Transcript Chapter 9

Pharmaceutical Manufacturers
Chapter 9
Technological Change A Major Determinant
of Improved Health Outcomes
• In high-income countries, life expectancy of females at
birth over past 160 years up 40 years or 3
months/year
• In 19th Century, marginal product of medical care was
0 or nearly 0, maybe negative (e.g., blood letting to
cure diseases)
• Technological change has had direct and indirect
effects on health
• New pharmaceuticals, including new vaccines, among
more important new health care products
In this Discussion, divide long-term issues,
E.g., technological change from short term
issues, E.g., how drugs should be priced.
Start with long-term issues
Observational Data Versus Data From
Randomized Controlled Trials
• What is observational data?
• Why might such data be inadequate for
assessing the effectiveness of a drug?
• What is a randomized controlled trial? Why are
RCTs conducted? How are they conducted?
Why are RCTs typically preferred to studies
relying on observational data?
Basic Facts of the Pharmaceutical R & D
Process
• Two stages: discovery and development
• From basic research to market launch, takes
about 14 years on average in U.S.
• Many drugs do not make it to market launch.
Benefits of Pharmaceutical Innovation
• Some empirical evidence from randomized controlled trials
(RCTs), but RCTs have some deficiencies, e.g., outcomes
measured over short time period, results may not generalize to
actual practice.
• Also evidence from observational data: cost- effectiveness
studies of individual technologies; (2) studies of relationship
between spending on pharmaceuticals and health outcomes
across countries and over time; (3) studies relating new
molecular entities (NMEs) to improvements in population
health. (Define NMEs.)
• Findings especially of types 2 and 3 suggest very large benefits
from pharmaceutical spending
Debate: New Pharmaceuticals are Very Productive
V. New Pharmaceuticals Often “Me Too’s”
• Article in journal Health Affairs by Skinner, Staiger, and Fisher
(2005) reconciles two opposing views
• Over time, technological change in pharmaceuticals shifts the
health production function upward (health on y-axis, quantity of
health inputs on x-axis)
• However at a point in time, consumption of health inputs may
be pushed to a margin at which the marginal product is low
• In sum, pharmaceutical innovation can be productive on
average, but the new technology can be applied at a level at
which the drug’s marginal product is low.
• This is particularly problematic in some high-income countries
in which drug use is comparatively high.
• Distinction between static and dynamic efficiency
Important Institutional Features of
Pharmaceutical R&D
• Estimated mean R&D cost per new chemical entity
estimated to be US$802 million (2000$). (DiMasi,
Hansen, and Grabowski 2003)
• Long time involved in developing new drug
• High failure rates in drug discovery and development
Determinants of Pharmaceutical R&D
Investment Behavior
• For profit-seeking firm, amount of investment in a
period determined where MEI schedule intersects
COC schedule
• Public policies affect the MEI and COC (Review from
Chapter 5 how MEI derived. What does COC drawn
with a zero slope imply?)
• Two-step decision process: (1) firm decides whether or
not to devote resources to a particular R&D project:
(2) firm decides on optimal price at which to sell newly
invented good
• Problem solved by backward induction
Fig. 9.1. Determination of Optimal Level of
R&D Investment
MEI (%)
COC (%)
Distinction between “Pull”and “Push” Public
Incentives for Investment
• Pull incentives: affect demand for final product
resulting from R&D and hence affect MEI, e.g.,
policies affecting market size, pricing policies
• Push incentives: affect marginal cost of funds COC,
e.g., government grants, depreciation policy,
investment tax credits
Fig. 9.2. The Effect of a Pull Incentive on R&D
Investment
Investment
Also, Pull and Push Disincentives
• Pull Disincentive example: low price for
pharmaceutical products; increase in variance in drug
pricing policies (alternate between highly regulatory
and loosely regulatory public policies ; increase in
probability of products liability suit (what products
liability is—more likely based on strict liability than on
negligence standard—see Chapter 7 for definitions)
• Push Disincentive example: increase in the probability
that assets of firm will be expropriated; increase in
corporate income tax
Argument that Pull More Promising than
Push Incentives
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See e.g., Kremer and Glennister (2004)
With pull, reward results of R&D
With push, subsidy based on promises
But empirical evidence on relative effectiveness of
push v. pull incentives in stimulating pharmaceutical
R&D is lacking, especially on push incentives
Patents to Promote Investments in R&D
• What is a patent?
• Conceptually, how do patents promote R&D?
• Why do you think patents are used much more
widely than are other public policies to promote
pharmaceutical R&D?
Incentives Under the Patent System: Overview
• Patent system offers added incentive to innovate
• Confers market power on holder of
patientmonopoly pricing, price discrimination
• Exercise of market power leads to reduction in
quantity, loss of consumer surplus
• Distinction between static and dynamic efficiency
Pull Incentives
Effective Patent Life (EPL)
• EPL=Nominal Patent Life – Time Lost Prior to Regulatory
Approval
• Nominal Patient Life now fixed at 20 years
• Speeding regulatory approval of an NCE is a pull policy
• Priority review can increase EPL by a year (Ridley,
Grabowski, Moe 2006)
• Passage of Hatch-Waxman Act increased EPL by 2.3
years (Grabowski and Vernon 2000)
Market Size
• Market size depends on size and demographic structure
of population, income, health policies
• 1% increase in potential market size 4% entry of new
non-generic drugs or NMEs (Acemoglu and Linn 2004)
• Market sizevaccine innovation (Finkelstein 2004)
• Introduction of Medicarepharmaceutical innovation
operating through effects on demand for physicians’
services: no effect (Acemoglu, Cutler, Finkelstein et al.
(2006)
Market Size, cont.
• Relationship been burden of disease and rates of
introduction of NCEs found for high-income but not
other countries (Lichtenberg 2005)
Regulation of Drug Prices
• Price regulation occurs under public health insurance
programs
• Empirical evidence from several studies shows
negative effect of price regulation on drug innovation:
Vernon (2005); Giaccotto, Santerre, and Vernon
(2005), using time series data for the U.S. 19522001, finding elasticity of real drug prices on R&D
investment of 0.6.
• New drug introductions occur earlier in countries with
less price regulation (Danzon and Chao 2000)
Regulation of Drug Prices, cont.
• Negative effects of price regulation on price
competition in branded and generic markets
(Ekelund and Persson 2003; Danzon and Chao
2000; Grabowski 2006)
• Price regulation encourages parallel imports which
in the long run discourages R&D investment
(Danzon, Wang, and Wang 2005)
Push Policies
Fig. 9.3. The Effect of a Push Incentive which Reduces the Market
Rate of Interest the Firm Pays on its Loans on R&D Investment
Fig. 9.4. Additional R&D Investment from Simultaneous
Implementation of Pull and Push Incentives
Industrial Policy
• Industrial policy aims to stimulate growth of a particular
industry in a country
• May be pull or push, but mainly push, e.g., investment
tax credit for R&D
Public Investment in Basic Research
• Pharmaceutical R&D process can be decomposed into
(1) discovery and (2) development stages.
• Given public good nature of basic research, private firms
lack incentives to do it (issue brought up last evening)
• Private firms do engage in product development
• Discovery and development are complements—by
subsidizing (1), R&D cost falls
• Governments can stimulate R&D investment by funding
basic research
• Issues of interface between basic and applied
mentioned last night
Incentive Mechanisms When Patents Fail:
Overview
• Patents have undesirable effect of constraining output
below optimal output in high-income countries.
• In low-income countries, patented drugs most often
unaffordable.
• Presumably there are some externalities in
consumption by the latter.
• Lack of effective demand in low-income countries
affects mix of R&D investments, e.g., vaccines for
diseases highly prevalent in low-income countries.
Incentive Mechanisms When Patents Fail:
Alternative Approaches
• Advanced Purchase Commitments (Kremer and
Glennerster 2004)
• Optional Rewards Based on Therapeutic Effect (Hollis
2004)
• Priority Review Voucher (Ridley, Grabowski, and Moe
2006)
Advanced Purchase Commitments
• Offer fixed payment per unit for given number of units
in advance with rest sold at marginal cost of
manufacture-distribution
• Approach suggested for vaccines to stimulate vaccine
R&D by the Institute of Medicine Committee on
Vaccine Financing (2004)
• Got a lot of publicity, but received firestorm of
opposition from pharmaceutical manufacturers and
insurers  dead in the water for political reasons
• Admittedly, is difficult to set price in advance, given
various uncertainties
Advance Purchase Commitments: Challenges
• Hard to specify technical characteristics of product in
advance—issue addressed in Cosgrove talk
• Setting standard gives power to technical committee
(e.g., NVAC)
• Firms do not have incentive to develop product
exceeding pre-specified standard
• No incentive for firm to engage in incremental
innovation to improve product later
Optional Rewards Based on Therapeutic Effect
• Proposal: Pharmaceutical company can choose between
reward and patient systems. If chose reward, paid
directly by sponsors based on therapeutic effectiveness
of drug (ex post).
• Do not need to set technical standard, which is
threshold for payment, in advance.
• Relies on (1) trust that sponsors will make good on
promises; and (2) valid and reliable measures of
therapeutic effectiveness.
Priority Review Voucher (PRV)
• Firms receive a PRV when they develop new drugs for
treating diseases most prevalent in low-income
countries
• PRV gives privilege for priority review for another NCE
for firm seeks regulatory approval
• One year saving in approval time for a blockbuster
drug worth US$300 million in revenue on average
• Value of the PRV depends on products company has
in pipeline
Pharmaceutical Company Decisions with
Technology Given
Pricing of New drugs
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If drug under patent, firm will have some market power.
High fixed cost of R&D leads to high fixed cost once new
drug (new clinical entity or NCE) is marketed.
With high fixed cost, get negatively sloped average cost
curve (see Fig. 9.5).
Compared to high fixed cost, marginal cost of producing,
packaging and distributing drug is low. MC is flat and lies
below AC.
With patent, AR curve is negatively sloped.
Since price exceeds AC, firm earns an economic profit.
Monopoly pricing achieves dynamic efficiency (can do this)
Fig. 9.5. A Pharmaceutical Firm’s Cost
Structure and Pricing
Welfare Loss from monopoly pricing
Static efficiency at output level where MC crosses
the demand curve.
 But output level at which profits are maximized
well below this output level.
 Shaded triangle shows loss in consumer surplus
attributable to keeping price above MC.
 Important to recognize that few drugs have pure
monopoly, e.g., although an antidepressant drug
may be on patent, there are other antidepressants
at a point in time on patent and off patent. These
substitutes but not perfect substitutes.
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Pricing New Drugs: Empirical Evidence
• Only few countries, e.g., U.S. and Germany,
allow companies to set prices without
government intervention of some sort.
• Hence much of the empirical evidence from
these countries.
• Evidence on launch prices from U.S. and from
Germany
Entry of Generic Drugs and its
consequences
• Pricing of generic drugs and pricing of branded
drugs when there are generic competitors
• How price regulation affects entry of generics
• Factors affecting generic competition: (1) cost of
generic entry; (2) expected profit from generic
entry; (3) public policies allowing generic
substitution; and (4) incentives for generic
substitution facing consumers, physicians, and
pharmacists
• Consequences of generic entry: cost savings;
pharmaceutical innovation
Drug Advertising
Information about drugs
• Sources of lack of consumer and physician
information
• Lack of “head-to-head” comparisons among
drugs
• Laws against drug advertising directly to
consumers (except in U.S. and N.Z.)
Optimal Level of Pharmaceutical Company
Marketing Effort
• As a profit-maximizer, pharmaceutical manufacturer expends
marketing resources up to the point where incremental net revenue
from sales resulting from the additional advertising expense = the
additional advertising expense
• Based on this condition, the ratio of the optimal advertising
expenditure (A) to sales (S) satisfies the following relationship
(Dorfman and Steiner 1954):
• A/S=εa[(p-MC)/p]=εa/εp
(9.1)
• where: εa = advertising elasticity of demand; p is the product price;
MC is marginal cost; (p-MC)/p = price-cost margin, which is equal to
1/εp . εp is absolute value of price elasticity of demand for drug
• Health insurers’ policies affect price by influencing εp.
Pharmaceutical Marketing
• Drug detailing and its effects
• Direct-to-consumer advertising and its effects
International Drug Pricing
Cross-national price differentials
Optimal pricing rule across markets (see next
slide)
Consequences of differential pricing
Fig. 9.6. Uniform versus Differential Pricing
O
Optimal Pricing Rule Across Markets
Assuming that these two conditions hold, an optimal pricing
rule across markets satisfies the following condition:
(pj-MCj)/pj=1/εpj
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(9.2)
where:
pj = price in country j
MCj = marginal cost
εp j = price elasticity of demand for pharmaceutical in
country j.
Ramsey Optimal Pricing
• Central issue in international pricing of drugs involves
allocation of joint cost of R&D among countries.
• Second-best (not the very best) solution involves two
necessary conditions:
pj≧MCj
(9.3)
Σpj-MCj)≧F
(9.4)
Where: F = global joint cost of R&D investment
Ramsey Equilibrium Pricing Rule
• The equilibrium pricing solution is:
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(pj-MCj)/pj=D/εp j
(9.5)
Where: D = profit constraint indicating that the rate of return be
at least equal to the cost of capital
This equation indicates that the mark-up of price over marginal
cost in country j is inversely proportional to the price elasticity of
the demand for prescription drugs in country j
If marginal cost is the same in all countries, the Ramsey optimal
pricing solution suggests that prices should differ across
countries in inverse relation to their demand elasticities.
Rule similar to pricing rule adopted by price discriminating
monopolist.
Empirical Evidence on Ramsey Pricing of
Pharmaceuticals
• Find that pricing in high-income countries
follows Ramsey pricing, but this not uniformly
true in middle-income countries.
• Why?
Conclusion
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Some key points:
(1) MEI=COC rule for optimal investment in R&D from
pharmaceutical company perspective
(2) tradeoff between static and dynamic efficiency
(3) pricing dynamics following generic entry
(4) demand for pharmaceutical products responsive to
advertising
(5) incentives to price differently among countries
(6) proposals to promote pharmaceutical R&D