Market size and pharmaceutical innovation

• Author: Olivier de Mouzon,Pierre Dubois,Fiona Scott‐Morton,Paul Seabright
• Date: 01 October 2015
• Published date: 01 October 2015
• DOI: http://doi.org/10.1111/1756-2171.12113

RAND Journal of Economics

Vol.46, No. 4, Winter 2015

pp. 844–871

Market size and pharmaceutical innovation

Pierre Dubois∗

Olivier de Mouzon∗∗

Fiona Scott-Morton∗∗∗

and

Paul Seabright∗∗∗∗

This article quantifies the relationship between marketsize and innovation in the pharmaceutical

industry using improved,and newer,methods and data. Wefind significant elasticities of innovation

to expected market size with a point estimate under our preferred specification of 0.23. This

suggests that, on average, $2.5 billion is required in additional revenue to support the invention

of one new chemical entity. This magnitude is plausible given recent accounting estimates of the

cost of innovation of $800 million to $1 billion per drug, and marginal costs of manufacture and

distribution near 50%.

1. Introduction

This article quantifies the relationship between financial returns and innovation in the

pharmaceutical industry. More precisely, we estimate the elasticity of innovation (as measured

by the number of new chemical entities appearing on the market for a given disease class) to the

expected market size as measured by the spending on treatment by sufferers of diseases in that

class (and others acting on their behalf, such as insurers and governments). When governments

engage in price regulation and reduce prices for pharmaceutical treatments, the short-run effect

may be small because the innovation expenditureis already sunk. However, such regulations will

∗Toulouse School of Economics (GREMAQ,IDEI); pierre.dubois@tse-fr.eu.

∗∗Toulouse School of Economics (GREMAQ, INRA); olivier.demouzon@tse-fr.eu.

∗∗∗Yale University; fiona.scottmorton@yale.edu.

∗∗∗∗Toulouse School of Economics (IAST); paul.seabright@tse-fr.eu.

Wethank Tamer Abdelgawad,Amber Batata, Bruno Jullien, Bernard Salani ´

e, and seminar participants at Toulouse,PEPC

Paris,Imperial College London for useful comments. The statements, findings, conclusions, views, and opinions contained

and expressed in this article are based in part on data obtained under license from the following IMS Health Incorporated

information service(s): MIDASTM (1997–2007), IMS Health Incorporated. All Rights Reserved. The statements, findings,

conclusions, views, and opinions contained and expressed herein are not necessarily those of IMS Health Incorporated

or any of its affiliated or subsidiary entities. We also thank Pfizer Inc. for its center research support to IDEI. Support

through the ANR-Labex IAST is gratefully acknowledged. The statements, findings, conclusions, views, and opinions

contained and expressed herein are those of the authors only.

[The copyright line for this article was changed on 7 January 2016 after original publication.]

844 C2015 The Authors. The RAND Journal of Economics published by Wiley Periodicals, Inc. on behalf of The

RAND Corporation. This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-

NoDerivs License, which permits use and distribution in any medium, provided the original workis properly cited, the

use is non-commercial and no modifications or adaptations are made.

DUBOIS, DE MOUZON, SCOTT-MORTON, AND SEABRIGHT / 845

affect firms’ incentives to invest in discovering new treatments. The elasticity of innovation is

therefore a critical parameter to measure to evaluate the cost to society of price regulation. This

question has no definitive answer in the literature, due to a number of estimation difficulties that

we discuss below.

In this article, we contribute what we believe to be a valuable new estimate using several

improvementsto existing methods. First, we have data on the global revenuesof all phar maceutical

products over an 11-year period, as collected by pharmaceutical data provider, IMS. These

detailed data allow us to calculate an excellent measure of innovation,namely, the number of new

molecular entities released on the global market during our time period. Much of the existing

literature measures intermediate outcomes in the innovation process, such as the number of new

clinical trials or available regimens. Other literature focuses onlyon data from the United States.

Although the United States is the largest and most important national market for pharmaceutical

products (with approximately 40% of demand), revenue in other nations is large and growingand

serves as an important stimulus to innovation. Global revenue data havenever, to our knowledge,

been used in the literature to measure the response of innovation to market size yet are likely to

be an important part of the incentive for firms.

Second,we employ instrumental variables to identify the relationship between innovationand

market size. Although a large expected market size maystimulate new pharmaceutical innovation,

it may also be the case that new pharmaceutical innovation creates sales and therefore market

size. Innovation may also intensify competition between products and therefore reduces prices

and margins. Innovation and sales may therefore move together for two distinct reasons: first,

innovationcreates sales of new products and affects the revenues on existing products, and second,

sales stimulate innovation. We are interested in isolating a measure of the latter. Because of the

likely existence of reverse causality, we instrument for market size in our estimation procedure

using the worldwide number of deaths from diseases in the relevant therapeutic class, as well as

country gross domestic product (GDP).

Our estimation technique is designed to obtain unbiased estimates from censored count

data, as well as accommodating our instrumental variables strategy. We find, as theory predicts,

that market size has a positive impact on global release of new molecular entities. Our elasticity

estimate is substantially belowunity; our preferred specification delivers an elasticity of innovation

to market size of 0.25. This indicates that when a market increases in potential size by 10%, that

stimulates a 2.5% increase in the number of treatments to serve that market. The previous literature

generally finds elasticities for new drug products to be in the vicinity of 0.5, though there are

exceptions, which we will discuss below. An elasticity below one could indicate the importance

of competition in a market: as the market grows and more treatments enter, margins fall. An

alternative explanation is that the fixed costs of innovation rise steeply with market size as the

best ideas for treatments are sequentially exploited. It is also possible that the previous literature’s

use of US data meant that margins were systematically higher than in our data, and this affects

estimated elasticities.

We follow up this estimate with regressions specific to a therapeutic class. There is signif-

icant variation between therapeutic classes, and the resulting average elasticity across classes is

somewhat higher than that estimated by pooling classes.

Our conceptual framework is very simple. We assume that for-profit firms in the pharmaceu-

tical industry choose innovation projects that theyexpect to be profitable. (Of course, governments

and nonprofits may engage in, or sponsor, research driven by other goals.) Profits will be de-

termined by costs and revenues, which in turn depend on market size. Expected market size is

influenced by broadly three types of factors. First, there are factors such as demographic and

socioeconomic change, which affect the numbers of people who are likely to sufferfrom a par tic-

ular medical condition and the resources they are likely to have available to spend on alleviating

their condition. A motivating example concerning research on gout from the New York Times

(“Disease of Rich Extends Its Pain to Middle Class,” New York Times, June 12, 2009) illustrates

the incentives for R&D. “Often called the ‘disease of kings’ because of its association with the

C

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