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Article Excerpt
1. Introduction
Most studies embed pharmaceutical companies within firms in different industries in studies of innovation, prices, and returns to make up for sample size and to infer aggregate industry performance from market structure. But the industry structure appears fragmented at best, with wave of mergers occurring to confront globalization and intellectual property rights (The Economist (US), June 23, 2001). Information about the structural direction that the industry will take resides within the brain cells of the CEOs of major companies.
The endogenous growth model predicts nonrivalrous behavior for R&D behavior in a national and global setting. This information translates into process and product innovation at the level of the firm, where R&D, advertising, and productivity are the driving forces for success. We have collected time series from 1980-1999 for 7 firms: Abbot Laboratories, American Home Products, Bristol-Myers Squibb, Eli Lilly, Merck, Johnson and Johnson, and Pfizer to investigate rivalry among them. We statistically fitted four equations corresponding to four hypotheses and found that smaller firms tend to set their R&D and advertising budgets taking Merck's previous outlays as given. However, when Total Factor Productivity is investigated for the same period, large firms tended to react to small firms, reaffirming concerns in the literature regarding size versus innovation.
2. Background
The U.S. Pharmaceutical Industry has enjoyed economies from the aging baby boomer population, aggressive R&D, advertising and productivity efforts; and now from the opportunities available in the global economy. The potential opportunities and challenges for pharmaceutical innovation are tremendous. Groundbreaking advances in technology have led to unprecedented pharmaceutical discoveries. Yet a major concern is that regulations by the FDA will generate low returns to investments in R&D. For instance, the rate of return in the late 1970s fell by a third to its 1960 levels, and the cost of discovering and developing new drugs increased 18-fold (Business Week, February 21, 1977).
During the 1980s, the pharmaceutical industry received a boost from the Reagan administration that lengthened the patents on prescription drugs and hastened the pace of approving generic drugs to substitute for drugs with expired patents. The immediate result in the 1980s was that R&D expenditure in drugs was about 10% of the industry's sales, versus 3% for all manufacturing industries (S&P Industry Survey, January 1985, H16). But the FDA's Center for Drug Evaluation and Research (CDER) still regulates the industry brand name, generic prescriptions and OTC drugs, placing a heavy time delay on production. The time it takes to develop a new drug has almost doubled from its 1960 levels. The actual trend is 8.1 years in the 1960s, 11.6 years in the 1970s, 14.2 years in the 1980, and a stable 14.9 years during 1990-1996 (Pharmaceutical Industry Profile, 2000, VI). CDER claimed that with the user-fee approach in the mid-1990s, where the applicant pays the government for its review, they have doubled the number of new drugs approved and halved the review time (FDA Consumer, September-October 1997, 21). Other policies such as the streamlining of the IND and the International Conference on Harmonization also reduced review time. However, the review time continues to generate concern. The industry's strategy is:
1. To have an ample supply of R&D projects and patents in the pipeline,
2. To lobby Congress and get extension of time on their patents in order to recoup their investment costs,
3. To allow the speedy approval of generic drugs in order to substitute for drugs whose patent has expired, and
4. To make drugs available before approval possible in special cases such as in the HIV cases in South Africa.
3. Globalization Effects
At the firm level, big changes such as NAFFA have not noticeably affected firms in the pharmaceutical industry relative to firms in other industries such as the textile, shoes, autos, and steel industries. An early concern in the international scene was the debate between Canada and the U.S. over compulsory licensing of firms' pharmaceutical patents (Hufbauer et al., 1992, 173, 179). This issue seems to be resolved under The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) under WTO that grants 20 years patent protection for pharmaceutical and other product. Today, the international scene is populated with demonstrations, such as in Seattle in December 1999 against the WTO and others against the G8. These demonstrations are not so much related to free trade as to issues of fairness, transparency, and environment (JAMA, June 12, 2001, V285, i22, 2844). Other specific concerns hover around generic pricing as it relates to South Africa. In that situation 39 drug companies tried to stop the importation of cheaper medicines and the substitution of generics, as was permitted under TRIPS. However, the lawsuit was dropped due to global political pressure on the companies.
On the employment impact side, competition from abroad has made little indent on the market of domestic firms. This might be because the American firms dominate the global market, where 6 of the top 10 firms are based in the United States (S&P: Industry Survey, June 28, 2001, 9).The statistics show that over the 1980-1999 period, pharmaceutical companies have filed only 28 petitions with the International Trade Commission (ITC), covering 4,535 employees, of which most were denied (20 with 3,906 workers) and few were approved (8 with 629 workers). Perhaps the reason for the small import impact had been that pharmaceutical companies have always been on guard against foreign competition. They use strategies such as drug licensing, joint ventures and mergers to counter foreign competition. The push for intellectual property rights through the WTO's TRIPS rules illustrates the former.
Beginning in the mid-1980s, the pharmaceutical industry has been characterized by larger and more frequent merger and acquisition activity. The threat of patent expirations has influenced the increased merger activity within the industry. Many pharmaceuticals with high sales histories fear losing their patent protection and face competition from generic copies. There has been evidence that sales can decrease by as much as 75 percent in the year preceding patent expiration. Through merging with other industry players, pharmaceutical companies are able to pool their advertising, R&D, and productivity efforts while simultaneously cutting costs.
While the literature has extensively assessed prices, profits, and R&D efforts, advertising and productivity efforts were generally given a lower profile. These issues were considered by the Kefauver Committee in 1962 and again by the Subcommittee on Monopoly in 1976, which notes that "The drug industry has vast resources at its disposal. Its expenditure for advertising and promotion of drugs is now well over $1 billion per year or about $5,000 per physician per year" (Subcommittee 1976, 1395). Considering that advertising outlay is substantially greater than R&D outlay, and that long-term productivity is a major source for its economic growth, it is surprising that the study of advertising and productivity have taken a back-seat in the literature.
In this paper we develop four hypotheses and associated corollaries in order to perform an integrated analysis of seven major firms in the pharmaceutical industry. The model section develops these hypotheses around the concepts of scale economies, R&D, advertising, and Total Factor Productivity. The rest of the paper is divided into sections on the statistical results of at least four equations that were developed to evaluate the hypotheses with data.
4. Model
Traditional models focus on how prices and quantity in a market are determined. The pharmaceutical industry is useful for investigating price and non-price competition. Commenting on Caves et al., 1991 article, Pakes (1991) wrote that it is "cleaner" than most related industrial organization problems for several reasons. First, there is a legal monopoly for the first T years of the product's existence, and then free entry occurs at a fixed sunk cost thereafter (the cost of approval by the Federal Drug Administration), giving us a well-defined set of rules to determine possible market interactions. Second, it is reasonable to argue that there are common and fairly constant costs of production for the drugs being sold. Third, after the introduction of the branded drug, there seems to be only one major type of investment (advertising), and we have reasonably detailed data on it. There is, however, a difficult set of economic problems in modeling demand and in defining precisely what we mean by "brand loyalty" (Pakes, 1991). We model the pharmaceutical industry from its price and non-price aspects, and bring out rivalry among the major firms within this framework. No one model is broad enough to account for all of these activities, hence we begin with some simple abstraction, namely that the firms arrive at a pricing strategy through non-market means, and that the firms rely heavily on non-price competition for their survival.
Fudenberg et al., (1993) provide the essence for a model in the form of a time game where a firm's strategy set includes a time to either "stop" or "not stop" their efforts, which can include pricing, R&D, advertising, and productivity efforts. A firm can, for instance, lower its R&D cost to C, from a higher level, C'. Assuming it rivals do not react, the firm will expect a stream of benefits V(t) from such research efforts. Such a formulation allows one to estimate social gains if a social gain function can be specified. Scherer (1967) was one of the earliest to advance such a model within a profit maximization framework to predict a firm's market structure. He gave it an exponential form, which was further expanded by other authors. Reinganum (1984) has summarized some of those models to derive stylized facts about firm's size, excess capacity, strategies for increasing or decreasing efforts in equilibrium, leadership role, pre-emption strategies, and licensing. Some of the modern features of the exponential model are summarized in Tirole's book (1997, Ch. 10). Rather than developing the model here in symbolic form for each of the variables, we next discuss the form it takes in the estimation of each of the price and non-price categories.
4.a. Price Competition
On the demand side, the consumer is not the one that usually makes the choice of using a particular drug. Mostly, drugs are prescribed by physicians, who sometimes lack the necessary information about relative prices (Ellison et al., 1997, 437). Consumers, in attempts to gather or aggregate decentralized information, may want to free-fide on information from another patient that has already gone through that experience, the so called "herd" behavior effect (Choi 1997, 409-410).
On the supply side,...
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