUSTRY GROWTH
The Centers for Disease Control (CDC) estimated that in 2005 more than 130 million Americans got prescriptions monthly. Physicians acting as the decision maker for patients and health insurance coverage of prescriptions create a market with fairly “inelastic product demand.” An inelastic product demand means that buyers’ percentage change in quantity purchase decisions are relatively insensitive to a given percentage price change that brought it about. Pharmaceutical product demand elasticity estimates vary depending on many factors, including the setting (e.g., inpatient versus outpatient or military versus noninstitutional population), brands versus generics, stringency of regulatory and provider reimbursements, and the strength of the consumption habits of consumers.
Some experts predict that the rise in insurance coverage is a major culprit in the undisciplined rising consumption of prescribed drugs. Other experts contend that the growth in prescription drug use is partly a function of greater marketing efforts of the drug firms. The pharmaceutical industry in 2003 spent $3.3 billion on direct-to-consumer advertising and marketing expenditures totaled $25.3 billion. Doctors’ prescribing habits are directly influenced by the probability of patient noncompliance, and advertising targeted at doctors and patients. Direct-to-consumer advertising reportedly slowed noncompliance rates. The U.S. drug firms spend a similar percentage of their sales revenue on advertising as on research and development.
The pharmaceutical industry manufactures innovative products with government-granted patent rights that may be extended after application approval from the FDA. Patents give researchers and inventors exclusive rights to market an invention for twenty years before others may duplicate and sell it. Therefore, producers of new drugs are free to limit the supply and set prices that reflect profit-maximizing mark-ups with exclusive marketing rights. Most pharmaceutical manufacturers in the United States are multinational enterprises operating globally across countries. In 2004 the Pharmaceutical Research and Manufacturers of America (PhRMA) recorded drug sales of $159 billion within the United States and $79 billion abroad. The industry boasts investment rate of return that is four times the magnitude of the typical Fortune 500 firm. Technological progress in this industry and in the broader health care sector has led experts to project the global pharmaceutical market sales to be $842 billion in 2010.
There were more than 700 companies operating in the “pharmaceutical preparations” industry in 2006. The leading ten firms accounted for more than 40 percent of total industry sales. Other factors in this industry include retail pharmacies, health care provider institutions, and wholesalers. According to a 2000 report, the pharmaceutical industry earned 80 percent of the drug sales directly from wholesalers, 12 percent from retailers, and 4 percent from hospitals. Consumers typically buy drugs from retail pharmacies but there has recently been a rising trend in purchased drug activities via the Internet and from mail-order services within and outside the United States. Prescription drug buyers consider nontraditional purchasing outlets more convenient and private relative to traveling to a retail drugstore. Physicians may suggest Internet pharmacies to some homebound patients in order to improve compliance.
RESEARCH AND DEVELOPMENT (R&D)
In the United States new drugs must be approved by the FDA. In order to satisfy safety and benefit considerations of the FDA, pharmaceutical companies conduct on average ten to fifteen years of research on a new medication. Approval of a new drug is a rigorous process and for every 5,000 to 10,000 compounds tested, only one receives FDA approval and becomes a new or improved treatment. The entire U.S. pharmaceutical industry spent an estimated $51.3 billion on research and development in 2005. Nearly 80 percent of global R&D spending takes place in the United States and the major portion of the remaining 20 percent occurs in Europe.
The drug discovery process begins with the screening of thousands of compounds and modifying them to raise disease-fighting activity and/or minimize undesirable side effects for patients. Both laboratory and animal studies may be used to evaluate a drug’s safety and efficacy during preclinical testing. Investigational new drugs go through a rigorous review by the FDA before moving to the clinical trials stage. Clinical trials of new medicines occur in three testing phases. Phase I includes drug tests in a small group of about 20 to 100 healthy volunteers to determine safety. During Phase II, 100 to 500 volunteer patients participate in controlled trials to determine whether the medicine effectively treats the disease. Phase III includes 1,000 to 5,000 patients taking the new drug and being monitored to confirm effectiveness and identify any side effects with comparison to patients in the placebo (inactive substance) group.
Drug development responds to the urgency and intensity of consumer demand, and economic harm, measured by disease-specific mortality, in the United States largely motivates the global distribution of drug development. The FDA approved 28 new drugs in 2005 and more than 350 medications became available for treating patients in the last decade. New medicines in development in 2006 included 682 to treat cancer, 531 to treat neurological disorders, 341 to treat infections, and 303 to treat cardiovascular disorders. One study in 2005 reported that new drugs generated 40 percent of the two-year gain in life expectancy achieved in 52 countries from 1986 to 2000.
When a company’s patent rights expire, other companies can imitate the drug and produce generic brands of the medication. According to PhRMA, the generics’ share of the U.S. prescription drug market was 57 percent in 2005. This share is expected to rise within the next decade as the rate of brand patent expirations increases.
ECONOMIC FEATURES
The discovery and manufacture of new drugs is a risky business without guaranteed profitability. The cost of developing one new medicine is estimated to be about $800 million (higher if genetically engineered) and on average, only three of every ten prescription medications available to treat Americans generate revenues that meet or exceed average R&D costs.
In the absence of patent protection, imitators could copy the new medication and manufacturers would lack practical incentives to invest millions of dollars on R&D of new drugs. Although patents nominally last for 20 years, the average effective patent life of prescribed medicines is only about 11.5 years due to time lost during the development and distribution of the new medicine to the market. Patent protection gives pharmaceutical manufacturers a monopoly status although generic drug makers can start preparing copies of drugs for FDA approval before patent expiration. A monopoly provides the patent owner with the sole right to manufacture the drug and determine the quantity to supply (hence the market price) according to its projected profit margin. The Treaty of Marrakech, signed in 2004 during the international trade negotiations, provided full patent protection for pharmaceutical products across industrialized nations as well as in the less-developed nations.
The pharmaceutical sector is controlled or strictly regulated by the government acting as a single buyer (payer) or a monopsony in countries with nationalized health systems (e.g., Canada, the United Kingdom). There are many end-users but they buy at government-regulated prices. Governments can regulate drug prices in a variety of ways. The most common methods of price regulation are reference pricing, formula pricing, capping or budgetary control, profit regulations and item-by-item negotiation. Reference pricing is a reimbursement rule where the government sets the maximum reimbursement for one drug by reference to the price of a comparable drug in the same market. Under formula pricing, governments use a wide criteria set, such as therapeutic novelty, to set drug prices. Capping or budgetary control would involve limiting reimbursement to the providers at a certain capitated level.
Other regulatory instruments generally target the profit margins of pharmaceutical companies and quality of manufacturing practices. For example, a 1990 law in the United States required drug manufacturers to apply on retail Medicaid prescriptions the largest discount they give any purchaser (the Medicaid drug rebate program). The U.K. government has used a rate of return regulation in which each firm negotiates with the government an allowed before-tax rate of return on its assets. Germany has used aggregate budget constraints and rollbacks. In this application, the government sets a tight overall budget and any amount above this budget would be deducted from payments to a third party (e.g., from the incomes of physicians, from the reimbursements to the drug manufacturers). These are all examples of government regulations to control drug prices and regulate excess profitability in the pharmaceutical industry.
The future pharmaceutical industry faces multi-faceted challenges that include setting and enforcing manufacturing standards; rapid patent expiration of widely used brand drugs; unregulated parallel trades (re-importation in the European context) that ignores intellectual property rights; highly fluid and unregulated Internet sales; shortage of pharmaceutical scientists; biotechnology drugs and genetically engineered products (As of 2006 the FDA had no generics approval process in place for patented biotechnology drugs whose patents are about to expire.); ineffective post-marketing surveillance; foreign manufacturing, regulatory, and pricing challenges of drugs for major diseases afflicting developing countries (e.g., AIDS and malaria); and counterfeit products.
Intellectual property abuse and counterfeiting, the fastest growing economic crime, is a $200 to $400 billion global industry. In 2006, the National Association of Boards of Pharmacy (NABP) reported that the prevalence of counterfeit medicines can range to over 10 percent of the drug supply globally. A dramatic growth of global counterfeit and piracy activities would seriously threaten the economic well-being of international pharmaceutical companies.
SEE ALSO Drugs; Industry; Medicine
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Albert A. Okunade
Mustafa C. Karakus