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Institute of Medicine (US) Committee on Technological Innovation in Medicine; Gelijns AC, Halm EA, editors. The Changing Economics of Medical Technology. Washington (DC): National Academies Press (US); 1991. (Medical Innovation at the Crossroads, No. 2.)

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The Changing Economics of Medical Technology.

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Appendix BThe Economics of Pharmaceutical Research and Development: An Industry Perspective

Commentary by


The purpose of this commentary is not to provide a complete view of all the risks, rewards, decisions, and debates inherent in research investment and drug development in the pharmaceutical industry, but instead to provide a personal perspective based on 25 years of wrestling with investment decisions and the requirement to address the needs of various interest groups: physicians and patients, government law makers and regulators, employees, and stockholders. I want to begin from a slightly different economic perspective, because our nation today finds itself not only in economic transition but also in a very precarious position that threatens our way of life and our standard of living. I want to first look at the U.S. pharmaceutical industry and its value to our nation's economy and competitiveness. In light of America's competitive slippage in world markets, it is curious that we are so slow to learn lessons from the past, even though we have seen our world leadership and market share erode in one industry after another.

Thus far, one exception has been the U.S.-based pharmaceutical industry, which maintains its world leadership, principally because of the industry's willingness to invest huge sums of money in research and development (R&D). As a secondary source of our success, however, we must cite a favorable public policy environment; a spirit of cooperation; and a collaborative relationship among industry, government, and academia on research projects.

Now, unfortunately, the environment threatens to change—in part, at least, because of a sincere concern for rising health care costs but also because of a poor understanding and simplistic analyses of the economics of the drug development process. As a nation, we must reach a better understanding of the case for public policies that encourage medical research and innovation, which will result in dramatic improvements in health, quality of life, and the economic well-being of our country. This nation can ill afford policies that discourage innovation in the pharmaceutical industry.

Those of us in the pharmaceutical industry frequently find ourselves having to develop a primer on the industry, its economics, and the nature of the discovery process. There is very little recognition, for example, that the R&D risk is enormous in our industry. Few people realize that it takes an average of 12 years and $230 million to develop a new drug (1). Nor do people realize that 7 of every 10 products that do reach the marketplace never recover the average cost of development. Most discouraging is that the message must be repeated in so many different ways. In the light of much-needed academic analyses—now planned or under way—of such subjects as the pharmaceutical industry's risks versus returns, I am hopeful that the economics of innovation in medicine will some day be better understood.

In the meantime, several broad-based initiatives are essential for drug innovation: we need increased government collaboration and support of basic biomedical research; we need better and broader science education at all levels; we need more equitable treatment for U.S. industry in world trade; and we need stronger worldwide protection of intellectual property—patents, copyrights, and trademarks. These are the specific issues of this paper.

Progress on these issues rests first on public policy, and any policy actions that affect the research-based pharmaceutical industry should be grounded firmly on an understanding of the economics of innovation in medicine. Merck & Co., Inc., the world's largest prescription drug company, is well positioned to contribute to such understanding. Merck has first-hand knowledge of the realities of the global marketplace, the challenges of research, and the economic policy environment that is conducive to success in business competition and in fighting disease.


Let us approach public policy in the context of a global pharmaceutical industry. Merck, for example, does business in nearly 200 countries, and about half of its sales are made outside the United States. The company is part of an enormous industry: annual sales of ethical drugs for human use by all pharmaceutical companies worldwide are estimated at $120 billion (2). The industry is highly competitive, with no company holding as much as 5 percent of the world market (2). Even though Merck ranks number one worldwide, with 1989 sales of approximately $6.6 billion, its market share is only 4.7 percent.

This competition forces those who want to succeed to be aggressive in the search for new drugs—a search that is increasingly expensive. In 1989 U.S.-based pharmaceutical companies spent $7.3 billion on R&D (3), exceeding the $7.1 billion that the National Institutes of Health (NIH) spent on biomedical research (4).


In addition to rising R&D costs and intensifying foreign and domestic competition, research-based drug companies face growing pressures on their pricing, profits, and patents. In this environment many pharmaceutical companies have found it necessary to merge in order to expand their research capacities and maintain their rate of growth. Such mergers are motivated by the need to make increasingly large R&D investments on the slim chance of bringing out new products that will have only a limited market life before their patents expire. Of course, in addition to the aim of building R&D mass and efficiency, companies merge to gain better market penetration.

Recently, Bristol-Myers merged with Squibb; Dow Chemical acquired Marion Laboratories; SmithKline merged with Beecham, the British firm; and Rhone-Poulenc acquired a majority interest in the Rorer Group. Other large foreign companies also are showing great interest in acquiring U.S. drug companies, no doubt because they are attracted by the huge size and free competition of the U.S. market.

Merck has chosen not to make a major merger or acquisition. Although it plans to obtain new products primarily from its own R&D efforts, the company will also continue to enter into strategic alliances to increase its access to new products and new research. Merck has determined that, in a global marketplace, it needs both internal and external strategies for growth.

Internally, Merck's total R&D spending for the 10 years 1980 to 1989 was nearly $4.5 billion, with a compound growth rate of 14.8 percent (5). The Pharmaceutical Manufacturers Association estimates that the U.S. pharmaceutical industry will have spent $8.2 billion on R&D in 1990. Thus, Merck's 1990 R&D budget of $850 million accounts for more than 10 percent of the total, and Merck accounts for an estimated 5 percent of the total worldwide spending for pharmaceutical R&D (6).


Public policies must take into account that, in addition to benefiting patients' health, the pharmaceutical industry's R&D productivity has a strong positive economic impact—on U.S. tax receipts, our economy, and the balance of trade. For example, Merck paid $788 million in worldwide income taxes for 1989—a sum quite close to the $751 million it spent on R&D (5).

Much of the money Merck pays in taxes comes from the return on its investment in research facilities and scientists in the United States. In 1989 Merck made a favorable contribution to the U.S. current account of approximately $1.1 billion. That amount, though relatively small, stood in dramatic contrast to the huge total trade deficit in other industries.


If the pharmaceutical industry is a national asset, we should enact public policies to protect and strengthen it. Therefore, those of us in industry, medicine, and universities need to demonstrate effectively the dynamics of drug discovery something we may not have been well equipped to do up to this point.

This effort will be helped by university scholars who are working to develop a model for analyzing pharmaceutical risk versus return, as well as other related subjects. In addition, studies are being conducted at Merck to complement university efforts. At a minimum, I would suggest that any economic model for the industry should consider four important issues:


We must reexamine the way research is treated. Should it be a profit and loss (P&L) expense or amortized as an asset? The answer is important because it will change a number of financial measurements, most notably return on assets.


Our analyses must consider pricing, including costs of research and launch prices fair to the patient and to the innovating company.


We need an adequate period of exclusivity for innovative products.


We need to factor in the impact of inflation on the cost of doing business and of future research.

Economic analyses are under way in four broad areas: industry dynamics, risk/return trade-offs, research productivity and innovation, and the regulatory environment.


Studies of industry dynamics will focus in part on product life cycles through development of economic models that accurately reflect the competitive environment, starting with R&D investments and going through all stages of the product cycle. This analysis is critical because of the rapid changes in the product life cycle, which has been getting shorter for two major reasons.

The first is the emergence of so-called fast-follower drugs. Today's rapid dissemination of scientific advances throughout the worldwide biomedical research community leads to simultaneous—often closely similar—research efforts by several companies. Even though the first company to succeed has the “breakthrough,” runner-up companies may introduce improved therapies shortly thereafter.

Although these fast-follower products intensify competition, they also serve useful purposes for society. Some patients, for example, may tolerate a fast-follower better than the breakthrough product. Fast-followers also permit more companies to enter the field, and the income these companies make can fund research.

A second reason for shorter product life cycles is generic competition. Generics today are being introduced very rapidly after patents expire, and they are supported by intense marketing efforts. From a public policy standpoint, we must ask ourselves if generics should be controlled more tightly. Clearly, the answer is important in terms of product safety. But also, from an economic viewpoint, if generics are able to reap windfall profits without investing in research, we must ask ourselves if our public policies are discouraging research by the U.S. pharmaceutical industry and thereby putting its worldwide leadership and competitiveness at risk.


In addition to life cycles, promotion, sales, and marketing practices are important elements to be considered in the dynamics of the industry. In many ways they are just as essential as R&D for delivering medicines to people who need them. With regard to any recent innovation in drug therapy, the largest single repository of scientific and medical information is the company that invented and/or developed it.


Perhaps the most valuable studies will be those of risk/return trade-offs, which will focus on the development of risk-adjusted economic returns. These studies will present a better view of the industry simply because economic returns are far more accurate than accounting returns as measures of profitability. They capture the asset value of patents and the time value of the very large investments necessary to conduct research, and they clarify the nature of the R&D enterprise.

An example will demonstrate how the accounting and economic models yield different results. In 1989, based on the accounting model, the average return on assets (ROA) for eight leading U.S.-based health care companies was approximately 16 percent. 1 Since the accounting methodology considers research an expense rather than an asset, the accounting model makes ROA appear high in comparison with other industries that are less committed to long-term R&D.

With the economic model R&D expenditures are capitalized and amortized on the theory that a firm's R&D investment is part of its economic asset base. Cash flow also is adjusted to reflect the capitalization of R&D. Consequently, use of the economic model lowers ROA for many industries. The effect is greatest for research-intensive industries.

Based on the economic model for the 1989 results of the eight leading health care companies, the average ROA is approximately 11 percent because of our substantial commitment to research.


In addition to R&D investments, public policy must focus on patent protection of new pharmaceutical products—another critical economic asset. It is well known that patents are essential to the future of the pharmaceutical industry, but it is not well known that patent laws often give less protection to pharmaceutical companies than to other industries.

In other U.S. industries patents may be only months old when new products reach the market. For the pharmaceutical industry the average prescription medicine, because of the long period of development and regulatory approval, has lost an average of 6.5 years of its patent life before it reaches the market (7).

Thus, for pharmaceuticals the 17-year patent term mandated by Congress is shortened dramatically, further compounding the risks of drug development. Public policy, therefore, should take account of the unique nature and extraordinary risks of pharmaceutical R&D: shorter effective patents, the fact that many projects never succeed, and, indeed, the fact that the overwhelming majority of projects fail to result in a viable product (8).

The studies of research productivity and innovation now under way will explore the many interrelated factors that drive innovation and will seek to define an optimal industry structure for productivity. Pharmaceutical research requires the investment of vast sums of money over long periods of time under extremely uncertain conditions. According to Grabowski, 12 years is now the industry average for drug development (1).


In addition to studies on risk, return, research productivity, and innovation, studies of the regulatory environment will assess the impact of government regulation—an impact that can determine a company's future. In many countries where the government is responsible for providing health care, government agencies intervene in virtually all aspects of research, marketing, and pricing of pharmaceuticals.

In response to concerns about rising health care costs, certain countries have pursued policies with the effect of limiting drug prices and profits. This is, I think, a very dangerous game in terms of discouraging the discovery process and threatening the battle against disease. I also think it more than coincidental that many of the countries that exercise the most control have failed to contribute significantly to the discovery of new chemical entities of therapeutic importance. In fact, only four nations have contributed to drug R&D in a meaningful way: the United States, the United Kingdom, Switzerland, and Germany. In the last three decades these four countries have contributed more than 70 percent of all significant drug products introduced in the U.S. market, with the United States being responsible for half of these. 2 Not surprisingly, Japan is developing quickly and may join this group in the near future (9).

A salient characteristic of all five countries is government policies that encourage innovation and reward success. Not coincidentally, in these countries prices, are commensurate with those in the United States.


Unfortunately, many of the complex issues I have just covered are not prominent in public policy debates. All too often the debate boils down to one issue: how much medicines cost. It is a critical issue to the public and to innovation for two major reasons:


Health care costs continue to increase faster than the rate of inflation and are causing budget problems for all who provide or pay for health care, including federal and state governments and corporations;


This situation sometimes causes payers, such as corporations, health maintenance organizations, and state governments, to make decisions aimed primarily at minimizing costs rather than helping patients. Whenever policy makers look for solutions to the problem of ever-increasing costs, pharmaceutical companies, with their rapid growth and relatively high levels of accounting profitability can easily be seen as constituting a large part of the problem.

The facts are very much at variance with this popular impression. Prescription drugs account for less than seven cents of every health care dollar (10). In addition, the percentage of health care costs attributable to drugs has been declining for many years (10). But the most important fact (and one that is hard to quantify) is that prescription drugs, by preventing, curing, or managing disease, often keep patients from entering higher-cost portions of a nation's healthcare system.


If we accept the fact that our nation's research-intensive industries hold the key to America's future, we have to conclude that the United States is not paying adequate attention to basic research—the foundation of new knowledge upon which technological innovation is built. The situation abroad is very different. Over the past decade West Germany has doubled spending on basic research—now 22 percent of its R&D budget and nearly twice the 12.2 percent that the United States invests (11). Japan's outlay has tripled, with approximately 13 percent of R&D going toward basic research (11).

One of the most important public policies that would significantly encourage pharmaceutical R&D in this country is increased government support of basic research through the NIH and the National Science Foundation. As a major source of basic biomedical research, training of scientists, and research funding for U.S. universities, the NIH has provided a tremendously fertile support structure for drug development by the industry.

Our nation's long term record of innovation notwithstanding, other countries are now rivaling traditional U.S. ascendancy in biomedical discovery. Since 1975, according to analyses by Merck, foreign firms have provided close to half of the new chemical entities that the U.S. Food and Drug Administration regards as therapeutic advances.


In addition to government-funded research, we must appreciate the vital role that universities play in the drug discovery process. That role is also one of basic research, not applied research. Industry—particularly in pharmaceuticals, still is the best source for applied research. The key to this industry's success is its ability to make optimal use of basic research findings flowing from the NIH and from universities. These findings serve as springboards for applied research by individual competing companies—research aimed at discovering new compounds and developing new drugs.


Other nations, realizing that a stronger base in science and technology will give them an edge in fiercely competitive international markets, are according research a high priority. As an integral part of this focus, they are allocating funding, establishing incentives, and training the talent pool needed to do research and commercialize technology. They are removing barriers to technological development and coordinating efforts to achieve economic growth. Unfortunately, the United States is not doing these things as well as other countries.

Even though U.S. universities and research institutions remain the envy of the world, this country clearly is failing to make its young people literate in science and mathematics. In the past decade we have witnessed a decline in the proportion of U.S. students majoring in science and engineering or receiving advanced degrees in those fields. Only 7 of every 1,000 U.S. students earn engineering degrees; in contrast, in Japan the figure is 40 of every 1,000 students (12). More than half of new U.S. doctoral degrees in engineering, mathematics, and physics are awarded to foreign nationals (13). Public policy must give science education a higher priority in our national agenda.


In a global economy it is clear that policy confined to the United States will not ensure technological progress or U.S. competitiveness. All around the world efforts should be made to establish a business and political climate in which innovation will flourish. As Eastern Europe finally admits to the potential rewards of such an environment, we in America need to remind ourselves and others of the benefits of free trade and competition. Local economies benefit as industry is encouraged; nations benefit by adding new export products. In terms of pharmaceuticals, society benefits through victories in our fight against disease.

Among our own national needs, one of the most urgent is for the United States to adopt policies that will result in more equitable international trade arrangements. We must encourage Congress and the administration to take steps to equalize the flow of trade by measures that will enhance the competitiveness of U.S. industry, eliminate unfair trade practices, and open markets to U.S. goods.

In particular, there is a need for increased worldwide protection of rights to patents, copyrights, and trademarks. Such protection will contribute significantly to the ability of research-based companies to compete successfully in the global marketplace.


Whatever policy positions we develop regarding specific issues affecting innovation in medicine, all issues fall under the shadow of another serious concern: the enormous and increasing U.S. national debt, now totaling almost $3 trillion (14). This debt burden increases risks for all innovative industries, including pharmaceuticals, that require long-range planning. A balanced plan to lower the budget deficit by cutting spending and selectively increasing taxes is critically needed.

Academic, economic, and financial studies will no doubt be very helpful in framing public policy. But the national debt creates economic burdens that hurt everyone across the board; they drive up interest rates, limit the financial strategies available to business and government, cause fluctuations in the value of the dollar, make our economy unduly dependent on foreign investment, and lower the standard of living for us and future generations.

The importance of correcting this pattern of living beyond the nation's means cannot be overemphasized. Hard decisions on resource allocation are needed and will have direct relevance to the economics of technological innovation in medicine, simply because money applied to reducing the national debt is no longer available to meet healthcare needs.


Since the pharmaceutical industry has been subject to a great deal of pressure and change in recent years, we must wonder where the industry is headed. Looking at its own future, Merck believes the company will continue to prosper only if it has an environment conducive to innovation. Merck can maximize its contribution to society by helping people remain healthy and productive. In this way Merck expects to continue to help contain health care costs and thereby demonstrate that the innovative drug industry is not part of the problem but is instead part of the solution.

As for the industry, we believe it will continue to thrive if it does the following:


It remains successful in discovering, developing, manufacturing, and selling innovative, cost-effective drugs;


it can be sure of a fair return on its R&D investment; and


in the arena of public policies, it can successfully convey the message of the costeffectiveness of its products and the reality of risk versus return in drug R&D.

The best way to reduce the cost of disease is to find cures. Makers of public policy should bear in mind that Alzheimer's disease costs the United States $88 billion a year because there is no effective treatment (15). Smallpox, in contrast, costs the world not one penny because it has been eliminated by medicine.

If Merck or any other drug company could discover an effective drug for Alzheimer's, it would reduce health care costs by billions of dollars and end untold suffering. Public policy should be aimed at encouraging this kind of outcome rather than primarily at cutting costs.

Studies of the kind mentioned above will be critical in enlightening legislators and the public about all facets of the economics of the pharmaceutical industry. In addition, such findings will help Merck and other companies move into the twenty-first century as members of a vital and viable industry, serving society by meeting the needs of patients everywhere.


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1. Merck's financial analysts developed this figure from 1989 annual reports of the following top research-based U.S. companies: Abbott, Johnson & Johnson, Eli Lilly, Merck, Pfizer, Schering-Plough, Upjohn, and Warner Lambert. Four companies were excluded: Glaxo, because it had not been resolved which accounting method—U.S, or U.K.—would be used; Bristol-Myers Squibb and American Home, because they both experienced major acquisitions, making it difficult to obtain historical data; and SmithKline Beecham, which was excluded for both reasons.

2. According to the Pharmaceutical Manufacturers Association New Product Survey, of the 1,217 new single chemical entity drugs introduced to the U.S. market between 1940 and 1988, nearly 62 percent were discovered in the United States. Switzerland ranked second with 7 percent.

Copyright © 1991 by the National Academy of Sciences.
Bookshelf ID: NBK234300


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