Market Power

Musings by an academic economist on the power of markets and the power over markets.

Friday, October 29, 2004

Pharmaceutical R&D

Monday used to be Share Day in my 4-year old's room at day care. Each child could bring a toy to share with his/her friends. Inevitably, some toys would get misplaced or broken. One parent complained about this and, consequently, Share Day is no more.

This is similar to the situation with the pain medicine Vioxx. Researchers were examining the effectiveness of Vioxx in preventing the recurrence of colorectal polyps. Compared to patients taking a placebo, patients taking Vioxx had a higher incidence of heart attack, stroke, and other cardiovascular nasties. You can find more information on this here. As a result, Merck pulled Vioxx worldwide.

This paper by Henry Grabowski at Duke provides some interesting numbers on pharmaceutical R&D. Here are a few that jumped out when I read the paper. Pharmaceutical patents in the US last for 20 years these days, but pharmaceutical companies apply for the patents well before the drug hits the market. In the US, patents can be restored for a few years. As a result, drugs that make it to the marketplace have an average of 12 years of patent life left. Grabowski refers to this as the "effective patent life." It is during this time that the company can use its market power to recoup its R&D investment and opportunity cost of this cash. Here is a quantification of this investment:

"We"Joe DiMasi, Ron Hansen, and Henry Grabowski - link here" found that the representative product" in the late 1990's " incurred out of pocket costs of over $400 million."

This does not include the opportunity cost of investing that money. Assuming a real interest rate of 11%, they estimate that the total cost of bringing a drug to market is over $800 million.

But the vast majority of compounds never make it to market:

"Typically, fewer than 1% of the compounds examined in the pre-clinical trials make it into human testing. Only 20% of the compounds entering clinical trials survive the development process and gain FDA approval."

Substitutes are another matter. Once the patent expires, competitors can develop substitutes - generics. Grabowski estimates that it only takes "a few years and costs one to two million dollars" to bring a generic to market. He also mentions that the probability of success in this case is high.

So, 0.2% of all the newly-developed compounds make it to market. The out of pocket and opportunity costs of these compounds is around $800 million, on average. The company then has 12 years of effective patent life (plus a little more time while the substitutes are being developed and approved) left in which to recoup these costs and to recoup a portion of the costs of developing the ultimately failed compounds.


This does not account for the risk that a new drug on the market will be found to have some nasty side effect that will cause the company to (voluntarily or involuntarily) pull the product from the market. Accounting for this risk would lower the time during which a company could recoup its costs before generics begin chipping away at its market power.

This also does not account for other patented drugs that compete with the drug in question. For example, Vioxx was a competitor to Celebrex. This limits the ability of a pharmaceutical company to recoup its costs.

I understand why Merck pulled Vioxx off the shelf. Call me an idealist, but it's too bad that patients no longer have a choice of whether to use Vioxx. I imagine that some would have been willing to continue using Vioxx and willingly take the risks.

Like Share Day, this won’t be able to happen.

Kudos to the folks at Marginal Revolution for the link to the Grabowski paper.