pricing, profits, and technological progress in the pharmaceutical industry

American Economic Association

Pricing, Profits, and Technological Progress in the Pharmaceutical IndustryAuthor(s): F. M. SchererSource: The Journal of Economic Perspectives, Vol. 7, No. 3 (Summer, 1993), pp. 97-115Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/2138445 .

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Journal of Economic Perspectives- Volume 7, Number 3-Summer 1993-Pages 97-115

Pricing, Profits, and Technological Progress in the Pharmaceutical Industry

F. M. Scherer

he decades-old debate over pharmaceutical industry prices, profits, and innovation has again intensified. As a candidate and again after taking office, President Clinton castigated the industry for its high

prices and profits.' Between 1990 and 1992, several Congressional committees aired similar complaints and drafted legislation to curb high and rising prescription drug prices. Further price control initiatives are expected to follow the report of the Clinton Health Care task force. As it did in the "administered prices" hearings chaired by Senator Estes Kefauver between 1959 and 1961, the pharmaceutical industry argues that its prices and profits have been appropriate, given the industry's uniquely high and risky expenditures on research, development, and the introduction of new products. A number of events coalesced to refocus public interest on pharmaceuticals.

One was the relentless escalation of U.S. health care costs, to 14 percent of gross national product in 1992-the highest fraction of any industrialized nation (Newhouse, 1992).

Instrumental in directing attention to pharmaceuticals, even though they account for only 6 percent of health care expenditures, were numerous widely- publicized cases of new drugs entering the market at prices implying unprece- dently high annual therapy costs. The best-known was AZT (azidothymidine), the first drug believed effective in delaying the acute phases of AIDS. AZT was commercialized in 1987 at prices cumulating to $10,000 per year (later reduced

'For example, "President Assails 'Shocking' Prices of Drug Industry," New York Times, February 13, 1993, p. 1.

* F. M. Scherer is Professor of Business and Government, John F. Kennedy School of Government, Harvard University, Cambridge, Massachusetts.



98 Journal of Economic Perspectives

to $4,000 and then $2,200) at recommended dosage levels (Chase, 1989). A single injection of genetically-eiigineered TPA, used to dissolve blood clots during heart attack emergencies, cost $2,200 at original prices. Annual maintenance therapy using factor VIII, effective against certain rare forms of hemophilia, costs from $300,000 to $520,000 per year, depending upon the specific biological variant. The annual cost of human growth hormone treat- ments can reach $35,000. Anti-ulcer therapy for a year at minimum dosage levels with Glaxo's Zantac, which in recent years has set new U.S. drug sales records, cost $1,043 at 1992 retail price levels.

Contributing to public concern were Bureau of Labor Statistics price index increases for pharmaceuticals far outpacing those for the products of other industries. Between 1982 and 1992, the producer price index for prescription drugs rose at an annual average rate of 8.4 percent, while the index for all commodities at wholesale increased by 1.6 percent and the (urban consumer) price index for all medical care rose at a 7.4 percent rate. Paradoxically, there were many price increases during this period for drugs experiencing new competition from lower-priced generic substitutes.

Another prominent characteristic of the pharmaceutical industry has been its extraordinarily high reported profitability. Between 1960 and 1991, pharmaceuticals held first or second rank in 24 years out of 32 on Fortune magazine's annual tabulation of median after-tax profit returns on stockholders' equity for its 500 largest industrial corporations, classified into between 21 to 28 industry categories. On average, over the 32-year period, the return on equity for pharmaceuticals was 18.4 percent, compared to 11.9 percent for all 500 industrials. Pharmaceuticals exceeded the all-500 median by 62 percent on average during the 1960s, by 39 percent during the 1970s, and by 53 percent during the 1980s.

This article examines the phenomena that precipitated the current pharmaceuticals debate, their historical antecedents, and the principal questions at issue.

Changing Conditions for the Pharmaceutical Industry

The pharmaceutical industry differs from other industries in several important respects. Since the 1930s, most high-potency drugs have been available in the United States only by prescription. Thus, the consumer and the consumption decision-maker (the prescribing physician) are not the same. During the 1930s and 1940s, there was a revolution in the techniques of drug discovery (Temin, 1979), as a result of which more than 1,200 new chemical entities have been introduced into U.S. therapeutic practice since 1940. The menu of drugs is so vast and complex that few physicians can inform themselves fully about the available alternatives. Information failures abound. Third-party reimbursement plans operated by the government and private insurers have expanded to cover an estimated 44 percent of prescription drug outlays in 1987, up from



F. M. Scherer 99

28 percent in 1977 (U.S. Office of Technology Assessment, 1993, p. 27). Thus, the prescription drug consumer is often removed not only from product decision-making, but also from paying the full price associated with a choice. The combination of physician decision-making, imperfect information, and third-party payment makes drug demand stronger and less price-elastic than it might otherwise be, conferring considerable monopoly power upon the sellers of well-accepted drugs.

Information failures led Congress to pass the Kefauver-Harris Act of 1962, extending the Food and Drug Administration's regulatory mandate from safety to the therapeutic efficacy of new drugs and prompting FDA to issue more stringent rules governing new drug testing and approval. Prior to that time, a study by Mansfield et al. (1971, pp. 35, 67) suggests, the average expenditure required to develop a new drug through the regulatory approval stage was approximately $6 million (converted to 1990 price levels). This estimate excludes pre-clinical research costs, but includes the cost of unsuccessful development projects. By contrast, a recent study by DiMasi et al. (1991) estimates that achieving a successful 1980s-vintage drug entailed research, development, and testing outlays (in 1990 dollars, counting the cost of failures) averaging $53 million during the clinical (human testing) stage plus $73 million at the pre-clinical stage.2 DiMasi et al. found that 23 percent of the new chemical entities put into human testing surmount all hurdles and receive approval for marketing.3 The average time required to bring a drug from the start of clinical trials to FDA approval exceeded eight years. Thus, drug development has become a high-stakes, high-risk game. Some of the observed cost increase would have occurred even without legal and regulatory changes as drug-makers tightened their testing routines to reduce tort liability risks and enhance marketing impact, but roughly half is attributable to tougher regulation (Grabowski et al., 1978; Thomas, 1990).

These changes and others precipitated new legislation in 1983 and 1984. Concerned that the high cost of testing discouraged the development of new drugs combatting low-incidence diseases, Congress passed the Orphan Drug Act in 1983. It authorizes a seven-year period of exclusive marketing for the first firm to win approval on a drug treating diseases afflicting fewer than 200,000 persons per year. Other provisions permit tax credits of up to 50 percent on clinical testing costs, direct subsidies, and streamlined FDA approval procedures for drugs designated as orphans. The law appears to have had a marked impact. In the first nine years after its enactment, 60 orphan drugs were developed (Hilts, 1992).

2The numbers reported publicly, among others by DiMasi et al. (1991), are often higher by a factor of two or more because outlays have been capitalized at an appropriate interest to the date of FDA product approval. 3This attrition rate is for the clinical testing stage only. Traditionally, thousands of molecules were tried in vitro and in animals during the pre-clinical phase to find a single entity carried into human tests. The increased predictive power stemming from advances in scientific knowledge has reduced pre-clinical attrition rates significantly.




Other legislation tried to mitigate the effects of regulation for mainstream drugs. One perceived problem was that the lengthy interval required for clinical trials and FDA approval reduced the duration of patent protection covering newly introduced drugs. Since patents on new drug chemical entities were typically obtained at about the time when clinical testing began, the effective period of patent protection was cut to roughly nine years (that is, 17 minus an average test period of eight years). This presumably made it more difficult to recoup rising R&D costs. Also, a 1983 U.S. Supreme Court decision held that even when patent protection ended, most generic imitations had to undergo clinical trials nearly as rigorous and costly as the originally approved molecule. Given the reputational advantage enjoyed by the original drug, this often made it prohibitively costly to secure the benefits of post-patent competition.

The Waxman-Hatch Act of 1984 effected a grand compromise seeking to solve both problems. The life of drug patents (and patents on other regulated products) can be extended by up to five years to compensate for regulatory delay, provided that the period of post-approval patent exclusivity does not exceed 14 years. At the same time, the procedures for approving generic substitutes for drugs without patent protection were radically simplified. The new would-be competitor must show only that its active ingredient is chemically identical to an approved drug and that blood levels in humans, usually demonstrated through 24 live subject tests, are within the statistical bounds (plus-or-minus 20 percent) imposed for the original drug. A torrent of generic drug approvals followed.

Accompanying these changes has been a second revolution in methods of drug discovery and development. Basic scientific research has begun to illumi- nate the chemical mechanisms of disease, permitting R&D teams to design synthetic drug molecules with structural properties that interact in predictable ways with target receptors in the human body. Genetic engineering has made it possible to replicate hard-to-isolate natural human immunogens and to clone mutant organisms with desired therapeutic properties. As a result, the number of new entities seeking FDA approval is expected to soar during the 1990s. Thus, it has become all the more important to strike the proper balance among economic incentives, competition, and controls.

The Generic Competition Paradox

The 1984 Waxman-Hatch Act was expected to stimulate strong competition from generics against drugs whose patent protection had expired. In some respects, that expectation was realized. Hundreds of generic substitutes were approved by the FDA under accelerated procedures (marred in a few instances

by fraudulent data submission, price-fixing, and bribery of FDA officials).4 By

4For example, see "How Far Has the Cancer Spread at the FDA?" Business Week, September 18, 1989, pp. 30-31; "More Charges Expected in Generic Drug Inquiry," New York Times, December 20, 1990, p. D-1; and "Indictments in Drug Case," New York Times, December 18, 1992, p. B-7.



Pricing, Profits, and Technological Progress in the Pharmaceutical Industry 101

1989, generics comprised more than a third of all prescriptions filled. Generics made stronger inroads -within hospitals than on the much larger volume of prescriptions filled at retail pharmacies. Even so, the generic dispensing rate at retail increased from approximately 17 percent in 1980 to 30 percent in 1989 (Masson and Steiner, 1985, p. 26; Caves et al., 1991, pp. 6-7).

What did not happen, however, was anything like active two-way price rivalry between "branded" and generic drug suppliers. Some studies indicate that on average, branded drug prices rose when generic competition materialized (Frank and Salkever, 1992; Grabowski and Vernon, 1992); another study found that on average, generic competition reduced incumbent brands' prices by just 2 percent (Caves et al., 1991). These mild responses materialized even though generic sellers quoted prices 40 percent (with one generic entrant) to 70 percent (with ten rivals) lower than the original incumbent's branded drug price. The most common scenario, then, is for the incumbent to maintain or increase its price, while ceding a substantial share of the market to much lower-priced generic rivals.

Two institutional regularities explain much of this seeming paradox. First, individual physicians tend to be risk-averse, insensitive to cost, and creatures of habit, prescribing drugs by brand name even when much less expensive generic substitutes exist. Hospitals and health maintenance organizations surmount these information hurdles by convening committees to recommend the most cost-effective choices for their organization's drug formulary. Recent increases in cost containment pressures have strengthened the power of the committees relative to member physicians who might otherwise be inclined to prescribe by brand. Second, consumers purchasing drugs at a retail pharmacy normally lack knowledge sufficient to evaluate the alternatives and (characteristically small) risks of substituting away from a prescribed brand-name drug, even when state laws permit or encourage generic substitution (as is now typical).

Thus, it is not too extreme an oversimplification to suppose that when generic substitutes exist, the world of drug buyers consists of two quite different groups-those who are price-sensitive and those who are not. When there is only one branded product, the pricing problem is straightforward. But once generic substitutes enter at much lower prices, the market is bifurcated, and the incumbent branded seller commonly finds it more profitable to desert the price-sensitive market than to reduce the prices quoted to price-insensitive customers.5 A strategy of price discrimination, with a high price for retail brand purchasers and a low price for likely generic substituters, might arguably yield superior profits. However, although well-known U.S. pharmaceutical houses frequently supply "branded generic" copies of competitors' products whose

5This two-market phenomenon is modelled in Frank and Salkever (1992), although their formal analysis does not highlight the probable concavity downward of the incumbent firm's residual demand curve in the price-sensitive market. A dynamic limit pricing model by Gaskins (1970) predicts an increase in product prices as the date of patent expiration approaches, but not later. This is the pattern observed in the most detailed empirical analysis by Caves et al. (1991).




patents have expired, they rarely offer generic versions of their own original drugs. The reason emphasized by industry executives (in discussions with the author) was fear of extensive arbitrage against the price-insensitive market. Yet as generic drugs continue to advance, industry practices may be changing. In 1992, industry leader Merck announced that a separate generic drug division, West Point Pharma, would market a generic version of Merck's analgesic Dolobid, whose patent expired in 1989 (Freudenheim, 1992b). This price discrimination strategy is said to be pursued more frequently in Germany. If it takes hold in the United States, one can expect patent expiration to be accompanied by price stability or increases for the branded version of the subject drug, along with appreciable price decreases for the original producer's generic version and even sharper price reductions for other firms' generic substitutes.

Drug Price Index Perplexities

Extraordinarily rapid increases in the producer and consumer price indices for prescription drugs during the 1980s have been a frequent target for criticism. For at least three reasons, however, the phenomenon has probably been exaggerated.

One concerns the way generic substitute products enter the standard price indices (Griliches and Cockburn, 1993). If, when patents expire, generics win half the market's physical volume at prices 50 percent or more below those of the branded product, as is common, the price of the relevant chemical entity has presumably decreased on average.6 But the market baskets and (Laspeyres) weights used in compiling Bureau of Labor Statistics price indices are changed infrequently, and so the new generics may not be sampled until several years after their appearance. Then, when they are eventually included, the generics are treated as new products in their own right, not as a lower-price substitute to some existing product. Thus, no reduction in the index value accompanies their inclusion. Given this procedure, generic entry induces index value de- clines mainly when the generic products' prices fall following index inclusion as a result of further entry by competing generic suppliers (Caves et al., 1991). Assuming conservatively that generic substitutes sell at half the price of original branded products and that their share of all prescriptions filled during the 1980s increased by 13 percentage points, this set of conventions implies an upward bias about 1.2 percent per year in the measured Producer Price Index trend for drugs.

Product inclusion lags bias the indices in a second way. Price increases have tended to be more rapid for mature branded pharmaceutical products than for

6This is not certain, if the generic is priced lower by exactly the amount reflecting uncertainty about its efficacy, and hence its inferior hedonic value (Griliches and Cockburn, 1993).



F. M. Scherer 103

new products. New products experience slower price increases, or even de- clines, because learning-by-doing reduces marginal production costs in the early product life cycle stages and perhaps also because drug-makers choose a "skimming" strategy to signal quality in the face of demand uncertainties. Under this strategy, they set prices high at the outset and then, if conditions warrant, reduce them to accelerate the diffusion process. Because new products are not included in price index market baskets until several years after their market entry, the declining-price stages are under-represented. Berndt et al. (1993a) found that when all of the products sold by four major drug companies were covered, and when moving-weight Divisia indices were substituted for fixed historical weight Laspeyres indices, average prices rose during the 1980s at only two-thirds the rate shown by the companies' official, less comprehensive, Bureau of Labor Statistics wholesale price indices.

Finally, it is conventionally assumed that new products win market acceptance only when they confer consumer benefits exceeding those associated with existing alternatives, that is, when they add to consumers' surplus. Some new drugs, by improving the quality of life or making expensive surgery unnecessary, plainly yield enormous increments of consumer surplus. Except in the case of computers, the Bureau of Labor Statistics does not use hedonic methods to derive its manufactured product price indices, and as a result, its indices do not capture the gain in consumers' surplus contributed by new products. This leads one to suppose that "true" (i.e., hedonic) rates of price increase are overstated. Whether such a bias holds uniformly for pharmaceuticals, with their rapid rate of product innovation, is less certain. It might be nullified if insurance shifts drug demand curves upward appreciably relative to the posi- tions that reflect underlying consumer valuations, or if drug-makers exploit the quality sensitivity and price insensitivity of physicians by setting particularly high prices on new products. Although research on the construction of hedonic price indices for drugs is underway (Berndt et al., 1993b), it is fair to say that solving the special drug industry problems identified in this paragraph lies beyond the current state of the price index art.

Thus, there is reason to believe that official price indices overstate the rate of price increase for pharmaceuticals during the 1980s. But the magnitude of the bias remains uncertain.

Industry Profitability

The persistently high profit returns reported in pharmaceutical company financial statements have provoked both debate and frontier-extending research on the limitations of accounting data.

An early defense against the claim that excess profits were being realized was that high average returns were necessary to induce investment in high-risk research and development. Some studies revealed that drug companies had




higher cross-sectional variance in their profit returns for given years than companies operating in other industries. This explanation was not persuasive, however, since the outlying values were mainly attributable to the unusually high returns of many firms, and not to sub-normal returns for less successful sellers (Comanor, 1986, pp. 1182-86). Time series analyses showed, if anything, more stable returns for pharmaceutical companies than the average for all manufacturing. Capital asset pricing model tests reveal drug company / values of unity or less, suggesting the absence of abnormal systematic (that is, non-diversifiable) market risk.

A more compelling objection is that accounting data on profits yield biased implications, given the special circumstances faced by the pharmaceutical industry. Under standard accounting practice, R&D and new product marketing outlays, both of which are atypically high in pharmaceuticals, are written off as current expenses. Since both, and especially R&D, affect revenues for many years to come, it would be more accurate in principle to capitalize the outlays and then depreciate them over appropriate time periods. Otherwise, the rate of return on "investment" is calculated using an asset base that improperly excludes accumulated intangible R&D and marketing capital. Accounting fig- ures tend to overstate the true rate of return on investment under these conditions.7 Most studies attempting to correct for this accounting bias have reached the same conclusion: reported drug company returns on stockholders' equity are overstated (for example, Helms, 1975, Part Two; U.S. Office of Technology Assessment, 1993, pp. 96-103).

7For the relevant theory, see Stauffer (1971). Overstatement occurs when the true rate of return on investment exceeds the growth rate of intangible investments. It may not occur if the firm is diverging from a steady-state growth path.

To illustrate the simplest case, assume a firm with non-growing (constant-dollar) sales of $100 and physical assets (with infinite life, and hence zero depreciation) of $100. Suppose that if the firm fails to invest $7.50 in R&D during any given year, its sales will fall, and/or costs will rise, sufficiently that profits decline by $1 each year for ten years. Saving profits of $1 per year over ten years, the R&D investment has an internal rate of return (with continuous discounting) of 6 percent. Suppose that the return on physical capital is also 6 percent, or $6 per year. Given the ten-year R&D effect life, each year's R&D depreciates by 75 cents per year. In the steady state, the undepreciated R&D stock is $7.50 + 6.75 + *- +.75 = $41.25. Variable production costs are $84 per year, so the annual net profit before accounting for R&D is $16. The accounting proceeds as follows:

Gross profit before R&D R&D expense Depreciation of R&D Net profit Physical plus R&D capital Return on capital (percent)

R&D Expensed

$16.00 7.50

$8.50 $100.00

8.5

R&D Capitalized

$16.00

7.50 $8.50

$141.25 6.0

The expensing approach yields a rate of return on capital above the true 6 percent return.




Whether supra-normal returns remain when such accounting biases have been purged has been investigated in a study commissioned by the U.S. Office of Technology Assessment (1993). Using unusually rich cash flow and expense data and conducting extensive sensitivity tests, Baber and Kang (1991) found that the corrected average returns on investment for 88 drug companies between 1976 and 1987 exceeded benchmarks for two control groups by two to three percentage points on average.

Corroborative evidence supports an inference that the pharmaceutical industry realized supra-normal returns on investment. During the 1980s, members of the U.S. Pharmaceutical Manufacturers Association increased their R&D outlays at an average compounded real rate of 9.8 percent per year (using the gross national product deflator to correct for inflation), or at 9.2 percent if only drug-makers' R&D outlays inside the United States are counted. Over the same period, all U.S. industries excepting pharmaceuticals raised their real company-financed R&D outlays at an annual rate of 3.7 percent. Had the returns to pharmaceutical R&D investment not been attractive, it seems implausible that drug-makers would have expanded their R&D so much more rapidly than their industrial peers.8

This inference holds, whether or not risk premia were required to induce investment in pharmaceutical R&D. It is instructive nevertheless to consider more fully the nature and magnitude of those risks. We recall that the lump of R&D costs sunk to achieve an average approved new product is large-on the order of $125 million for 1980s-vintage products. However, product marketing approval by the FDA is not the only relevant measure of success. Products must be sold, and the distribution of new product sales is highly skewed. A few new products are "blockbusters;" most achieve much lower sales.9

Using detailed annual sales survey data covering 100 new chemical entities introduced into the United States between 1970 and 1979 and making a host of complex but plausible assumptions concerning time durations, foreign sales,

8Two alternative hypotheses deserve mention. One, the scope of the universe sampled by PMA may have increased. Some new biotechnology firms joined PMA, but other companies exited. PMA membership included 144 companies in 1980 and "more than 100" in 1990. Second, there were advances in drug-finding technology during the 1 980s that might have created new profit opportunities. These, however, have clear antecedents in the 1980s. 9The shape of the sales distribution is important, because certain forms-notably, the so-called Pareto-Levy distribution-lack asymptotically finite means and variances, and hence do not con- form to the weak law of large numbers. This implies that the observed sales averages (and for given R&D outlays and v4riable cost ratios, profit averages) from different product cohorts can exhibit violent instability. Also, stable results cannot be assured by building portfolios containing more projects. See Mandelbrot (1963). If a distribution is Pareto-Levy, it follows the equation: N = uS', where N is the number of sample observations greater than or equal to some sales value S. The standard test is for linearity of the equation for values of S and N in the logarithms.

A test using data on the 1986 expenditure shares of the 75 most-purchased drugs in a large health maintenance organization revealed significant downward concavity, indicating less skewness than would emerge under Pareto-Levy. The log normal distribution, which is less skewed and better-behaved statistically, had a much closer fit. The data are from Rinaldo V. DeNuzzo, "31st Annual Prescription Survey," Medical Advertising News, April 1, 1987, pp. 7-8.




gross profit margins, and R&D costs, Grabowski and Vernon (1990) found that seven-tenths of the new drugs had discounted quasi-rents well below R&D costs. Entities in the third most profitable decile barely broke even; those in the second decile had discounted quasi-rents nearly twice discounted R&D costs. Of the sample's revenues, 55 percent came from the top ten drugs, whose average discounted quasi-rents exceeded discounted R&D costs by a factor of five. Thus, new drug development resembles a risky lottery that throws out rich rewards to a few big winners while the majority of entries lose money. Although these risks (unsystematic, in capital asset pricing parlance) can probably be pooled to insignificance by common stock investors holding multi-company portfolios, pooling within companies may be insufficient to avoid substantial variability in individual company returns, especially for smaller companies (Thomas, 1990). The importance of this point will become evident shortly.

Price Controls, Implemented and Proposed

Convinced that drug prices and profit returns have been excessive, the U.S. Congress passed in 1990 a new law (Public Law 101-508) mandating rebates on drug purchases reimbursed with federal funds. The 1990 law required that pharmaceutical companies rebate to the federal government any surplus of the prices they charged for prescriptions filled at retail under the Medicaid reimbursement program (covering low-income citizens) over the discounts they routinely granted to other high-volume purchasers. In 1989, approximately 14 percent of all U.S. prescriptions by dollar volume were covered under Medicaid. Traditionally, retailers have received a 40 percent discount off the suggested retail list price on their purchases from wholesalers, who in turn (along with direct retail chain purchases) secured an additional 15 to 20 percent discount off the price to most retailers. Large hospitals, city and state procurement authorities, and the Department of Veterans Affairs commonly obtained further discounts of 10 to 20 percent off the price to wholesalers.10 The new law in effect requires drug manufacturers to apply on retail Medicaid prescriptions the largest discount they give to any purchaser, rather than the smaller discount they normally offered to wholesalers.

The Medicaid discounts were to be at least 12.5 to 15 percent off the wholesale price, depending upon the applicable year. Compliance is encour- aged by a quid pro quo-for manufacturers offering rebates, the removal of formulary restrictions barring Medicaid reimbursement of their newest, usually most expensive, drugs. The program is enforced by having pharmacists submit information on individual prescriptions to a central accounting office, which attempts to match Medicaid prescriptions to individual manufacturers.

'0One implication is that more than half the price of drugs to retail consumers is captured at stages in the value chain other than manufacturing.



F. M. Scherer 107

Manufacturers then pay a lump-sum rebate to the federal Treasury based upon the annual volume of Medicaid prescriptions attributed to them, multiplied by the percentage gap between minimum and average wholesale prices. Rebates totalling $3.3 billion over the first five years of the law's existence were anticipated by the lawmakers.11

Along with imposing appreciable paperwork requirements, the 1990 law created a potential incentive problem. The Department of Veterans Affairs, which purchases approximately 1 percent of all prescription drugs, has historically received some of the highest discounts off wholesale prices. Drug manufacturers might raise their effective prices to veteran's hospitals (and to other high-discount purchasers) to,reduce the amount they would otherwise have to rebate on Medicaid sales. There have been numerous assertions (but only equivocal evidence) that a compression of discounts followed the law's passage. 12

Anticipating the problem, the 1990 law added complex provisions requiring further rebates to the federal government if manufacturers raised their prices (calculated product-by-product initially, but optionally after 1993 from individual company all-product price indices) at a rate exceeding the general rate of increase for all consumer prices.

In 1991 and 1992, several attempts were made to intensify federal pressure on drug prices. Because drug manufacturing and transportation costs are modest in relation to product prices and because the geographic locus of patent rights ownership is easily transferred, the pharmaceutical companies have been particularly aggressive in obtaining U.S. federal income tax credits by locating their production operations in Puerto Rico (Freudenheim, 1992a). Senate bill S-2000 would have reduced drug-makers' Puerto Rico tax credits by as much as 20 percent for each percentage point by which their price increases exceeded general inflation rates.13 However, an attempt to attach S-2000 to an omnibus tax bill failed. A parallel but unsuccessful House of Representatives Bill (HR- 3823) would have denied research and development tax credits to drug companies whose new products sustained price increases exceeding urban Consumer Price Index inflation rates by more than 2 percent.

Other price suppression efforts attempted to close what had come to be seen as loopholes in the Orphan Drug Act of 1983. Orphan drug status is normally designated at an early phase in the product testing cycle. With a rapidly spreading disease such as AIDS, the less-than-200,000 cases criterion could be satisfied, even though the incidence exceeded that threshold when

I"A later Congressional Budget Office estimate put the five-year savings on an expanded rebate program at $6.4 billion. 12A General Accounting Office study unearthed only equivocal evidence that HMO and hospital drug prices rose disproportionately as a consequence of the law (F-D-C Reports, January 25, 1993, pp. T & G7-8). 13The principal sponsors of the bills cited here were as follows: S-2000, David Pryor; HR-3823, Fortney Stark; HR-4638, Henry Waxman; S-2060, Howard Metzenbaum; and HR-1713, Fortney Stark.




AZT and similar drugs were eventually marketed. Also, the act made no distinction between drugs prescribed once to deal with acute symptoms and those administered repeatedly for chronic symptoms-the latter yielding po- tentially larger sales for a given patient population. In November 1990, Presi- dent Bush vetoed a bill (HR-4638) that would have removed orphan drug status for any drug whose clientele had grown to exceed 200,000. The vetoed bill would also have required companies applying for orphan drug status on a given chemical entity within a year of one another to share the market competitively, rather than allowing the first company receiving FDA approval (a process subject to random delays) to enjoy exclusive rights. In 1992, S-2060, seeking to end orphan drug status on substances whose sales had accumulated to more than $200 million, was voted out of a Senate committee, but failed to gain passage. Also unsuccessful was a 1992 House bill (HR-1713) to limit "windfall" profits gained from orphan drugs.

Some orphan drugs have emerged from inventions made through federal government programs, especially those sponsored by the National Institutes of Health (NIH). If the government obtains patents, it is allowed under policy revisions implemented during the 1980s to assign to private drug (and other) companies exclusive rights to their commercialization. NIH also cooperates in the development and testing of new drugs, especially orphan drugs. On December 2, 1992, NIH convened an advisory meeting to consider what actions, if any, the agency should take to ensure that drugs developed coopera- tively are priced to reflect "public investment in the product, and the health and safety needs of the public," as stipulated under boilerplate provisions of the NIH-industry cooperative R&D agreements. NIH was visibly reluctant to assume price control functions, but under heavy pressure from Congress, perceived that it might be compelled to do so."4

The Clinton Administration's health care reform plan, scheduled for re- lease in Summer 1993, was expected to build upon these Congressional initiatives by proposing some form of drug price controls. At the time this article was completed, the controls were expected to be imposed through moral suasion or "jawboning" rather than being legally binding.

Overseas Sales Revenues

Pharmaceutical industry-specific price controls are a new phenomenon for the United States, but an institution of long standing abroad. Many nations with extensive governmental health care programs bring their substantial purchasing power to bear on the prices charged by pharmaceutical manufacturers, in effect forcing the drug-makers to price-discriminate across geographic

14See "NIH Drafting Interim Pricing Policy Statement for Congressional Hearings," F-D-C Reports, December 7, 1992, pp. 7-8.




markets. They negotiate price concessions; impose individual product price ceilings; withhold approval of high-priced drugs; regulate pharmaceutical company profits; threaten or impose compulsory licensing of patents to generic drug producers; tie subsidies to price concessions; and employ diverse other techniques. There is abundant evidence that, as a result of these pressures, and recognizing exceptions such as Japan, drug prices tend to be substantially lower on average abroad than they are in the United States (for example, Johnston and Zeckhauser, 1990; Kolata, 1991; U.S. General Accounting Office, 1992).

American pharmaceutical manufacturers and government officials have complained that through these interventions, other nations are free-riding (or more accurately, cheap-riding) on the drug development efforts of U.S. firms. As a practical matter, not much can be done to remedy the situation, given traditions of international comity. Presumably, even with price restrictions, foreign sales help defray the sunk R&D costs of U.S. companies-which in 1989 conducted about a third of all world pharmaceutical R&D (Ballance et al. 1992, p. 89)5 -even though the contribution is less than it would be under weaker regulation. Yet if other nations made compensating adjustments in their drug pricing policies, it is conceivable that the United States could force domestic drug prices down without jeopardizing the rate of technological progress.

Aggressive initiatives are afoot to advance toward this condition on one important front-patent policy. Historically, drugs (along with other chemicals and foods) have been singled out for weaker patent protection under the laws of many nations than mechanical and electrical inventions. Switzerland, for example, had long granted patents on drug manufacturing processes, but did not award patents on product formulas until 1977. This is a significant differ- ence, since product patents normally provide much stronger barriers to generic imitation than process patents. Italy granted neither product nor process patents for drugs until it harmonized its patent system with those of other European Community nations in 1978. As late as 1989, pharmaceutical products were not patentable in nearly half of the 101 national signatories to the Paris Convention for the Protection of Intellectual Property (Rao, 1989). In addition, numerous national laws authorize compulsory licensing when patented inventions are not "worked" (that is, produced) within the patent-granting nation. And many nations, especially less-developed countries, leave patents in force for much shorter durations than the 17 to 20 year periods customary in the United States, Europe, and Japan. All of these practices are consistent with the Paris Convention as long as there is no discrimination in the treatment of foreign as compared to domestic patent recipients.

15This includes the U.S. R&D of the dozen or more U.S. Pharmaceutical Manufacturers Association members with home bases in other nations. In 1989, PMA members conducted ethical drug R&D valued at $5.8 billion in the United States and $1.26 billion abroad. Ethical drugs are defined as drugs used to combat disease which are promoted primarily to the health care professions. Pharmaceutical Manufacturers Association, Statistical Fact Book (Washington: September 1991).




Canada's patent policies were a particularly proximate thorn in the side of the U.S. pharmaceutical industry. In 1969, the Canadian Parliament directed the Commissioner of Patents to approve applications for compulsory licenses to drug patents "except [when]... he sees good reason not to grant such a license." Between 1970 and 1978, 227 licenses to produce and/or import drugs competing with those of patent holders were granted. Early interpretations made it clear that the "reasonable royalty" to be paid by the licensee would be modest-typically, 4 percent of the generic drug's sales. Rejecting pleas for higher royalties to maintain incentives for drug research, the Exchequer Court observed, "It would ... be unrealistic to think that the returns from the Canadian market have any important bearing on whether research on an international scale will go on or not. 16 Thus, cheap-riding was expressly acknowledged. With the extensive entry of generic competition, average drug prices in Canada fell from an estimated 9 percent above U.S. levels in 1968 to 21 percent below U.S. levels in 1976 (U.S. Office of Technology Assessment, 1993, p. 253).

Under heavy pressure from U.S. pharmaceutical makers and to facilitate free trade agreement negotiations, Canada amended its law in 1987, granting seven to ten years of exclusivity (that is, free from compulsory licensing) on new drugs approved for Canadian marketing. As a quid pro quo, multinational companies agreed to increase their Canadian R&D to 10 percent of Canadian drug sales by 1996. In addition, they were brought under the authority of a new Patented Medicine Prices Review Board. Further amendments proposed to the Parliament in late 1992 would eliminate compulsory licensing of drugs altogether and confer a full 20-year patent term, but retain Review Board regulatory functions.

Even before the U.S. pharmaceutical companies won this partial victory in Canada, they expanded their horizons. Making common cause with publishers, software houses, and motion picture producers, they formed a powerful interest group, the Intellectual Property Committee (Santoro, 1992). IPC joined its efforts with like-minded industry groups in Europe and Japan. Lobbying induced governmental action on two fronts.

For one, the U.S. Congress was persuaded to make weak patent and other intellectual property laws a prime target for measures under Section 301 ("Super 301") of the 1988 Omnibus Trade and Competitiveness Act. The U.S. Trade Representative was instructed to evaluate the patent and copyright laws of U.S. trading partners, warn miscreants of inadequate protection, and if no corrective actions were forthcoming, to impose retaliatory trade sanctions against them. Many nations, mostly less developed countries, were put on warning lists of varying severity. Some target nations such as Korea, Mexico, Indonesia, and the People's Republic of China agreed to strengthen their laws,

16Merck & Co. Inc. v. Sherman & Ulster Ltd., 65 C.P.R. 99, 108-109 (1971). See also Scherer (1977, pp. 40-47).



F. M. Scherer 111

but others continue to resist. Punitive duties were levied against Brazil in 1989, and Thailand's benefits under the U.S. System of Generalized Preferences were revoked. In 1992, Taiwan, India, and Thailand were threatened with escalating trade sanctions unless they increased the protection granted to pharmaceuticals and computer software, among other goods.

Meanwhile, industry groups from the United States, the European Com- munity, and Japan joined forces to have their national governments make stronger, more uniform national intellectual property laws a top priority goal in the Uruguay Round of negotiations to amend the General Agreement on Tariffs and Trade. Preliminary agreements were reached to strengthen retro- grade nations' laws, but on a time schedule more leisurely than industry lobbyists had sought. At the time this was written, it remained uncertain whether these and other compromises reached under the Uruguay Round would be ratified.

Few international trade negotiation issues have juxtaposed such bitterly conflicting national preferences. Pharmaceutical industry executives express moral outrage over the "piracy" of their hard-won new drug formulae. They claim also that if they had stronger patent rights in less-developed nations, they could sell more output at higher prices there, gaining revenues that would induce more research, development, and clinical testing, and hence the discovery of more beneficial new drugs, in their home jurisdictions.'7

Industry's economic claim must be true in principle. But how large will the inducement effect be? Developing nations accounted for roughly 19 percent of world pharmaceutical consumption in 1990 (Ballance et al., 1992, p. 31), so the increase in drug company profits from stronger intellectual property protection could be appreciable.'8 Yet it is overly optimistic to believe that the incremental impact on the supply of new drug products would be large. Despite weak patent protection, multinational drug companies manage to win substantial shares of drug markets in less developed countries-an estimated 84 percent in Brazil, 72 percent in Indonesia, and 25 to 30 percent (down sharply from previous decades) in India (Ballance et al., 1992, p. 76). Second, there are

17Could there plausibly be too much drug R&D? Yes, but the conditions for determining the socially optimal R&D program are too complex to reach a confident judgment as to whether the market has overshot or undershot. Strong differentiation of therapeutic effects by disease class and individual consumer sensitivities implies sharply peaked surplus functions and hence large surpluses from product proliferation. That drugs can save lives, improve the quality of life, and make expensive surgery unnecessary also implies large surpluses. Large surpluses plus considerable technological and market uncertainty call for multiplication of parallel development paths. On the other hand, extensive "cannibalization" of producers' surplus (e.g., as Glaxo's Zantac takes profits from SmithKline Beckman's Tagamet) can mean that too much product variety-increasing research is being done. So also do large wedges between demand curves, given medical insurance, and the demand curves that would prevail without insurance (Scherer and Ross, 1990, pp. 602-607 and 637-44). 18From the data on 147 nations in Ballance et al. (pp. 226-33), the average income elasticity of demand for pharmaceuticals appears to be roughly 0.9, although there are hints that demand is more income-elastic in less developed nations and less elastic in the more prosperous nations.




almost surely diminishing marginal returns in R&D payoff functions, since drug companies seem able at least roughly to give higher developmental priority to molecules with large potential markets, in effect removing those products from the margin that would be affected by global revenue changes.'9

Less-developed nations advance several arguments against the extension of strong drug patent protection to their home territories. Most compellingly, because they are poor, they suffer inequitably from the income 'redistributions and deadweight losses to which price increases permitted by strengthened patents give rise. The local losses in a less developed country attributable to monopoly prices almost surely exceed the local gains from an enhanced supply of general-purpose drugs.2" Also, payments for imported drugs and the remis- sion of higher profits on drugs produced locally by multinational corporations appropriate scarce hard currency, badly needed in these countries to buy machinery, technological know-how, and other requisites for economic development. Representatives of less developed countries accuse the United States of hypocrisy in this respect, since the early industrial development of the United States was aided by machinery and machine designs smuggled from England in contravention of British law. Furthermore, on at least six occasions during the 1950s and 1960s, the United States ordered compulsory licensing of more than 100 drug patents on its home turf under antitrust case settlements (Scherer, 1977, p. 41). And last but probably not least, the citizens of less-developed nations resent what they consider to be "bullying" tactics used by the United States to force changes in patent practices.

In sum, international patent policy negotiations join strongly conflicting values. Drug manufacturers from industrialized nations, and probably also their domestic consumers, gain from promoting strengthened patent systems for less developed nations. Citizens of less developed countries have good reasons to oppose such changes. Bargaining power carries more weight in resolving the conflict than equity considerations. In recent years, the United States- has used its power to advance its parochial interests, but not in a manner that (at least, as perceived by the author) enhances its stature as an enlightened world leader.

19This proposition is supported inter alia by the evidence that the development of drugs targeted toward small markets rose sharply following the 1983 Orphan Drug Act. A corollary is that modest reductions in U.S. market revenues owing to price controls not biased toward the most important new drugs would have only modest innovation-inhibiting consequences. 2OAssuming straight-line demand functions and constant marginal costs, the short-run consumers' surplus gain from an additional monopolized drug is one-third the loss of consumers' surplus from monopolistic pricing of a comparable drug that would otherwise be available at competitive (that is, marginal cost) prices. To keep less developed country consumers equally well-off under these assumptions, the number of new drugs developed and sold as a result of strengthened LDC patent laws would have to be three times the number of drugs available without strengthening-a highly unlikely outcome. For a more complete analysis along these lines, see Deardorff (1992).




Evaluation

In the author's considered judgment, a pell-mell march toward regulation of pharmaceutical industry pricing could seriously impair the industry's incentives for investment in new products. Governmental bodies that regulate prices and profits characteristically have a myopic bias. They are inclined toward what might be called "Willie Sutton" regulation,21 emphasizing recapture of "excess" profits on the relatively few highly profitable products without taking into account failures or limping successes experienced on the much larger number of other entries. If profits were held to "reasonable" levels on blockbuster drugs, aggregate profits would almost surely be insufficient to sustain a high rate of technological progress. This tendency would be aggravated when, as is likely, individual companies are too small to pool internally the combination of (highly skewed) market and regulatory risks. If in addition developing a blockbuster is riskier than augmenting the assortment of already known molecules, the rate at which important new drugs appear could be retarded significantly. Assuming that important new drugs yield substantial consumers' surplus untapped by their developers, consumers would lose along with the drug companies. Should a tradeoff be required between modestly excessive prices and profits versus retarded technical progress, it would be better to err on the side of excessive profits.22

A much better approach, the author believes, would be to work toward improved information in the pharmaceuticals market so that, when the patents on once-new drugs expire, generic products become more effective substitutes. If, as is likely, the United States moves increasingly toward organizing health care in sizable groups under a "managed competition" approach, this is likely to happen automatically as the decision-making role of health maintenance organization formulary committees grows and the power of individual physicians (more apt to continue prescribing branded drugs) wanes.23 Helping the invisible hand function in this way would be preferable to Willie Sutton regulation, for the truly new and important drugs will be attractive to

21To Willie Sutton is attributed the concept of robbing banks because "that's where the money is." I am indebted to Henry Grabowski for the metaphor. For supporting evidence on profit recapture from the history of military procurement contract renegotiation, see Scherer (1964, pp. 252-61). 22The U.S. Office of Technology Assessment (1993) calculated that drug prices during the 1980s could have been reduced by 3.4 percent on average without driving profit returns to sub-normal levels. The method was to divide the supra-normal returns on capital, estimated by methods similar to those of Grabowski and Vernon (1990), by a sales denominator. 23This change is likely also to impose discipline upon another aspect of industry conduct that drew Congressional criticism in 1993-high expenditures on marketing. In 1977, the last year for which detailed "Line of Business" breakdowns are available, ethical drug-makers devoted 19.4 cents per sales dollar to marketing. Only 21 out of 238 manufacturing industry categories had higher total marketing/sales ratios. As drug purchasing decisions migrate to HMO formulary committees, expensive one-on-one "detailing" of individual physicians will become less attractive.




formulary committees and individual physicians alike. Thus, strong incentives for the drug companies to seek therapeutic breakthroughs will be preserved.

The loss of R&D-inducing revenue due to more vigorous competition or stringent regulation in the United States might be compensated in part by revenue gains abroad owing to strengthened patent institutions-but only at high welfare costs to the citizens of less developed nations. As advances in medical and biological science expand the menu of investment opportunities, perhaps ushering in a new golden age of pharmaceutical innovation, substantial consumer benefits hinge on finding sensible public policy choices.

* Much of the background knowledge for this paper was gained through the author's service as chair of a U.S. Office of Technology Assessment advisory committee on pharmaceutical R&D. The author thanks members of the advisory committee and especially Judith Wagner, project director, for their educational eforts. Valuable critical comments on the paper were received from Joan Curran, Gurcharan Das, Edgar Davis, Lorraine Eden, Alison Keith, Joe Newhouse, Carl Shapiro, Joe Stiglitz, Timothy Taylor, and Judith Wagner.

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pricing, profits, and technological progress in the pharmaceutical industry

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