An explosion of knowledge and a growing array of tools and technologies have transformed modern drug R&D, while its cost has risen by a sizable amount. At the same time, the unchecked increase in health care and prescription drug spending has spawned cost containment policies that are restricting the demand for drugs in all major markets. This Perspective explores the interplay between technological advances and regulatory policies and their likely impact on the dynamics of the pharmaceutical industry. Advances in the life sciences have profoundly transformed the drug research and development (R&D) process. That transformation has come at a price, boosting the cost of developing a new molecular entity (NME) to $802 million by 2000. More expensive R&D, combined with an aging population and better diagnostic techniques, has swelled drug spending in the United States, which reached $141 billion in 2001. These increases have in turn induced a spate of cost containment measures that are affecting demand for pharmaceuticals in all major markets. This Perspective considers the impact of the interplay between technological advances and health care policy on the future dynamics of the pharmaceutical industry.Pharmaceutical Industry, R&D Productivity, Health Care Policy

Pammolli, Fabio

Riccaboni, Massimo

English

Research Papers in Economics

Market Structure And Drug Innovation  
Fabio Pammolli and Massimo Riccaboni 
 
 
 
Abstract 
  
An explosion of knowledge and a growing array of tools and technologies
 have transformed modern drug 
R&D, while its cost has risen
 by a sizable amount. At the same time, the unchecked increase
 in health care 
and prescription drug spending has spawned cost
 containment policies that are restricting the demand for 
drugs
 in all major markets. This Perspective explores the interplay
 between technological advances and 
regulatory policies and their
 likely impact on the dynamics of the pharmaceutical industry.
  
 
Advances in the life sciences have profoundly transformed the
 drug research and development (R&D) 
process. That transformation
 has come at a price, boosting the cost of developing a new molecular
 entity 
(NME) to $802 million by 2000.
1 More expensive R&D,
 combined with an aging population and better 
diagnostic techniques,
 has swelled drug spending in the United States, which reached
 $141 billion in 2001.
2 
These increases have in turn induced
 a spate of cost containment measures that are affecting demand
 for 
pharmaceuticals in all major markets. This Perspective considers
 the impact of the interplay between 
technological advances and
 health care policy on the future dynamics of the pharmaceutical
 industry.
  
 
Productivity and growth. 
During the 1990s the U.S. pharmaceutical sector enjoyed remarkable
 productivity growth, measured by 
capital, labor, and total factor
 productivity (TFP).
3 Compared with Europe and Japan, the United
 States has 
attained the highest average growth in the value
 of pharmaceutical production. This can be chiefly attributed
 
to two causes: First, there are strong differences in absolute
 sizes and rates of growth between the U.S. 
market and those
 of other countries. For instance, the U.S. pharmaceutical market
 has grown from being 
roughly equal to the European market at
 the beginning of the 1990s to being almost twice as large in
 more 
recent years.
4 Second, the U.S. industry has been able
 to respond to market dynamics through substantial 
growth in
 nonlabor inputs, such as research and capital.
  
How much of this increase is structural and how much is transient
 is an important question, at a time when 
growth seems to be
 abating. To a certain extent, productivity in pharmaceuticals
 will increase, as in other 
sectors, as a pure consequence of
 economic recovery, since firms have already reduced the share
 of 
personnel costs devoted to production value. Moreover, consolidation
 through mergers and acquisitions, 
together with a further diffusion
 of information and communication technology, can further fuel
 growth in 
productivity. In particular, substantial gains in
 efficiency can likely be achieved by redesigning and 
reorganizing
 distribution channels, to adapt them to the growing roles of
 buyers’ groups and the Internet. 
However, in the long
 run, productivity and pharmaceutical innovation will be critically
 affected by the interplay 
between technological and demand dynamics.
  
Application of new disciplines. 
The past twenty-five years have witnessed a revolution in biological
 sciences, with basic advances in 
molecular and cell biology,
 biochemistry, protein and peptide chemistry, physiology, and
 pharmacology. The 
application of these new disciplines to the
 drug industry, together with the growing convergence between
 life 
sciences and information sciences, has had an enormous
 impact on R&D activities, on the organizational 
capabilities
 needed to discover and develop new drugs, and on the dynamics
 of industry evolution.
5 By most 
metrics used in pharmaceutical
 discovery and development, output per person-hour has risen
 impressively 
over the past fifteen years. Yet this has not yet
 had a measurable impact on the flow of new drugs. There can
 
be several reasons for this paradox: On the one hand, as scientists
 gain an increasingly detailed 
understanding of pathological
 processes at the molecular level, they can formulate better
 hypotheses that avoid dead-end tracks. On the other hand, as
 more targets are discovered, the body of knowledge required
 
to understand them, let alone use them for new therapies, increases
 dramatically, which delays the time 
when new or better therapies
 become available. In short, there can be sharply diminishing
 returns in drug 
R&D.
  
The balance between these two opposing trends will eventually
 tilt to the side of increased productivity, but 
this might be
 years away and, moreover, is critically dependent on regulation,
 demand, and the pricing of 
new products. In short, pharmaceutical
 R&D for complex pathologies might be facing sharply rising
 marginal 
costs, but the price/value of those drugs tends to
 be higher and higher (socially). It is not uncommon for a 
new
 target to require many years of painstaking discovery to sort
 through the divergent conjectures and 
research hypotheses, which
 reflect the uncertainty, irreversibility, and lock-in of pharmaceutical
 R&D.
6 Since 
geneticists have recently increased our supply
 of targets from several hundred to several thousand, the 
magnitude
 of the work required to turn this into drug innovation cannot
 be underestimated.
  
In fact, the task at hand is so momentous that a spontaneous
 division of labor in R&D has emerged that 
unites the traditional
 large pharmaceutical companies to thousands of "small pharmas"
 and public research 
institutes in complex, dynamic webs in which
 knowledge, assets, and technological know-how are traded.
7 
This
 provides the flexibility necessary to accommodate an exploding
 body of knowledge and to match 
opportunities with capital and
 know-how. It is apparently already producing tangible gains
 in R&D 
productivity, since both the probability of success
 and the speed of development are higher for collaborative 
versus
 in-house R&D projects.
  
Industry structure and evolution. 
Competition dynamics in pharmaceuticals results from the market
 interaction of breakthrough products, 
imitative ("me-too") compounds
 that offer various degrees of incremental improvement, and generics.
8 
Breakthrough molecules enjoy rapid growth until imitative products
 are introduced and slow the growth of the 
innovative drug. After
 a while, all drugs tend to grow at about the same rate, with
 highly asymmetric shares in 
favor of the early entrants.
9  
Interestingly, innovation is highly specific to indications,
 biological targets, and chemical families and is not 
easily
 transferred to other families or targets, even within the same
 therapeutic area or the same company. 
For instance, firms with
 solid franchises in selective serotonin reuptake inhibitors
 (SSRIs) or statins have 
been unable to parlay these strengths
 into leadership of newer modes of action, which would have helped
 
refresh their franchises as they matured. More often than not,
 a company’s franchise becomes extinguished 
with the expiration
 of the blockbuster patent that created it. There does not seem
 to be a durable, long-term 
first-mover advantage that can be
 exported to a different drug class. This has hindered the persistence
 of 
dominant positions and limited industry concentration.
  
In summary, growth and industry structure in pharmaceuticals
 are driven by two basic mechanisms: the 
creation of new markets
 through the introduction of new families of products and rare
 arrivals of major 
breakthroughs, and competition among products
 within each submarket, before and after patent expiry. 
Against
 this backdrop, it is easier to understand why some cost containment
 initiatives recently implemented 
or under study across the world
 could permanently and adversely affect competition in the industry.
 For 
example, convergence toward price-control schemes such as
 reference pricing for on-patent drugs within 
broad equivalency
 classes would reduce expected revenues from horizontal product
 differentiation and would 
reinforce first-mover advantages,
 which would in turn lead to higher concentration. In this scenario,
 fewer of 
the giant firms would survive. Survivors would be companies
 that succeed in retooling their innovation to 
produce a consistent
 flow of first-in-class breakthrough drugs (instead of "me-too"
 compounds). Other 
competitors would gradually lose their status
 as growth companies that can be relied upon to deliver 
consistent
 growth and profits. They would in effect become cyclical drug
 companies, whose fortunes would 
follow the cycles of their (rare)
 blockbusters. As cyclical companies go, their valuation would
 be severely 
penalized and would likely attract corporate raiders
 bent on unlocking their intrinsic value by taking over 
those
 firms and selling off the pieces. Industry concentration would
 increase. A few biotech companies might 
seize the opportunity
 to join the ranks of Amgen and Genentech, and some might pair
 off with like-minded 
larger drug firms to become specialist
 drug companies. But the financial vulnerability of both the
 large cyclical 
and the biotech firms would be a barrier to growth.
 Innovation in pharmaceuticals is influenced by market 
size and
 expected profitability, which are sensitive to regulation.
10  All in all, international convergence toward price control and
 reference pricing for innovative drugs would 
have negative effects
 on industry structure and innovation. A new industry landscape
 would take shape, but 
one that might look quite different from
 what policy-makers originally had in mind.
  
Notes 
 
1.  J. DiMasi et al., "The Price of Innovation: New Estimates of Drug Development Costs," Journal of 
Health Economics 22, no. 2 (2003): 151–185.[CrossRef][Web of Science][Medline]  
2. PhRMA,  Pharmaceutical Industry Profile, 2001 (Washington: PhRMA, 2001).  
3.  A. Gambardella, L. Orsenigo, and F. Pammolli, "Global Competitiveness in Pharmaceuticals: A 
European Perspective," Enterprise Paper no. 1 (Brussels: European Commission, 2001).  
4.  E.R. Berndt, "The U.S. Pharmaceutical Industry: Why Major Growth in Times of Cost Containment?" 
Health Affairs (Mar/Apr 2001): 100–114.  
5. A.  Gambardella,  Science and Innovation: The U.S. Pharmaceutical Industry during the 1980s 
(Cambridge: Cambridge University Press, 1995); and L. Galambos and J. Sturchio, "The 
Pharmaceutical Industry in the Twentieth Century: A Reappraisal of the Sources of Innovation," 
History and Technology 13, no. 2 (1996): 83–100.  
6.  L. Orsenigo, F. Pammolli, and M. Riccaboni, "Technological Change and Network Dynamics: 
Lessons from the Pharmaceutical Industry," Research Policy 30, no. 3 (2001): 485–508[CrossRef]; 
and F. Pammolli and M. Riccaboni, "Technological Regimes and the Growth of Networks: An 
Empirical Analysis," Small Business Economics 19, no. 2 (2001): 205–215.  
7.  J. Owen Smith et al., "A Comparison of U.S. and European University-Industry Relations in the Life 
Sciences," Management Science 48, no. 1 (2002): 24–43; and[Abstract/Free Full Text]A. Aror, A. 
Fosfuri, and A. Gambardella, Markets for Technology: The Economics of Innovation and Corporate 
Strategy (Cambridge, Mass.: MIT Press, 2001).  
8.  A. Arora et al., "The Nature and the Extent of the Market for Technology in Biopharmaceuticals," 
Cahiers de l’Innovation no. 7 (Paris: Centre Nationale de la Recherche Scientifique, April 2001).  
9. J.  Sutton,  Technology and Market Structure: Theory and History (Cambridge, Mass.: MIT Press, 
1998); andF. Pammolli et al., "Innovation and Corporate Growth in the Evolution of the 
Pharmaceutical Industry," International Journal of Industrial Organization 19, no. 3 (2001): 1161–
1187.[CrossRef]  
10. D. Acemoglu and J. Linn, "Market Size in Innovation: Theory and Evidence from the Pharmaceutical 
Industry," NBER Working Paper 10038 (Cambridge: National Bureau of Economic Research, 
October 2003). 
 

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