Focus on Pharmaceuticals: Industry Structure and Competitive Advantage

In November 1993, Merck & Company, the worldwide leader in prescription pharmaceuticals, acquired Medco Containment Services, a mail-order pharmacy and prescription-benefits-management company (PBM). Analysts interpreted the transaction as part of an effort to secure a favorable competitive position for Merck as the pharmaceutical industry undergoes substantial change. The management of several other pharmaceutical companies apparently found this logic compelling: SmithKline Beecham and Eli Lilly recently announced plans to acquire Diversified Pharmaceutical Services and McKesson’s PCS Health Systems, respectively. These transactions attracted attention both because the general public was unfamiliar with PBMs and because the proposed acquisition prices were so high: $2.3 billion for Diversified Pharmaceutical Services and $4 billion for PCS Health Systems. Merck paid $6.6 billion, more than two and a half times Medco’s sales and 45 times its earnings in fiscal 1993.

Explanations for these acquisitions typically emphasize changes in the health care environment in the last decade, especially in the growth of managed-care organizations. PBMs act on behalf of payers to encourage the use of less expensive alternatives to branded drugs. In the course of providing this service, PBMs acquire information on patients and physicians, which may include data on the health histories of patients who have used certain prescription drugs. Executives of pharmaceutical companies note that access to those data could be invaluable for research and marketing productivity.

The mergers also attracted critical attention. One criticism deals with the PBMs’ practices for obtaining permission from physicians to substitute less expensive alternatives for drugs originally indicated on patients’ prescriptions. In their function as mail-order pharmacies, PBMs employ pharmacists to telephone doctors for their permission to make substitutions. Some PBMs also reportedly offer incentives to retail pharmacists who succeed in obtaining permission to switch. Critics observe that a PBM owned by a pharmaceutical company may use these incentives to promote its parent’s products as low-cost options and thereby increase market share.

Another criticism addresses the effect of the acquisitions on the research and development of new drugs. Some observers express concern that aggressive growth of acquired PBMs contributes to price competition, which may diminish profits and thus the incentives for research. Critics argue that lower prices will therefore decrease investment in the discovery of new drugs and hence slow advances in health care.

This article briefly reviews the historical structure of the prescription-pharmaceutical industry and the changes that led to the acquisitions of PBMs.1 The final sections outline an outsider’s perspective on the controversy surrounding these transactions, although it is too early for a comprehensive assessment.

The Prescription-Pharmaceutical Industry Until 1993

The mergers between pharmaceutical companies and PBMs stunned observers because they represent diversification from an industry that has been attractive by most standards. Historical profitability in prescription pharmaceuticals is difficult to measure because products are introduced after research and development that often takes place over many years. Nonetheless, many analysts agree that the prescription-pharmaceutical industry has been one of the most profitable in U.S. manufacturing for the past two decades.

Pharmaceutical companies posted high profits during that period partly because they introduced products that greatly improved the quality of health care for many patients. Examples include Mevacor, a drug for cholesterol conditions; Tagamet, an antiulcerant that often eliminates the need for surgery; and Ceclor, an antibiotic. By 1993, revenues in prescription pharmaceuticals at the wholesale level were about $60 billion in the United States and about $200 billion worldwide.

Although the worldwide industry was populated by hundreds of companies in 1993, none of which had more than 5% market share, competition was mitigated by several factors. Pharmaceutical companies were differentiated by therapeutic class, with no company manufacturing a leading product in every major category. The top three classes—cardiovascular treatments, antibiotics, and central nervous system therapies—accounted for approximately 36% of industry revenues in 1993. The top ten classes accounted for about 68%. Within each class, several companies offered drugs at various stages in their product life cycles. In gastrointestinal treatments, three companies accounted for an estimated 48% of worldwide revenues in 1992. Other classes were not as concentrated. Historically, differentiation of products within segments helped blunt competition on price.

The absence of pressure from buyers also contributed to the profitability of pharmaceutical companies. Decisions about purchases were made by doctors, whose primary interest was obtaining the most medically effective treatment for patients. Studies indicate that doctors were unaware of prices in many cases.2 Prescribing habits of doctors tended to favor branded products, perhaps because brand names were easier to remember than lengthy, complex chemical names.3

Product differentiation, the absence of buyer pressure, and high entry barriers protected drug-company profits.

Throughout the 1980s and early 1990s, pharmaceutical companies directed marketing efforts at doctors. Although little has been published on the sales and marketing budgets of these companies, they were known to sponsor conferences and offer research grants for the purpose of educating doctors about new products. Salespeople sometimes drew criticism for offering gifts to obtain doctors’ attention. Industry sources estimate that pharmaceutical companies spent about $1 billion more on promotion than on research in 1991.

During this period, patients had little influence on the prices of pharmaceuticals. First, their incentives to shop for low prices diminished as insurers and employers extended prescription benefits. In the United States in 1993, third parties paid about 50% of prescription-drug bills, up from 4% in 1960. Second, although patients were responsible for paying the balance out-of-pocket, most probably did not perceive any alternative to their local community pharmacies, which accounted for 61% of U.S. pharmaceutical revenues in 1991.4 Nonetheless, a mail-order channel had been developing since the 1960s to serve price-sensitive patients who needed regular deliveries of medicine to treat their chronic conditions. These patients were often elderly and had less third-party coverage than the average coverage for the population under 65. By 1991, mail-order pharmacies accounted for 6% of U.S. prescription-drug sales.

Substantial entry barriers also contributed to the industry’s attractiveness. To compete effectively against the industry’s leaders, a company had to spend hundreds of millions of dollars annually on large sales forces and other marketing and promotional activities. Obtaining access to markets could also be difficult because new drugs were protected by patents. During the late 1970s and 1980s, patents on new drugs prevented generic competition for a period that typically lasted 8 to 12 years from the date of FDA approval, according to the 1993 study by the U.S. Congressional Office of Technology Assessment (OTA) cited above.

A successful research and development program—including the clinical trials required for FDA approval—was also necessary for entry into the industry. The OTA study reported that the R&D required to develop a new drug introduced during the 1980s took an average of 12 years and cost about $194 million (in 1990 after-tax dollars), taking into account failures and the risk-adjusted cost of capital. The equivalent pretax figure was $359 million. Large pharmaceutical companies typically pursued multiple research programs simultaneously. The R&D required to develop generics could be much lower. In efforts to gain entry, hundreds of biotechnology companies also engaged in research, but only a few drugs based in the science had been introduced by the early 1990s. Biotechnology companies with successful discoveries sometimes allied with established pharmaceutical companies to gain access to marketing and sales functions.

Changes in Industry Structure

The attractiveness of the industry began to deteriorate in the late 1980s and early 1990s as managed care introduced price competition into some segments of the market. The opportunity for negotiating lower prices improved with the 1984 legislation on generics and with the development of PBMs. Analysts now forecast that the growth in managed care will lead to deterioration of drug company profits by the end of the 1990s regardless of the outcome of the current congressional debate on health care reform.

The Waxman-Hatch Act of 1984.

In 1984, the U.S. Congress passed the Drug Price Competition and Patent Term Restoration Act, known as the Waxman-Hatch Act, which simplified the requirements for FDA approval of generics. A generic pharmaceutical is therapeutically equivalent to a “branded” drug; a company may produce a generic either by arrangement with a patent holder or after expiration of patents on the branded product. The act was designed to encourage competition, but it did not independently generate widespread declines in the profitability of pharmaceutical companies for several reasons.5

First, the habits of doctors and pharmacists were apparently difficult to break. Although state laws allowed a pharmacist to substitute a generic equivalent for a branded drug unless the prescription indicated otherwise, such substitution was not common. Physicians’ fear of legal liability may also have contributed to their hesitation to depart from established prescription practices.

Second, the credibility of independent companies specializing in the production of generics was undermined by a scandal in 1989. Manufacturers of generics were charged with falsifying laboratory tests and bribing FDA officials to obtain approval for their products. This scandal reinforced the effects of physicians’ and pharmacists’ reluctance to substitute generic equivalents for branded drugs. By the early 1990s, several major pharmaceutical companies stepped into the breach by establishing their own divisions to market generics or by obtaining interests in companies that sold generics. Some observers suggested that integration into generics prevented the major pharmaceutical companies from ceding share to independent competitors with greater incentives to compete on price. Because patents on many major drugs are scheduled to expire between 1994 and 2000, leading companies may find integration into generics increasingly important to maintain revenue.

Third, the Waxman-Hatch Act did not diminish pharmaceutical profitability because payers had just begun to develop the institutional structure for comparing prices of therapeutic alternatives. During the 1980s, the first generic drug to enter a market usually attracted a large portion of patients inclined to switch. As a result, the company offering the first generic might maximize revenue by setting its price below the price of the existing branded drug, but not as low as marginal costs, because the second generic would not present much competition. Of course, the manufacturer of the existing branded product would suffer a decline in volume after introduction of the first generic. To offset this decline, the best response might be to recapture revenue through a price increase levied on the manufacturer’s base of remaining customers. The introduction of a generic substitute could therefore result in little change in the average price of a treatment or even an increase in average price.

By simplifying requirements for FDA approval on generics, Waxman-Hatch greatly reduced the research necessary for entry into some segments. With the subsequent growth of managed care and PBMs, demand for generics increased dramatically. By the middle of 1994, generic drugs accounted for about 37% of pharmaceutical prescriptions.

Managed Care.

The growth of managed care was a critical factor in the predictions of deterioration in the profits of prescription-drug companies. The term managed care refers to systems in which responsibility for payment is linked more tightly to decision making about the provision of health care services than it is in traditional indemnity insurance plans. Although managed-care arrangements take a variety of contractual forms, they typically provide members with medical insurance and basic health care services, using volume and long-term contracts to negotiate discounts from health care providers.

Managed-care organizations developed in the 1980s and early 1990s to meet the demand for lower health care costs, especially for hospital and physician services. Much of this demand originated with private businesses, which pay most of the premiums on private health insurance. Changes in Medicare reimbursement guidelines in 1983 also created strong cost-containment pressures.

The integration of basic services and insurance in single organizations has led to an unprecedented emphasis on disease prevention and early detection of medical problems. Health maintenance organizations, innovators in managed care, provide full coverage for prescription-drug expenses more frequently than traditional medical insurance plans. During the 1980s, employers also expanded prescription-benefits programs. Increases in coverage for prescription drugs may have been designed to lower total health care costs by improving access to medicinal treatment rather than inducing subscribers to delay treatment until more expensive services were required.

Managed-care organizations monitored the prescription and usage of drugs through a variety of mechanisms. First, HMOs often adopted formularies—lists of drugs compiled by committees of pharmacists and physicians who compare the prices and therapeutic benefits of various drugs. Member physicians were encouraged to specify drugs from the formulary when writing prescriptions. Some reports suggest that the first formulary adopted by an organization usually listed almost all commonly prescribed drugs. Nevertheless, formularies raised awareness among physicians about prices and created a process through which administrators could begin to align incentives.

The next step toward lowering costs was greater restrictiveness in formulary management. An organization with an “actively managed” formulary relied on a relatively short list of acceptable drugs that favored generics. Management also intervened when a physician prescribed an unlisted drug. In January 1994, Smith Barney Shearson reported estimates by Medco that organizations with actively managed formularies accounted for 15% of prescription drug sales, a percentage projected to reach as much as 50% by 1999.6

Medco estimates that by 1999, organizations with actively managed formularies could account for 50% of drug sales.

Managed-care organizations also monitored physicians’ prescribing patterns and patients’ usage through a process called drug utilization review. In this process, medical professionals set up systems to determine whether different doctors had prescribed multiple drugs with adverse interactions for a patient and whether patients were ordering refills at the pace prescribed by their physicians. The audit also revealed physicians’ prescribing habits and created additional opportunities for intervention by formulary administrators.

Formulary management and drug utilization review had important implications for the marketing and sales activities of prescription-pharmaceutical companies. Managed-care organizations used these programs to consolidate decision-making authority and to increase awareness of price in the purchase decision. The results suggest that personal sales visits to physicians may no longer be as effective as they were in the 1980s. Between 1991 and 1993, pharmaceutical companies announced plans to cut 23,000 jobs, about 8% of their total workforce.7 These job cuts are particularly severe in marketing and sales.

Prescription-Benefits Management.

The precursors of today’s PBMs reportedly began operations in the 1960s to administer benefits programs for employers that offered prescription coverage to current employees and retirees. In this capacity, PBMs verified subscriber eligibility, processed claims, and managed communications with retail pharmacists.

During the same period, mail-order pharmacies developed independently of PBMs to serve patients who regularly refilled prescriptions and did not need recurrent instruction from a community pharmacist on proper usage. More than 100 companies eventually entered the market. By the late 1980s, Medco was the largest, with an estimated 50% share of mail orders in early 1993. Through an acquisition in 1986, Medco may have been the first mail-order pharmacy to integrate fully into PBM services. Several PBMs had also entered the mail-order business by the 1990s.

More than 100 companies eventually entered the market for mail-order pharmaceuticals.

By most accounts, sales through PBMs exploded during the late 1980s and early 1990s. At the time of the Merck-Medco merger announcement in July 1993, many managed-care organizations and employers had contracted with PBMs for formulary management and drug utilization review.

Formulary management in PBMs occurs when prescriptions are received by mail order and through retail pharmacists. PBMs that act as mail-order pharmacies obtain information about prescriptions from patients who submit orders. Pharmacists employed by the PBMs telephone doctors with requests to make substitutions that will generate cost savings (this practice varies by state). PBMs also set up systems to provide retail pharmacists with formulary information and encourage them to call doctors with substitution requests.

Anecdotal evidence indicates that these calls are often effective because doctors understand that the PBMs’ pharmacists make recommendations from a formulary that has been reviewed by the relevant managed-care organization. PBMs have also often been successful when they represent employers. Martin J. Wygod, president of Medco, told Fortune in 1991 that 35% of doctors contacted agree to requested changes:

Say we told a doctor in Lansing, Michigan, we were calling on behalf of General Motors. Most of his patients are GM employees or retirees, and he knows who’s paying the bills.8

Reports in the trade press suggest that this practice is more lucrative for mail-order pharmacies than for retail pharmacies. Prescriptions filled by mail order typically generate an annuity of monthly payments that requires little intervention after the initial contact.

PBMs also offer drug utilization review to employers and managed-care organizations. To perform this service, a PBM electronically analyzes patients’ records for problems in rates of use, adverse interactions with other drugs, and histories of health problems that might be related to a current condition. In problem cases, physicians are contacted prior to dispensing a prescription. In addition, PBMs can generate reports for employers and managed-care organizations on particular physicians’ sensitivity to cost-containment efforts.

A PBM electronically analyzes patients’ records for adverse interactions between drugs and a history of health problems.

Integrated PBMs—companies that process mail orders for prescriptions and offer administrative services—are the linchpin to lower drug prices. PBMs provide the institutional mechanism required for competition among generics, drastically reducing the first-mover advantage. By the time of the Merck-Medco merger in November 1993, PBMs were negotiating deeper discounts from drug companies and affecting the market share of pharmaceutical manufacturers in the segments that they served. Although the sizes of these segments were still limited in 1993, analysts forecasted that PBMs would play a larger role with the growth of managed care.

In sum, the structural attractiveness of the prescription-pharmaceutical industry has diminished considerably in just a short time, independently of the debate on new health care legislation. Current industry trends suggest that profits will soon be affected by greater rivalry within therapeutic classes, greater buyer power, and lower barriers to entry. The PBM acquisitions are attempts to confront these challenges.

Does Ownership of PBMs Create Competitive Advantage?

Companies achieve competitive advantage when they perform activities more efficiently or effectively than their rivals do. Proponents of the mergers between pharmaceutical companies and PBMs argue that vertically integrated companies will achieve competitive advantage over nonintegrated pharmaceutical companies from three sources: superior information about market conditions, better access to customers, and opportunities to meet patient needs with new products.

Owning a PBM may provide better access to customers and more new-product opportunities.

Consider first the information available to a vertically integrated pharmaceutical company through ownership of a PBM. As a consequence of formulary management and drug utilization review, PBMs capture data on individual physicians’ and pharmacists’ habits and on patients’ patterns of usage. This information will create strategic advantages for vertically integrated pharmaceutical companies only if it is more timely, accurate, or comprehensive than the information available to nonintegrated rivals. The question that is relevant to capturing competitive advantage is, Would comparable data be available at reasonable cost from the PBM—or from an HMO, insurance company, or other source—in, for example, a long-term contractual arrangement? If the answer is yes, then there is no advantage to owning the PBM instead of negotiating an arm’s-length transaction.

It is difficult to accept the argument that information gained from owning a PBM will create competitive advantage in researching and developing new chemical entities. R&D for new drugs is a lengthy process, and pharmaceutical companies exchange information through scientific, regulatory, consultatory, and trade groups. Even if an integrated company were to obtain valuable information on patient characteristics, for example, its ownership of a PBM would create competitive advantage only if the information significantly affected the company’s research productivity before the information became available to rivals.

The informational advantages from PBM ownership appear greater in marketing and sales. The pharmaceutical companies’ traditional activities—informing doctors about products—might be more effective with immediate access to data on doctors’ prescribing habits and patients’ patterns of usage. The opportunity to gain advantage arises because physicians—even physicians on the formulary committees of HMOs—must limit the attention they pay to pharmaceutical company sales representatives. Vertically integrated pharmaceutical companies may use data from PBMs to construct convincing arguments about the effectiveness of drugs and then achieve advantages over rivals through targeted sales calls on doctors with high potential for increased prescriptions of a specific treatment. This advantage will erode, however, as physicians develop independent systems for comparing therapies and as nonintegrated rivals search for comparable information through other sources.

Proponents also argue that the mergers create competitive advantage by providing parent pharmaceutical companies with better access to customers. For example, better access to customers helped some of the airlines that owned computerized reservation systems gain market share: when a customer asked for a flight between two cities, early versions of some programs showed the advantaged airline’s flights at the top of the list. Similarly, a PBM can direct market share to its parent if the parent offers a product comparable to the drug originally prescribed at a competitive price. This advantage may become particularly important as patents expire and more generics compete with branded drugs.

Vertically integrated pharmaceutical companies have incentives to exploit their preferential access across therapeutic categories. Some analysts foresee the development of large horizontal consortia and even mergers between pharmaceutical companies as they compete for preferred positions with a limited number of PBMs. The outcome of this competition depends on patent expiration dates, differentiation within categories, contact between companies across categories, the order of contracting, and other factors. These issues are reflected in the current business press: observers have reported concern among Merck’s competitors about the effects of the Medco purchase on sales of their products. Varying predictions about the results across therapeutic categories and PBMs no doubt affect forecasts of the cash flows to PBMs and hence the acquisition premiums they command.

In the long run, PBMs will lose market share if they compromise service by promoting products that offer neither superior therapeutic benefit at a reasonable price nor acceptable therapeutic benefit at a low price. Buyers—principally administrators in HMOs and employer-benefit offices—can now credibly threaten to switch among PBMs if their PBMs are not competitive. As the industry develops, the loss of share for a compromised PBM will principally depend on this threat. The threat will somewhat diminish if economies of scale or learning limit the number of competitors that operate at minimum efficiency in the PBM industry.

Proponents cite a third source of competitive advantage available to vertically integrated pharmaceutical companies: opportunities to meet patient needs with new products. Analysts have recently devoted substantial attention to capitation and disease management, two new products available from PBMs that are often mentioned in connection with vertical integration. Reports suggest that market penetration of capitation and disease management is still relatively limited, hence the associated advantages to parent pharmaceutical companies are best characterized as unrealized option values.

Under capitation, the employer or managed-care organization pays a flat fee to a PBM, and the PBM supplies all necessary pharmaceuticals to subscribers over a specified period. Disease management extends this concept: the PBM accepts a flat fee and agrees to provide all required health services to patients with a specified disease. The product will likely be limited to diseases like diabetes that are principally treated by regular medication over long periods.

Both capitation and disease management are insurance arrangements, hence both involve limited forward integration into markets served by HMOs, employers, and insurance companies. The PBM adopts the risk that patients will require medication (and other medical services, in the case of disease management) for a fee based on actuarial information in its database.

These complex products may eventually increase profit in several ways. First, they allow PBMs to obtain even more information about the characteristics of patients using specific therapies. Access to additional information could make the PBMs more persuasive in promoting their products—pharmaceutical treatments, formulary management, and drug utilization review—than they are with the information currently captured in their databases. This advantage is closely related to the informational advantages in marketing and sales discussed earlier. The difference is that the prospective advantage is based on data not currently captured by PBMs. If vertically integrated PBMs successfully sell capitation and disease management, and if these products generate persuasive information about the parent companies’ drugs, then parent companies may become more productive in marketing and sales to medical decision makers.

Second, bundling pharmaceuticals with insurance services may reduce purchaser inclinations to switch. An article in the American Medical News indicates that pharmaceutical companies “are willing to cap total costs involving their drugs in return for varying degrees of exclusivity with hospital chains and managed care companies.”9 Such dependence on integrated PBMs could partially neutralize the negotiating power of managed-care organizations. But these organizations will likely agree to exclusivity only if they calculate that the total price of capitation and disease management is less than the full cost of purchasing each of the bundled products (pharmaceuticals, formulary management, drug utilization review, medical services, and insurance) separately. Ultimately, the prices required for wide adoption of capitation and disease management may be too low to allow vertically integrated pharmaceutical companies to achieve competitive advantage.

A final possibility is that capitation and disease management may eventually create opportunities to introduce new pharmaceutical products. By tailoring the characteristics of new drugs to subsegments of an afflicted population, a vertically integrated company could conceivably differentiate drugs and obtain price premiums. The achievement of competitive advantage through this route, however, depends on many conditions: wide interest in capitation and disease management, the accumulation of relevant and proprietary information on diseases, and successful R&D programs.

There are considerable impediments to the success of capitation and disease management. Capitation, for example, creates incentives for pharmaceutical companies to encourage less use of therapeutics. These types of programs may be difficult to administer in a medical culture that has historically emphasized the therapeutic value of products without regard to costs. Integrated PBMs may be less efficient or effective than HMOs or other insurers at providing the medical services required for disease management or at calculating appropriate prices that are based on actuarial data. If products based on risk sharing become popular, PBMs may also face increased entry into their industry from traditional insurers.

Concerns About Vertical Integration

Criticism has arisen with respect to the financial incentives offered to pharmacists by vertically integrated PBMs. PBM executives explain that the purpose of these incentives is to compensate pharmacists for taking on the job of encouraging the substitution of low-priced drugs for more expensive therapies. The following excerpt from Drug Topics, a trade publication, reports the views of community pharmacists who do not receive financial incentives but are asked to encourage substitution of less expensive drugs:

For a community pharmacist, a formulary is like the Internal Revenue Service: Nearly everybody agrees it has a valid function, but nobody likes dealing with it…

…The biggest complaint those contacted by Drug Topics have about formularies is that pharmacists—rather than physicians or patients—bear the brunt of formulary enforcement without reward.

“Oftentimes there’s not much incentive for us to adhere to any particular formulary,” explained Bert Lee, pharmacy systems coordinator at Save Mart Supermarkets, Modesto, Calif….

“Is it really the pharmacist’s obligation to start calling the doctors to make changes to adhere to the formulary?” he asked. “I think we’re taking on the role now of accepting the third-party plan’s work in trying to hold the costs down.”10

Defenders say that the incentives promote efficiency by motivating pharmacists and physicians to consider price in their evaluations of medically appropriate treatments.

At least two sets of issues emerge in connection with the PBMs and vertical integration. The first deals with the obligations of pharmacists to be objective advisers. One group of critics expresses concern that any financial incentive may cloud the judgment of professionals as they evaluate therapeutic alternatives. The second deals with physicians’ lack of knowledge about the commercial arrangements that may motivate pharmacists to contact them with requests for changes in prescriptions. Some observers are particularly concerned about advice that has the effect of shifting market share toward a PBM’s pharmaceutical parent. They argue that financial incentives to pharmacists are not inappropriate per se, but that pharmacists should disclose them when requesting permission for therapeutic substitution.

The practice of offering incentives to pharmacists has not been confined to PBMs. This summer, the Upjohn Company, a major pharmaceutical company, agreed to pay $675,000 to eight states for their investigations and other activities related to an Upjohn marketing program. Under the program, Upjohn paid pharmacists for counseling patients on diabetes treatment when the patients switched to one of Upjohn’s treatments. According to the New York Times story on the payment, the attorney general of New York said he

had introduced legislation in New York to make it illegal for companies to pay pharmacists to induce patients to switch drugs. He said he had also asked the Food and Drug Administration to make it illegal for companies to pay pharmacists to market their drugs.11

In August 1994, the Office of the Inspector General at the U.S. Department of Health and Human Services issued a “Special Fraud Alert” about the marketing of prescription drugs reimbursed under Medicaid that would also apply to reimbursement under Medicare. Among other things, the alert covered incentives to pharmacists and inappropriately large research grants to doctors.

If vertical integration accelerates the growth of PBMs, and if PBMs offer pharmacists financial incentives to a greater extent than other companies that sell pharmaceuticals, then the acquiring pharmaceutical companies may have contributed to the adoption of these controversial practices. Nonetheless, these practices also occurred independently of the mergers themselves. The Upjohn case, for example, involves the payment of incentives prior to announcement of the mergers.

Vertically integrated drug companies must confront questions about the payment of incentives to pharmacists.

The issues raised by the payment of incentives are broadly related to the distribution of responsibility for evaluating the costs and benefits of specific drugs on behalf of patients and payers. Under current practice, physicians and pharmacists share responsibility for evaluating the benefits, but physicians do not always have complete information about costs. The resolution of current debates about the dispersion of responsibility will have strong implications for the competitive advantages of pharmaceutical companies and PBMs.

Vertical integration is also closely related to trends that affect the R&D of unprecedented new drugs. As managed care forces pharmaceutical companies to compete on price, there will be less incentive to devote resources to research, and aggregate resources devoted to R&D may diminish considerably. Nonetheless, the link between lower prices and the mergers (as opposed to arm’s-length relationships between pharmaceutical companies and PBMs) has not been established. Again, it is hard to accept that the mergers per se have had a significant enough effect on pricing trends to influence the prospective returns to R&D on drugs with unprecedented therapeutic value.

The purchase of PBMs by pharmaceutical companies occurred in response to trends that will make the pharmaceutical industry less profitable than in the past. These trends have emerged independently of the current debate on new health care legislation. The most compelling logic for the acquisitions is that PBMs provide pharmaceutical companies with opportunities to increase market share as prices decrease across the industry.

Vertically integrated pharmaceutical companies face considerable challenges: They must quickly confront the ethical and legal questions that arise with the payment of incentives to members of the medical community. They must negotiate internal transfer prices that do not compromise their PBMs’ market positions. As the purchasing process changes, traditional marketing and sales to doctors become less relevant. Pharmaceutical companies must therefore streamline their marketing and sales functions and redeploy employees who have previously had the greatest contact with critical decision makers in the buying process. Vertically integrated pharmaceutical companies must also negotiate contracts to obtain complementary products from rivals—both generic drugs and patented blockbusters—at competitive prices. Finally, over the long term, they must manage R&D in an environment that may favor less investment. The challenges are enormous.

1. The framework for this analysis draws on Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press, 1980).

2. Peter Temin, Taking Your Medicine: Drug Regulation in the United States (Cambridge: Harvard University Press, 1980), pp. 102–19.

3. In “Patent Expiration, Entry, and Competition in the U.S. Pharmaceutical Industry,” Brookings Papers on Economic Activity: Microeconomics (1991), pp. 1–66, Richard E. Caves, Michael D. Whinston, and Mark A. Hurwitz make this point about the simplicity of the brand name. See their paper for a rigorous analysis of competition in markets formerly dominated by 30 drugs on which patents expired between 1976 and 1987.

4. U.S. Congress, Office of Technology Assessment, Pharmaceutical R&D: Costs, Risks and Rewards, OTA-H-522 (Washington, D.C.: U.S. Government Printing Office, February 1993), p. 238.

5. Competition after Waxman-Hatch is the subject of Henry G. Grabowski and John M. Vernon, “Brand Loyalty, Entry, and Price Competition in Pharmaceuticals After the 1984 Drug Act,” Journal of Law and Economics (October 1992), pp. 331–50.

6. The Medco estimate is cited in the Smith Barney Shearson Analyst Report, “Drug Industry: January 1994” (January 20, 1994), by Christina Heuer and Jane Kearns, p. 6.

7. Joseph Weber, “Withdrawal Symptoms,” Business Week (August 2, 1993), p. 20.

8. Brian O’Reilly, “Drugmakers,” Fortune (July 29, 1991), p. 60.

9. Mike Mitka, “Drug Makers Move to Shared Risk to Sell Managed Care,” American Medical News (March 7, 1994), p. 3.

10. Greg Muirhead, “Learning to Live with Formularies,” Drug Topics (February 21, 1994), pp. 38–39.

11. Gina Kolata, “Upjohn Will Repay 8 States Over Drug Marketing Plan,” New York Times (August 2, 1994), pp. D1, D4.

A version of this article appeared in the November–December 1994 issue of Harvard Business Review.