health economics- lecture ch17

8/3/2019 Health Economics- Lecture Ch17

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The Pharmaceutical Industry

Dr. Katherine Sauer Metropolitan State College of Denver

Health Economics



I. Structure and RegulationII. Health and Substitutability

III. Pricing and ProfitsIV. R&D and InnovationV. Cost Containment



Drug therapies have supplemented nutrition, sanitation,

and medical care in preserving health.

What would health be like without pharmaceuticals?vaccines

antibioticschemotherapy

Pharmaceutical firms are some of the largest and most

profitable businesses in the US.



I. Structure and Regulation

In 2006, spending on prescription drugs amounted to $217 billion.

This is 10.3% of national health expenditures.8.9 percent in 20004.7 percent in 1980



The pharmaceutical industry has always interested

economists in the field of industrial organization.- high profits- patent protection- high R&D spending

- intense product promotion- heavy regulation



Concentration Ratios for Selected Industries



By looking at the number of firms and concentrationratios, the pharmaceutical industry looks relativelycompetitive.

- misleading- drugs in different therapeutic classes reallyaren’t substitutes



A. Barriers to Entry

A patent is a legal barrier to entry.- Patents are vital to the pharmaceutical industry.

Advertising/promotion can also create barriers to entry.- brand loyalty- familiarity

- free samples to physicians- advertising in medical journals

In 1997, the FDA relaxed rules governingadvertising in mass media.

- Direct to Consumer (DTC) marketing



The long and costly process for getting a new drug FDA

approved is also a barrier to entry.

About 1 out of every 5,000 to 10,000 chemicalcompounds screened eventually become a drug.

3 out of every 10 drugs approved eventually become profitable.



B. Regulation

Pharma is one of the most heavily regulated industries.

1906 Food and Drug Act – dealt with labeling1938 Federal Food, Drug, and Cosmetic Act –

requirements for testing and safety

1959 – Senate hearings on questionable drug industry practices

1956 – 1962 thalidomide tragedy in Europe

1962 – FFDCA amendments give FDA more control



Process:1. drug discovery

- screen / engineer thousands of compounds

2. pre-clinical tests- lab/animal tests (3-6 years, 250 compoundsenter)3. Investigational New Drug application filed with FDA

4. clinical trials (Phase I, II, and III)- humans (5 compounds enter)5. New Drug Application

- 100,000 pages (1 compound)6. FDA review/approval

- 10-15% of applications rejected- 16.9 months to review

7. on-going studies



II. Health and Substitutability- role of prescription drugs in producing health- relationship to other health inputs

Consider two inputs to health production:medical caredrugs

What might the isoquants look like?- perfect substitutes?- needed in fixed proportions?

- “too much” pharmaceuticals can harm a person



A. Least-Cost Production

Suppose a patient utilizes two types of health inputs:medical care (M) pharmaceutical drugs (D)

The total cost of care (C) can be written:C = PDD + PMM

or if M is on the vertical axis:M = C/PM - (PD/PM) D



If a patient has no insurance, then the cost of care line isthe same as their health budget line.

The rational patient wants to find the combination of medical care and pharmaceuticals that will yield a certainhealth status, while minimizing spending.



D

M

HS

C2

The patient will seek to attain acertain level of health (HS), butspend as little as possible to doso.

The slope of the cost line is- PD/PM

D*

M*

C3C1



B. What if the patient has insurance?

Consider a policy that covers a constant proportion of expenses on both D and M.

Ex: suppose initially PD= 50 and PM = 100the budget line has a slope of - 1/2

suppose now insurance covers 80% of spending

The out-of-pocket prices are now (0.2)(50)= 10

(0.2)(100) = 20

The price ratio is still the same, 1/2



Since the slope of the budget line has not changed, theconsumer’s optimal combination of medical care anddrugs has not changed.

Since the combination of M and D has not changed, thetotal cost of care has not changed.



Now consider a policy that pays 80% of medicalexpenses but requires a $5 co-pay for prescriptions.

now PD= 5 and PM = 20

slope of budget line = -1/4- it is now flatter

The patient will choose a new optimal combination of drugs and medical care

- more drugs (they are cheaper)

Since the patient chooses a new combination of M and D,the total cost of care also changes.



D

M

HS

C

D1

M1

M2

D2

BL

Notice that the tangency pointfalls outside the original costline.

The total cost of care hasincreased.

The patient still achieves thesame level of health status.



C. Technological change

Technological improvement means that fewer inputs can be used to produce a given health outcome.

- or the same amount of inputs can generate ahigher outcome



HS*

M

D

C1

Suppose there is a technologicaladvancement that allows HS* level of health while using the level of inputs

that would previously only haveyielded HS1.

- use fewer inputs to achievethe same level of health

- lower cost

HS1

D1

M1

M*

D*



HS*

M

D

C1

Case 1:The ratio of M to D hasgotten steeper

- greater reduction in

use of drugs relative toreduction in medical care

Medical care utilization

increases relative todrugs.

HS1

D1

M1

M*

D*

M/D 1

M/D *

Technologicalchange was infavor of drugs.



HS*

M

D

C1

Case 2: The ratio of M to D has gottenflatter

- greater reduction in use

of medical care relative toreduction in drugs

Drug utilization increases

relative to medicalcare.

HS1

D1

M1

M*

D*

M/D 1

M/D *

Technologicalchange was infavor of medical

care.



If the new optimal combination of D and M lies on the

original ray (D/M), then the change in technology was“neutral”.

[we solely did the example of using fewer inputs toachieve the same initial level of health status – try onyour own to use the same level of inputs and achieve ahigher level of health status]



III. Pricing and Profits

Many studies have found that pharmaceutical profits, as

reported in financial statements, are consistently amongthe highest of all industries.



A. Monopoly Pricing

DMR

AC

MC

P

QQ*

P*

AC*

The gap between the market price and the marginal cost isquite large.



If the drug was a breakthrough, what would the demandcurve look like?

If the drug was a “me too” drug, what would the demand

curve look like?



B. Price Discrimination

Third-degree price discrimination is possible for pharmaceuticals.- segment market into groups of buyers

- retail pharmacies

- veterinarians- countries- hospitals- managed care

Charge according to elasticity of demand.



Q QQ*Q*

P*

MC

MR D MR D

P

P*

P

US Mexico



C. Behavior other than profit-maximizing

The negative publicity associated with high prices and profits may change a firm’s behavior.

Ex: Burroughs Wellcome (now GSK) brought AZT tomarket- AZT was the first promising treatment for AIDS- AIDS causes almost-certain death

- inelastic demand- $8000 for a year’s treatment

BW reduced prices after receiving considerable public pressure.



D. Monopsony pricing and price controls

Many foreign governments regulate prices of drugs or aremonopsony buyers.

E. Competition and Generic entry

Once a patent expires, many firms can sell the drug.- much lower barriers to entry

- don’t have to re-do clinical trials, etc- don’t have to advertise- don’t have to do R&D



IV. R&D and Innovation

The usual length of a patent is 20 years.

For drugs, a patent is filed years before the drug actuallymakes it to market.

- shortened patent life

The Drug Price Competition and Patent Restoration Actof 1984 allows an extension of up to 5 years from drugs.

- total effective patent life can’t exceed 14 years



Investment decisions:

There are roughly 3 periods of a drug patent’s life.

1.research, testing, and review period (m years)2.effective period of patent protection (n years)3. period following patent expiration (s years)

m+n+s= T T is the life of the project



In the first phase, the firm incurs only costs and earns norevenue.

In the second phase, the firm earns monopoly profits.

In the third phase, the firm faces competition from

generics.

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NPV 1 1 1 111

0

Riskier projects should be discounted more heavily.



R&D Spending:

US1980: $1.5billion

2007: $ 35billion

Many drugs do not have a positive NPV.



Empirics:

Mansfield (1986)found that 60 percent of pharmaceutical drugs between1981 and 1983 would not have been developed without

patent protection.

DiMasi et al (1991)estimated total costs, computed as capitalized expectedcosts and discounted at 9 percent, at $231 million in1987 dollars per new chemical entity that was marketed.



DiMasi, Hansen, and Grabowski (2003)estimated average out-of-pocket R&D costs for newchemical entities at $403 million, in year 2000 dollars.

This figure reaches $802 million when capitalized at 11 percent.

Grabowski and Vernonfound that a product has an effective patent life of about 9to 13 years and a market life of about 20 years.

Cash flows do not become positive until the third year after launch, and sales peak in the tenth or eleventh year.



Vernon (2005)estimates that a price control policy that would lower

pre-tax pharmaceutical profit margins to the average of those in non-U.S. markets would lower industry R&Dinvestment by between 23 and 33 percent.

Other studies find a consistent and substantial directrelationship between higher real drug prices andincreased innovation.



V. Cost Containment

The rapid growth in drug expenditures has led to great policy interest in cost containment.

We will focus on three strategies:

higher copaymentsuse of generic drugsadoption of drug formularies



A. Copayments

We know that the lower the out-of-pocket price, people

tend to use more.

What about higher co-pays?- reduce the use

- substitute toward more medical care- could increase total cost of care

- substitute toward generics



Motheral and Henderson (1999)

examined two plans with tiered systems that increased brand-name copayments more than copayments for generics.They found little effect on total drug utilization.

However, utilization of brand-name products decreasedabout 18 percent relative to a control group that had no

price increases.



Goldman et al. (2004)found substantial decreases in utilization within themost common drug classes from a doubling of copayments.

Reductions ranged from a low of 25 percent for antidiabetics to highs of 44 percent for antihistaminesand 45 percent for nonsteroidal anti-inflamatory drugs.



Gibson and colleagues (2005)

concluded that these arrangements generally work asintended—by encouraging generic use and limitingoveruse.

But their study also found reports that higher costsharing can also disrupt treatment through lower levelsof adherence, lower use of essential medicines, and, insome cases, drug discontinuation.



B. Generic Substitution

About 70% of all prescriptions are written for drugs withmultiple sources.

The US has a much higher utilization rate of genericdrugs than other nations.

While “therapeutically equivalent” generics don’t alwayshave the exact same effects as the name-brand drug.

- Ambien vs zolpidem



C. Drug Formularies

Managed care’s strong financial interest in costcontainment has led to policies that go well beyondcopayment strategies to promote generics.

Many plans monitor physicians and require substitutionwhen generics are available.

Many also use pharmacy benefit managers to negotiatediscounts and improve the efficiency of their claims-

processing and pharmacy operations.

- only covered for certain drugs



Discussion Questions:

In 2004, Congressman Dennis Kucinich proposed theFree Market Drug Act. This legislation would haveremoved patent protection on drugs developed with

public funds and given control over pharmaceutical

R&D to the National Institutes of Health.

Evaluate this type of proposal in terms of the effects on price, competition, and level of innovation.

health economics- lecture ch17

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