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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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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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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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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 benefits—i.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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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.
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Representative terms from entire chapter:
medical devices
