CASE: 1       THE PHARMACEUTICAL INDUSTRY

Managers in pharmaceutical firms face a dynamic and challenging task environment that creates both opportunities and threats. Demand for pharmaceuticals is strong and has been growing steadily for decades. Between 1990 and 2005 there was a 12.5 percent annual increase in spending on prescription drugs in United States. The strong growth was driven by demographics. As people grow older they tend to consume more prescription medicines, and the population in most advance nations has been growing older as the post – World War II baby boom generation ages.

Moreover, successful new prescription drugs can be extraordinarily profitable. Consider Lipitor, the cholesterol-lowering drug sold by Pfizer. Introduced in 1997, by 2005 this drug generated a staggering $12 billion in annual sales for Pfizer. The costs of manufacturing, packaging, and distributing Lipitor amounted to only about 10 percent of revenues, or around $1.2 billion. Pfizer spent close to $400 million on advertising and promoting Lipitor and perhaps as much again on maintaining a sales force to sell the product. That still leaves Pfizer with a gross profit from Lipitor of perhaps $10 billion.

Lipitor is highly profitable because the drug is protected from direct competition by a 20-year patent. This temporary monopoly allows Pfizer to charge a high price. Once the patent expires, other firms will be able to produce generic versions of Lipitor, and the price will fall—typically by 80 percent within a year—but that is some time away.

Competing firms can produce drugs that are similar (but not identical) to a patent-protected drug. Drug firms patent a specific molecule, and competing firms can patent similar, but not identical, molecules that have a similar pharmacological effect. Thus Lipitor does have competitors in the market for cholesterol-lowering drugs—such as Zocor, sold by Merck, and Crestor, sold by AstraZeneca. But these competing drugs are also patent protected. Moreover, due to Federal Drug Administration regulations and requirements for demonstrating that a drug is safe and effective, the cost and risks associated with developing a new drug and bringing it to market are very high. Out of 5,000 compounds tested in the laboratory by a drug company, only five enter clinical trials, and only one of these will ultimately make it to the market. On average, estimates suggest that it costs some $800 million and takes anywhere from 10 to 15 years to bring a new drug to market. Once on the market, on the market, only 3 out of 10 drugs ever recoup their R&D and marketing costs and turn a profit. Thus the high profitability of the pharmaceutical industry rests on a handful of blockbuster drugs. To produce a blockbuster, a drug company must spend great amounts of money on research, most of which fails to produce a product. Pfizer, for example, spent over $7.4 billion on R&D in 2005 alone, equivalent to 14.6 percent of its total revenues.

In addition to R&D spending, the incumbent firms in the pharmaceutical industry spend much money on advertising and sales promotion. Although the $400 million a year that Pfizer spends promoting Lipitor is small relative to the drug’s revenues, it is a large amount for a new competitor to match, making market entry difficult unless the competitor has a significantly better product.

There are also some big opportunities on the horizon for firms in the industry. new scientific break-throughs in genomics portend that within the next decade pharmaceutical firms might be able to bring new drugs to market that treat some of the most intractable medical conditions, including Alzheimer’s, Parkinson’s disease, cancer, heart disease, stroke, and HIV.

On the other hand, managers in the industry face serious challenges. Many patent-protected medicines are scheduled to come off patent in the next decade, and to maintain profitability, pharmaceutical firms must find new drugs to replace them. In addition, as spending on health care rises, seniors are complaining about the high costs of prescription medicines, and politicians are looking for ways to limit this. One possibility is some form of price controls on prescription drugs. Pharmaceutical price controls are already in effect in most developed nations, and although they have not yet been introduced in the United States, that could happen. Another possibility is to make it easy for U.S. residents to purchase pharmaceuticals from foreign nations where prices are lower.

A further challenge is associated with the growth of large health care providers, who have millions of subscribers and are starting to use their power to reduce the drug prices their subscribers pay. In some cases they are refusing to provide insurance coverage for high-priced pharmaceuticals when lower-priced generic alternatives are available.

Questions

 

1. What are the barriers to entry into the pharmaceutical industry? To what extent do you think these entries barriers protect established pharmaceutical companies from new competitors?
2. The pharmaceutical industry has long been one of the most profitable in the United States. Why do you think this is the case?
3. What forces in the general environment influence the nature of competition in the task environment facing pharmaceutical firms?
4. Are there reasons for believing that the profitability of the industry might come under threat over the next decade? What do you think managers in the industry should do to counter this threat?

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