PART I CHAPTER GLOBAL PHARMACEUTICAL MARKETS: BRANDNAME VS GENERIC DRUGS In Part I of the thesis, we analyze certain aspects of the behaviour of international pharmaceutical markets. The global pharmaceutical industry is undergoing rapid changes, both from the demand and supply sides. The demand side dynamics reflect the affordability and access of drugs while the supply side changes correspond to innovations of new drugs through R&D. While policymakers are concerned about rising costs of health care, pharmaceutical companies are seeking ways to discover new domestic and international markets to cover the accelerating costs of R&D. Estimating the demand for pharmaceutical products is challenging since demand is usually determined by the physician’s prescription for pharmaceutical products and patients are usually covered by some sort of insurance in developed countries. Thus, there may be a discrepancy between the realized marginal benefits and the price paid for pharmaceutical products in developed countries. In developing countries, most of the expenditure on prescription drugs is made by patients’ own funds. On the supply side, the cost of producing and marketing the first unit of the drug is very high, but the marginal cost of manufacturing additional units of the drug is small. While developed countries produce new drugs, developing countries usually produce generic versions of brandname drugs not only for domestic use but also for export to the rest of the world. For instance, the destination of exports of Indian pharmaceuticals is North America, Western Europe, Japan and Australia. In 2002-03, India exported nearly 40 percent of its total pharmaceutical output with exports valued at nearly $2.6 billion. The major market is the U.S. which accounted for 17 percent of all Indian pharmaceutical exports in 2002-03. Moreover, the generic markets in the U.S. and E.U. are likely to expand at 10-15 percent per year, as attempts are made to contain rising health care costs by switching to less expensive drugs. 1.1. BACKGROUND From a worldwide perspective, the pharmaceutical industry consists of a large number of firms producing a variety of drugs including brandname and generic drugs. It was after World War II that the modern pharmaceutical industry emerged in its present form with its characteristic features of high research intensity and high sales promotion. Large pharmaceutical multinational corporations (MNCs) co-exist with small firms in this industry. The competition in pharmaceutical markets is based on product differentiation based on R&D efforts and hence the need for patents to reward the innovator for undertaking risky ventures and spending huge resources for inventing new drugs. The reason why patents are crucial for pharmaceutical firms is that it takes hundreds of millions of dollars to discover, develop and get regulatory approval for a new medicine. In the absence of patent protection, imitators can duplicate the innovator’s chemical compound at a fraction of the latter’s cost since imitation costs are low compared to the costs of discovering and developing a new drug. Moreover, with or without patent protection, the pricing policy for the product is likely to be different at each stage of the product’s life cycle. Throughout the product cycle, continual changes occur in price elasticity and in costs of production and distribution, so that these changes call for price adjustments. 1.1.A. Patent system The pharmaceutical industry is one of the most research-intensive manufacturing industries with product quality subjected to close regulation by regulatory authorities like the USFDA (U.S. Food and Drug Administration), which regulates the introduction of new drugs and maintains high product quality standards, and approval requires difficult and lengthy pre-clinical and clinical trials. Given the uncertainty in predicting the outcomes of pharmaceutical research, there is intense debate on the issue of pharmaceutical pricing, financing of research and optimal length of patent protection. Given that knowledge (including knowledge about pharmaceutical technology) is a global public good, national self-interests are often in conflict with the worldwide harmonization of patent legislations propagated by the Agreement on Trade Related Aspects of Intellectual Property Rights (TRIPs). According to TRIPs, all member-countries of the World Trade Organization (WTO) have to provide exclusive marketing rights to an inventor through the grant of patents for 20 years from the date of filing the patent application. Patents can be either product patents or process patents. Product patents are granted for a new product while process patents are granted for a novel method of manufacturing a similar or identical product. In principle, the patent system provides incentives to innovators to engage huge resources in drug innovation and development and earn monopoly profits till the patent expires. However, the effective patent life is 12-15 years because of the time taken in clinical testing and obtaining regulatory approval. When the patent expires, generic competitors can enter the market with barriers to entry being reduced. Pharmaceutical R&D expenditures have increased sharply over the years. It has been estimated that at 1987 prices, the out-of-pocket cost for every new chemical entity (NCE) approved was $231 million (DiMasi et al., 1991). More recent estimates show that since then, costs have increased at an annual rate of 7.4 percent above general inflation. DiMasi et al. (2003) surveyed costs of drug development of 10 large pharmaceutical firms producing 68 drugs over the period 1980-99. At 2000 dollars, they reported the average estimated base case cost of every new drug development to be $403 million and the total pre-approval capitalized cost up to the marketing stage to be $802 million. Once a drug is developed and ready to be marketed, these R&D costs become sunk costs and thus become irrelevant for short-run pricing decisions. The decision to carry on with such high-risk projects thus depends on potential therapeutic benefits and future revenues which are guaranteed by patents till the patent term expires. As noted above, under patent protection, brandname drugs enjoy market exclusivity for a limited time period. The nominal patent life is the time between patent registry and expiration whereas the effective patent life is the time between product entry and expiration. Grabowski and Vernon (2000) found that for NCEs introduced between 1990 and 1995 in the U.S., the effective patent life was only 11.7 years, despite the 20 year patent term stipulated by TRIPs. The extent to which market exclusivity for brandname drugs guarantees monopoly rights depends on the competition they face from other brands within a therapeutic class. An improved competitor “me-too” drug treating the same ailment can be awarded patent rights as long as it is sufficiently different from the original drug, raising the issue of patent breadth or scope. Thus, the analysis of patent protection requires a two-dimensional approach that includes patent length and patent breadth. 1.1.B. Process of drug innovation New drug development is a lengthy sequential process fraught with risk and uncertainty. Typically, even though the development of NCEs may be spread over many years, only a small proportion of these new products finally get approval for marketing. The process of drug innovation begins with research by chemists and biologists to develop concepts for new compounds, which are then synthesized and tested for pharmacological activity. If found promising, the innovator firm files for an investigational new drug application with the regulatory authority and on approval, it goes on to the next stage of clinical trials for testing the efficacy and toxicity of the drug. DiMasi et al. (2003) describe the three phases of clinical trials. In phase I, usually tests are carried out on a small number of healthy volunteers to determine the safety, absorption, metabolism and toxicity of the compound. In phase II, the testing is done on more patients having the targeted condition or disease. In the final phase III of clinical trials, testing is done on a large scale in different locations to establish efficacy and look for side-effects. These clinical trials require testing on humans and are very time-consuming. Once the phase of clinical development is successful, the innovator firm can apply for a new drug application (NDA). In general, the USFDA takes one to four years to grant approvals after reviewing the applications, but if the firm concerned is a researchintensive firm reputed for its quality, the review period may be considerably shortened (Olson, 1997). With the USFDA clearing the drug, the innovator firm can start marketing the product. 1.2. PHYSICIAN AS AGENT A pharmaceutical product can be viewed as a bundle of characteristics that affects patient well being such as efficacy, safety and reliability. Ideally, a physician tries to prescribe the drug that perfectly matches the patient idiosyncrasies. However, there is evidence of habit formation by physicians while prescribing drugs (Hellerstein, 1998; Coscelli, 2000; Lundin, 2000 and Richard and Horn, 2004). 1.2.A. Prescription drug insurance One of the reasons attributed for habit persistence in drug prescriptions is the insurance coverage provided for drug expenditure, particularly in developed countries. In a study of the U.S., Berndt (2002) found that costs for prescription drugs increased from 5.1 percent of total health care costs in 1980 to 9.7 percent in 2000, which translates into $121.8 billion or $450 per person. At the same time, he found that pharmaceutical expenditures grew at about 11.9 percent between 1987 to1994 and 12.9 percent between 1994 and 2000. In the first sub-period, the price growth of 6.1 percent annually was responsible for more than half the sales growth but in the second sub-period, price growth was responsible for only a fifth of revenue growth, four-fifths being accounted by volume changes. Thus, in recent years, price increases have become less important for explaining rising pharmaceutical expenditures, and instead, quantity growth in terms of greater use of brandname products, has become the prime mover for increased spending. Nearly 40 percent of prescriptions in the U.S. are covered by insurance (Scott Morton, 2000). Given that a patient is only concerned about quality and is not paying out of her own pocket for prescription drugs, it is likely that she will not purchase the cheaper generics available in the market after patent expiration. Many empirical studies have found that expenditure on prescription drugs is higher for patients with higher insurance coverage (Leibowitz et al. 1985; RAND Health Insurance Experiment, 1993; Lundin, 2000; Pavcnic, 2002; Cleanthouse, 2003 and Buchmueller et al., 2004). In fact, while insurance leads to greater spending, growth in insurance coverage is itself stimulated by the availability of better and newer drugs (Danzon and Pauly, 2001 and 2002). 1.2.B. Detailing Sales promotion for pharmaceuticals takes several forms, the most important of which is detailing. This is a costly process that requires visits by medical representatives to physicians, pharmacists and other professional distributors to promote new drugs and answer queries. The large force of detailers is a fixed cost for brandname firms and acts as an incentive for continuous innovations. While detailing no doubt helps in information dissemination, it also encourages brand consciousness among physicians since detailing is not aimed at the consumer but is primarily aimed at increasing the likelihood that physicians prescribe brandname pharmaceutical products. Moreover, despite large expenditures on marketing and promotion, about 20 to 30 percent of sales, promotional information seldom reports actual prices (Brekke and Kuhn, 2003). The fact that physicians not know the price of the drugs they prescribe suggests that they cannot be fully price sensitive and at best can only estimate the magnitude of cost saving from generics. Medical journal advertising is also an important promotional activity aimed at maintaining the general goodwill of the brandname firm. Expenditures on detailing are four to five times higher than for journal advertising in the U.S pharmaceutical industry (Berndt et al., 1999). 1.2.C. Consumption Externalities Besides physician prescription and advertising, consumption externalities also play a role in affecting demand for pharmaceuticals (Berndt et al., 2003a). Consumption externalities arise when demand for pharmaceuticals by patients and physicians depends on the number of other patients that have taken the drug and demand is influenced by their opinion regarding its efficacy, safety and acceptability. Thus, herd behaviour can also create captive markets for a particular drug despite the availability of close substitutes. 1.2.D. Demographic Changes Finally, demographic changes in the industrialized countries with the ageing of baby-boomers have increased the demand for health care services. Since the bulk of the demand for drugs comes from senior citizens, as the baby-boomer population reaches the 60+ age group in 2005, demand for drugs is expected to rise. 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Pesta (2001). ‘Drug Industry, AIDS Community is Jolted by Cipla AIDS-Drug Offer’, The Wall Street Journal, February 8, 2001. 180 [...]... patent expiration 1.4.C Brand price response The price response of brandname drugs to generic entry has been a source of controversy However, most studies show that prices of brandname drugs rise after generic entry (Grabowski and Vernon, 1990; Caves et al., 1991; Frank and Salkever, 1992 and 1997; Suh et al., 2000; Ellison and Ellison, 2000; Danzon and Chao, 2000) Grabowski and Vernon (1990) studied... patent expiration, profit opportunities in a particular market, whether a drug treats chronic conditions as opposed to acute illness and the extent to which the drug is purchased by hospitals 15 Scott Morton (1999) found that the estimated costs of filing an ANDA range from $250,000 to $20 million depending on different drugs and drug-firm combinations and that generics enter brandname markets with annual... Romania Russian Federation Rwanda Saint Kitts and Nevis Saint Lucia Saint Vincent and the Grenadines Samoa San Marino Sao Tome and Principe Saudi Arabia Senegal Seychelles Sierra Leone Singapore Slovakia Slovenia Solomon Islands Somalia South Africa Spain Sri Lanka Sudan Surinam Swaziland Sweden Switzerland Syrian Arab Republic Tajikistan Thailand Yugoslav Togo Tonga Trinidad and Tobago Tunisia Turkey... for the group of pharmaceuticals where entry is predicted to be likely, and continue to rise for pharmaceuticals where the probability of entry is low or medium high 17 Danzon and Chao (2000) found that competition from generics had little effect on the price of brandname drugs, but this may not reflect the true extent of competition because rebates are given to managed care customers to get included... when there is likely to be fierce competition in the generic market Empirical studies on the impact of generic entry on brandname drugs show that quantity demanded of brands is adversely affected with the availability of cheaper therapeutic equivalents According to Caves et al (1991), the demand 14 for brandname drugs falls by 20 percent in the year of patent expiration and continues to decline at the... provisions of the Agreement on Trade Related Aspects of Intellectual Property Rights (TRIPs) under the World Trade Organization (WTO) regime While knowledge is a public good, patent legislations for rewarding innovations are national In order to do away with the national incentive to freeride on R&D conducted elsewhere in the world, TRIPs was signed in 1994 under the aegis of the WTO Before 1995, many developing. .. developing economies had different patent regimes, often involving weaker forms of patent legislation and shorter periods of protection, than in the developed countries However, TRIPs regulations call for a harmonization of patent laws such that developing countries 34 are required to enforce the same patent laws as prevalent in developed countries which include both product and process5 patents together with. .. depends in a complex way on the length of patent protection, the breadth or scope of patents that determine how different a new version of a drug has to be in order to be patented as a different drug, and on the nature of competition among different versions of a drug As has 7 8 See Graboswki and Vernon (2000) See Frank and Salkever (1997) and Scott Morton (1999) 36 ... in demand of brandname drugs and if the demand curve for cross-price sensitive consumers is more elastic than the demand curve for loyal consumers (Frank & Salkever, 1992) 1.5 REGIONAL DISPARITY IN HEALTH EXPENDITURES Given the disparities in health spending across different regions of the world, in general, and low purchasing power of consumers in developing countries, in particular, there continues... Aronsson et al (2001) analyzed the impact of generic competition on the market shares of 12 brandname drugs from 1972 to 1996 In five out of twelve cases, entry by cheaper generics adversely affected the market share of the brandname drug Berndt et al (2003b) found consumers benefited from generic entry and the introduction of over-thecounter (OTC) versions of prescription drugs on patent expiration . and Salkever, 1992 and 1997; Suh et al., 2000; Ellison and Ellison, 2000; Danzon and Chao, 2000). Grabowski and Vernon (1990) studied the effect of generic entry on 18 drugs between 1984 and. every new drug development to be $403 million and the total pre-approval capitalized cost up to the marketing stage to be $802 million. Once a drug is developed and ready to be marketed, these R&D. 9 1.2.C. Consumption Externalities Besides physician prescription and advertising, consumption externalities also play a role in affecting demand for pharmaceuticals (Berndt et al., 2003a). Consumption