Economics of the Pharmaceutical Industry Explained

Introduction

The pharmaceutical industry is the heart of the healthcare system. Pharmaceuticals are necessary — sometimes as necessary as food and water when a condition is life-threatening. Some people cannot live without these life-sustaining chemical compounds. However, from a financial perspective, the pharmaceutical industry is one of the most volatile sectors in the market. Among the key difficulties it faces are the costs of research and development, the long time period before products reach the marketplace, and the influences of health insurance agencies and government regulators.

The pharmaceutical industry is complex because it involves more than simply the producer and the end consumer. The ability of pharmaceutical companies to generate profit depends on the interactions of many outside influences. This paper explores the economics of the pharmaceutical industry and supports the hypothesis that, in order to improve profit margins, vertical integration is the key to survival.

Overview of the Pharmaceutical Industry

The pharmaceutical industry differs from other market sectors in many ways. Capital expenditure and return on investment is the key area where this industry diverges from others. In most industries, companies invest capital, quickly bring a product to market, and begin realizing a return in a relatively short time. In the pharmaceutical industry, the return on investment is typically long-term — possibly a decade or more, if it materializes at all.

Researchers must first convince investors of the merits of their theory and the potential their research offers. They must demonstrate a need and identify a significant market base. Only then can the long process of research and development begin. When the area is entirely new — as was the case in the early days of human genetics research — the time required to bring an actual product to market can be considerable, given the amount of preliminary research that must be completed before product-specific research can begin. Once product development is underway, any number of factors can slow the process or halt it altogether.

The process of bringing a product to market must follow a rigorous procedure established by the Food and Drug Administration (FDA). This process includes extensive animal testing long before any new product can be tested on humans. The product must pass safety tests and then efficacy tests before it can come to market. Often, use of the product is limited to patients who resemble the test population. At any point in the process — or after the product has reached the market — a safety recall can occur, eliminating the product as a viable asset to the company.

The process of developing drugs and bringing them to market is referred to as the "pipeline." This term describes pharmaceutical product development from concept to commercial availability. Successful pharmaceutical companies typically have multiple products at various stages of the pipeline. They cannot rely on a single product; if something goes wrong and the FDA withdraws it, the company has little chance of financial recovery. Risk management in the pharmaceutical industry therefore means continual innovation and the pursuit of new avenues for product development. New product development generally stems from either accomplishing something that has never been done before, or doing something better than it is currently being done.

The key to success in the pharmaceutical industry lies in controlling the enormous costs associated with bringing products to market. In addition to these substantial costs and the long wait for a return on investment, pharmaceutical companies face limits on their ability to raise prices to increase profits. Insurance companies, healthcare providers, and government regulations cap the prices pharmaceutical companies can charge, limiting their ability to recover investment capital and expand profit margins. To cope with these challenges, many pharmaceutical companies must take drastic measures to improve their economic position. For many, this means that mergers and acquisitions become essential.

Industry Structure

The pharmaceutical industry is unique in several respects. One of its key distinguishing characteristics is that consumers cannot obtain certain products without a prescription from a licensed physician (Scherer, 2000). The purchase decision is controlled by the physician, who bears no financial responsibility for the cost of the medication in most circumstances. At the macro level, the market is divided into two primary segments: prescription and over-the-counter (OTC) products. These categories represent quite different markets. The OTC segment operates much like other consumer product markets — the consumer makes an independent purchase decision and pays directly, as with any retail product. The prescription segment is far more complex. Adding to this complexity, certain drugs begin their commercial life as prescription medications and are later permitted to shift into the OTC segment.

The demand side of the market must interact with a largely monopolistic supply side. Monopolies on the supply side support prices, allowing drug companies to achieve substantial margins. Nearly 640 pharmaceutical companies operate in the United States, and many of the top manufacturers are multinational enterprises (Scherer, 2000). In developed nations, exports account for slightly less than 10% of the market, while in some developing nations, imports can account for as much as 20% of the drug supply (Scherer, 2000).

As competition intensifies, vertical integration becomes a key survival strategy (Scherer, 2000). During the 1990s, aggressive vertical integration resulted in just four top companies accounting for 80% of U.S. wholesale pharmaceutical production (Scherer, 2000). In addition to outright acquisitions, many manufacturers chose to pool their research and development activities to reduce costs (Scherer, 2000). Strategic alliances have since become the norm in the industry.

Outsourcing is becoming another popular alternative to mergers and acquisitions. It has been found to decrease the time from discovery to market (Coulson & Kleiner, 2008). The outsourcing of pharmaceutical activities to other countries has raised concerns about security, privacy, and human rights (Aruru & Salmon, 2008). Concerns about counterfeit and substandard drugs are also affecting the current state of the pharmaceutical market, increasing the importance of trust associated with established brand names (Yankus, 2008).

The pharmaceutical industry is highly specialized. Many of the products developed are designed to treat only one specific disease or condition. Research has found that the costs of treating psychosis are the highest among all pharmaceutical sectors (Garis & Farmer, 2002). There are few drugs or drug categories widely applicable across a variety of conditions. Vertical integration is therefore one of the few means of achieving economies of scale. Many companies have chosen to specialize within a particular area — for instance, focusing on oncology or cardiovascular conditions — and acquire only companies that operate within that specialty. While few companies hold a monopoly over the entire pharmaceutical industry, several hold dominant positions within a specific specialty or therapeutic category.