January 1, 1970 (Vol. , No. )
Nicholas Sifer Department of Defense
The answer may surprise you.
The Food and Drug Administration (FDA) plays a key role in the development of new biopharmaceutical products. In particular, the FDA provides an essential public service by orchestrating an increasingly complex regulatory approval process for licensing of safe and effective biopharmaceuticals. This regulatory process instills consumer confidence in approved marketed products. It also provides the drug’s intellectual property owner with the potential for significant pricing power and return on investment via substantial revenue generation from approved drugs. The potential revenue generation is evidenced by independent biopharmaceutical industry analysts’ annual revenue estimates of $40–50 billion or ~0.3% of U.S. nominal GDP in 2012.1,2,3 Yet biopharmaceutical industry members, advocates, and members of the public contend that the FDA regulatory process destroys business value through a combination of the high capital costs and the long duration of time to complete the process.4 Critics claim that the burden of the FDA approval process is not conducive to sustainable investment in and discovery of novel biopharmaceutical products and further jeopardizes national security.
Sustainable investment in research and development of innovative products and services supports growth of the overall market for biopharmaceuticals. Without these innovation investments, product differentiation within the overall market erodes over time and forces firms to compete on price and market share. While this helps reduce prices for consumers over the short run, it diminishes the number of products and services over the long run that contribute to personal and public health, growth of the domestic economy, and national security.
FDA Approval Process and Market Failure Mechanisms
Federal regulations provide policy makers with a broad spectrum of tools to execute national policies and laws. For example, some federal regulations, including those for biopharmaceutical products governed by the FDA, are intended to regulate consumer products to safeguard the health and safety of the general public. Other regulations attempt to control economic markets in order to remove obstacles that prevent those markets from achieving the right equilibrium price and quantity.
Unlike most other federal regulations that simply either prohibit or endorse certain actions, the FDA regulatory process to approve new biological drugs as safe and effective can be viewed as an actual service, with a unique economic supply and demand relationship. The American public demands this regulation as a public health service, and Congress primarily pays for this demand via appropriations that set the FDA’s annual budget. The FDA itself supplies this service at a quantity based on the federal appropriation amount and those allowable fees it can collect from industry under the Prescription Drug User Fee Act (PDUFA). Biopharmaceutical firms consume this service as they apply for FDA approval and execute the regulatory process. Under ideal economic conditions, the FDA’s services should spread benefits equitably amongst the consumers and suppliers while minimizing public costs and maximizing public benefits. Unfortunately, the current market for FDA services is hampered by at least two proposed market failure mechanisms that affect the larger commercial biopharmaceutical market.
First, the market for FDA regulation exhibits what economists refer to as a positive externality. A positive externality describes an economic condition in which the value of the good or service to society is greater than the value to the individual purchaser; therefore both the equilibrium price and the quantity produced are too low. The entire U.S. populace benefits by new biopharmaceutical products and services that the FDA certifies to be both safe and effective. Therefore, society stands to benefit from those increases in the supplied quantity of FDA regulatory services that result in reduced review times, higher throughput of new drug certifications, and improvements to the quality of the FDA’s regulatory services.
To illustrate this point, consider the biopharmaceutical industry’s consumption of the FDA’s services, proposed as the number of annual new biological licensing applications, over the last decade. In 2008, the FDA noted a 20% increase over the five-year average for new biological drug applications, highlighting a growing consumption of this service by the biopharmaceutical industry.5 Just three years later, however, the FDA noted that the number of new applications had dropped to the second lowest level in 10 years.6 Despite these short-term reductions in market-driven consumption, the biopharmaceutical industry continues to cite long lead times to gain FDA approval. This repeated criticism lends weight to the analysis that there is a supply bottleneck in, or otherwise underproduction of, FDA services that hampers the industry at large and leads to suboptimization of societal benefits gained from existing supply levels of FDA services.
Congress passed and has made several amendments to the PDUFA in response to growing evidence of a supply bottleneck at the FDA. PDUFA allows the FDA to charge and collect a fee from the industry applicant for each new biological licensing application. The Act does, however, place a ceiling on the total annual amount of fees collected and the level of each fee. In effect, the PDUFA reoriented market equilibrium price for FDA services, providing greater societal benefits through increased FDA services. PDUFA provides the FDA with a pricing subsidy mechanism that encourages it to supply additional regulatory services (~62% of annual budget for pharmaceutical regulation) at a higher price point then it could otherwise achieve based on Congressional Appropriations.7 Indeed, the FDA noted significant reductions in median approval times for applications after passage of PDUFA.8 However, it remains to be seen whether the current version of PDUFA provides adequate revenue ceilings to optimize the supply of FDA services to maximize societal benefits without jeopardizing the quality of service.
The second market failure that arises from the unique market for FDA regulation is the fact that the FDA enjoys a monopoly as the sole service provider. As a monopoly, the FDA has little competition to further drive down the price (in this case the quantity of resources provided given an appropriated budget) of its service. There is also no domestic peer competitor to benchmark the FDA’s performance or compare quality of service against. Despite pressure from Congress, the biopharmaceutical industry, and the general public on the FDA to achieve higher quality at reduced cost, the lack of a true peer competitor provides no other baseline for comparison and alleviates some of the pressure on the FDA to improve efficiency and reduce costs.
The combination of the two identified market failures signal that the market for the FDA’s services has not fixed at either an optimal price point or quantity supplied. This leads to lost market transactions for FDA services that should otherwise be occurring or lost social benefit derived from an increased supply of the FDA’s services. This analysis lends credence to the biopharmaceutical industry’s claim that every day lost to FDA review leads to potentially millions of dollars in lost profit.9
Quantitative financial data for the biopharmaceutical market, however, sheds a different light on the FDA’s impact on the industry. The financial figure known as Return On Investment (ROI) is a useful metric in identifying the profit a firm earns in relation to the capital it spends to achieve the profit. Focus is now shifted to particular quantitative indicators, the one-year and five-year ROI figures of the larger pharmaceutical sector to better understand if the two identified market failures have significant impacts on the financial health of the industry.
On average, firms that achieve greater than a 10% ROI (with 10% being a generally referenced breakeven point on an investment when compared to an economic figure known as the weighted average cost of capital) are considered profitable.10 A first look at the financial data for the larger domestic pharmaceutical sector reveals one-year and five-year ROI figures of approximately 19%.11 This financial performance clearly exceeds the 10% average breakeven profitability point. To put this sector’s performance in perspective, the airline sector, which largely competes on pricing rather than product differentiation, achieved a one-year and five-year ROI of 8.5% and 4.1% respectively over the same time period.11 Furthermore, the larger healthcare industry, of which the pharmaceutical sector is a subset, achieved one-year and five-year ROIs of only 9.3% and 9.9% respectively.12 Perhaps most notable in all of this is that the pharmaceutical sector remained considerably profitable over the last five-year period, most of which was spent during the global economic downturn and saw the U.S. economy dip far into domestic output gap in GDP. A one-year and five-year ROI of 19% offers a strong counterargument against critics’ claims of the FDA’s negative impact on pricing power and profit potential. In fact, the FDA’s stamp of approval may even boost profit potential due to customer and end-user preferences for independently certified safe and effective products.
The quantitative analysis indicates that the biopharmaceutical sector remains profitable even with the time and resource-intensive FDA regulatory process. An argument could even be made that the FDA may actually afford the biopharmaceutical industry with a moderate level of control over revenue generation and profit due to the public demand for certified pharmaceutical products. At the very least, the biopharmaceutical industry’s ROI and annual revenue figures suggests adequate profit levels to sustain investments into product and service innovation. These continued innovation investments allow firms to compete via product differentiation, which, unlike price competition that is common in the airline sector, is a key element of sustained growth for the biopharmaceutical industry.
The sustained growth and survival of the biopharmaceutical industry is directly tied to sustainable investment into basic research and novel product and service development. The point of view remains valid that each dollar spent on activities outside of research and development, such as funds used for FDA regulatory approval, or lost revenue from delayed approval times is a dollar lost on research to support the future of the industry and jeopardizes the health of our national security. However, the analysis presented in this paper indicates that the costs associated with the FDA regulatory process are only one side of the issue. The same regulatory cost driver also enables the biopharmaceutical industry to achieve high profitability levels as indicated by ROI figures and presents the industry with an opportunity to reinvest profits back into product and service innovation.
Looking forward, therefore, policy makers need to tread carefully and avoid sweeping cost-cutting measures solely aimed at reducing the perceived excessive costs and time associated with the current regulatory process. Arbitrary and sweeping cost cuts could jeopardize the foundation of trust that consumers and end users place in the safety and efficacy of products and services provided by the biopharmaceutical industry. The loss of this public confidence could lead to a significant collapse and consolidation within the industry. Instead, policymakers should focus on those potential obstacles that may significantly hamper industry product and revenue streams, such as domestic patent laws and medical reimbursement rates, and future cost drivers and resource bottlenecks within the FDA’s regulatory departments. A significant decline in revenues, cost growth, or resource shortages associated with regulatory activities may jeopardize private investment into innovative research.
Nicholas Sifer is a federal employee within the Department of Defense where he has served over eleven years as a chemical engineer.
1 Pharmaceutical Industry: Life Beyond the Patent Cliff, Accenture, 20 Dec 2012, www.accenture.com/us-en/Pages/insight-life-beyond-pharma-patent-cliff-infographic.aspx
2 National Income and Product Accounts Gross Domestic Product, 4th quarter and annual 2012 (second estimate), U.S. Department of Commerce Bureau of Economic Analysis, 28 Feb 2013, http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
3 Sophia Snyder, Biotechnology in the U.S., IBISWorld Industry Report NN001, pg 4, August 2012
4 Big Pharma’s gripes about the FDA, The Economist, Cancer Drugs, 1 Jul 2011, http://www.economist.com/blogs/schumpeter/2011/07/cancer-drugs
5 Trends in NDA and BLA Submissions and Approval Times, http://www.fda.gov/AboutFDA/ReportsManualsForms/Reports/UserFeeReports/PerformanceReports/PDUFA/ucm209349.htm
6 FY11 Performance Report to the President and Congress for the Prescription Drug User Fee Act, Food and Drug Administration, Department of Health and Human Services, pg 4.
7 FY10 PDUFA Financial Report, Total Costs of the Process for the Review of Human Drug Applications (FY 2010 PDUFA), http://www.fda.gov/AboutFDA/ReportsManualsForms/Reports/UserFeeReports/FinancialReports/PDUFA/ucm262850.htm
8 FY11 Performance Report to the President and Congress for the Prescription Drug User Fee Act, Food and Drug Administration, Department of Health and Human Services, pg 4.
10 Michael Ehrhardt and Eugene Brigham, Corporate Finance: A Focused Approach, 3rd Edition, South-Western Cengage Learning, 2008
11 Reuters Finance, www.reuters.com, accessed 31 Jul 13.