Economics - General Pharmaceuticals Public Policy Regulation

Economics of the Pharmaceutical Industry

Darius Lakdawalla has an very interesting review article in the Journal of Economic Literature on the Economics of the pharmacuetical industry.  Do read the whole thing, but below I have listed some highlights.

A model of firm R&D decisions

Lakdawalla uses a simple model based on Nordhaus (1969) to derive some important implications about pharmaceutical firms’ decision to invest in R&D:

  1. All else equal, innovation investment rises with the expected gain from discovery
  2. Investment also rises with increases in the marginal productivity of investment (i.e., investment is more likely the higher the likelihood the marginal R&D dollar will find a drug discovery)
  3. Increased cost of capital decreases R&D


What share of drugs in development ultimately become approved?

“Among the largest drug companies, roughly 20–30 percent of drugs that began in phase I end up being approved for use (Adams and Brantner 2006).”


The relationship between market size and innovation

Lakdawalla writes: “…expansions in expected market size stimulate innovation effort. There is widespread empirical support for this relationship, but much debate over its magnitude.”

Lakdawalla cites research from Acemoglu and Linn (2004), which finds that a 1% increase in market size is associated with a 4-6% increase in new drugs entering the market.  Other studies have found that subsidies to purchase vaccines have stimulated vaccine R&D (Finkelstein 2004) and Medicare Part D stimulated R&D for drugs targeted to Medicare beneficiaries (Blume-Kuhout and Sood 2013).  Some have claimed, however, that some of the Part D investments were more likely to be ‘me too’ products with multiple treatments already on the market rather than first in class innovation (Dranove, Garthwaite, and Hermosilla, 2014)


Regulation and prices

Prices for pharmaceuticals in more heavily regulated, non-U.S. markets are typically 18-67% lower than in the U.S.  A US Department of Commerce study found that price deregulation in 11 OECD countries would increase pharmaceutical revenues by 25 to 38 percent (U.S. Dept of Commerce 2004). Danzon and Chao (2000) and Sood et al. (2009) both find that more regulation leads to lower prices.


Tax credits spur R&D

A study by McCutchen (1993) found that for every dollar of tax credit given to pharmaceutical firms, R&D spending increased by 29 cents.  Mansfield (1986) finds that for every $1 of government spending on tax credits, R&D increases by 30-40 cents.  Publicly funding R&D also appears to spur private R&D. According to a paper by Toole (2007) “Each $1.00 increase in expenditures on basic and clinical research correlates with $8.38 and $2.35 more pharmaceutical R&D expenditures, respectively.”


The impact of innovation on clinical trial participation

Previous innovation may make increase the cost of R&D for future innovation.  Why?  Malani and Philipson (2012) propose that innovation discourages clinical trial participations, since there may already be good treatments available.  Thus, recruiting participants for clinical trials becomes more expensive for pharmaceutical firms among diseases with previous successful innovations.


How much social surplus to innovators capture

Based on a study from Nordhaus (2004) the answer is about 2%.  Looking specifically in the healthcare sector of the economy, Philipson and Jena (2006) put the figure at about 5-10% of social surplus.

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