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ECON 456/643: Health Economics
Emmanuelle Piérard2
University of Waterloo, Department of Economics
Week 10 - Pharmaceuticals
2These notes are heavily based on Hurley’s Health Economics and on course notes
from Logan McLeod and Robert Nuscheler
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Introduction: Pharmaceuticals
Pharmaceuticals constitute an increasingly important component
of health care.
Therapeutically, prescription drugs are becoming an
ever-more-important input to health production
Drugs are used to treat a growing array of conditions for which:
No treatment was previously available (e.g., Alzheimer’s disease,
AIDS)
Previously required major surgery (e.g., ulcers)
Drugs are also now used prophylactically for an array of
preventable health conditions (e.g., statins drugs to lower
cholesterol)
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The Pharmaceutical Sector - Canada
An increasing share of the
health care system
1975: 8.8%
2010: 16.8%
2020: 13.4%
On a per-capita basis,
annual spending on
prescription drugs in Canada
also rose
Just under $100 in
1981
$1163 in 2020
Private spending rising
slightly faster than
public
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Pharmaceutical Development
Developing new drugs is a research-intensive endeavour
Undertaken predominately by large, multinational, for-profit companies
Undertaking nearly 10% of all industrial R&D spending in Canada
(Statistics Canada 2008)
Public policy must recognize:
The special nature of research as an economic activity and
acknowledge it as an economic commodity
The strategic challenges in regulating an industry that moves
investments across borders with ease
The increasing calls for policy coordination among countries, most
notably the pressure for international harmonization of patent policies
through international trade agreements
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Pharmaceuticals
A few definitions
Brand-Name Drug: New drug that has been produced and
patented by a drug company
Generic Drug: Certified as bio-equivalent to the brand-name:
the active ingredients are identical but the non-active ingredients
aren’t necessarily. They are certified to produce the same clinical
effects as the brand-name drug.
Prescription Drug: Drugs for which you need a prescription
written by a certified health care provider, usually a doctor.
Over-the-counter Drug: Drugs that can be obtained without a
prescription. Some drugs that used to be prescription drugs
become over-the-counter after evidence has been accumulated
that they are safe to be used by consumers without prescriptions
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Pharmaceutical Industry
Historically, one of the most profitable industry
From 1955 to 2002, it was the most profitable industry ranked by
return on sales, return on assets and return on equity (Fortune, 2009)
The industry includes two distinct types of drug manufacturers:
1 Brand-Name Drug Manufacturers: Pharmaceutical companies
that undertake research to develop new drugs (e.g., Bayer,
Glaxo-Smith-Kline, and Merck-Frosst).
Small number of large multinationals to take advantage of the
economies of scale in drug development.
Some small biotech start-ups that focus on a single drug or narrow
set of products
2 Generic Drug Manufacturers: Pharmaceutical companies that
produce and sell drug products that have already been
developed, either under license from a brand-name manufacturer
or after the brand-name manufacturer’s patent has expired.
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Government Regulation
Government regulation of the pharmaceutical industry takes four
important forms:
1 Regulation of intellectual property through patent policy
2 Regulation of drug safety
3 Regulation of drug prices
4 Regulation of drug advertising and promotion
1. and 2. are relatively standardized internationally
3. and 4. are more country-specific and can best be appreciated
through an examination of the nature of competition in the drug
sector
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Pharmaceutical R & D is a Public Good
R & D is a central activity of the brand-name drug manufacturers
The goal being to produce new knowledge
Costs are not trivial: there are massive fixed/sunk costs involved
Is risky (many chemical compounds never make it to market)
To finance research, a firm must charge a premium price per unit and
sell enough units to recoup the R & D and advertising costs
Problem: Information is costly to produce but cheap to disseminate
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Heath Care Knowledge as a Public Good
Economists view heath care knowledge as a public good
Public Good: A good that can be simultaneously consumed by many
individuals and from which it is very costly to exclude others from
consuming.
In economic terms, a public good is a good that is non-rivalrous
and non-excludable.
Non-rivalry: The consumption of the good by one person does not
reduce availability of the good for consumption by others
Non-excludability: No one can be effectively excluded from using
the good
Examples:
Parks, military, police, lighthouse, fireworks
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Pharmaceutical R & D is a Public Good
Theoretically, competition makes recouping R & D costs impossible
Market allocation fails for such public goods: markets produce too little
of a public good.
The policy response to this market failure takes two basic forms:
1 Direct public investment in research
2 Patent protection
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Direct Public Investment in Research
Partially fills the void left by a lack of private investment
Focuses particularly on basic scientific research
The government of Canada funds basic scientific research through
Research granting councils
National Science and Engineering Research Council (NSERC)
Social Sciences and Humanities Research Council (SSHRC)
Canadian Institutes of Health Research (CIHR)
Research infrastructure programs
Canadian Foundation for Innovation (CFI)
Other funding programs that support research in specific areas
Similar programs exist in nearly all OECD countries
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Patent Regulation
The second response is regulation to create incentive for private-sector investment in
research→ patent legislation
Patent: An exclusive right, granted by government, to produce and sell a
patented product for a defined period of time. It grants a legal monopoly to the
developer of the good or process covered by the patent
Patent policy must balance two counteracting effects on social welfare:
By increasing the chances of earning a profit on a new product, patents spur the
development of important new knowledge and products
Improving social welfare
By granting monopoly power to the developer for a period of time, the price for
the product is (temporarily) set above the socially optimal level
Reducing access to this welfare-enhancing product
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Patent Regulation
The impact of a country’s patent protection on innovation depends on
the size of the country’s market relative to the international market
Canada’s policy has little impact on international sales and on the
pace of innovation in the international drug market
This implies that Canada could provide lesser patent protection and
capture more of the social gain associated with new drugs.
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Patent Regulation
Equilibrium in PC industry with
demand curve D and CRS
production with MC=c0.
Equilibrium is at p0 and q0,
profits are null and CS is A
A firm patents a production
process that lowers production
costs to c1. It can reduce price
to below p0 and capture all
sales, earn profits just less
than B.
Could also license the
technology and earn
royalty per unit sold=c0-c1
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Patent Regulation
After the patent, the
technology can be used freely
by all firms, the new
equilibrium is p1 q1 and social
welfare is increased by A+B+C
Innovation would not have
happened without patents in
this case
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Patent Regulation
Patent length should balance the need for long patents to entice firms
to invest in R & D for inventions that are R & D intensive
Not too long to not reward minor /low-cost inventions for too long
Effects of patents:
Welfare Loss: estimated to be up to 60% of sales revenues
Counterfeiting: reduces returns of patents and makes them less
effective
Parallel Trade: High but unequal prices across countries
encourage purchases in low-price countries for resale in
high-price countries
Excessive Patent Litigation: on validity of patents, patent
infringement, etc.
Patent extension and gaming: Filing patents for minor variations
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Patent Regulation
Deleterious effects of patents:
Patent Races: When more than one firm is competing to develop
a technology, the patent creates a “winner take all” system
Hold-up problem: research and innovation is cumulative:
individuals build on earlier innovation. Latter developers must
obtain license to use earlier innovation and holder of initial patent
can hold out for a large share of profits if the latter one becomes
profitable
High administrative costs: high cost to government, patentees
and patent holders of the current system
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Patent Regulation
Other options to patents:
Government subsidies of R & D
Incentives for innovations that operate on different principles than
the current patent system such as
Auction of rights to an innovation
Payments to innovator based on the health gain produced
Prizes of various types for desired innovations)
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Patents and Generic Drugs
Generic drugs enter the market after the patent expires
More generic entrants lead to lower generic prices
Prices usually get bid down towards marginal cost with competition
Truth: brand-name drugs tend to not lower prices in response (due to
first-mover advantage)
Generic drugs are NOT like no-name peanut butter
They are certified as chemically equivalent to brand-names
Evidence finds no systematic differences in health outcomes
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Canada’s Patent Legislation: a Short History
1923: The Patent Act is amended to allow a compulsory license to be
issued if the ingredients for the drug product are manufactured in
Canada
A compulsory license grants a generic manufacturer permission to manufacture
and sell a patented drug before the patent has expired, but it must pay a royalty to
the patent-holding firm, but the active ingredient must be produced by the
patent-holding firm
1969: Compulsory licenses can be issued when the ingredients are
imported into Canada. Generic manufacturer must pay 4% in royalty
of the net selling price of the drug
1983: This had a dramatic impact on the generic industry: it became
a little too successful. Call for re-examination of the compulsory
licensing policy to encourage growth of the pharmaceutical industry in
Canada.
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Canada’s Patent Legislation: a Short History
1987: Bill C-22 amends the patent act:
Brand-name drug manufacturers are guaranteed 10 years of protection against
compulsory licenses for generic manufacturers seeking to import active
ingredients and 7 years against generic manufacturers who would manufacture
active ingredients in Canada
No compulsory licenses to import would be issued for drugs invented and
developed in Canada
Change the term of a patent from 17 years following the date of issue to 20 years
from the date the application is filed
1991: Bill C-91 amends the patent act to align its policies with
provisions of the NAFTA. It
Eliminated compulsory licensing altogether
Included provisions that enable brand-name manufacturers to delay the
introduction of generics following the patent expiry
Requires generic manufacturers to notify brand-name manufacturers that it
intends to market a generic
Provides brand-name manufacturers the opportunity to legally challenge the
generic company’s claim that it does not infringe on any of the brand-name
manufacturer’s patents. This can delay the introduction of the generic by up to 24
months (and forces the generic manufacturer to incur legal costs).
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Drug Safety and the Drug Approval Process
Before a newly developed drug can be sold to the public it must be certified
as safe and efficacious by the relevant government agency
Canada→ Therapeutic Products Branch of Health Canada
U.S.→ Food and Drug Administration (FDA)
European Union→ European Medicinal Products Evaluation Agency
(EMEA)
The modern era of safety and efficacy regulation began in the early 1960s
Following a # of instances where drugs marketed to the public were
found to cause severe harmful side effects
E.g., Thalidomide
Marketed to pregnant woman
Subsequently found to cause severe birth defects in children
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Regulation of Pharmaceuticals (Drug testing)
Three demand curves
representing:
DNT : No testing
DT1: Testing shows drugs
are not as effective as
thought
DT2: Testing shows drugs
are more effective than
thought
Assume a fixed price (P∗)
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Regulation of Pharmaceuticals: Adverse Side Effects
or Less-than-Expected Efficacy
If testing a drug shows it has
adverse side effects
Demand shifts from DNT
to DT1
Period of delay:
Consumers lost benefit
= 4CDP∗(Bene.) +
4DEH(Costs)
Following test
Avoid loss 4DEH
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Regulation of Pharmaceuticals: Adverse Side Effects
or Less-than-Expected Efficacy
Period after introduction:
Regulation avoids a
welfare loss of 4DEH
Overall:
Loss avoided over the life
of the drug likely exceeds
any temporary loss of
welfare
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Regulation of Pharmaceuticals: Unanticipated
Benefits
If testing a drug shows it has
unanticipated benefits
Demand shifts from DNT
to DT2
Period of delay:
Consumers benefit
= 4AGEP∗
Following test
Welfare gain of 4AFP∗,
greater than it would have
been if regulations had
not established the
unanticipated benefits
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Regulation of Pharmaceuticals: Unanticipated
Benefits
Overall:
Extra benefits after
introduction likely exceed
the lost benefits from
delayed availability
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Regulation of Pharmaceuticals: Costs of Testing
Prevent the Drug from Reaching Market
Consumers lose the
benefit the drug would have
provided over the life of the
drug, e.g. AGEP* for all
periods
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Regulation of Pharmaceuticals
The challenge is to impose testing that is sufficiently rigorous to
identify the true effects of a drug and apply decision criteria that
balances losses and gains from its decisions, while not imposing
such large costs that inhibit drug development
Regulatory process is usually
1 A drug company synthesizes a promising new drug compound
2 The drug is tested in animals to establish basic properties and
effects
3 If promising, clinical tests in humans
Phase 1: 20-100 healthy volunteers to establish safe dosage and
other information required for safe testing in larger populations
Phase 2: 50-300 patients with target disease
Phase 3: 1000-5000 patients with target disease
4 Results of the tests are submitted to a regulatory agency
5 Agency makes a decision: Approve for sale, not approve for sale
or request additional information before making a decision
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Costs of Developing New Pharmaceuticals
Average time from the synthesis of a new drug molecule was 12.8
years in the 1990s, much of this due to longer periods of clinical
testing
Costs of developing a new drug range from $500M to $1.8B
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Competition in the Pharmaceutical Industry
Brand-Name Competition
Seldom about price
Often about securing and extending monopoly power
Want to be first to market with a breakthrough drug
Breakthrough Drug: The first drug to treat effectively a particular
illness or which provides substantial improvement over existing
drugs
Want to extend the market power gained from the first patent
through the strategic use of secondary patents
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Building Brand Loyalty
Drug companies strive to build brand loyalty through:
Detailing: A promotional practice by drug companies in which a
company drug representative visits a doctor to promote the
company’s drugs
Direct-to-Consumer Advertising: Advertising by drug
companies targeted directly at consumers rather than physicians
or pharmacies
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Regulating the Prices of Brand Name Drugs
Patented Medicines Prices Review Board (PMPRB) only regulates
prices during the patent. 4 basic principles set out by the Patent Act:
Price of a new patented drug should be in the range of the cost
of therapy for existing drugs sold in Canada used to treat the
same disease
Price of a new breakthrough drug cannot exceed the median
price for the same drug in 7 other industrialized countries (they
are France, Germany, Italy, Sweden, Switzerland, UK and US)
Rate of increase in the prices of existing patented drugs cannot
exceed the CPI
Canadian prices of patented medicines can never be the highest
in the world
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Extending Patent Protection
A second strategy is the strategic use of patents to extend the effective length of patent
protection
The introduction of low-cost, “me-too” version of a drug
Me-too Drug: A minor variant of an existing drug that offers little improvement
over existing drugs. E.g. A slow-release version of the drug, capsule rather than
tablet formulation.
Can inhibit entry after the original patent expires
Example - Lipitor:
Cholesterol-lowering drug
One of the best-selling drugs in history
First patent for the drug in 1990 (expired in 2011)
Approval to sell the drug in Canada in 1997
Since 1990, Pfizer has filed 16 additional patents related to Lipitor. The patent
eventually expired in 2022.
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Extending Patent Protection
One can also introduced authorized generics prior to the end of
patent protection to capture a portion of the generic market before
generic manufacturers are able to introduce their generic versions
Authorized generic: Drug manufactured by a brand-named drug
company (or under license from the brand-name company) that is
identical to its brand-name version, is introduced at the time of patent
expiry under a different name, and sells at a lower price to compete
with generic drugs
An authorized generic can deter entry by generics and allow price
discrimination.
Ranbaxy was an authorized generic for Lipitor to start selling in 2011
or 2012
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Competition Among Generic Manufacturers
Main decision for generic manufacturers is whether or not to enter a
market and whether to be the first generic into the market
Decision depends on
Size of the market
Potential responses by the brand-name manufacturer
What other generic manufacturers are expected to enter the
market
Costs of developing a bio-equivalent generic drug
Legal costs and financial risks of a challenge by the brand-name
manufacturer fall solely on maker of the first generic on the market:
the brand name company is unlikely to challenge other generic
makers after loosing once it court
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Competition Among Generic Manufacturers
Incentive is therefore to free-ride on the effort of the first entrant
Once many generics have entered the market, competition is
primarily on price to pharmacies who will only keep one or two
generic versions of the same drug in stock (40 to 80% rebates to
pharmacies from the list price)
Pharmacies capture the price spread (difference between list and
discounted price)
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Why are Canadian Generic Drug Prices so High?
PMPBR found that on average, prices for generics in 2005 were
higher in Canada than in 11 comparator countries.
Two provincial regulations are particulary cited
Price Regulation in Ontario: before 2006, first generic to enter a
market was priced at 70% of the brand-name price and
subsequent entrants would be priced at 90% of that. What was
meant as a price ceiling became a floor
“Most favoured Nation” Clauses (Quebec & Newfoundland: The
most a province will pay is the lowest price offered in any other
province. Inhibits competition as lowering a price in one province
lowers it elsewhere
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Why are Canadian Generic Drug Prices so High?
After 2006, Ontario changed its policy to pricing the first generic at
50% of the brand-name price
This lowered prices in Quebec but raised prices elsewhere in Canada
and for private payers: it created a two-tiered system
Some experimentation is ongoing with competitive tendering
processes to lower prices of generics
The PMPRB reports that the situation is much better now than in
2006.
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Design of Pharmaceutical Benefit Programs
Main insurer in most industrialized countries are public drug
insurance programs. 2 major goals
Purchase the lowest-cost version of available drugs
Ensure that only necessary effective medications are purchased
Policies can therefore
Target the Type and Quantity of Drugs Consumed
Ensure that the Lowest-Cost Product is Purchased
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Targeting the Type and Quantity of Drugs Consumed
Drug Formulary: List of all the drugs eligible for reimbursement by a
drug insurance plan
Drug formularies are provincial and each include a subset of all drugs
approved in Canada
Public drug plans account for about 45% of all prescription drug
purchases in Canada and getting a drug listed on the public drug
formulary is essential for gaining market share
Most stringent criterion: economic efficiency, which is judged against
other drugs currently available on the market
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Targeting the Type and Quantity of Drugs Consumed
A greater source of inefficiency is clinically inappropriate use of
existing covered medicines
To combat this:
Conditional Coverage: reimburse drugs to patients with identified
clinical conditions
Academic detailing: Government representatives visit MDs to
provide unbiased evidence on the effectiveness of drugs and the
appropriate conditions for their use
Provide greater scope for pharmacists to be involved in the
process of drug selection
Auditing and feedback to clinicians to improve their prescribing
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Policies to Ensure that the Lowest-Cost Product is
Purchased
Reimbursement at the Price of the Lowest-Cost Bio-Equivalent
Drug
Usually applies when one or more generics are available
Little effect on prices themselves, although it saves tens of millions of
dollars annually to insurers
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Policies to Ensure that the Lowest-Cost Product is
Purchased
Reference-Based Pricing: A policy of reimbursing only the price of
the lowest-cost drug intended to treat the condition in question,
including drugs that are not bio-equivalent
Only used in British Columbia in Canada
Most common example: simple hypertension
ACE Inhibitors, Beta-blockers, Calcium Channel Blockers and
thiazide diuretics
1/8 to 1/3 of cost for the latter compared to the former
But these drugs are NOT bio-equivalent: would all be reimbursed
under Reimbursement at the Price of the Lowest-Cost
Bio-Equivalent Drug
All the same class: only thiazide diuretics under
Reference-Based Pricing
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