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Question: Explain why drugs are not price-sensitive.Pricing, patents and profits in the pharmaceutical industry

This case study explains how the pharmaceutical industry uses the patent system to ensure it reaps rewards from the drugs that it develops. Increasingly, however, there is alarm at the high costs of these drugs to the underdeveloped world, especially against a backcloth of the AIDS epidemic in South Africa. While the pharmaceutical industry has responded with several concessions, the case against the industry is that it is enjoys a privileged position partly due to the patent system.


There is a story about a pharmaceutical executive on a tour of the US National Mint who inquired how much it cost to produce each dollar bill. On hearing the answer, the man smiled. Making pills, it seemed, was even more profitable than printing money. Whether true or not, the three most profitable businesses in the world are reputed to be narcotics, prostitution and ethical pharmaceuticals. A recent Oxfam report showing the scale of the AIDS problem in Southern Africa has brought the pharma-companies into the spotlight. The allegation is that these companies exploit the poor in the developing world. With a median 35 per cent return on equity, pharmaceuticals is far and away the world's most profitable major industry. With profits of more than $6 billion, pharma-companies such as Pfizer and GlaxoSmithKline dwarf the likes of Unilever, BT or Coca-Cola. Yet every year in the developing world millions of people die from diseases, such as malaria and tuberculosis, which the rich developed world has eradicated. Table 5.2 shows the scale of the problem. 

In the past the pharmaceutical industry has maintained that many of the drugs that could benefit the suffering in the underdeveloped world are expensive and have taken years to research and develop. The only way the pharmaceutical industry can claw back its expenditure on research and development is by patenting their drugs thereby providing them with a 20-year monopoly in which to generate sales and profits. The social contract underlying the patents system is based on an agreement that in return for such investment - and for publishing through patents the details of the research results - a company is entitled to an exclusive right to the sale of the resulting product for a limited period of time: 20 years.


The case against the pharmaceutical industry

Most drug prices bear no relation to the very small cost of production because the industry has a contract with society, enshrined in the patent system. For a limited period (usually 10 years not allowing for clinical trials, etc.) pharmaceutical companies charge monopoly prices for patented medicines. In return, they invest huge amounts of research dollars in pursuit of the next innovation. 

At a time when the AIDS epidemic appears to have stabilized in most advanced countries, thanks largely to the use of sophisticated drugs, the disease is continuing to spread at an ever more alarming rate through developing countries (see Table 5.2).

Yet those countries now suffering the most from the disease are also those least able to afford the drugs necessary to control it. The issue, of course, challenges the whole patenting system. 

It is not just the underdeveloped countries

that are experiencing difficulties with intellectual property laws and medicine. A 30-year-old London woman contacted Bristol-Myers Squibb, a US pharmaceutical company, begging help to obtain Taxol. This drug could have controlled her breast cancer, but her National Health Service region did not prescribe it because of its exorbitant cost. There is no patent on Taxol as the US government discovered it. But Bristol-

Myers Squibb, because it performed minor work calculating dosage levels, holds the intellectual property rights on dose-related data, even though the data was originally collected by the government. Ultimately, the company was shamed into offering her free medicine if she moved to the United States. However, doctors concluded that the offer was probably too late.

In AIDS and breast cancer, the stricken

North and South share a horrific

commonality as the new landless peasantry

in the apartheid of intellectual property


(The Guardian, 27 July, 2000)

The developing countries are demanding changes. They argue that patent laws should be relaxed allowing, for example, either for their own companies to produce cheaper generic versions

of the expensive anti-AIDS drugs, or for the import of such generic copies from other countries. In February 2001 the Indian company Cipla offered to make a combination of AIDS drugs available at about one-third of the price being asked by companies in developing countries. This price is already less than those in the West. If ever there was a good example of profiteering here it is. Worst of all, it seems to be profiteering at the expense of the poor. The charge of unethical behaviour seems to be ringing loudly. But for how long will the legal systems and courts in the world tolerate thousands of deaths before one of them decides enough is enough? The pharmaceutical industry is aware of the strength of public opinion and the mounting pressure it is under and has made significant concessions, including cutting the price of many of its drugs to the developing world. Will this, however, be enough? The whole industry, it seems, is now under pressure to justify the prices it charges for its drugs. If it fails to convince governments, it may see the introduction of legislation and price controls.

The case for the pharmaceutical industry

The pharmaceutical industry can claim that it has been responsible for helping to rid many parts of the world of dreadful diseases. It is able to claim that the enormous sums of money that it spends each year on research and development is only possible because of the patent system. Any change in the system will put at risk the billions of dollars that are spent on research into heart disease, cancer and other killers. This is usually enough for most governments and others to back away from this very powerful industry. Not surprisingly, the drugs industry is appalled at the prospect of price controls. Sidney Taurel, chief executive of the US drugs company Eli-Lilly, has warned 'If we kill free markets around the world, we'll kill innovation.' 

The industry clearly has a unique structure and differs markedly from many others, but whether there is evidence for supra-normal profits is questionable. Professor Sachs, director of the Center for International Development at Harvard University, argues that if price controls were introduced, companies would simply scale back their investments in research. This is often seen by many as a 'threat' that the industry uses against governments. Once again there is limited evidence to suggest this would necessarily happen. Sachs suggests 'This is an extremely sophisticated, high cost, risky business with very long lead-in times and an extremely high regulatory hurdle', he says. 'My sense is that every rich country that has said, "You're making too much money" and has tried to control prices has lost the R&D edge.' 

The pharmaceutical industry has a powerful voice. It is a large employer, invests large sums of money in science and technology and is without doubt an industry that will grow in this century. Most governments would like to have a thriving pharmaceutical industry and hence try to help and not hinder their efforts. Moreover, there are thousands of people in the developed world whose lives are being saved and extended from new sophisticated drugs that are being developed every month. The industry has many advocates and supporters.

Price cuts

In June 2001 Britain's biggest drugs company, GlaxoSmithKline, reduced the cost to the developing world of drugs for treating malaria, diarrhoea and infectious diseases. Merck and Bristol-Myers Squibb, two of the world's largest drugs companies, had already announced earlier in the year that they were supplying AIDS drugs at cost price or less to all developing countries. Bristol-Myers Squibb also announced that it would not be enforcing its patent rights in Southern Africa. 

The field of pricing pharmaceutical products is complicated because in most countries prices are determined by what governments, the main buyers in the industry, are prepared to pay. The same pill made by the same company may cost half in Canada of what it does in the United States. In Mexico, it may cost still less. Such differential pricing is fundamental to the pharmaceutical industry. Because consumers are not paying for raw materials, but rather for intellectual property, drug companies charge what they can get away with and governments pay what they deem affordable. The United States, however, is the exception, as here prices are determined on the open market. However, it seems things are about to change, for the US upper house, the Senate, has challenged the existing market arrangements. It argues that US citizens should not be paying substantially more for patented drugs, while citizens in other countries get the same drugs at much lower prices because their government is only willing to pay a certain price. The Senate's amendment would allow drugs to be imported from any foreign factory approved by the Food and Drug Administration. As there are plenty of those in India and China, Senators are effectively demanding that US citizens get medicine at developing world prices. Clearly, social and economic pressures are mounting on the industry. In December 2003 the National Health Service (NHS) in the United Kingdom launched a £30m lawsuit, which accuses seven firms of price-fixing by controlling and manipulating the market in penicillinbased antibiotics (Meikle, 2003).


It is the unique structure of the industry and the patent system that is at the crux of the problem. Europe, the United States and Japan account for virtually all the profits of the pharmaceutical companies. In most other markets profits are driven down by the power and price sensitivity of customers. But in pharmaceuticals, neither the patient who consumes the drugs nor the doctor who prescribes them is price sensitive. Customers for medicines are not price sensitive because they do not pay for them. In Europe it is the taxpayer who foots the bill. 

Whereas most companies have profits capped by aggressive industry buyers, the pharmaceutical firms have to negotiate only with civil servants, and, argues Professor Doyle, 'when taxpayers' money is available, commercial disciplines frequently disappear' (Doyle, 2001). But, even in the United States where a free market exists, the pharmaceutical companies are able to charge even higher prices, hence the US Senate's proposed changes. Once again this is because the pharmaceutical companies are frequently selling to private health insurers. Many US employers offer health insurance as part of the employment package.

Competition is another key force that drives down prices in most industries. In electronics - an industry even more innovative than pharmaceuticals - excess profits from a new product soon disappear as competitors bring out copies. But, in the pharmaceutical business, it is the patent system that ensures high profits continue for an average of 10 years. The consequence of this ability to negotiate very high prices and the absence of competitive threat is that the giant pharmaceuticals have no incentive to compete on price. It also helps to explain why the pharmacompanies have been unwilling to sell cheap medicines to the poor in Africa and Asia. The real worry is that dropping prices to the developing world would undermine the enormous margins being received in Europe and the United States. Buyers would soon be reimporting medicines at a fraction of the official price, which may be the case soon in the United States.

The industry's justification for its high prices and patent monopolies is that it encourages innovation, but to what extent is this true? In most other industries it is intense competition and a fight to survive and win market share that drives forward innovation. Without new and better products companies such as Hewlett- Packard and Canon know they will not maintain growth and market share. As we have seen in

Chapters 1, 2 and 3, innovation is dependent on a collection of factors and the patent system alone cannot stimulate innovation. It is necessary but not sufficient.

The industry's most popular argument to defend the patent system is that it has unusually high cost structures due to the enormous sums of money it has to invest in science and technology. Increasingly, however, the industry is spending more on marketing existing products than it is on developing new ones. Professor Doyle argues that marketing costs are now typically almost double the R&D spend. GlaxoSmithKline, for example, has 10,000 scientists but 40,000 salespeople! Even this well-rehearsed argument is now beginning to sound hollow.

The pharmaceutical industry has enjoyed 50 years of substantial growth and substantial profits and many people have benefited. The patent system is intended to balance the interests of the individual and society; increasing numbers of people are questioning this balance. The pharmaceutical companies need to consider every step carefully for they surely do not want to become the unacceptable face of globalisation.

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Table 5.2 The scale of the AIDS epidemic in Southern Africa (% of adult population infected) Botswana 35.8 Lesotho 23.5 Malawi 15.9 Mozambique 13.2 Namibia 19.5 South Africa 9.9 Swaziland 25.2 Tanzania 8.9 Zambia 19.9 Zimbabwe 25.6 Source: UNAIDS (2000) Reproduced by kind permission of UNAIDS,

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Table 5.2 The scale of the AIDS epidemic in Southern Africa (% of adult population infected) Botswana 35.8 Lesotho 23.5 Malawi 15.9 Mozambique 13.2...
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