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Analysis Of The Pharmaceutical Industry Economics Essay

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The most important definition of industry was given by Michael Porter in 1979: a “group of competitors producing substitutes that are close enough that the behavior of any firm affects each of the others either directly or indirectly.” Later, Porter defined the term more precisely as “a group of companies offering products or services that are close substitutes for each other, that is, products or services that satisfy the same basic customers’ needs.” This new definition emphasizes the importance of industry borders and industry’s role as a market supplier or producer of goods and services, as distinguished from a market, defined as a consumer of goods and services.

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Furthermore, inside every industry there are groups of companies that follow similar strategies, defined by Michael S. Hunt in his unpublished 1972 Ph.D. dissertation as strategic groups. Between these groups there are differences in entry barriers, bargaining power with buyers and suppliers and skills and resources . Strategic groups compete against each other within the industry as a result of these differences.

1.2 Models to Analyze the Industry and Its Environment

The literature agrees that comprehension of the industry structure is essential to developing a firm’s strategy and has a greater effect on the firm’s performance than whether it is business-specific or corporate-parent. The comprehension of the structure requires analyses of the industry’s life cycle. It also requires step-by-step political, legal, technological, social and economic analyses as well as the five driving forces of business, provided by Michael Porter. By utilizing these analysis techniques, it is also possible to anticipate changes in industry competition and profitability over time.

1.2.1 Industry Life Cycle Analysis

There are different phases during the development of an industry. Every phases is characterized by a different environments which make competition assumes different the form. Through studying the life cycle, the industry realizes its stake in the market and its influence on consumers. The industry life cycle model includes four different phases: introduction, growth, maturity and decline.

The first phase, called introduction, is characterized by a low demand, whereas prices are high as a consequence of firm’s inability to realize economies of scale. For this reason profits are low and losses are possible due to high amount of investments in new categories. Barriers to entry are primary based on technologies and competencies. Strategy is focused mainly on R&D and production, with the goal of enhancing novelty and quality. Competitors, attracted by the rising demand, attempt to replicate the new product.

In the second phase, growth, the use of the product is extended, demand grows, prices decline due to economies of scale, barriers to entry are lower and the threat of new entry is high. At this phase the technology is usually not exclusive property of one or more firms, and the primary reaction to competition is marketing expenditure and initiatives; profits are not very high because prices decline as competitors enter the market. There is a transition period, or shakeout, between the second and the third phases. The shakeout involves finding and using all investment opportunities, because the market is near saturation and demand grows more slowly.

In the third phase, maturity, market growth is low or nonexistent, and the focus shifts to gaining market share; demand is represented only by the substitution of products, investment in R&D decreases and there is little innovation. In this phase firms seek cost reductions, and competition is based primarily on advertising and quality because of the low differentiation between products. Big firms acquire smaller players, while others are forced to exit. As a conseguence of high barrier to entry, the threat of new entrants are low.

The last phase is decline, so called because of the continued decline in demand. Industries arrive at this stage for a variety of reasons. These include a change in social behaviors, demographic changes, international competition, technological innovations and increased customer knowledge. The buying process is based primarily on price rather than innovation. As a result, profit and revenues decline, and the industry as a whole may be supplanted.

1.2.2 PEST Analysis

The word “PEST” is an acronym of several aspects that influence business activities at any given moment. An industry operates under Political, Economic, Social and Technological conditions. These conditions are identify and analyzed using the PEST Analysis technique. Due to their independent influence on any industry, it is essential that each be considered individually.

The political aspect of analysis encompasses various factors that influence business activities in a given country at several levels: national, subnational and supranational levels. These include trade policies control imports, exports and international business partners, government ownership of industry, attitude toward monopolies and competition and trade policies. Hence, failure to consider these policies may result in loss of revenue due to taxes or penalty fees. Government stability is also very important, because it eradicates the risks associated with wars and conflicts. For an industry to thrive, political stability must be uncompromised; otherwise, sales and business activities will be uncertain, and investors will lose interest. The internal political issues in any country influence the running of industries. Politics based on race or religion may define the course for certain industries, especially if an industry falls short of political expectations. Elections and changes in leadership also influence an industry’s strengths and opportunities and thus should be considered during the analysis. In addition to internal issues, international pressures and influences may affect some industries, such as environmental degradation or product safety. Another factor is terrorism. Though uncommon in many countries, poor or unstable governance may attract terrorist activities, vengeful or otherwise, which can have adverse effects on the industries operating in that country. All these issues may influence industry and firm expansion and industry attractiveness from stakeholder’s point of view.

The economic aspect of analysis includes many factors. The first factor to consider is the current economic situation and trends in the country in which the industry is based. Companies should note inflation and economic decline so that when it comes to investing, they can avoid being financially affected. Failure to do this results in an economically blind platform that may cause the industry’s sudden collapse. Another factor to consider in analysis is taxation rates. When there are high taxation rates in a given country, price-based competition may affect a given industry in the international market. International economic trends are also very important, because they define currency exchange rates, imports and exports. Other factors to consider are consumer expenditure and disposable income and, finally, legal issues, including all trade legislation in a given country and other legal regulations that inhibit or encourage expansion of business activities. Also to be considered are consumer protection laws, employment laws, environmental protection laws and quality standardization regulations. Industrial laws regulating competition, market policies and guidelines also play an important role in influencing industry’s stability and future expansion possibilities .

When considering the social aspect, factors including demographic changes, shifts in values and culture and changes in lifestyle are important to note so as to strategize on expansion and growth . Certain factors, such as media and communities, influence an industry’s growth and returns. Brand name and corporate image are also very important in influencing growth and returns since they shape customer loyalty and shareholder investment. The media’s views on certain industrial products should be incorporated into the analysis, as should consumer attitudes and sensibility to “green” issues, that is, issues that affect the environment, energy consumption and waste and its disposal. A company’s information systems and internal and external communications should also be analyzed to ensure that it keeps pace with its competitors. Other factors are the policies regulating education, health and distribution of income, all of which, in the long run, influence consumer use of products .

The technological aspect of analysis encompasses a variety of factors. In addition to developing technologies, all associated technologies, along with their innovation potentials, speed of change and adoption of new technology, should be analyzed for a proper evaluation of the industry. Other technological factors are transportation, waste management and online business. The level of expenditure on R&D should also be considered in order to secure the industry’s competitive position to prevent losses and collapse .

1.2.3 Porter’s Five Competitive Forces Analysis

Porter’s model, as described by Kay, is an evolution of the Structure-Conduct-Performance paradigm conceived by Edward Mason at Harvard University in the 1930s and detailed by Scherer in the 1980s. , The model aims to determine the intensity of industry competition, major issues in determining strategy and whether an industry is attractive or not. Porter identified five competitive forces that act on an industry and its environment: threat of entry, intensity of rivalry among existing competitors, threat of substitutes, bargaining power of buyers and bargaining power of suppliers.

The first competitive force, threat of entry, refers to the threat of new entrants in an established industry or acquisition to gain market share. Reactions of participants and barriers to entry are the main factors used to establish whether the threat is high or low. Six major entry barriers have been identified:

• capital required to compete in the industry (especially in risky industry, such as advertising or R&D)

• switching costs

• access to distribution channels

• economies of scale

• cost disadvantages independent of scale, such as patents, access to know-how, access to limited resources, favorable locations, government subsidies or policies and learning or experience curves

• product differentiation

• expected retaliation from existing firms against the new entrants

Strong barriers to the entry of new firms enable a few firms to dominate the market and thereby influence prices.

The second force is intensity of rivalry among existing competitors. Rivalry takes place when one or more firms inside an industry try to improve their position using tactics such as price competition, new product introduction or new services. Rivalry depends on several factors: number and size of competitors, industry growth, product characteristics (which determine whether the rivalry is based on price or differentiation), cost structure, exit barriers, diverse competitors, operative capacity and high strategic stakes. If an industry is inhibited, then firms will experience difficulties when trying to expand. The growth of foreign competition and the corporate stakes should also be included in the analysis.

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Threat of substitutes is the third forces. Substitutes are those products manufactured by other industries but serving the same purposes as the initial product. These substitute products cause the demand to decline. The implications are reduced profits and reduced market command by the original capital investor. This is of particular importance when the buyer has no switching costs and can easily compare products in terms of price and efficiency.

Bargaining power of buyers is the fourth force. High bargaining power positions weak firms inside the industry, forcing price down, enhancing competition between industry players and resulting in bargaining for higher quality or services. This power is particularly high under certain conditions, such as few and specific buyers, undifferentiated products, low switching costs, the possibility of backward integration and information about demand and the availability of market price to the buyers. Furthermore, bargaining power is high if product quality is not a crucial factor of decision-making and if what the buyer is acquiring is a modest fraction of his total costs. Bargaining power is even higher when the buyer is a retailer or a wholesaler able to influence the consumer’s purchasing decision.

The fifth and last force is the bargaining power of suppliers. This can act on the industry in several ways: raising prices, lowering quality or privileging some buyers. Supplier power can be divided into several elements. One of these elements is supplier concentration. Suppliers are in a stronger position when there are few suppliers, switching costs are high, the industry they are serving account for a small fraction of their business or their products are an important part of the buyer’s business. The bargaining power of suppliers is low or nonexistent when there are substitute products. Lastly, purchase volume and the supplier’s influence on cost are very important.


2. Pharmaceutical Industry Analysis

A general overview of the pharmaceutical industry is the primary objective of this chapter. First, this chapther will define the industry in order to identify the main players in the pharmaceutical market. Second, using the instruments and models described in the first section, it will highlight the main characteristics of the industry and the factors that influence it.

2.1 Definition of Pharmaceutical Industry

The pharmaceutical industry is composed of companies developing, manufacturing and marketing products licensed for use as medications. Their goal is to prevent, diagnose or treat diseases. A medicinal product, also called a pharmaceutical, according to the EU, is an exogenous substance or a combination of exogenous substances that can be organic or inorganic, natural or synthetic, and able, once inside the human or animal body, to modify physiological functions or to make a medical diagnosis through physical, chemical or physicochemical action.

This industry is subdivided into two sub-industries characterized by different business models and players: prescription and OTC pharmaceuticals. Prescription pharmaceuticals, also referred to as “Rx,” are medicines that are available to the consumers for purchase in a pharmacy or drug store only with a prescription from a physician or administered only in hospitals. These medicines target specific diseases and, therefore, are prescribed for and used by one person only. OTC pharmaceuticals are instead used by more than one person which present the same symptoms in the same or in different time. These medicines are available to the consumer at every time and the consumer don’t need any prescription from a physician for purchase.

Furthermore, inside this industry there are two types of firms: Big Pharma and Biotech. These two types, despite being in the same business, vary in several ways: IP, drug methodology, expenditure and productivity of R&D . The primary drug R&D techniques used by Big Pharma firms are chemoinformatics and in silico screenings. Biotech firms are companies that use biotechnology in R&D . Biotechnology, according to the Organization for Economic Cooperation and Development, is “the application of science and technology to living organisms, as well as parts, products and models thereof, to alter living or nonliving materials for the production of knowledge, goods and services.” Generally, Biotech firms tend to have a strong academic culture, are more risk treatment and spend less than half what Big Pharma spends on R&D; in 2004, Biotech firms spent $20 billion, versus $50 billion spent by Big Pharma. Generally, a Biotech product has multiple IP covering manufacture, formulation and stability, as opposed to Big Pharma IP, which covers only the product, allowing generics to be produced quickly. While they may appear to have the same phenotype, their genotypes are distinct, so much so that they can be considered two industries, as stated by Arthur D. Levinson, Chairman and CEO of Genentech. Nevertheless, this distinction is not always clear, as many Biotech and Big Pharma firms are hybrids to varying degrees.

The focus of this thesis are Big Pharma involved in the development of prescription pharmaceuticals to treat and prevent human diseases in the EU market.

2.2 Analysis of the Pharmaceutical Industry

The purpose of this chapter is to provide a brief overview of the pharmaceutical industry lifecycle and investigate the major force acting inside it .

2.2.1 Industry Lifecycle Analysis

People over the years have always tried to discover diseases causes and to find remedies against it. The most complete medical test, the Ebers Papyrus, is dated 1550 BC and it was written by Egyptians . However, the industrial production of drugs dates back to the year 1827 when Heinrich E Merck in Germany founded the first company for the production of cocaine and morphine . This event started the introduction phase of the pharmaceutical industry in Europe. In Europe, this industry was born in different way, reflecting the different strategic groups inside it. In the German-speaking countries, pharmaceutical companies were born as a branch of the chemical industry, with firms like Bayer and Hoechst in 1863, BASF in 1865 and Schering in 1871 in Germany, and CIBA in 1884 and Sandoz in 1886. Only Hoffman-La Roche in 1894 in Switzerland was originally a drug firm. On the other hand, in Italy, France and the UK companies were born from small shop pharmacies, such as Glaxo which traces its origins to a pharmacy in Plough Court in 1715 . During the 1800s many compounds were already being isolated, but none was being synthetically produced. The first synthetic drug was Phenacetin, produced by Bayer and commercialized in 1888 . Ten years later Bayer commercialized Aspirin, which marked a milestone in the pharmaceutical industry. Many firms rose to prominence in the 1920s-30s with these kinds of pharmaceuticals, but also with a new class of pharmaceuticals: vaccines and serums .

During the Second World War II the demand for drugs increased and mass production started, primarily with drugs such as antibiotics (penicillin, streptomycin and neomycin) and sulphonamide . The availability of these drugs dramatically changed the quality and the average life-span of people. In this period the German pharmaceutical industry, a leader along with the Swiss in pre-war times, was taken over by American firms who came to Europe to taking advantage of the condition of the continent after the war.

The period 1950-60 was the start of the industry’s growth phase , and this saw a proliferation of new drugs and high return to drug discovery. New drugs included tranquilizers such as MAO inhibitors in 1952, anti-tuberculosis drugs such as Isoniazid in 1952 and oral contraceptives in 1956. Other discoveries included Librium in 1960 and Valium in 1960. The latter was sold from 1963 and later became one of the most prescribed medicines in history before controversy emerged over its link to habituation and dependency.

In the 1950s, legislation was put in place to regulate the industry, mainly touching on labelling and approval by health authorities as well as drawing distinctions between non-prescription and prescription medicines. In this apparently unstoppable process of pharmaceutical progression and optimism the industry was stalled by a drama concerning one drug sold in Europe and Japan, Thalidomide. This drug, synthesized in Germany in 1954, was introduced to the market to treat the symptoms of morning sickness and nausea in pregnant women. Between 1954 and 1960, it caused around 5,000 and 10,000 severe deformities in infants. In fact, the drug had not been sufficiently tested on animals to assess its safety, and after this revelation, in an attempt to better regulate the industry, drug oversight authorities were established to exercise control over the industry. The World Medical Association met in Finland and issued the Declaration of Helsinki, setting the standards for clinical research. Among other things, the declaration stated that pharmaceutical companies must prove the efficacy of a new drug in clinical trials before releasing it to the market, and subjects must consent to experiments done to test the efficacy of drugs in clinical studies.

The industry remained small up to the late 1970s . Two events characterized the 1970s. First, chemical production for raw materials and early intermediates shifted out of Europe to low cost destinations such as India and China which later began producing active pharmaceutical ingredients and finally non-patented pharmaceuticals . Second, there was the birth of biotechnology. This new science had its roots many years before with the discovery of the double helix in 1953 by Watson and Crick, which followed the advances in molecular genetics, recombinant DNA technology, and molecular biology. Until then, drugs in commerce were produced by extraction from natural substances or chemical synthesis. These new techniques of molecular biology marked the birth of a new industry which became a competitor to and a substitute of the pharmaceutical industry. This new industry was pioneered by firms like Genentech and Amgen which introduced revolutionary drugs such as Epogen and recombinant human insulin.

In the 1980s, legislation was passed in most European countries requiring adherence to strong patents for both the pharmaceutical products and their production processes. There were also new regulations such as the introduction of the Good Clinical Practices, which were guidelines regulating ethics and the reliability of clinical studies. In Europe, several states also initiated health maintenance organizations and managed care in an effort to limit rising medical costs, and a preference for preventive rather that curative medication took root.

As the industry entered the 1990s, new discoveries and projects, such as the Human Genome Project 1990, changed the business environment. Also, there was a huge wave of M&A to build on synergies. This included Ciba-Geigy and Sandoz forming Novartis, Hoechst and Roussel-Rhone Poulenc-Rorer forming Aventis and Glaxo Wellcome and SmithKline forming GlaxoSmithKline. In this way, the manufacturing of pharmaceuticals came to be concentrated in Western Europe and North America, with dominant firms and a few small companies that produced drugs in each country. The major European companies are still the dominant players not only in Europe but also in the global market. They include Novartis of Switzerland, Bayer of Germany, GlaxoSmithKline of the UK, Hoffman-la Roche of Switzerland and AstraZeneca of UK/Sweden.

As the European pharmaceutical industry entered the 21st century, signs of the growth phase have become even more evident. This has been characterized by intense marketing to physicians and internet commerce. This, in part, has been facilitated by the liberalization of marketing rules requiring presentation of risks as well as the advertising message. Internet has enabled the direct purchase of raw materials by the manufacturers. The development of drugs has moved from the hit-and-miss approach to research and informed discovery. Alternative medicines and lifestyle medicines have presented new challenges and opportunities and have raised the level of competition in the industry. The aging population in western European economies has increased opportunities for raising revenues. In fact, because of the ageing population in the developed economies, drug consumption will increase since the aged have a higher frequency of contracting diseases than younger people. New epidemics, such as the recent H1N1 flu outbreak, continue to batter the world population, and increased globalization makes them spread more quickly than ever.

As the industry advances through the growth phase, companies are undertaking research and development initiatives both to develop new drugs and improve production processes. Further, the increased role of state-supported medical schemes across Europe, as well as other state-managed health programs around the world will greatly increase the reach of healthcare, extending it to more of the middle class and the poor who constitute the larger part of the population in most countries. As the medical programs continue to gain efficacy, the sales of pharmaceutical firms are expected to grow. In addition,, the emerging economies like Brazil, Russia, India, China, Turkey, Mexico, and South Korea will add to potential consumer numbers in the industry for European manufacturers. Together, these countries constitute a huge percentuage of the world’s population, meaning that their entry into the high income category will no doubt present an enormous potential market for pharmaceutical products. In fact, the growth in these markets is expected to reach 14-17% by 2014, compared with only 3-6% growth in the developed markets. Thanks to agreements signed by the Asia-Pacific and Europe governments concerning liberalization of the Asia-Pacific pharmaceuticals and investments market, many companies have already started to establish relationships with emerging markets. An example is GlaxoSmithKline, who partnered in 2009 with India’s Dr. Reddy Laboratories. GlaxoSmithKline will distribute the drugs manufactured and supplied by Dr. Reddy in Africa, the Middle East, Asia-Pacific, and Latin America.

Even with these last considerations, the European pharmaceutical industry has only a limited chance of entering the maturity phase of the cycle. The barriers to entry are so great that they choke any new entrant in almost every facet of operation: in research and development, in product distribution, and in compliance with rules and regulations. In fact, this industry has complex manufacturing capabilities which are hard to replicate, and are protected by way of patent, as well as huge consumer attachment to preferred brands from specific companies, often informed by experience. Furthermore Europe generic penetration is very low (less than 10% in total). Thus the industry might remain in the growth phase for a considerable time.


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