Reference no: EM132300128

The pharmaceutical industry is highly profitable. Between 2000 and 2008 the average rate of return on invested capital for firms in the industry was 22.6 per cent. Put differently, for every Kwacha of capital invested in the industry, the average pharmaceutical firm generated 22.6 per cent of profit. This compares with an average return on invested capital of 15.9 per cent for firms in the software industry, 11.9 per cent for publishing firms, 11.2 per cent for retail firms, 6.6 per cent for steel firms, and 1.8 per cent for firms in the air transportation industry. The high profitability of the pharmaceutical industry can be best understood by looking at several aspects of its underlying economic structure. First, demand for pharmaceuticals is strong and has been growing steadily for decades. Between 1990 and 2003 there was annual increase in spending on prescription drugs in Zambia. This strong growth was driven by favourable demographics. As people grow older, they tend to need and consume more prescription medicines; furthermore, it has been increasingly possible for people in rural areas to access drugs at health centres which have been established in practically all districts of Zambia. Second, successful new prescription drugs can be extraordinarily profitable. Lipitor, the cholesterol-lowering drug sold by Pfizer, was introduced in Zambia in 1997, and by 2003 this drug had generated a staggering K9.23 billion in annual sales for Pfizer. The costs of manufacturing, packing, and distributing Lipitor amounted to only about 10 per cent of revenues, or under K1 billion. Pfizer spent close to K400 million on promoting Lipitor and perhaps as much again on maintaining a sales force to sell the product. That still left Pfizer with a gross profit of perhaps K7 billion. Since the drug is protected from direct competition by a twenty-year patent, Pfizer has a temporary monopoly and can 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 per cent within a year-but that is some way off. 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, the high costs and risks associated with developing a new drug and bringing it to market constitute a formidable barrier to entry, limiting competition. Out of every five thousand 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, 3 estimates suggest that it costs some K800 million and takes anywhere from ten to fifteen years to bring a new drug to market. Once on the market, only three out of ten 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 large amounts of money on research, most of which fails to produce a product. Only very large companies can shoulder the costs and risks of doing this, and it is very difficult for new companies to enter the industry. Pfizer, for example, spent some K7.13 billion on R&D in 2003 alone, equivalent to almost 18 percent of its total revenues. In a testament to just how difficult it is to get into the industry, although a large number of companies have been started in the last twenty years in the hope that they might develop new pharmaceuticals, only one of these companies, Amgen, was ranked among the top twenty in the industry in terms of sales in 2003. Most have failed to bring a product to market. In addition to R&D spending, the incumbent firms in the pharmaceutical industry spend large amounts of money on advertising and sales promotion. While the K400 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 very difficult unless the competitor has a significantly better product. Thus promotional spending constitutes another formidable barrier to entry. In sum, patent protection that grants a temporary monopoly to some firms, high R&D costs, significant risk of failure, and high marketing costs make it very difficult for new firms to enter the pharmaceutical market. The industry tends to be dominated by large established enterprises that have the scale required to bear the considerable costs and risks associated with developing new drugs and can afford to spend large amounts of money to promote those drugs in the marketplace. Furthermore, there are some big opportunities on the horizon for firms in the industry. New scientific breakthroughs in genomics are holding out the promise 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 diabetes, hypertension, cancer, heart disease, stroke, and AIDS. But there are also some threats to the long-term dominance and profitability of industry giants like Pfizer. Most notably, as spending on health care rises, politicians are looking for ways to limit health care costs, and one possibility is some form of price control on prescription drugs. Price controls are popular in Zambia given the high levels of poverty and the persistent attitude-a hangover from the Second Republic-that government should play an interventionist role in times of crisis.