1 Regulation of the Pharmaceutical - Biotechnology Industry Patri c ia M. Dan z on Eric L. Keuffel Revised January 15, 2013 Patricia Danzon is the Celia Moh Professor of Health Care S yste m s, Insurance and Risk Manage m ent at the W h a rton Schoo l , University of Pennsylvania, and Research Associate of the NBER. 207 Colonial P enn Center, 3641 Locust W alk, Philadelphia, PA, 19104 - 6218. Eric Keu ff el is a n Assistant Professor in the Risk, Insurance and Healthcare Management Department at the Fox School of Business, Temple University. 610 Alter Hall, 1801 Liacouras Walk, Philadelphia, PA 19122. Paper prepared for : “Economic Regulation and Its Reform: What Have We Learned?” (NBER / University of Chicago Press ) 2 Regulation of the Pharmaceutical - Biotechnology Industry Introducti o n Phar m aceuticals and h u m an biologic products are reg u lated in virtually all as p ects of the product life - cycle: safet y , efficacy and m anufactu r ing quality as a conditi o n for m arket acces s ; pro m otion; and pricing. Since the regulatory structure dev e loped for phar m aceuticals has largely been extended to hu m an biologic m edicines, we hereafter use “p h ar m aceutic al s” to include b i ologics, and w e note ex p li c itly wh e re b i ologics are treated di ff erently. The r a tion a le for heavy regulation of phar m aceuticals is n o t i n trinsic nat u ral m onopoly , since any m arket power enjoyed by individual products derives u l ti m ately from govern m ent - granted patents (See Chapter 2 in this volume for more on natural monopoly) . Rather, regulation of m arket access, m anu f acturing and promotion arise because product efficacy and safety can b e critical to patie n t health but are n o t i m m ediately observable . Evaluating s afety and efficacy a s a c o ndition of market acce s s and m onitoring m anufacturing quality and pro m otion accuracy o v er the prod u ct life - cycle are public go o ds that can in theory be efficiently provided by an expert agency such as the Food and Drug Ad m i nistration (FDA). By contrast, price regulation is best understood as a response by pu b lic insurers to the fact that insurance makes consu m ers price - insensitive. When consu m ers are heavily insured, producers of patented products face highly inelastic de m and and hence can charge higher prices than they would in the absence of insurance. Price regulation and other rei m burs e m ent controls are a response of govern m ent p ayers to this interaction of insurance and patents. Although these considerations s uggest that regulation of the phar m aceutical industry is potentially welfare enhancing, designing the opti m al structure of such regulation is not si m ple. Market access regul ation entails both resource c o s t s and fore g one patient benefits in ter m s of 3 fewer drugs and delay of those that do launch. Measuring these costs, designing the opti m al regulatory structure and finding the best balance between costs and benefits has been the subject of both aca d e m ic research and policy debate and experi m entation. Opti m al reg u lation of pro m otion and the expansion of post - marketing regulatory control are relati v ely rece n t exte n sion s of this debate. On the pricing side, regu lati o n should ideally constrain pricing moral hazard while preserving insur a nce coverage for patients and sufficient patent power to assure in c entiv e s f or a ppropri a te r esearch and develop m ent (R&D). Much has been learned from the experience with different price regulatory regi m es, mostly in countries with national health insurance syste m s. But designing regulato r y structures that are both theoretically sound and e m pirically practical re m ains an i m portant theoretical and policy challenge. In this p aper, Section I d escri b es t h e technolo g ical characteristics of the p har m aceutical sector and the pri m ary objectives of regulation. S ections II provides an overview of safety and efficacy re g ulation in t h e US and abroad. Sec t i o n III reviews the e m piri c al evi d ence, lessons lear n ed and proposals f o r change in safety and efficacy regulation . Section IV discusses patents , focusi n g on those aspects of p h ar m aceutical patenting t h at interact with regulation, which include patent extension policy and regulatory exclusivities , regulation of generic entry, the exten s ion of patents to d eveloping countries and affordability concerns . Section V d escri b es re g ulation of pric i ng, rei m burse m ent and profit ; the evidence on effects of this regulatio n ; and ev idence on industry structure and co m petition . Section VI summarizes evidence on phar m aceutical pro m oti o n, focusing m ainly on direct to cons u m er advertising (DTCA) in the USA , wh i ch has beco m e far m ore i m portant ov e r the last 15 years , following changes in regulatory oversight that re m ain contentious and unsettled. The final section concludes on lessons learned a nd areas for future research. 4 I. Technological Background and Objectives of Regulation The phar m a ceutical industry is characterized by unusually high costs of R&D. Historically, t he research - based industry has invest ed between 15 - 20 percent of sales in R & D (CBO, 2006; EFPIA, 2011) and the R&D cost of bringing a new compound to market was estimated at $1.3 Billion in 2005 (an update from the commonly cited $802 million estimated in 2001 ) , an increase from $138m in the 1970s and $318 m in the 1990s . (Adams and Brantner, 2006; DiMasi and Grabowski, 2007; DiMasi et al., 2003; DiMasi et al., 1991; Hansen, 1979) . V ariation in the expected cost exist s across therapeutic categories and depends on a range of factors (DiMasi et al., 2004) . Generally, the high cost per new drug approved reflects high costs of pre - clinical testing and human clinical trials, high failure rates and the opportunity cost of capital tied up during the 8 - 12 years of deve l op m ent. To so m e extent, this high and rising cost of R&D ref l ects regulations that exist in all industrialized countries, requiring t h at new co m p ounds m eet standar d s of safety, efficacy and m anufacturing q uality as a condition of m arket access. The m ain initial foc u s of regulati o n since the 1 930s was safety, and this has ree m erged recently as a critical issue. Si nce the 196 0 s m ost countries also re q uire pre - approval evidence of efficacy, m onitor m anu f acturing quality throughout the product life, and regulate promotion and advertising to physicians and consumers. The economic rationale for these require m ents derives from the fact that the risks and benefits of phar m aceuticals are non - obvious, can differ across patients, and can only be known from controlled studies in large patient popul a tions. Gathering and eva l uating such infor m ation is a public good, and a regulatory agency that has both m edical and statistical expertise can more accurately and efficiently m onitor and e v aluate t h e evi d ence from clinical trials than can individual physicians or patients. However, regulation that requires e x te n siv e pre - la u nch cli n ical trial data on safety and efficacy inc r eases the R&D c o sts inc u rred by fir m s, increases 5 delay in launch of new m edicines, and m ay reduce the nu m ber of drugs developed and the extent of c o mpetition. T he size and duration of clin i cal tri als required to d etect re m ote risks o r cu m ulative r i sks f rom long term the r apies c an be large. The rising co s t s o f R&D, combined with new technologies f o r eval u ating infor m ation, have pro m pted recent i n itiati v es to accelerate approvals and opti m ally integrate evidence from pre - ap p roval cli n ical t r ials with post - approval observational experience. In the US, the statutory regulation o f pha r m aceuticals t h rou g h the Food and Drug Ad m i nistration (FDA) is in a ddition to – and uncoordinated with the increasing level of indir e ct regulation through tort liability. Critical unres o lved issues in m arket access regulation are: ( 1 ) how m uch infor m ation on risks and benefits sh o uld be req u ired prior to launch; (2) what is the approp r iate trad e - o f f between ben e f its and risks, given that so m e risks are i n evitable; and ( 3 ) what is the a p propriate mi x of pre - and post - launch m onitoring of risks, what m ethods should be used, and what is t h e appropriate m i x of regulation by an expert agency (s uc h as the FDA or an independent agency) and t o rt lia b ilit y ? A second importa n t characteristic of the phar m aceutical ind u stry is the critical role of patents, which results from its research intensity. Given the cost structure with high, globally joint fixed costs of R&D and low m a rginal cos t s of production, patents a r e essential to enable innovator fir m s to recoup their R&D invest m ents. However, patents work by enabling innovator fir m s to charge prices above m arginal cost, which raises issues of appropriate levels of prices a nd profits and appropriate str u cture and duration of patents. Concern that prices m ay be excessive is one rationale for price regulation in m any countries (although, as discussed below, insurance coverage is probably an equally i m portant deter m inant of pric e levels ). Defining regul a t ory c riteria f or a d m itting post - pate n t gen e ric e n tra n ts remains a conte n ti o us issue, e ve n f or tra d itio n al che m ical compounds. More co m plex and yet to b e fully resol v ed b y regulatory agencies are t h e con d itions for a p proving biosimilars , that is, altern a tive v e rsions of large 6 m o lecule, biotechnology products such as proteins, m onoclonal antibodies etc. As the nu m ber and utilization of these expensive biologics exp a nd, so does concern to establish a low - cost regulatory path for approval of generic biologics w ithout full scale clinical trials, in order to sti m ulate p o st - patent p rice co m petition. The global n ature of phar m aceutical p roducts h a s also raised contentious q uestions o v er opti m al patent regi m es in developing countries and cross - nationally. The WTO’s Ag r ee m ent on Trade - related Aspects of Intell e ctual Property Rights (TRIPS) requ i res all m e m ber countries to recognize 20 year product patents by 2015. However, in response to concern that patents would m ake drugs unaffordabl e in low inco m e countr i es, TRIPS per m its m e m b er states to issue co m pulsory lice n ses under certain conditions, including a “nation a l e m ergency.” TRIPS also leaves decisions on allowing parallel i m ports to the discret i on of individual me m ber states. In m ost industrialized countries inclu d ing t h e US, the tr a ditio n al r u le has been n a tional ex h au s tion of pate n t rig h ts, which m eans that a patent holders can bar the unauthorized i m po r tation of the paten t ed product (parallel trade) from other countries. Proposals i n the US to legalize parallel trade, including commercial drug i m portation by wholesalers, w ould under m ine t h e traditional rule of national exhaustion of patent rig h t s . If enacted, this would u nder m ine manu f actur e r s ’ ability to p rice d i s c ri m i nate between countries, which could have serious welfare con s eq u ences as d i s cussed bel o w. A third characteri s tic of the phar m aceutical ind u s t ry is the d o m i nant role of third party pay m ent through social and private health insur a nce. Like any insurance, third party pay m ent for drugs creates m oral h azard, with incenti v es for consu m ers to overuse and/or use unnecessarily expensive drugs. In addition, by m aking de m and less elastic, insurance creates incentives f or fir m s to charge hig h er prices than they would in the absence of insurance. In response to these insurance - ind u ced distortions, since the 1980s government - run health syste m s in m ost countries have adopted ela b orate regulatory syste m s to control p h ar m aceutical 7 expenditures, through regulation of m anufacturer prices a nd/ or rei m burs e m ent and li m its on total drug spending and on c o mpany revenues. Private insurers in the US also use formularies of covered drugs, co - payments and negotiated prices ; however, because these private ins u rers m ust compete for market s h are, t h eir controls lack the l e verage of public payer controls. The controls adopted by both public and private insurers have significant effects on de m and for phar m aceuticals, on the nature of c o mpetition a n d hence on p rofitability, incenti v es for R&D and the su pply of new m edicines. Because phar m aceuticals are potentially glo b al products and R&D incentives depend on expected g l o bal re v enues, national regulat o rs face free ri d er incenti v es. E ach country faces a short run incentive to adopt regul a tory policies that drive its do m estic prices to country - specific m arginal cost, free riding on others to pay for the joint costs o f R&D. But if all cou n tries pay only their country - specific m arginal cost, R&D cannot be sustained. The global nature of phar m aceuticals and the long R&D lead ti m es – roughly 12 y ears from drug discovery to product approval, on average – m ake the incenti v es for short run free riding by individual countries particularly acute. W hile there is w i despread consensus in support of differential pricing b et w een the richest and poorest nations, no consensus exists on a p propriate price levels for these c o untries or between high and m i ddle - inco m e countries. In practice, the a b ility of phar m aceutical fir m s to price d i scri m i nate is di m i nishing as m ore countries ado p t national p rice regulatory policies that reference prices in oth e r countries and/or legalize drug i m portation (also called parallel trade or i n tern a tional exhaustion of patent rights). These cross - national price spillo v ers in turn c r eate incenti v es f or f i r m s to delay or n o t l a unch new drugs in low p rice m arkets, if these low prices would under m ine pote n tially higher prices in other m arkets. Thus the design o f each country’s price regulat o ry system can aff e ct not o n ly their do m estic 8 availability of drugs but also availa bi lity in other countries t h rough price s pillo v ers in the short run, and through R&D incenti v es in the long run. Unlike so m e other industries, regulat i on of the phar m aceutical industry h as not di m i nished or undergo n e fu nd a m ental changes o ver recent d ecades, alt h ough focus of m arket access regulation has shifted betwe e n concerns f or safety vs. cost and delays, a nd the structure of price/reimbursement regulation has beco m e more co m p l ex. The m otivations for regulation of phar m aceuticals i m perfect and/or asymmetric info r m ation for m arket access reg u lation, patents and insurance - related m oral hazard for p r ice/reimbursement re g ulation – re m ain and have, if anything, increased over ti m e. These are sum m arized in Table 1. Re gulatory trends over ti m e within the US and cross - national differences pro v ide a wealth of useful experience from which so m e lessons can be lea r ned. This r e view will fo cus pri m arily on US issues and evi de nce, reflecting t h e do m inance of US - based literature . Moreover, US r e gulatory policy has a disproportionately large effect on the industry, because the US m a rket accounts for almost fifty perce n t of global phar m aceutical revenues. Howev e r, we draw extensively on experience from other countries for evidence on price and rei m burse m ent regulation, cross - national spillover effects and access to p h ar m aceuticals in develo pi ng countries. Insert Table 1 about here The appropriate economic m odel of the ph a r m aceutical industry is either monopolistic co m petition or ol igop o ly with product differ e ntiation. However, both positive and normative analysis m u st also take into account the roles of phy s ician prescribing and third party pay m ent as key determinants of de m and elasticit i es and cross - p rice elasticities. Moreover, m odels of opti m al pricing m ust recognize the i m portance of R&D a nd fixed costs. In this context, welfare conclusions about optimal levels of R&D, product variety or drug use are proble m atic. Most 9 analysis to date and m ost of our discussion are therefore pos itive rat h er t h an nor m ative. Although the industry is characterized by high fix e d costs, m odels in which fir m s endogenously choose sunk costs, in the form of either R&D or promotion to retain co m petitive advantage and deter co m p e tition / entry (Sutton, 1991) , do not seem appropriate and appear to be clearly refuted by t h e evidence o f entry over the last two decades by thousands of s m all fi r m s. We return to t h is below. II. Overview of Safety and Efficacy Regulation 1. The US The first comprehensive federal legislation regulating food and drugs in the US was the Pure Food and Drug Act of 1906 (The W iley Act) which required that product labels and packaging not contain false state m ents about curative effects, but stopp e d short of requiring m anufacturers to pro v ide evidence to prove safety or efficacy (Palumbo FB, 2002) . The 1938 Food, Drug and Co s m etics Act (FDCA), which r e placed the W iley Act, required any firm seeking to market a new che m ical entity ( N CE) to file a new drug application (NDA) to de m onstrate that the drug was safe for use as suggested by the proposed labeling. The Food and Drug Ad m i nistration ( F DA) had 180 days to reject the NDA. As new for m s of print and radio advertising had e m erged since the W iley Act, the FDCA e s tablished jurisdiction over drug advertising, but policing was left to the Federal Trade Com m i ssion (FTC) rather than the FDA. This Act al s o esta b lish e d the req u ir e m ent that patie n t s obt a i n a pres c ri p tion f rom a physician in order to obtain retail drugs. The 1962 Kefauver - Harris A m endments to the 1938 FDCA were the outco m e of hearings that were initiated due to concern ov e r the proliferation, pricing and advertising of 10 drugs of dubious efficacy. The final legislation also reflected concern to strengthen safety require m ents, following the thalido m ide tragedy that caused hundreds of birth defects in Europe whereas the drug was still under review in the US. The 1962 A m endments define the regulations that largely still operate today. They strengthened safety require m ents; added the require m ent that drugs show proof of efficacy, usually by double blind, rando m ized controlled trials of the drug relative to pla c ebo; re m oved the ti m e li m it (pr e viously 180 days ) within which the FDA could reject an NDA; extended FDA regulation to cover c l inical testing and m anufacturing; and restricted m anufacturers’ promotion to approved indications. Basic require m ents for pro m o t ional m aterials were defined, including that such m aterials cannot be false or m i sleading; they m ust provide a fair balance of ris k s and benefits; and they m ust provide a “brief sum m a r y” of contraindications, side effects and effectiveness. Regulatory oversight of pro m otional m aterial was ce d ed back to t he FDA from the FTC. The presumption underlying the re q uire m ent for proof of efficacy was t h at i m perfect and possibly asym m etric infor m ation prevent e d physicians and consu m ers from m aking accurate evaluations, leading to wasted expenditures on ineffecti v e drugs and other a s sociated costs, and excessive product differentiation t h at under m ined price co m p e tition. Although Phase III trials, in v olving double - blinded, rando m i zed placebo - co n t rolled trials in large p atient populations, were initially intended to esta b lish efficacy, over ti m e these trial req u ire m ents have been expanded to detect re m ote risks and/or cu m ulative treat m ent risks of chronic m e dications. The size and duration of cli n ical trials, toget h er with increased regulatory review time, added to de lay in the launch of new drugs, leading to for e gone benefits for consu m ers, shorter effective patent life and foregone revenue f o r fir m s, albeit with the intent of avoiding potentially larger costs for co n su m ers. 1 Moreover, since so m e regulato r y costs are fixed, independent of [...]... Effects of Safety and Efficacy Regulations: Evidence and Issues 18 1 Costs of Regulation Much of the early economic analysis of pharmaceutical regulation focused on effects of the 1962 Kefauver-Harris Amendments on R&D costs, delays in launch of new drugs, decline in the number of new drug introductions and changes in industry structure that occurred in the 1960s and 1970s, raising questions of causation... eligible, off-patent scripts that are filled generically, which can exceed 80% within 3 months of patent expiry in the US The growth of generic share of scripts reflects not only increased generic penetration of compounds that are off-patent but also the growing number of major drugs that are off-patent Several research-based pharmaceutical firms attempted to enter the generics market in the 1990s,... pharmacies capture the margin between the MAC and their acquisition cost, they have strong incentives to substitute the cheapest generics, and this in turn creates incentives for generic suppliers to compete on price If patients want the brand, they must pay the difference between the MAC and the cost of the brand (plus any other co-payment) Thus the main customers of generic firms are the large pharmacy... country-specific trials 2 Benefits of Safety and Efficacy Regulation 23 Compared to costs, there are many fewer studies of the benefits to consumers from regulation The only significant attempt to weigh both the benefits and costs of the 1962 Amendments is Peltzman’s (1973) study He attempts to measure the benefit associated with the new efficacy standards by comparing the growth of market shares of drugs... appropriate calculation of costs over time, other recent attempts have found similar cost levels.(Adams and Brantner, 2006) Roughly half of the total 20 cost is out -of- pocket expense, including spending on drugs that ultimately fail; the remainder is foregone interest or opportunity cost of capital Updating the cost of capital calculation with the Fama-French three factor model rather than the traditional... 1978; Peltzman, 1973; Wiggins, 1981b) Number of new drug launches Grabowski, Vernon et al (1978) report that the number of NCEs fell from 233 in the five-year period 195 7-1 961 to 93 in 196 2-1 966 and 76 in 196 7-1 971 Some decline would be consistent with the intent of the legislation, if some of the prior introductions were ineffective However, the percentage of total ethical drug sales accounted for by... While these survey estimates may be useful benchmarks, they do not necessarily provide an accurate estimate of the counter-factual level of R&D effort in a world without patents Although a full review of pharmaceutical patents is beyond the scope of this paper, issues that intersect with regulation are briefly reviewed here 1 Patent Length and Conditions for Generic Entry The effective patent life of pharmaceuticals... patients take therapeutic drugs because they are sick; these drugs claim to increase the probability of cure but with no guarantees and with some risk of side effects In these circumstances, if an individual patient is not cured by the drug or suffers an adverse effect, determining whether their condition is inappropriately caused by the drug or is simply the inevitable progression of 30 their disease... industries rely on patents to the extent that the pharmaceutical industry does The pharmaceutical industry benefits from the same patent provisions (20 years from filing) available to firms in any industry, except for the special patent term restoration granted for pharmaceuticals under the 1984 Hatch-Waxman Act, to restore time lost in clinical trials (see section II) However, pharmaceutical product patents... quality as a condition of market access However, the optimal integration of post-launch data with the pre-launch RCT data remains an important issue to be resolved A second critical regulatory issue is the optimal mix and coordination of agency regulation and tort liability The theory of optimal policy to control safety when markets suffer from imperfect information generally views regulation and tort