Economics of the Pharmaceutical Industry

By Danzon, Patricia M. | NBER Reporter, Fall 2006 | Go to article overview

Economics of the Pharmaceutical Industry


Danzon, Patricia M., NBER Reporter


The pharmaceutical industry is important because it is a major source of medical innovation. The U.S. research-based industry invests about 17 percent of sales in R and D, and R and D drives performance of individual firms and industry structure. It is also a heavily regulated industry. Drugs are evaluated for safety, efficacy, and manufacturing quality as a condition of market access, and promotional messages must adhere to approved product characteristics. Drug prices also are regulated in most countries with national health insurance systems. My research on the pharmaceutical industry has examined issues related to R and D performance and industry structure, and the effects of regulation on prices, availability, and utilization of drugs, and on productivity.

R and D, Firm, and Industry Structure

Regulation of market access and promotion derives from uncertainty about drug safety and efficacy. These product characteristics can only be determined from accumulated experience over large numbers of patients in carefully designed trials or observational studies. The design, monitoring, and evaluation of these studies are public goods that in theory can be efficiently produced by an expert regulatory agency. (1) The 1962 Amendments to the FDA Act extended the powers of the FDA to review safety, efficacy, manufacturing quality, and promotion. Subsequent studies concluded that the safety and efficacy requirements added to the intrinsically high cost of R and D, led to launch delay of new drugs and favored large over small firms.

However, more recently the biotechnology revolution has transformed the nature of drug discovery and the structure of the industry. Increasingly, new drugs originate in small firms, which often out-license their products to more experienced firms for later-stage drug development, regulatory review, and commercialization. In any year the biotechnology industry may comprise a couple of thousand firms, but the identity of these firms changes, as new start-ups are formed and established firms grow, merge, or are acquired by other established companies. Although larger firms have grown in market share, because of mergers, their performance has lagged that of smaller firms, on whom the large firms increasingly rely for new products.

In a series of papers, I and my coauthors have examined the effects on R and D productivity of firm experience and alliance relationships; the nature of the market for alliances between small and large firms; and the effects of mergers and acquisitions. In a study of the determinants of drug success in clinical trials, (2) we find that returns to a firm's overall experience (number of drugs developed across all therapeutic

categories) are small for the relatively simply phase 1 trials, but significantly positive (with diminishing returns) for the larger and more complex phase 2 and phase 3 trials that focus on efficacy and remote risks. We find some evidence that focused experience is more valuable than broad experience ("diseconomies of scope across therapeutic classes"). Products developed in an alliance have a higher probability of success in the more complex late stage trials, particularly if the licensee is a large firm. Thus although larger firms enjoy economies of scale in experience for the complex trials, smaller firms can tap into this expertise through licensing agreements.

Product development deals thus define the sharing of responsibilities and rewards between large and small firms. q-he small firm typically gets cash and/or equity up front, plus contingent milestone and royalties payments, and may choose to participate in late-stage development and co-marketing, in order to gain experience. In return, the large firm obtains rights to develop and market the new product, retaining the majority of product revenues, with specifics depending on the stage of the deal. The efficiency of the market for deals is important because it allocates rents between the smaller and originator firm, as opposed to the larger developer/marketer, and hence influences incentives. …

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