ABSTRACT. Prices for a patented pharmaceutical drug will often decline significantly once a drug comes off-patent. These declines occur due to the drug’s transition from a period of market exclusivity, when an innovative drug manufacturer has the opportunity to cover its cost of capital, to the period of competition, when the drug manufacturer no longer has the opportunity to cover these costs. During the period of market exclusivity, prices will reflect both the costs of production and the innovator’s cost of capital for R&D. Once the market is opened to generic competition, prices only reflect the costs of production. It is the elimination of the cost of capital from the pharmaceutical’s pricing structure that creates the steep price declines often observed when pharmaceuticals go off-patent. The cost of capital for R&D expen- ditures compensate investors for the large period of time it takes to develop a new pharmaceutical product (estimated between 10 to 15 years), the dollar expenditures that must be incurred to develop and test the new drug (estimated to be as high as $5.5 billion per successful pharmaceutical drug), and the risks that the investors must bear regarding whether the pharmaceutical research program will be successful. This paper uses a two-part methodology to estimate an average pharmaceutical cost of capital. First, assuming constant annual expenditures and a 10 to 15 year R&D timeframe, the total capital costs accrued during the R&D phase are estimated. The calculation is based on the weighted average cost of capital (WACC) for the pharma- ceutical industry of 8.33 percent, which accounts for the higher risks associated with the pharmaceutical industry. Second, once the drug is available for sale while on patent (assumed to be 11 ½ years), the estimated payment stream that pays off the capital costs accrued during the R&D phase are estimated. The payment stream accounts for the additional capital costs that accrue during the payoff period. Based on this methodology, this paper estimates that the capital costs on the average R&D outlays of $5.5 billion over 15 years are $17.2 billion, accounting for the cost of time and risks. These figures indicate that each patented pharmaceutical’s annual cost of capital is approximately $1.5 billion a year – a successful drug must earn $1.5 billion in revenues each and every year just to cover the capital costs for the R&D expenditures. pp. 59–79

Keywords: pharmaceutical pricing; innovation; competition; cost of capital

How to cite: Winegarden, Wayne (2015), “The Pharmaceutical Pricing Process Over Time: Balancing the Competing Needs of Rewarding Innovation and Promoting Competition,” American Journal of Medical Research 2(2): 59–79.

Received 16 June 2015 • Received in revised form 28 July 2015
Accepted 28 July 2015 • Available online 20 September 2015

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