R&D in the Pharmaceutical Industry

THE COMPARISON OF DOLLARS SPENT VERSUS NEW DRUGS PRODUCED DOESN’T GIVE THE ENTIRE PICTURE. THERE ARE A VARIETY OF METRICS THAT NEED TO BE CONSIDERED WHEN COMPARING CURRENT RESULTS VERSUS THOSE IN THE PAST.

Recent concerns about escalating drug prices and rising health care spending have sparked considerable interest in how new drugs are discovered, tested and sold—and in how well those processes serve the interests of U.S. consumers. Public dialogue on those issues, however, suggests that the complex economic forces that govern the drug-discovery process are not widely understood.

Even some of the basic economic facts about the pharmaceutical industry have been subject to debate. This study describes the current state of pharmaceutical research and development (R&D), analyzes the forces that influence it, and considers how well markets are working to deliver new drugs.

Much of the public interest in pharmaceutical R&D concerns the relationship between drug prices, drug firms’ costs, and the pace and direction of innovation. Average prices of new drug products have been rising much faster than the rate of inflation, and annual R&D spending has grown faster still. Nevertheless, introductions of innovative new drugs have slowed. At the same time, drug companies have been able to charge high retail prices for new drugs that are only incrementally different from older drugs whose prices have fallen. With consumers paying more for new drugs in the United States than almost anywhere else in the world, and with the perception that the drug industry has become less innovative, many observers have wondered whether some kind of policy intervention is warranted.

Pharmaceutical markets, however, are extremely complex in many respects. Large public-sector investments in basic biomedical R&D influence private companies’ choices about what to work on and how intensively to invest in research and development. The returns on private-sector R&D are attractive, on average, but they vary considerably from one drug to the next. Consumer demand for prescription drugs is often indirect, mediated by doctors and health insurers. New drugs must undergo costly and time-consuming testing before they can be sold. Moreover, it may cost hundreds of millions of dollars to develop an innovative new drug that then will cost only a few cents per dose to manufacture—and the price of the drug will have no obvious connection to either cost.

Comparative information about drug quality from unbiased, head-to-head clinical trials of competing drugs is seldom published, although it would help drug purchasers make the best choices—and in turn improve the market signals that guide private companies’ decisions about research and development. An understanding of how such factors interact with the industry’s R&D process is necessary to recognize the underlying causes of any failure of the market to encourage a socially optimal level of drug R&D.

THE COST OF DEVELOPING A NEW DRUG

Research and development costs vary widely from one new drug to the next. Those costs depend on the type of drug being developed, the likelihood of failure, and whether the drug is based on a molecule not used before in any pharmaceutical product (a new molecular entity, or NME) or instead is an incremental modification of an existing drug.

INNOVATIVE DRUGS

A recent, widely circulated estimate put the average cost of developing an innovative new drug at more than $800 million, including expenditures on failed projects and the value of forgone alternative investments. Although that average cost suggests that new-drug discovery and development can be very expensive, it reflects the research strategies and drug-development choices that companies make on the basis of their expectations about future revenue.

If companies expected to earn less from future drug sales, they would alter their research strategies to lower their average R&D spending per drug. Moreover, that estimate represents only NMEs developed by a sample of large pharmaceutical firms. Other types of drugs often cost much less to develop (although NMEs have been the source of most of the major therapeutic advances in pharmaceuticals).

The study that produced that cost estimate also calculated how long it takes to develop a new drug and the relative contribution of capital costs to a drug’s total R&D costs. On average, developing an innovative new drug takes about 12 years, the study concluded, and a firm’s actual expenditures make up only about half of the total reported cost. The rest represents the financial cost of tying up investment capital in multiyear drug development projects, earning no return until and unless a project succeeds. That “opportunity cost” of capital reflects forgone interest or earnings from alternative uses of the capital. (Opportunity costs are common to all innovative industries, but they are particularly large for pharmaceutical firms because of the relatively long time that is often required to develop a new drug.)

Research and development spending per NME has grown significantly in recent years, for various reasons. First, failure rates in clinical trials have increased, possibly because of greater research challenges or a willingness to test riskier drugs in such trials. Second, larger drug firms are said to have shifted the focus of their development efforts away from drugs for acute illnesses and toward drugs for chronic illnesses. Drugs that treat chronic illnesses can be more expensive to develop because they often require larger and longer clinical trials. Third, greater technological complexity in drug development and greater specificity in disease targets have helped to raise average R&D costs, as firms now identify drugs with particular molecular characteristics rather than using trial-and-error methods to find compounds that work in some desired way.

Not all new molecular entities provide unique therapeutic functions. Many NMEs are so-called “me-too” drugs. Despite that name, they are not necessarily imitations of other drugs. Rather, they may be innovative products that lost the race to be the first drug on the market in a given therapeutic class (such as antidepressants, antibiotics, or antihistamines). Such products can benefit consumers by competing with, and sometimes improving on, the pioneering drug in a class.

INCREMENTALLY MODIFIED DRUGS
 
Most new drug products have much lower R&D costs than NMEs because they are incremental improvements on existing drugs. Those costs can still be considerable if the new product requires clinical trials. Nevertheless, because non-NMEs constitute about two-thirds of the drugs approved by the Food and Drug Administration but account for only about one-third of the industry’s R&D spending (by some estimates), their average direct cost may be only about one-fourth that of an NME.

Their opportunity costs are also lower to the extent that they take less time to develop than drugs based on new molecules.

Incrementally modified drugs sometimes provide significant benefits to consumers. For example, more convenient dosing forms (say, a pill that can be taken once a day rather than every four hours) can increase the likelihood that patients will take their medicine as directed and can result in better health. At the same time, given the indirect nature of demand in pharmaceutical markets, the higher prices that are charged for some drugs that are merely extensions of current product lines may not be commensurate with the additional value that those drugs provide.

THE ROLE OF FEDERAL RESEARCH AND DEVELOPMENT

The federal government spent more than $25 billion on health-related R&D in 2005. Only some of that spending is explicitly related to the development of new pharmaceuticals. However, much of it is devoted to basic research on the mechanisms of disease, which underpins the pharmaceutical industry’s search for new drugs.

The primary rationale for the government to play a role in basic research is that private companies perform too little such research themselves (relative to what is best for society). In general, the information generated by basic research can be readily replicated at low cost. Thus, many of the benefits of that research accrue not to the company that performs it but to the public and to other firms.

With pharmaceuticals, those spillover benefits can be significant because the development of new drugs depends on scientific advances. Federal funding of basic research directly stimulates the drug industry’s spending on applied research and development by making scientific discoveries that expand the industry’s opportunities for R&D.

Government-funded basic research can also stimulate private- sector R&D indirectly. By supporting graduate students and postdoctoral researchers in academic labs where basic research is conducted, federal grants help to train many of the researchers who are hired by drug companies.

That training enhances the productivity and profitability of the companies’ R&D investments, while also allowing researchers to command higher salaries. Given the extent of federal funding for life-sciences research, however, there is a risk that some of that funding could crowd out private-sector investment in R&D.

In general, the government tends to focus on basic research, whereas private firms focus much more on applied research and development. That difference diminishes the risk of direct crowding out. But the distinction between basic and applied research is not well defined, and the division of labor between the two has become less pronounced as the potential commercial value of basic life-sciences research has become more widely recognized. Government and private R&D efforts have sometimes overlapped (as in the race to finish mapping the human genome); thus, the government may have funded some research that the private sector otherwise would have financed. Identifying specific cases where direct crowding out has occurred is difficult, but it is probably most likely to happen when the government funds research whose potential commercial applications are obvious and valuable.

Federal R&D spending can also crowd out private spending indirectly by causing labor costs to rise. Although students and postdoctoral researchers form part of the workforce for federally funded research, the government and the drug industry both draw on the same supply of trained professional researchers. That supply is relatively fixed in the short run, and higher R&D spending in either sector can cause salaries to rise by increasing the demand for researchers. That is more likely to occur when R&D spending is growing rapidly. In recent years, both real (inflationadjusted) salaries for biomedical researchers and total employment in biomedical research have increased along with real R&D spending. When R&D spending is growing more slowly, however, there is probably little such effect on labor costs for researchers.

ASSESSING THE DRUG INDUSTRY’S R&D PERFORMANCE

Total spending on health-related research and development by the drug industry and the federal government has tripled since 1990 in real terms. However, the number of innovative new drugs approved by the Food and Drug Administration each year has not shown a comparable upward trend. NME approvals shot up for a few years in the mid-1990s and then fell again; on the whole, such approvals have consistently ranged between about 20 and 30 per year. Measured by the number of drugs approved per dollar of R&D, the innovative performance of the drug industry appears to have declined.

However, if new drugs were of higher quality than older drugs, on average, that improvement would partly or fully make up for a decline in the raw number of drugs per R&D dollar. Drug quality is multidimensional and difficult to measure, however. As a result, no careful and comprehensive estimate exists to show how changes in quality have affected the industry’s actual R&D performance.

Other factors have contributed to the impression that the pharmaceutical industry’s innovative performance has declined. Over the past decade, a growing share of the industry’s R&D output has consisted of incremental improvements to existing drugs rather than new molecular entities. Performance measures that consider only entirely new drugs—such as the number of NME approvals per year—miss that shift and undervalue the industry’s R&D output. Moreover, comparing output per R&D dollar over long spans of time can be misleading because of shifts in the types of drugs being developed.

Notwithstanding concerns about innovative performance and how to measure it, the range of illnesses for which drug therapies exist has never been broader, and technological advances have yielded new drug treatments of increasing sophistication, convenience, and effectiveness.

Even so, it is difficult to determine whether the returns to society from the money spent on drug R&D have declined or not. There are several possible reasons why the industry’s R&D performance could have slipped.

Companies may not yet have fully mastered the complex new research technologies with which they work; the pool of relatively inexpensive research discoveries may be temporarily depleted, pending further advances in basic science; and strong consumer demand for new drugs may have encouraged firms to invest in R&D beyond the point of diminishing returns. Furthermore, the frequency with which leading drug companies have merged with one another over the past decade—which may have resulted partly from a decline in the number of new drugs in development—has sparked concerns about the industry’s R&D productivity. According to some observers, large firms tend to be less innovative than smaller firms.

Those mergers have had little initial effect on the combined firms’ total R&D spending, although the ultimate impact on the introduction of innovative new drugs remains uncertain.

If the industry’s R&D performance has slipped, recent advances in basic sciences (such as molecular and cellular biology and biochemistry) could eventually reverse that trend by stimulating the development of more new drugs.

In addition, new-drug approvals could increase simply because of the rising number of potential new products that have entered the development pipeline in recent years, according to drug companies. The greater commercialization of basic R&D and the increased specialization that has occurred in the drug industry may also enhance productivity. At the same time, though, the greater role of the private sector in basic R&D may have made the pace and direction of progress in drug development more dependent on financial factors in the industry.

THE DRUG INDUSTRY’S PROFITS AND R&D INVESTMENT

By standard accounting measures, the pharmaceutical industry consistently ranks as one of the most profitable industries in the United States. Those measures, however, treat most R&D outlays as expenditures rather than as investments that add to the value of a firm. Thus, they omit from a firm’s asset base the value of its accumulated stock of knowledge. For R&D-intensive industries, such as pharmaceuticals, that omission can significantly overstate profitability. Adjusted for the value of its R&D assets, the drug industry’s actual profitability still appears to be somewhat higher than the average for all U.S. industries, but not two to three times higher, as standard measures of profitability indicate.

The notion that pharmaceutical companies enjoy extraordinary profits is reinforced by the relationship between prices and costs in the drug industry. The industry’s high R&D spending and relatively low manufacturing costs create a cost structure similar to that of, for example, the software industry. Both industries have high fixed costs (for research and development) and low variable costs (to put a software application onto a CD-ROM or to produce a bottle of prescription medication). Consequently, prices in those industries are usually much higher than the cost of providing an additional unit of the product, because revenue from sales of the product must ultimately cover those fixed costs. Even though conventional accounting measures overstate the profitability of the drug industry, strong growth in the industry’s R&D spending over many years suggests that the returns on pharmaceutical R&D have been attractive.

Ultimately, how adequately prices and profits indicate the kinds of drugs that consumers want to buy determines the extent to which the pace and direction of drug innovation are themselves adequate. High prices on new drugs encourage continued innovation. But because health insurance (private plans as well as Medicaid and Medicare) keeps consumers from bearing the full weight of those prices, the demand for new drugs is higher than it otherwise would be at any given price. That effect is magnified because employment-based health insurance benefits are not subject to income or payroll taxes, which reduces their cost to consumers. As a result, more people have health insurance, and many have higher levels of coverage, than would be the case otherwise.

The effect of health insurance on drug companies’ revenues— combined with strong patent protection that helps firms maintain higher prices—may sometimes create incentives to invest too much in R&D (from the standpoint of the amount of investment that is optimal for society). The role of health insurance can be tempered in several ways, however. Insurers and other large buyers of drugs may be able to exercise more power to negotiate lower prices, and insurers can give patients and doctors stronger incentives to consider price differences between drugs. The more accurately a drug’s price reflects its value to consumers, the more effective the market system will be at directing R&D investment toward socially valuable new drugs. However, prices can only serve that directing role to the extent that good information exists about the comparative qualities of different drugs and that consumers and health care providers use that information. ♦

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