The new england journal of medicine
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`health policy report
`
`The Pharmaceutical Industry — Prices and Progress
`F.M. Scherer, Ph.D.
`
`For more than four decades, beginning with an in-
`vestigation chaired by Senator Estes Kefauver in
`the 1950s, debate has raged over the economics of
`the pharmaceutical manufacturing industry. Crit-
`ics point to monopolistic pricing and high profits;
`defenders emphasize the advances in medical ther-
`apy achieved by the industry. In this article, I will at-
`tempt to clarify components of the debate, although
`this discussion cannot resolve the uncertainties and
`value judgments required to achieve closure.
`The bounds of the industry are indistinct. From
`statistics compiled by the industry’s principal trade
`association, “Big Pharma” companies reported U.S.
`prescription-drug sales in 2002 of $145 billion.1
`Included in this figure are drug sales of companies
`that have successfully marketed new biopharma-
`ceutical products. A higher estimate, $192 billion,
`comes from Intercontinental Marketing Services, a
`leading independent collector of industry data. The
`latter figure includes the sales of smaller compa-
`nies, generic drug specialists, and some over-the-
`counter drugs.2 In 2000, prescription-drug outlays
`made up 9 to 10 percent of total U.S. health care ex-
`penditures.3,4
`
`research and development,
`new products, and patenting
`
`The pharmaceutical industry is the most research-
`intensive of U.S. industries that support their re-
`search and development with private funds (as dis-
`tinguished from defense and space contractors). In
`2002, Big Pharma companies devoted 18 percent
`of their sales revenue to research, development, and
`testing activities.5 The much lower percentages of-
`ten reported in the press are misleading because
`they use companywide data, including the sales of
`less research-intensive activities such as pharmacy
`benefit-management services and the production
`of high-purity chemicals, cosmetics, prosthetics,
`over-the-counter drugs, vitamins, and so forth.
`Excluded from the 18 percent figure was roughly
`
`$10 billion of activity by start-up companies in bio-
`technology doing little else but research and devel-
`opment that had not yet yielded salable products.
`From the industry’s research-and-development
`efforts has come a stream of new therapeutic prod-
`ucts, most offering modest variations on existing
`therapies but some providing groundbreaking new
`approaches to the treatment of disease. From 1963
`to 1999, the number of new chemical entities (or
`molecules) approved for marketing in the United
`States averaged 18.7 per year, with an upturn to 27
`(plus 4 new biologic entities) per year during the
`1990s and a downturn in number more recently.6,7
`Using advanced statistical techniques with avail-
`able (but necessarily limited) data, Frank Lichten-
`berg found that the use of new drug therapies con-
`tributed appreciably to the extension of life spans
`and the reduction of hospital stays.8 Lichtenberg
`estimates that during the last two decades of the
`20th century, drug innovations that were rated “pri-
`ority” by the Food and Drug Administration (FDA)
`increased life expectancy in the United States by an
`average of 4.7 months.
`Pharmaceutical companies customarily apply
`for patent protection on new chemical entities short-
`ly before clinical tests in humans commence. The
`basic statutory patent life is 20 years, and by the
`time commercial marketing is allowed, approxi-
`mately 12 to 13 years of basic product patent life
`remain, under regulatory conditions of the late
`1990s.9 Drug patents provide particularly strong
`protection against competition from other com-
`panies because even a slightly different molecular
`variant must undergo the full panoply of clinical
`tests required by the FDA. Numerous cross-indus-
`try surveys have shown that managers of pharma-
`ceutical research and development assign unusual-
`ly great importance to patent protection as a means
`of recouping their investment in research, develop-
`ment, and testing.10 Striving to prolong the period
`of patent protection, pharmaceutical companies
`have obtained patents on minor variants in product
`
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`Exhibit 1087
`IPR2017-00807
`ARGENTUM
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`The New England Journal of Medicine
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`The new england journal of medicine
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`formulation and production processes, and some
`have entered into agreements delaying entry of ge-
`neric manufacturers challenging their patents. Sev-
`eral of these competition-impeding agreements
`were abandoned in recent years after antitrust com-
`plaints.11
`Only about 21 to 23 percent of the new chemical
`entities that are subjected to human testing emerge
`at the end of the process with marketing approval;
`the rest fail at various stages. A recent survey esti-
`mated that the cost of research, development, and
`evaluation of new chemical entities approved by the
`FDA, mostly during the 1990s, was $802 million on
`average, with the costs of preclinical research and
`failed tests allocated to the “winners.”12 However,
`this estimate must be regarded with caution. Only
`about half the estimated price tag entailed actual
`out-of-pocket costs; the remainder was an estimat-
`ed 11 percent annual cost of financial capital in-
`vested in research and testing. Also, the voluntary
`sample from which the estimates were drawn num-
`bered only 10 companies, including mainly Big
`Pharma members that placed a disproportionate
`emphasis on drugs for chronic diseases, which re-
`quire extensive testing to identify long-term effects.
`Higher costs for testing may also have been in-
`curred to differentiate a drug’s efficacy from that of
`rival products. There is reason to believe that drugs
`used to treat acute symptoms and those directed
`toward small “orphan” markets are developed at a
`much lower average cost. On the other hand, some
`costs are ignored — notably, those incurred for ac-
`ademic research that often identifies molecules
`likely to have therapeutic effects.
`
`monopoly pricing power
`
`Once a patented drug enters the market, its pro-
`ducer has some degree of monopoly power — that
`is, the ability to hold the product’s price apprecia-
`bly above the current production cost without in-
`curring dramatic losses in sales. This is a broader
`definition of monopoly power than the classic no-
`tion of a market in which there is only one seller.
`Few drugs lack any substitutes at all. What matters
`most is that the drugs are differentiated substan-
`tially from their substitutes; the seller can then
`make a trade-off between price and volume. Differ-
`entiation occurs because various chemical mole-
`cules targeted toward a particular disease have di-
`verse therapeutic effects and contraindications.
`Differentiation can be physical, perceptual, or (most
`
`frequently) both. There is powerful evidence that
`the first successful product in some category —
`whether it is a drug, a breakfast cereal, or a deter-
`gent — implants an image of superiority in the
`minds of consumers and, for a drug, of the physi-
`cians who make decisions about prescriptions.13,14
`These images are built initially by innovations in
`technology or marketing and are reinforced by ad-
`vertising and sales promotion.
`The classic methods of sales promotion in phar-
`maceuticals were presentations made by “detail”
`people meeting face to face with physicians, plus
`advertising in professional journals. Since a per-
`missive FDA ruling in 1997, direct-to-consumer ad-
`vertising has grown rapidly. In 2001, U.S. pharma-
`ceutical companies were reported to have spent
`$2.7 billion, or roughly 2 percent of domestic sales,
`on direct-to-consumer advertising, along with
`$5 billion on “detailing” efforts and $11 billion for
`the distribution (often by detailers) of free sam-
`ples.1,2 The free-sample figure is based on the prod-
`ucts’ retail value. The out-of-pocket production cost
`of samples could not have been much more than
`$2 billion to $3 billion.
`In the most thorough study of the pricing of new
`drugs, which focused on drugs introduced from
`1978 to 1987, Lu and Comanor found that mole-
`cules contributing important therapeutic gains, as
`evaluated by FDA staff, were priced at about 3.2
`times the level of substitute products that were
`deemed to be inferior; those offering modest gains
`were priced, on average, at 2.17 times the level of
`substitutes; and products providing little or no gain
`were at rough parity with existing substitutes.15 In-
`troductory prices tended to be 8 to 10 percent lower,
`on average, for each additional competing substi-
`tute drug available at the time of the introduction
`of the product. Pricing strategies have changed
`perceptibly since the period studied by Lu and Co-
`manor, but I am not aware of any similar follow-
`up study.
`Insurance coverage for drugs reduces the sensi-
`tivity of consumers’ demand to price differences
`and enhances the ability of pharmaceutical compa-
`nies to set their prices well above the cost of pro-
`duction and distribution, all else being equal. In-
`surance coverage of drug purchases in the United
`States increased dramatically during recent dec-
`ades. In 1980, roughly 30 percent of prescription-
`drug purchases were paid for directly or indirectly
`by insurance plans; the remainder came from con-
`sumers’ pockets. By 2000, the insured fraction had
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`increased to 68 percent.16 Further increases are
`likely as the changes in the 2003 Medicare law take
`effect.
`
`linking price, profit, and research
`
`It is sometimes asserted that drug prices are high
`because research-and-development costs are high
`and must be defrayed. Assuming that companies
`maximize their profits or the contribution of profits
`to the repayment of past research-and-development
`costs, this is a fallacy. Sunk research-and-develop-
`ment costs are bygones and are therefore irrele-
`vant in current pricing decisions. For rational prof-
`it maximizers, what matters is the position of the
`demand curve (including adjustments for expected
`competitive reactions) and the variable costs of pro-
`duction and distribution. To be sure, errors may be
`made under conditions of uncertainty, and prices
`may be held below the profit-maximizing level if
`adverse public reaction is feared.
`It would be equally wrong, however, to infer
`that drug prices are unrelated to the cost of research
`and development. The short-term monopoly prof-
`its that can be realized from patented and success-
`fully differentiated drug sales are the lure, which
`prompts investments in research, development, and
`testing. Indeed, the linkage is surprisingly close: as
`drug prices rise or the difference between drug sales
`revenues and production costs increases, research-
`and-development outlays also tend to rise relative
`to their trend; as drug prices fall, so in tandem do
`research-and-development outlays.17,18 But the
`chain of causation runs from the expectation of
`high profits to increased research-and-development
`outlays. Similar logic holds for promotional out-
`lays, which tend to be concentrated in the early
`phases of a drug product’s marketing cycle.
`Year after year, the pharmaceutical industry has
`ranked at or near the top of Fortune magazine’s an-
`nual list of the most profitable American indus-
`tries, which are rated in terms of accounting returns
`as a percentage of either stockholders’ equity or to-
`tal assets. But here, too, there is an element of falla-
`cy. Under standard accounting practice, outlays for
`research and development are written off in the year
`they occur. But, in fact, such expenditures are an
`investment, yielding fruit many years after they are
`incurred. They ought, in principle, to be included
`in the company’s assets and then depreciated over
`an appropriate time period. When they are not, the
`capital base to which profits are related in standard
`
`measures tends to be undervalued, and percentage
`returns on that capital base are overstated. A gov-
`ernment study found that, when appropriate cor-
`rections were made, the true returns on investment
`by the pharmaceutical industry during the 1980s
`were only 2 to 3 percent higher, on average, than
`“normal” competitive rates of return, which were
`estimated to average roughly 10 percent (exclud-
`ing the effects of inflation).19,20 This differential of
`2 to 3 percent might have been attributable, at least
`in part, to technological risks not readily avoided
`through the portfolio strategies available to finan-
`cial market investors.21 Whether the differential
`has remained within that range in recent years has
`not been tested by broadly accepted analyses.
`
`methods of restraining
`pricing power
`
`Health care payers are understandably concerned
`about the potential for monopoly pricing and the
`high prices of pharmaceuticals. In virtually all in-
`dustrialized nations, government agencies imple-
`ment explicit price controls.22 These take several
`forms, including capping the prices of new drugs
`at the level of prior substitute therapies and some-
`times of the lowest-price substitute; allowing prices
`that are no higher than those levied for the same
`product in other named “reference” nations; item-
`by-item price setting that takes into account, among
`other things, the degree of innovation of the drug
`and whether it is locally produced; imposing on in-
`dividual physicians annual budgets for drug expen-
`ditures, which if exceeded lead to fee reductions;
`and (only in the United Kingdom) rate-of-return
`profit regulation akin to the system used for regu-
`lated public utilities in the United States.
`The United States and Switzerland are consid-
`ered to be the least aggressive among industrial-
`ized nations in imposing governmental price con-
`trols. Excluded from “controls” in this context are
`the competitive bidding procedures used by large
`governmental purchasers such as the Department
`of Defense and the Veterans Administration. The
`principal exception to a no-government-controls
`policy thus far in the United States has been for
`drugs reimbursed under Medicaid, which in 1999
`covered $16.6 billion in prescription-drug purchas-
`es.23 Perhaps most important is the rule of “maxi-
`mum allowable cost,” under which providers are
`reimbursed no more than the price of the lowest-
`price approved version of a drug, which, after pat-
`
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`ents have expired, is usually a low-price generic
`product. Also, pharmaceutical companies are re-
`quired to extend on brand-name drugs reimbursed
`by Medicaid a rebate that is at least as great as the
`largest discount offered to purchasers in the private
`sector for the same drug, and in no case less than
`15.1 percent of the announced wholesale price. At
`the state level, Medicaid reimbursement is some-
`times denied case by case for the most expensive
`drugs that still have patent exclusivity.
`Under Medicare, the regulatory scheme is more
`complex and rapidly changing. The 2003 Medicare
`act extended the federal insurance program so that
`in 2006 Medicare will begin covering most outpa-
`tient purchases of drugs by seniors, but the act pre-
`cluded governmental “negotiation” with produc-
`ers to secure lower prices. Medicare Part B already
`covers several hundred drugs, notably those ad-
`ministered in physicians’ offices and in clinics for
`hemodialysis and cancer chemotherapy. From 1992
`to 1997, such drug purchases were mainly reim-
`bursed at “average wholesale price” (AWP), which
`is, in effect, the wholesale list price announced by
`manufacturers and published in the so-called Red
`Book. Beginning in 1997, reimbursement rates were
`pegged at 95 percent of the AWP for single-source
`drugs (usually, those that still have patent protec-
`tion) and, for multisource drugs, 95 percent of the
`lower of either the median AWP of all generic forms
`or the lowest AWP of brand-name products.24 Since
`the prices at which private organizations actually
`purchased drugs tended to be well below the AWP
`(for reasons to be discussed shortly), the govern-
`ment frequently paid more than the best available
`price. In such cases, care providers were reimbursed
`more than they paid their drug suppliers, which in
`effect cross-subsidized other services and distorted
`choices toward the drugs with the largest gap be-
`tween the AWP and the actual purchase cost. This
`tangle of regulatory problems was the subject of
`complex remedial changes in the 2003 Medicare
`act, which, among other things, reduced the rates
`of effective reimbursement and increased direct
`payments to providers for administering the drugs.
`Powerful checks against the pricing power of
`pharmaceutical companies for drugs with feasible
`substitutes have emerged during the past three dec-
`ades with changes in hospital purchasing practices
`and the growth of institutions such as health main-
`tenance organizations (HMOs) and pharmacy-ben-
`efit managers (PBMs). The most important devel-
`opment has been the increasing substitution of
`
`generic drugs for so-called “branded” drugs. Hos-
`pitals and HMOs establish substitution rules spec-
`ifying the drugs of which generic versions are fa-
`vored or required, and for outpatient purchases, the
`choice of low-cost alternatives is encouraged by
`graduated patient copayments — lowest for gener-
`ic drugs, higher for favored branded drugs, and still
`higher for the most costly branded drugs. Phar-
`macies have incentives to substitute generic drugs
`when permitted because the dollar margins on ge-
`nerics (often negotiated with PBMs) tend to be high-
`er, on average, than those for the original branded
`products. Such substitutions were encouraged by
`changes in previously restrictive state pharmacy
`laws.25 After passage of the Hatch–Waxman Act of
`1984, which substantially eased requirements for
`pre-entry clinical testing for producers of generic
`drugs, the use of generic drugs in the United States
`rose from an estimated 18 percent of prescriptions
`(by number) in 1980 to 47 percent in 2000.26
`HMOs, hospitals, and PBMs also use formular-
`ies to encourage pharmaceutical companies to of-
`fer substantial price discounts on drugs still under
`patent protection, asserting in negotiations, in es-
`sence, “If the discount you grant us is insufficient,
`you’re excluded from our formulary altogether. Or
`if we don’t exclude you, we will assign you an ad-
`verse position relative to alternative branded drugs
`in our prescriber guidelines.” A government study
`revealed that in 1991, the “best price” offered by
`a manufacturer to a private-sector customer implied
`a discount of 50 percent or more off the wholesale
`list price for 32 percent of all patented drugs.27 Par-
`adoxically, such discounting has been inhibited by
`the “most favored customer” rule under Medicaid.
`If a drug company offers an unusually large price
`concession to a hard-bargaining HMO or PBM, it
`must also extend that discount on its possibly large
`volume of Medicaid sales. As a result, the substan-
`tial discounts achieved before the rule’s enforce-
`ment began in 1991 subsequently dwindled to
`values in the neighborhood of the 15.1 percent
`discount mandated by Medicaid.27,28
`
`international price differentials
`
`It is common knowledge that for many of the larg-
`est-selling, still-patented drugs, prices charged by
`Canadian pharmacies are often much lower than
`those charged by their counterparts in the United
`States.29 The reason is that in Canada, pervasive
`price controls limit a manufacturer’s prices to the
`
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`median of prices charged in seven reference na-
`tions. What is little known is that the Canadian
`price-control scheme was accepted by multinational
`pharmaceutical companies in 1987 as preferable
`to Canada’s previous policy of licensing out at a
`4 percent royalty rate the right to produce generic
`substitutes for drugs still covered by patents. Low,
`regulated prices in Canada encourage drug-pur-
`chasing trips to Canada by many U.S. citizens, as
`well as the emergence of electronic middlemen
`brokering mail shipments to U.S. patients from
`Canada and, most recently, decisions by purchas-
`ing organizations in some states to buy their drugs
`from Canada. The latter two developments have
`been opposed by the FDA, which has argued that
`“unapproved” drugs might be imported, and by
`U.S. drug manufacturers, which have attempted to
`ration the supply of drugs to re-exporting whole-
`salers and retailers at volumes just sufficient to sat-
`isfy Canadian demand.30,31 If the latter effort suc-
`ceeds and re-exporting continues to grow, Canadian
`consumers will face shortages, with further reper-
`cussions and controversy.
`The difference in pricing policies between Can-
`ada and the United States is only the tip of a very
`large iceberg. For the 60 percent of the world’s pop-
`ulation living in nations with annual per capita in-
`comes of less than $1,000, prices at U.S. or even
`Canadian levels would preclude most treatments
`for such containable diseases as AIDS and tubercu-
`losis and for much else. World health authorities
`have encouraged multinational drug companies to
`sell their products in those nations at sharply dis-
`counted prices — often at less than a fifth of First
`World prices.32 This form of price discrimination
`can be shown by economic analysis to be a desir-
`able solution to the problem of providing drugs to
`the poor while permitting some recoupment of re-
`search-and-development costs.33,34 However, this
`pricing approach poses two problems. First, as
`with Canada, the lower prices create incentives for
`the re-export of drugs to higher-price jurisdictions,
`possibly undermining the discriminatory system.
`Second, citizens in high-price nations may believe
`that they are being treated unfairly, or even that the
`prices they pay are elevated in order to subsidize
`low-price sales in the Third World. The subsidy in-
`ference is wrong as long as Third World sales are
`made at prices that cover incremental production
`and distribution costs. But the perception exists
`and is a source of discontent and possible political
`
`action. The solution must come from an education-
`al effort to dispel the subsidy myths and from ap-
`peals to compassion on the part of citizens of rich
`nations.
`
`conclusions
`
`To sum up, the complex economics of pharma-
`ceutical research and development and pricing
`pose many policy dilemmas. There is a natural ten-
`dency for voters and their legislators to demand
`policies that repress prescription-drug prices. How-
`ever, the more pervasive and tougher price con-
`trols are, the less stimulus there will be to develop
`new, more effective medicines. One might propose
`that rich nations enter a mutual accord to forgo
`price controls so that research and development
`will be stimulated and their financing more wide-
`ly and fairly shared. But that is unlikely on politi-
`cal grounds.35
`Within the United States, political pressure to
`contain rising drug costs seems inevitable. Strength-
`ening the efforts of HMOs and PBMs to counter-
`vail the pricing power of pharmaceutical makers,
`as encouraged in the 2003 Medicare bill, could help
`stem the tide. One prerequisite for success under
`the HMO or PBM approach is to eliminate rules re-
`quiring that the most favorable price negotiated
`by a private entity also be applicable to purchases
`directly reimbursed by federal and state agencies,
`notably under Medicaid. The ability of HMOs and
`PBMs to use their formulary choices as a bargain-
`ing tool could be enhanced with better information
`on the relative therapeutic efficacy of still-patented
`drugs. To this end, the FDA might insist that when-
`ever possible, the best-accepted approved drug
`be used instead of inert placebos in double-blind
`phase 3 clinical trials. This would require a change
`in approval standards, letting new drugs pass mus-
`ter even if they are not demonstrably better than ex-
`isting therapies, as long as they are not significant-
`ly inferior.
`If private cost-containment initiatives should
`fail, pressure for formal governmental price con-
`trols will increase. In that case, too, better and worse
`policy alternatives exist. Targeting the most profit-
`able “blockbuster” drugs, as proposed in 1993 as
`part of the ill-fated Clinton health care reforms,
`could have an especially debilitating effect on re-
`search-and-development incentives. Less impair-
`ment of such incentives would be expected with a
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`system such as that used in Great Britain, under
`which drug companies are allowed a generous profit
`rate of return on their assets, including capitalized
`research-and-development investments. Even that
`system, however, biases the results against smaller
`but innovative drug companies, which in the Unit-
`ed States have made important contributions.36
`Achieving the best trade-off between technological
`progress and the affordability of drugs remains a
`challenging goal.
`Dr. Scherer reports having served as an expert witness on behalf
`of Apotex, Canada, in an action brought by Eli Lilly and on behalf of
`plaintiffs in a class-action suit against Abbott Laboratories.
`I am indebted to Judith Wagner for constructive comments above
`and beyond the call of duty.
`
`From the Kennedy School of Government, Harvard University,
`Cambridge, Mass.
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`com/vgn/images/portal/cit_40000873/43609907Business%20Watch.
`pdf.)
`3. Statistical abstract of the United States. 2002. Washington, D.C.:
`Bureau of the Census, 2002:Section 3.
`4. Medicare and Medicaid statistical supplement. Table 4. (Ac-
`cessed August 5, 2004, at http://cms.hhs.gov/review/supp.)
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`al Bureau of Economic Research, 2000.
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`tion: new estimates of drug development costs. J Health Econ 2003;
`22:151-85.
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`tion in two prescription drug markets. Washington, D.C.: Federal
`Trade Commission, 1977.
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`14. Scherer FM, Ross D. Industrial market structure and economic
`performance. Boston: Houghton Mifflin, 1990:582-92.
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`Rev Econ Stat 1998;80:108-18.
`16. Center for Medicare and Medicaid Services. National health
`expenditure projections. Table 11. (Accessed August 5, 2004, at http://
`www.cms.hhs.gov/statistics/nhe/projections-2002/t11.asp.)
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