Patents: a key driver of pharma industry profits

Imagine you invested in a firm that spent billions of dollars figuring out how to cure cancer, only for someone else to swoop in and copy its treatment at the last minute. It’s fair to say you wouldn’t be too happy.

That’s why pharma firms get “patent protection”, which ensures they’re the only ones allowed to manufacture and sell the new drug for a certain period of time – normally 20 years. That guarantees them a monopoly, meaning they can charge more to recoup their development costs and then some: brand drugs have a net profit margin – revenues minus costs as a percentage of the product’s sale price – of 28%, among the highest margins of any industry.

The pharma companies aren’t the only ones profiting, either. They sell their drugs to wholesalers, which then sell on to pharmacies and, in the US, prescription benefit managers. Those “PBMs” buy the treatment in bulk for insurance plans, and ultimately have final say over which drugs are covered. In the UK, middlemen are cut out, and pharma firms negotiate with the NHS.

But the biggest difference between the US and the UK – and lots of other countries that abide by the same rules – is that the UK puts a cap on its drug prices. America doesn’t, which is part of the reason almost 50% of pharma sales by value come from the US. Pharma companies, then, spend a lot of money making sure it’s their drugs – as opposed to competing medications – doctors are giving to patients. And that’s why they often spend a lot more – sometimes twice as much – on marketing as on research and development.

They’re on the clock, after all: pharma companies have 20 years to make big profits before their patents expire, and once they do, that source of income can evaporate. In fact, according to the Federal Trade Commission, the sudden competition can cause prices to drop by over 85%. That competition also changes who makes the money: wholesalers and PBMs make a lot more from non-branded drugs than branded ones, because they can negotiate even bigger discounts. The big losers are the pharma firms themselves, whose profit margins drop from 28% to “just” 18%.

Take Pfizer’s drug Lipitor as an example. It once brought in $13 billion in annual revenue, but that dropped below $2 billion when its patent expired and its rivals entered the fray. And since those rivals didn’t have to spend the millions on R&D that Pfizer did, they could afford to be significantly more competitive on price.

Of course, pharma firms have other ways to shore up their profits. For one, they take incentives. Part of the reason so much money is spent on researching cancer and diabetes is that there’s a massive market for treatments. But not all diseases are as common or high-profile. So to encourage research into rarer illnesses, governments offer incentives – like tax benefits and longer exclusivity periods – for so-called “orphan drug” development.

For another, they often choose to work on drugs that are expensive to manufacture, which protects the drug’s profits by making it harder for competitors to muscle in on the market. It’s also part of the reason behind the recent push toward biotechnology drugs – or those made from living organisms. You’d need to make a “biosimilar” drug if you wanted to copy a biotech – and that’s a lot more expensive and a lot more complicated to do than copying a standard medication.

And last but by no means least, pharma firms are constantly “refilling the pipeline”. As soon as a new drug’s approved, the clock starts on the 20 years of profits it’ll give the company. And since it could take another 20 years to develop your next blockbuster, the research has to restart all over again. The cycle never ends – though as we’ll see in the next session, it does change...

The takeaway: Pharma profits are sky-high while a drug’s under patent protection, but once competition’s allowed, prices and profits drop.