The pharmaceutical industry at a crossroad

Pharmaceutical companies contribute crucially to the health and welfare of individuals. This issue is particularly relevant nowadays: as the Covid-19 pandemic has shown, no country is immune to new diseases. In parallel, the population in many countries is experiencing deep demographic transformations which increase life expectancy and raise new challenges.

The economic importance of the industry is also fundamental. The pharmaceutical sector employs highly skilled labor and exhibits one of the largest figures of R&D intensity (defined as expenditure in R&D as a share of sales). As it is well known, human capital and R&D are key drivers of economic growth, productivity and prosperity.

The current scenario

Several factors are generating big challenges for the pharmaceutical industry. New diseases as the Covid-19 demand quick, pathbreaking solutions. R&D costs grow exponentially because conditions become chronic and more complicated. Investments seek increasingly high risk/high premium drugs. Official agencies accumulate requirements for drug approvals. Firms must cope with the expiration of patents and with reductions in public expenditure in healthcare due to stability measures and fiscal adjustments.

Meanwhile the business model in the industry has experienced deep transformations over the last decades. Some firms have specialized in particular steps of the value chain: for instance, biotechnological companies with respect to R&D, and contract research organizations (CROs) regarding clinical research. Reductions in R&D productivity have brought about mergers and acquisitions, in many cases to profit from the expertise in research and the pipeline of other companies. Other common practices are technological alliances and outsourcing.

Are these transformations helping the industry adquire larger levels of productivity and efficiency?

The conceptual framework

In a recent paper which can be accesed here, Ricardo F. Díaz and myself address this issue empirically for a sample of European firms over the years 2010-2018.

We have performed a two-stages analysis of efficiency. In the first stage we compute efficiency levels for the firms in our sample by non parametric, DEA techniques. In the second stage we explore the connection between the efficiency scores obtained in the first stage and a set of variables potentially correlated with efficiency.

In accordance with the literature on this issue, we have defined efficiency as the distance to the efficient frontier. The closer a firm to the frontier, the larger its level of efficiency. Firms on the frontier register the largest level of efficiency, 1, by construction.

Figure 1 illustrates these ideas. The frontier (solid line) represents optimal combinations of inputs and outputs. It is immediate to notice that B provides more output than A, yB > yA, while using the same amount of input since xA= xB. Alternatively, D and E produce the same output, yD = yE, but firm D consumes a smaller amount of input than E, xD < xE. Hence B is more efficent than A and D is more efficient than E.

These ideas may sound very familiar. Aren’t they the cornestones of Microeconomics? Yes and no. It is obvious that this notion of efficiency is akin to that of productivity, with just one additional detail: in the DEA framework efficiency is normalized or computed in relative terms, i.e. with respect to the frontier, in turn encompassed by those firms that achieve the maximum level.

On the other hand, standard microeconomic theory implicitly assumes that all firms operate at the frontier (often called production possibility frontier). Here, instead, it is acknowledged that just some companies (the more efficient) lie in the frontier, while the bulk of an industry operates below it.

Figure 1

How efficient is the industry?

We have analyzed microdata from a large sample of European firms. Our investigation suggests that the level of efficiency in the European pharmaceutical industry is moderate and has displayed a decreasing trend over the period 2010–2018.

The mean efficiency for the entire sample and over the period 2010–2018 is 0.341. Thus, firms could increase their efficiency on average in 65.9%.

In terms of activity, companies operating over the complete value chain register higher levels of efficiency than firms that specialize in the R&D area.

If we classify the firms according to their main activity, we find that the mean efficiency for the manufacturers is 0.381 whereas for the R&D firms the figure is smaller, 0.281.

One possible explanation for our results is that many manufacturers have been in the market longer, and their historical performance have endowed them with expertise, knowhow and managerial practices which have increased their productivity. This is related to the phenomenon called learning curve in engineering or learning by doing in economics.

Instead, many R&D firms are still relatively young; it is feasible, therefore, that there is still room for them to optimize their processes and value chains and improve their productivity and efficiency.

Our findings suggest as well that larger firms are more efficient but only beyond a certain threshold of income, located around 500 million euros. Companies above this figure are considerably more efficient, suggesting the possibility of scale economies for high levels of turnover.

Firms with turnover between 38 and 500 thousand million euros also perform better than the whole sample, although their particular advantage amounts just to less than 10 points.

Intermediate and small firms do not profit from either scale economies or the flexibility and specialization associated to very small firms, and therefore register the poorest results as far as efficiency is concerned.

The second stage. Variables correlated with efficiency

We introduce in the second stage of our empirical work a set of variables potentially correlated with efficiency, capturing different aspects of firm management and the macroeconomic environment where companies operate.

According to our findings, the geographical market where firms operate seems to matter for their efficiency. In particular, UK, German, Italian and Swedish companies display higher levels of efficiency than their French and Spanish counterparts, controlling for other factors.

UK and Sweden enjoy a dynamic biotechnological landscape, favourable to alliances and collaborations and to successful and fast adjustments to changing market conditions.

The Italian industry is populated by highly skilled, agile firms, with a large component of exports and close ties to US companies. These companies encompass an important hub for foreign investment in the industry, which in turn enhances the productivity of local firms through technology diffusion and learning by watching.

Our findings also suggest that sound financial structures (with a large component of equity), lower employee costs and higher margins are correlated with higher levels of efficiency.

Implications

These findings have some interesting economic implications. In order to succeed, firms in the industry should strive to achieve an adequate combination of external and internal finance, aligned with the risky and slow-paced nature of R&D activities.

There are implications for policymakers as well. Efficiency in the pharmaceutical sector, according to the empirical evidence, hinges on the sound functioning of the labor and financial markets. Measures to improve their flexibility may have a noticeable impact on the performance of the firms in the industry.

Summing up…

The idiosyncratic aspects of the country of origin of the firms in this industry may foster or jeopardize productivity. And the survival and buoyancy of companies in the pharmaceutical industry seems closely linked to the sound functioning of the input markets.

The experience of some countries, in particular UK, suggests that the existence of agile, dynamic biotechnological firms is beneficial for the whole sector. The removal of unnecesary paperwork and bureaucracy and other obstacles for the constitution of companies, often advocated for Europe, is also recommended for the good functioning of the pharmaceutical industry.

It is true that the peculiarities of the sector demand explicit regulations on some issues, but this feature should not be taken as an alibi in order to justify too interventionist practices.

Finally, the higher levels of efficiency obtained for larger firms suggest that mergers and acquisitions may enhance the performance of pharmaceutical companies due to the influence of scale economies. These financial transactions should not be discouraged or jeopardized by policymakers on the basis of an allegedly competitive strategy. It is important to keep in mind that the pharmaceutical and biotechnological industry relies heavily on R&D, and that R&D is only feasible for firms if their size is large enough.


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