¶ … Gross Profitability and Pharmaceutical R&D Spending Are the pharmaceutical companies - as they claim to be doing - re-investing their substantial profits into research and development for better, more patient-friendly and badly-needed medicines? Or, do the pharmaceutical firms just use that explanation to justify raking in huge profits at the expense of the already-financially-strapped consumer? Those are the questions asked - and answered, to a certain degree - in the Health Affairs Chevy Chase article, which this paper will focus on for a more full understanding of the issues presented. The article is written by F.M. Scherer, who is the Aetna Professor of Public Policy Emeritus at Harvard University's Kennedy School of Government; he is also a lecturer in the public affairs field at Princeton University.

The article claims that profit can indeed be "linked" to R&D in three ways. One, by R&D "leads, with long and variable lags, to new products," which can add to the profits a pharmaceutical company enjoys, providing that the marketplace receives the product with open arms (and wallets); however, the "distribution of those profits," according to Henry Grabowski and John Vernon, "is highly skewed, because only a "minority" of new products do well with consumers, and a "majority" of new products fail financially. Two, pharmaceutical profits are a good source of funding for research and development investments, and R&D investments can also be funneled through new "capital issues."

And the third way R&D can be linked to profit is "managers' expectations of future profit opportunities...can exert a demand-pull influence on R&D development."

Meanwhile, it is all well and good to lay out these three ways to use profit, but the Pharmaceutical Research and Manufacturers of American (PhRMA) surveys these dynamics each year, and part of that research looks into the "ethical drug R&D outlays." And the ways in which PhRMA approaches the study of the ethics of pharmaceutical investments in R&D is twofold: "Time-series analysis," and "Gross margins vs. R&D outlays."

The first, Time-series analysis, does not work very well in analyzing the link between profits and R&D. By measuring the year-to-year "sharp changes" in the variable of interest, not much is revealed, in terms of evaluating spending profits on new projects. Why? Because it basically measures the "surplus of revenues over in-plant production costs," as the funds available to fund R&D - along with "depreciation, marketing costs, central office costs, debt service costs, income taxes and net profits." Hence, it is not a perfect way to examine the ethical representation of profits poured into R&D, because there are "possible inaccuracies in the gross margin measure" which are too small to affect the results, according to the Scherer research in Health Affairs Chevy Chase.

The Gross Margins vs. R&D outlays system of studying the ethics of these drug company investments shows that the growth rate of "deflated gross margins" was 4.23% each year lower than the percent of growth rate (7.51%) for R&D outlays. The differences between the time-series and gross margins evaluations, are, according to Scherer, "so closely correlated that it would be implausible to infer a chain of causation running from R&D to profits. Why? Typically, lags of ten to fifteen years exist between R&D spending on a new project, and profitability for that new product. And, further, "it is conceivable," Scherer writes, that the various cycles presented in his article reflect "spuriously correlated changes in industry aggregates," e.g., using the books to conjure up apparent profit-vs.-R&D outcomes that suggest "cyclical co movement in pharmaceutical industry gross margins and R&D outlays."

However, if those making executive decisions within pharmaceutical companies have the vision to see what will sell on the market two or three years down the road - as for example, Tagamet sold well in 1977, and it was an R&D launch - there are great opportunities for great new profits. That means drug companies are not just hiding profits or concealing profits on so-called R&D, to satisfy stockholders and other interested parties.

And then, Scherer writes that in a virtuous rent-seeking model, "profit rates of return on pharmaceutical industry R&D investments" have a tendency to be more than "risk-adjusted capital costs by only modest amounts." Hence, the reality is that there is deception within the framework of profits being poured into R&D by pharmaceutical companies.

When the profit opportunities expand, companies are then in competition to "exploit [profits] by increasing R&D investments, and perhaps also promotional costs, until...

Daniel Mullins, Junling Wang, Francis B. Palumbo and Bruce Stuart, in Health Affairs Chevy Chase, points out that the fastest-growing aspect of all health care expenditures for consumers is prescription drug costs. The rate of growth of spending by consumers on prescription drugs during the period 1995-1999, according to the article, showed an increase of 10-17%. Compare those numbers with the average national health expenditures by consumers during the same period (4-6%), and one can clearly see the dramatic escalation of prescription drugs to consumers.
There are two other components that go into the upward surge of drug spending by consumers, however. Those two are "product shift" and "utilization."

Product shift" is when newly approved (by the FDA) medicines enter the market, to replace older medicine. When the new drug products hit the shelves of drug and food stores, "they often bear higher price tags than do the older drugs they replace," and often "expand the market." And when the authors talk about "pipeline drugs," they are alluding to products that are still being tested but as yet have not received a go-ahead from the FDA, the U.S. Food and Drug Administration.

How many drugs are being tested as they await approval from the FDA? The article reports that 643 different drugs were "undergoing clinical trials" at the Phase II/III or Phase III level during the year 1999. How many drugs being tested in Phase II actually get approval by the FDA? "...One should keep in mind that only one of every 3.5 drugs entering Phase II is ultimately approved..."

While the new therapies on the market that receive approval will surely provide benefits to many consumers, "such as reduced side effects or greater clinical effectiveness," they will cost more. So, drug companies will make greater profits because once it is established that the new product helps more people in more ways that leads to "greater utilization," according to the article.

An example given is Lipitor, a drug that reduces cholesterol; of course, during the late 1990s, there was an enormous amount of publicity about cholesterol, and the damage it can do to people's bodies. So, Lipitor sales "skyrocketed to more than 1.5 million prescriptions" in the first 13 months that it was on the market. If a person was being treated for high cholesterol by use of another drug, word got out and that person likely gave up the first medication and switched to Lipitor.

Meanwhile, the increase in consumer spending on drugs can be categorized in three sections: price, utilization, and product shift. The impact of each new drug on the market can quite easily be predicted, using those three components.

The writers of the article used three existing studies to prove their points, and found that the use of "common drugs" (those medicines not introduced to the market after 1996) grew by six point two percent between 1998-1999, and accounted for 38.8% of the total increase. In addition, their research of existing data shows that as to increased spending by consumers on drugs between 1993 and 1998, higher prices for drugs accounted for 64% of that rise in spending. Higher drug prices are obviously taking money out of the pockets of consumers who need those medicines, and have no choice but to shell out the money to get the drugs.

The "American Druggist" group reported that the top 100 drugs sold in 1995-1998 represented "approximately 40% of drugs dispensed in community pharmacies."

The authors of the article also calculated, based on existing empirical data that "slightly less than one-third of the drug spending increase between 1995 and 1998 was due to" price hikes on existing medicines. The facts show that one third of the increased spending was due to "increases in usage of existing drugs," and the other roughly one third was due to "product shift" - which was described earlier as those new drugs hitting the market, which cost more, and create a momentum shift away from older drugs which purport to do the same thing.

Their research shows that "although newer drugs, as a proxy for pipeline drugs, constituted 45% of the top 100 drugs...they contributed 75.3% of…