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Private Investment in Medical Device Innovation ANTHONY A. ROMEO Medical device innovations have been developed by a mix of private and public funding. Of course, support from the private sector has been motivated, at least in part, by a quest for profits. This prospect has spurred the research and development (R&D) and risk-taking necessary for innovation. This paper examines some of the business considerations that lie behind private investment in medical device innovation. To date, business investment decisions have reflected an optimism about the rich technological opportunities for developing new products and the attractive sales potential in an apparently expanding market. But are changes in the economic, legal, or regulatory environment likely to destroy the incentives for business investment? Is federal support of private investment called for? DECISIONS ABOUT R&D R&D is an investment. Decisions about R&D funding can be approached, in principle, like other investment decisions. One com- pares costs and returns and invests in a project, or set of projects, if the expected returns are deemed satisfactory. Such an evaluation is particularly difficult for R&D. In essence, investment in R&D is an investment in knowledge (Arrow, 1962~. Outcomes cannot be readily specified in advance. Such decisions require the commitment of existing real resources to an uncertain future. Creative people have developed a variety of techniques for making 62

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PRIVATE IMJESTMENTIN MEDICAL DEVICE INNOVATION 63 such decisions. All involve balancing market and technological criteria, and each technique balances the criteria and adjusts for uncertainty in various ways. Techniques range from formal models that rely primarily on quantitative methods to informal models that rely primarily on personal judgment. The R&D literature is full of discussion advocating one approach or another (Coopers and Lybrand, 1986; Kay, 19794. There is no clear consensus, but it appears that in practice most firms lean toward a more judgmental approach. There is much reliance on heuristics and rules-of-thumb. This would especially seem to be the case in the medical devices industry. The industry has a high population of small firms, and small firms generally tend to eschew the more formal decision-making techniques. Moreover, in fast-changing industries such as this, much of the quantitative data available are obsolete or irrelevant. Intuition may be crucial. Yet, in all cases, the evaluation will consider a variety of factors that determine the technical possibilities and market potential of the innovation. These factors will vary within segments of the medical devices industry. Moreover, interpretation of the evidence will vary among firms according to personal judgment and attitudes. But there are factors that are likely to be broadly relevant to all firms in the industry, and these are worth considering in detail. TECHNICAL FACTORS Technical factors determine the ease with which an innovation can be developed and brought to the market. There are two key technical factors that distinguish development efforts in the medical devices industry. One is the nature of the scientific base on which development builds. The other is the regulatory environment in which development occurs. Investments in R&D build on an existing scientific base. That base seems to hold considerable promise for this industry. For example, potential applications in biotechnology are generating considerable excitement, and technological advances in materials and microelec- tronics seem likely to find further applications. As any venture capitalist will tell you, there is no shortage of ideas for new medical devices. Strengthening the base will expand technological horizons and opportunities, effectively reducing the cost of achieving specific per- formance objectives. The future strength of the scientific base in turn depends heavily on the federal government, which is by far the major source of funds for basic scientific research. Private industry cannot be relied on to do much basic research; the payoff from such activity

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64 CURRENT TRENDS is too distant and elusive to be justifiable in a business environment that is committed to short-term results. Only larger firms or speculators will make such commitments. Even then, the amounts spent on basic research will be small relative to applications-oriented R&D. Federal investment in basic research, then, is clearly a complement and a spur to private R&D efforts (Nelson, 19761. In the case of applied research, however, federal funds are occasionally seen as a substitute for private funds. As such, they are often viewed as an inefficient use of scarce resources. But there is little convincing evidence on this score. Indeed, a recent study suggests that federally funded industrial R&D has actually tended to stimulate private spending (Levy and Terleckyj, 19851. Again, the principle is the same; such research provides a base on which further efforts can build. Certainly, the research base in universities, however funded, has contributed to innovation in medical devices. Examples abound of cases in which university research was the starting point for a new device. For example, Technicon's continuous-flow Auto Analyzer, which was introduced 30 years ago, had its origins in the work of a researcher at Case Western Reserve University (E. Whitehead, De- velopment of Technicon's Auto Analyzer in the paper "Inventing Medical Devices: Five Inventors' Stories," this volume). Today, many businesses try to tap the base of knowledge and expertise in universities. Although it is difficult to; judge the overall economic effects, there is no doubt that universities and businesses are often tied together in the innovation process. As an illustration of this trend, consider the glucose sensor now marketed by Baxter Travenol. This sensor was invented by a research team at Oxford University, developed into a prototype model at Cranfield Institute of Technology, and then brought to commercial quality by Genetics International, Inc., which had funded the academic work. Any stimulative effects of a strong research base will be influenced by the ease with which the base is tapped. Certain institutional features could affect private efforts to use the base. For example, if the information is widely dispersed or difficult to gain access to, then opportunities may be missed. More directly, the producers of new knowledge may decide to raise its price. For example, universities now seem to be becoming more marketwise, guarding expertise and patents more carefully than they have in the past. Some are forming companies to exploit their research discoveries. Even with a strong scientific base, innovation will require corporate in-house efforts to develop a device and bring it to market. For medical devices, these efforts are complicated by regulatory requirements.

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PRIVATE INVESTMENTIN MEDICAL DEVICE INNOVATION 65 Most notable are the 1976 Medical Devices Amendments to the Food Drug and Cosmetics Act. The possible effects of the 1976 Medical Devices Amendments have been discussed extensively (U.S. Congress, Office of Technology Assessment, 19841. Of course, because the actual regulatory procedures have been in effect for a relatively short time, there is little hard evidence about their effects on innovation. What evidence exists is anecdotal or is based on parallels drawn with the 1962 Drug Amend- ments to the Food, Drug and Cosmetics Act, whose effects also have been extensively, if not conclusively, investigated (Grabowski, 1976, 1983; Grabowski et al., 1978; Peltzman, 1974; Schwartzman, 1950; Wardell and Lasagna, 19751. The principles involved, however, are clear. Certainly, if a device is placed in class III and requires "premarket approval," the costs of innovation are likely to be higher than for devices placed in classes I and II. These are costs of both time and physical resources. The prospects of having to incur these costs will tend to discourage corporate investment in class III device innovation (Harris and As- sociates, 1982; Arthur D. Little, Inc., 1982; U.S. Congress, Office of Technology Assessment, 1984~. Increased uncertainty may be even more critical than actual costs. To the extent that regulation increases uncertainty, it will discourage activity among the many managers who are, by their nature, averse to risk. Of course, as manufacturers gain experience with the regulatory process and confidence in their ability to deal with it, uncertainty is reduced and its discouraging effects lessened. However, this will require consistency and stability in the regulatory process. Constant changes in rules and interpretations can be quite discouraging. Regulatory concerns can also affect the direction of activity. For example, there could be a bias toward categories of devices that do not require an involved approval process. This could result in a preference for developing diagnostic instead of therapeutic devices. Or it could lead to a strategy of small, incremental changes resulting in the production of devices that can be classified as "substantially equivalent" to devices in use before 1976. Smaller and shorter-term projects will also be preferred because of a desire to avoid the uncertainty inherent in long-term projects. Regulatory pressure may indirectly affect innovation by altering the internal structure of the medical devices industry. At present, most firms in the industry are small, but larger firms may be able to cope more effectively with regulation (Harris and Associates, 1982; Arthur D. Little, Inc., 1982; Schifrin with Rich, 19841. Large firms can better

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66 CURRENT TRENDS afford the costs of regulation and seem to learn more quickly how to manage the regulatory process. They are secure enough financially to weather some failures and are better able to appropriate the benefits of success. Even in the absence of regulation, the natural evolution of "high-tech" industries may result in fewer and larger medical device manufacturers. A change in structure of the industry may change the nature of innovation. Many would argue that it is smaller firms that produce most of the significant innovations (Edwards and Gordon, 1984; Gellman Research Associates, 19821. Certainly, smaller firms possess more entrepreneurial spirit. Although there are many articles in the business literature explaining how large firms can maintain entrepre- neurial flair (for example, how they can practice "intrapreneurship" [Pinchot, 19851), the environment for innovation in most large firms will be different than that in small ones. In large firms, the process of innovation will be brought under the control of general management. Technological products will be more closely tuned to perceived market needs and wants. There will be less of a tendency to try to create new markets or complete new products and more of an emphasis on refining and improving current products (Ansoff, 1987; Porter, 19801. Such a pattern is evident, for example, in the now well-established wheelchair market (Shepard and Karon, 1984). Note, however, that this process does not necessarily result in more or less innovation, just a different form of it. MARKET FACTORS Ultimately, the innovator's success will be determined by the market's reaction to the innovation. Will customers buy a new device in the quantities and at a price sufficient to generate a profit? To justify investing in innovation, the answer should be yes. But I suspect that, for many innovators, the answer has been based more on faith than on analysis. The industry has been more technology-driven than market-driven. The attitude often seems to have been that a particular technical idea is so good that there has to be a market out there for it. Certainly, the market for medical devices looks attractive. If one hired some of the major business consulting firms to gauge market attractiveness using portfolio models, the industry would probably score highly (Porter, 19851. Growth prospects look good, demographic trends seem favorable, and demand for the underlying product- health will remain strong. In this context it is easy to understand the

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PRIVATE INVESTMENTIN MEDICAL DEVICE INNOVATION 67 enthusiasm of scientists-entrepreneurs, of venture capitalists, and of large, established firms seeking to diversify from low-growth markets into health care. But this enthusiasm should be tempered with an awareness of several additional factors. First, the attractions of the health care market are widely known. As firms rush to take advantage of obvious opportunities, markets or market segments will become crowded. Large firms seeking to expand into new market segments, entrepreneurs with a good idea, and foreign firms eyeing the vast U.S. health care market will all be there. All this interest may be good for the consumer, but the manufacturer may find a crowded market a difficult one in which to make profits. For example, this seems to be the case in certain areas of biotechnology (Imman, 1987~. Second, developing a new product that embodies some technological advance will not be enough. The firm that develops the product may not be able to capture its full benefits, and imitators may gain some of the profits. Additionally, there may be alternative products with a legitimate claim to performing the same function. Convincing con- sumers of the superiority of a new product may prove difficult and costly. And, in a fast-moving environment, such superiority can dissipate quickly. Marketing skills will be crucial, and small firms may find they lack the expertise to compete on this basis. Liability laws will also affect medical device manufacturers' deci- sions. Many will be reluctant to introduce innovations which present substantive liability risks. Also, the regulatory system will have some effects on market attractiveness. A number of studies have been done on the effects of Certificate of Need and Prospective Payment System regulations on the diffusion of innovations (Cromwell and Kanak, 1982; Hillman and Schwartz, 1985; Russell, 1979; Sloan et al., 1986; Wagner et al., 19824. They suggest that, in some situations, regulation may have discouraged the adoption of high-cost and quality-enhancing innovations. If market potential is limited in this way, expected returns are reduced and private investment in innovation is likely to be discouraged. But some studies have suggested that the Prospective Payment System may stimulate the adoption of cost-saving innovation (Anthony, 1985; Romeo et al., 1984; Sloan and Valvona, 1986~. The effect could be complicated (Garrison and Wilensky, 1986), but there could be redirection of some investments from new technologies that are quality- enhancing to those that are predominantly cost-saving. This seems to have been the case for hollow-fiber dialyzers, for example (Rettig, 19801. Changes in reimbursement can affect the direction of investment in

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68 CURRENT TRENDS other ways, too. For example, some recent reimbursement changes are interpreted as creating pressures on hospitals and physicians to shift the locus of care from hospitals to the home. To the extent that health care treatment modalities and equipment are location-specific, their ability to attract investment will change accordingly. In the case of kidney dialysis, reimbursement changes have supported continuous ambulatory peritoneal dialysis, a home-based procedure, and have led to increased research and development on devices associated with that form of treatment (Romeo, 19841. Again, the specter of uncertainty arises. Firms can adjust to changes in reimbursement procedures, changes in legal interpretations, and changes in the mix of health care needs. They will respond by choosing a portfolio of investments that are tuned to the market environment. But what firms deal with less effectively is uncertainty. Not knowing what will happen or not understanding leads to a reluctance to invest. CONCLUSIONS Given the many factors affecting innovation, can we be assured that there is enough, or the right kind, of innovation in medical devices today? Is increased federal support for medical device research and development necessary or appropriate? Discussion of innovation of medical devices has largely focused on the negative incentives for innovation created by government regula- tion. Certainly, there is reason to believe that some regulatory activities may diminish investment in innovation. From this conclusion, many go on to argue that regulatory disincentives ought to be compensated for: R&D in the industry should be subsidized. There are a variety of ways to generate R&D incentives and a variety of ways to lessen the negative effects of reimbursement policies. But to advocate these, one must be confident of the basic premise that too little is being invested . . now In Innovator. Let us examine that premise. Economists often argue that private firms tend, from a social perspective, to underinvest in R&D (Arrow, 19621. From society's point of view, firms should invest in R&D as long as the social benefitsi.e., the benefits to society at large exceed the costs. However, the private firm will invest in R&D only as long as its private benefits exceed costs. These two criteria diverge when private and social benefits diverge, and there is ample evidence that they do (Mansfield et al., 1977; Robert R. Nathan Associates, 1978; Tewksbury et al., 19801. Innovators rarely appropriate the full benefits of their innovation. Benefits are sometimes passed on to consumers and suppliers and may be secured by imitating

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PRIVATE I~JESTMENT IN MEDICAL DEVICE INNOVATION 69 competitors. Thus, there are circumstances when an investment in R&D would yield an attractive social return but an inadequate private return. In such cases, the private firm does not invest, even though the investment would be valuable to society. This situation seems to merit government intervention to encourage research and development. This reasoning lies behind several govern- ment programs, including the recent federal tax credit for incremental research and development (Eisner et al., 19841. But this argument relies on defining benefits to consumers and to society on the basis of their willingness to pay for a good or service (Eisner et al., 1984; Mansfield, 1986), which is determined by reference to market prices. When market prices reflect value to consumers, this argument makes good sense. In the health care field, however, it is unclear that prices are a reasonable reflection of consumer value. Market valuations and the corresponding signals for investment in R&~are greatly affected by insurance provisions, consumer igno- rance, physician preferences, and other factors. Relying on consumers' willingness to pay may be misleading. Indeed, one could argue that the alleged overspending on medical care that has prompted many of the recent changes in reimbursement policies may have created an excessively strong signal to invest in R&D. New incentives may be simply countering previous inappropriate signals. Overall, the basis for arguing for industry-wide federal subsidies in support of medical device research and development is rather weak. With R&D spending in the industry at twice the national average and with the industry continuing to show vigorous growth, justification of federal subsidies would require more proof than the argument that regulation creates disincentives (Geiger, 1986; Mannen and Campbell, 1985; Pollard et al., 19861. We need careful study and clear evidence on innovation activities in the medical device industry. But what about the direction of medical device research and development? Even if the overall magnitude is high, will socially appropriate sorts of innovation be done? Clearly, private investment will tend to be directed toward making profits, and private firms will respond to market signals. Where these are weak, little investment will flow. There are, therefore, likely to be "orphan" devices and, more generally, imbalances in innovation. To some extent, government also sends signals to manufacturers. For example, the decision to fund the end-stage renal disease program stimulated considerable research in dialysis equipment (Romeo, 19841. But, as suggested earlier, there is no assurance that market or government signals in health care accurately reflect social values or that they will stimulate a balanced mix of investments. Presuming that

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70 CURRENT TRENDS a definition of social appropriateness can be agreed upon, government intervention may be required to achieve the desired balance. However, we need much more study before we can determine the precise ways in which such a balance can best be accomplished. REFERENCES Ansoff, H. I. 1987. Strategic management of technology. Journal of Business Strategy 7(3):28-39. Anthony, F. H. 1985. New product opportunities with DRGS. Hospital Pharmacy 20(10): 1~11. Arrow, K. 1962. Economic welfare and the allocation of resources for inventions. Pp. 609~24 in The Rate and Direction of Inventive Activity. National Bureau of Economic Research. Princeton, N.J.: Princeton University Press. Coopers and Lybrand. 1986. Evaluating R and D and New Product Development Ventures: An Overview of Assessment Methods. Report to the U.S. Department of Commerce, Office of Productivity, Technology and Innovation, Washington, D.C. Cromwell, J., and J. Kanak. 1982. The effects of prospective reimbursement programme on hospital adoption and service sharing. Health Care Financing Review 4(2):67. Edwards, K. L., and T. J. Gordon. 1984. Characterization of innovations introduced on the U.S. market in 1982. Report to the Office of Advocacy, U.S. Small Business Administration, Washington, D.C. Eisner, R., S. Albert, and M. Sullivan. 1984. The new incremental tax credit for R&D. National Tax Journal 37(June):1971-1983. Garrison, L. P., and G. R. Wilensky. 1986. Cost containment and incentives for technology. Health Affairs 5(2):4~58. Geiser, N. S. 1986. The evolving medical device industry: 1976 to 1984. Medical Device and Diagnostic Industry (November):51-54. Gellman Research Associates. 1982. The Relationship Between Industrial Concentration, Firm Size and Technological Innovation. Report prepared for the U.S. Small Business Administration. Washington, D.C.: Gellman Research Associates. Grabowski, H. G. 1976. Drug Regulation and Innovation. Washington, D.C.: American Enterprise Institute. Grabowski, H. G. 1983. Studies on Drug Substitution, Patent Policy and Innovation in the Pharmaceutical Industry. Report prepared for the National Science Foundation. Grabowski, H. G., J. M. Vernon, and L. C. Thomas. 1978. Estimating the effects of regulation on innovation: An international comparative analysis of the pharmaceutical industry. Journal of Law and Economics 21:133-163. Harris and Associates. 1982. A Survey of Medical Device Manufacturers. Report to the Food and Drug Administration, Bureau of Medical Devices. Washington, D.C.: Harris and Associates. Hillman, A. L., and J. S. Schwartz. 1985. The adoption and diffusion of CT and MRI in the United States: A comparative analysis. Medical Care 23(November):1283- 1294. Imman, B. 1987. Biotech's acquired income deficiency syndrome. Business (Febru- ary):8~83. Kay, N. M. 1979. Corporate decision-making for allocations to research and development. Research Policy 8:46 69. Levy, D. M., and N. E. Terleckyj. 1985. Trends in Industrial R&D Activities in the

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PRIVATE INVESTMENTIN MEDICAL DEVICE INNOVATION 71 United States, Europe and Japan, 1963-1983. Report to the National Science Foundation, Washington, D.C. Arthur D. Little, Inc. 1982. Cost of Compliance with Good Manufacturing Practices Regulations by the Medical Devices Industry. Final report for the Food and Drug Administration, Department of Health and Human Services. Washington, D.C.: Arthur D. Little, Inc. Mannen, T., and P. Campbell. 1985. Interim funding suggested for specific kinds of new technologies prior to DRG adjustments. Interview. Review. Federation of American Hospitals 18(4):41 47. Mansfield, E. 1986. The R&D tax credit and other technology policy issues. American Economic Review 76(2):190-194. Mansfield, E., J. Rapoport, A. Romeo, S. Wagner, and G. Beardsley. 1977. Social and private rates of return from industrial innovations. Quarterly Journal of Economics 91 :221-240. Robert R. Nathan Associates. 1978. Net Rates of Return on Innovations, vole. 1 and 2. Report to the National Science Foundation, Washington, D.C.: Robert R. Nathan Associates. Nelson, R. R. 1976. Institutions supporting technical advance in industry. American Economic Review 76(2):186-189. Peltzman, S. 1974. Regulation of Pharmaceutical Innovation: The 1962 Amendments. Washington, D.C.: American Enterprise Institute. Pinchot, G. 1985. Intrapreneuring: Why You Don't Have to Leave the Corporation to Become an Entrepreneur. New York: Harper & Row. Pollard, M. R., G. S. Persinger, and J. G. Perpich. 1986. Data watch: Technology innovation in health care. Health Affairs 5(2):135-147. Porter, M. E. 1980. Competitive Strategy. New York: The Free Press. Porter, M. E. 1985. Competitive Advantage. New York: The Free Press. Rettig, R. A. 1980. The politics of health cost containment: End stage renal disease. Bulletin of the New York Academy of Medicine 56:115-138. Romeo, A., J. Wagner, and R. Lee. 1984. Prospective reimbursement and the diffusion of new technologies in hospitals. Journal of Health Economics 3(1): 1-24. Romeo, A. A. 1984. The Hemodialysis Equipment and Disposables Industry (Health Technology Case Study 32). OTA-HCS-32. Washington, D.C.: U.S. Congress, Office of Technology Assessment. Russell, L. 1979. Technology in Hospitals: Medical Advances and Their Diffusion. Washington, D.C.: Boorhinge Institute. Schifrin, L. G., with W. J. Rich. 1984. The Contact Lens Industry: Structure, Competition, and Public Policy (Health Technology Case Study 31). OTA-HCS-31. Washington, D.C.: U.S. Congress, Office of Technology Assessment. Schwartzman, D. 1950. Innovation in the Pharmaceutical Industry. Baltimore: John Hopkins University Press. Shepard, D. S., and S. L. Karon. 1984. The Market for Wheelchairs: Innovations and Federal Policy (Health Technology Case Study 30). OTA-HCS-30. Washington, D.C.: U.S. Congress, Office of Technology Assessment. (This case study was performed as part of OTA's assessment of Federal Policies and the Medical Devices Industry.) Sloan, F. A., and J. Valvona. 1986. Prospective payment for hospital capital by Medicare: Issues and options. Health Care Management Review 11(2):25-33. Sloan, F. A., J. M. J. Perrin, and K. W. Adamache. 1986. Diffusion of surgical technology. Journal of Health Economics 5:31-61. Tewksbury, J. G., M. S. Crandall, and W. E. Crane. 1980. Measuring the societal benefits of innovation. Science 209(August):658-662.

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72 CURRENT TRENDS U.S. Congress, Of lice of Technology Assessment. 1984. Federal Policies and the Medical Devices Industry. OTA-H-230. Washington, D.C.: U.S. Congress, Office of Tech- nology Assessment. Wagner, J. L. 1982. A Study of the Impact of Reimbursement Strategies on the Diffusion of Medical Technologies, vole. I and II. Report prepared for the Health Care Financing Administration, Washington, D.C. Wardell, W., and L. Lasagna. 1975. Regulation and Drug Development. Washington, D.C.: American Enterprise Institute.