Tutorial on the Regulation of the Pharmaceutical Industry

Excerpts from the book

Confronting Complexity

X-Events, Resilience, and Human Progress


John L. Casti

Roger D. Jones

Michael J. Pennock



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Roger D. Jones, PhD

January 5, 2013

The pharmaceutical market place is not entirely a free market. The extreme demand for lifesaving products can make standard economic assumptions inoperable. Therefore, regulatory mechanisms have emerged to protect patients and to provide patients access to affordable medications. There are three aspects of pharmaceutical operations in the U.S. that are regulated by the government:

1. The amount of business risk that a pharmaceutical company is allowed to mitigate and the time interval that the risk is mitigated

2. the quality and safety of pharmaceutical products

3. and the cost of the products and the efficiency in which products get into the market

These three regulatory goals can be thought of as nodes of a triangle.

In the U.S. the temporal/risk node is controlled by the Patent Office. A pharmaceutical company that develops or licenses a drug has a certain amount of time to market and sell the drug without competition. Upon expiration of the patent, competitors are allowed to sell the drug, and the price of the drug nearly always falls precipitously. The expiration of the patent can be extended under certain conditions, such as significant improvements to the drug protected by follow-on patents.

The Food and Drug Administration controls the quality/safety component of the regulatory triangle. The FDA is responsible for approval of drugs entering the market. Their decisions are based on safety and efficacy of the drug. The approval process is extensive involving several levels of clinical trials and post-launch monitoring. In addition, the FDA regulates the advertising and promotion of the drug.

The cost/efficiency component of the triangle is quite complex. The mechanism of control is through formularies. These are lists of drugs with the requirements for compensation for each drug. The requirements for compensation for the drug are determined by a myriad of entities. About 35% of healthcare expenditures are paid through the federal government and the Center for Medicare and Medicaid Services (CMS). Private insurers, which are not regulatory entities themselves, pay for most of the remainder. State governments regulate the private insurers. State regulation of private insurers focuses on solvency of insurance companies, risk spreading, fraud and ensuring customers are paid benefits.

The interplay of these three regulatory nodes can determine the profitability of a pharmaceutical product, the patients’ access to the product, and the risk that patients incur from the product. Pharmaceutical business is as much about navigating the regulations as it is dealing with the competition.

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