| Quarter
1, 2003
by Carrie Conaway
PDF version, including charts
(1.4MB) 
Like many things in life, some cholesterol is good, but
too much of a good thing can be bad. Cholesterol is necessary
for producing the bile that helps digest the fats in our food.
It also helps stabilize and protect cells, and it plays a
key role in the production and use of vitamin D and certain
sex hormones. But extra cholesterol can build up and constrict
or block arteries, leading to angina, heart attacks, and stroke.
Doctors had suspected for years that cholesterol played a
role in heart disease. But their suspicions weren’t
confirmed until 1984, when a national study demonstrated that
cutting cholesterol significantly reduced the risks of heart
attacks and death from coronary heart disease. On this news,
doctors rushed to help their patients with high cholesterol
find a way to bring it under control. But at the time, the
available treatments were only mediocre. A few anti-cholesterol
drugs such as Lopid, Cholybar, and Questran were on the market,
but none were very effective and patients complained about
their flavor and gastric side effects. The other proven remedy,
diet and exercise, was as unpopular, difficult, and frequently
unsuccessful then as it is now. Yet the potential market for
a new anti-cholesterol treatment was huge, since about one-half
of Americans have cholesterol levels above the magic number
of 200 milligrams per deciliter. The drug race was on.
Just three years later, Merck Pharmaceuticals introduced
Mevacor, a blockbuster new drug that promised to cut cholesterol
levels by 30 percent with minimal side effects. In less than
18 months, Mevacor had captured 42 percent of the market for
cholesterol-reducing drugs. Through the success of Mevacor
and a follow-on product, Zocor, Merck would dominate the anti-cholesterol
pharmaceutical market for almost a decade.
But don’t let this fast timeline fool you. By the time
of the 1984 cholesterol study, Merck was already well on its
way to putting Mevacor on the market. The research behind
the new class of drug Merck discovered, known as statins,
originated decades earlier when scientists began to uncover
how cholesterol was produced in the body. It took many years
and thousands of rejected compounds to move statins from research
idea to the drugstore shelf, even after the basic science
of cholesterol was known.
The payoff on this investment of time and resources has been
huge, for Merck and for society. Today cholesterol-reducing
drugs are the nation’s pharmaceutical sales leaders,
with more than $11 billion of sales per year in the U.S. alone,
and physicians have rated statins the fourth-most-important
medical breakthrough of the last 30 years after magnetic resonance
imaging, ACE inhibitors, and angioplasty.
The cost and uncertainty of the drug development process
mean that pharmaceutical firms need to receive large returns
on any successful drug in order to counterbalance the failures
along the way. Yet the products they make, once discovered,
are extremely easy for other firms to copy. Without some kind
of legal right to the economic returns from their research
findings, pharmaceutical companies would have no incentive
to develop new drugs—and society would miss out on the
new and improved treatments for disease and illness that the
companies would discover. To solve this problem, the government
grants drug manufacturers patents—short-term monopolies
that limit competition and thus help ensure that companies
receive a return on their research. But this benefit to inventors
comes at a social cost. The shield from competition that patents
provide gives manufacturers the economic power to set prices
higher than competitive markets would allow, on the very goods
that society regards as critically important to make available.
There is no doubt that patents foster innovation, especially
for pharmaceuticals. But it is harder to know whether their
current structure has struck the right balance between their
costs and benefits for society. With drug patents, as with
cholesterol, too much of a good thing may be bad.
LONG TIME IN COMING
Research and development is critical to the long-term health
of any pharmaceutical firm, as these companies live and die
on their pipeline of new drugs. Without a steady stream of
new products on the horizon, a drug company will falter as
its older products are superseded by other companies’
inventions. But new products are not easy to find. Only 10
percent of potential drugs advance to the human trial stage,
and only a small fraction of those tested ever make it to
market.
The first steps towards what ultimately became Mevacor were
taken in the early 1950s, when a Merck scientist isolated
mevalonic acid from a yeast extract and demonstrated that
it could be converted into cholesterol. But Merck didn’t
make much more progress with cholesterol drug development
until 1973, when researchers at the University of Texas uncovered
critical details about the chemical reactions behind cholesterol
production in the liver (where 70 percent of the body’s
cholesterol is made).
Three years later, scientists at Sankyo, a Japanese pharmaceutical
firm, found a fungus-derived compound that could block the
activity of HMG CoA reductase, an enzyme at the head of the
cholesterol production chain. By looking at similar fungi,
in 1978 Merck zeroed in on another compound, lovastatin, which
successfully blocked cholesterol production in animals. They
were now ready to take the next step in getting the drug on
the market—obtaining approval from the federal Food
and Drug Administration (FDA).
The FDA requires that any consumer pharmaceutical product
go through a series of rigorous clinical trials to demonstrate
the drug’s safety, efficacy, and proper dosage in humans.
Once Merck knew its new compound worked in animals, it launched
into human testing. But worries about a potential cancer risk
in Sankyo’s similar compound halted the trials for almost
four years, and they weren’t resumed in full force until
May 1984. Lovastatin turned out not to be carcinogenic and
in fact had very few side effects, leading the FDA to approve
the drug only 10 months after application—near-record
time. Merck received final approval to put lovastatin, trade-named
Mevacor, on the market on September 1, 1987.
The length of the research and development process for Mevacor
—two decades before the initial research on cholesterol
production led to a target for a potential drug, and another
11 years before Mevacor went on the market—is not at
all atypical for the pharmaceutical industry. And companies
can invest years in searching for a drug treatment and still
find nothing at all. As a result, pharmaceutical development
is extremely expensive. The Pharmaceutical Research and Manufacturers
of America, the pharmaceutical industry’s trade association,
estimates that the U.S. pharmaceutical industry spent over
$30 billion just on research and development in 2001. This
amounts to almost onesixth of their sales revenue, near the
highest among high-technology industries. In total, each new
drug that makes it to market can cost half a billion dollars
to develop from beginning to end, including the cost of all
the wrong turns along the way.
When a pharmaceutical company thinks it has identified a
possible winner, then, it begins to worry about how to protect
its research investment. And that was exactly Merck’s
situation in 1979. It had a promising molecule in hand and
knew it was facing competition, especially from Sankyo, in
turning the chemical into a marketable drug. So on June 15,
1979, the company applied for a patent with the U.S. Patent
and Trademark Office.
THE ECONOMICS OF SECRETS
For firms in which research drives growth, nothing is more
valuable than the knowledge they create—their intellectual
property. The longer they keep their trade information secret
from their competitors, the more money they make. This is
why many companies require employees to sign noncompete contracts
preventing them from jumping ship to work for a competitor,
and it’s why they spend billions of dollars each year
to keep their research and product designs from being stolen
by computer network attacks, reverse engineering, and industrial
espionage.
But while keeping this information secret may reward inventors,
it doesn’t always benefit society. If no product designs
were ever publicly released, innovation would stagnate. Inventors
would be forced to start from scratch on every new product
and would wastefully duplicate others’ efforts. Knowing
a product’s design also helps to accelerate the use
of the new technology and to improve the quality of future
innovations, especially in cases where the new product must
be compatible with earlier versions.
To adjudicate between inventors’ interest in maximizing
the return on their investment and society’s interest
in disclosing product designs, the U.S. Constitution provides
for patents: exclusive time-limited property rights granted
to inventors in exchange for their publishing information
about how they design and make their product. During the life
of the patent (currently 20 years from the date of application
filing), no other manufacturer may make the same product without
first obtaining a license or other permission from the patent
owner. Once the patent has expired, the product is fair game
for anyone to copy.
Since there are almost always competing—though possibly
inferior —products on the market when a new design arrives,
patents do not typically create true monopolies. But they
do limit the competition a product will face during the life
of its patent, since no other company can make an exact copy.
This is the social tradeoff of patent protection. The very
shield from competition companies need as an incentive to
innovate can translate into higher prices and reduced access
for the rest of society while the patent is in effect. In
many cases, patented products turn out to have limited commercial
value, mitigating this problem. But for the few especially
successful products, the economic value of their patents—and
the potential impact on society in terms of price and access—can
be quite large.
Empirical estimates of this value are hard to come by, since
it is not easy to determine what a company’s prices
or profits would have been were it not for its patent protection.
But there is no doubt that the value of patent protection
is higher for drugs than for most other high-tech products.
While other companies can rely on inventive lead time and
employee secrecy to keep competitors at bay, with pharmaceuticals
the cat is out of the bag once the product hits the market.
With only the pill itself in hand, it can take just weeks
for a competitor to replicate it, a trifle compared to the
years of work invested in its discovery. Copycatting is made
even easier by the FDA approval process, since the application
itself discloses key details about how the drug is manufactured.
And the potential payoff to copying is especially great because
drugs work by themselves, instead of being just one element
of a complex machine (think of all the innovations that go
into the average DVD player or computer).
To be sure, patents are by no means the only reason why pharmaceutical
prices are high. As noted earlier, the process for discovering
and developing drugs is quite time-intensive and expensive.
Furthermore, consumers and even doctors are often not well
informed about prescription options and prices and often choose
brand-name products marketed to them by pharmaceutical companies,
rather than the cheapest drug that will treat their problem.
Those with insurance coverage for drugs don’t pay the
full cost of their prescriptions, reducing their incentive
to shy away from the most expensive brand-name products. And
regulated drug prices overseas mean that pharmaceutical companies
must charge more in the unregulated U.S. market to make up
for losses elsewhere. Notwithstanding these and other issues,
patents are a significant factor in pharmaceutical prices,
since they leave the door open for drug companies to restrict
competition and raise prices.
DISTINCTION WITHOUT A DIFFERENCE
With a patent in hand by 1980 and FDA approval for Mevacor
in 1987, Merck was ready to take on the anti-cholesterol market.
Thanks to an easy-to-use product with a large potential audience
—and to the success of its direct-to-consumer advertising,
one of the first times a drug company used this approach—Mevacor
quickly became one of Merck’s biggest sellers. In Mevacor’s
first year on the market, it earned an estimated $260 million,
the highest sales ever for any prescription medicine to that
date.
In response, other pharmaceutical companies ramped up their
efforts to find a drug that could compete. They could not
literally replicate the molecule Merck had patented; that
could only come once the patent expired. But they could design
around it, using the knowledge Merck had gained to find a
similar, but not identical, compound that generated similar
results.
This approach makes sense in an environment in which intellectual
property is protected with patents. Short of inventing an
entirely new product, designing around an existing product
is the quickest and easiest way for manufacturers to enter
a market. Indeed, it can take as little as one year before
the first designaround products make their way to store shelves.
The strategy is to capture market share either by pricing
the product at a discount or by improving on the original
in some way. These new products will be fighting an uphill
battle to gain sales, since the name recognition and familiarity
of the original product will help the innovating firm to maintain
its revenues. But design-arounds can often make a significant
dent in market share—sometimes as much as 15 or 20 percent
in their first year on the market.
From a social perspective, though, there’s a tradeoff.
The incentive to design around an existing product is also
an incentive to create products with distinctions that make
no difference. Products that make substantial improvements
to the original design —in the case of pharmaceuticals,
perhaps drugs that are more effective or easier to tolerate—are
always welcome. And these improved products carry the added
benefit of increasing competition, which tends to hold the
line on prices. But design-arounds can also be “me-too”
products with little to no advantage over the original. While
they might help increase competition, this benefit may not
outweigh the cost of discovering the copycat drug. Furthermore,
it would be less socially wasteful if the effort that went
into developing me-too drugs had instead gone toward truly
novel innovative activity, which could have had greater benefits
in terms of quality or cost.
Because of its unprecedented success and large potential
audience, Mevacor was a natural target for me-too drug development.
The first on the market, in October 1991, was Bristol-Myers
Squibb’s pravastatin sodium, sold as Pravachol. Pravachol
is a classic me-too drug. It is less effective at reducing
cholesterol than Mevacor, but it is also priced 5 to 10 percent
lower, making it attractive to managed care plans and others
looking to cut prescription costs. Pravachol’s price
advantage was enough to capture 20 percent of the statin market
by 1994.
But Merck had another trick up its sleeve. During the period
when human testing on lovastatin was halted, Merck scientists
continued to look for another agent that blocked HMG CoA.
They came up with simvastatin, which turned out to cut cholesterol
more effectively than either Mevacor or Pravachol. Tradenamed
Zocor, simvastatin entered the market at the end of 1991 and
quickly outstripped both Mevacor and Pravachol in sales and
new prescriptions. Zocor and Mevacor continued to dominate
the market for the next six years, even as two more copycat
drugs entered the market. Only in late 1996 did a product
finally appear that significantly improved on Zocor. Both
cheaper and more effective than any other statin, Pfizer’s
Lipitor vaulted into first place in sales by 1998 and has
remained there ever since.
THE GENERIC THREAT
Competition from copycat drugs had been cutting into Mevacor’s
market share for years. But its patent expiration on December
17, 2001, was its death knell. The axe had been slated to
fall the previous June, but at the last minute, the FDA granted
Merck an additional 6 months of market exclusivity in exchange
for studies on Mevacor’s safety and effectiveness in
children. The very day that extension expired, seven separate
generic manufacturers put generic lovastatin on the market
at around $1 per pill—half the cost of Mevacor.
What makes generics so threatening to brand-name drug companies
is that they are exact copies of an FDA-approved drug that
can be sold at a much lower price since they cost much less
to develop. Federal legislation passed in 1984 helped open
the markets for generics, which prior to that point had comprised
only about 20 percent of prescriptions (see
sidebar). Today nearly half of all prescriptions are written
for generics (see chart in full text
PDF), and they cost an average of 70 percent less than
tradename drugs. Generics typically capture almost half of
the market for their brand-name equivalent within their first
year of availability, substantially cutting consumers’
prescription costs. A 1998 Congressional Budget Office study
showed that using generics saved consumers $8 billion to $10
billion in 1994 alone.
One might expect that drug companies would try to compete
with generic equivalents by lowering their prices. But instead,
they typically keep prices high, capitalizing on the fact
that patients tend to be loyal to drugs that they have found
effective. In a rare break with this practice, Merck once
offered a two-week discount of about 4 percent off Mevacor
and Zocor in 1993 in response to price competition from Pravachol.
But prices quickly returned to their normal levels, and the
discount was never repeated. Today, even though its patent
has expired, a single Mevacor pill still costs around $2—almost
the same as its 1991 price in real terms.
BALANCING ACT
Merck certainly stood to lose financially when generic lovastatin
hit drugstore shelves. But it’s easy to forget that
by 2001, Mevacor controlled less than 1 percent of the statin
market. Mevacor had long ago lost the pole position, first
to Merck’s own Zocor and later to Pfizer’s Lipitor.
In general, competition from similar brand-name drugs can
shave four times more off a drug’s present discounted
value than does generic competition. And truly innovative
products can completely decimate a previously successful drug
class, as Mevacor did for Lopid, Cholybar, and Questran in
the late 1980s. For most drugs, the real revenue losses come
not when they are copied, but when they are superseded.
Yet drug companies spend millions of dollars each year staving
off generic competition at the end of their products’
lives. They routinely sue generic firms for patent infringement.
They separately patent the active ingredient of a drug, its
form of administration, and even the by-products of its breakdown
in the body to make it more difficult for competitors to design
around the original product. They make the existence of some
patents known only at the last minute, forcing potential generic
competitors to go back and prove that they are not violating
these “submarine patents.” A few have even paid
generic competitors not to make their drugs, a tactic which
has not won them friends with the Federal Trade Commission,
the nation’s antitrust enforcement agency.
Drug companies do this for two reasons: it pays off, and
they can. Every year that drug companies add to a product’s
effective patent life increases the drug’s expected
return by an average of $12 million, according to a 1990 Congressional
Budget Office study; the figure would likely be significantly
higher today due to pharmaceutical price inflation. This may
not be much relative to the returns for finding a blockbuster
new drug, but it’s enough to justify the expense of
litigating the patent violations. Plus this income is far
more certain than the unpredictable returns from new product
development. More important, while brand-name drug companies
can’t do anything about the me-too products that design
around their patents, they can use their patent protection
to limit the competition they face from exact duplicates.
The reason society grants patents, however, is to ensure
a fair balance of returns for both inventors and society,
not to keep competition at bay indefinitely. Inventors should
be able to reap the rewards of their innovations, but so too
should society be able to profit from product design disclosures
and from the lower prices and increased access to products
once the patents expire. Some are now arguing that in the
case of pharmaceuticals, the scales may have tipped out of
balance. One recent proposal to address this problem would
limit drug companies to one 30-month extension of protection
upon patent litigation versus the unlimited number of extensions
available today. Another would disallow generics from being
paid by brand names not to market their drugs.
An even more effective tactic would be to foster greater
pharmaceutical innovation. Drug companies would not need to
be so concerned with patent expirations if they had lucrative
drugs waiting in the wings, and developing new drugs would
also have the additional advantage for society of creating
more and better treatments for disease. The pharmaceutical
industry is already moving in this direction, using clues
from basic science research to identify new treatments rather
than relying on blind searches for pharmacologically active
chemicals. This approach should lead to more efficient research
processes and therefore greater innovation. Another way to
promote innovation is to create a more competitive marketplace.
Adjudicating more antitrust claims and reducing the restraints
on generic entry, for example, would provide a greater incentive
for drug companies to find new treatments.
Ironically, however, it may not make sense to try to encourage
innovation by extending patent life or breadth. Patent protection
is already strong in the United States. In this legal environment,
adding on to the life of a patent or allowing patents to cover
more aspects of a product’s design could actually stall
innovation by preventing later inventors from improving on
the original design.
Nonetheless, patent law will always play a key role in protecting
the rewards from discovery in the pharmaceutical industry.
It has proven itself effective at ensuring both that inventors
receive the economic benefits of their innovation and that
valuable treatments see the light of day. But reaping the
full social benefits of pharmaceutical invention, including
fair drug prices and quantities and abundant treatment options,
takes more than just patent protection. It takes more invention,
and patents are only a piece of that puzzle.
Sidebar: THE HATCH-WAXMAN
ACT: RX FOR THE GENERIC DRUG MARKET
Until 1984, federal regulations made it extremely difficult
to get a generic drug on the market. Generic manufacturers
had to perform the same safety and efficacy testing required
for brand-name drugs, even though they were producing a drug
chemically identical to one that had already been approved.
Few companies were willing to take on this costly process
unless they knew their generic would capture significant market
share, so manufacturers made generic equivalents only for
the most popular and effective drugs. In 1984, less than 20
percent of pharmaceutical prescriptions were written for generics.
But spiraling drug costs in the early 1980s spurred Congress
to pass the Hatch-Waxman Act, with the hope of fostering the
generic drug market while also protecting brand-name drugs.
Generic manufacturers would no longer have to repeat the safety
and efficacy tests; they would only need to demonstrate that
their product was bio-equivalent to its trade-name counterpart.
The legislation further laid out criteria under which generic
manufacturers could challenge a patent’s validity and
thereby start making a protected product before its patent
actually expired. They also received additional protection
from patent infringement lawsuits brought by brand-name drug
companies.
In exchange, brand-name manufacturers were granted five years
of guaranteed market exclusivity before any generic competitor
could challenge a patent, along with patent life extensions
to compensate them for the time lost between patent filing
and FDA approval. These changes added an average of about
three years to the effective life of pharmaceutical patents.
In addition, unlike any other patent owners, brand-name drug
makers were also guaranteed 30 months of protection from generic
competition for each time a generic manufacturer filed a suit
over a patent’s validity, to allow time to sort out
the competitor’s claims before any economic damage was
done. (In other industries, if a competitor claims a patent
is invalid, the patent owner must obtain a preliminary injunction
from a court to prevent the competitor from making its product,
and this injunction is not guaranteed.)
In the two decades since the Hatch-Waxman Act was passed,
the generic market has opened up considerably. Today nearly
half of all prescriptions are written for generics, saving
consumers and insurers billions of dollars each year. And
the Act appears to have had little impact on pharmaceutical
innovation levels. While it didn’t solve every problem
in the pharmaceutical market, most observers agree that the
Hatch-Waxman Act has struck a good balance between protecting
intellectual property and promoting market entry for generics.
PDF version, including charts (1.4MB)
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