The Economics of the Pharmaceutical Sector: Innovation, Competition, and Patent Policy
The pharmaceutical industry plays a crucial role in developing medicines that can save lives and enhance the quality of those lives. The industry is characterized by a complex mix of market forces, regulations, and legal precedent that define competition, pricing, and, ultimately, patients’ access to drugs. This essay examines how economic factors and patent policy interact to shape competition between brand-name and generic drug manufacturers.
Patents and Market Exclusivity
Given the substantial investments and risks involved in drug development, patents have come to play a prominent role in the pharmaceutical-industry business model. Patents provide their owners with the power to “exclude others from making, using, offering for sale, selling, or importing into the United States the invention claimed.” Typically, patent protection lasts for 20 years—a time limit that is set by statute. However, in the pharmaceutical industry, several years of that patent term are usually consumed by the clinical trial and regulatory review process. As a result, most new drugs have 12 to 15 years of effective protection remaining by the time they reach the market. During this time, the drug manufacturer has no direct competitors and can collect above-market returns as a government-protected monopolist.
In exchange for market exclusivity, patents are published to expand the intellectual commons by including a written description of the invention so that any person skilled in the art can understand the invention. Patents are not meant to be permanent monopolies; they disclose ideas for others to expand upon and potentially create competing products. In the pharmaceutical industry specifically, generic drug manufacturers play a key role in challenging patents and injecting competition into the marketplace.
Drug Development and Market Structure
Bringing a new drug to market is both costly and time-consuming. In 2023, the FDA approved 55 new drugs (consistent with the average over the last five years of 53). Pharmaceutical companies invest billions of dollars to identify new drug candidates, followed by extensive clinical trials to prove safety and efficacy as required by the U.S. Food and Drug Administration (FDA). The pharmaceutical industry spent $83 billion on research and development in 2019. Adding to this cost, drug development can take 10 to 15 years from initial discovery to regulatory approval.
For these reasons (in addition to failures during clinical trials), relatively few new drugs make it all the way through the pipeline to approval; in fact, only 12 percent of the drugs that enter clinical trials are ever approved by the FDA. Consequently, pharmaceutical companies are constantly in pursuit of the next “blockbuster” drug (annual sales of $1 billion or more) to recoup their broader investments in research and development.
Although patents may provide temporary monopolies on specific drugs, large pharmaceutical companies compete with one another to develop new drugs targeting the same diseases or biological pathways. In this light, as one might expect, being first-to-market with a new therapy can provide significant market advantages. Companies also attempt to identify new indications for their products to expand patient populations. Pricing and formulary placement of similar drugs are also competitive, and mergers and acquisitions are often undertaken to bolster market share and expand product portfolios.
Product Lifecycle Management and Competition Among Brands
When a patent expires, companies face a new competitive threat known as a “patent cliff,” where lower-cost generic rivals can enter the market and drive prices down to competitive levels. Once the market for a blockbuster drug becomes competitive, revenues may fall by as much as 79 percent. This dropoff in earning power poses a major threat to pharmaceutical companies’ revenues, particularly when the drug goes off patent—indeed, analysts project that more than $200 billion in annual pharmaceutical revenue is at risk between now and 2030 due to expiring patents and the threat of competition.
To navigate patent cliffs and maximize potential revenues, pharmaceutical companies typically engage in product lifecycle strategies that seek to extend market exclusivity and protect monopoly sales for as long as possible. These strategies may include developing new formulations or delivery methods for existing drugs, finding new indications or uses for approved therapies, or combining multiple drugs into one new product. While some of these modifications may offer useful innovations that benefit patients, others are simply evergreening tactics with minimal therapeutic value that aim to extend a company’s monopoly position.
The Generic Drug Industry Emerges
Prior to the 1960s, most drugs were branded and protected by patents. To enter the market, generic manufacturers were required to submit full New Drug Applications (NDAs), basically duplicating the trials of the initial branded drug, which was costly and time-consuming. Introduced in the 1960s, “Paper NDAs” (new-drug applications) created a pathway for approval based on published literature demonstrating a drug’s safety and efficacy without new clinical trials. However, this approach was limited to drugs backed by extensive published research. More generally, bringing generic drugs to market was significantly restricted: the process was inefficient and costly, and patent challenges were difficult and risky for generic manufacturers. Additionally, through the 1970s, many states had anti-substitution laws that made it illegal for a pharmacist to use generic alternatives to brand-name prescriptions.
The modern generic drug industry was born in 1984 when Congress passed the Hatch-Waxman Act, officially known as the Drug Price Competition and Patent Term Restoration Act. In exchange for additional market exclusivity for brand-name drugs, generics were granted an abbreviated new-drug application (ANDA) that significantly lowered the cost and time required to enter a given drug market. The Act also provided structural incentives for generic manufacturers to challenge patents, including a 180-day period of exclusivity for the first generic-drug manufacturer to invalidate a patent successfully.
The ANDA process greatly streamlined the approval of generic drugs. Unlike the extensive testing required for new drugs, generic-drug manufacturers needed only to demonstrate the bioequivalence of their product to an already approved brand-name drug, meaning that
[t]he rate and extent of absorption of the drug [did] not show a significant difference from the rate and extent of absorption of the listed drug when administered at the same molar dose of the therapeutic ingredient under similar experimental conditions in either a single dose or multiple doses….
This new approval process revolutionized the pharmaceutical industry, paving the way for generic competition and more affordable medication options. However, advances in medicine brought new challenges, as next generation biologic drugs did not quite fit into the generic drug model.
Generics 2.0: Biosimilars
Rapid advances in biotechnology ushered in the next generation of medicines—biologics—which began entering the market in the 1980s. The first biologic to receive FDA approval was recombinant human insulin in 1982. Since that time, the FDA has licensed nearly 900 biologic products. Unlike traditional small-molecule drugs, which are simpler in elements and structure, biologics are larger and more complex and are often derived from living cells, making them difficult to replicate exactly. Consequently, biologics pose unique challenges for creating generic equivalents (known as “biosimilars”). The regulatory pathway for FDA approval of biosimilars is unclear because the Hatch-Waxman Act was designed to address small-molecule generics rather than the larger, more complex variety.
To handle this issue, Congress passed the Biologics Price Competition and Innovation Act (BPCIA) of 2009 in order to create a pathway for the approval of biosimilars that was as efficient and well-defined as that for small-molecule drugs. In this context, the FDA defines a biosimilar as “a biological product that is highly similar and has no clinically meaningful differences from an existing FDA-approved reference product.” It took until 2015 for Zarxio, the first biosimilar drug, to be granted approval. Today, 57 biosimilars are sanctioned by the FDA.
The Role of Generic Competition
The introduction of generic and biosimilar competitors at the time a patent expires is the primary driver of price reductions and expanded access in pharmaceutical markets. Not surprisingly, then, since passage of the Hatch-Waxman Act, the modern U.S. generic-drug market has undergone a major transformation. In 1984, the generic-drug market was small, with generics accounting for only about 19 percent of prescriptions filled. In contrast, while generic and biosimilar drugs account for approximately 90 percent (by volume) of all prescriptions dispensed in the United States today, they account for only about 17.5 percent of total prescription-drug spending. Conversely, brand-name drugs, while comprising only 10 percent of prescriptions by volume, account for roughly 80 percent of total prescription-drug spending.
How Patents Can Impede Market Competition
Competition between brand-name manufacturers and generics is governed by the patent system. While patents play an important role in incentivizing pharmaceutical innovation, they also can be used strategically to impede competition by delaying generic drugs’ entry into the market. Ironically, while the Hatch-Waxman Act and the BPCIA sought to expedite the entry of generics and biosimilars once a drug goes off patent, brand-name manufacturers often responded to this new drug landscape by deploying tactics designed to extend their market exclusivity well beyond the life of the original patent. While technically legal, such delays impeded the entrance of generic competitors into the market while offering little in the way of improved therapeutic value. Particular competition-thwarting practices that have drawn extensive regulatory scrutiny include evergreening, patent thickets, and product hopping.
Evergreening extends market exclusivity on popular drugs beyond the original patent term through minor modifications or reformulations in the drugs’ composition, modifications to delivery systems, or changes in dosages. For example, Revlimid, a cancer treatment developed by Celgene (now part of Bristol Myers Squibb) was originally approved by the FDA in 2005. Since then, Celgene has applied for 52 additional patents to extend its market exclusivity, including approvals for new indications, new formulations and drug combinations, and patenting various ancillary aspects of manufacturing the drug. This extensive use of evergreening strategies not only delayed full generic competition, but also kept prices high.
Patent thickets are also used to stave off competition. Building a patent thicket involves filing numerous overlapping patents on various aspects of a drug that make it difficult for generic competitors to “pierce the thicket” in order to enter the market. For example, AbbVie has used patent thickets and other tactics to extend market exclusivity for its blockbuster drug Humira to more than 20 years. All told, AbbVie applied for 257 patents on Humira, of which 130 were issued—and 90 percent of these were issued after FDA approval. While the original patent was approved in 2003, biosimilars did not reach the U.S. market until 2023.
Finally, product hopping involves shifting patients to reformulated versions of a drug just before the patent expires in order to prevent generic substitutions. AstraZeneca’s drugs for treating gastroesophageal reflux disease (GERD) provides a good example of this patent-life-extending strategy. Originally, AstraZeneca marketed Prilosec (omeprazole), which became a popular drug for treating GERD. However, as the patent expiration for Prilosec approached in 2001, the company developed and patented a new version of the drug with a slightly different isomer profile. The company then launched Nexium (esomeprazole), which netted $48 billion in the first 10 years after its launch despite only minor clinical differences between the two drugs. Furthermore, in order to provide additional protection, AstraZeneca proceeded to build a patent thicket, giving the new drug 97 protections from 16 patents.
The bottom line: these strategies can significantly delay generic competition, thereby keeping drug prices elevated for years beyond the intended patent term.
Conclusion
Competition in the pharmaceutical industry is shaped by a complex interplay among market exclusivity, the entry of generic competitors, and ongoing innovation. Unfortunately, the current pharmaceutical patent system has been increasingly exploited in ways that stifle competition and keep drug prices artificially high rather than living up to the patent system’s original promise of promoting innovation.
As a result, policymakers continue to grapple with how to strike a better balance between a patent system that adequately rewards innovation while also ensuring timely generic and biosimilar market entry and, consequently, more affordable drug prices. Possible areas for reform include stricter standards for obtaining secondary patents beyond the primary patent on the active ingredient, limits on patent-term extensions, and measures to prevent patent-system abuse through tactics like evergreening and product hopping. Additionally, streamlining the FDA’s approval process for generics and biosimilars could help to bring much needed competition to artificially constrained monopolistic markets.
A Broken Patent System and High Drug Prices
R Street explores how economic factors and patent policy interact to shape competition between brand-name and generic drug manufacturers. We analyze the public policy landscape, regulatory agencies, proposed reforms, and how the broken system can be fixed.