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The cost of R


The cost of R&D: How much money is needed to address the current need? Andrew Farlow Department of Economics, and Oriel College University of Oxford – PowerPoint PPT presentation

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Title: The cost of R

The cost of RD How much money is needed to
address the current need?
  • Andrew Farlow
  • Department of Economics, and Oriel College
  • University of Oxford
  • Médecins Sans Frontières (MSF) Campaign for
    Access to Essential Medicines 
  • International Conference on Ensuring Innovation
    for Neglected Diseases
  • London, United Kingdom
  • 8 June 2005

Its not just RD
  • 42 of Africas population 300 million people
    have no access to safe water.
  • Without clean water, anti-retroviral treatment
    for AIDS sufferers is not as effective, and
    formula milk cannot safely be used to prevent
    transmission of HIV from mother to child.
  • Better water management can greatly reduce
    malaria mosquito breeding sites.

Its not just RD
  • Two-thirds of all the African children who die
    under the age of five could be saved by low-cost
    treatments such as vitamin A supplements, oral
    rehydration salts and insecticide-treated
    bed-nets to combat malaria.
  • A tenth of all the diseases suffered by African
    children are caused by intestinal worms
  • These can be treated for 25 US cents per child
  • Research on virus resistant maize for Africa

But RD is vital
  • Huge range of issues
  • Better drugs, e.g. artemisinin combination
    therapies (ACTs) for malaria
  • Better diagnostics
  • Better prevention
  • Better delivery systems
  • More heat-stable products
  • Better
  • Gates Grand Challenges
  • Why should the poor not benefit from
    technological advances too?
  • A matter of equity.

A mix of RD cost studies
  • Tufts (DiMasi, Hansen, and Grabowski)
  • The Price of Innovation New Estimates of Drug
    Development Costs 2003
  • Assessing Claims about the cost of new drug
    development A Critique of the Public Citizen and
    TB Alliance Reports 2004
  • Public Citizen
  • Rx RD Myths The Case Against the Drug
    Industrys RD Scare Card 2001
  • The Global Alliance for TB Drug Development
  • The Economics of TB Drug Development 2001

Views of one side
  • (Referring to Public Citizen Report) fundamental
    economic principles were ignoredtheir estimates
    using published data are deeply flawed and
    substantially understate RD cost.grossly
    technically inappropriate fallacious economic
    reasoning about the nature of investment in RD
    and an erroneous view of the corporate income
    tax Tufts 2004
  • For numerous reasons, the projections in the TB
    Alliance Report cannot be appropriately compared
    to our 802 million resultOur RD estimates are
    costs per approved drug, not costs per approved
    indication Tufts 2004

And the other side
  • But this RD scare card or canard is built
    on myths, falsehoods and misunderstandingsan
    unfounded or false, deliberately misleading
  • Public Citizen referring to TUFTS

Average cost of a drug?
  • Tufts 802m now 1.2bn in some versions.
  • TB Alliance 115m-240m.
  • Another angle if divide total global
    pharmaceutical spending by output of NCEs 50bn
    per NCE

Role of CIPIH and others
  • Most of the above are studies of drug development
  • We need more data on non-drug RD too.
  • Vaccines
  • Innovative interventions of all sorts too
  • Flip side to CIPIH work is costs of RD. Better
    ways (including IP) to do RD gt lower RD costs.
  • We need to gather information on RD costs and
    other factors needed for economic analysis.
    (CIPIH Open Forum 1 June 2005, Overview slide 40)

All studies have issues TUFTS
  • Just a few issues
  • 1) Sampling issues
  • Those approached to join sample were not
    themselves a random sample.
  • Failed to check that the voluntary nature of
    response did not create further sample bias
    toward more costly firms (Tufts found anecdotal
    evidence of this).
  • Mergers may also have helped bias the sample, by
    self-selecting firms to take part in the
    direction of high cost firms.
  • Trial size issuesespecially that they are
    measured as high size and high cost in Tufts
    compared to other approaches to working out costs
    of development.
  • Secrecy of the underlying data.. Cant
    independently replicate the RD cost
    experiment a standard scientific requirement.

All studies have issues TUFTS
  • 2) Skewed cost distributions, with mean greater
    than median, but the mean used in calculations.
  • Since successful trials were used to price the
    unsuccesful trials, and since we know that firms
    strategically spend more on trials that are
    likely to succeed, we record a higher cost for
    failed trials than those trials did on average
    actually cost.
  • Ideally we would like the size-distribution of
    surviving and non-surviving trials at each phase
    and calculate out of pocket cost on that basis.
  • Another problem of the secrecy.

All studies have issues TUFTS
  • 3) Covers self-originated new molecular entities
    (NMEs). Adequate for the described task.
  • But the self-originated makes them a more
    expensive sample than average.
  • May be inadequate for many of the issues raised
    by current neglected drug projects.
  • Hard to read into Tufts cost data what it might
    mean for, say, current neglected diseases work.
  • Date a poor proxy for e.g. AIDS drugs (c.f. South
    African Competition case)
  • Inadequate for debating in an informed fashion
    the relative roles of private/PPP v public

All studies have issues Public Citizen
  • Just a few issues
  • 1) If the point is to work out what the real
    resource costs are of developing a drug/vaccine,
    then should not adjust down to remove tax
    breaks. Should leave pre-tax.
  • If want to have a debate about profitability of
    the industry, gov. subsidies, excessive pricing,
    etc. then we want to adjust for some of these
  • Meanwhile real resource cost is a pre-tax
  • 2) Wrong to remove capital costs.
  • Who pays capital costs, and where risk ends
    up is part of the problem and helps choose
    between RD systems. Capital costs need to be
    factored in.
  • 3) Not enough time spent on worrying about TUFTS

General points
  • Claim of an average cost to develop a
    drug/vaccine is nice but misleading
  • Its not an exact science.
  • It depends what you are looking for (cryptic
    comment sorry!).
  • A wide range is to be expected.
  • Mechanisms highly dependent on knowing this
    supposed average cost are to be avoided.

Some general themes instead
  • 1) Opportunity Cost
  • 2) Rent seeking behaviour
  • 3) Risk and the cost of risk
  • 4) Emerging economy costs of RD

1) There is always a budget constraint
  • Massive level and range of needs there is
    always a budget constraint.
  • Opportunity cost is not a dirty phrase
  • The alternative you were prevented from doing
    because you spent on this project
  • For any given budget for developing
    drugs/vaccines/diagnostic devices/delivery
    devices you could have achieved MORE
    drugs/vaccines/ diagnostic devices/delivery
    devices and access by avoiding high cost
  • It should guide intertemporal policy decisions
  • The overall RD cost matters (i.e. efficiency of
    underlying RD approach taken) and not the timing
    of the flow of funding per se.

Commission for Africa costings There is always a
budget constraint
Opportunity cost the alternative you were
prevented from doing because you spent on this
2) Minimize rent seeking to keep RD costs down
  • Say, in a perfectly functioning RD scheme,
    it would cost an expected 1bn to discover the
    drug/vaccine for a disease in a way that
    maximizes the social surplus at 5bn.
  • You wish to get as close to the optimal scheme
    as possible (you never make it the world is
  • You want to leave consumers themselves with as
    much of the social surplus as possible and not
    have it taxed or priced away from them
    especially if they are poor and the opportunity
    cost of resources is high.

2) Minimize rent seeking
  • What happens if instead you offer all the 5bn of
    surplus to cover the RD? 

2) Minimize rent seeking
  • Rent seeking Even very inefficient projects
    that would not survive under the perfect scheme
    will survive.
  • Although their probabilities of success are poor,
    they will still attract financial backers, since
    on average they generate positive expected
  • In markets with a lot of economic rent
    possibilities, a large part of the social surplus
    is dissipated
  • Excessive marketing (though we need to allow
    for useful marketing).
  • Excessive me toos (again allow for useful
    me toos).
  • High cost forms of RD, including large sample
    sizes to prove small differences in therapeutic
    value, trials that include marketing reasons (big
    industry literature on this), etc.
  • Inefficient use of IP.
  • Inefficiency is compounded by the deadweight loss
    of having to raise the 5bn if it is raised
    through, say, taxation.

2) Minimize rent seeking
  • Fair return on industry capital entirely
    consistent with inefficiencies in end product
    and/or intermediate product markets.
  • (Scherer example) If for example, patents turn
    out to be inefficiently long, rather than
    perennial excess returns being earned, most of
    the potential private benefit is dissipated in
    rent seeking behaviour transforming these rents
    into costs even if there is little or no social
  • This drives profits to the point where price
    equals average costs, where fair return is
  • High measured RD cost figures are endogenous to
    market power and industry structure as much as
    being dependent on any fundamental notion of
    RD costs.

2) Minimize rent seekinglessons
  • Other thoughts on this We want reward to be
    linked as much as possible to the true costs and
    difficulty of developing products for each
    disease as well as therapeutic value,
    epidemiology, etc.
  • So the optimal RD cost of any project should
    depend on a range of variables (all expected
  • Complexity of underlying science
  • Costs of doing RD (also depending on types of
    firms encouraged)
  • Epidemiology
  • Production costs of the eventual product, etc.
  • NOTE Not just information on the medical
    condition itself.
  • Note not necessarily linear tradeoffs.

2) Rent seeking and neglected disease?
  • The tight budget constraints of neglected disease
    research suggest that rent-seeking and forms of
    wasteful activity are likely much lower than for
    developed economy disease RD
  • RD for neglected diseases especially cost
  • At the margin a spent on neglected disease RD
    is likely to be especially productive.
  • RD cost studies based on developed economy
    markets are likely to ill-fit RD costs of
    neglected disease markets.
  • Need for more separate neglected disease specific
    RD cost studies.

2) Rent seeking and neglected disease?
  • The distortion away from neglected diseases is
    linked to rent seeking activity in developed
    economy markets
  • Developed economy health RD problems and
    neglected disease RD problems are linked.
  • Change incentives/reforms in one what happens in
    the other?

2) A lesson avoid rent seeking in any new RD
  • OBSERVE When considering new mechanisms to
    support neglected disease RD, RD costs are
    lower by avoiding mechanisms that create rent
    seeking (or by thinking of ways to modify them to
    avoid rent seeking)
  • E.g. An APC two-stage game.
  • If lots of discretion and need to ex post adjust,
    then APC has firms competing twice - at the RD
    stage, and again, at the committee stage.. The
    second stage competition is rent seeking
  • Or rent seeking happens at start of mechanism to
    reduce the number of potential players at the
    second stage.
  • Any mechanism with committees (including
    Treaties) and discretion, and large sunk costs
    still to be paid at the end will encourage rent
    seeking and higher per unit RD costs.

2) A lesson
  • OBSERVE not just emphasis on therapeutic value
  • Eg. Prize-based models could not just reward by
    therapeutic outcome.
  • It would ignore the differential underlying cost
  • Choice of prize-based scheme over alternatives
    (front loaded, open source, directed research,
    etc.) would boil down to relative efficiencies at
    achieving close to the optimal 1bn scheme.
  • Similarly models that just target costs, miss out
    on the therapeutic profile.

3) RISK and cost of RD finance
  • Tufts half the RD cost of developing a new drug
    is cost of capital i.e. reward to risk taking.
  • Wrong to exclude capital/risk costs from
    commercial RD cost figures.
  • Wrong to exclude capital/risk costs of
    non-commercial RD models too someone bears the
  • But it is also wrong to exclude the value of
    risk-saving of such RD models!
  • If PPPs/NIH activity takes away risk from later
    players, should that not be properly valued and
    ascribed too (currently it is not in RD cost
  • Debate about relevant level of capital costs and
    who bears the risk, should be part of the choice
    about how and where to do RD.

3) RISK and cost of RD finance
  • Is RD high risk? Well, yes and no.
  • Degree of individual variance of an RD project
    or of a pharmaceutical firm is not what matters
  • What matters is the degree of covariance of that
    firm with the overall market.
  • If financial markets are efficient, risk can be
    spread, with investors holding well-diversified
    portfolios and bearing little or no idiosyncratic
  • This is in the capital (CAPM) cost methodology
    used But this is lost from the rhetoric and PR
  • The talk is always about individual financial
    gambles on technology, and never the covariance
    of these financial gambles with other financial

3) RISK and cost of RD finance
  • Most of the TUFTS capital cost is the market
  • Big increase in capital costs component in Tufts
    study was not because RD got riskier per se
    (that is a separate issue) but because the stock
    market bubbled in the late 1990s
  • Pulled up average cost of capital rate up
  • This got applied on earlier sunk RD costs too

3) Equity/non-equity based RD finance
  • Traditional model of drug development has been
    equity-based RD.
  • PPP and others have changed this.
  • What are the implications of this for the RD
    cost question?
  • This is an under-considered point.
  • But all mechanisms of RD, including all proposed
    new mechanisms, have different presumed financial
    mechanisms underlying themand this has
    implications for RD costs.

3) Equity/non-equity based RD finance
  • Some thoughts on the role of equity finance in
    drug/vaccine RD.
  • Fundamental financial problem separation of
    ownership and control of firms engaged in
    research. Two affects
  • A managers/scientists have a preference to
    invest in things that benefit them (a larger firm
    size, nicer offices, more staff under their
    control, higher pay, prestige projects, etc.)
  • B being risk averse they wish to avoid risky
  • Normally, one would think to use more debt than
    equity finance (leveraging) to mitigate problem

3) But leverage is of limited use in the case
of RD-intensive firms
  • 1) The knowledge asset created by RD
    investments is intangible, often contains a lot
    of know-how, is partly, if not largely,
    embedded in human capital, and is often very
    specific to the firms . for debt-holders there
    is no physical asset to secure loans (i.e..
  • 2) Servicing debt requires a stable cash flow.
    Often RD must be sustained at a certain stable
    level to be productive and it would make RD even
    more expensive if it had to compete with this
    cash flow requirement.
  • 3) If bankruptcy is a possibility, managers may
    avoid variance-increasing RD projects that have
    value and that shareholders would want, leading
    to fewer long term projects.

3) Role of equity finance in RD
  • So, the apparent solution to the first problem
    doesnt work.
  • So, most pharmaceutical RD instead takes place
  • firms based on equity-based, external, finance
  • older firms with already established cash flow
  • or newer firms with access to venture
    capital...(but venture capital is also

3) Role of equity finance in RD
  • But this leads to a new set of problems
  • One reason firms do not do certain kinds of
    research is because it is hard to communicate to
    equity-based markets the value of research (even
    if they want to be truthful since they will not
    be believed) and hence to raise the finance for
  • asymmetric information and moral hazard gt extra
    gap between the private rate of return and the
    cost of capital when the innovator-investor and
    financier are different.
  • Firms therefore do not invest in innovations that
    would pass the private returns hurdle.
  • Short termism too Jon Horton, GSK, says firms
    like to see a return on investment by the end of
    year 3.

3) Role of equity finance in RD
  • Also by its very nature drug RD is very long
    term. The lemons premium is higher for RD than
    for ordinary investment because the difficulty of
    separating good from bad projects when projects
    are long-term RD investments is much greater
    than with short-term low-risk projects.
  • The problem is made worse by the fact that many
    firms are also reluctant to release information
    to financial markets, afraid of revealing
    information to competitors.
  • Paradox Need secrecy to secure the end
    payment, but this enforces lack of sharing and
    higher cost forms of finance.

3) Where is this argument going?
  • Are PPPs, breaking some of these information
    problems? Or not?
  • Are PPPs reducing risks and enabling cheaper
    forms of finance or not?
  • Are pay-as-you go ways to finance RD lower (or
    higher) cost approaches to neglected drug RD
    compared to end-to-end (i.e. all reward at the
  • How do PPPs diversify their portfolio if they are
    less equity based?
  • This should instruct our choice of RD mechanism?
  • E.g. 10-15 malaria vaccines entering clinical
    trials in Africa in next few years ten of them
    European. Who to direct funding to these
    developers or big industry players?

3) Costs of finance matter case of HIV
  • HIV vaccines likely to take a minimum of 15 years
    to develop.
  • If we take (at face value) 1.2bn per year of
    out-of-pocket research and trial costs needed
    (IAVA 2004).
  • Replacing this flow for 15 years with a payment
    at the end, and relying heavily on biotechs and
    venture capital at the start and large
    pharmaceutical firms later. How much would it

3) Costs of finance matter case of HIV
  • Required rate of return to investment needs to
    capture many risks above and beyond required
    market return
  • Uncertainty about ever getting a vaccine
  • Uncertainty about internalizing value of research
    in a highly open iterative discovery process such
    as that required for HIV
  • Risk that the mechanism collapses at any point
    between now and end
  • High level of time-inconsistency risk
    (all-at-the-end APCs still contain a great deal
    of time inconsistency risk)
  • High cost of venture capital for early
    discoveries (30-40 is typical VC rate we need
    to average that into the 15 year rate), with
    later rates lower
  • High reputational risk for the last big firm in
    the chain.

3) Costs of finance matter case of HIV
  • How much above normal required market rate of
  • And how much to pay at the end?
  • 65bn, if required nominal rate of return 15,
    real 12)
  • 105bn, if required nominal rate of return 20,
    real 17)
  • 165bn, if required nominal rate of return 25,
    real 22)
  • This excludes the (still likely very high) costs
    after 15 years since APC would not pay out all in
    first year so as to allow follow-on vaccines.
  • These are low rates of return compared to
    speculative investments that venture capital
    normally makes.
  • But are they too high for this case? Or too low?
  • What are the exact sizes of the risks in the case
    of HIV and how high are capital costs going to

HIVlooking from the other side
  • Average expected horizon until repayment
  • 10 year horizon each 1billion pays for about
    100m-150m of early out-of-pocket HIV research
  • 15 year horizon each 1billion pays for about
    35-66m of early out-of-pocket research costs.
  • All in expected terms and all very, very rough

HIVthe other way..
  • Add in crowding out
  • say, half (maybe push payments prove hard to
    remove from winners, and Russia, India and
    China cannot be barred from spoiling markets
    for products later)
  • 1billion of promised HIV payment paying for
  • 50-80m of genuinely additional new early
    out-of-pocket private RD at 10 year horizon
  • 15m-30m at 15 year horizon

HIVthe other way..
  • Maybe this is why current levels of private
    funding are so low?
  • It is claimed there is no market.
  • Maybe it is the very high risk, high capital
    costs and high risks of crowding out?
  • Does a 3bn fund have any impact at all?
  • If it, at most, creates a few months worth of
    what IAVI says is needed, will firms bother? It
    would be too risky?

HIV. The dangers.
  • Unfortunately, as public budget deficits prevail
    across OECD countries, there seems little
    prospect of major new public initiatives on a
    scale to make a significant difference. Harvey
    Bale, CIPIH posting CIPIH Forum, 7 Mar 2005.
  • Strong pressures to trim current levels of
    funding for HIV vaccine research due to the size
    of budget deficits.
  • Proposed U.S. budget, includes only 0.5 percent
    increase in overall funding for the NIH
  • Substantially less than the rate of inflation
    during the past few years
  • Way below the rates of funding increase of the
    past decade.

HIV The dangers
  • Our belt is being tightened for us...the
    previous largess that was associated with all
    research, particularly HIV, is now not going to
    be a reality for the future." Dr. Anthony Fauci,
    head of the National Institute of Allergy and
    Infectious Diseases, NIAID,
  • Fauci says that this tightening may well hit HIV
    vaccine research especially hard
  • So, lots of hype about power of HIV APCs for
    HIVcombined with pressures to cut back funding
    for vaccine research
  • But we saw just how weak an HIV APC would be..
  • What are the consequences for HIV vaccine RD and
    that chances of ever getting a HIV vaccine?

4) The role of emerging countries
The Global Alliance for TB Drug Development The
Economics of TB Drug Development, 2001, p58.
4) The role of emerging countries
The Global Alliance for TB Drug Development The
Economics of TB Drug Development, 2001, p59
Concluding Thoughts
  • Not driven by what is the cost of RD... More
    important is to work out the most efficient way
    to do RDincluding nature of financial
    instruments used to pay for research and then
    see what that costs
  • Then use that to work out how much is needed