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How Increased Competition from Generic Drugs Has Affected Prices and Returns in the Pharmaceutical Industry July 1998

Competition in the pharmaceutical market has changed significantly. During the past decade, many health insurance companies have contracted out the management of their prescription drug benefits to specialized pharmaceutical benefit management companies (PBMs), and enrollment in managed care health plans has increased. In the previous decade, many states repealed antisubstitution laws that had prohibited pharmacists from dispensing generic drugs in place of brand-name ones, and changes in federal law sped up the approval process for generic drugs. All of those factors have contributed to a dramatic rise in sales of generic prescription drugs. Generic drugs contain the same active ingredient as a brand-name drug and enter the market after the patent on the brand-name drug has expired. Higher sales of generic drugs in turn have led to lower average prices for prescription drugs in general and a decline in returns from marketing new drugs.

The prices of brand-name prescription drugs are also facing downward pressure as many more purchasers try to negotiate discounts from manufacturers. In particular, PBMs and health maintenance organizations (HMOs) compile lists of suggested drugs (known as formularies) for their enrollees that encourage the use of generic drugs and less expensive brand-name drugs. The lure of being included on a large health plan's formulary allows those plans to leverage discounts on some brand-name drugs. According to the statistical analysis in this study, the discounts and rebates that some purchasers receive on brand-name drugs tend to be larger when more therapeutically similar brand-name drugs are available from different manufacturers and when generic copies are available. Such discounting may be an important source of price competition among brand-name drugs. However, assessing the amount of drugs sold at a significant discount is difficult, because sufficient data do not exist.

Market competition and federal policies have affected not only drug prices but also the incentives for companies to research and develop new drugs (in other words, to innovate). This study assesses the extent to which longer patents for innovative drugs--the result of 1984 legislation--have offset the effects of increased generic competition on the returns from marketing new drugs. The Drug Price Competition and Patent Term Restoration Act of 1984 (commonly known as the Hatch-Waxman Act) established provisions for extending patent terms for innovative drugs. At the same time, it reduced the testing requirements for approval of generic drugs, allowing them to enter the market--and thus cut into the sales of brand-name drugs--more quickly.

Many other changes have occurred on both the demand and supply side of the pharmaceutical market that affect the returns from innovation. This study examines many of those changes, but it does not attempt to explicitly measure their impact. On the supply side, recent breakthroughs in genetics and biomedical research have increased the technological opportunities for developing new drugs. On the demand side, the increase in HMO enrollment and the spread of managed care techniques to all forms of health insurance have made many purchasers more sensitive to drug prices and helped hold down those prices. At the same time, under some forms of managed care, the demand for prescription drugs may grow. Because of those diverging trends of lower prices and higher demand, it is difficult to assess the net impact of the rise in managed care on profits in the pharmaceutical industry.
 

The Basis for Competition Among Drug Companies

Prescription drugs can be divided into two categories: innovator drugs and generic drugs. (See Box 1 for a glossary of various terms for prescription drugs.) Innovator drugs (which this study also refers to as brand-name drugs) generally have a patent on their chemical formulation or on their process of manufacture.⁽¹⁾ They have been approved by the Food and Drug Administration (FDA), after extensive clinical testing, under an original "new drug application" (NDA). Patented brand-name drugs that are therapeutically similar may exist, but each has a different chemical formulation. While they are still under patent protection, innovator drugs are called single-source drugs, because only the company that holds the patent produces them. After the patent has expired, generic copies of the exact chemical formulation usually become available. Then such drugs are referred to as multiple-source drugs.
 

Generic drugs obtain FDA approval under a shorter process than innovator drugs. They are required only to demonstrate "bioequivalence" to an innovator drug--in other words, to show that the active ingredient is released and absorbed at the same rate for the generic drug as for the corresponding innovator drug. Because they are copies rather than original formulations, generic drugs are not patentable.

Manufacturers of prescription drugs can be divided along similar lines: companies that primarily produce innovator drugs, and companies that focus on generic drugs. The two types of manufacturers compete very differently in the market. Producers of innovator drugs invest heavily in research and development (R&D), hoping to recoup that investment in profits from future sales while a drug is under patent and they have a monopoly on its manufacture. Producers of generic drugs do not need to duplicate the research effort of the innovator firm or invest nearly as much in getting FDA approval for their drugs. However, since those producers have neither patents nor a costly approval process to deter potential competitors, they quickly face competition from other companies producing identical drugs. That intense competition forces generic manufacturers to charge much lower prices than the innovator firm--which, even after its patent expires, typically enjoys a market advantage based on its reputation for producing a high-quality product.

Although companies invest in research and development because they expect high returns from the future sales of their discoveries, those returns are considerably skewed. Some drugs have billion-dollar sales, whereas others bring in less than $25 million a year. For drug manufacturers to be successful, the present value of their future profits from the sale of new products (discounted to the date the products were introduced) must exceed the capitalized cost of their original R&D investment (capitalized to the date of market introduction), including investment in drugs that never make it to the market. Patents increase the rewards for innovation by giving companies a temporary monopoly over marketing their discoveries. Although that monopoly status rewards the company with high profits, consumers pay a higher price and get less output than would be the case under competition. But that temporary monopoly status is often necessary to provide sufficient incentives for drug companies to invent the new products that benefit consumers. Without patents, many new drugs could be easily and quickly duplicated by other manufacturers, preventing the innovator firm from obtaining enough reward to justify its investment.

Patents do not grant total monopoly power to companies in the pharmaceutical industry. In many cases, several chemicals can be developed that use the same basic mechanisms to treat a disease. Since a patent applies to a specific chemical or production process, different firms can end up patenting similar, competing drugs based on the same innovative principle. In addition, drug therapies often compete with nondrug therapies. Rather than having a pure monopoly, frequently drug companies produce slightly different products--leading to a form of imperfect competition that allows an innovator firm to earn higher profits than it could in a perfectly competitive market but less than it would with a pure monopoly.
 

Changes Made by the Hatch-Waxman Act

In passing the 1984 Hatch-Waxman Act, the Congress attempted to balance the interests of the generic drug industry against those of manufacturers of innovator drugs. That act contained two sets of changes. First, it eliminated the duplicative testing requirements necessary to obtain approval for a generic copy of a previously approved innovator drug. Specifically:

• It created an abbreviated approval process for generic copies of innovator drugs. A similar abbreviated process already existed under FDA regulations for generic copies of antibiotics and of innovator drugs approved before 1962.
  
  
• It allowed manufacturers of generic drugs to file an abbreviated new drug application and conduct clinical tests demonstrating bioequivalence with a brand-name drug before that drug's patent expires. As a result, the FDA can approve many of those applications immediately after patent expiration. That provision overturned a 1984 decision by the Court of Appeals for the Federal Circuit that clinical tests conducted by generic manufacturers before patent expiration constitute patent infringement.⁽²⁾
  
  
• It also established a process to handle patent disputes between generic manufacturers and innovator firms.
  
  

Those provisions helped to increase the availability of generic drugs following patent expiration.

Second, the act established patent-term extensions for innovator drugs. Because such drugs receive patents from the Patent and Trademark Office before they receive approval from the FDA, part of their time under patent is spent in the clinical trials necessary for FDA approval. The patent extensions were intended to offset part of the patent term used up during the approval process.⁽³⁾ Under the new procedures:

• Manufacturers of a newly approved innovator drug that contains an active ingredient never before approved by the FDA can apply for a patent-term extension that equals the sum of all the time spent in the NDA review process plus half of the time spent in the clinical testing phase. Two limitations exist. A patent-term extension cannot exceed five years, nor can it allow the period between product approval and patent expiration to exceed 14 years. The average length of patent-term extensions granted under this provision is three years.
  
  
• If an innovator drug is not protected by a patent, it may still benefit from certain exclusivity provisions that delay the approval or filing of an abbreviated new drug application in some cases.

By extending patents on brand-name drugs while making it easier for generic drugs to enter the market after patents expire, the Hatch-Waxman Act aimed to benefit consumers by increasing the supply of generic drugs while preserving drug companies' incentive to invest in research and development.⁽⁴⁾

Since the act took effect, pharmaceutical sales in the United States have risen dramatically. Between 1985 and 1995, sales of all prescription drugs by manufacturers grew faster than total health care spending. Valued at manufacturer prices, those sales increased from $21.6 billion to $60.7 billion--or from 5.7 percent to 6.9 percent of total health care expenditures in the United States.⁽⁵⁾ Over the same period, spending on drug research and development rose even faster, growing from 15.1 percent to 19.4 percent of brand-name drug sales.⁽⁶⁾ Although increased competition from generic drugs by itself reduces the returns from innovation, the rise in R&D spending indicates that, all factors taken together, a strong environment still exists for investing in drug development.
 

Data Used in This Analysis

This study contains a variety of empirical estimates that help to characterize competition in the pharmaceutical market and its impact on consumers and the returns from marketing new drugs. To produce those estimates, the study draws on several data sets. The largest is a set of data on retail sales by pharmacies; it represents about 70 percent of all sales of prescription drugs through pharmacies at retail prices and covers 66 therapeutic classes of drugs. Most of the estimates in Chapter 3--which include market shares and prices of brand-name and generic drugs and an attempt to approximate the savings obtained from generic substitution--rely on that data set. The statistical analysis of discounting in the pharmaceutical industry discussed in Chapter 3 also relies on that data set, as well as on price information made available through Medicaid's drug rebate program.

The calculation in Chapter 4 of changes in the returns from marketing innovator drugs relies on another set of data: figures on the U.S. sales of 67 drugs (introduced between 1980 and 1984) during their first eight to 12 years on the market. That calculation also uses the retail pharmacy data set to estimate the market share of generic drugs immediately after the patent expiration of a brand-name drug.

Each of those data sets has its own strengths and weaknesses, which are discussed along with the empirical results. A summary of the estimates made in this study, together with the methods and data sets that were used, appears in Appendix A.

1. In a very small number of cases, generic drugs go by a brand name rather than the drug's chemical name. Those types of drugs are an exception and represent less than 2 percent of total retail pharmacy sales (based on tabulations of the Congressional Budget Office's data set on retail pharmacy sales). In this study, "brand-name drug" means an innovator drug.

2. The case was Roche Products, Inc. v. Bolar Pharmaceutical Company, Inc. (733 F. 2d 858 Federal Circuit 1984). See also Alan D. Lourie, "Patent Term Restoration," Journal of the Patent Office Society, vol. 66, no. 10 (October 1984), pp. 526-550; and Donald O. Beers, Generic and Innovator Drugs: A Guide to FDA Approval Requirements, 11th ed. (Englewood Cliffs, N.J.: Aspen Publishers, 1995), pp. 4-75 to 4-77.

3. See 35 U.S.C. 156(c), 98 Stat. 1598.

4. See, for example, the opening statement by Senator Orrin Hatch before the Senate Committee on Labor and Human Resources, June 28, 1984.

5. Data on total sales of prescription drugs, net of discounts and rebates and valued at the prices obtained by manufacturers, were provided by the Pharmaceutical Research and Manufacturers of America on April 28, 1997. If prescription drug sales had been valued at retail prices--the prices used for measuring national health expenditures--they would represent a higher percentage of such expenditures. Health care expenditures in the United States totaled $376.4 billion in 1985 and $878.8 billion in 1995; see Katherine R. Levit and others, "National Health Expenditures, 1995," Health Care Financing Review, vol. 18, no. 1 (Fall 1996), p. 179.

6. Pharmaceutical Research and Manufacturers of America, 1997 Industry Profile (Washington, D.C.: PhRMA, March 1997), p. 57.

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