A question came up at an event I was at the other day about the structure of the pharmaceutical industry - in particular the issue of companies buying new drugs from other, smaller companies, with the purchasing companies bringing the drugs to market. The argument was made, and I've heard it before, that the bigger company hadn't actually done any of the research and development underlying the drug (although it's not unusual for this kind of buyout to happen while the drug in question is still in clinical trials), so the company that brings the drug out can't make the usual claim that it needs the monopoly revenues from the remaining period of patent protection to recover its research costs.
There's been an ongoing debate in the pharma Industrial Organization field about what form of organization would be most productive of new drugs. One argument is that the best structure is the large, integrated corporation because it's got more fire-power to devote to research and because it has a portfolio of drugs in development, so that the failure of some can be compensated for by the success of others. The opposing argument is that big pharma are a bunch of slow, ponderous dinosaurs and that it's the small, agile, very focussed research outfits which are most likely to come up with breakthrough drugs, but that because those outfits are small they don't have the resources necessary to take new drugs all the way through clinical trials, so they should sell promising new drugs to companies which can pay for large scale clinical trials and use the proceeds of the sale to start work on developing still more new drugs.
From the economist's perspective, this is an example of Ronald Coase's (1937) question about the nature of the firm (pdf here). As we usually express it, Coase was asking why large, vertically integrated firms exist at all. After all, economic theory argues that the price system is the most efficient mechanism for allocating resources (see Adam Smith's description, in Wealth of Nations, Book I, Chapter 1, pp. 4, of the market-linked stages in the production of a labourer's woollen coat), so why do we have what are essentially command-and-control structures with resource allocation decisions handed down from the top, rather than have firms at the final stage of the production chain buy all of the components from competitive suppliers?
Back in the latter part of the 19th century and the early years of the 20th century, the American auto industry didn't consist of a small handful of very large, vertically integrated corporations. In those days if you bought a Buick, while Buick would have assembled the bits and put its name on the car, it would have bought most of the components which went into the final product from other small, specialized manufacturers. It was Henry Ford who invented the modern automotive firm, bringing all of the stages of production under one roof and under one controlling force - his. One suggestion as to why he did this was that it was inspired by a strike at one of his parts suppliers, which put a serious hitch in his production plans. If he bought all of his parts suppliers and brought them all under his own roof, it would take a firm-wide strike to stop his production - no single part of the chain could go out on strike on its own. So he created a new form of automotive producer, and the rest of the industry followed him.
Presumably it followed him because he had it right - vertical integration and command and control had advantages over the market-coordinated system which had preceded it. The explanation usually given for what those advantages are tends to involve transaction costs - there must be extra costs associated with market coordination that can be eliminated through imposing at least some degree of command and control.
Most industries seem to have more or less settled down into what are presumably transaction-cost determined structural equilibria. Pharma, though, seems to be an exception. In Pharma the wheel seems to turn without ceasing.
To come back to the starting point for this post, if there are no transaction-cost advantages to vertical integration, it wouldn't matter which organizational structure the industry adopted. If the market could co-ordinate everything, there would be no difference in costs, profitability or the ultimate price of the product between the case where everything was done within big Pharma and the case where everything was done by small, specialized firms which sold their products and services (services in the case of CROs - Contract Research Organizations - which specialize in organizing and running clinical trials of drugs under contract to whatever firm owns the drugs) which means that the price of drugs would be unaffected and the research would ultimately be paid for by the marketing company which bought the final product with the aim of putting it on the market. The money would simply pass from firm to firm along a chain of markets instead of passing from division to division within a single firm.
One thing which might create a transactions cost equilibrium is the cost of financing the research in the first place. The research will eventually be paid for out of market revenues, but especially in the case of a small, new firm, the research will have to be funded from other sources before the revenue from marketing the drug comes in (assuming the drug doesn't wash out before getting to market, as about 83% of drugs which enter the clinical trials process these days do). In pharma, as F. M. Scherer has shown, most research is funded out of retained earnings.
In fact, Gerben Bakker has suggested most research intensive industries fund their R&D out of cash, rather than, for example, by borrowing. One possible explanation is informational asymmetry: the borrower is likely to have a better idea than the lender which R&D projects are likely to be more successful and which are riskier. Since the borrower has an incentive to downplay the riskiness of any individual R&D project for which it is trying to obtain funding, lenders will tend to add an extra risk premium element to the interest rate charged for any loans raised for R&D purposes. As a result, it might be cheaper for the firm to finance its R&D out of retained cash.
If that's the case then over the long run the integrated firm is likely to dominate in pharma, at least. On the other hand presumably the transactions cost advantage to being large and integrated can't be overwhelming, or the Industrial Organization wheel wouldn't keep on turning the way it does.
