CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

STUDY

OCTOBER 2006

Research and

Development in the

Pharmaceutical

Industry

CBO

© Unlisted images, Inc.
Pub. No. 2589
The Congress of the United States O Congressional Budget Office

CBO

Research and Development in the

Pharmaceutical Industry

October 2006

A

STUDY

Preface

Perceptions that the pace of new-drug development has slowed and that the pharmaceutical industry is highly profitable have sparked concerns that significant problems loom for 

future drug development. This Congressional Budget Office (CBO) study—prepared at the 

request of the Senate Majority Leader—reviews basic facts about the drug industry’s recent 

spending on research and development (R&D) and its output of new drugs. The study also 

examines issues relating to the costs of R&D, the federal government’s role in pharmaceutical 

research, the performance of the pharmaceutical industry in developing innovative drugs, and 

the role of expected profits in private firms’ decisions about investing in drug R&D. In keeping with CBO’s mandate to provide objective, impartial analysis, the study makes no recommendations.

David H. Austin prepared this report under the supervision of Joseph Kile and David Moore. 

Colin Baker provided valuable consultation. Jim Baumgardner, Anna Cook, Doug Hamilton, 

and Dennis Zimmerman of CBO provided comments, as did Iain Cockburn of Boston University, Mark Duggan of the University of Maryland, and Judith Wagner of the Institute of 

Medicine. (The assistance of external reviewers implies no responsibility for the final product, 

which rests solely with CBO.)

Christian Howlett edited the study, and Kate Kelly proofread it. Angela Z. McCollough prepared drafts of the manuscript. Maureen Costantino prepared the report for publication, with 

assistance from Allan Keaton, and designed the cover. Lenny Skutnik printed the initial copies, and Simone Thomas prepared the electronic version for CBO’s Web site (www.cbo.gov).

Donald B. Marron

Acting Director

October 2006

Contents

1 Introduction and Summary 1

The Cost of Developing a New Drug 1

The Role of Federal Research and Development 2

Assessing the Drug Industry’s R&D Performance 3

The Drug Industry’s Profits and R&D Investment 4

2 Trends in R&D Spending and Output of New Drugs 7

Spending for Research and Development 7

R&D Intensity 9

Output of Innovative New Drugs 11

Leading Therapeutic Classes 12

Modifications and Approved New Uses of Drugs 14

3 What Does It Cost to Develop a New Drug? 19

Primary Determinants of R&D Costs 19

Why Have R&D Costs Risen for Innovative New Drugs? 21

4 Does Federal R&D Spending Stimulate or Substitute for 

Private-Sector Spending? 27

Public and Private R&D Spending 27

Does Government R&D Crowd Out Private R&D? 29

A Changing Role for Public-Sector Research 33

5 Has the Drug Industry’s Innovative Performance Declined? 35

Recent Innovative Performance 35

Did Changes in the Size of Drug Companies Affect 

Research Productivity? 39
VI RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

6 Profitability and R&D Investment in the Drug Industry 43

Recent Estimates of Profitability 43

Expected Profits as a Signal for Performing Drug R&D 45

References 51
CONTENTS VII

Tables

2-1. Therapeutic Classes with Three or More Leading Brand-Name Drugs in 2003 13

3-1. DiMasi and Others’ Estimate of Average Research Costs and Times for

Successfully Developed New Molecular Entities 20

5-1. Merger History of the Top Ten Pharmaceutical Companies in 2004 by 

Global Sales 40

Figures

2-1. Estimates of the U.S. Drug Industry’s Annual Spending on Research and 

Development 8

2-2. Research and Development Spending as a Percentage of Sales Revenue for 

Various U.S. Industries 10

2-3. Number of New Molecular Entities Approved by the Food and Drug 

Administration Each Year 11

2-4. Number of Non-NMEs Approved by the Food and Drug Administration 

Each Year, Compared with Total New-Drug Applications 15

3-1. Various Estimates of the Average R&D Cost of a Successfully Developed 

New Molecular Entity 22

3-2. Percentage of New Molecular Entities Entering Each Phase of Clinical Trials 23

4-1. Annual Spending on Research and Development by Drug Companies and the 

National Institutes of Health 28

4-2. NME Approvals and Public-Sector Spending on Basic Research 32

5-1. NME Approvals and Drug Companies’ Spending on Research and Development 36

5-2. Research and Development Spending and Productivity for Various U.S. Industries 38

6-1. Return on Assets for Drug Companies Versus for All Major Companies, by 

Standard Accounting Methods 44

Boxes

4-1. Do Private Firms Benefit Disproportionately from Taxpayer-Funded 

Basic Research? 30

6-1. Drug Prices and Consumer Value in R&D Spending 46

CHAPTER

1

Introduction and Summary

Recent concerns about escalating drug prices and 

rising health care spending have sparked considerable 

interest in how new drugs are discovered, tested, and 

sold—and in how well those processes serve the interests 

of U.S. consumers. Public dialogue on those issues, however, suggests that the complex economic forces that govern the drug-discovery process are not widely understood. 

Even some of the basic economic facts about the pharmaceutical industry have been subject to debate. This study 

describes the current state of pharmaceutical research and 

development (R&D), analyzes the forces that influence 

it, and considers how well markets are working to deliver 

new drugs.

Much of the public interest in pharmaceutical R&D concerns the relationship between drug prices, drug firms’ 

costs, and the pace and direction of innovation. Average 

prices of new drug products have been rising much faster 

than the rate of inflation, and annual R&D spending has 

grown faster still. Nevertheless, introductions of innovative new drugs have slowed. At the same time, drug companies have been able to charge high retail prices for new 

drugs that are only incrementally different from older 

drugs whose prices have fallen. With consumers paying 

more for new drugs in the United States than almost anywhere else in the world, and with the perception that the 

drug industry has become less innovative, many observers 

have wondered whether some kind of policy intervention 

is warranted.

Pharmaceutical markets, however, are extremely complex 

in many respects. Large public-sector investments in basic 

biomedical R&D influence private companies’ choices 

about what to work on and how intensively to invest in 

research and development. The returns on private-sector 

R&D are attractive, on average, but they vary considerably from one drug to the next. Consumer demand for 

prescription drugs is often indirect, mediated by doctors 

and health insurers. New drugs must undergo costly and 

time-consuming testing before they can be sold. Moreover, it may cost hundreds of millions of dollars to 

develop an innovative new drug that then will cost only a 

few cents per dose to manufacture—and the price of the 

drug will have no obvious connection to either cost. 

Comparative information about drug quality from 

unbiased, head-to-head clinical trials of competing drugs 

is seldom published, although it would help drug purchasers make the best choices—and in turn improve the 

market signals that guide private companies’ decisions 

about research and development. An understanding of 

how such factors interact with the industry’s R&D process is necessary to recognize the underlying causes of any 

failure of the market to encourage a socially optimal level 

of drug R&D.

This study presents basic facts about the pharmaceutical 

industry’s spending on research and development and 

about the types and numbers of new drugs that result 

from it. The study also analyzes several major issues 

related to pharmaceutical R&D:

B What explains the cost of developing new drugs?

B Does federal investment in R&D stimulate or displace 

private investment?

B Has the drug industry’s innovative performance 

declined?

B How profitable are drug firms, and how do profits 

affect the amount and type of R&D that companies 

conduct?

The Cost of Developing a New Drug

Research and development costs vary widely from one 

new drug to the next. Those costs depend on the type of 

drug being developed, the likelihood of failure, and 

whether the drug is based on a molecule not used before 
2 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

in any pharmaceutical product (a new molecular entity, 

or NME) or instead is an incremental modification of an 

existing drug. 

Innovative Drugs

A recent, widely circulated estimate put the average cost 

of developing an innovative new drug at more than $800 

million, including expenditures on failed projects and the 

value of forgone alternative investments.1 Although that 

average cost suggests that new-drug discovery and development can be very expensive, it reflects the research 

strategies and drug-development choices that companies 

make on the basis of their expectations about future revenue. If companies expected to earn less from future drug 

sales, they would alter their research strategies to lower 

their average R&D spending per drug. Moreover, that 

estimate represents only NMEs developed by a sample of 

large pharmaceutical firms. Other types of drugs often 

cost much less to develop (although NMEs have been 

the source of most of the major therapeutic advances in 

pharmaceuticals). 

The study that produced that cost estimate also calculated how long it takes to develop a new drug and the relative contribution of capital costs to a drug’s total R&D 

costs. On average, developing an innovative new drug 

takes about 12 years, the study concluded, and a firm’s 

actual expenditures make up only about half of the total 

reported cost. The rest represents the financial cost of 

tying up investment capital in multiyear drugdevelopment projects, earning no return until and unless 

a project succeeds. That “opportunity cost” of capital 

reflects forgone interest or earnings from alternative uses 

of the capital. (Opportunity costs are common to all 

innovative industries, but they are particularly large for 

pharmaceutical firms because of the relatively long time 

that is often required to develop a new drug.)

Research and development spending per NME has grown 

significantly in recent years, for various reasons. First, failure rates in clinical trials have increased, possibly because 

of greater research challenges or a willingness to test riskier drugs in such trials. Second, larger drug firms are said 

to have shifted the focus of their development efforts 

away from drugs for acute illnesses and toward drugs for 

chronic illnesses. Drugs that treat chronic illnesses can be 

more expensive to develop because they often require 

larger and longer clinical trials. Third, greater technological complexity in drug development and greater specificity in disease targets have helped to raise average R&D 

costs, as firms now identify drugs with particular molecular characteristics rather than using trial-and-error methods to find compounds that work in some desired way.

Not all new molecular entities provide unique therapeutic 

functions. Many NMEs are so-called “me-too” drugs. 

Despite that name, they are not necessarily imitations of 

other drugs. Rather, they may be innovative products that 

lost the race to be the first drug on the market in a given 

therapeutic class (such as antidepressants, antibiotics, or 

antihistamines). Such products can benefit consumers by 

competing with, and sometimes improving on, the pioneering drug in a class.

Incrementally Modified Drugs

Most new drug products have much lower R&D costs 

than NMEs because they are incremental improvements 

on existing drugs. Those costs can still be considerable if 

the new product requires clinical trials. Nevertheless, 

because non-NMEs constitute about two-thirds of the 

drugs approved by the Food and Drug Administration 

but account for only about one-third of the industry’s 

R&D spending (by some estimates), their average direct 

cost may be only about one-fourth that of an NME. 

Their opportunity costs are also lower to the extent that 

they take less time to develop than drugs based on new 

molecules.

Incrementally modified drugs sometimes provide significant benefits to consumers. For example, moreconvenient dosing forms (say, a pill that can be taken 

once a day rather than every four hours) can increase 

the likelihood that patients will take their medicine as 

directed and can result in better health. At the same time, 

given the indirect nature of demand in pharmaceutical 

markets, the higher prices that are charged for some drugs 

that are merely extensions of current product lines may 

not be commensurate with the additional value that those 

drugs provide. 

The Role of Federal Research and 

Development

The federal government spent more than $25 billion on 

health-related R&D in 2005. Only some of that spend1. Joseph A. DiMasi, Ronald W. Hansen, and Henry G. Grabowski, 

“The Price of Innovation: New Estimates of Drug Development 

Costs,” Journal of Health Economics, vol. 22, no. 2 (March 2003), 

pp. 151-185.
CHAPTER ONE INTRODUCTION AND SUMMARY 3

ing is explicitly related to the development of new pharmaceuticals. However, much of it is devoted to basic 

research on the mechanisms of disease, which underpins 

the pharmaceutical industry’s search for new drugs. 

The primary rationale for the government to play a role 

in basic research is that private companies perform too 

little such research themselves (relative to what is best for 

society). In general, the information generated by basic 

research can be readily replicated at low cost. Thus, many 

of the benefits of that research accrue not to the company 

that performs it but to the public and to other firms. 

With pharmaceuticals, those spillover benefits can be significant because the development of new drugs depends 

on scientific advances. Federal funding of basic research 

directly stimulates the drug industry’s spending on 

applied research and development by making scientific 

discoveries that expand the industry’s opportunities for 

R&D.

Government-funded basic research can also stimulate 

private-sector R&D indirectly. By supporting graduate 

students and postdoctoral researchers in academic labs 

where basic research is conducted, federal grants help to 

train many of the researchers who are hired by drug companies. That training enhances the productivity and profitability of the companies’ R&D investments, while also 

allowing researchers to command higher salaries. 

Given the extent of federal funding for life-sciences 

research, however, there is a risk that some of that funding could crowd out private-sector investment in R&D. 

In general, the government tends to focus on basic 

research, whereas private firms focus much more on 

applied research and development. That difference 

diminishes the risk of direct crowding out. But the distinction between basic and applied research is not well 

defined, and the division of labor between the two has 

become less pronounced as the potential commercial 

value of basic life-sciences research has become more 

widely recognized. Government and private R&D efforts 

have sometimes overlapped (as in the race to finish mapping the human genome); thus, the government may 

have funded some research that the private sector otherwise would have financed. Identifying specific cases 

where direct crowding out has occurred is difficult, but it 

is probably most likely to happen when the government 

funds research whose potential commercial applications 

are obvious and valuable.

Federal R&D spending can also crowd out private spending indirectly by causing labor costs to rise. Although students and postdoctoral researchers form part of the workforce for federally funded research, the government and 

the drug industry both draw on the same supply of 

trained professional researchers. That supply is relatively 

fixed in the short run, and higher R&D spending in 

either sector can cause salaries to rise by increasing the 

demand for researchers. That is more likely to occur 

when R&D spending is growing rapidly. In recent years, 

both real (inflation-adjusted) salaries for biomedical 

researchers and total employment in biomedical research 

have increased along with real R&D spending. When 

R&D spending is growing more slowly, however, there is 

probably little such effect on labor costs for professional 

researchers.

Assessing the Drug Industry’s

R&D Performance

Total spending on health-related research and development by the drug industry and the federal government 

has tripled since 1990 in real terms. However, the number of innovative new drugs approved by the Food and 

Drug Administration each year has not shown a comparable upward trend. NME approvals shot up for a few 

years in the mid-1990s and then fell again; on the whole, 

such approvals have consistently ranged between about 

20 and 30 per year. Measured by the number of drugs 

approved per dollar of R&D, the innovative performance 

of the drug industry appears to have declined. 

However, if new drugs were of higher quality than older 

drugs, on average, that improvement would partly or 

fully make up for a decline in the raw number of drugs 

per R&D dollar. Drug quality is multidimensional and 

difficult to measure, however. As a result, no careful and 

comprehensive estimate exists to show how changes 

in quality have affected the industry’s actual R&D 

performance. 

Other factors have contributed to the impression that the 

pharmaceutical industry’s innovative performance has 

declined. Over the past decade, a growing share of the 

industry’s R&D output has consisted of incremental 

improvements to existing drugs rather than new molecular entities. Performance measures that consider only 

entirely new drugs—such as the number of NME 

approvals per year—miss that shift and undervalue the 

industry’s R&D output. Moreover, comparing output per 
4 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

R&D dollar over long spans of time can be misleading 

because of shifts in the types of drugs being developed. 

Notwithstanding concerns about innovative performance 

and how to measure it, the range of illnesses for which 

drug therapies exist has never been broader, and technological advances have yielded new drug treatments of 

increasing sophistication, convenience, and effectiveness. 

Even so, it is difficult to determine whether the returns to 

society from the money spent on drug R&D have 

declined or not. There are several possible reasons why 

the industry’s R&D performance could have slipped. 

Companies may not yet have fully mastered the complex 

new research technologies with which they work; the 

pool of relatively inexpensive research discoveries may be 

temporarily depleted, pending further advances in basic 

science; and strong consumer demand for new drugs may 

have encouraged firms to invest in R&D beyond the 

point of diminishing returns. Furthermore, the frequency 

with which leading drug companies have merged with 

one another over the past decade—which may have 

resulted partly from a decline in the number of new drugs 

in development—has sparked concerns about the industry’s R&D productivity. According to some observers, 

large firms tend to be less innovative than smaller firms. 

Those mergers have had little initial effect on the combined firms’ total R&D spending, although the ultimate 

impact on the introduction of innovative new drugs 

remains uncertain. 

If the industry’s R&D performance has slipped, recent 

advances in basic sciences (such as molecular and cellular 

biology and biochemistry) could eventually reverse that 

trend by stimulating the development of more new drugs. 

In addition, new-drug approvals could increase simply 

because of the rising number of potential new products 

that have entered the development pipeline in recent 

years, according to drug companies. The greater commercialization of basic R&D and the increased specialization 

that has occurred in the drug industry may also enhance 

productivity. At the same time, though, the greater role of 

the private sector in basic R&D may have made the pace 

and direction of progress in drug development more 

dependent on financial factors in the industry.

The Drug Industry’s Profits and

R&D Investment

By standard accounting measures, the pharmaceutical 

industry consistently ranks as one of the most profitable 

industries in the United States. Those measures, however, 

treat most R&D outlays as expenditures rather than as 

investments that add to the value of a firm. Thus, they 

omit from a firm’s asset base the value of its accumulated 

stock of knowledge. For R&D-intensive industries, such 

as pharmaceuticals, that omission can significantly overstate profitability. Adjusted for the value of its R&D 

assets, the drug industry’s actual profitability still appears 

to be somewhat higher than the average for all U.S. 

industries, but not two to three times higher, as standard 

measures of profitability indicate.

The notion that pharmaceutical companies enjoy extraordinary profits is reinforced by the relationship between 

prices and costs in the drug industry. The industry’s high 

R&D spending and relatively low manufacturing costs 

create a cost structure similar to that of, for example, the 

software industry. Both industries have high fixed costs 

(for research and development) and low variable costs (to 

put a software application onto a CD-ROM or to produce a bottle of prescription medication). Consequently, 

prices in those industries are usually much higher than 

the cost of providing an additional unit of the product, 

because revenue from sales of the product must ultimately cover those fixed costs.2 Even though conventional accounting measures overstate the profitability of 

the drug industry, strong growth in the industry’s R&D 

spending over many years suggests that the returns on 

pharmaceutical R&D have been attractive.

Ultimately, how adequately prices and profits indicate the 

kinds of drugs that consumers want to buy determines 

the extent to which the pace and direction of drug innovation are themselves adequate. High prices on new drugs 

encourage continued innovation. But because health 

insurance (private plans as well as Medicaid and Medicare) keeps consumers from bearing the full weight of 

those prices, the demand for new drugs is higher than it 

otherwise would be at any given price. That effect is magnified because employment-based health insurance benefits are not subject to income or payroll taxes, which 

reduces their cost to consumers. As a result, more people 

2. Strictly speaking, a product’s fixed development costs are not relevant to how it is priced because they are sunk (already incurred 

and not recoverable) before the product reaches the market. But a 

company incurs R&D costs in expectation of a product’s likely 

price, and on average, it must cover those fixed costs if it is to continue to develop new products.
CHAPTER ONE INTRODUCTION AND SUMMARY 5

have health insurance, and many have higher levels of 

coverage, than would be the case otherwise. 

The effect of health insurance on drug companies’ revenues—combined with strong patent protection that helps 

firms maintain higher prices—may sometimes create 

incentives to invest too much in R&D (from the standpoint of the amount of investment that is optimal for 

society). The role of health insurance can be tempered in 

several ways, however. Insurers and other large buyers of 

drugs may be able to exercise more power to negotiate 

lower prices, and insurers can give patients and doctors 

stronger incentives to consider price differences between 

drugs. The more accurately a drug’s price reflects its value 

to consumers, the more effective the market system will 

be at directing R&D investment toward socially valuable 

new drugs. However, prices can only serve that directing 

role to the extent that good information exists about the 

comparative qualities of different drugs and that consumers and health care providers use that information.

CHAPTER

2

Trends in R&D Spending and

Output of New Drugs

The pharmaceutical industry spends more on 

research and development, relative to its sales revenue, 

than almost any other industry in the United States. 

According to various estimates, the industry’s real 

(inflation-adjusted) spending on drug R&D has grown 

between threefold and sixfold over the past 25 years—

and that rise has been closely matched by growth in drug 

sales. Despite those increases, there has been little change 

in the number of innovative new drugs approved for use 

each year, even though the federal government has 

streamlined its drug-approval process. 

Only about one-third of the drugs approved annually in 

the United States are new compounds; the rest represent 

modified forms of—or new uses for—existing drugs. 

Firms develop new drug products in response to various 

factors. Those factors relate not only to likely demand in 

a given drug market—which is influenced by available 

health insurance coverage, doctors’ prescribing practices, 

and demographic changes—but also to government policy toward drug safety and innovation and to the pace of 

scientific advances in the understanding and treatment of 

disease.

Spending for Research and 

Development

In 1980, U.S. companies spent a total of $5.5 billion (in 

2005 dollars) on research and development of pharmaceuticals and medicines, according to the National Science Foundation (NSF). By 2003, that figure had grown 

to more than $17 billion—an average increase of 5 percent per year in real terms (see Figure 2-1). The pharmaceutical industry’s trade association, Pharmaceutical 

Research and Manufacturers of America (PhRMA), 

reported even larger expenditures and faster growth. 

Spending by its member organizations rose more than 

sixfold between 1980 and 2004, from about $6 billion 

(in 2005 dollars) to $39 billion.1 Those figures represent 

a real growth rate of about 8 percent a year, on average. 

By comparison, drug firms’ gross margins—sales revenue 

minus costs and income taxes—have been increasing 

more slowly, by about 4 percent annually.2

The differences between NSF’s and PhRMA’s estimates of 

R&D spending stem largely from differences in which 

drug companies are included in the samples and which 

expenditures are counted. PhRMA’s totals include all 

R&D spending in the United States by the association’s 

members (foreign and domestic) as well as expenditures 

abroad by U.S. firms and U.S. divisions of foreign firms. 

Spending by foreign companies that occurs outside the 

United States is excluded. NSF’s totals cover only domestic R&D spending by firms “engaged in for-profit activity 

in the United States.” They exclude all research and 

development not conducted in the United States, including that performed by foreign subsidiaries of U.S. firms 

or by other foreign organizations.3

1. For comparison with NSF’s numbers, total R&D spending by 

PhRMA members in 2003 was $37.6 billion in 2005 dollars 

(including $29.6 billion for domestic R&D by U.S. firms). 

PhRMA estimates that total R&D spending by the drug industry, 

including nonmember firms, was $49 billion in 2004, the first 

year the association estimated that total. Overall R&D spending 

by PhRMA members has grown even though the number of 

members has fallen by more than half since the early 1990s (to 34 

organizations in 2004). Mergers account for some of that decline. 

2. F.M. Scherer, “The Link Between Gross Profitability and Pharmaceutical R&D Spending,” Health Affairs, vol. 20, no. 5 (September/October 2001), pp. 216-220.

3. National Science Foundation table, “Company and Other (Except 

Federal) Funds for Industrial R&D Performance, by Industry and 

by Size of Company: 1953–98,” notes section, and “Technical 

Notes for 1998,” available at www.nsf.gov/statistics/iris/excel-files/

NSF%2001-305/tn.doc.
8 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Figure 2-1.

Estimates of the U.S. Drug Industry’s Annual Spending on Research and 

Development

(Billions of 2005 dollars)

Source: Congressional Budget Office based on the sources described below.

Note: Spending was adjusted for inflation using the biomedical research and development price index from the Bureau of Economic Analysis.

a. Expenditures reported by members of the Pharmaceutical Research and Manufacturers of America (PhRMA). Unlike the National Science 

Foundation data, PhRMA’s estimates include research and development performed outside the United States by U.S. companies (or U.S. 

divisions of foreign companies) as well as further research and development that occurs after a drug has gone on the market. The data 

come from Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 2006 (Washington, D.C.: PhRMA, 

March 2006).

b. The data series starts in 1980 and ends in 2003. It includes only research and development conducted in the United States on drugs that 

have not yet reached the market. Data for 1980 to 1998 come from the National Science Foundation table “Company and Other (Except 

Federal) Funds for Industrial R&D Performance, by Industry and by Size of Company: 1953-98,” available at www.nsf.gov/statistics/iris/

search_hist.cfm?indx=10 (see the row for “Drugs and Medicines”); data for 1999 to 2003 come from National Science Foundation, Division of Science Resources Statistics, annual “Research and Development in Industry” tables, available at www.nsf.gov/statistics/industry 

(see the rows for “Pharmaceuticals and Medicines”).

The National Science Foundation’s estimates also exclude 

spending on phase IV clinical trials (which are conducted 

after a drug has reached the market) and on the development of manufacturing processes—both of which 

PhRMA counts as R&D. In addition, NSF’s figures do 

not include R&D by pharmaceutical firms that sell their 

own products, if sales activities account for the largest 

share of their payroll. (The Census Bureau classifies such 

firms as part of the “wholesale trade” sector.)4 NSF estimates that postmarketing expenditures have recently constituted nearly 20 percent of PhRMA’s total.5

 With those 

expenditures and drug R&D by “wholesale trade” firms 

included, NSF’s total for 2003 would be within $1.7 billion, or about 5 percent, of the PhRMA estimate.6 Much 

of the remaining difference can be explained by PhRMA’s 

inclusion of some overseas R&D spending.

Those differences aside, the rise in research and development spending in both sets of estimates partly reflects an 

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

0

5

10

15

20

25

30

35

40

National Science

Foundation Estimateb

PhRMA Estimatea

4. NSF uses Census Bureau classifications and says that “true drug 

manufacturers are often assigned to the wholesale trade industry” 

because of a trend toward drug firms selling their own products. 

See Raymond M. Wolfe, Increase in U.S. Industrial R&D Expenditures Reported for 2003 Makes Up for Earlier Decline, National Science Foundation InfoBrief (December 2005), p. 4, available at 

www.nsf.gov/statistics/infbrief/nsf06305/nsf06305.pdf.

5. Personal communication to the Congressional Budget Office by 

Raymond Wolfe of the National Science Foundation.

6. See National Science Foundation, National Science Board, Science 

and Engineering Indicators 2006, vol. 1 (January 2006), pp. 4-17 

and 4-18 and note 18, available at www.nsf.gov/statistics/seind06/

pdf/volume1.pdf. 
CHAPTER TWO TRENDS IN R&D SPENDING AND OUTPUT OF NEW DRUGS 9

increase in the average R&D cost per drug that is attributable to a variety of factors. The scope of drug research 

has greatly expanded, fueled not only by growth in sales 

revenue for drugs but also by advances in basic science. 

The number of drug targets (typically, a protein molecule 

on which a drug is intended to act) has gone from 500 to 

more than 3,000 in recent years, and according to one 

analyst, “the expansion of research activity to investigate 

them is a natural . . . consequence.”7 The same scientific 

advances have also induced a shift from “chemistrybased” drug development to drug research based on 

molecular biology, which has led pharmaceutical firms to 

spend more for capital equipment and training. Further, 

in the wake of a 1980 decision by the U.S. Supreme 

Court governing the patenting of living organisms, biological molecules can now be patented.8

 That development has created a marketplace for basic research in the 

biological sciences. Consequently, pharmaceutical companies now often pay for access to basic research performed by specialized firms—research that traditionally 

would have been conducted in the public domain. Those 

additional research expenses have contributed to drug 

firms’ higher R&D spending, even though the net cost to 

society of that research has not necessarily changed.9

R&D Intensity

The pharmaceutical industry is one of the most researchintensive industries in the United States. Pharmaceutical 

firms invest as much as five times more in research and 

development, relative to their sales, than the average U.S. 

manufacturing firm. 

Because increases in spending on drug R&D have been 

nearly matched by increases in revenue from drug sales, 

the industry’s R&D intensity—the ratio of research and 

development spending to total sales revenue—has not 

risen to the extent that R&D expenditures have. Over the 

past 25 years, R&D intensity has grown by about 50 percent. Most of that growth occurred in the 1980s; since 

then, the industry’s R&D intensity has hovered around 

19 percent, according to PhRMA (see Figure 2-2).10

A relatively close relationship exists between drug firms’ 

current R&D spending and current sales revenue for two 

reasons. First, successful new drugs generate large cash 

flows that can be invested in R&D (their manufacturing 

costs are usually very low relative to their price). Second, 

alternative sources of investment capital—from the bond 

and stock markets—are not perfect substitutes for cash 

flow financing. Those alternative sources of capital are 

more expensive because lenders and prospective new 

shareholders require compensation (in the form of higher 

returns) for the additional risk they bear compared with 

the firm, which has more information about the drug 

under development, its current status, and its ultimate 

chance of success.11

The National Science Foundation also estimates that the 

R&D intensity of the pharmaceutical industry has been 

fairly stable in recent years, ranging between about 8 percent and 10 percent since 1985. That estimate is less than 

half of PhRMA’s, in part because NSF includes lessR&D-intensive products not related to prescription pharmaceuticals (such as vitamins, over-the-counter drugs, 

reference chemicals sold to researchers for experiments, 

and consumer and animal care products). Even at that 

lower estimate, pharmaceuticals ranked as the most 

R&D-intensive industry in the U.S. manufacturing sector for most of the 1990s, according to NSF (until it was 

overtaken by communications equipment, whose R&Dintensity was 12.7 percent in 2003).

The relative stability of the relationship between pharmaceutical R&D and sales revenue suggests that firms find it 

7. See Iain M. Cockburn, “Is the Pharmaceutical Industry in a most profitable to invest any additional dollar of sales revProductivity Crisis?” (paper prepared for the National Bureau of 

Economic Research’s Innovation Policy and the Economy Conference, Washington, D.C., April 19, 2006), available at www.nber. 

org/books/innovation7/cockburn4-29-06.pdf; and Iain M. Cockburn, “The Changing Structure of the Pharmaceutical Industry,” 

Health Affairs, vol. 23, no. 1 (January/February 2004), p. 12.

8. Diamond v. Chakrabarty, 447 U.S. 303.

9. Substituting private payment for public funding of basic scientific 

research may have a cost to society if it affects the pace or direction 

of that research; otherwise, it simply transfers the responsibility for 

paying for the research from the public sector to the private sector. 

10. Although Figure 2-2 depicts domestic R&D as a share of domestic 

sales (according to PhRMA), total R&D intensity—including 

non-U.S. R&D and international sales by U.S.-owned firms and 

all R&D by U.S. divisions of foreign-owned firms—has been 

comparable. Total R&D intensity ranged from 9 percent to 

15 percent through the late 1980s and has been about 16 percent 

to 17 percent since then. 

11. See Uwe E. Reinhardt, “Perspectives on the Pharmaceutical Industry,” Health Affairs, vol. 20, no. 5 (September/October 2001), 

pp. 136-149.
10 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Figure 2-2.

Research and Development Spending as a Percentage of Sales Revenue for 

Various U.S. Industries

(Percent)

Source: Congressional Budget Office based on Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 

2005 (Washington, D.C.: PhRMA, March 2005); and National Science Board, Science & Engineering Indicators 2000, Appendix Table 

2-57, available at www.nsf.gov/statistics/seind00/pdf/append/c2/at02.pdf, and Science & Engineering Indicators 2006, Appendix 

Table 4-22, available at www.nsf.gov/statistics/seind06/pdf/volume2.pdf. 

Notes: Industry data for which no source is shown come from the National Science Foundation. The NSF data are in two series: 1985-1997 

and 1999-2003. The first series is based on the Standard Industrial Classification system. In the second series, some industry classifications changed because firms were recategorized according to the North American Industry Classification System. The data for those 

two periods are not fully comparable. Because no data were available for 1998, CBO used 1997 values for 1998 for graphing purposes. 

No estimate was reported in 1991 for communications equipment; for graphing purposes, CBO used the average of the 1990 and 1992

values for that industry.

enue in their own drug research. However, changes in real 

drug prices can affect companies’ R&D intensity or their 

propensity to invest in R&D from their revenue.12 The 

reason is partly that, as noted above, higher drug prices 

tend to increase firms’ cash flow, and internally generated 

cash is a relatively inexpensive source of investment capital. But changes in price levels also affect firms’ expectations about profits. Thus, higher real drug prices may 

increase the value of completing existing projects more 

quickly and encourage companies to undertake more new 

research than they would otherwise. Both effects involve 

increased R&D spending and thus greater R&D intensity. Analysts generally view that connection as having 

clear implications for efforts to reduce industry prices and 

profits, in that such interventions would dampen R&D 

investment.13

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

0

5

10

15

20

25

Computers

Pharmaceuticals

(PhRMA)

Pharmaceuticals

(NSF)

Communications Equipment

All Manufacturing Firms

12. One study concluded that a 10 percent increase (or decrease) in 

real U.S. drug prices would, if everything else remained the same, 

boost (or reduce) R&D intensity by almost 6 percent. See Carmelo Giaccotto, Rexford Santerre, and John Vernon, Explaining 

Pharmaceutical R&D Growth Rates at the Industry Level: New Perspectives and Insights, Publication 03-31(Washington, D.C.: AEIBrookings Joint Center for Regulatory Studies, December 2003).

13. Scherer, “The Link Between Gross Profitability and Pharmaceutical R&D Spending,” p. 220. 
CHAPTER TWO TRENDS IN R&D SPENDING AND OUTPUT OF NEW DRUGS 11

Figure 2-3.

Number of New Molecular Entities Approved by the Food and Drug 

Administration Each Year

Source: Congressional Budget Office based on Food and Drug Administration, Center for Drugs and Biologics, New Drug Evaluation Statistical Report (1985), Table III-1, Graph III-2, and Appendix B, and New Drug Evaluation Statistical Report (March 1986 and April 

1987), Table II-1 and Graph II-2; Food and Drug Administration, Center for Drug Evaluation and Research, Office of Management, 

Offices of Drug Evaluation Statistical Report (1987-1989), Table II-1, Graph II-1, and Graph II-2; Food and Drug Administration, 

“CDER NDAs Approved in Calendar Years 1990-2004 by Therapeutic Potential and Chemical Type” (March 22, 2005), available at 

www.fda.gov/cder/rdmt/pstable.htm; and Food and Drug Administration, “FDA Facts: The Center for Drug Evaluation and 

Research,” available at www.fda.gov/bbs/topics/news/2006/NEW01342/Fact_Sheet_CDER.pdf.

Notes: New molecular entities (NMEs) are drugs that contain an active substance not previously approved for marketing in the United States. 

“Priority” NMEs are ones that receive accelerated reviews by the Food and Drug Administration because of their potentially significant 

therapeutic value. (Before 1992, priority NMEs were known as category A or B drugs.) 

Data for 2004 and 2005 include therapeutic biologic products.

Output of Innovative New Drugs 

Continued growth in R&D spending has appeared to 

have little effect on the pace at which new drugs are 

developed. Annual approvals of innovative new drugs—

so-called new molecular entities—by the Food and Drug 

Administration (FDA) increased over the 1980s and 

peaked sharply in the mid-1990s but then experienced a 

pronounced six-year decline.14 In that decline, the total 

number of NMEs approved each year fell from a high of 

53 in 1996 to 17 in 2002 (see Figure 2-3). Annual 

approvals rebounded to 36 by 2004 but fell again in 

2005, to 20.15 (The number of applications for approval 

of new molecular entities has exhibited a similar pattern. 

Applications rose sharply in 1995—the year before the 

peak in approvals—generally declined from 1998 to 

2002, and rose again in 2003 and 2004.) The drop in 

approvals since 1996 could simply mark a return to their 

long-term average, but even so, the pace of new-drug 

approvals has not matched the rise in real R&D spending. As a result, the average R&D cost per new drug has 

grown significantly.

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

0

10

20

30

40

50

60

Total NMEs

Priority NMEs

14. The FDA defines an NME as “a medication containing an active 

substance that has never before been approved for marketing in 

any form in the United States”; see Food and Drug Administration, Center for Drug Evaluation and Research, “FDA’s Drug 

Review and Approval Times” (July 30, 2001), available at 

www.fda.gov/cder/reports/reviewtimes/default.htm.

15. See Food and Drug Administration, “FDA Facts: The Center for 

Drug Evaluation and Research,” available at www.fda.gov/bbs/

topics/news/2006/NEW01342/Fact_Sheet_CDER.pdf. Of the 

20 NMEs approved in 2005, 15 were given priority review. 
12 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Most of the upsurge in NME approvals that occurred in 

the mid-1990s resulted not from “priority” NMEs—

those judged by the FDA to provide “a significant therapeutic or public health advance” over existing drugs—but 

from an increase in approvals of “standard” NMEs.16

Approvals of priority NMEs have shown no sustained 

increases or decreases over the past 20 years. 

Some analysts have concluded that the spike in total 

NME approvals may have been partly caused by a federal 

law designed to hasten the review process, the Prescription Drug User Fee Act of 1992.17 The law imposed a 

large increase in the filing fee for new-drug applications 

submitted for FDA approval; that increase funded additional FDA staff to review applications.18 As a result, the 

median FDA review time fell by nearly one-half, from 

22 months in 1992 to 12 months in 1999.19 That change 

suggests that if a backlog of applications existed when the 

law was enacted, faster processing could have contributed 

to the record number of NME approvals in 1996. A 

backlog may have accumulated in the early 1990s, 

because the annual number of applications was rising at 

that time, while FDA approvals were falling. The decline 

in NME approvals in the late 1990s would be consistent 

with a decrease in the backlog, although NME applications were also in decline at that time. It is not clear why 

the number of applications rose and then fell, but that 

pattern could indicate that the prospect of faster (and 

thus less costly) reviews induced firms to complete, and 

to prepare approval applications for, their late-stage development projects more quickly.

The number of NME approvals has varied more widely 

over the past 10 years than it did before—meaning that 

the number of drugs under patent, and thus firms’ revenue streams, have become more variable. Most manufacturers of brand-name drugs earn the majority of their revenue from drugs under patent. Wider fluctuations in 

revenue heighten companies’ uncertainty about their 

main source of R&D funding. If that variability persists, 

firms may have to rely to a greater extent on external, 

more costly forms of financing. Such a change could 

make firms less likely to invest in drug projects with 

smaller, more uncertain, or more distant payoffs.

Leading Therapeutic Classes

Brand-name drug products span a wide array of therapeutic classes (groups of drugs that are similar in their 

chemical structure, pharmacological effect, or clinical 

use). In 2003, 17 therapeutic classes included at least 

three brand-name drugs that ranked in the top 200 for 

prescriptions dispensed among all brand-name drugs (see 

Table 2-1). Those products are mostly newer drugs, since 

sales of brand-name drugs typically drop sharply once 

generic versions become available. As such, the 17 therapeutic classes indicate where the industry’s recent R&D 

spending has been directed.

In several classes—such as antihypertensives, antibiotics, 

and antidepressants—a striking number of brand-name 

drugs are available. That is particularly true of therapeutic 

classes with higher sales. In addition to the first (or pioneer) compound, some leading classes have as many as 

five to 10 subsequent brand-name drugs (known colloquially as me-too drugs). Those other drugs are not necessarily imitative: often, advances in basic science can 

spark multiple competitive innovations, with total R&D 

costs that may be as high as or even higher than the costs 

of developing the pioneer compound.20 In fact, most of 

the me-too drugs developed in recent years were in clini16. Food and Drug Administration, “FDA’s Drug Review and 

Approval Times.” Priority NMEs receive accelerated FDA reviews 

(intended to take no more than six months). The FDA adopted 

the priority classification system in 1990; it previously used an 

A-B-C scale in which ‘A’ corresponded to drugs offering significant therapeutic gains. 

17. Public Law 102-571. For its effect on NME approvals, see Ernst 

R. Berndt and others, “Industry Funding of the FDA: Effects of 

PDUFA on Approval Times and Withdrawal Rates,” Nature 

Reviews: Drug Discovery, vol. 4, no. 7 (July 2005), pp. 545-554.

18. In 2007, the fee will be $896,200 for an application with clinical 

data. See Food and Drug Administration, “Prescription Drug User 

Fee Rates for Fiscal Year 2007,” Federal Register, vol. 71, no. 148 

(August 2, 2006), p. 43780, available at www.fda.gov/CBER/

pdufa/userfees07.pdf. 

19. Food and Drug Administration, “FDA’s Drug Review and 

Approval Times.” The median approval time increased somewhat 

in 2000, in part because the FDA processed fewer of its speedier 

priority applications that year. 

20. U.S. Congress, Office of Technology Assessment, Pharmaceutical 

R&D: Costs, Risks, and Rewards, OTA-H-522 (February 1993), 

p. 7.
CHAPTER TWO TRENDS IN R&D SPENDING AND OUTPUT OF NEW DRUGS 13

Table 2-1.

Therapeutic Classes with Three or More Leading Brand-Name Drugs in 2003

Source: Congressional Budget Office based on “The Top 20 Brand Drugs in 2003 (by retail dollars),” Drug Topics (March 8, 2004); “The Top 

20 Brand Drugs in 2003 (by units),” Drug Topics (March 22, 2004); and information about therapeutic classes from IMS Health.

Note: SSRI = selective serotonin reuptake inhibitor; SNRI = serotonin-norepinephrine reuptake inhibitor; ARB = angiotensin receptor 

blocker; ACE = angiotensin-converting enzyme; COX-2 = cyclooxygenase-2; ADHD = attention-deficit hyperactivity disorder.

a. Includes only unique new molecular entities (not variants such as different dosing mechanisms) that are among the top 200 drugs on the 

basis of units sold.

b. Total for the top-200 drugs shown here, not the entire therapeutic class.

c. Number of units sold is measured in terms of packages (such as bottles), not individual doses.

cal trials before the respective pioneering drugs received 

approval from the FDA.21

In cases where actual imitation occurs, it can still create 

consumer benefits (as it does in the markets for cars, 

colas, computers, or any other product). Me-too drugs 

benefit consumers by competing with incumbent products and providing alternatives for people who do not 

respond equally well to all drugs. Some of those benefits 

come at the expense of producers of pioneering drugs, 

who see their monopoly profits eroded by competition.22

But total benefits to society increase when consumers 

have more choices. 

The availability of so many brand-name drugs in popular 

therapeutic classes may result partly from the willingness 

of insurers and patients to sometimes pay high prices for 

drugs that are only slightly better than less expensive 

competitors. Drugs may be able to command a price premium in such cases for several reasons: 

B Consumers and health professionals do not always 

have enough information about differences in quality 

between drugs or about the clinical significance of 

those differences,

Therapeutic Class (Major subclasses)

Antidepressants (SSRIs, SNRIs) 8 11.6 114.5

Antihyperlipidemics (Statins) 6 11.1 108.4

Antiulcerants (Proton-pump inhibitors) 5 10.4 70.0

Antihypertensives (ARBs, ACE inhibitors) 11 5.8 88.1

Antibiotics (Broad- and medium-spectrum) 9 5.5 89.2

Diabetes Therapies (Oral, injectible) 6 4.9 63.5

Antiarthritics (COX-2 inhibitors) 4 4.8 48.4

Antipsychotics 3 4.2 20.2

Antihistamines (Oral) 3 4.1 63.2

Neurological Drugs (For seizures or pain) 5 4.0 36.2

Other Vascular Drugs (Calcium- or beta-blockers) 7 3.7 68.7

Antiasthmatics 5 3.6 28.1

Analgesics (Nonnarcotic) 3 2.8 20.1

Bone Density Regulators 4 2.3 32.0

Oral Contraceptives 3 2.1 44.4

Antiallergy Drugs (Nasal steroids) 4 2.0 29.9

Analeptics (ADHD treatments) 3 1.3 16.9

Prescriptions 

(Millions of units sold)b, c in the Top 200a

Number of Drugs 

(Billions of dollars)b

Total Sales

21. See Joseph A. DiMasi and Cherie Paquette, “The Economics of 

Follow-on Drug Research and Development: Trends in Entry 

Rates and the Timing of Development,” PharmacoEconomics, 

vol. 22, supplement 2 (2004), pp. 1-14.

22. For evidence of price competition among brand-name drugs, see 

Z. John Lu and William S. Comanor, “Strategic Pricing of New 

Pharmaceuticals,” Review of Economics and Statistics, vol. 80, no. 1 

(February 1998), pp. 108-118. See also Congressional Budget 

Office, How Increased Competition from Generic Drugs Has Affected 

Prices and Returns in the Pharmaceutical Industry (July 1998), 

p. 27.
14 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

B Some patients place a high value on small improvements in quality, 

B Doctors may be generally unaware of drug prices or 

may not take them into account, or 

B Consumers’ incentives to consider the prices of various prescription drug choices may be weak. 

To the extent that incomplete information and weak 

incentives distort drug prices, they also distort firms’ 

decisions about drug R&D, and they may partially 

explain the existence of multiple competing drug products in some markets. (The availability of comparative 

drug information and the strength of price incentives are 

discussed in Chapter 6.)

Companies are also drawn to invest in particular therapeutic classes by expected growth in those markets. Various institutional and demographic factors affect that 

growth. For example, the number of new drugs in therapeutic categories that are associated with young people 

has declined—and the number of new drugs for older 

adults has increased—as the baby-boom generation has 

aged. That demographic shift has allowed economists to 

identify the effect of changes in market demand on 

spending for drug R&D: one study estimated that 1 percent growth in the potential market for a category of 

drugs leads to an increase of roughly 4 percent in the 

entry of new nongeneric drugs in that category.23 In 

addition, research spending by private industry on 

malaria drugs increased after the General Agreement on 

Tariffs and Trade was amended to address concerns about 

intellectual-property rights.24 And federal policies relating to immunizations, liability limitations for vaccine 

manufacturers, and Medicare coverage decisions have had 

“substantial” and “sustained” effects on the privatesector’s development of certain new vaccines, according 

to another study.25 The study concluded that for every 

additional dollar in expected revenue because of those 

policies, firms invested an average of six additional cents 

(in present-value terms) in R&D on related vaccines.

The drug industry’s practical opportunities for technological innovation are strongly affected by advances in basic 

science, but those advances too are responsive to demographic and institutional factors, as reflected in public 

priorities for spending on basic R&D.26 Health insurers’ 

decisions about coverage can also affect the types of products that drug companies try to develop.27 Ultimately, 

the relationship between higher sales and more drug 

choices in a therapeutic class not only reflects the attraction of R&D dollars to potentially larger markets and to 

research opportunities created by advances in science but 

also reflects the market expansion that can occur when 

multiple drugs offer consumers additional therapeutic 

choices and lower prices through competition.

Modifications and Approved 

New Uses of Drugs

On average, only about one-third of new-drug applications submitted to the FDA are for new molecular entities. Most of the rest are either for reformulations or

23. See Daron Acemoglu and Joshua Linn, “Market Size in Innovation: Theory and Evidence from the Pharmaceutical Industry,” 

Quarterly Journal of Economics (August 2004), p. 1051. 

24. See Jean Lanjouw and Iain Cockburn, “New Pills for Poor People? 

Empirical Evidence After GATT,” World Development, vol. 29, 

no. 2 (February 2001), pp. 265-289. At that time, some developing countries also strengthened their intellectual property protection for drug innovations.

25. See Amy Finkelstein, “Static and Dynamic Effects of Health 

Policy: Evidence from the Vaccine Industry,” Quarterly Journal of 

Economics (May 2004), p. 528. The policies studied were a 1991 

recommendation by the Centers for Disease Control that all 

infants be vaccinated against Hepatitis B; a 1993 decision by 

Medicare to cover influenza vaccinations without copayments; 

and the 1986 adoption of the Vaccine Injury Compensation 

Fund, which indemnified drug firms against liability stemming 

from childhood vaccinations against polio, diphtheria-tetanus, 

and measles-mumps-rubella. Some of the increased R&D spending might have been socially wasteful in the sense that firms raced 

to develop new vaccines and may have duplicated some of their 

rivals’ research. Finkelstein concluded, however, that the combined social benefits of those vaccine policies (the flu vaccination 

policy in particular) far outweighed the costs.

26. See Michael R. Ward and David Dranove, “The Vertical Chain 

of Research and Development in the Pharmaceutical Industry,” 

Economic Inquiry, vol. 33, no. 1 (January 1995), pp. 70-87. The 

authors found that research at the National Institutes of Health 

tended to be directed toward illnesses with growing mortality rates 

(consistent with a process incorporating public comment and 

advocacy), whereas private-sector research was more responsive to 

the prevalence of an illness, as that relates to potential market size.

27. For a detailed discussion of that issue, see Burton Weisbrod, “The 

Health Care Quadrilemma: An Essay on Technological Change, 

Insurance, Quality of Care, and Cost Containment,” Journal of 

Economic Literature, vol. 29, no. 2 (June 1991), pp. 523-552.
CHAPTER TWO TRENDS IN R&D SPENDING AND OUTPUT OF NEW DRUGS 15

Figure 2-4.

Number of Non-NMEs Approved by the Food and Drug Administration Each Year, 

Compared with Total New-Drug Applications

Source: Congressional Budget Office based on Food and Drug Administration, Center for Drugs and Biologics, New Drug Evaluation Statistical Report (1985-1987), Table II-1, Table III-1, and Graph II-1; Food and Drug Administration, Center for Drug Evaluation and 

Research, Office of Management, Offices of Drug Evaluation Statistical Report (1987-1989), Table II-1; and Food and Drug Administration, “CDER NDAs Approved in Calendar Years 1990-2004 by Therapeutic Potential and Chemical Type” (March 22, 2005), available at www.fda.gov/cder/rdmt/pstable.htm.

Note: NME = new molecular entity. Non-NMEs include modifications of, or new approved uses for, existing drugs.

incremental modifications of existing drugs or for new 

“on-label” uses (additional health conditions for which an 

existing drug can be prescribed). None of those types of 

new drugs involve a new active ingredient, although firms 

must conduct clinical trials to gain FDA approval for new 

uses.

Whereas almost half of NME applications are classified 

by the FDA as “priority,” most of the other new-drug 

applications are rated as “standard.”28 Even so, modifications to pharmaceutical products can create substantial 

value for consumers. For example, more-convenient dosing forms can increase the likelihood that patients will 

take all of their medication as directed and thus improve 

their health outcomes. In addition, approved new onlabel uses can become the primary source of demand for a 

drug, suggesting that the new use is more valuable to 

patients than the original use.29

The annual number of non-NME drug approvals has varied greatly over the past 15 years, with no pronounced 

trend (see Figure 2-4). However, comparing patterns in 

those approvals with patterns in the annual number of 

new-drug applications of all types suggests that applications tend to precede approvals by a year or two.

1975 1980 1985 1990 1995 2000 2005

0

50

100

150

200

250

300

Total New-Drug

Applications

Non-NME Approvals

28. From 1990 to 2004, the FDA approved 1,284 new drugs, including 431 new molecular entities. Of those NMEs, 42 percent were 

rated “priority,” versus 12 percent of non-NMEs. See Food and 

Drug Administration, “CDER NDAs Approved in Calendar Years 

1990-2004 by Therapeutic Potential and Chemical Type” (March 

22, 2005), available at www.fda.gov/cder/rdmt/pstable.htm, and 

“FDA Facts: The Center for Drug Evaluation and Research,” 

available at www.fda.gov/bbs/topics/news/2006/NEW01342/

Fact_Sheet_CDER.pdf.

29. For example, about three-quarters of the demand for drugs in the 

therapeutic classes of selective serotonin/norepinephrine reuptake 

inhibitors (SSRIs and SNRIs) and H2-blockers/proton-pump 

inhibitors (H2/PPIs) comes from patients with conditions other 

than the ones for which the drugs were originally approved (acutephase major depression and duodenal ulcers, respectively). See 

Ernst R. Berndt, Iain M. Cockburn, and Karen A. Grépin, “The 

Impact of Incremental Innovation in Biopharmaceuticals: Drug 

Utilization in Original and Supplemental Indications,” PharmacoEconomics (forthcoming, 2006).
16 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

The practice of incrementally changing and improving 

existing products is common to all industries. For the 

drug industry, however, several government policies have 

given firms extra incentives to alter their products. The 

main such policies have been provisions of the 1984 

Hatch-Waxman Act and the drug rebate system in the 

Medicaid program.30

The Hatch-Waxman Act protects new versions of existing 

drugs for a limited time from competition from generic 

drugs. By awarding three years of market exclusivity to 

incrementally modified versions of original, patented 

drugs, the law gives companies an additional incentive to 

alter their existing drugs.31 That incentive has grown over 

time as generic competition has become more effective 

and materialized more quickly.

The Hatch-Waxman Act also eliminated clinical trials for 

generic versions of existing brand-name drugs. Increasingly, once generic versions do enter a market, they 

quickly gain market share at the expense of brand-name 

drugs. In the first few years after the law took effect, the 

average market share of generic drugs one year after the 

patent on a brand-name drug expired was 35 percent. A 

decade later, that figure had almost doubled to 64 percent. By the late 1990s, nearly all brand-name drugs 

could be expected to face generic competition once their 

patents expired.32 The loss of sales to generic versions can 

occur particularly quickly for best-selling drugs. For 

example, Prozac lost more than 80 percent of its U.S. 

sales to lower-priced generic versions in the first month 

after its patent expired.33

To have their products covered by the Medicaid program—which provides prescription drugs to most of the 

roughly 60 million lower-income people enrolled in the 

program—drug manufacturers must enter into a rebate 

agreement with the Centers for Medicare & Medicaid 

Services.34 For a brand-name drug purchased in the feefor-service sector on behalf of a Medicaid beneficiary, the 

manufacturer agrees to rebate to Medicaid a percentage of 

the price it receives on certain private-sector sales of that 

drug.35 Like the changes in the Hatch-Waxman Act, that 

rebate affects firms’ incentives to incrementally modify 

certain drugs. If a company raises the price of a brandname drug faster than the rate of inflation, it must pay a 

larger rebate. However, that provision does not apply to 

the way a modified version of an existing drug is priced in 

relation to the original drug. Thus, if a manufacturer 

wants to raise the price of a drug more quickly while 

avoiding the additional rebate, it can develop a new version of the drug—for example, with a different dosage or 

form of delivery—and introduce it at a higher price. 

For firms, that option is more valuable when Medicaid is 

a drug’s primary source of revenue. Indeed, a recent study 

finds that newer drugs with high Medicaid sales and no 

generic competitors “are significantly more likely to [be 

introduced in] new versions” than other drugs are.36

Modified products command significantly higher prices 

for the same dosage—in the range of 7 percent to 20 percent higher—than earlier versions of the drugs do. (In 

general, generic competition makes it more difficult to 

charge higher prices for brand-name drugs because such 

30. The Hatch-Waxman Act (Public Law 98-417) is officially the 

Drug Price Competition and Patent Term Restoration Act of 

1984.

31. In addition, the FDA provides expedited regulatory approval 

of incrementally modified drugs, via the so-called 505(b)(2) 

pathway.

32. See Congressional Budget Office, How Increased Competition from 

Generic Drugs Has Affected Prices and Returns in the Pharmaceutical 

Industry.

33. Henry Grabowski, “Patents and New Product Development in the 

Pharmaceutical and Biotechnology Industries,” in John V. Duca, 

ed., Science and Cents: Exploring the Economics of Biotechnology

(Dallas: Federal Reserve Bank of Dallas, September 2003), p. 92. 

Patricia M. Danzon, Andrew Epstein, and Sean Nicholson state 

that generic drugs now gain over 80 percent of prescription volume within one year. See Danzon, Epstein, and Nicholson, 

Mergers and Acquisitions in the Pharmaceutical and Biotechnology 

Industries, Working Paper No. 10536 (Cambridge, Mass.: 

National Bureau of Economic Research, June 2004), footnote 2.

34. For Medicaid enrollment numbers, see Congressional Budget 

Office, “Fact Sheet for CBO’s March 2006 Baseline: Medicaid 

and the State Children’s Health Insurance Program,” available at 

www.cbo.gov/budget/factsheets/2006b/medicaid.pdf

35. For more information about Medicaid’s rebates from drug manufacturers, see Congressional Budget Office, The Rebate Medicaid 

Receives on Brand-Name Prescription Drugs (June 21, 2005), and

Prices for Brand-Name Drugs Under Selected Federal Programs (June 

2005).

36. See Mark Duggan and Fiona Scott Morton, “The Distortionary 

Effects of Government Procurement: Evidence from Medicaid 

Prescription Drug Purchasing,” Quarterly Journal of Economics,

vol. 71, no. 1 (February 2006), pp. 20 and 23. Note that because 

Medicaid’s share of sales of antipsychotic drugs has fallen since 

that study was conducted, the program’s effect on the introduction of new versions of those drugs may have declined.
CHAPTER TWO TRENDS IN R&D SPENDING AND OUTPUT OF NEW DRUGS 17

competition increases the likelihood that a drug will lose 

sales to generic versions if its price is set too high.) 

Medicaid’s pricing rules have affected some drug companies’ decisions about R&D by encouraging the development of incrementally modified versions of drugs with 

high Medicaid sales. Those rules avoid other difficulties 

and R&D distortions that the government could create if 

it tried to set drug prices itself. But studies of the impact 

of the Medicaid rebate program, along with studies of the 

effects of the Hatch-Waxman Act, illustrate that firms’ 

R&D investments are responsive not only to market 

forces but also to public policy—sometimes in unanticipated ways. 

CHAPTER

3

What Does It Cost to Develop a New Drug?

An innovative new drug that contains a previously 

untried active ingredient can take years to develop and 

test. After sifting through a large set of chemical compounds to find one with the desired action, a firm must 

test the drug using a formal and rigorous protocol so that 

its safety and efficacy can be determined with statistical 

validity. That testing can take much longer than the laboratory research that produced the drug. With expenditures steadily accumulating at each stage, the research and 

development costs of developing a new drug can be high. 

Moreover, for every successful new drug, a firm will have 

had many failed drug projects that did not survive clinical 

trials or that never won approval from the Food and Drug 

Administration. Estimates of average R&D costs per drug 

include the costs of those failures. 

The total cost of developing a new drug may be twice as 

high as those direct costs, however, because the indirect, 

financial costs of tying up investment capital for years in 

research projects (which will not pay off until a marketable drug is developed) can be as large as a firm’s actual 

R&D spending. Those financial costs—often called 

opportunity costs—reflect the returns that a firm could 

have earned from alternative investments if its capital had 

not been tied up in drug development. Opportunity costs 

exist in all industries and for all innovative products, but 

they are particularly large in the pharmaceutical industry 

because drugs have longer development times than many 

other types of products.

With the drug industry’s R&D spending rapidly increasing but the number of new drugs approved each year 

showing little change, the average R&D cost per new 

drug has grown significantly. According to a widely cited 

estimate, that cost averages more than $800 million for 

innovative new drugs, including both direct and indirect 

costs. Possible reasons for the rise in R&D costs per drug 

include changes in the number and size of clinical trials 

that new drugs undergo. Some of those changes involve 

additional, postmarketing tests that firms conduct to try 

to distinguish their drug from products made by rival 

companies, and some of the changes reflect a possible 

shift in the focus of R&D toward drugs for chronic illnesses (which can require larger and longer trials). The 

development of complex new research technologies and 

advances in basic science may also have helped to drive 

up R&D costs.

Primary Determinants of R&D Costs

A frequently cited 2003 study by Joseph DiMasi, Ronald 

Hansen, and Henry Grabowski (DHG) estimated that 

the average cost of successfully developing a new molecular entity, including R&D spending on failed drug 

projects, was $802 million in 2000.1 Although that 

estimate suggests that new drugs can be very costly to 

develop, it is an average that reflects the costs of successes 

and failures alike. It also reflects the research strategies 

and drug-development choices that firms make on the 

basis of their expectations about future revenue. If companies expected to earn less revenue from future drug 

sales, they would adjust their research strategies to reduce 

their average R&D spending per drug.

Research and development costs for new drugs are highly 

variable. Although the DHG study surveyed drugs from a 

representative set of therapeutic classes, it excluded some 

types of new drugs that have lower average R&D costs, 

such as those that do not introduce new active ingredients but rather are modifications of existing drugs. In 

addition, the estimate may not be representative of R&D 

costs for smaller pharmaceutical firms, which did not participate in the survey on which the study was based. 

However, by focusing on new molecular entities, the

1. Joseph A. DiMasi, Ronald W. Hansen, and Henry G. Grabowski, 

“The Price of Innovation: New Estimates of Drug Development 

Costs,” Journal of Health Economics, vol. 22, no. 2 (March 2003), 

pp. 151-185. 
20 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Table 3-1.

DiMasi and Others’ Estimate of Average Research Costs and Times for

Successfully Developed New Molecular Entities

Source: Joseph A. DiMasi, Ronald W. Hansen, and Henry G. Grabowski, “The Price of Innovation: New Estimates of Drug Development 

Costs,” Journal of Health Economics, vol. 22, no. 2 (March 2003), pp. 151-185.

Note: FDA = Food and Drug Administration.

a. The estimate for the duration of the preclinical phase is based on the comprehensive drug database maintained by the Tufts University 

Center for the Study of Drug Development. 

b. Opportunity costs are the costs associated with keeping capital tied up in a specific drug-development project for a given period (that is, 

the forgone interest or earnings that a company might have gained from investing its capital in other ways). DiMasi and others assumed 

the forgone rate of return to be 11 percent per year.

DHG study did base its cost estimate on the types of 

drugs that have been the source of most pharmaceutical 

breakthroughs.2

The average successfully developed NME in the study’s 

sample required 4.3 years for discovery and preclinical 

development and another 7.5 years for clinical trials and 

FDA approval.3 (Approval itself took an average of 1.5 

years.) Thus, developing an NME and bringing it to market required 11.8 years, on average (see Table 3-1). 

For those various phases of research and development, the 

DHG study estimated average out-of-pocket (or direct) 

costs and fully capitalized costs (assuming a capital cost 

rate of 11 percent per year). The difference between the 

two represents opportunity costs. For the drug projects in 

the DHG survey, opportunity costs constitute about half 

of the total average cost of developing a drug. Those costs 

would make up a smaller percentage of the total cost for 

shorter projects. But in all cases, opportunity costs constitute a greater share in the preclinical phase than in the 

clinical-trial phase because investments made in the earlier phase are tied up longer.

The study’s cost data are proprietary and cannot be independently verified. However, analysts at the Federal Trade 

Commission who sought to replicate the study’s results 

found average research durations that were substantially 

121 282 403

214 185 399 ____ ____ ____

Total Costs 335 467 802

(Millions of 2000 dollars)

Research and Development Costs

Direct costs

Opportunity costsb

Average Length of Research Phase

Preclinical Phase

(4.3 years)a

Clinical Trials and 

FDA Approval

(7.5 years)

Total

(11.8 years)

2. In some cases, however, breakthroughs have been achieved by 

enhancing existing drugs or by discovering important new uses for 

older drugs. For instance, new roles have been found for aspirin in 

reducing the risk of heart attacks, for antiepileptic drugs in treating bipolar disorder, and for antibiotics in treating peptic ulcers. 

See Iain M. Cockburn and Rebecca Henderson, Public-Private 

Interaction and the Productivity of Pharmaceutical Research, Working Paper No. 6018 (Cambridge, Mass.: National Bureau of Economic Research, April 1997), pp. 9-10. 

3. In the DHG sample, the three phases of human clinical trials—

tests for safety in a small sample of healthy human volunteers, efficacy and further safety testing in a larger sample of people with 

the condition that the drug is intended to treat, and large-scale 

clinical trials to establish efficacy and identify side effects—took 

an average of 2 to 2.5 years each. Elsewhere, DiMasi reported 

average phase lengths of 3.8 years (preclinical) and 10.4 years 

(clinical and FDA approval), or 14.2 years in all, for the 1990-

1999 period. See Joseph A. DiMasi, “New Drug Development in 

the United States from 1963 to 1999,” Clinical Pharmacology & 

Therapeutics, vol. 69, no. 5 (May 2001), pp. 286-296. For a different sample of drugs, Grabowski estimated an average of 3.5 years 

in discovery and preclinical testing (excluding basic research), 

more than 6 years in clinical trials, and 2.5 years for FDA review, 

or more than 12 years in total. See Henry Grabowski, Health 

Reform and Pharmaceutical Innovation (Washington, D.C.: AEI 

Press, 1994).
CHAPTER THREE WHAT DOES IT COST TO DEVELOP A NEW DRUG? 21

similar, for a much larger sample of drug projects.4 They 

also found that average research lengths varied significantly for different therapeutic classes and different firms. 

The Office of Technology Assessment (OTA) evaluated 

an earlier survey by DiMasi and others that used a very 

similar methodology. OTA concluded that the average 

time profiles and rates of change in R&D spending 

reported by companies that responded to the survey were 

“congruent” with those firms’ public, audited financial 

records.5 And although OTA could not rule out that the 

survey responses might have overestimated actual research 

spending, it noted that the responses were “at least internally consistent with one another” from year to year.

An editorial in the Journal of Health Economics concluded 

that the DHG study’s $802 million cost estimate was rigorously and carefully constructed.6 However, it also 

argued that the average R&D cost of developing an incrementally modified drug was probably much lower than 

that amount. Available data indicate that, roughly speaking, spending to modify existing drugs accounts for less 

than one-third of total R&D expenditures, although 

modified versions of existing drugs make up about twothirds of all new drug products.7 Thus, the average direct 

R&D cost of an incrementally modified drug may be no 

more than one-fourth that of a new molecular entity. Its 

fully capitalized R&D costs may be an even smaller fraction—if, as seems likely, modifying a drug takes less time 

than discovering one.

Another analyst has asserted that the DHG estimate is 

representative only of research done by the type of large, 

leading pharmaceutical firms that participated in the survey.8

 Such firms are said to place more emphasis on treatments for cancer and chronic diseases than smaller firms 

do. Drugs for those kinds of illnesses can be costly to 

develop compared with drugs for acute illnesses because 

they often require larger and longer clinical trials. 

In addition, the R&D costs that companies report may 

be somewhat inflated because the federal research and 

experimentation tax credit gives firms an incentive to be 

expansive in classifying expenses as R&D-related.9

 Thus, 

the DHG estimate may include some ancillary expenses 

not strictly for research and development. The Congressional Budget Office has no evidence, however, about 

whether that is or is not the case.

Ultimately, because the expected returns from individual 

drug projects depend as much on expected sales revenue 

as on R&D costs, an inexpensive drug project may be 

either more or less attractive to a company than an expensive one. As a result, an estimate of average R&D costs 

may be of little help to firms in deciding whether to 

undertake a particular new drug project. The main utility 

of studies such as the DHG survey lies in showing how 

long it takes and how expensive it is, on average, to 

develop the kinds of innovative drugs represented in 

those surveys, as well as how that duration and expense 

have grown over time as the industry has pursued different kinds of drug treatments using increasingly sophisticated research technologies.

Why Have R&D Costs Risen for 

Innovative New Drugs?

Various surveys conducted between 1976 and 2000 suggest that during that period, the average amount that surveyed firms reported spending on research and development of new molecular entities increased nearly sixfold in 

real terms (see Figure 3-1). DiMasi, Hansen, and 

Grabowski estimate that average R&D costs, including 

opportunity costs, rose at an annual rate that was 7.4 percent above inflation during the 1980s (the most recent 

decade for which they have made such an estimate) and

4. See Christopher P. Adams and Van V. Brantner, “Estimating the 

Cost of New Drug Development: Is It Really $802 Million?” 

Health Affairs, vol. 25, no. 2 (March/April 2006), pp. 420-428.

5. See U.S. Congress, Office of Technology Assessment, Pharmaceutical R&D: Costs, Risks, and Rewards, OTA-H-522 (February 

1993), pp. 61-62; and Joseph A. DiMasi and others, “Cost of 

Innovation in the Pharmaceutical Industry,” Journal of Health Economics, vol. 10, no. 2 (July 1991), pp. 107–142.

6. Richard G. Frank, “New Estimates of Drug Development Costs,” 

Journal of Health Economics, vol. 22, no. 2 (March 2003), p. 327.

7. Ibid., p. 327, citing CMR International’s 2002 estimate that 

product-line extensions account for 30 percent of research and 

development and PhRMA’s 1999 estimate that they account for 

“about 18 percent” of R&D expenditures. 

8. F.M. Scherer, “The Pharmaceutical Industry—Prices and 

Progress,” New England Journal of Medicine, vol. 351, no. 9 

(August 26, 2004).

9. See Gary Guenther, Federal Taxation of the Drug Industry: 1990 to 

1999 (Congressional Research Service, July 22, 2002). See also 

Michael Kremer and Rachael Glennerster, Strong Medicine: Creating Incentives for Pharmaceutical Research on Neglected Diseases

(Princeton, N.J.: Princeton University Press, 2004), Chapter 9. 
22 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

9.4 percent above inflation during the 1970s.10 Observers attribute the continuing growth in R&D costs for 

innovative new drugs to several factors:

B An increase in the percentage of drug projects that fail 

in clinical trials;

B A trend toward bigger and lengthier clinical trials as 

well as a possible rise in the number of trials that firms 

are conducting (including trials for marketing purposes, such as to differentiate a product from its competitors); 

B A shift in the types of drugs that companies work on, 

toward those intended to treat chronic and degenerative diseases;11

B Advances in research technology and in the scientific 

opportunities facing the pharmaceutical industry;

B The increased commercialization of basic research, as 

firms more often pay for access to basic research findings that in earlier years might have been freely available;12 and

B A lengthening of the average time that drugs spend in 

preclinical research.

In the other direction, various developments—faster 

FDA reviews, regulatory changes, and speedier methods

Figure 3-1.

Various Estimates of the Average 

R&D Cost of a Successfully Developed 

New Molecular Entity

(Millions of 2000 dollars)

Source: Congressional Budget Office based on R.W. Hansen, “The 

Pharmaceutical Development Process: Estimates of Current Development Costs and Times and the Effects of Regulatory Changes,” in R.I. Chien, ed., Issues in Pharmaceutical Economics (Lexington, Mass.: Lexington Books, 

1979), pp. 151-187; Joseph A. DiMasi and others, “Cost of 

Innovation in the Pharmaceutical Industry,” Journal of 

Health Economics, vol. 10, no. 2 (July 1991), pp. 107-142; 

U.S. Congress, Office of Technology Assessment, Pharmaceutical R&D: Costs, Risks, and Rewards, OTA-H-522 (February 1993); and Joseph A. DiMasi, Ronald W. Hansen, 

and Henry G. Grabowski, “The Price of Innovation: New 

Estimates of Drug Development Costs,” Journal of Health 

Economics, vol. 22, no. 2 (March 2003), pp. 151-185.

Notes: R&D = research and development.

The year shown for each estimate is the year in which the 

cost survey was performed, not the year in which the results 

were published.

of identifying potential R&D failures—may have kept 

research and development costs from growing as quickly 

as they would have otherwise.

Higher Failure Rates

To be approved by the FDA for use, a drug must undergo 

three phases of human clinical trials: tests for safety in a 

small sample of healthy human volunteers (phase I), effi10. DiMasi, Hansen, and Grabowski, “The Price of Innovation,” 

pp. 167-168. OTA estimated a higher rate of increase over the first 

half of the 1970s, 12.4 percent above inflation. It attributed that 

rise largely to an increase in the size of clinical trials and to a 

lengthening of drug-development times (from 9.6 years to 11.8 

years during that period) because of longer time spent in preclinical research and in gaining FDA approval. See Office of 

Technology Assessment, Pharmaceutical R&D.

11. Note that the earlier mention of chronic illnesses was in the context of the greater emphasis placed on them by larger firms. Here 

the context is the growth in that emphasis over time. For the 

industry’s shift toward such illnesses, see DiMasi, Hansen, and 

Grabowski, “The Price of Innovation,” p. 181; and Grabowski, 

Health Reform and Pharmaceutical Innovation, p. 12.

12. According to the Association of University Technology Managers, 

universities’ total royalty income on patents has lately exceeded 

$1 billion per year. Much of that income is from biomedical patents. See Association of University Technology Managers, AUTM 

U.S. Licensing Survey: FY 2004—Survey Summary (Northbrook, 

Ill.: AUTM, 2005), p. 26, available at www.autm.net/events/File/

FY04%20Licensing%20Survey/04AUTM-USLicSrvy-public.pdf.

1976 1980 1984 1988 1992 1996 2000

0

200

400

600

800

1,000

$137

$319

$445

$802
CHAPTER THREE WHAT DOES IT COST TO DEVELOP A NEW DRUG? 23

cacy testing and further safety testing in a larger sample of 

people with the condition that the drug is intended to 

treat (phase II), and large-scale clinical trials to establish 

efficacy and identify side effects (phase III). According to 

the FDA, the proportion of all news drugs entering phase 

I trials that ultimately gain approval has fallen to 8 percent from a historical average of about 14 percent.13 That 

decline could explain a significant part of the increase in 

average R&D costs per new drug—the more so the later 

those additional failures occur in the trial process. 

Rising failure rates could indicate that the stock of easily 

discoverable new drugs has been temporarily depleted, 

pending further advances in science. However, they could 

also result from growing consumer demand for new 

drugs. Firms are likely to invest first (if all else is equal) in 

projects with the highest expected returns, which are 

partly a function of how likely those projects are to succeed. Increases in demand induce firms to develop additional, less promising projects that they had held in 

reserve, including those less likely to succeed.

The average success rate for new molecular entities is 

much higher than for new-drug applications as a whole, 

but it still illustrates how relatively few drugs survive the 

clinical-trial process. Of the NMEs in the Tufts Center 

for the Study of Drug Development’s database (from 

which the DHG sample was drawn), 71.0 percent survived phase I clinical trials to enter phase II, and 31.4 

percent survived to phase III (see Figure 3-2). Because 

phase III trials are much larger and more expensive than 

earlier trials, the cost of failure rises disproportionately 

though the trial process. Overall, 21.5 percent of the 

NMEs completed phase III trials and were approved by 

the FDA, a rate nearly three times higher than for all 

new-drug applications.14

Changes in Clinical Trials

Contributing to the rise in R&D costs, average clinicalphase costs grew fivefold between 1987 and 2000, 

according to the DHG study—or at an average rate of 

more than 12 percent a year in real terms.15 That growth 

Figure 3-2.

Percentage of New Molecular Entities 

Entering Each Phase of Clinical Trials

Source: Congressional Budget Office based on Joseph A. DiMasi, 

Ronald W. Hansen, and Henry G. Grabowski, “The Price of 

Innovation: New Estimates of Drug Development Costs,” 

Journal of Health Economics, vol. 22 (2003), pp. 151-185.

Note: FDA = Food and Drug Administration.

resulted from increases in the size and duration of clinical 

trials. The DHG study estimates that the average number 

of people per trial grew by 7.5 percent annually, from 

about 2,300 in the 1980s to more than 5,600 by the early 

2000s.16 The average length of the clinical-trial phase 

increased by 27 percent over the 1980s and then declined 

by 4 percent over the 1990s.17

Companies may also be undertaking more clinical trials 

now than in the past, performing head-to-head trials for

13. Food and Drug Administration, Innovation or Stagnation: Challenge and Opportunity on the Critical Path to New Medical Products

(March 2004), p. 8.

14. DiMasi, Hansen, and Grabowski, “The Price of Innovation,” 

p. 162.

15. Ibid., p. 162.

16. Ibid., p. 177. OTA agreed that clinical trials had grown larger in 

terms of number of subjects; see Office of Technology Assessment, 

Pharmaceutical R&D, pp. 144-146. 

17. DiMasi, “New Drug Development in the United States from 

1963 to 1999.” Those estimates were based on a larger sample of 

NMEs than in the DHG study. Another study, using a different 

sample of drugs, found no evidence that the average length of 

clinical trials fell between 1992 and 2002; see Salomeh Keyhani, 

Mari Diener-West, and Neil Powe, “Are Development Times for 

Pharmaceuticals Increasing or Decreasing?” Health Affairs, vol. 25, 

no. 2 (March/April 2006), pp. 461-468.

Phase I Phase II Phase III FDA Approval

0

10

20

30

40

50

60

70

80

90

100
24 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

marketing and product-differentiation purposes.18 (In 

the FDA approval process, a drug is compared with a placebo rather than with other drugs.) In some cases, a firm 

may sponsor clinical trials whose primary purpose is to 

familiarize participating doctors with the company’s new 

drugs; such trials may not even be intended to be scientifically rigorous.19 In other cases, firms may face pressure 

from health insurers to demonstrate their drugs’ superiority with scientific rigor as a condition of being included 

in insurers’ formularies of preferred drugs. To the extent 

that extra tests establish that a drug is superior to available substitutes, such tests can also allow firms to set 

higher prices.20 However, quality differences between 

approved drugs are likely to be smaller than differences 

between a drug and a placebo, so showing that the differences are clinically and statistically significant requires 

larger and more costly clinical trials. 

Changes in the Types of Drugs Being Developed

A shift in companies’ R&D efforts toward drugs for 

chronic and degenerative illnesses rather than drugs for 

acute illnesses could also have contributed to higher 

R&D costs. Since chronic-illness drugs take longer to 

achieve measurable results, they may require bigger and 

more expensive trials. Also, because such drugs are meant 

to be taken for a long time, they must be tested for side 

effects over a longer period. Furthermore, their therapeutic effects may be subtle—reducing the severity of symptoms rather than curing a disease—and difficult to distinguish from the health effects of other, unrelated factors in 

the patient population. In such cases, a larger study with 

more participants may be necessary for statistical reasons. 

Finally, as the DHG study notes, therapies for chronic 

conditions typically require more-complex patient care 

and monitoring, further adding to the expense of clinical 

trials.21

Scientific Advances

Another change that may have played a role in boosting 

R&D costs is the retooling that the drug industry has 

undertaken in response to advances in basic science.22

The sequencing of the human genome, which was completed in 2003, is expected ultimately to open productive 

new branches of drug research. However, that scientific 

milestone coincided with an unexpected slowdown in 

submissions of new-drug applications worldwide.23 One 

explanation for the slowdown may be that new research 

technologies and capabilities—such as the industry’s shift 

from traditional chemical methods in randomly screening 

for new drug compounds to computer-automated screening—have imposed learning costs that temporarily 

damped research output and raised firms’ R&D costs.24

Factors Slowing the Growth of R&D Costs

Despite the overall increase in average research and development costs for new drugs, some changes have helped 

slow that growth. Additional review staff at the FDA, 

funded by revenue from the Prescription Drug User Fee 

Act of 1992, helped slow the growth rate of R&D costs 

by reducing the time required for FDA approval. The 

average development time for new drugs declined by 

about 10 percent over the 1990s, from nearly 99 months 

to about 90 months, according to the DHG study. Much 

18. Scherer, “The Pharmaceutical Industry—Prices and Progress,” 

p. 928. 

19. David A. Kessler and others cite evidence that firms have conducted “seeding” clinical trials that lacked control groups, were 

not blinded, and appeared to be for marketing rather than scientific purposes; see Kessler and others, “Therapeutic-Class Wars—

Drug Promotion in a Competitive Marketplace,” New England 

Journal of Medicine, vol. 331, no. 20 (November 17, 1994), 

pp. 1350-1353. A recent study concludes that doctors who conduct clinical trials sponsored by a pharmaceutical company subsequently increase their prescribing of the sponsoring firm’s drugs; 

see Morten Andersen, Jakob Kragstrup, and Jens Søndergaard, 

“How Conducting a Clinical Trial Affects Physicians’ Guideline 

Adherence and Drug Preferences,” Journal of the American Medical 

Association, vol. 295, no. 23 (June 21, 2006), pp. 2759-2764.

20. DiMasi, Hansen, and Grabowski, “The Price of Innovation,” 

p. 181, citing F-D-C Reports, “NDA Submissions Are Shrinking 

in Size but Increasing in Complexity,” The Pink Sheet, vol. 61 

(1999), p. 28.

21. DiMasi, Hansen, and Grabowski, “The Price of Innovation,” 

p. 181. 

22. See Iain M. Cockburn, “The Changing Structure of the Pharmaceutical Industry,” Health Affairs, vol. 23, no. 1 (January/February 

2004), p. 12.

23. Food and Drug Administration, Innovation or Stagnation, p. 3. In 

2003, the National Human Genome Research Institute at the 

National Institutes of Health stated that “most new drugs based 

on the completed genome are still perhaps 10 to 15 years in the 

future, although more than 350 biotech products—many based 

on genetic research—are currently in clinical trials, according to 

the Biotechnology Industry Organization.” See National Human 

Genome Research Institute, “The Human Genome Project Completion: Frequently Asked Questions” (November 2005), available 

at www.genome.gov/11006943.

24. See Peter Landers, “Drug Industry’s Big Push into Technology 

Falls Short,” Wall Street Journal, February 24, 2004, p. A1.
CHAPTER THREE WHAT DOES IT COST TO DEVELOP A NEW DRUG? 25

of that decline was attributable to the 1992 law, which is 

estimated to have reduced FDA review times by almost 

10 months.25 Other changes at the FDA—including a 

streamlining of the preclinical regulatory process, as 

called for in the FDA Modernization Act of 1997—may 

also have kept drug-development times shorter than they 

would have been otherwise.

The FDA asserts that methods to better predict the outcome of R&D and to demonstrate a drug’s safety and 

efficacy more quickly hold promise as an important 

source of reductions in future R&D costs. According to 

the agency, research in the areas of prediction and demonstration has lagged behind advances in basic science. 

The FDA says that better predictive tools could reduce 

the number of drugs that enter clinical trials by more 

effectively identifying likely failures before clinical testing 

begins.26 In any case, some evidence suggests that companies have become more adept at identifying failures earlier in the trial process: success rates for early-phase trials 

declined slightly between the 1991 study by DiMasi and 

others and the 2003 DHG study, while the likelihood of 

success in phase III trials rose by 5 percentage points.27 25. For the average new molecular entity in the DHG survey, that 

time savings would have reduced development costs by about 

$40 million (or about 5 percent of total costs), assuming that it 

eliminated 10 months of capital-cost accumulation on an average 

of $403 million in direct R&D costs, at an assumed capital-cost 

rate of 11 percent per year.

26. Food and Drug Administration, Innovation or Stagnation, p. 8.

27. DiMasi, Hansen, and Grabowski, “The Price of Innovation,” 

p. 163.

CHAPTER

4

Does Federal R&D Spending Stimulate or 

Substitute for Private-Sector Spending?

Federally funded research plays a major role in the 

discovery of new pharmaceuticals. Most of the important 

new drugs introduced by the pharmaceutical industry 

over the past 40 years were developed with some contribution from public-sector research.1 In the past decade, 

federal outlays on health-related research and development have totaled hundreds of billions of dollars at the 

National Institutes of Health (NIH) alone.2

 Although 

only some of that spending was explicitly related to pharmaceuticals, much of it was for the basic research on disease mechanisms that underlies the search for new drugs. 

Federally supported basic research in genomics, molecular biology, and other life sciences has greatly expanded 

the drug industry’s technological opportunities, stimulating private investment in pharmaceutical R&D.

Given the extent of public R&D spending in the life sciences, however, there is a risk that such spending could 

“crowd out” (or discourage) private investment in some 

cases by substituting for it rather than complementing or 

stimulating it. The government’s focus on basic research, 

while the drug industry concentrates on applied research 

and development, tends to minimize that risk. But the 

distinction between basic and applied research is not 

always clear—and it has blurred to some degree as drug 

development has become more dependent on scientific 

knowledge. 

Aggregate statistical data suggest that, overall, private 

R&D spending responds positively to federal R&D. In 

specific cases, however, the government may have funded 

some research that the private sector otherwise would 

have paid for. Identifying where such direct crowding out 

has occurred is difficult, but it is probably more likely to 

happen in areas where potentially valuable commercial 

applications of government-funded research are more 

apparent. 

In addition, an indirect form of crowding out may occur 

if increases in federal R&D spending cause total employment in the research field to rise. Higher demand for 

researchers could cause research salaries—and thus firms’ 

labor costs—to increase. Salaries are more likely to be 

affected in that way when federal funding is growing rapidly. In general, however, federal funding trains many 

graduate students for research careers in the drug industry, contributing indirectly to the productivity and profitability of pharmaceutical R&D.

Public and Private R&D Spending

Health-related research receives the second largest 

amount of federal support for R&D (behind only 

defense-related research). That support has been steadily 

growing for several decades. Research spending by 

NIH—by far the primary recipient of government funding for health-related basic research—totaled $5.8 billion 

(in 2005 dollars) in 1970, more than doubled to $12.3 

billion by 1990, and reached $28.5 billion by 2004 (see 

Figure 4-1). In comparison, R&D spending reported by 

the members of the Pharmaceutical Research and Manu1. Out of 21 of the most influential drugs introduced between 1965 

and 1992, only five were essentially developed entirely by the private sector. See Iain M. Cockburn and Rebecca M. Henderson, 

“Publicly Funded Science and the Productivity of the Pharmaceutical Industry,” in Adam B. Jaffe, Josh Lerner, and Scott Stern, 

eds., NBER Innovation Policy and the Economy, vol. 1 (Cambridge, 

Mass.: National Bureau of Economic Research, 2000), pp. 20-21.

2. NIH receives the majority of the government’s funding for human 

life-sciences research. The rest goes to the National Science Foundation, the National Aeronautics and Space Administration, the 

Environmental Protection Agency, the Veterans Administration, 

and the Departments of Energy, Commerce, Defense, and Health 

and Human Services (of which NIH is a part). See National Science Foundation, Federal Funds for Research and Development (various years), available at www.nsf.gov/statistics/fedfunds/.
28 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Figure 4-1.

Annual Spending on Research and Development by Drug Companies and the 

National Institutes of Health

(Billions of 2005 dollars)

Source: Congressional Budget Office based on Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 

2006 (Washington, D.C.: PhRMA, March 2006); and National Science Foundation, Federal Funds for Research and Development

(various years), available at www.nsf.gov/statistics/fedfunds/.

Note: Spending was adjusted for inflation using the biomedical research and development price index from the Bureau of Economic Analysis.

facturers of America was just two-thirds the size of NIH’s 

spending in 1980. PhRMA’s R&D spending surpassed 

NIH’s in 1987 and has remained higher since then, 

although both grew at similar rates in the late 1990s and 

early 2000s.3

Much of the government’s R&D spending is for basic 

research, but a 1993 study by the Office of Technology 

Assessment found that some of it has funded applied 

research specifically related to the development of new 

drugs. OTA identified multiple federal programs, many 

of them at NIH, “whose specific mission [was] to conduct R&D involving actual or potential pharmaceutical 

products.”4 At that time (in the late 1980s), federal 

spending on such research amounted to slightly less than 

10 percent of the government’s total spending on healthrelated R&D.5 However, much of the rest of that spending supports pharmaceutical R&D by improving the 

understanding of disease mechanisms. Although it is 

difficult to say exactly how much of the federal government’s health-related R&D spending is relevant to the 

pharmaceutical industry, much of it probably is.

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

0

5

10

15

20

25

30

35

40

PhRMA Members

National

Institutes of

Health

3. That comparison excludes R&D spending abroad by foreign 

PhRMA members. Domestic R&D by domestic PhRMA members has exceeded NIH outlays since 1991 (by $3 billion to $5 billion in most years).

4. U.S. Congress, Office of Technology Assessment, Pharmaceutical 

R&D: Costs, Risks, and Rewards, OTA-H-522 (February 1993), 

p. 211.

5. CBO calculation based on Office of Technology Assessment, 

Pharmaceutical R&D, Tables 9-4 and 9-6, pp. 214 and 215, and 

total government spending on health-related R&D of less than 

$10 billion a year. Since 2000, NIH has classified all of its R&D 

as research rather than development. See Ronald L. Meeks, Proposed FY 2003 Budget Would Complete Plan to Double Health 

R&D Funding, Considerably Expand Defense R&D, National Science Foundation InfoBrief (July 2002), footnote 3, available at 

www.nsf.gov/statistics/infbrief/nsf02326/. In NIH’s 2007 R&D 

budget, basic research accounts for 58 percent of total spending, 

with applied or clinical research accounting for the rest. See American Association for the Advancement of Science, Intersociety 

Working Group, AAAS Report XXXI: Research and Development, 

FY 2007 (Washington, D.C.: AAAS, 2006).
CHAPTER FOUR DOES FEDERAL R&D SPENDING STIMULATE OR SUBSTITUTE FOR PRIVATE-SECTOR SPENDING? 29

The rationale for government funding of basic scientific 

research is that if such research were left solely to the private sector, too little of it would be done, in the sense that 

the benefits to society from doing additional basic R&D 

(beyond what firms alone would conduct) would far outweigh the costs. A company’s incentive to invest in R&D 

is limited to its own expected returns. In the case of basic 

research and development, those returns can be particularly low compared with the social benefits, because it can 

be difficult for private companies to capture more than a 

small fraction of the total social value of their basic 

research.6 Although the distinction between basic and 

applied R&D is not always clear, it is useful to think of 

basic research as generating information or knowledge 

that is not readily embodied in physical products.7

 Companies can have trouble keeping the benefits of their basic 

R&D to themselves because the information can generally be communicated at very low cost.

Given the increasingly scientific basis of drug development, the pharmaceutical industry has come to view publicly funded basic R&D as a “critically important source 

of immediately useful knowledge and techniques.”8 Drug 

firms cite “immediate access to leading-edge publicly 

funded science” as an important competitive advantage.9

Government funding for basic research also pays for the 

laboratory training that graduate students receive as they 

prepare for careers as professional researchers in the pharmaceutical industry. 

Despite the difficulties of capturing more than a small 

part of its value, many drug companies perform some 

basic research themselves. In addition to supporting their 

applied R&D programs, such research helps to attract 

motivated scientists who might otherwise prefer to work 

in an academic setting. Doing its own basic research and 

publishing the findings may also enhance a firm’s capacity 

to benefit from academic and government basic 

research.10

Does Government R&D Crowd Out 

Private R&D?

Even as it produces substantial social benefits, federal 

spending on basic research and development can also discourage private investment in R&D.11 Such crowding 

out can occur directly, as when the government sponsors 

research that the private sector would otherwise have conducted. Or it may occur indirectly, as the government 

competes for trained scientists and other scarce resources 

and bids up their prices. 

Government-sponsored R&D can also influence competitive interactions between firms. As a result of its own 

research and technical capabilities, one company may be 

better positioned than its rivals to take advantage of new 

scientific findings from government-sponsored basic 

research. Or the research may help competitors narrow a 

leading firm’s advantage by expanding the scope of common scientific knowledge. In either case, public funding 

of basic research can affect private R&D spending by 

revising firms’ expectations about profits.

Examples of Crowding Out

In the past, direct crowding out may have been relatively 

uncommon in the pharmaceutical industry because the 

public sector mainly focused on basic research and the 

private sector mainly concentrated on applied research 

and development. However, structural changes in the 

industry have increased the private sector’s role in basic 

research. And advances in biological sciences have helped 

to blur the distinction between basic and applied 

research.

6. A basic research discovery cannot be patented unless the inventor 

can credibly describe the discovery’s “specific and substantial” utility. See U.S. Patent and Trademark Office, “2107 Guidelines for 

Examination of Applications for Compliance with the Utility 

Requirement,” available at www.uspto.gov/web/offices/pac/mpep/

documents/2100_2107.htm. 

7. See F.M. Scherer, New Perspectives on Economic Growth and Technological Innovation (Washington, D.C.: Brookings Institution 

Press, 1999), pp. 54-57; and Nathan Rosenberg, “Why Do Firms 

Do Basic Research (With Their Own Money)?” Research Policy,

vol. 19 (1990), especially p. 170 for the distinction between basic 

and applied research in health and medicine.

8. Cockburn and Henderson, “Publicly Funded Science and the Productivity of the Pharmaceutical Industry,” p. 17. 

9. Ibid., p. 4.

10. Ibid.; and Rosenberg, “Why Do Firms Do Basic Research?”

11. Material in this and the following paragraph comes from Cockburn and Henderson, “Publicly Funded Science and the Productivity of the Pharmaceutical Industry,” and from Iain Cockburn 

and Rebecca Henderson, “Absorptive Capacity, Coauthoring 

Behavior, and the Organization of Research in Drug Discovery,” 

Journal of Industrial Economics, vol. 46, no. 2 (June 1998), 

pp. 157-182.
30 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Box 4-1.

Do Private Firms Benefit Disproportionately from Taxpayer-Funded 

Basic Research?

Some observers have noted that companies can save 

significantly on research and development when they 

develop new drugs from chemical compounds that 

were discovered in government or academic laboratories. Such drugs should therefore be “reasonably” 

priced, according to those observers. 

The Bayh-Dole Act of 1980 grants the government a 

royalty-free license to use inventions, such as new 

drugs, that it had a hand in developing, but that 

license is rarely exercised.1

 A chemical compound 

discovered through publicly funded research may be 

licensed to a private firm on terms specified by (or 

negotiated with) the institution where the compound 

was discovered. If the terms include royalty payments 

based on future sales revenue, restrictions on a drug’s 

price are not in the best interest of either the institution or the licensed manufacturer.2

For U.S. taxpayers, the primary benefits of publicly 

funded research come from the therapeutic value of 

drugs that ultimately result from that research and 

the Treasury’s receipt of corporate income taxes on 

profits from those drugs. Constraining the prices of 

such drugs would tend to weaken firms’ incentives to 

develop government-funded research discoveries into 

new drugs, which is a primary rationale behind the 

Bayh-Dole Act.

The larger issue, however, is not how much firms 

charge for such drugs but on what terms the original 

research discoveries are licensed to them. Most of the 

costs involved in developing a new drug come not 

from the initial discovery research but from clinical 

testing and regulatory approval—costs that firms 

tend to bear themselves. Even so, unless licenses for 

taxpayer-funded research discoveries fully cover the 

costs of that initial research, the savings that firms 

gain by licensing under favorable terms may induce 

them to invest in developing taxpayer-funded discoveries in preference to other, more socially valuable 

R&D projects that they may have available. Such 

savings in research costs may also lead companies to 

invest more in R&D overall than they would otherwise. That added investment could broaden the types 

of drugs that firms tried to develop beyond what the 

market would otherwise demand or could cause 

drugs to be developed more quickly than the market 

demanded.

1. According to the Government Accountability Office (formerly the General Accounting Office), the license provision 

entitles the government to a discounted price only when a 

drug is actually produced under its license, which is rarely the 

case. See General Accounting Office, Technology Transfer: 

Agencies’ Rights to Federally Sponsored Biomedical Inventions, 

GAO-03-536 (July 2003), p. 7. For a broad discussion of the 

issue, see Wendy H. Schacht, The Bayh-Dole Act: Selected 

Issues in Patent Policy and the Commercialization of Technology,

CRS Report for Congress RL32076 (Congressional Research 

Service, June 10, 2005).

2. For a specific example of development costs, licensing terms, 

revenues, and royalty payments for a particular drug, see Jeff 

Gerth and Sheryl Gay Stolberg, “Medicine Merchants: Birth 

of a Blockbuster; Drug Makers Reap Profits on Tax-Backed 

Research,” New York Times, April 23, 2000, p. A1.
CHAPTER FOUR DOES FEDERAL R&D SPENDING STIMULATE OR SUBSTITUTE FOR PRIVATE-SECTOR SPENDING? 31

The mapping of the human genome in the 1990s and 

early 2000s developed into a race between a public 

agency (NIH) and a private firm (Celera) that saw potential commercial value in mapping human gene sequences. 

In that case, NIH’s Human Genome Project supplanted 

some private R&D, but it did so intentionally: NIH scientists wanted to avoid delay in placing the sequenced 

human genome in the public domain, and they used a 

sequencing method that complemented Celera’s method 

and arguably hastened the completion of the project.12

The potential for overlap between the public and private 

sectors in that area continues, since both NIH and the 

pharmaceutical industry are said to be “funding work in 

structural genomics . . . the next step beyond mapping 

the human genome.”13

In other cases, chemical compounds discovered in the 

public sector have sometimes provided the active ingredients for privately developed drugs (see Box 4-1). In general, the risk of crowding out seems likely to be greatest 

where the potential commercial applications of the government’s research are most apparent.

Evidence of a Stimulus Effect

It is seldom possible to identify particular cases in which 

the private sector would have performed research if the 

government had not. Thus, most of the available empirical evidence is based on aggregate studies. On balance, 

that evidence suggests a positive relationship between 

public and private pharmaceutical R&D. 

A 1995 study estimated that a 1 percent increase in NIHfunded research produced, on average, a 2.5 percent 

increase in private R&D spending (with a lag of about 

seven years while the basic research was conducted and its 

findings published).14 Moreover, about two-thirds of the 

private response amounted to “spillovers”—new research 

outside the field in which the NIH research was conducted. Although those findings do not address whether 

the drug industry would eventually have done the original research itself, the study is suggestive because the private response is disproportionate: the federal spending 

appears to have stimulated total private investment rather 

than simply shifting it. 

A more recent, unpublished study concludes that 

increases in public-sector spending for basic research are 

associated with eventual increases in approvals of new 

molecular entities (see Figure 4-2).15 The aggregate evidence in that study suggests a lag of about 18 years 

between the initial funding for basic research and the 

Food and Drug Administration’s approval of additional 

new drugs. That gap is approximately consistent with the 

seven-year lag noted above plus the time required for 

drug development, which averages about 12 years.16 By 

implication, current federal funding for life-sciences 

research may broadly predict the number of NMEs that 

will be approved in the future. But the evidence in that 

study remains tentative, and the most recent data used in 

the study are now a dozen years old. The findings may 

not hold up when newer data are included. 

In general, studies that compare different industries find 

that, on balance, increases in government R&D spending 

appear to complement private R&D investment.17 Such 

comparisons, however, cannot rule out the possibility 

12. The Human Genome Project was NIH’s highest-priority R&D 

project during its race with Celera. In 2003, NIH and Celera were 

both credited with completing the map of the human genome. 

For the assertion that complementary sequencing approaches hastened that mapping, see National Institutes of Health, National 

Human Genome Research Institute, “International Human 

Genome Sequencing Consortium Announces ‘Working Draft’ of 

Human Genome” (news release, June 26, 2000), available at 

www.nih.gov/news/pr/jun2000/nhgri-26.htm. For the publicdomain motivation and the characterization of the NIH/Celera 

genome mapping as a race, see Encyclopedia Britannica Online, 

“Human Genome Project: Road Map for Science and Medicine” 

(December 1, 2005), p. 4, available at www.britannica.com/eb/

article-215220.

13. Richard E. Rowberg, Pharmaceutical Research and Development: A 

Description and Analysis of the Process, CRS Report for Congress 

RL30913 (Congressional Research Service, April 2, 2001), p. 23.

14. Michael R. Ward and David Dranove, “The Vertical Chain of 

Research and Development in the Pharmaceutical Industry,” Economic Inquiry, vol. 33, no. 1 (January 1995), pp. 70-87.

15. Andrew A. Toole, The Impact of Public Basic Research on Industrial 

Innovation: Evidence from the Pharmaceutical Industry, Discussion 

Paper 00-07 (Stanford, Calif.: Stanford Institute for Economic 

Policy Research, November 2000).

16. Joseph A. DiMasi, Ronald W. Hansen, and Henry G. Grabowski, 

“The Price of Innovation: New Estimates of Drug Development 

Costs,” Journal of Health Economics, vol. 22, no. 2 (March 2003), 

pp. 151-185.

17. See Paul A. David, Bronwyn H. Hall, and Andrew A. Toole, 

“Is Public R&D a Complement or Substitute for Private R&D? 

A Review of the Econometric Evidence,” Research Policy, vol. 29, 

nos. 4-5 (April 2000), pp. 497-529. The review covers studies of 

crowding out conducted over the past 35 years.
32 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Figure 4-2.

NME Approvals and Public-Sector Spending on Basic Research

(Millions of 1986 dollars)

Source: Congressional Budget Office based on Andrew A. Toole, The Impact of Public Basic Research on Industrial Innovation: Evidence 

from the Pharmaceutical Industry, Discussion Paper 00-07 (Stanford, Calif.: Stanford Institute for Economic Policy Research, 

November 2000).

Note: NME = new molecular entity.

a. Four-year moving average (for example, the number of NMEs shown for 1978 is the average of the numbers approved in 1975, 1976, 

1977, and 1978, to smooth the variation in the pattern of approvals).

b. Research and development grants by the National Institutes of Health and other agencies of the Public Health Service. Excludes intramural research and extramural grants for activities that Andrew Toole judged not to be relevant to pharmaceutical research. Such excluded 

grants include training, education, construction, demonstration, and institutional block grants, as well as grants to organizations considered to do little basic science relevant to pharmaceuticals (such as the National Institute on Dental Research, the National Institute on 

Environmental Health Sciences, and several others). The data for research funding were plotted 18 years ahead (for example, the 1972 

number was plotted onto 1990) to show the correlation between the pattern for NME approvals and the pattern for federal funding of 

basic research.

that changes in public and private R&D spending may 

simply reflect similar responses to underlying shifts in 

available technological opportunities rather than having 

any causal link. Firm-level studies avoid that possibility 

by including companies that conduct research in different 

areas of technology; those studies have been somewhat 

more likely than cross-industry studies to conclude that 

government spending for R&D displaces private-sector 

spending. 

In the end, the prevalence of crowding out or stimulus 

probably depends on the industry in question. For pharmaceuticals, the importance of advances in basic science 

to the search for new drugs, and the ease with which the 

benefits of basic research flow beyond the researcher’s 

control, provide rationales for a government role in basic 

R&D, even if such R&D can directly displace private 

investment in some circumstances.

Impact on Salaries and Other Research Costs

Government spending on research and development can 

also indirectly crowd out private investment by causing 

R&D costs to rise. Pharmaceutical research requires 

highly trained scientists, and the supply of those researchers cannot adjust quickly to changes in demand. Rapid 

increases in government (or private) R&D spending may 

cause salaries for researchers to rise in both public- and 

private-sector organizations.18 The supply of researchers 

1978 1980 1982 1984 1986 1988 1990 1992 1994

0

5

10

15

20

25

0

200

400

600

800

1,000

1,200

1,400

1,600

Federal Funding for Basic Research,

Lagged by 18 Yearsb (Right scale)

Number of NMEs Approveda

(Left scale)

18. See Austan Goolsbee, “Does Government R&D Policy Mainly 

Benefit Scientists and Engineers?” American Economic Review, 

vol. 88, no. 2 (May 1998), pp. 298-302.
CHAPTER FOUR DOES FEDERAL R&D SPENDING STIMULATE OR SUBSTITUTE FOR PRIVATE-SECTOR SPENDING? 33

eventually increases in response to higher salaries. But 

that response takes several years, because new workers 

drawn to the field by higher pay must first receive graduate training. 

When additional researchers enter the labor force, real 

salaries tend to decline to reflect the increase in supply. 

Until that adjustment occurs, however, increases in government R&D spending can push private R&D costs 

higher, which may discourage or delay some privatesector investment. That form of indirect crowding out 

is more likely to occur when federal R&D spending is 

growing more quickly. In addition, it may have a greater 

effect on firms’ decisions about whether to undertake 

specific future projects (or cancel specific current projects) that are of marginal expected profitability than on 

projects with higher expected payoffs. Public and private 

spending levels on R&D have been growing rapidly in 

recent years; during that time, both total employment in 

biomedical research and researchers’ real salaries have also 

risen.

A Changing Role for Public-Sector 

Research

The role of the public sector in the development of new 

drugs has evolved with changes in science and public policy. The potential returns to the private sector from academic and government-sponsored biomedical research 

have increased dramatically over the past generation, raising the issue of how best to maximize the benefits from 

publicly funded research. In 1980, lawmakers enacted the 

Bayh-Dole Act to address concerns that only a small fraction of government patents were being developed commercially.19 The law gave universities, nonprofit organizations, and small businesses the property rights to 

inventions stemming from government-funded research 

they conducted. As a result, the marketing of such 

research discoveries has greatly increased, generating significant royalty income for those institutions and perhaps 

substantial benefits for society as well.

Basic research discoveries tend not to be patentable, so 

the assignment of property rights has less effect on the 

social value that results from basic research than it would 

have otherwise. Much of that value instead derives from 

academic traditions of scientific openness and the free 

flow of ideas. As the Supreme Court’s decision in Diamond v. Chakrabarty illustrates, however, the scope of 

what is patentable can shift over time—and thus the balance between the social benefits of “open science” and of 

property rights and commercial development can change 

as well. 

Some analysts argue that in addressing such issues, it may 

be counterproductive in the long run to further weaken 

the institutions of open science, increase the market orientation of public-sector researchers, or give taxpayers a 

greater share of the benefits that private companies derive 

from developing ideas generated in the public sector.20

For example, gaining price concessions from drug firms 

that benefit from publicly funded research would increase 

taxpayers’ current benefits but could reduce their future 

benefits. Such concessions would reduce firms’ expected 

profits from licensing and developing taxpayer-funded 

research and thus would affect their future decisions 

about R&D (see Box 4-1).

Moreover, benefits can also flow the other way: academic 

and government researchers have sometimes made valuable discoveries that built on research done in the private 

sector. For example, public-sector researchers have discovered new approved uses for aspirin, antiepileptics, and 

antibiotics—drugs that were originally developed in the 

private sector.21

19. The Bayh-Dole Act (officially called the Patent and Trademark 

Law Amendments Act of 1980) was enacted as Public Law 96-

517. Amendments to it were enacted in 1984 as P.L. 98-620. For 

the rationale behind the Bayh-Dole Act, see Wendy H. Schacht, 

The Bayh-Dole Act: Selected Issues in Patent Policy and the Commercialization of Technology, CRS Report for Congress RL32076 

(Congressional Research Service, June 10, 2005).

20. Cockburn and Henderson, “Absorptive Capacity, Coauthoring 

Behavior, and the Organization of Research in Drug Discovery,” 

p. 180.

21. See Iain M. Cockburn and Rebecca Henderson, Public-Private 

Interaction and the Productivity of Pharmaceutical Research, Working Paper No. 6018 (Cambridge, Mass.: National Bureau of Economic Research, April 1997).

CHAPTER

5

Has the Drug Industry’s

Innovative Performance Declined?

The number of new drugs introduced each year has 

not kept pace with research and development spending 

in the drug industry. Over the past three decades, the 

number of new molecular entities per annual dollar of 

research spending on such drugs—a conventional, if 

incomplete, measure of R&D performance—has 

declined significantly. Although that decline may result 

solely from higher R&D costs, concerns persist that rising technological complexity and structural changes 

(such as from mergers) have hurt the real research productivity of the pharmaceutical industry. 

Conventional measures of R&D performance—such as 

annual approvals of new-drug applications or NMEs, 

either in total or per dollar of R&D spending—are misleading, however, and do not adequately summarize the 

industry’s R&D performance. Carefully conducted studies of specific drug markets indicate that major gains have 

been achieved in a number of therapeutic areas, albeit at a 

growing cost per innovation. The difficulty and expense 

of such studies are obstacles to developing a comprehensive measure of R&D performance in the pharmaceutical 

industry. 

Recent Innovative Performance

From the 1970s into the 1990s, the number of new 

molecular entities approved by the Food and Drug 

Administration each year generally increased (with some 

variability). At the same time, the drug industry’s real 

R&D spending also grew, at first gradually and then 

more quickly. After the mid-1990s, however, NME 

approvals dropped sharply although R&D spending continued to rise (see Figure 5-1). Worldwide, the number of 

drugs with new active substances approved in major 

international markets also fell by half during the 1990s, 

while private-sector spending on drug R&D tripled.1

Measures of R&D performance based on numbers of patents or new-drug applications show similar patterns of 

decline.

Whether that decline indicates a decrease in the industry’s 

actual R&D productivity is uncertain, since the quality of 

NMEs and their value to consumers are not directly 

observable (and have been estimated only for selected 

drugs). Given the nearly 12-year average lag between initial R&D spending and NME approval that has been 

estimated, it is too soon to know how the sharp rise in 

R&D spending in the 2000s will affect future approvals 

of NMEs. However, growth in R&D spending during 

the 1990s resulted in a lower average number of annual 

approvals in the 2000s than in the 1980s and early 1990s 

(even including 1980, when an unusually low number of 

NMEs were approved). Thus, current growth in R&D 

expenditures does not necessarily portend an increase in 

the number of new drugs. 

The industry’s innovative performance depends not only 

on the number of those drugs but also on their characteristics. Thus, if fewer NMEs were approved but they 

included enough important, pioneering, or more effective 

drug therapies, the industry’s actual R&D productivity 

would not necessarily be lower. For that to be the case, 

however, increases in quality would have to at least match 

the increases in R&D spending.

Shortcomings of the Usual Measures of 

Performance

Conventional and readily accessible measures of innovative performance—which are based on the number of

1. See European Federation of Pharmaceutical Industries and Associations, The Pharmaceutical Industry in Figures—2003 Update 

(Brussels: EFPIA, 2003).
36 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Figure 5-1.

NME Approvals and Drug Companies’ Spending on Research and Development

(Billions of 2005 dollars)

Source: Congressional Budget Office based on Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 

2006 (Washington, D.C.: PhRMA, March 2006); and Food and Drug Administration, Center for Drugs and Biologics, New Drug Evaluation Statistical Report (1985), Table III-1, Graph III-2, and Appendix B, and New Drug Evaluation Statistical Report (March 1986 

and April 1987), Table II-1 and Graph II-2; Food and Drug Administration, Center for Drug Evaluation and Research, Office of Management, Offices of Drug Evaluation Statistical Report (1987-1989), Table II-1, Graph II-1, and Graph II-2; Food and Drug Administration, “CDER NDAs Approved in Calendar Years 1990-2004 by Therapeutic Potential and Chemical Type” (March 22, 2005), 

available at www.fda.gov/cder/rdmt/pstable.htm; and Food and Drug Administration, “FDA Facts: The Center for Drug Evaluation 

and Research,” available at www.fda.gov/bbs/topics/news/2006/NEW01342/Fact_Sheet_CDER.pdf.

Note: Spending was adjusted for inflation using the biomedical research and development price index from the Bureau of Economic Analysis.

new molecular entities approved per year—are incomplete because they do not count all of the output from 

research and development. They exclude incremental 

modifications to existing drugs, which (as described in 

Chapter 2) can sometimes benefit consumers significantly by reducing side effects, being more convenient to 

take, or treating additional conditions.2

 Since a growing 

share of the drug industry’s R&D has been directed 

toward product improvements—which now account for 

about one-third of the industry’s R&D spending—failing 

to consider those drugs along with NMEs is a significant 

omission. If the benefits of product improvements are 

smaller than the benefits of the original new drugs (which 

is not always the case), they are often achieved at a lower 

R&D cost too. But although the number of product 

improvements per year has increased since 1990, that rise 

has been slight compared with the growth in R&D 

spending during that time.

Even performance measures that include modifications to 

existing pharmaceuticals are limited because they give 

every new drug or drug product equal weight, despite 

sometimes large differences in quality or value. For example, a pioneering drug treatment that benefited a large 

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

0

10

20

30

40

50

60

0

5

10

15

20

25

30

35

40

Number of NMEs Approved

(Left scale)

Spending by PhRMA

Members (Right scale)

2. For example, demand for selective serotonin reuptake inhibitors 

and proton pump inhibitors (PPIs) comes primarily from patients 

with conditions other than those drugs’ original primary approved 

uses. Some PPIs, such as Prilosec and Zantac, can now be purchased over the counter for heartburn, further expanding the 

demand for nonprimary uses. Drug treatments for HIV illustrate 

the potentially large value to be gained from simplified dosing regimens. Zidovudine, or AZT, the first FDA-approved drug for 

HIV, originally required a dosing regimen of six times per day 

(every four hours around the clock). The required dosage of AZT 

is now just two or three times per day, often in combination with 

other drugs (see AIDS Education Global Information System, “So 

Little Time . . . An AIDS History,” available at www.aegis.com/

topics/timeline). Moreover, the FDA recently approved a onceper-day combination drug for treating HIV. 
CHAPTER FIVE HAS THE DRUG INDUSTRY’S INNOVATIVE PERFORMANCE DECLINED? 37

patient population would count the same toward a firm’s 

R&D performance as a drug for a less prevalent condition for which other effective drugs were available. 

The reason that conventional measures of R&D output 

do not account for drug quality is that quality can be very 

difficult to estimate. Doing so may require collecting 

large amounts of field data and using carefully designed 

statistical analyses, and the results of such studies are not 

always conclusive. Nevertheless, many examples exist of 

major therapeutic gains achieved by the industry in 

recent years.3 Statins, which reduce cholesterol levels, did 

not exist a generation ago; now they are by far the bestselling class of drugs in the United States.4

 Selective serotonin reuptake inhibitors, which unlike earlier drugs for 

depression can be prescribed by nonspecialists, have 

“enormously” expanded the market for antidepressants 

and are credited with creating a sharp decline in the prevalence of untreated depression.5 Significant gains have 

been made in the diagnosis and treatment of many types 

of cancer.6 And new antiulcer drugs have drastically 

reduced ulcer surgeries.7

 One analysis finds that although 

annual approvals of NMEs have declined over the past 

20 years, approvals of “high-quality” NMEs have risen 

slightly over that period.8

 Thus, anecdotal and statistical 

evidence suggests that the rapid increases that have been 

observed in drug-related R&D spending have been 

accompanied by major therapeutic gains in available drug 

treatments. There is not enough detailed evidence about 

how drug quality has changed over time to support a rigorous analysis of the productivity of pharmaceutical 

research. However, the evidence suggests that looking at 

the number of new drugs without considering their therapeutic value omits an important factor in that analysis.

Another problem with using a traditional productivity 

measure—output per unit of input—to assess R&D performance is that it treats the new drugs approved in a 

given year as if they were produced by the R&D dollars 

spent that year (rather than over the preceding 12 years or 

so). It is difficult to know whether such a measure overstates or understates actual productivity in any particular 

year. But it will be accurate only by chance. 

Factors That Could Diminish 

Innovative Performance 

In the absence of accurate, comprehensive statistical measures, the drug industry’s R&D performance can be considered qualitatively. Even if drug quality has been 

increasing, the industry’s performance may still have 

declined, for several reasons. 

First, the supply of not-yet-discovered innovations ebbs 

and flows. Major scientific advances can generate a fresh 

supply of “easier” discoveries with lower development 

costs. Those discoveries would be exploited before costlier 

ones with comparable expected revenues. Because science 

does not advance at a steady pace, the pool of undeveloped discoveries will at times be smaller and more expensive to exploit. At those times, real research productivity 

will be lower. Indeed, the currently feasible opportunities 

for biomedical research have been described as tending 

toward diseases that are more complex or with drug targets that are more difficult to treat.9

3. See W.S. Comanor, “Pharmaceutical Prices and Expenditures,” in 

R.M. Andersen, T.H. Rice, and G.F. Kominski, eds., Changing the 

U.S. Health Care System (San Francisco: Jossey Bass, 2001). For a 

more comprehensive perspective going back to the 1950s, when 

the industry offered few effective drugs beyond broad-spectrum 

antibiotics, see Frederic M. Scherer, Industry Structure, Strategy, 

and Public Policy (New York: HarperCollins, 1996), Chapter 9.

4. IMS Health, “20 Leading Therapeutic Classes by U.S. Sales, 

2005” (January 2006), available at www.imshealth.com/ims/

portal/front/articleC/0,2777,6599_73915261_77140565,00. 

html.

5. Ernst R. Berndt, Iain Cockburn, and Zvi Griliches, “Pharmaceutical Innovations and Market Dynamics: Tracking Effects on Price 

Indexes for Antidepressants,” Brookings Papers on Economic Activity: Microeconomics (1996), pp. 149-150.

6. Frank Lichtenberg credits new cancer drugs with adding about 

one year to the life expectancy of people diagnosed with cancer 

between 1975 and 1995; see Frank R. Lichtenberg, The Expanding Pharmaceutical Arsenal in the War on Cancer, Working Paper 

No. 10328 (Cambridge, Mass.: National Bureau of Economic 

Research, February 2004).

7. Comanor, “Pharmaceutical Prices and Expenditures,” p. 2. 

8. See Henry Grabowski and Richard Wang, “The Quantity and 

Quality of Worldwide New Drug Introductions, 1982-2003,” 

Health Affairs, vol. 25, no. 2 (March/April 2006), pp. 452-460. 

The authors defined high-quality NMEs as those that have been 

introduced in at least four of the world’s seven largest pharmaceutical markets (Canada, France, Germany, Italy, Japan, the United 

Kingdom, and the United States) or that represent the first NME 

launched in a particular therapeutic class in the United States.

9. Iain M. Cockburn, “The Changing Structure of the Pharmaceutical Industry,” Health Affairs, vol. 23, no. 1 (January/February 

2004), p. 12.
38 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Figure 5-2.

Research and Development Spending and Productivity for Various U.S. Industries

(Index, 1980 = 1.0)

Source: Congressional Budget Office based on National Science Foundation table “Company and Other (Except Federal) Funds for Industrial 

R&D Performance, by Industry and by Size of Company: 1953-98,” available at www.nsf.gov/statistics/iris/search_hist.cfm? 

indx=10; and Bronwyn H. Hall, Adam B. Jaffe, and Manuel Tratjenberg, The NBER Patent Citation Data File: Lessons, Insights, and 

Methodological Tools, Working Paper No. 8498 (Cambridge, Mass.: National Bureau of Economic Research, October 2001).

Notes: This figure measures productivity as the number of patents granted in an industry per dollar of research and development spending. 

R&D spending in one year is compared with successful patents two years later, reflecting the lag with which such spending leads to 

patent applications.

The figure stops at 1995 (including patents applied for through 1997) because most patent applications filed after 1997 had not yet 

been approved by 1999, when the data set for patents ended. Thus, successful patent applications for 1998 and 1999 are underrepresented in the data and would provide an artificially low measure of R&D productivity for those years.

Second, growing technological complexity could dampen 

the industry’s R&D performance, unless the new technologies boosted drug quality by enough to offset the 

effects of higher research costs. 

Third, rising real wages would have the same effect if they 

were not accompanied by an increase in real research 

output (that is, in the annual number of new drugs 

approved, adjusted for quality). Both scientific employment and real wages have been growing in the pharmaceutical industry. Between 1980 and 2000, total R&D 

employment in the drug industry grew at an average rate 

of 5.4 percent a year (employment among scientific and 

professional staff grew by 7.4 percent annually). The 

industry’s labor costs rose at an even faster rate during 

that period: by an average of 9.3 percent a year, adjusted 

for inflation.10 If R&D output has not increased by at 

least that much, then (unless capital costs are lower) 

R&D productivity will have declined.

1980 1985 1990 1995

0

1

2

3

4

5

6

Drug R&D Spending

Drug R&D Productivity

Computer R&D

Productivity

Communications

R&D Productivity

Communications

R&D Spending

Computer R&D

Spending

10. Joseph A. DiMasi, Ronald W. Hansen, and Henry G. Grabowski, 

“The Price of Innovation: New Estimates of Drug Development 

Costs,” Journal of Health Economics, vol. 22, no. 2 (March 2003), 

p. 178
CHAPTER FIVE HAS THE DRUG INDUSTRY’S INNOVATIVE PERFORMANCE DECLINED? 39

Fourth, an empirical study of various industries suggests 

that decreases in R&D output per dollar may, in part, 

merely indicate strong consumer demand for an industry’s new products.11 Such demand would cause firms to 

invest more in research and development, in some cases 

to the point of diminishing marginal returns.12 The 

study looked at differences between industries in growth 

of R&D spending and concluded that such growth was 

negatively associated over time with an industry’s number 

of patents per dollar. During the past quarter century, it 

concluded, the number of patents per R&D dollar has 

declined in industries in which R&D spending has risen 

the most—but has recovered when an industry’s rate of 

spending growth has slowed. If that pattern was the 

outcome of profit-maximizing behavior in a wellfunctioning market, a decline in patents per dollar (or 

drugs per dollar) would not necessarily be a problem. 

Higher demand could lead to diminishing returns on 

R&D for two reasons: because increased R&D spending 

could put upward pressure on researchers’ wages, and 

because higher demand could encourage companies to 

reach more deeply into their inventories of potential 

R&D projects to ones with lower expected returns.

The pharmaceutical industry provides a good illustration 

of that study’s conclusions. The growth of R&D spending has been particularly high in the drug industry compared with other industries, and the drop in patents per 

dollar has been greater (see Figure 5-2). Declines in R&D 

output per dollar have not been confined to the pharmaceutical industry, however, or to industries in the United 

States. Patents per research dollar have fallen in many 

industries in the United States and around the world. 

(For the computer and communications industries, 

patents per dollar rebounded when the growth of R&D 

spending slowed.)

Did Changes in the Size of 

Drug Companies Affect 

Research Productivity?

In the 1990s, a wave of mergers of large, traditional 

pharmaceutical companies transformed the structure of 

the drug industry. By 2002, the 10 largest drug firms 

accounted for 48 percent of pharmaceutical sales worldwide, up from about 20 percent in 1985.13 Currently, 

eight of the top 10 firms are the products of horizontal 

mergers between two or more large drug companies, all of 

which occurred since 1989 (see Table 5-1).14

Consolidation in the pharmaceutical industry may have 

been motivated by several factors. With the rise of generic 

drugs, the rapid loss in sales that now occurs when a 

drug’s patent expires can leave firms with excess capacity 

in production and marketing. Merging with another 

company can help fill that capacity. Firms may also merge 

to exploit potential economies of scale or scope in 

research and development.15

To many observers, however, the decline in the introduction of new drugs indicates that the industry has become 

less innovative. The popular press has sometimes suggested that large drug firms are less innovative than small 

firms or that mergers have reduced R&D productivity by

11. Jean O. Lanjouw and Mark Schankermann, Research Productivity 

and Patent Quality: Measurement with Multiple Indicators, Discussion Paper EI/32 (London: London School of Economics and 

Political Sciences, Toyota Centre, December 2002), available at 

sticerd.lse.ac.uk/dps/ei/ei32.pdf. To allow for comparisons among 

industries, the study measured R&D output by counting patents 

rather than new products.

12. “Diminishing marginal returns” refers to a situation in which each 

additional unit of investment produces a smaller return than the 

one before it.

13. Patricia M. Danzon, Andrew Epstein, and Sean Nicholson, Mergers and Acquisitions in the Pharmaceutical and Biotechnology Industries, Working Paper No. 10536 (Cambridge, Mass.: National 

Bureau of Economic Research, June 2004), p. 2.

14. “Horizontal” here refers to mergers between drug manufacturers, 

even if they do not compete directly in the marketplace. In the 

Federal Trade Commission’s analyses of mergers, pharmaceutical 

markets are usually defined narrowly in terms of drugs for specific 

illnesses and conditions. Antitrust concerns arise when merging 

firms compete directly and together would represent a large share 

of a given market or would perform much of the R&D in that 

market. In such cases, the FTC can require the companies to 

divest themselves of products, intellectual-property rights, or 

R&D projects in order to make it harder for them to raise prices 

or block the development of potentially competing drugs. A 

merger between two large pharmaceutical firms need not reduce 

competition in individual markets, although many of the mergers 

in Table 5-1 required some divestitures.

15. Economies of scale are decreases in average R&D costs from, for 

instance, having larger laboratories (which could allow expensive 

equipment to be shared among projects); economies of scope are 

decreases in average R&D costs from researching a wider variety 

of products (because knowledge gained in one product area can 

benefit researchers in other areas).
40 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Table 5-1.

Merger History of the Top Ten Pharmaceutical Companies in 2004 by 

Global Sales

Source: Congressional Budget Office based on information from IMS Health and the companies listed above.

distracting companies’ research scientists.16 The economic evidence for those assertions is ambiguous.

Direct empirical evidence about the effects of mergers on 

the performance of drug companies is scarce. Given the 

length of the drug-development process, assessing R&D 

performance requires more years of postmerger data than 

yet exist. But an analysis of how mergers have affected 

other aspects of performance concluded that the recent 

mergers in the drug industry have had, on average, no 

initial effect on a range of measures of firms’ inputs and 

outputs.17 Companies’ propensity to merge appears to be 

associated with factors such as low expected growth in 

earnings and approaching patent expirations. Adjusting 

for that propensity, the study found no significant 

changes during the first three years after a merger in the 

growth rates of a firm’s sales, number of employees, R&D 

expenditures, or market value. However, such firms’ 

R&D expenditures grew more slowly than those of comparable firms that did not merge, suggesting that mergers 

may initially divert resources away from R&D.

Comparisons of the performance of large and small pharmaceutical firms from the 1960s to the early 1990s suggest that larger companies had an advantage in being able 

to sustain a broader range of research programs of a given 

size—and thus could capture more of the resulting 

knowledge than if the programs were housed in separate, 

smaller firms. Those economies of scope boosted research 

productivity at the drug-discovery phase.18 (Firm-specific 

factors such as experience and managerial ability were 

even more important.)19

Since the early 1990s, however, biotechnology and 

genomics have changed the research landscape. Numerous small, research-oriented companies have arisen to 

specialize in new-drug discovery. In theory, with firms 

increasingly focused on either early- or late-stage R&D, 

the potential gains from alliances between specialized 

companies may also have grown: small firms could license 

their drug discoveries to larger companies to gain access 

to greater resources and expertise for conducting large, 

complex clinical trials. But recent evidence suggests that a 

company’s likelihood of succeeding in later-stage trials 

may be greater the more focused (less broad) its research

Large Entities That Have Merged Since 1989 to Create Current Firm

1. Pfizer Pfizer, Warner-Lambert, Pharmacia, Upjohn, Monsanto

2. GlaxoSmithKline Glaxo, Wellcome, SmithKline Beckman, Beecham

3. Sanofi-Aventis Rhone-Poulenc, Rorer, Hoechst, Marion Merrell Dow, Sanofi

4. Johnson & Johnson

5. Merck

6. Novartis Ciba-Geigy, Sandoz

7. Astrazeneca Astra, Zeneca

8. Roche Roche, Syntex, Genentech

9. Bristol-Myers Squibb Bristol-Myers, Squibb, DuPont Pharmaceuticals

10. Wyeth American Cyanamid, American Home Products, Genetics Institute

Ranking/Firm

16. See, for example, James Surowiecki, “The Pipeline Problem,” New 

Yorker, February 16, 2004; and Gardiner Harris, “Where Are All 

the New Drugs?” New York Times, October 5, 2003, Section 3,

p. 1.

17. See Danzon, Epstein, and Nicholson, Mergers and Acquisitions in 

the Pharmaceutical and Biotechnology Industries.

18. See Rebecca Henderson and Iain Cockburn, “Scale, Scope, and 

Spillovers: The Determinants of Research Productivity in Drug 

Discovery,” RAND Journal of Economics, vol. 27, no. 1 (Spring 

1996), pp. 32-59. That study examined the R&D programs of 10 

large pharmaceutical firms between 1961 and the early 1990s.

19. See Iain M. Cockburn and Rebecca Henderson, “Scale and Scope 

in Drug Development: Unpacking the Advantages of Size in Pharmaceutical Research,” Journal of Health Economics, vol. 20, no. 6 

(November 2001), pp. 1033-1057.
CHAPTER FIVE HAS THE DRUG INDUSTRY’S INNOVATIVE PERFORMANCE DECLINED? 41

experience has been.20 Thus, in the current environment, 

hosting a wide range of research activities within one firm 

may have become a disadvantage in drug development.

The rise of small, specialized biotechnology companies 

has blurred the once-clear division between basic science 

conducted “upstream” in university and government labs 

and applied research performed “downstream” in the 

commercial sector. A generation ago, the pharmaceutical 

industry essentially consisted of a moderate number of 

large drug companies doing their own applied R&D on 

the basis of publicly available basic research discoveries. 

Now, small firms perform some of that basic research. 

That change may lead to a more efficient allocation of 

research resources, to the extent that well-defined property rights exist for basic research discoveries that have 

commercial value and that markets for those discoveries 

are competitive.21

Some analysts believe that smaller biotechnology firms 

tend to be more agile and more willing to take risks than 

larger pharmaceutical firms and thus innovate more 

quickly and cost-effectively. But greater specialization in 

drug research—as, for instance, with smaller companies 

focusing more on drug discovery and larger ones emphasizing drug development and clinical trials—requires 

greater effort to work out licensing agreements between 

firms, diverting resources that more highly integrated 

companies could use on R&D or other productive activities. A larger number of small firms can also mean more 

competition and more racing to patent and license discoveries, which (beyond a certain point) can lead to a less 

efficient use of resources. 

On balance, increased specialization could improve R&D 

productivity in the drug industry. But the commercialization of research relationships that formerly existed outside the marketplace makes those relationships—and the 

industry’s R&D productivity—potentially vulnerable to a 

decline in profits.

20. See Patricia M. Danzon, Sean Nicholson, and Nuno Sousa 

Pereira, “Productivity in Pharmaceutical-Biotechnology R&D: 

The Role of Experience and Alliances,” Journal of Health Economics, vol. 24, no. 2 (March 2005), pp. 317-339. 

21. For a more detailed discussion of the ideas in this and the two following paragraphs, see Cockburn, “The Changing Structure of 

the Pharmaceutical Industry,” p. 14.

CHAPTER

6

Profitability and R&D Investment in the

Drug Industry

People place a great deal of value on their health. 

Since most of the demand for pharmaceutical products 

comes from consumers who are not at full health, their 

willingness to pay for some kinds of drugs may be quite 

high (not only in absolute terms but also in relation to 

the cost of manufacturing and supplying those drugs). 

Moreover, health insurance insulates many consumers 

from the full cost of their prescription drug choices. 

When few competing drugs are available, demand may be 

particularly insensitive to price. For all of those reasons, 

many brand-name drugs are sold at a sizable markup over 

their unit cost of production. 

The pricing of brand-name drugs highlights multiple tensions. One is between the high long-run cost of developing a new drug and the much lower short-run cost of producing it. Another tension is between shareholders’ 

expectations that drug firms will maximize their profits 

and consumers’ notions of fairness. The perception that 

drug prices are high—combined with rapid growth in 

total U.S. spending on prescription drugs—has frequently focused attention on the sensitive issue of the 

drug industry’s profitability.

Recent Estimates of Profitability

On paper, the pharmaceutical industry has consistently 

ranked as one of the most profitable industries in the 

United States. In 2005, pharmaceutical firms in the Fortune 500 averaged a 10.3 percent return on assets, compared with a median return of 4.7 percent for all industries (see Figure 6-1). That return put the drug industry 

ninth out of the 50 industries ranked that year (it ranked 

second in 2003 and 12th in 2004).1

However, those figures misrepresent the industry’s actual 

profits. The reason is that the standard accounting measure of profits overstates true returns to R&D-intensive 

industries, such as pharmaceuticals, and makes it difficult 

to meaningfully compare profit levels among industries. 

Accounting measures treat most R&D spending (except 

for capital equipment) as a deductible business expense 

rather than as a capitalized investment.2 But the intangible assets that research and development generate—such 

as accumulated knowledge, new research capabilities, and 

patents—increase the value of a company’s asset base. 

Not accounting for that value overstates a firm’s true 

return on its assets.3

By standard accounting measures, the pharmaceutical 

industry’s return on assets (even with a recent decline) 

1. In 2005, the industry also ranked fifth in return on revenues (15.7 

percent versus a median value of 5.9 percent for all firms) and fifth 

in return on shareholder equity (23.4 percent compared with a 

median of 14.9 percent). 

2. The federal tax code also encourages firms to report their 

R&D investments as business expenses, since noncapitalized 

(“expensed”) R&D spending qualifies for R&D tax credits, but 

capitalized spending does not. See U.S. Congress, Office of 

Technology Assessment, Pharmaceutical R&D: Costs, Risks, and 

Rewards, OTA-H-522 (February 1993), pp. 184-185. For a discussion of several other differences between accounting and economic measures of profit, see ibid., p. 96.

3. Return on assets is defined as earnings divided by assets; thus, the 

smaller the measured assets, the larger the return. The accounting 

treatment of R&D expenses also overstates returns by ignoring the 

opportunity costs of capital, which are larger than average in the 

pharmaceutical industry because of the longer-than-average lag 

between investment in R&D and introduction of new products. 

See Frederic M. Scherer, Industry Structure, Strategy, and Public 

Policy (New York: HarperCollins, 1996), p. 336. Uwe Reinhardt 

notes, however, that expensing R&D investments could also 

understate returns by overstating expenses, and that when R&D 

spending is growing rapidly, the net effect of expensing on returns 

is uncertain. See Uwe E. Reinhardt, “Perspectives on the Pharmaceutical Industry,” Health Affairs, vol. 20, no. 5 (September/

October 2001), p. 143. 
44 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

Figure 6-1.

Return on Assets for Drug Companies Versus for All Major Companies, by 

Standard Accounting Methods

(Percent)

Source: Congressional Budget Office based on Fortune magazine (various issues).

has consistently been two to three times higher than the 

median for Fortune 500 firms.4 Adjusted for intangible 

R&D assets, the industry’s actual profitability is still 

somewhat above average, but by less than shown in 

Figure 6-1. The Office of Technology Assessment estimated that in the early 1990s, standard accounting rates 

of return were overstating the drug industry’s profits by 

20 percent to 25 percent.5 OTA found that adjusting for 

firms’ intangible assets halved the gap between the drug 

industry’s average returns and those of a matched sample 

of nondrug firms with similar financial characteristics.

Allowing for differences in capital costs between industries, which largely reflect differences in the riskiness of 

investing in a particular industry, companies should 

achieve comparable returns, on average, in the long run. 

Differences in returns between industries will tend to be 

minimized as investors pursue the highest available 

returns: capital will flow into an industry with aboveaverage returns on R&D until the industry reaches the 

point of diminishing marginal returns, at which point, 

investors will seek higher returns in other industries. 

Thus, the persistently above-average returns on pharmaceutical R&D in Figure 6-1 could simply reflect a greater 

cost of capital for the drug industry, commensurate with 

its riskier investment environment.

In the short run, industries’ rates of return need not 

reflect differences in capital costs. One study found that 

the average rate of return on innovation for new drugs in 

the 1990s modestly exceeded the industry’s cost of capi1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

0

2

4

6

8

10

12

14

16

18

20

Median Return for

Drug Companies

Median Return for All

Fortune 500 Companies

4. A 1998 CBO study found that increased competition from 

generic drugs had begun to reduce the drug industry’s profitability. See Congressional Budget Office, How Increased Competition 

from Generic Drugs Has Affected Prices and Returns in the Pharmaceutical Industry (July 1998), p. 47.

5. See Office of Technology Assessment, Pharmaceutical R&D,

pp. 96-101. By standard accounting measures, the drug industry’s 

profits would have amounted to about 1.4 percent of U.S. health 

care spending in 2001, according to one analyst. See Reinhardt, 

“Perspectives on the Pharmaceutical Industry,” pp. 143-144. That 

year, the share of total health care spending in the United States 

that was attributable to prescription drugs was 9.4 percent (it is 

currently about 10 percent). See Centers for Medicare & Medicaid Services, “National Health Care Expenditures Projections: 

2005-2015,” available at www.cms.hhs.gov/NationalHealth

ExpendData/downloads/proj2005.pdf.
CHAPTER SIX PROFITABILITY AND R&D INVESTMENT IN THE DRUG INDUSTRY 45

tal.6 OTA ruled out capital-cost differences as a reason for 

the pharmaceutical industry’s higher returns, concluding 

that “R&D drives profitability in the industry and has 

produced returns over reasonably long periods of time 

that may exceed the cost of capital.”7

 Consistent with the 

notion that investors pursue the highest returns, one analyst has suggested that if the pharmaceutical industry was 

actually earning significantly higher returns than average 

(adjusted for differences in risk), outside firms would 

have sought to merge with drug companies.8

 Economists 

broadly agree that a reduction in profits would cause 

private-sector investment in drug R&D to grow more 

slowly or to decline.9

Expected Profits as a Signal for 

Performing Drug R&D

The profitability of the drug industry is an important 

issue not only because of its connection to rising U.S. 

spending on prescription drugs but also because profits 

provide a way for pharmaceutical firms to gauge what 

types of products consumers value most. If profits do not 

accurately reflect that value, however, they may induce 

the drug industry to perform too much or too little 

R&D, either on specific kinds of drugs or as a whole. 

Various factors may reduce the accuracy of profits as an 

indicator of social value. In the case of drugs to treat or 

prevent illnesses (such as tuberculosis, malaria, and other 

diseases of the developing world) that disproportionately 

affect lower-income populations, potential profits are 

often too low for market forces alone to encourage 

private-sector R&D, despite the high social value of 

treating such illnesses.10 Even when higher-income populations are the likely market, the ability of profits to guide 

firms toward the most socially valuable kinds of R&D is 

highly dependent on three factors:

B How well informed health care professionals and consumers are about the attributes of existing drugs, 

B How patents and health insurance coverage of prescription drugs affect pharmaceutical companies’ 

revenues and returns on R&D, and 

B How strong incentives are for doctors and patients to 

consider price when choosing among prescription 

drugs.

Product Information

To the degree that available information about drugs’ true 

therapeutic benefits is incomplete, health insurers and 

consumers may be willing to pay too much for one drug 

and not enough for another. Clinical trials for FDA 

approval compare prospective drugs with a placebo, not 

with other drugs. Thus, postmarketing clinical trials and 

field studies that compare multiple drugs may add valuable information to what is learned from the FDA 

approval process. Currently, however, no systematic pro6. See Henry Grabowski, John Vernon, and Joseph DiMasi, 

“Returns on Research and Development for 1990s New Drug 

Introductions,” PharmacoEconomics, vol. 20, supplement 3 

(2002), pp. 11-29. The authors estimated an 11.5 percent rate of 

return on R&D, compared with a real cost of capital of 11 percent. (The standard accounting measure of profitability implies a 

gap of 2 to 3 percentage points.) A 1994 study reached very similar conclusions; see Henry G. Grabowski and John M. Vernon, 

“Returns to R&D on New Drug Introductions in the 1980s,” 

Journal of Health Economics, vol. 13, no. 4 (December 1994), pp. 

383-406. It also estimated a gap of about 0.5 percentage points 

between the rate of return on R&D and the annual cost of capital. 

7. Office of Technology Assessment, Pharmaceutical R&D, p. 103. 

OTA noted that over an industry’s lifetime, average returns must 

exactly reflect the cost of capital, but it is when returns exceed capital costs that industries attract investment capital and grow.

8. Ernst R. Berndt, “Pharmaceuticals in U.S. Health Care: Determinants of Q and P,” Journal of Economic Perspectives, vol. 16, no. 4 

(Fall 2002), p. 62.

9. See, for example, Frederic M. Scherer, “Pricing, Profits, and Technological Progress in the Pharmaceutical Industry,” Journal of Economic Perspectives, vol. 7, no. 3 (Summer 1993), p. 105.

10. That problem has led some governments and nongovernmental 

organizations to take steps to stimulate research and development 

in such cases. For example, in 2004, the United Kingdom committed to buy between 200 million and 300 million doses of a yetto-be-developed malaria vaccine at a price intended to encourage 

the vaccine’s development. In addition, the Gates Foundation and 

the World Bank have each pledged several hundred million dollars 

toward malaria research or drug purchases. The potential for such 

efforts to spur increased R&D on malaria is discussed in Jean O. 

Lanjouw and Iain M. Cockburn, “New Pills for Poor People? 

Empirical Evidence After GATT,” World Development, vol. 29, 

no. 2 (February 2001), pp. 265-289. The authors conclude that 

private R&D spending on malaria rose after policy shifts increased 

its potential returns (the General Agreement on Tariffs and Trade 

was amended to address intellectual-property concerns, and some 

developing countries strengthened their protection for intellectual 

property in drug innovations).
46 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

cess exists for generating that information. Firms often 

conduct their own head-to-head drug comparisons in 

clinical trials, but those studies may have little value for 

consumers. With antipsychotic drugs, for example, a 

recent analysis found that in 90 percent of firmsponsored trials, the results favored the drug made by the 

sponsoring firm.11 Many doctors depend at least partly 

on pharmaceutical companies’ sales representatives for 

information about the drugs they prescribe.

If better information caused drugs’ prices to align more 

closely with their therapeutic value—and especially if 

doctors used that information in choosing which drugs to 

prescribe—companies would have an incentive to reallocate their R&D resources (in search of higher returns) 

toward drugs with relatively greater social value. (See Box 

6-1 for a discussion of pricing and value of new antipsychotic drugs.) In cases where drug prices fell as a result of 

improved information, firms would perform less R&D; 

in cases where drug prices rose, firms would conduct 

more research and development.

There are limits, however, to how much could be gained 

from more-extensive study of drug quality. The information is costly to produce, underlying scientific complexiBox 6-1.

Drug Prices and Consumer Value in R&D Spending

Higher prices for new drugs imply higher returns on 

research and development (if everything else, such as 

the level of consumer demand, is unchanged). In 

turn, higher returns attract more investment in R&D. 

To the extent that drug prices reflect the value that 

consumers receive from different drugs, prices will 

encourage pharmaceutical companies to try to 

develop more of the kinds of drug products that consumers value most. 

Drug prices do not necessarily provide an accurate 

signal of consumers’ preferences in all cases, however. 

For example, it is not always clear why the market 

sustains high prices for some new drugs when cheaper 

alternatives of seemingly comparable quality are available. One possibility is that because drugs function in 

ways that are complex and often not fully understood, 

it can take a long time to assess how well they actually 

perform relative to the available alternatives.

Antipsychotic drugs are a case in point. In the 1990s, 

an expensive new class of “atypical” antipsychotic 

drugs was introduced that avoided the often debilitating neurological side effects of older antipsychotics. 

When state Medicaid programs switched to the new 

drugs, their total spending on antipsychotics 

increased significantly. California’s Medicaid program, for instance, spent seven times more on antipsychotic drugs in 2001 than it did in 1993, although 

the number of claims it processed for schizophrenia 

(one of the primary illnesses for which those drugs are 

prescribed) rose by only 10 percent during that 

period.1 Some observers expected that the new drugs 

would lower California’s other Medicaid costs by 

reducing hospital stays. However, no such savings 

materialized.2 In addition, a large, federally funded 

study that compared several of the new drugs with a 

much cheaper antipsychotic drug dating from the 

1950s found little difference between them in terms 

of tolerability or effectiveness.3 Such findings could 

cause consumers to revise how much they value the 

1. See Mark Duggan, “Do New Prescription Drugs Pay for 

Themselves? The Case of Second-Generation Antipsychotics,” Journal of Health Economics, vol. 24, no. 1 (January 

2005), pp. 1-31. 

2. Ibid.

3. See Jeffrey A. Lieberman and others, “Effectiveness of Antipsychotic Drugs in Patients with Chronic Schizophrenia,” 

New England Journal of Medicine, vol. 353, no. 12 (September 22, 2005), pp. 1209-1223. The new atypical antipsychotics have side effects of their own (notably, an increased risk of 

diabetes because of weight gain). The neurological side effects 

of the older drug, perphenazine, were avoided by administering it at lower dosages. 

11. See Stephan Heres and others, “Why Olanzapine Beats Risperidone, Risperidone Beats Quetiapine, and Quetiapine Beats Olanzapine: An Exploratory Analysis of Head-to-Head Comparison 

Studies of Second-Generation Antipsychotics,” American Journal 

of Psychiatry, vol. 163, no. 2 (February 2006), pp. 185-194.
CHAPTER SIX PROFITABILITY AND R&D INVESTMENT IN THE DRUG INDUSTRY 47

ties limit how precisely quality can be determined, and 

the benefits of generating more information will be 

greater for some kinds of drugs than for others. The 

potential gains from additional information are likely to 

be greater in markets that have many competing drugs, 

widely varying prices, and high sales than in smaller markets with fewer drugs or lower prices.

The Role of Health Insurance and Patents

The interaction of health insurance—Medicaid, Medicare, and private plans—with strong patent protection of 

pharmaceutical innovations can create particularly large 

incentives for drug companies to invest in R&D. Patents 

provide stronger intellectual-property protection in the 

pharmaceutical industry than in many other industries.12

Firms’ expectations of being able to set prices for new 

drugs above competitive levels and thus recoup their 

R&D investment are crucial to their decisions to 

innovate. Strong patent protection supports those 

expectations. 

Because health insurance insulates many consumers from 

the full effects of high prices, however, the demand for a 

new drug—and firms’ resulting revenue—are higher at 

any given price than they would be otherwise.13 Moreover, much of the health insurance in the United States is 

provided as an employment benefit that is not subject to

Box 6-1.

Continued

new antipsychotics (subject, as always, to revision on 

the basis of future studies) and could influence the 

industry’s R&D spending on that class of drugs.

In the case of drugs (such as the new antipsychotics) 

that have strong Medicaid sales, prices may be higher 

than they would be if Medicaid constituted a smaller 

share of the total demand for those drugs. The price 

that Medicaid pays for a drug depends on the average 

price that the manufacturer earns on sales to retail 

pharmacies. Thus, the manufacturer may be able to 

make more profit on a drug with large Medicaid sales 

by setting higher prices for its retail customers, who 

are fewer in number in such cases. The company will 

lose some sales as a result, but it can make up for 

them with increased revenue from Medicaid sales 

(which tend to be less sensitive to price, because Medicaid patients tend to have much lower copayments 

than people with private health insurance do).4 The 

resulting higher profits—although not an intended 

consequence of the Medicaid program—encourage 

additional private-sector investment in R&D on such 

drugs. That outcome is a distortion of the decisions 

about R&D that firms would make in the absence of 

the program. However, it does help low-income Medicaid patients, whose below-average ability to pay 

would not, on its own, attract as much R&D on 

drugs for illnesses that affect Medicaid patients at 

greater rates than the general population. 

4. In the first quarter of 2005, the maximum Medicaid copayment required by any state was $3, and in most states, that 

payment was the same regardless of the price of the drug. See 

Mark Duggan and Fiona Scott Morton, “The Distortionary 

Effects of Government Procurement: Evidence from Medicaid Prescription Drug Purchasing,” Quarterly Journal of Economics, vol. 71, no. 1 (February 2006), p. 4, footnote 3. The 

authors found that for every increase of 10 percentage points 

in Medicaid’s share of a drug’s total sales, the average prescription price of that drug was 7 percent to 10 percent higher 

than it would be otherwise. As a result, non-Medicaid customers also paid more: an average of 13.3 percent more for 

drugs of all types in 2002.

12. See Edwin Mansfield, “Patents and Innovation: An Empirical 

Study,” Management Science, vol. 32 (February 1986), pp. 173-

181. See also Scherer, Industry Structure, Strategy, and Public Policy.

13. Although this discussion focuses on the long-term impact of 

health insurance on R&D investment, insurance has another 

important effect. By covering consumers’ prescription drug purchases, it lessens the primary cost of the patent system—that is, 

the potentially significant loss of social benefits when consumers 

who would purchase a new drug at a lower price are dissuaded by 

its higher price under patent. See Alan M. Garber, Charles I. 

Jones, and Paul M. Romer, Insurance and Incentives for Medical 

Innovation, Working Paper No. 12080 (Cambridge, Mass.: 

National Bureau of Economic Research, March 2006).
48 RESEARCH AND DEVELOPMENT IN THE PHARMACEUTICAL INDUSTRY

income or payroll taxes.14 By reducing the cost of health 

insurance to consumers, that tax subsidy encourages 

more people to obtain coverage, and induces some of 

them to purchase more coverage, than they would otherwise.15 The additional revenue that results from the effect 

of insurance on the demand for prescription drugs—

combined with strong patent protection—can give companies excessive incentives to invest in drug R&D.16

(Incentives are excessive if they draw additional resources 

toward drug research and development and away from 

other, more socially valuable uses.) 

Incentives to Consider Drug Prices

The effects of insurance and market power from strong 

patents can be tempered through greater exercise of buyers’ power to reduce drug prices, as well as through 

increased incentives for consumers and doctors to consider price differences between drugs. Large insurance 

and retail buyers often can negotiate lower prices for the 

drugs they purchase. For example, health insurance plans 

have increasingly gained price reductions from manufacturers as a condition of including a drug in a plan’s formulary of preferred products. 

Health plans have also expanded their use of multitiered 

copayment price structures, which give consumers a 

stronger incentive to use less expensive drugs. In 2004, 

more than two-thirds of U.S. workers with employmentbased health insurance faced a three-tiered structure of 

prescription drug prices (with low, medium, and high 

prices for generic, formulary brand-name, and nonformulary brand-name drugs, respectively). Use of such 

copayment structures has more than doubled since 

2000.17 To the extent that multitiered systems still do not 

charge consumers the full difference in price if they prefer 

a more costly drug, room exists to strengthen price incentives further.18

Doctors’ prescription-writing practices heavily influence 

which drugs consumers use. Insurers, therefore, have also 

been exercising greater control over prescription drug 

spending by giving doctors stronger incentives to know 

about the various drugs they may prescribe and the prices 

of those drugs.19

Implications of Improved Profit Signals

The average returns to society from past drug research 

and development appear to have been large.20 However, 

because of the various sources of inefficiency in the allocation of R&D resources described above, the marginal 

return (the benefit from the “last” dollar of R&D) could 

be less than the marginal cost (that last dollar) in some 

areas of drug research. Overinvestment in specific areas of 

R&D could be tempered through better information 

about product quality or copayment prices that more 

fully reflected differences in what insurers pay for different drugs. Those changes would provide pharmaceutical 

14. According to the Congressional Research Service, “more than 

60 percent of the non-institutionalized population under age 65 

is insured through employment-based plans. On average, large 

employers pay about 80 percent of the cost of this insurance, 

though some pay all and others none.” See Bob Lyke, Tax Benefits 

for Health Insurance and Expenses: Overview of Current Law and 

Legislation, CRS Report for Congress RL33505 (Congressional 

Research Service, June 30, 2006), p. CRS-2.

15. The demand for insurance has also expanded with the number 

and variety of prescription drugs on the market. In 1961 (when 

far fewer prescription drugs existed, and Medicare and Medicaid 

had not yet been created), less than 0.5 percent of consumer 

spending on prescription drugs was covered by health insurance. 

That figure rose to more than 30 percent by 1980, nearly 50 percent by 1990, and 70 percent by 2005. For recent figures, see 

Centers for Medicare & Medicaid Services, “National Health Care 

Expenditures Projections, 2005-2015,” Table 11, available at 

www.cms.hhs.gov/NationalHealthExpendData/downloads/

proj2005.pdf. For earlier figures, see Department of Health and 

Human Services, Report to the President: Prescription Drug Coverage, Spending, Utilization, and Prices (April 2000), Table 2-30.

16. On the relationship between innovation and insurance coverage, 

see Burton Weisbrod, “The Health Care Quadrilemma: An Essay 

on Technological Change, Insurance, Quality of Care, and Cost 

Containment,” Journal of Economic Literature, vol. 29, no. 2 (June 

1991), pp. 523-552.

17. See Henry J. Kaiser Family Foundation, Prescription Drug Trends,

Fact Sheet No. 3057-03 (June 2006), available at www.kff.org/

rxdrugs/upload/3057-05.pdf.

18. See Reinhardt, “Perspectives on the Pharmaceutical Industry,” 

pp. 140-146.

19. See Scherer, “Pricing, Profits and Technological Progress in the 

Pharmaceutical Industry.”

20. See, for example, discussions of antidepressants and several other 

important health care technologies in David M. Cutler and Mark 

McClellan, “Is Technological Change in Medicine Worth It?” 

Health Affairs, vol. 20, no. 5 (September/October 2001), pp. 11-

29, and of cancer drugs in Frank R. Lichtenberg, The Expanding 

Pharmaceutical Arsenal in the War on Cancer, Working Paper 

No. 10328 (Cambridge, Mass.: National Bureau of Economic 

Research, February 2004).
CHAPTER SIX PROFITABILITY AND R&D INVESTMENT IN THE DRUG INDUSTRY 49

companies with more-accurate signals about the relative 

value of different drug treatments. 

By itself, the rapid growth that has occurred in spending 

on prescription drugs is not necessarily a sign of inefficiency in drug utilization or R&D. Health care innovations have often caused consumer spending to rise, just as 

the introduction of any new or improved product can 

cause spending on that type of product to increase. (For 

example, total spending on computers increased for many 

years as their attributes—such as speed, storage, and 

memory—improved.)21 Prescription drugs that offer new 

therapies or that substitute for other forms of treatment 

are particularly likely to cause total drug spending to rise. 

Thus, even if better profit signals induced drug firms to 

shift their R&D resources toward new treatments with 

higher social value, it might not follow that total spending on prescription drugs would decline, or even grow 

more slowly. Better signals would, however, lead to 

greater efficiency in the use of drug treatments as well as 

in the research and development of new treatments.

21. See Congressional Budget Office, The Role of Computer Technology 

in the Growth of Productivity (May 2002), pp. 9-11. 

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