Economics of the Pharmaceutical Industry Thesis

Excerpt from Thesis :

Since its inception, the Food and Drug act developed into the Food and Drug Administration, which is responsible for oversight and administration of the rules. Once an application to test a new drug compound has been approved, it must pass a series of tests. Only about 23% of all drug compounds that enter into Phase I ever make it through this phase and into the second phase (Scherer, 2000). This failure rate means a lot of wasted money in the research and development stages of product development. This means that the drug companies have only a slim chance to see profit from any of their ideas and efforts. The efforts of pharmaceutical companies fail many more times than they result in success. Capital investment in new drugs is risky business. Government regulation limits the company's chances for success. This factor makes the investment of initial capital for research and development risky business.

Role of Patents

During the 1970s and 1980s, the FDA was criticized for creating a 'lag' that placed the U.S. behind international competitors in making the newest technology available to consumers. The FDA responded with the explanation that it made the process so costly and difficult to obtain to discourage the introduction of too many variants of similar products on the market. Changed to FDA policy resulted in an increase in post-new drug application patent time during the 1990s. These changes included a reduction in review time, patient extensions, pediatric exclusivity, and other changes in legal definition (Seoane-Vasquez, Schondelmeyer, & Szeinbach, 2008). It was felt that having too many variants of what had already been done before did not benefit the consumer. For instance, having numerous drugs that were all for the treatment of warts would do little, particularly when there were so many other conditions or diseases that could have benefited from attention.

In order to prevent the overabundance of similar products and to spread out the market concentration, drug products must now be patents. Patents for new products are difficult to obtain. Not only does the product have to pass all of the FDA regulations, it must prove that it is unique. Failure to prove degrees of difference and obtain a patent can mean costly lawsuits from competitors. This adds another layer of complexity to an already complex process.

Pricing in a Complex Industry

Price elasticity of demand varies according to several factors. For instance, well-established pharmaceutical can charge a premium price for their products and still realize a substantial amount of price elasticity (Sherer, 2000). Many pharmaceutical products may mean the ability to extend life. These products have considerably more price elasticity than those that are for relatively minor ailments. Consumer are wiling to share costs and forego purchases in other industries in order to afford their medications (Mukherjee, 2008). There are many factors that affect the pharmaceutical industry that are not a factor in price elasticity in other industries.

Prices were found to differ for the same drugs according to geographic area in the United States (Lal, Mathur, & Arbuckle, 2008). Prices are also influenced by supply and demand, just like another other product. For instance, drug shortages result in price rises, while patent expiration can result in a price downturn (Kelton, Rebelein, & Dusing et al., 2008). When compared to the market driven system of the United States, it was found that price mark-ups were similar to those found in Finland's regulated pharmaceutical industry (Hermans & Linnosmaa, 2008). A more transparent price-setting model has been proposed in the United States, but thus far it has not gained much support (Capri & Levaggi, 2008).

Companies enjoy the benefits of patent protection for many years. However, this does not necessarily mean that they are immune from direct competition. Other companies may discover a different molecule that treats similar symptoms. Therefore, competition in the pharmaceutical industry depends on the number of drugs per symptom group. In 1993, it was estimated that there were 141 specific symptom groups (Scherer, 2000). The number of drugs per symptom group has a significant impact on the ability of the company to obtain a premium price for their products. The number of drugs per symptom group creates the existence of an oligopoly in that group. This affects the pricing scheme of the individual companies. The number of drugs in the group can range form one to fifty, directly affecting the pricing scheme of the companies within that group (Scherer, 2000).

Branding plays an important role in the pharmaceutical industry, just as it does in other products. The number of substitute products affects the success of the brand. Now, companies are entering into a new area that was considered taboo in the past. They are advertising their products on television and in popular print advertisements. This attempt to build branding with the patients is highly controversial. Direct to Consumer Advertising has had a negative impact on the ability of insurance carriers to control cost, as consumers insist on advertised name brands (Friedman & Gould, 2008).

Companies are afforded a considerable degree of protection when they first obtain patent and bring their product to the market. However, patents are only good for a certain number of years. When patents expire, others are welcome to begin production of the compound. Generic competition is a difficult hurdle for major brands to overcome. The generic can often produce and market the branded drug compound and offer it at a fraction of the cost of the original. They do not have the massive expenditures involved in bringing the drug to the market. They do not have the same financial risk, as the product is already on the market and familiar to physicians and the public. These factors create an unfair advantage to the generic drug manufacturers and limits the advantages of being first to market with a new product. Generic medicines often have greater price variability than name brand products (Ziqiang & Sadda, 2008).

Brand loyalty by physicians and preferences for the original brand or fears of the unreliability of generics is not the only factor that influences drug prices. Health insurance plans and their quest to reduce the costs of care is another factor in the ability of generic drugs to gain popularity. Incentive plans can have an impact on pricing in the pharmaceutical industry. For instance, a product incentive plan (PIP) in British Columbia resulted in a 43.4% increase in the probability of generic substitution (Bhatti, Einarson, & Austin et al., 2008). Several propositions have been introduced that would allow direct dispensing of pharmaceuticals by physicians. However, physicians have some reservations regarding these proposed strategies, primarily concerning the quality of patient-physician communication and concerns over a lack of information concerning other drugs that they may be taking (Hunt, Siemiencuk, & Koch, 2008).

Health insurance companies often control what a physician can or cannot prescribe. Perhaps the physician has a preference for a certain branded product, but they must issue prescriptions for the generic due to the limitations imposed by the patient's insurance provider (Costea, 2008). Price sensitivity is not always determined by the patient or the physician. The insurance companies have considerable control over the pricing of prescription medication. Historical trends tend to favor less of the burden being placed on insurance companies and a greater burden being placed on consumers (Hayford, 2009). According to Scherer, this has resulted in the development of two markets. One consists of price-insensitive consumers and the other consists of price sensitive consumers. Typically, price sensitive consumers are at the mercy of their insurance agencies and other third-party payers. The generic and branded companies operate in two different market segments as a result.


The risks and challenges faced by pharmaceutical companies are difficult to overcome, particularly for small companies that do not have the expansive capital resources of larger corporations. The ability to fund multiple research and development projects, as well as to compete on a larger scale depends on the ability to obtain a market of considerable scale. In order to do this, many companies are dependent upon vertical integration. At the current time, only four companies control a majority of the U.S. market. These companies have many products in various stages of development. They achieve diversification by operating in various market segments within the industry and developing products in a variety of symptom categories.

As costs continued to climb, many smaller companies saw vertical integration as the only way to survive. This provided them with access to greater resources and the ability to sell their products under the parent company's name. They could take advantage of the brand equity associated with the larger company. For the larger companies, vertical integration allowed them to diversify their holdings and compete in different markets without having to start from the beginning. Vertical integration has many advantages for both the smaller companies and the larger parent entity.

In the pharmaceutical market, vertical integration is often…

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