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The Economics of Pharmaceutical Research and Development: Investment Models, Capital Market Imperfections, and Policy Considerations

Vernon, J. A. (2001). The Economics of Pharmaceutical Research and Development: Investment Models, Capital Market Imperfections, and Policy Considerations. (Unpublished Doctoral thesis, City, University of London)


Pharmaceutical research and development (R&D) is the scientific process by which new medicines are discovered, developed, and brought to market. The social benefits of innovative new medicines are, and have been, enormous. In fact, few other health care technologies have improved the social welfare of the world’s population as much, and as profoundly, as pharmaceuticals have. For example, breakthrough medicines and vaccines have played a vital role in the treatment of fatal diseases. As a result, most of this century’s leading causes of death have been eliminated, and people of all ages enjoy increased life expectancy and vastly improved qualities of life (PhRMA, 2000).

Pharmaceutical R&D is also, not surprisingly, a very long and costly process. The average drug spends 14.9 years in development and costs approximately 320 million dollars to bring to market (Tuft’s Center for the Study of Drug Development 1998, DiMasi, 1991). Consequently, the pharmaceutical industry has, in recent years, consistently ranked first in R&D investment intensity (the ratio of R&D to sales) among U.S. industries. Interestingly though, once the technology—and, more specifically, the vast safety and efficacy information accumulated through the R&D process—is fully established, the manufacturing costs of the pharmaceuticals are quite small compared to other manufacturing industries.

These unique characteristics of pharmaceuticals, and pharmaceutical R&D in particular, have resulted in the pharmaceutical industry being the focus of a great deal of political attention in recent years. This has been especially true given the perceived high cost of prescription medications —especially in the United States. Indeed, real pharmaceutical prices have been growing steadily over the past decade (U.S. Statistical Reports 1990-1999). As a result, there has been a pressing need, both political and academic, to better understand the economics of pharmaceutical R&D—the benefits, the risks, and the costs.

Consequently, the aim of this thesis will be to investigate, both theoretically and empirically, the economics of pharmaceutical R&D investment. As such, the main body of our research will focus on the firm R&D investment decision—with a particular focus paid to the role played by internal cash flows. Specifically, it will be hypothesized that, because of the unique characteristics associated with pharmaceutical R&D, capital market imperfections exist in the markets for external R&D finance. This, in turn, it will be argued, results in firm cash flows having a lower cost of capital relative to external debt and equity. Hence, a positive relationship is expected to exist between firm cash flows and firm R&D investment levels. This hypothesis, which runs contrary to classical investment theory—where internal and external capital are considered perfect substitutes (Miller and Modigliani 1958)—will be shown to have important policy implications.

The thesis is separated into a background section, a theoretical section, and several empirical sections. The background section will review the clinical and economic characteristics of the pharmaceutical R&D process, and discuss the major research findings in this area.

Next, the theoretical section will review the literature on capital market imperfections and develop, from sound microeconomic principles, a framework from which the pharmaceutical R&D decision may be analyzed. This section will demonstrate why, theoretically, cash flows are expected to exert a positive influence on pharmaceutical R&D investment.

Lastly, the empirical sections will estimate several models of R&D investment using recent data from 60 of the world’s leading pharmaceutical firms. These models, which employ several variables designed to measure a firm’s internal cash flow, will be used to test our hypothesis that cash flows are an important determinant of pharmaceutical R&D investment. Models will be estimated over multiple samples of firms and time periods.

Our general findings from this research will reveal that cash flows are a very significant determinant of pharmaceutical R&D investment. This is the case independent of the sample of firms considered or the time period studied. We found that the coefficient estimates for the cash flow variable ranged from 0.08 to 0.27, depending on the sample and model specification. This indicates, based upon our general model specification, that a $1 decrease (increase) in cash flows will result in an approximate $0.08-$0.27 decrease (increase) in firm R&D investment.

In addition to testing the capital markets imperfections hypothesis, investment models were also developed to address the important public policy of issue prescription drug price controls in the U.S. This has been a particularly controversial political topic in recent years. This section will use a modified version of our investment model and estimate the impact of a new U.S. prescription drug price control policy. We will demonstrate that such a policy can be expected to result in an approximate 10% to 30% decline in R&D investment.

Throughout the course of the aforementioned research, we will also investigate several other related issues. For example, in the context of our general R&D investment model, we will consider the issues of structural change, simultaneity, and causality

Publication Type: Thesis (Doctoral)
Subjects: H Social Sciences > HG Finance
R Medicine > RA Public aspects of medicine
Departments: School of Policy & Global Affairs > Economics
School of Policy & Global Affairs > School of Policy & Global Affairs Doctoral Theses
Doctoral Theses
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