HADM 712 Pharmaceutical Industry
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Pharmaceutical industry
Comanor, W.S., "The Political Economy of the Pharmaceutical Industry," Journal of Economic
Literature, September 1986, 24:1178-1217.
Big issues:
prices
sales promotion
safety regulation
innovation
Industry profit strategy:
High prices relative to manufacturing cost to generate profit.
Supporting high prices
sales promotion, mainly to physicians to increase demand
patent protection to prevent generic competition
which requires innovation, because
patents run out
me-too drugs -- similar action or better
action with different chemical
Industry (can't defend high prices or lax safety regulation per se) poses issue as
low price and strict regulation
versus
innovation
Industry: High prices provide incentive and wherewithal to do research and development
leading to innovation.
Excessive safety/efficacy regulation slows innovation. Sales promotion is actually
education.
Issue sometimes posed to physicians and hospitals: Should you prescribe or stock
brand-name drugs to encourage innovation? That question now extended to managed
care plans and government.
Price
and sales promotion
1940s to 1980 strategy was to introduce new drug at high markup but then hold
price steady or reduce it over time. Patent expiration or entry of "me too" drugs brought
price competition. Profit came from early-year markup on stream of new drugs.
HADM 712 Pharmaceutical Industry
Drugs -- price cuts 1960-1980
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Drugs -- biggest price increases since 1980.
1980 - present strategy includes increasing prices on drugs over time.
Might 1960s safety regulations have reduced the quickness of me-too drug
innovation, reducing that check on price hikes?
History of charging what the market will bear. Examples: oral insulin at injected
insulin's price. AZT.
Industry spending on sales promotion embarasses industry claims about price,
cost, and innovation.
Feldstein lauds drugs as major contributors to decline in morbidity and mortality. Quite a
contrast with his earlier dismissal of the contribution of the medical care system to health.
Do the drugs prescribe themselves?
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The percentage of personal health care spending that's on prescription drugs:
1960
1970
1980
1990
23.9
64.9
219.4
591.5
2.7
5.5
12
32.7
Ratio
11%
8%
5%
6%
Out of pocket % for
prescriptions
96%
85%
65%
57%
Private insurance %
1%
6%
21%
24%
Medicaid %
0%
8%
12%
15%
Personal health expenditures
$bil
Prescription drugs $bil
Notes: Hospital drug purchases not included.
No Medicare drug coverage, yet.
Drug price trends shown above. "Linking" of new drugs' prices is reason for declining
price index despite introduction of new, more expensive drugs. Example:
cephalosporins.
"Ethical" (as distinct from proprietary) drug manufacturers started as makers of chemicals
for physicians and pharmacists, who would roll their own pills.
1940s saw revolution in industry thanks to new antibiotic "wonder drugs" and production
requirements of World War II.
No product patent on penicillin G, and US government held process patents and freely
licensed them, and it was a generic product with no brand name differentiation, so
competition dramatically lowered the price.
Year
Bulk price per billion units Penicillin G
1945
$6000
1948
$1000
1952
$ 100
1965
$ 15 (K salt)
For brand-name drugs, though, patent protection (17-year monopoly in return for
revealing formula) and differentiated product (brand name) stemmed competition,
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provided route to big profits.
1948 American Cyanamid's Lederle Lab came out with first tetracycline,
chlortetracycline under Aureomycin brand name. Blitzed physicians with flashy journal
advts, direct mail (two mailings per doc per week for a year), and ten freight cars of
samples that alone cost $2 million ($14 average per active physician in the US).
Detail People (formerly "detail men") -- sales people to visit docs.
Aureomycin was a big hit. Other drug companies quickly imitated.
By 1962, docs were getting >10 pieces of direct mail per day.
I estimate that pharm industry now spends close to $15,000 per year per active physician
in US on sales promotion (based on $5000 published figure for 1969 plus inflation).
That's comparable to medical school tuition.
1959 US Senate investigation led by Estes Kefauver found that, for 22 major drugs,
selling price was over triple the production cost. Some drugs sold for 7 to 20 times
production cost. R&D and sales promotion come out of that markup. Rate of return
(Profit rate) was 20+%, >2x average for manufacturing.
Industry counter: drug R&D is uncertain, so premium is required.
Kefauver counter-counter: much drug R&D is trivial, returns are excessive relative to
required uncertainty premium, more is spent on sales promo than on R&D, and much of
sales promo is misinformation.
1968 Nelson Subcommittee (US Senate Subcommittee on monopoly) reprinted some
bulletins from a regional sales manager to his detailmen regarding promotion of
indomethacin, an anti-rheumatic drug. One bulletin called the elderly patients who use
this drug "the real crocks and cruds of everyday practice." Another told detailmen to hint
to docs that only "a gambling sole" [sic] would risk malpractice suit by prescribing a
competing drug. The bulletin's concluding advice: "Tell 'Em Again and Again and
Again -- Tell 'Em Until They're Sold and Stay Sold."
Allegations of "expanded claims" -- salesmen instructed to make therapeutic claims
verbally to docs that Food and Drug Association would prohibit from print advertising as
unsubstantiated.
Nevertheless, surveys show detail people are docs' prime source of information about
new drugs.
Until very recently, pharmaceuticals industry had consistently been the highest or close to
the highest profit manufacturing industries.
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Safety and efficacy regulation
The industry likes regulation that favors it. Until 1970s 48 of 50 states prohibited the
advertising of prescription drug prices.
Quality regulation dates from the 1906 Pure Food and Drug Act. "U.S.P." standard
established for purity. No safety or efficacy requirement.
1937 -- an elixir of Sulfanilamide dissolved in ethylene glycol killed over 100 children.
=>
1938 Food, Drug, and Cosmetics Act created the modern Food and Drug Administration
(FDA). Marketing new drug has since required prior approval of New Drug Application
(NDA). Despite "effective" in name, only proof of safety was required.
1960-62 Thalidomide near-disaster.
Thalidomide was a sedative widely marketed over the counter in Europe. In 1960,
Richardson-Merrill got a US license from the European patent holder, filed an NDA, and,
as part of the testing that was then allowed under the 1938 act, distributed 2.5 million
doses of the drug to 1300 physicians for a "clinical testing" program that was more like
pre-promotion. At that time, an NDA was automatically approved in 60 days unless
negative evidence appeared. FDA could extend review for up to 120 days more.
The heroine was Dr. Francis O. Kelsey of the FDA, handling her first NDA. Concerned
about reports of tingling sensations in the extremities, she delayed approving the
Thalidomide NDA for the maximum period, then concocted further bureaucratic delays
to keep Thalidomide off the market, despite daily visits from Merrill lobbyists, and a
letter from Merrill calling her complaints about false data on Merrill's NDA "libellous."
By late 1961, investigators in West Germany had linked Thalidomide with a severe birth
defect, phocomelia. 5900 cases in W. Ger. Had it not been for Dr. Kelsey, there might
have been 10,000 cases in the US. Instead there were 10, from Merrill's loosely
controlled clinical testing program. It took months to inform the medical profession and
recover the Thalidomide samples. JFK gave Kelsey the Distinguished Federal Civilian
Service medal.
Reaction => 1962 Kefauver-Harris Amendments
positive NDA approval required, no time limit
proof of efficacy in addition to safety
retroactive efficacy proof required for post-1938 drugs
=> removals from market of about 90 senseless drugs, like antibiotics in
combination.
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clinical testing tightened:
animal tests first
then IND (Investigational New Drug) application
controlled clinical tests by qualified investigators
advertising restrictions
generic name must appear
side-effects and contraindications
therapeutic claims cannot exceed evidence submitted to FDA
Industry complaints:
New process makes pharm innovation more costly
Future income stream from innovation is reduced because:
17 year patent protection is partly used up by the FDA approval process
Policies that encourage substitution of generic for brand name drugs further erodes
future income. Indeed, there have been big changes here, particularly in state
laws. Where formerly price advt and substitution were banned, now price advt is
allowed and substitution is positively encouraged by, e.g., requiring doc to make
special notation on prescription form if doc insists upon brand name.
Higher initial costs and lower returns means lower rate of return to research
overall.
Innovation is thus slowed.
Good drugs are thus kept off market.
The industry argues:
Higher initial costs and lower returns means lower rate of return to research overall.
Innovation is thus slowed.
Good drugs are thus kept off market.
F. cites Wardell's discussion of benzodiazepine hypnotic. It took 5 years longer to
approve this drug in the U.S. than in Europe. Wardell estimated that there were
1200 deaths from overdoses of drugs of this class that would have been averted
had this drug been available.
Feldstein's treatment reflects industry concerns.
The rate of introduction of new drugs did fall after 1962. It's not clear, though, to what
extent this is because of the 1962 law or because the avenues of research at the time had
been played out.
A 1984 law eased some FDA restrictions
bioequivalence to existing approved drug sufficient for marketing without repeat
testing
patent protection extended up to 5 years more
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Comanor says the "essential trade-off" that has framed the debate is between low prices
and rapid innovation. (p. 1180) That's true in the context of how the US has historically
encouraged innovation in this and other manufacturing industries, which is by patents.
Patents give the patent holder exclusive right to sell the patented product for 17 years. To
obtain a patent one must submit the formula, design, or manufacturing method, etc., to
the US Patent Office, which makes the information public. When the patent expires,
anyone can use the information. Compare Coca-Cola formula.
A patent provides a temporary monopoly. The monopoly profits are the plum that
induces invention.
Agriculture is a highly innovative and competitive industry. Its research is done at ag
universities with public funds and grants from farm input and output industries. Those
industries also do their own research, for which patents are important.
High-markup prices, profits, and research
F. lauds drugs as major contributors to decline in morbidity and mortality.
Quite a contrast with his earlier dismissal of the contribution of the
medical care system. Do the drugs prescribe themselves?
The percentage of personal health care spending that's on drugs and sundries:
1950 -- 15.9%
1985 -- 7.7%
1991 -- 8.1%
Monopoly pricing
Selling prices have been found to be 7 to 20 times manufacturing costs for some individual
drugs. This overstates monopoly pricing because these are the winners in the new drug lottery.
Most big drug makers depend on a handful of drugs for most of their revenues and profits.
Watch out for research fund theory, which says doc should prescribe brand name drugs so that
companies will have the funds to do research. This is backwards. The right way to express it is:
If the drug companies can anticipate that physicians will continue to prescribe brand name drugs
even after the patent protection runs out, then drug companies have more incentive to turn out
more patentable brand-name drugs.
Most big drug makers depend on a handful of drugs for most of their revenues and
profits. Watch out for research fund theory, which says doc should prescribe brand name
drugs so that companies will have the funds to do research. This is backwards. What
matters is the incentive.
Some classic examples of tacit collusion in pricing are from the drug industry. For
HADM 712 Pharmaceutical Industry
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example, in 1955 the Veterans Admin solicited sealed bids to supply 5640 100-capsule
bottles tetracycline. Five bids were received, all for $19.1884 per bottle. Here's where
that came from:
The manufacturers' original list prices were all
They had recently all cut the list 15% to
Retail druggists got a 40% markup, so jobber price was
Jobber price was 20% above wholesale, which was
The government got a 20% discount, to (rounded)
Minus 2% standard trade discount for bulk order gives
$60.00
$51.00
$30.60
$24.48
$19.58
$19.1884
A series of round number discounts applied identically by five "competing" firms. The
VA estimated that the actual production costs at the time were $3/bottle. (Scherer, 181,
447)
High drug industry profits? One can get into arcana of the proper treatment of
expenditure on advertising and research and development. Book profit rates are based on
(Sales - Current Expenditures) / Capital invested
If you account advt and R&D as investments which depreciate slowly, rather than current
expenditures, then you increase current income (sales revenue minus current
expenditures) and also increase capital invested. The denominator grows faster than the
numerator, and the difference is greater the slower is the depreciation. Clarkson
recalculated profits for various industries, making a correction for this, showing that drug
industry profits were much reduced. Comanor points out that Clarkson may have overcorrected, and besides, pharmaceuticals still head his Clarkson's of profitable industries.
It's noteworthy in this context that starting in the late 1960s, the pharmaceutical industry
began buying academic studies. As a major supporter of the American Enterprise
Institute, the industry funded Clarkson's study and several others like it that drew similar
conclusions. Besides money, the drug industry provided data that was not generally
available to other investigators. The ethics of doing research under such circumstances
was subject to considerable discussion at the time. The industry did succeed in framing
the debate, though, as Comanor's article shows.
(The industry recognizes the value of information/marketing for its political position as
well as for its sales position. I get regular unsolicited mailings from the Pharmaceutical
Manufacturers Association on policy issues.)
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One series of studies, fostered by industry funding, have found that rates of return to drug
R&D are low. Statman found that the rate of return fell from 20% in the 1950s to 1012% in the 1970s (p. 1195). These results put the researchers in the awkward position of
having to explain why, if R&D was such a bad investment, the industry nearly doubled
its R&D spending 1965-1980.
Advertising and promotion
The prescription pharmaceutical industry spends over 20% of sales revenue on
promotion, more than twice what it spends on research.
Industry defenders say that detail people provide information that would be more costly
for docs to obtain otherwise. Do we presume that docs can discern tendentious from
accurate information?
Schwartzman (another heavy recipient of drug industry research $): eliminating promo
would save consumers only 5% of their drug bill. (Assumptions about wholesale-retail
markup may account for some of this. Also, what do we mean by drug "bill"?)
Huge advt expenditure here, as in cigarette and beer industries, suggests fierce non-price
competition.
Walker study (Comanor p. 1197) makes point that blizzard of advt may have function for
industry as entry barrier. Hard to test.
Regulation
Can marketplace determine whether drugs are effective, or is government regulation
needed? If former then, as Peltzman found, regulation is worse than useless. If latter,
then regulation is needed.
Rate of introduction of new drugs did fall after 1962. Is this bad? Is it because of the
new regulations?
Which is worse, the delays engendered by the fear of another Thalidomide and by
bureaucratic inertia, or by the risk of another Thalidomide?
Where to Go from Here
Comanor doesn't like having the debate framed in terms of a tradeoff between higher
drug prices to encourage innovation and lower drug prices so people can afford to buy
them. He approvingly quotes Spence (p. 1214) that R&D knowledge is a public good.
That implies that the public should provide it. Does he mean like the ag schools?
Prepaid health plans will hopefully be knowledgeable buyers, for whom costeffectiveness will determine what they will buy for their patients. Hospitals have already
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responded to DRGs by encouraging docs to prescribe cheaper drugs. These financing
changes and the resultant cost-consciousness may be reducing the expected return from
drug advertising to docs. What good is sending a detail person or sample to a doc who'll
be taking his/her cues from an HMO's pharmacopeia committee?
Some say we must not put too many restrictions on the industry, killing the goose that's
been laying golden eggs for us. But if regulation is too loose, what kind of eggs will we
get?
Economic theory point:
You don't pay high prices because sales promotion is so costly. Rather, sellers spend on
sales promotion because they can more than recover it with what they can persuade you
to pay.
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Other articles:
Prescribing Decisions Increasingly Are Made By the Cost-Conscious
Wall St. J 9/25/93 p.1.
HMOs, pharmacy management companies for self-insuring employers, are making
cost-benefit decisions on what drugs they will buy or cover. Negotiating discounts.
Reshaping industry sales efforts. End of detail people?
Long article. Lots of quotable stuff.
Burroughs Wellcome Faces U.S. Challenge for Control of AZT
Wall St J 5/29/91
abstract only. NIH wants to break patent monopoly to lower price
(Also saw one on Norplant, but can't find. Both are drugs that Medicaid spends $$ on.)
Methods of Marketing Infant Formula Land Abbott in Hot Water
Wall St J 5/25/93 p.1
Abbott Lab's 15% annual profit increases over past two decades are thanks partly to
infant formula. Similac's price has more than tripled since 1980, 6 times the increase in
the price of cow's milk, Similac's main ingredient. $75/month for typical baby.
Price is estimated six times manufacturing cost.
In mid-1980s, Abbott persuaded rivals to agree to industry sales code that restricted new
entrants by banning advertising to consumers.
Sucked in American Academy of Pediatrics to support advertising ban that kept out
Nestle. Generous contributions.
Later, Nestle did enter U.S. market by buying Carnation, and did advertise to public.
Abbott and others fought with pitches to pediatricians bad-mouthing advertising.
Uniform bidding for WIC contracts. May be cracking.
Schizophrenia Drug Reduces Hospital Stays
Wall St J 11/8/93 p. B6
New industry-funded study of Clorazil shows that it's cheaper to use the drug than to pay
for the hospitalization that would otherwise be necessary. Net savings of $8700 per
patient year for all patients, $23,000 per year for patients who stayed on Clorazil.
Sandoz, Clorazil's maker, may soon face competition from Johnson and Johnson's
Risperdal, which is priced lower and doesn't require the weekly blood test that costs
$300-$3000 per year.
Sandoz used to control the blood test and charge $9000 per year. Cutting that reduced
criticism, as did drug's success in helping some patients dramatically reduce their
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paranoia and psychosis.
Vital Statistic: Disputed Cost of Creating a Drug
Wall St J 11/9/93 p. B1
Industry estimates of cost of new drug brough to market $230 to $500 million.
OTA roughly agrees, with $359 million average.
Those are before taxes. After taxes OTA says $200 million. Sen. Pryor says that's high
end.
Merck complains about regulatory creep as FDA keeps asking for more and better data.
FDA says some industry research is poor.
Whittle Is Facing Big Battle to Retain Drug Advertisers for Medical Network
Wall St J 9/15/93 p.B8
Changing economics of drug industry affects firms' marketing decisions.