'Profitability and drug discovery' by Enes Işık and Özgür Orhangazi in (2022) Industrial and Corporate Change comments
Pharmaceutical firms are highly profitable due to high markups enabled by high drug prices. This is justified by the argument that high profits provide incentives for innovation and help fund high research and development (R&D) costs. We investigate the link between past profitability and drug discovery for large publicly-listed pharmaceutical firms between 1980 and 2018. Our sample includes 118 firms with 2534 firm-year observations and in terms of sales corresponds to 55% of the global spending on drugs. By merging three data sets on firm financials, new patent applications, and new drug approvals, we show that pharmaceutical firms’ markups and profitability are consistently higher than average nonfinancial firm profitability, with secularly increasing trends since 1980. Whereas R&D spending has also increased, the number of new drug approvals has not increased at the same pace and the productivity of R&D spending has been declining. In statistical analysis, we fail to identify any strong positive relationship between profitability and new drug discovery. Results are broadly in line with the earlier findings of research on the pharmaceutical industry and provide a contribution to the discussion on the link between profitability and innovation as well as on formulating policies for increasing drug innovation and ensuring the provision of essential drugs while keeping their costs low.
The authors argue
The Covid-19 pandemic once again put the pharmaceutical industry under the spotlight. While developing a number of vaccines in a historically short time span was recognized as an extraordinary achievement and the perception about pharmaceutical firms turned “from greedy patent exploiters to the saviors of humankind,” 1 some were quick to point out the essential role of public funds and technology behind this success2 and how monopolization of the vaccine production through patents decreases the overall social welfare of the world population.3 In fact, profitability, productivity, and innovation capacity of the pharmaceutical industry have long been subject to detailed investigations and controversy. The recent body of research suggests that it has consistently been among the most profitable industries (Spitz and Wickham, 2012; Ledley et al., 2020), while, at the same time, it is one of the most research-intensive industries measured by research and development (R&D) spending and the number of patents (Rikap, 2021: 99). However, despite high profitability and high R&D spending, a productivity crisis has been affecting the industry as indicated by a decline in pharmaceutical innovation (e.g., Munos, 2009; Paul et al., 2010; Pammolli et al., 2011; Khanna, 2012; Scannell et al., 2012; Scannell and Bosley, 2016), which, according to some, is due to the increased financialization and shareholder value focus of the industry (Montalban and Sakınç, 2013; Lazonick et al., 2017; Tulum and Lazonick, 2018). The high cost of drugs in the USA has also led to a criticism of the high markups of the industry (Kesselheim et al., 2016), while others defended the high profits on two grounds: it gives incentives for innovation and helps pharmaceutical firms recoup high R&D costs to continue investment in R&D and innovation (e.g., DiMasi et al., 2003, 2016). Yet, these grounds have also been challenged as it has been argued that most of the new drugs that come to the market are not invented by the large and highly profitable pharmaceutical firms but by smaller labs and through partnerships with publicly funded research labs (Jung et al., 2019; Rikap, 2021).
We focus on the profitability and productivity of large pharmaceutical firms by combining and analyzing three different data sets on firm financial statements, patents, and new drugs approved by the Food and Drug Administration (FDA). We specifically focus on the link between profitability and innovation as measured by new drug approvals. Our analyses reveal four things: First, large pharmaceutical firms indeed charge higher markups and earn higher profits compared with the average markups and profitability of the rest of the nonfinancial corporate sector; and both rates have significantly increased over time. Second, while it is true that they devote a higher share of their profits to R&D, this share has declined in the late 2000s and only recovered to its previous high after the mid-2010s, whereas payments to shareholders have been taking up a much larger share of pharmaceutical firms’ profits. Third, even though the total number of patents filed by the pharmaceutical firms has significantly increased, new drug or biologics license approvals, especially ones constituting highly innovative forms have slowed down and R&D productivity measured in terms of drug innovation has been declining. Fourth, firm-level statistical analyses show no evidence of a positive relationship between profitability and drug innovation. These results are broadly in line with the earlier findings of research on the pharmaceutical industry and provide a contribution to the discussion on the link between profitability and innovation as well as on formulating policies for increasing drug innovation, ensuring the provision of essential drugs, while keeping their costs low.
2. Profitability and innovation
The pharmaceutical industry is perhaps one of the most researched industries. There is a voluminous literature in economics, business, and finance investigating various dynamics of the industry. While we will not attempt to present yet another review of this literature (for a recent review of the literature, see Lakdawalla, 2018), it is important to highlight that a central question regarding the industry has been the link between its high profitability and innovation capacity. This is because the pharmaceutical firms are among the most profitable in the nonfinancial corporate sector and their business model essentially depends on continuous innovation. A number of recent studies compare the profitability of large pharmaceutical firms with the rest of the nonfinancial corporate sector and find that pharmaceutical firms’ profitability has been significantly higher than average profitability (e.g., Spitz and Wickham, 2012; Ledley et al., 2020). This high profitability has been accompanied by high R&D spending and a large number of patents produced (Rikap, 2021: 99). The high markups and profitability of the industry drew criticism, especially because of the high costs of drugs in the USA (Kesselheim et al., 2016).
It has generally been argued that the monopoly rents arising from patent protections and the resultant high profits are necessary rewards for high risk-taking. Innovations that provide monopoly rents and high profits will generate larger funds to further invest in R&D and for further innovation. These arguments are reminiscent of Schumpeter’s (1942) two types of innovative regimes. The first one, Mark 1, is the entrepreneurial regime that is mostly dominated by small innovative firms; and the second one, Mark 2, is the regime where innovations are mostly carried out by large established firms While the former is referred to as “creative destruction”, the latter is referred to as “creative accumulation.” In the latter, the R&D efforts of the large firms are sustained by the high profits of the previous periods that help finance innovative activities. Along these lines, Nordhaus (1969) argues that investments in innovation increase with high expected profits from innovation. Hence, the high profitability of the pharmaceutical firms is defended. First, on the ground that the monopoly rents that are behind the high profits generate incentives for taking risks and innovating. Second, since not all R&D activity results in profitable innovation, high profits are also seen as necessary for recouping these high R&D costs (e.g., DiMasi et al., 2003, 2016).
There has been a number of empirical studies looking at profitability, cash flow, and R&D relationship for pharmaceutical firms. For example, Scherer (2001) finds that short-term deviations in profitability predict R&D expenditures, while works such as Grabowski (1968) and Grabowski and Vernon (2000) find that cash flow is an important determinant of R&D expenditures. However, as Lakdawalla (2018: 415) also notes most of this literature has not been clear whether the explanation relies on a financial constraints argument or a profitability argument. Yet, a number of recent studies point out that the industry has been suffering from a productivity crisis as revealed by the decline in pharmaceutical innovation (e.g., Munos, 2009; Paul et al., 2010; Pammolli et al., 2011; Khanna, 2012; Scannell et al., 2012; Scannell and Bosley, 2016). Focusing on this productivity crisis, Montalban and Sakınç (2013), for example, emphasize that the business model of the pharmaceutical industry in the USA has historically been based on “the exploitation of monopoly rents of innovation” and was supported by large amounts of public funding of basic research and strong patent protections. (p. 992). They go on to argue that a large part of this productivity crisis is due to increased financialization and shareholder value focus of the industry (Montalban and Sakınç, 2013; Lazonick et al., 2017; Tulum and Lazonick, 2018). In fact, some recent works argue that the existing innovation models of the pharmaceutical industry not only lack directionality to meet key needs but also lead to inefficient collaboration (Mazzucato and Li (2021: 39).
Another significant challenge to the argument about profitability and innovation is that most of the new drug innovation does not come from highly profitable, large pharmaceutical firms but from smaller labs and/or publicly funded research labs (Jung et al., 2019; Rikap, 2021). In fact, according to this argument, large pharmaceutical firms profit from the marketing of the innovations that are due to small labs and/or publicly funded research labs.
In the light of these discussions on the link between profitability and innovation, we ask in the following sections whether it is possible to empirically identify a link between profitability of the large pharmaceutical firms and their drug innovation.
