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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, how-ever, 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 pharma-ceutical 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 consider-ably 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. More-over, 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. This study presents basic facts about the pharmaceutical industry’s spending on research and development and about the types and numbers of new drugs that result from it. The study also analyzes several major issues related to pharmaceutical R&D:
B What explains the cost of developing new drugs? B Does federal investment in R&D stimulate or displace private investment? B Has the drug industry’s innovative performance declined? B How profitable are drug firms, and how do profits affect the amount and type of R&D that companies conduct?
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 reve-nue. 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 calcu-lated 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 pio-neering 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 map-ping the human genome); thus, the government may have funded some research that the private sector other-wise 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 work-force 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 (inflation-adjusted) 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 professional researchers.