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1 Overview of U.S. Pharmaceutical Industry The importance of research and innovation for competition among major pharmaceutical firms places the ethical drug industry in a select grouping of high-technology industries. The most distinc- tive feature of pharmaceutical innovation lies in the spending strategies of the major firms high rates of investment in RED expenditures (as percentages of sales and profits), relatively high rates of spending for basic research, and little government financing of industrial RED. These trends are illustrated in Table 1-1 and indicate that, while one or more of these features are present in other industries, rarely are all three. The pharmaceuti- cal industry, along with the computer, photographic, an d specialized machinery industries, all spend more than 50 percent of their recorded profits on research and development. On the basis of this innovation, American firms were prey dominant in world markets during the period 1950 to 1960, accounting for a large majority of research expenditures and new products, over half of world pharmaceutical production, and one third of international trade in medicinals. American preeminence persisted, though in attenuated degree, through the 1960s. In the past decade, however, the competitive advantage of American firms has been not only reduced, but apparently eliminated. This study seeks to define and document these changes of competitive position within the multinational pharmaceutical industry, to determine why these changes have occurred, and to suggest an array of policy options to address the relative decline. This first chapter provides a primer on competition within the ethical drug industry. EMERGENCE OF THE MODERN PHARMACEUTICAL INDUSTRY The drug industry before 1930 was profoundly different from that of today. Innovation was infrequent and externally derived, and

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8 TABLE 1-1 Research Attnbutes of Vanous U.S. Based Industnes, 1977 Government Basic Research R&D as Funding as es percentage of Percentage Percentage of Industry Total R&D of Sales R&D Funds Drugs and medicines 11.4 6.2 1.0 Industrial chemicals 9.7 3.6 19.0 Food and kindred products 5.2 0.4 na Stone, clay, and glass products 14.0 1.2 na "Other" chemicals 9.6 2.1 na Petroleum refining and extraction 5.3 0.7 8.1 Communications equipment 5.2 7.6 43.1 SOURCE: Research and Development in Industry, 1977. Washington, DC, National Science Foundation, 1979. f irms manufactured a limited number of unpatented products which were largely marketed without prescription directly to consumers. The mix of products available to consumers has been described by a pharmaceutical executive, Henry Gadsden of Merck, when he described the nature of the market in the 1930s: You could count the basic medicines on the fingers of y our two hands. Morphine, quinine, digitalis, insulin, codeine, aspirin, arsenicals, nitroglycerin, mercurials, and a few biologicals. Our own Sharp and Dohme catalog did not carry a single exclusive prescription medicine. We had a broad range of fluids, ointments, and extracts, as did other firms, but we placed heavy emphasis on biological medicines as well. Most of our products were sold without a prescription. And 43 percent of the prescription m edicines were compounded by the pharmacist, as compared with 1.2 percent today.1 None of these products mentioned by Gadsden had resulted from research efforts of the pharmaceutical industry. Only a handful of drug discoveries from any source had been made by 1930 (principally salversan in 1908 for treatment of syphillis and insulin in 1922 for treatment of diabetes) and these discoveries were infrequent, unrelated, and unanticipated, and resulted from prolonged and tedious research. Nothing about these discoveries suggested a method of research or a mechanism of disease prevention that could be economically exploited for development of new pharmacological agents. This non-innovative technological environment changed rapidly just before and during World War II, in a "therapeutic revolution" that transformed the industry. First, during the period 1930 to 1950, a series of natural products, particularly the vitamins and

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9 hormones, were discovered, developed, and commercialized.2 These discoveries led to the conquest of scurvy, pernicious anemia, beri-beri, and pellagra as well as significant endocrine therapies. Second, the foundation was laid for modern research in anti-infectives. The discovery of the therapeutic properties 0 f sulfanilamide by I. G. Farbenindustrie in 1935 and of penicillin by Oxford scientists in 1940 indicated the possibilities for systematic research in finding new sulfa drugs and new antibiotics. Neither sulfanilamide nor penicillin were patentable at the time, having been known discoveries with belated demonstration of therapeutic properties. Nonetheless, the tremendous demand for anti- infective agents by allied military forces during wartime made the manufacture of these scarce substances a national priority. The U.S. government spent almost t3 million to subsidize wartime penicillin research and encouraged private construction of peni- cillin manufacturing plants by allowing accelerated depreciation. The returns from sales of these and other drugs were subject to wartime "excess profits" taxes, but at the conclusion of World War II, federal penicillin plants were sold to private firms at half cost. The simultaneous demonstration of new technological opportunities and of potential profits combined to dramatically change the pharmaceutical industry. The final step necessary for the emergence of the industry in its modern form was a legal m echanism to allow commercial exploitation of the new tech- nological opportunities for biological products. This step occurred with the 1948 decision of the U.S. Patent Office to grant a patent for streptomyicin. A patent, of course, is a legal monopoly for 17 years over commercial exploitation of a new discovery. During the period before expiration of the patent, the innovative firm m ay charge prices above manufacturing costs and thus recoup earlier research expenditures that led to the innovation. Rapidly, a new form of competition emerged in the pharmaceutical industry- - ompetition through product development. At the outset of the 1 950s, pharmaceutical competition remained largely national in scope, with the significant exception of the Swiss multinationals. Economic linkages among the various national pharmaceutical industries were largely confined to inter- national trade, and even then were relatively unimportant. Imports amounted to less than 10 percent of domestic consump- tion in the major industrial nations, again with the exception of Switzerland. Firms engaged in new product development faced essentially three methods for foreign distribution of their innovations: · Export§ - omestic production by the innovating firm for sale abroad through local distributors.

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10 TABLE 1-2 Domestic and Foreign Sales of U.S. Owned Pharmaceutical Firms, Various Years (percentages) Year Domestic Foreign 1956 88 12 1961 73 27 1966 71 29 197 1 66 34 1976 60 40 1978 s7 43 NOTE: Table statistics are based on sales of human dosage. They exclude sales of bulk drugs and veterinary drugs. SOURCE: Annual Survey Reports (Washington, DC: Pharmaceu- dcal Manufacturers' Association, various years). · Licensing-~roduction abroad by a foreign firm with profits shared between the innovating firm and the producer. · Multinational expansion--production abroad by a subsidiary of the innovating firm. Starting in the 1950s, American firms began and Swiss firms continued substantial multinational expansion of operations (to r data on U.S. firms, see Table 1-2~. The presence of tariff and regulatory barriers imposed by foreign governments, grease r physician and consumer acceptance of local production sources, and a general tendency toward vertical integration by pharma- coutical firms made reliance on exports a less viable and profitable strategy. In general, the choice between licensing and multinational investment depended on the breadth of a firm's product line. American and Swiss firms that enjoyed a surge in the number of new patented drugs during the 1 950s and 1 960s were able to spread the substantial overhead costs of direct foreign investment over the several drugs distributed abroad by their firms, making direct investment relatively less burdensome. NomSwiss, European, and Japanese firms with narrower product lines that might have attempted direct investment abroad would have been forced to cover these overheads entirely from sales of just a few drugs- potentially unprofitable endeavor. An additional factor that limited non-Swiss, European, and Japanese direct investment arose from the economic devastation of World War II and the financial burdens of reconstruction. The resulting pattern of multinational expansions can be seen in Table 1-3. After 1960 the costs of developing commercially viable new drugs dramatically increased. One consequence of this important trend has been that larger earnings, available only from a larger market, were essential to cover the greater costs of RED for each

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12 compound. This industrial need to cover rising research costs, along with the almost universal cross-cultural use of pharma- ceuticals, and the dramatic expansion of third-party payments for health-care costs combined to insure the emergence of a world market in ethical drugs. While this world market is severely frag- mented due to non-tariff barriers to trade and due to differing national regulations, it is nonetheless increasingly inescapable that the competitive vitality of the major pharmaceutical firm s depends on distribution of new products on a worldwide scale. NATURE OF PHARMACEUTICAL COMPETITION Prior to the therapeutic revolution of the 1 940s, the pharma- ceutical industry exhibited three distinct divisions, each with its own form of competition. The first subindustry, Proprietary drugs, or over-the-counter (OTC ~ medicines as they are also called, encompasses products sold directly to consumers without prescription in the context of extensive advertising. Competition in this segment of the pharmaceutical industry depends largely on marketing of established brands with occasional new product development. New proprietary drugs rarely represent break- throughs in treatment and often are simple reformulations o f existing therapies that facilitate consumer convenience or are products switched from prescription to OTC status as a result of the U.S. FDA OTC drug review. Proprietary drugs are thu s characterized by high advertising intensity but a very low research intensity. Sales of proprietary drugs have grown at a markedly slower rate than other pharmaceutical sales and currently comprise less than 15 percent of total industry sales, as can be s een in Table 1-4. 4 About 550 firms in the U.S. produce and distribute exclusively OTC medicines.5 The second division of the industry, generic products or multi- source drugs, exhibits the classical form of market competition. Generic drug products are off-patent, welLestablished compounds that are produced as standardized commodities by more than one f irm. Generic products are generally unadvertised and usually subject to price competition among the various producers with the result of low profit margins for generic producers. Multisource drugs accounted for about 45 percent of ethical drug sales within the United States in 1979, though only 7 percent of these sales (or 3 percent of all drug sales) were achieved by the smaller, non- research-i ntensive firms. About 600 additional firms produce generic drugs in the United States. Almost all of these firms have exclusively domestic distribution, and many sell only to regional markets. Most generic drug houses have annual sales of less than Al 0 million .~

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13 TABLE 1-4 Market Divisions of the Domestic U.S. Pharma- ceutical Industry, Various Years (millions of dollars) Prescription Drugs Prescription All as a Percentage of Year Drugs Medicines all Medicines 1929 190 600 32 1949 940 1,640 57 1969 5,395 6,480 83 SOURCE: Peter Semen, Taking Your Medicine: Drug Regulation in the United States. Harvard University Press, Cambridge, 1980. This study focuses on the remaining segment of the pharma- ceutical industry, patented drugs? distributed by prescription. Patented drugs represent the driving force of the modern pharma- ceutical industry and are responsible for the spectacular growth in sales since 1940. About 150 firms conduct research for and produce patented drugs in the United States. Only 20 of these f irms have significant U.S.-based multinational operations, and about an equal number (20) are U.S.-located operations of f oreign-owned multinational firms. The remaining firms have largely domestic sales, and some have very small research facilities. Industrial competition in this segment of the industry is quite distinctive and occurs through corporate development of new patented therapies. Under patent protection, firms that introduce new products are able in principle to earn large returns on their innovations. There are, however, two constraints on the abilities of firms to generate earnings through innovation. The first is that it is general! y technically possible for another firm to produce compounds of similar therapeutic action, though with different and hence also patentable molecular structure. The second constraint is, of course, that pharmaceutical innovation is a highly uncertain process that does not predictably yield therapeutically, let alone commercially, important products. Numerous firms have expended substantial funds for pharmaceutical RED without development of a commercially successful product. Table 1-5 provides a tabu- lation of U.S. sales in 1972 of all new medicinal chemical compounds introduced into the U.S. market in the mid-] 960s. While a very few products enjoyed substantial commercial success, the vast majority of products were relative commercial failures and did not contribute significantly to defraying RED costs. Given that the majority of contemporary pharmaceutical sales are comprised of generic products and patented drugs (both sold through prescription) and that profit margins in the generic products division of the industry are relatively low, it is clear that many industry profits are drawn from sales of patented drugs.

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14 TABLE 1-5 New Chemical Entities (NCEs) Introduced in U.S. 1962-1968 by 1972 U.S. Domestic Sales Sales $000 O- 999 1,000- 1,999 2,000- 3,999 4,00~ 5,999 6,000- 7,999 8,000- 9,999 10,000-14,999 15,000-1 9,000 20,000-29,999 30,000-39,999 40,000 49,999 50,00~59,999 60,000-99,999 100,000+ Number of Drugs 33 14 9 s 3 1 4 2 2 2 2 o 1 1 Total 70 SOURCE: David Schwartzman, Innovation in the Pharmaceutzeal Industry, Johns Hopkins University Press, Baltimore, 1976. Finally, given that most pharmaceutical innovations are com- mercially not very successful, it is clear that modern pharmaceu- tical firms depend crucially for positive cash flow on a small handful of successful innovations, as is demonstrated for the United States in Table 1-6. Failure to produce new products continuously to replace those that lose market share to imitation or on which patents expire would ultimately be devastating to the financial health of a pharmaceutical company. In short, competi- tive advantage in sales of patented drugs, by far the most financially lucrative segment of the modern pharmaceutical industry, depends crucially on the ability of the firm to produce a slow but steady stream of commercially successful new products through industrial innovation. BENEFITS AND RISKS 0= TECHNICAL CHANGE Th e rapid introduction of novel and complex products in any industry presents both social benefits and social costs. Because ethical drugs directly affect the health and lives of millions of consumers, the nonmarket implications of pharmaceutical innovation are especially pronounced. As regards benefits, modern pharmaceutical products hav e substantially contributed to modern treatment of ill health. In this context, Victor Fuchs has observed:

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15 TABLE 1-6 Proportion of Total Domestic U.S. Pharmaceu- tical Sales Pronded by Three Best Selling Products, Selected Pharmaceutical Corporations, Selected Years (percentages) 1970 1975 1979 Abbott 36 33 28 American Home Products Ayerst 64 74 84 Wyeth 37 44 43 Bristol-Meyers Bristol 69 46 28 Mead-Johnson 40 38 37 Burroughs Welleome na 56 51 Ciba 47 na 55 Lederle 48 31 32 Lilly 46 60 43 Merck 35 44 44 Pfizer 52 65 65 Robins 43 45 46 Roehe 80 80 70 Sehering 42 48 40 Searle 45 49 44 Smith Kline 44 42 66 Squibb 28 31 23 Upjohn 47 50 56 Warner-Lambert Warner 53 na na Parke-Davis 25 27 22 SOURCE: Merck & Co., Ine., MSD Strategic Planning and MSD Marketing and Sales Research, West Point, PA. Original data from Intereondnental Medical Statistics (IMS), Ine., Ambler, PA. Drugs are the key to modern medicine. Surgery, radiotherapy, and diagnostic tests are all important, but the ability of health care providers to alter health outcome - -Dr. Walsh McDermott's "decisive technology"- - epends primarily on drugs. Six dollars are spent on hospitals and physicians for every dollar spent on drugs, but without drugs the effective- ness of hospitals and physicians would be enormously diminished. Until this century the physician could with confidence give a smallpox vaccination, administer quinine for malaria, prescribe opium and morphine for the relief of pain and not much more. A quarter-century later the situation was not much different. Some advances had been made in surgery-, but the death rates f ram tuberculosis, influenza and pneumonia, and othe r infectious diseases were still extremely high. With the introduction and wide use of sulfonamide and penicillin, however, the death rate in the United States from influenza

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16 and pneumonia fell by more than 8 percent annually from 1935 to 1950. (The annual rate of decline from 1900 to 1935 had been only 2 percent.) In the case of tuberculosis, while some progress had been made since the turn of the century, the rate of decline in the death rate accelerated appreciably after the adoption of penicillin, streptomycin, and PAS (pareamino- salicylic acid) in the late 1940s and of isoniazid in the early 1950s. New drugs and vaccines developed since the 1920s have also been strikingly effective against typhoid, whooping cough, poliomyelitis, measles, diphtheria, and tetanus; more recently great advances have been made in hormonal drugs, antihyper- tension drugs, antihistamines, anticoagulants, antipsychotic drugs, and antidepressants.7 Tables 1-7 and 1-8 illustrate the continuing influence of pharmaceutical products in lessened incidences of disease and death in the United States.8 These statistics provide documen- tation for the impact of ethical drugs on public health, but only few data are available to quantify the additional importance of pharmaceuticals for private health. These private health benefits are often of considerable importance: the effects of anti- inflammatory agents on the functional capacity of arthritis patients, the implications of antianxiety and antidepressive drugs for patient quality of life, the cost savings of cimetidine in treatment of peptic ulcers. Nonetheless, the ordinary measures of public health produced by government agencies fail to capture these benefits. Offsetting these social benefits, there are clear social costs to pharmaceutical innovation. The complexity and diversity of patient reactions to ethical drugs restricts the abilities of con- sumers, their physicians, and often even pharmaceutical firms themselves to detect potential low incidence or long-term adverse side effects in the very potent drugs introduced since the thera- peutic revolution of the 1940s. It is by now well-established that laissez-faire policies under these market circumstances will result in distribution of pharmaceuticals whose risk is not fully appre- ciated, with occasional disastrous results. As a result of such social cost, national government regulation of product safety and distribution for pharmaceuticals has emerged in all the developed nations. Unfortunately, safety regulation of the pharmaceutical industry presents its own social benefits and costs as well. In addition to reducing the frequency of adverse reactions and inappropriate therapies, contemporary regulations reduce the availability of and increase the delay and cost for new pharma- ceutical substances. Appropriate regulatory policy must strive to balance these social benefits and costs in order to insure the — v ~ . . .

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17 TABLE 1-7 Reported Cases of Selected Diseases, 1951-1976 Decline 195 1-1976 Diseases 1951 1960 1965 1976 (percent) Measles (rubeola) 530,118 441,703 261,904 41,126 92 Meningococcal infections 4,164 2,259 3,04.0 1,60S 61 Mumps naa na 152,109C 38,492 75 (from 1968) Whooping Cough 68,687 14,809 6,799 1,010 99 Poliomyelitis 28,386 3,190 70 14 99 Rubella (German Measles) na na 45,975d 12,491 73 (from 1966) Tuberculosis 85,607b 55,494 48,016 32,105 62 Typhoid Fever 2,128 816 454 419 80 ana = not available. bl952 figure (1951 not available). C1968 (not previously reportable). d1966 figure. SOURCE: U.S. Department of HEW, Public Health Service, Reported Morbidity and Mortality in the United States, 1976, Morbidity and Mortality Weekly Report, Vol. 25, No. 53 (Atlanta: Center for Disease Control, August 1977), p. 2; and U.S. Department of HEW, Public Health Ser- v~ce, Annual Reported Incidence of Notifiable Diseases In the United States, 1960, Morbidity and Mortality Weekly Report, Vol. 9, No. 53 (Atlanta: Communicable Disease Control, October 30, 1961), p. 4. optimal use of medicinal products. In determination of this balance, polls repeatedly suggest that the American people are unwilling to make sacrifices in the safety and quality of ethical drugs simply to promote jobs and economic growth, and this panel explicitly endorsed this view. On the other hand, numerous reforms of U.S. FDA regulation have been proposed on purely medical grounds, to improve therapy for American patients, and the panel endorses many of these reforms. It is most important for the reader to recognize that any advancement of the eco- nomic position of U.S. pharmaceutical firms caused by these reforms is an explicitly and appropriately secondary reason for their adoption. One important point, however, should be made: any balanced and appropriate policies toward the pharmaceutical industry should seek to sustain a large and rapid flow of truly safe and significant new drugs from American firms. It is precisely such balanced and appropriate policies that in the long run will most effectively advance both the public health and the competitive position of the U.S. pharmaceutical industry. OVERVIEW AND LIMITATIONS OF THIS STUDY The preceding has been an introduction to the U.S. and foreign pharmaceutical industries. Chapter 2 is an assessment of the

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18 TABLE 1-8 Death Rate per 100,000 Population, 1920-1978 Decline 1920-1978 Cause of Death 1920 1940 1960 1978 (percent) . . . Tuberculosis, all forms 113.1 45.9 5.9 1.3 99 Dysentery 4.0 1.9 0.2 0 0a 100 Whooping Cough 12.5 2.2 0.1 0.0 100 Diphtheria 15.3 1.1 o.ob _ 100 Measles 8.8 0.5 0.2 0.0 100 Influenza and Pneumonia 207.3 70.3 36.6 26.7 87 aBacillary dysentery and amebiasis. bl959 (figures for 1960 and 1978 not available). SOURCE: Ernst B. Chain, Academic and Industrial Contributions to Drug Research Nature (November 2, 1963) p. 441; and U.S. Department of HEW, Public Health Service, Health Resources Administration Final Mortality Statistics, 1978, Monthly Vital Statistics Report, Vol. 29, no. 6 (National Center for Health Statistics, Sept. 17, 1980). competitive position of the U.S. pharmaceutical industry as it has developed since 196 0. Chapter 3 evaluates the reasons for the current U.S. competitive position, Chapter 4 provides a brief discussion of new developments in the industry, and Chapter 5 offers options for public policy to strengthen the U.S. position internationally. The focus of the report throughout is on the competitive position of U.S. pharmaceutical firms in the developed nations. This topic will be addressed directly, without extended discussion of the many peripheral issues that relate to health and medical care. Because many of these peripheral issues, however, are of considerable policy importance in their own right, it is useful to delineate some of them before consideration of the topic at hand. Drug consumption in LDCs. The health concerns of less developed countries (LDCs) are different in many ways from those of Europe, North America, and Japan. Distinctive patterns of disease, wide- spread poverty, and illiteracy that reduce the efficacy of pharma- ceutical treatments, and limited technical capacities of local regulatory officials all provide a unique set of concerns for the LDCs. These concerns have recently generated attempts by international institutions, notably the World Health Organization (WHO), to address the pharmaceutical-related medical problems of the LDCs through international regulation. While the LDC concerns and the WHO responses are of significance from the standpoints of world public health and international politics, the fact remains that LDC markets account for only a small minority of world ethical drug sales and virtually none of new drug intro-

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19 d actions. Th us developments in these m arkets will have only limited impact on the relative competitive position of multi- national drug firms. Further, an extreme paucity of data restricts any analysis of competition in the LDCs. For these reasons, this report examines exclusively the pharmaceutical markets and policies of the developed nations. Genetic engineering. The biological production of chemical substances through genetically designed organisms offers exciting and eventually significant consequences for the pharmaceutical industry.] 0 The short-term impact of this new technology, however, will be limited to particular market segments (vaccines and insulin) and major competitive effects will be delayed for as much as a decade or more. Such long-term technological developments were therefore beyond the scope of this study. American health policy. Financial arrangements for the rapidly gr owing expenditures on health care for American citizens remains an area of controversy. Not only government policies toward Medicaid, Medicare, and hospital regulations, but also the policies of private insurers have been criticized for encouraging excessive consumption of health services. Suggested reforms in this area will indeed affect both U.S. and foreign firms, bu t consideration of U.S. health policy issues is beyond the scope of this study. NOTES 1. Cited in Peter Temin, Taking Your Medicine, Dru ~ R egulation in the United States, Harvard University Press, Cambridge, MA, 1980, p. 59. 2. Products of this era include thiamine, riboflavin, ascorbic acid, vitamin B6 and vitamin B12, along with thryoxine, testosterone, estrone, and progesterone. The discovery 0 f cortisone also occurred in this period. 3. There are exceptions to the generally non~nnovative character of OTC drugs. Fluoride toothpaste is one. 4. In recent years the growth of prescription drug sales has markedly slowed, largely due to the decreased frequency of new drug introductions. As a consequence, proprietary drug sales may now grow more rapidly than prescription drug sales. 5. For additional discussion of the competitive structure of the U.S. pharmaceutical industry, see Office of Technology Assessment, Patent Term Extension and the Pharmaceutical Industry, U.S. Government Printing Office, Washington, D.C., 1981, pp. 16-19.

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20 6. Charles River Associates, "The Effects of Patent Term Restoration on the Pharmaceutical Industry," Boston, MA, May 4, 1981, Deport of OTA) pp. 17 and 74. 7. Victor Fuchs, Who Shall Live?, Basic Books, New York, 1974. 8. New drugs are not the sole cause of recorded declines in mortality and morbidity. Improvements in sanitation, education, and income have also contributed substantially. 9. For a brief discussion of the nature and significance of private health benefits, see William Hubbard, "Defining the Role of Medicinals in Health," presentation to the Tenth IFPM A Assembly, October 1980. 10. For a discussion of the long-run effects of genetic engineering on the pharmaceutical industry, see Office of Technology Assessment, Impacts of Applied Genetics, U.S. Government Printing Office, Washington, D.C., 1981.