Transcript 3 Basic Steps in Economic Evaluation

Chapter 14: The Pharmaceutical
Industry
Health Economics
Outline

Competitiveness of the pharmaceutical
industry

Conduct

Performance
Benefits of Drugs

Reduce mortality.

Reduce morbidity/improve quality of life.

Reduce cost of treating diseases.
Industry Structure
# and size distribution of sellers.
 Buyers’ side characteristics.
 Barriers to entry.
 Government regulation.

Leading Pharmaceutical Companies, 2000
Company
Merck
Johnson & Johnson
Pfizer
Bristol-Myers Squibb
Pharmacia
Abbott Laboratories
American Home Products
Eli Lilly
Schering-Plough
Amgen
Fortune Magazine, 2001
Sales $b
40.3
29.1
29.6
21.3
18.1
13.7
13.8
10.9
9.8
3.6
Best-Selling Drugs, 1998
Drug
Sales $m
Prilosec
$2,933
Prozac
$2,181
Lipitor
$1,544
Zocor
$1,481
Epogen
$1,455
Zoloft
$1,392
Prevacid
$1,245
Paxil
$1,190
Claritin
$1,150
Vasotec
$1,086
4-Firm Concentration Ratios 1997
Industry
4-firm CR %
Apparel
9.4
Basic chemicals
13.9
Computer software
28.2
Food & non-alcoholic beverages 13.9
Footwear
22.6
Furniture manufacturing
24.7
Passenger cars
70.5
Pharmaceuticals
43.3
Can competition be accurate
measured at the industry level?
Most drugs are not substitutes to the
patient.
 The relevant product market is the
therapeutic market.

Only a few major drugs compete in most
therapeutic markets.
Concentration ratios at this level are higher
than for industry as a whole.

Concentration Ratios
for Therapeutic Markets, 1997
Therapeutic Market
Four-Firm Ratio
Antidepressants
68
Antihistamines
90
Antihyperlipdemics
74
Antihypertensives
49
Anti-Rheumatics/NSAIDs
55
Antivirals
18
Caphalosporins
79
Gastrointestinal Diseases
62
Nasal Corticosteroids
72
Express Scripts Drug Trend Report, 1997
Firms tend to make most profits from 1
or a few key drugs.
Top 3 Drugs as a %
of total Prescription Sales, 1992
Company
Percentage
Glaxo Inc.
75
Pfizer
60
Upjohn
58
Eli Lilly
56
SmithKline Beecham
53
Merck & Co.
52
Marion Merrell Dow
50
American Home Products
32
Johnson & Johnson
30
Bristol-Myers Squibb
28
BCG, The Changing Environment for U.S. Pharmaceuticals, 1993
The Buyer Side
Buyers of Prescription Drugs, 1999
Expend.
Source
($billions) Percent
Total
99.6
100.0%
All private
77.9
78.2
Out-of-pocket
34.9
35
Private insurance
43
43.2
All government
21.7
21.8
Federal
12.4
12.4
State
9.2
9.2
www.phrma.org
How 3rd parties influence drug demand
Even if consumers exert little influence
over drug choice, 3rd parties are
making the market more competitive.
 Formularies - list of selected drugs
physicians may prescribe.

 Used
by hospitals to limit inventories and
costs.
 Used by most HMOs and many PPOs.
 Used by many state Medicaid programs.
 Drug
utilization review
 Used
by insurers to enforce formularies,
identify inappropriate prescribing practices.
 Government
 1990
influence
Omnibus Budget Reconciliation Act Federal funding provided for drug only if
state Medicaid program receives
manufacturer rebate agreement
 Government
influence (cont.)
 1992
Veterans Health Care Act - price
discounts for Federal Supply Schedule, VA,
Dept. of Defense.
 These
programs may restrict costs for
government, but drug firms may be forced
to raise nonfederal prices.
“…managed care emphasizes less-expensive, preventive
types of treatment.”
“The rate of growth for drugs to treat high blood
pressure and high cholesterol in certain managed-care
strongholds on the West Cost has gone off the charts.”
WSJ 10/17/96
“Consumers in the $94
billion prescription drug
market are mostly
indifferent to price.
What will happen when
they all become budget
conscious?
Forbes 4/5/99
Pharmacy Benefit Managers
General Strengths

Information - e.g. Medco’s 60m patients.
 How
drugs prescribed, used, impact on
disease.
Can prevent inappropriate drug
interactions, under/over medication

PBMs provide drugs at lower costs.
 Achieve
econ. of scale in pharmacy
benefits by serving multiple plan sponsors.
 Large market share on buyer’s side 
stronger negotiating power w/ drug
companies.
Vertical Integration

Brand name drug companies are
purchasing PBMs.
Estimated
Date
Acquirer
Target
Exp. ($m)
Nov-93 Merck
Medco
$6,600
May-94 SmithKline Beecham Diversified
$4,000
Jul-94 Eli Lilly
PCS Health
$2,925
Vertical Integration

Good or bad idea?
 Buy

the information, not the PBM
“Industry consultants and Medco competitors
argue that Merck could have bought that
information from Medco or others in the field
without buying the company.” NYT 8/5/93
 Critics
argue that PBMs will only serve to
lower prescription pharmaceutical prices.
Vertical Integration

Comments from Roy Vagelos, former
Merck CEO
 “In
classic terms of competition, we could see
that the power of the buyers was growing…PBMs
were…bringing together the person who chooses
the drug and the person who pays for the drug.”
 “Having
salespeople visit doctors’ offices does
not allow us to reach PBMs, HMOs, or plan
sponsors -- the major players in the emerging
market.”
Vertical Integration
 Merck
bought Medco as a response to
managed care.
 Strategic
attempt to  market power. How?
 Followup
on patients w/ chronic illness
who may stop taking prescribed meds.
 Position Merck drugs favorably on
formulary.
 e.g.
lower patient copay, or lower cost to plan
sponsor.
Vertical Integration
 Offer
risk sharing to  demand.
 e.g.
refund Proscar if no effect on BPH after 1
year.
 Offer
disease management.
 Improves
patient health, gives company more
influence in tx process.
Vertical Integration

PBM purchase will also affect Merck’s
product development.
 “Consider
what happens if instead of having
20 products on the formulary we have 40.”
 more incentive to develop generics.

Impact of PBMs on drug prices:
 Price
competition is inevitable.
 “Merck will have to grow through increased
volumes without considerable price increases.
That seems obvious now, but it wasn’t six or
seven years ago.”
Barriers to entry

Government patents.

Brand loyalty advantage.

Control over a key input.
Government Patents

Innovating firm gains the right to be sole
producer of a drug for legal maximum of
20 years.
 Preserves
incentives for firms to undertake
risky and costly research and development
(R&D) that is socially valuable.
 Rationale:
Monopoly restriction of output
better than having no output at all.
Monopoly power of patents is not
always strong.
 Patents
granted for chemical
composition, not therapeutic novelty.
 Tagamet
& Zantac both were patented,
competing in antiulcer market.
 Significant
part of patent life may be
spent trying to get FDA approval.
 “effective”
patent life = 8 years.
Monopoly power of patents is not
always strong.
 1984
Waxman-Hatch Act - benefits for
both brand-name and generic
companies.
 Effective
life of new drug patent can be
extended up to 5 years of FDA delayed
market introduction.
 Fast approval process for generics:
eliminated proof of safety & effectiveness.
Pharmaceutical Industry Conduct




Pricing
 Does more intense competition   drug
prices?
Promotion
 Does drug advertising promote or impede
competition?
Product innovation
 Are large firms necessary for drug
innovation?
Preview: Empirical evidence indicates that
competition is at work, but the industry does not
exhibit perfect competition.
Pricing Behavior

Can the brand-name firm maintain its
price once its patent expires and
generics enter?
 Average
price differential between brand-name
and generic firms = 127%, but brand name
market share = 63.4%. (Hurwitz & Caves, 1988)
drugs’ prices 11% 2 years after
generic entry. (Grabowski & Vernon 1992)
 Yet brand-name drugs lost 1/2 of market
share.
 Average market price fell to 79% of preentry price.
 Branded
Pricing Behavior
 Brand-name
firms segment the
market.
 Remaining
customers relatively price
insensitive.
 Inelastic demand curve allows them to
maintain price.
Express Scripts Drug Trend Report, 1998
Promotion Strategies

Promotion Magnitude:
 Research-base
firms spend as much as
20-30% of sales on promotion.
 70% pharmaceutical salespersons
(detailing).
 27% advertising.
 3% direct mail.

Impact:
drugs on market  timely, valuable
information.
 May impede competition.
 22,000
Product Innovation
Product Innovation
Product Innovation
Www.phrma.org
Product Innovation

Innovation is very risky and time
consuming.
 R&D
process takes many years.
 Only a small fraction of new drug
discoveries are eventually marketed.
 75% of NCEs in Phase 1 go to Phase 2.
 36% of NCEs in Phase 1 go to Phase 3.
Genentech's Big Sellers
Year Drug
Use
1998 sales $m
1985 Protropin/ Growth hormone for
214
Nutropin
for short stature
1987 Activase
Blood-clot buster
213
1994 Pulmozyme Cyctic fibrosis
93.8
1997 (Dec.)
Rituxan
Low-grade NH
162.6
lymphoma
1998 Herceptin Breast Cancer
30.5
Merck's New Products, 1998
Use
Drug
Singulair Asthma
Migraines
Maxalt
Aggrastat Acute Coronary Syndrome
Propecia Male Pattern Hair Loss
Cosopt Glaucoma
Roy Vagelos’ Views on R&D

Priority areas are those where:
 No

therapies or drugs are available.
 Science must be advanced enough to
make a breakthrough.
 Must have enough knowledge of the
disease to have an idea how to arrest it.
Rational drug discovery - create specific
molecules to attack specific molecular drugs.
 Enzyme
inhibition, which was successful in
Merck drugs treating high cholesterol, high
blood pressure, and prostate disease.
Pharmaceutical Industry Performance
Does the absence of perfect competition
higher prices & restricted output?
Urban Consumer Price Inflation Rates
Year All Items Prescription Drugs
1970-79
7.1
3.6
1980-89
5.6
9.6
1990-94
3.6
6.9
1995
2.8
1.9
1996
3
3.4
1997
2.3
2.6
1998
1.6
3.7
Cautionary note on inflation
The inflation rate calculated by BLS is
based on a price index, which may
overstate the true  in drug costs.
 Price index

 the
relative cost of purchasing a fixed
“basket” of drugs in year t, vs. the costs of
same basket in a base period.

Price Index =

t
N
p
x
it
io
i 1
N
i 1
pio x io
i  1,.... N drugs
Cautionary note on inflation

BLS “basket” undersamples new drug
products, which generally have smaller price
increases than older drugs.

BLS treats generics as new products, not as
substitutes for more expensive drugs.

BLS uses list rather than transactions prices.

BLS doesn’t adjust prices to reflect quality
improvements.
Are profits in the drug industry “too high?”
Return on Assets for Pharmaceutical
Companies in the Fortune 500
1997 Profits
Rank Company
as % of Assets
4 Schering-Plough
22.2
6 Bristol-Myers Squibb
21.4
10 Merck
17.9
12 Abbott Laboratories
17.4
19 Johnson & Johnson
15.4
22 Pfizer
14.4
500 Median
3.9
Are profits in the drug industry too high?

Under standard accounting practices, R&D is
written off as a current expense.

But R&D affects revenues for years to come.
 Rate of return on investment is calculated
using an asset base that improperly
excludes intangible R&D.
 Should capitalize R&D outlays &
depreciate them over appropriate time
periods.
Accounting figures overstate the rate of
return on assets for drug companies.