patients to hospitals to the government). In this model, not surprisingly, investors rewarded pharmaceutical companies based on the amounts they spent on R&D (secure in their belief that the costs could be passed on to customers) and the fullness and balance of their product pipelines. So, how has the story changed over the last decade? The growth rate in health care costs seems to have slowed down and the pricing power of drug companies has waned for many reasons, with changes in health care laws being only one of many drivers. First, we have seen more consolidation within the health insurance business, potentially increasing their bargaining power with the pharmaceutical companies on drug prices. Second, the government has used the buying clout of Medicaid to bargain for better prices on drugs, and while Medicare still works through insurance companies, it can put pressure on them to negotiate for lower costs. Third, the pharmacies that represent the distribution networks for many drugs have also been corporatized and consolidated, and are gaining a voice in the pricing process. The net effect of all of these changes is that R&D has much more uncertain payoffs and has to evaluated like any other large capital investment: that it is good only when it creates value for a business. To test the hypotheses that pharmaceutical companies have lost pricing power between 1991 and 2014 and that R&D no longer has the revenue punch it used to have, I started by looking at the average profit margins at pharmaceutical companies in figure 5.5, using different measures of profit margins (Net Income, Operating Income, EBITDAR&D), each year: The evidence is only weakly supportive of the hypothesis that pricing has waned over the period, since margins, while down slightly have not changed much over the time period. I followed up by looking at whether the payoff to R&D in terms of revenue
patients to hospitals to the government). In this model, not surprisingly, investors rewarded pharmaceutical companies based on the amounts they spent on R&D (secure in their belief that the costs could be passed on to customers) and the fullness and balance of their product pipelines. So, how has the story changed over the last decade? The growth rate in health care costs seems to have slowed down and the pricing power of drug companies has waned for many reasons, with changes in health care laws being only one of many drivers. First, we have seen more consolidation within the health insurance business, potentially increasing their bargaining power with the pharmaceutical companies on drug prices. Second, the government has used the buying clout of Medicaid to bargain for better prices on drugs, and while Medicare still works through insurance companies, it can put pressure on them to negotiate for lower costs. Third, the pharmacies that represent the distribution networks for many drugs have also been corporatized and consolidated, and are gaining a voice in the pricing process. The net effect of all of these changes is that R&D has much more uncertain payoffs and has to evaluated like any other large capital investment: that it is good only when it creates value for a business. To test the hypotheses that pharmaceutical companies have lost pricing power between 1991 and 2014 and that R&D no longer has the revenue punch it used to have, I started by looking at the average profit margins at pharmaceutical companies in figure 5.5, using different measures of profit margins (Net Income, Operating Income, EBITDAR&D), each year: The evidence is only weakly supportive of the hypothesis that pricing has waned over the period, since margins, while down slightly have not changed much over the time period. I followed up by looking at whether the payoff to R&D in terms of revenue