Pharmaceutical profits and the discovery of new medicines. (Pfizer forum).(adapted from Health Affairs, September/October 2001)(Brief Article)

Since the late 1950s, when the Kefauver Committee investigated the business practices of U.S. pharmaceutical companies, representatives of that sector have argued that its profits are an important stimulus to, and source of funding for, research and development -- which in turn leads to a stream of health-enhancing new products. Although the argument is plausible on its face, quantitative evidence on the robustness of the linkage has been scarce. This article reports the results of a recent data analysis that yields surprising new insights on the connection between pharmaceutical profits and innovation.

Profitability and investments in R&D can, in principle, be linked in three rather different ways. First, successful R&D leads, with long and variable lags, to new products, which, depending upon their reception in the market, can add greatly to company profits. Second, the profits earned by a company serve as a source of funds to support R&D investment, and some managers are known to set R&D budgets using rules of thumb emphasizing an indicator of current cash flow or sales. Third, managers' expectations of future profit opportunities can exert a demand-pull influence on R&D investment.

In a recent study, I analyzed R&D outlays and profits at the aggregated industry level, using U.S. Census Bureau data on pharmaceutical manufacturing plants' gross margins -- i.e., the surplus of revenues over in-plant production costs available to cover R&D costs along with depreciation, marketing costs, central office costs, debt service costs, income taxes, and net profits.

The growth rate of the pharmaceutical sector's deflated gross margins was 4.23 percent per year -- much lower than the 7.51 percent growth rate found for R&D outlays. The disparity of growth rates implies a likely slackening of R&D growth rates in the future. If R&D were covered solely by domestic gross margins, continuation of growth trends experienced since 1962 would mean that R&D outlays would exceed gross margins in 2025. To be sure, profits from overseas sales also help to repay R&D costs, but since the United States is the largest single market for U.S. drug companies' products, retardation of R&D growth rates seems likely in the long run.

Both R&D investment and the pharmaceutical sector's gross margins exhibit long swings around their exponential time trend. But the degree of coincidence between ...