The role of firm characteristics in pharmaceutical product launches.

I examine the determinants of new pharmaceutical launches since 1980 in G7 nations. Both market and firm characteristics, and their interaction, are important in explaining entry. New drugs are 1.5 times more likely to be launched in markets that share a border or a language of a drug company's country of headquarters. The effect of competition depends on the characteristics of both the potential entrant and incumbents: domestic entrants prefer to compete with domestic incumbents. Despite the potential for licensing and low transportation costs, the match between the innovating firm and market conditions remains an important determinant of entry.

1. Introduction

This paper examines the influences of market structure, firm, and product characteristics on the launch of new drugs in the largest pharmaceutical markets, the G7 nations. Despite the incentives to amortize large and sunk development costs over many markets, only one-third of the prescription pharmaceuticals sold in one of these countries (the United States, Japan, Germany, France, Italy, the United Kingdom, and Canada) are also marketed in the other six. Economic theory suggests that entry is a function of market size, the level of competition, and the fixed costs associated with product launch. Research in strategic management suggests that firms are heterogeneous: some are better suited to a particular market than others. Joint testing of economic and strategic hypotheses is rare, largely because it requires a setting with a clear set of potential entrants and separate markets. Disentangling these various effects is an empirical challenge, but one for which this setting is ideal. An identical product is launched (or not launched) in different markets, yielding three sources of variance to exploit: variation across countries, variation across therapeutic classes, and changes over time.

Besides the obvious effects on available medical treatments in a country, there are a number of reasons why the entry patterns of new pharmaceuticals are important. Understanding them may provide insights into the diffusion of other new technologies, particularly those characterized by large development costs, relatively low marginal or transportation costs, and susceptibility to creative destruction by subsequent innovators. Theories on entry suggest that some features of this industry will result in "too little" entry in equilibrium. In addition, identifying the sources of competitive advantage in this industry has implications for industry structure and, perhaps, the regulation of entry within a country, as well as managerial decisions such as the choice of a licensing partner.

My main finding is that firm-level characteristics and their interaction with other variables are at least as important in understanding competition as the "usual suspects" like market size and entry barriers. In particular, market characteristics alone correctly predict entry for only about 30% of the sample. Including firm characteristics improves this prediction substantially. These firm variables affect entry in several ways. First, there is a great deal of heterogeneity in firms' cost of entry, related to country of origin, size, and experience. Second, these costs vary within a firm across markets, i.e., the interaction of firm and market characteristics matters. Similarities between the country of headquarters and the target country, such as a shared border or language, greatly increase the likelihood of product launch. Finally, entry also depends on the interaction between a potential entrant's characteristics and those of the incumbent competitors. The effect of competition on profitability also depends on the characteristics of both the potential entrant and the incumbents: domestic entrants prefer to compete with domestic incumbents and are more sensitive to foreign competition than are foreign entrants.

The rest of the article is organized as follows. Section 2 reviews the theoretical and empirical literature on entry. It also provides a brief description of the pharmaceutical industry and presents the rationale for examining market, firm, and product characteristics in this setting. I explain the empirical model in Section 3 and the data in Section 4. Section 5 presents the results, and Section 6 concludes.

2. Background on entry and the pharmaceutical industry

The literature on entry. A wealth of theoretical work exists on the welfare consequences of free entry when firms must incur fixed costs. Many theories predict too little entry relative to the social optimum (Spence, 1976; Dixit and Stiglitz, 1977): the marginal entrant is welfare enhancing. Others (von Weizacker, 1980; Perry, 1984) generate the opposite result, especially in homogeneous product markets. Then, an additional entrant reduces welfare by merely "business stealing" while incurring fixed costs. Mankiw and Whinston (1986) demonstrate the conditions under which there is too much or too little entry. In general, with imperfect competition, a fixed cost of entry, and homogeneous products, the marginal entrant decreases welfare, although this effect decreases as the fixed entry cost approaches zero. But in settings where variety is important--so that the marginal entrant adds to product diversity--the welfare effects of entry are ambiguous. Accounting for the incentives to invest in innovation adds yet more complexity: it is necessary to compare the dynamic efficiency resulting from innovation with the static inefficiency of market power--and prices in excess of marginal cost--in the short run. While this article does not speak directly to the effects of entry on social welfare in pharmaceutical markets, more entry is likely to be welfare enhancing in this setting. (1)

Several general findings emerge from the empirical literature on entry. Both market size and the degree of competition influence the entry decision. The number of firms in equilibrium increases at a decreasing rate with the size of the market, and profit margins fall as the number of competitors increases (Bresnahan and Reiss, 1987, 1990, 1991; Berry, 1992; Scott Morton, 1999). Second, firms tend to enter in markets that are similar to those they already compete in. Berry (1992) shows airlines that serve one or both of the cities in a city-pair market are more likely to enter that market (though this may reflect network effects rather than similarity). Scott Morton (1999) demonstrates that generic drug firms in the United States tend to enter product markets that match well to their existing products. Finally, the match between a product and a market is important. For example, Mazzeo (2002) finds that competing motels strategically themselves from each other in quality space to soften price competition. All these studies of entry have the advantage of requiring little or no data on price and quantity, which is often expensive and difficult to obtain. However, these authors relied on a single cross-section of markets, which precludes simultaneous consideration of market, firm, and product characteristics. (2)

* Background and studies on the pharmaceutical industry. Expenditures on health care range from 5% of GDP in South Korea to over 13% in the United States, and the share of pharmaceutical sales in total health expenditures account for anywhere from 4% in the United States to nearly 18% in France and Italy. The United States is the largest single market, at $97 billion of annual revenue; the five largest European markets amount to $51 billion, as does Japan. (3) The importance of certain therapies can vary substantially across countries. For example, nearly 22% of revenues in the United States derive from drugs for the central nervous system, while in Japan this figure is only about 6%. Italian expenditures on anti-infectives are over twice those of the United Kingdom. These markets also differ on a number of other dimensions, of which regulation is the most notable. The entry of pharmaceuticals is restricted by the Food and Drug Administration in the United States, or an equivalent agency in other countries. The price of drugs is also regulated in most countries, including four of the G7 markets. For a more detailed description of price controls, see Jacobzone (2000) or Kyle (2005).

The industry is highly fragmented: there are thousands of small firms around the world, only several hundred of which are research-based and have brought at least one drug to market. About forty multinational firms dominate the market, and are responsible for half of all drugs available somewhere in the world. Table 1 lists the number of firms in each major market, the number of drugs they have developed, and the average number of countries to which those drugs diffuse. The United States is the origin of over a quarter of all drugs, and these products reach an average of about nine markets. Though many drugs are invented in Japan, they are launched in fewer foreign markets. Drugs with small domestic markets like Denmark, Switzerland, and the Netherlands spread to more foreign markets than drugs with large home markets. Pharmaceutical firms tend to specialize in certain therapeutic categories, (4) and competition within therapies is relatively concentrated. A new drug is reported to require an average of 7.1 years to develop at a cost of $500-600 million. (5) In 2000, pharmaceutical companies spent approximately $8 billion on sales and marketing and distributed samples worth an additional $7.95 billion in the United States alone (IMS).