Pharmaceutical R&D

by on August 5, 2009 at 7:05 am in Economics, Medicine | Permalink

In an over-the-top post Megan McArdle goes all Xena warrior princess on Ezra Klein and Jerry Avorn.  I especially liked this bit: Here's Avorn on why we need not worry that regulating drug prices will reduce innovation:

There are a couple reasons that this is a specious argument. One is that according to their filings with the SEC, the drug companies only spend about 15 cents of every dollar on research and development. That's compared to more than 30 cents in administration and marketing and more than 20 cents on shareholder equity. As an investment in R&D, I think any venture capitalist would say a company spending 15 percent on research is not a robust innovation engine.

and here is McArdle swinging the sword of truth:

This makes about as much sense as saying that Dr. Jerry Avorn cannot be that smart because his brain only weighs about three pounds. Presumably, you can't be really smart–really innovative–unless your brain is at least 30 percent of your body weight!

This is obviously ludicrous–so why would Dr. Avorn say it about an R&D department? Like your brain, the R&D department is part of a complex system that does a lot of important stuff. You can argue that the R&D department is the most important part of a company, not least because it couldn't survive long without it. I think the same thing about my brain–but I'd still be just as dead without my liver. You certainly can't prove anything about my effectiveness as a journalist by pointing out that [my brain] weighs less than my bones. So how big should a "brain" be? Hard to say. But let's look at some companies that are generally recognized as pretty innovative, and their R&D as a percentage of revenue:

Apple:  three cents out of every dollar

Google:  ten cents out of every dollar

Intel:  fifteen cents out of every dollar

Genzyme (innovative biotech startup!):  sixteen cents of every dollar

US Government:  three cents out of every dollar

I can assure Dr. Avorn that any venture capitalist would be happy to invest in these hidebound laggards who haven't had a new idea in centuries. The first few, anyway.

By the way, I liked Jerry Avorn's book Powerful Medicines (see also here) but I thought it was weak on economics, a fact which really shows in this interview (he does make a few good points about comparative effectiveness research). 

Zamfir August 5, 2009 at 7:43 am

The interest paid by those respective organizations suggest that investors are especially happy to invest in the last one.

ogmb August 5, 2009 at 7:50 am

I can assure Dr. Avorn that any venture capitalist would be happy to invest in these hidebound laggards who haven’t had a new idea in centuries.

Uh no, Ms. McArdle. Venture capitalists invest in pre-IPO startups, not established companies.

Willie August 5, 2009 at 8:30 am

Very smart words from Acorn.

In fact, I can’t understand why he doesn’t apply his superb logic to other markets.

It’s simply absurd that we have many supermarkets competing to sell food. Did you know that 30% of the price of food comes from the marketing costs associated with selling?

The manufacturers and retailers of food all needlessly waste money on fancy advertising, engaging in unproductive dog-eat-dog competition.

Not to mention that they selfishly return dividends to their shareholders. All paid for by us poor consumers!

Wasteful competition, and unreasonable profit margins are driving up the cost of food.

What we need to do, is fold all the supermarkets into a single entity. This way, we could cut the cost of food for buyers by at least 30% – saved by eliminating needless competitive advertising. This saving wouldn’t be the only benefit, we’d also reduce the cost further due to reduced adminstrative costs as a result of the better economies of scale of having a single, efficient company retailing food.

y81 August 5, 2009 at 9:08 am

It depends on what your standard is, but certainly Ms. McArdle isn’t “over the top” compared to the sorts of things Paul Krugman or Brad DeLong writes. (As when Prof. Krugman called Greg Mankiw “remarkably ignorant.”) Maybe university professors aren’t subject to the normal rules of etiquette?

Noah Yetter August 5, 2009 at 9:51 am

Well it makes no sense to be the only country not regulating drug prices. None.

Actually it makes perfect sense. It is only because American prices are not controlled that other nations have the luxury of doing so.

When price controls affect the relevant market scope, they fail at their intended purpose every single time, and have failed every single time in recorded human history, and will fail every future time they are tried.

charlie August 5, 2009 at 10:06 am

I’d argue that both Apple and google heavily underinvest in R&D. Apple learned from their mistakes in the 1980s and keep their R&D cheap, which is why they are using a 20 year old OS. Google, well, who knows what they are doing — it is all on the spare time of their brilliant engineers, no? And I doubt those generous pay packages are counted as R&D. The US numbers seem a bit low and may not include military R&D.

TGGP August 5, 2009 at 10:33 am

Alex, doesn’t your point about distributional effects not increasing social welfare conflict with Megan’s defense of marketing costs?

Nate August 5, 2009 at 11:15 am

Couldn’t the patent system be considered the initial market distortion?

Doc Merlin August 5, 2009 at 11:24 am

@ Charlie: “The US numbers seem a bit low and may not include military R&D.”

Actually they do, and we are among the top nations in R&D expenditure.

R&D typically gets a tiny percent of the budget EXCEPT for medical companies which typically have the highest R&D expenditure of just about anyone.

Tracy W August 5, 2009 at 12:02 pm

Why is this true? Why wouldn’t companies cut down on less essential parts of their business (advertising, employee salaries, lobbying to prevent bargaining for drug prices :) instead of R&D?

Well, to take a mad, wild guess, because they’re not less essential?
If the company could cut down on employee salaries without losing employees or a loss in morale causing a drop in productivity, wouldn’t it already have done that?

Advertising is rather essential because if no one knows if your product exists you’re not going to sell much of it. Note that politicans spend a lot of money and time on advertising in the hope that people will vote for them.

I am not sure what you mean by lobbying to prevent bargaining for drug prices, but as long as drug companies risk being adversely affected by laws they have a financial interest in participating in the political process. Being driven to bankruptcy by an adverse regulation is just as bad as a bankruptcy as if you let costs exceed revenues, or the finance department forgot to pay taxes, or all the other ways of going bankrupt.

spencer August 5, 2009 at 12:59 pm

For 30-40 years the US government has been the biggest single buyer of drugs and has invested heavily in basic research for drugs.

The system has worked although innovation or the number of new drugs has slowed sharply in recent years even though there has been no big change in the returns drug firms enjoy. They are still one of the most profitable economic sectors. So maybe the thesis that drug innovation is dependent on drug profits is less then compelling.

But never mind that point, She is making an argument that suddenly the government will change its policy and sharply cut the price drug companies receive. If that is true innovation and developmen of drugs probably would suffer. I do not know of anyone that seriously disputes this.

But where is the evidence that the government is planning on doing what she claims?

It seems to be a strawman made up by the right wing that the government is planning on cutting drug prices.

Where is the evidence that the left is preparing to do this?

Megan McArdle August 5, 2009 at 1:21 pm

Spencer, the Obama administration and the Democrats in Congress have been pushing the idea of letting Medicare “use its bargaining power” to negotiate for pharmaceuticals–which means pushing down the cost of drugs hugely.

ed August 5, 2009 at 2:02 pm

“drug companies only spend about 15 cents of every dollar on research and development. That’s compared to more than 30 cents in administration and marketing and more than 20 cents on shareholder equity”

What does that even mean? Shareholder equity is a balance sheet item, R&D and SG&A are income sheet items. One is a stock, the other a flow. Plus, shareholder equity is a residual. This guy knows less than an intelligent MBA student. People who have obviously never taken an accounting class shouldn’t use accounting numbers in their arguments.

Joe August 5, 2009 at 2:07 pm

Megan,

Does your employer use its purchasing power to push down its costs? If it has shareholders it has to. Why should anyone else be any different?

Apostate,

You can only do medical reserach on most people; you cannot do outcomes research on one individual. Most people will respond well to any statin chosen, and in teh aggregate reduce MI/CV eevents (this has been proven). It has also been proved that to prevent 1 event you need to treat 100 people…

Andrew August 5, 2009 at 6:23 pm

“Does your employer use its purchasing power to push down its costs? If it has shareholders it has to. Why should anyone else be any different?”

First, I think most businesses are moving from the adversarial stance towards a win-win approach to supplier relationships. Second, her employer is not the government. Third, what if the government goes to negotiate on drug prices and the drug company says “No”? This is what doctors are saying to sub-profitable medicare reimbursements. What is important here is not the size of the government, but the size of the drug companies.

“I am not a big fan of government efficiency but I think they do better than 15 cent on the dollar.”

Drug companies are not R&D shops. They are compliance and marketing business that need to do R&D because their products have limited life cycles.

With a lot of these things, people stumble upon mature industries and say to themselves, “this doesn’t look that hard to do, we’ll have the government do it.” They also cherry-pick their time periods. For Merck and Pfizer, it seems revenues have gone down and R&D spending has nearly tripled since 1999. When the pipeline is full, it makes sense to spend a greater proportion on marketing. It also makes sense that such a business needs to make money while the sun is shining. There is a limit to the results they can get for R&D. For the trailing 12 months, it looks like PFE spent about 17% and MRK 22% out of revenues(!). And, if I didn’t make that clear, that was REVENUES(!!!). Think about that.

He says drug marketing could be done in universities instead of drug makers. Where are all the grad students going to work after they get their degrees? Anyway, it is plausible, but the ability for drug companies to do it is demonstrated.

He complains that a large part of drug company innovation comes from buying smaller companies. Then he says that drug development requires capital but that’s okay, because small companies demonstrate capital is available. I suppose the venture capitalists are surprised when drug companies buy them out.

People are complaining that drug companies don’t do research. They collectively do more research than the government. Then people complain that the have too high marketing costs. Those are the costs they need to spend to make money. Don’t you think they’d prefer not to spend the money? People complain that the prices are too high, but the government choose to pay.

mulp August 6, 2009 at 12:39 am

Google spends only 10% on R&D?

What are they spending money on? People who type up the responses to my queries?

According to an article reporting on google’s cost cutting:
“But Google still plans to spend money on research and development, and is setting aside 18% of its budget in that area. That’s about the same percentage as in the past year.” — “Google cuts contractors and employee perks” Posted Jan 08 2009, 02:06 PM by Kim Peterson

But how much googling is R&D? for me its easily 25% or maybe 50% depending on where draw the line.

dkahn August 6, 2009 at 7:36 am

Riccardo – I thought that it was the other way around. The U.S. taxpayers pay boeing for R&D and boeing uses that knowledge on their commercial products.

Andrew August 6, 2009 at 11:52 am

To be more clear, a customer-supplier relationship for a purchase agent buying sugar is different than someone buying routers, drugs, etc. People sound like they are talking about the “pricing power” of government as if drugs are pure commodities. They aren’t. The government makes sure of it. Then, after patents run out, they are (more) commoditized as generics. Yes, me-too drugs are annoying, but it’s not clear to me that the drug companies are not simply financing their future successes.

As a budding researcher, I have a great deal of respect for the people who can actually finish as opposed to just bumping their gums all day. If drug companies don’t “finish” they don’t get paid. Here’s an interesting comment on what the drug companies are doing. They are not supposed to do basic research, but oftentimes the basic research provided by public sources is not of much value, or of negative value.

http://pipeline.corante.com/archives/2009/07/20/amyloid_in_trouble.php

Eric H August 6, 2009 at 11:57 pm

“Megan, Does your employer use its purchasing power to push down its costs? If it has shareholders it has to. Why should anyone else be any different?”

Somehow I doubt that Megan’s employer is a the legal monopsony for economics writers.

jonahClint May 22, 2010 at 8:23 am

We must not worry that regulating drug prices will reduce innovation because when a drug like Metronidazole becomes public for production, the company making in will have to develop new drugs to preserve it’s income.

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