Pharmaceuticals Industry Economics Essay

The Pharmaceuticals Industry

Part A:

There are several sources of economies of scale in the pharmaceuticals industry. The main advantage of being a large firm in this industry is the ability to manage risk better. According to Keynote (2005) it takes around ten to twelve years and 550m to bring a new drug to the market and even then only around 14% of approved drugs go on to become commercially successful. Even if a drug is successful, the company must be able to effectively exploit it before any patents expire (patents are usually granted for around 20 years (Economist, 1998)) and the market is opened up to competition. Larger firms tend to be more effective at exploiting drugs within this timeframe. The large profits realised from a few popular drugs can cover any loss made through developing unsuccessful drugs. This ability to manage risk allows large firms secure finance relatively easily.

These are the main two economies of scale in the industry but there are also other benefits to being a large firm. Firms conducting a variety of different research projects are likely to find that there are areas which overlap. This should create synergy and make researching activities more effective and therefore more profitable. As well as these industry specific economies of scale there are more generic ones e.g. the ability to bulk buy; managerial economies etc.

These economies of scale can act as a barrier to entry. Barriers to entry are factors which either make entry in to an industry difficult or prevent entry at all. Economies of scale make it very difficult for a new firm to enter an industry. One of the main benefits to being a large firm in this industry is the ability to manage risk. A small firm is more likely to concentrate on a particular area which means that if one of the drugs they are researching turns out to be unsuccessful, they could face problems. This makes it more difficult for a small company to secure a source of finance. When the other benefits of being a large firm (managerial economies, for example) are added to these factors, a new firm will find it very difficult to enter the industry. There is another type of barrier to entry in this industry: legal barriers. These legal barriers exist in the form of patents. New firms are legally prohibited from producing drugs which are similar to drugs covered by patents.

While it is still difficult to enter the pharmaceutical industry the barriers to entry are reducing. The main factor driving this change is the technology made available by new advances in biotechnology; particularly areas such as pharmacogenomics (NCBI, 2004), combinatorial chemistry, high-throughput screening and laboratories-on-a-chip. These new areas allow firms to predict which lines of research are likely to be worth pursuing and how different types of patients will react to different drugs. This has two benefits. The first is that the cost of the clinical trials required to launch a new drug is greatly reduced. It also allows firms to offer more customised drugs rather then a ‘one-size-fits-all’ approach. This should allow small firms to operate in a niche market. If successful in this niche market the firm could expand. This process could be helped by the larger firms in this industry since they are willing to pay a small firm for a good idea or promising line of research. This trend is likely to increase the competition in the industry and could lead to a large number of small to medium sized companies rather than a few large firms controlling most of the market.

Part B:

Traditionally, pharmaceutical companies have been highly vertically integrated dealing with research and development (R&D), clinical trials, manufacturing, marketing and distribution. Recent advances in technology are making this model redundant.

In the past, the economies of scale gained by these large companies were essential to operate in the industry and it was almost impossible for new firms to enter. These economies of scale are losing their importance. Advances in biotechnology make identifying lines of research which are likely to be fruitful much easier and greatly reduce the cost of conducting clinical trials. These costs are likely to fall further as these relatively new technologies develop. Small firms are particularly well suited to researching in this way. These small firms then have a number of options when deciding how to operate: they can attempt to imitate the larger companies and try to bring the drugs to market themselves; they can form joint ventures with other small firms or they can sell their discoveries to large firms in the industry.

These small firms are a new feature and are likely to cause profound changes in the structure of the industry. Instead of being involved in all stages of the production process, large firms can choose to outsource specific functions to other companies. This arrangement can benefit both companies involved. Small firms can specialise and become experts in a niche of the market. They can also utilise their resources better than a large firm since a large firm may only be able to use specialist labour or capital sporadically leaving it underemployed. Transaction cost theory (Coase, 1937) can be used to understand this process of outsourcing. According to this theory a firm should produce something itself only if the cost of producing it in-house is less than the market price for buying in the good or service. It is highly likely that most firms would find it beneficial to outsource many of their activities to specialists. Another benefit is that it is easier to track costs and assign them to specific research areas if each of the areas is being carried out by a separate firm. Outsourcing activities in this way would leave the large company free to concentrate on areas where they can add value. One of the potential disadvantages of outsourcing is that the firm will lose direct control over the activity. Formulating contracts with the outsourcing firms could also be problematic and costly. This is particularly true with regards to research since it cannot be measured easily. A firm may also lose a particular company if a rival offers them a better deal. On balance it appears that there would be a net benefit to firms engaging in outsourcing.

These changes in the industry could lead to new types of organisations being formed. The large pharmaceutical companies could become more like holding companies with a large number of subsidiaries. These subsidiaries could specialise in their chosen areas while the holding company coordinates their activities and makes sure that useful discoveries are developed and brought to market. Another possibility is that virtual organisations could emerge. These would be groups of companies with joint ventures or strategic alliances. As with the holding company model each firm would specialise in a particular area but then work with other companies to take advantage of their core competencies.

Whatever way the industry develops it is highly likely that there will be a proliferation of small to medium sized companies. This should lead to a greater level of competition in the industry which should benefit both the firms in the industry and consumers.

Part C:

The principal-agent problem is defined by Sloman (2000, pp G:13) as the problem where people (principals), as a result of lack of knowledge, cannot ensure that their best interests are served by their agents. There are many examples of this, both in everyday-life and in the world of business. Consider someone taking their car to a mechanic. If they do not understand the workings of the car then they have to rely on the advice of the mechanic. This is a problem since it is in the interest of the mechanic (agent) to get a high price and the interests of the customer (principal) pay a low price. This conflict of interest is also relevant to the pharmaceuticals industry.

As stated in part B, firms in the pharmaceuticals industry are likely to become far less vertically integrated in the coming years. This will lead to more firms engaging in outsourcing, joint ventures and strategic alliances. As was alluded to in part B, there are potential problems related to working with an outside firm. Both firms wish to maximise their profits which leads to a conflict of interests. The ‘agent’ firm will want to keep the cost to the principal as high as possible. This is not necessarily a problem if the principal company has the knowledge to evaluate what the agent is doing and whether the arrangement offers value for money. Proper contracts can also be formulated which should minimise any problems between the two firms. If however the principal firm has little knowledge of the area in question then they may be unable to devise an effective contract and the agent may take advantage and leave the principal worse off.

As well as proper contracts there are other strategies which can be employed to alleviate the problem. One way is for the principal firm to maintain a core research and development department of its own. As well as carrying out research the department could be used to evaluate potential companies to outsource to and monitor their progress. This should increase the accountability agent companies and ensure that the principal company gets a good deal. Another strategy which could be used in conjunction with the previous suggestion would be to pay the external researchers with share options instead of cash. Share options give the holder the right to either buy or sell shares at a fixed price at a fixed date in the future. This means, for example, that someone with a share option may be able to buy a share at 100p and immediately resell it at the market price of 150p. This alleviates the principal-agent problem by aligning the self interest of the principal and the agent. The more profitable the principal company, the higher the share price and the higher the value of the options. This means that external researchers would want to do what is best for the principal company. Paying in cash would not have the same effect since the researcher would be paid regardless of what happens to the profitability of the firm (assuming the firm does not go out of business). This could lead them to act in a way which is detrimental to the principal company.

As can be seen the principal agent problem is serious and must be given careful consideration. The problem should not, however, deter firms from engaging in outsourcing. If a correct mix of strategies is employed, then the size of the problem will be negligible in relation to the benefits available.


  • Coase, R.H. (1937), The Nature of the Firm, Economica, IV
  • Keynote, Fenn, Dominic (June 2005), Market Review 2005: Pharmaceuticals Industry, Fifth Edition, Keynote
  • National Centre for Biotechnology Information (March 2004), Just the Facts: A Basic Introduction to the Science Underlying NCBI Resources, Available at: [Accessed 26-Aug-05]\
  • Sloman, John (2000), Economics, Fourth Edition, Prentice Hall
  • The Economist (February 19th, 1998), Survey: The Pharmaceutical Industry

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