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Drugs may be able to command a price premium in such cases for several reasons: Consumers and health professionals do not always have enough information about differences in quality between drugs or about the clinical significance of those differences, For evidence of price competition among brand-name drugs, see Z. John Lu and William S. Comanor, “Strategic Pricing of New Pharmaceuticals,” Review of Economics and Statistics, vol. 80, no. 1 (February 1998), pp. 108-118. See also Congressional Budget Office, How Increased Competition from Generic Drugs Has Affected Prices and Returns in the Pharmaceutical Industry (July 1998),
B Some patients place a high value on small improvements in quality,
B Doctors may be generally unaware of drug prices or may not take them into account, or
B Consumers’ incentives to consider the prices of various prescription drug choices may be weak.
To the extent that incomplete information and weak incentives distort drug prices, they also distort firms’ decisions about drug R&D, and they may partially explain the existence of multiple competing drug products in some markets. (The availability of comparative drug information and the strength of price incentives are discussed.) Companies are also drawn to invest in particular therapeutic classes by expected growth in those markets. Various institutional and demographic factors affect that growth. For example, the number of new drugs in therapeutic categories that are associated with young people has declined—and the number of new drugs for older adults has increased—as the baby-boom generation has aged. That demographic shift has allowed economists to identify the effect of changes in market demand on spending for drug R&D: one study estimated that 1 per-cent growth in the potential market for a category of drugs leads to an increase of roughly 4 percent in the entry of new nongeneric drugs in that category. In addition, research spending by private industry on malaria drugs increased after the General Agreement on Tariffs and Trade was amended to address concerns about intellectual-property rights. And federal policies relating to immunizations, liability limitations for vaccine manufacturers, and Medicare coverage decisions have had “substantial” and “sustained” effects on the private-sector’s development of certain new vaccines, according to another study. The study concluded that for every additional dollar in expected revenue because of those policies, firms invested an average of six additional cents (in present-value terms) in R&D on related vaccines.
The drug industry’s practical opportunities for technological innovation are strongly affected by advances in basic science, but those advances too are responsive to demo-graphic and institutional factors, as reflected in public priorities for spending on basic R&D.Health insurers’ decisions about coverage can also affect the types of products that drug companies try totion of R&D dollars to potentially larger markets and to research opportunities created by advances in science but also reflects the market expansion that can occur when multiple drugs offer consumers additional therapeutic choices and lower prices through competition.
Modifications and Approved New Uses of Drugs
On average, only about one-third of new-drug applications submitted to the FDA are for new molecular entities. Most of the rest are either for reformulations or incremental modifications of existing drugs or for new “on-label” uses (additional health conditions for which an existing drug can be prescribed). None of those types of new drugs involve a new active ingredient, although firms must conduct clinical trials to gain FDA approval for new uses. Whereas almost half of NME applications are classified by the FDA as “priority,” most of the other new-drug applications are rated as “standard.” Even so, modifications to pharmaceutical products can create substantial value for consumers. For example, more-convenient dos-ing forms can increase the likelihood that patients will take all of their medication as directed and thus improve their health outcomes. In addition, approved new on-label uses can become the primary source of demand for a drug, suggesting that the new use is more valuable to patients than the original use. The annual number of non-NME drug approvals has varied greatly over the past 15 years, with no pronounced trend. However, comparing patterns in those approvals with patterns in the annual number of new-drug applications of all types suggests that applications tend to precede approvals by a year or two. The practice of incrementally changing and improving existing products is common to all industries. For the drug industry, however, several government policies have given firms extra incentives to alter their products. The main such policies have been provisions of the 1984 Hatch-Waxman Act and the drug rebate system in the Medicaid program. The Hatch-Waxman Act protects new versions of existing drugs for a limited time from competition from generic drugs. By awarding three years of market exclusivity to incrementally modified versions of original, patented drugs, the law gives companies an additional incentive to alter their existing drugs. That incentive has grown over time as generic competition has become more effective and materialized more quickly. The Hatch-Waxman Act also eliminated clinical trials for generic versions of existing brand-name drugs. Increasingly, once generic versions do enter a market, they quickly gain market share at the expense of brand-name drugs. In the first few years after the law took effect, the average market share of generic drugs one year after the patent on a brand-name drug expired was 35 percent. A decade later, that figure had almost doubled to 64 per-cent. By the late 1990s, nearly all brand-name drugs could be expected to face generic competition once their patents expired. The loss of sales to generic versions can occur particularly quickly for best-selling drugs. For example, Prozac lost more than 80 percent of its U.S. sales to lower-priced generic versions in the first month after its patent expired.