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Pharmaceuticals and Biotechnology1 IAIN COCKBURN University of British Columbia and National Bureau of Economic Research REBECCA HENDERSON Massachusetts Institute of Technology and National Bureau of Economic Research LUIGI ORSENIGO Universita Commerciale Luigi Bocconi GARY P. PISANO Harvard Business School The pharmaceutical industry has been by almost any measure outstandingly successful. It is one of the few high-technology industries that American firms have dominated almost since its inception, and it is one of the few in which American firms continue to have an indisputable lead. During the 1980s and 1990s, double-digit rates of growth in earnings and return on equity were the norm for most pharmaceutical companies, and the industry as a whole ranked among the most profitable in the United States.2 To what degree can this success be viewed as a triumph of U.S. public policy? This question cannot be answered definitively because the roots of the industry's success are complex, and causality cannot be attributed to any single factor with precision. A plausible case can be made, however, that in the case of the pharma- ceutical industry public policy has played a particularly important role in contrib- uting to the global success of American firms. Public policy has always played an enormously important role in shaping the pharmaceutical industry in the United States. On the supply side, public funding for health-related research supplies both new knowledge and highly trained em- ployees to pharmaceutical firms. New drugs can be sold only with the explicit ~ This paper draws on an ongoing program of work exploring the determinants of research produc- tivity in the pharmaceutical industry, funded by the Program on the Pharmaceutical Industry and the Center for Innovation in New Product Development under NSF Cooperative Agreement Number EEC-9529140. Their support is gratefully acknowledged. 2 Note that these figures are based on accounting rates of return. Figures that are recalculated to account for heavy spending by the industry on advertising and research suggest that rates of return were actually somewhat lower than the accounting figures would suggest. 363

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364 U.S. INDUSTRYIN2000 approval of the federal government, an approval that is typically granted only after potential candidates have passed a series of rigorous clinical tests. On the demand side, the federal government has an enormous impact on the market for new drugs, both by virtue of its role as a major consumer of drugs through its funding of Medicare and Medicaid and through its regulation of how pharmaceu- tical firms may advertise and market their products. Public policy toward the protection of intellectual property also has a very significant effect because the pharmaceutical industry is one of the few in which intellectual property protec- tion plays a central role in product market competition. Public policy also plays a more indirect but nevertheless important role in shaping the industry through its effects on both the labor markets and the markets for new capital, particularly the market for venture capital. Taken together these policy instruments have been instrumental in building an exceptionally strong industry. Before World War II public policy played little role in shaping the industry's evolution. In the postwar period, however, the federal government's heavy investment in basic research, its support of a strong intellectual property regime, and its imposition in 1962 of tight product approval criteria combined to help create an industry whose leading firms were not only increasingly able to translate scientific advances into effective therapies but also well positioned to exploit the new opportunities opened up by the revolution in molecular biology. The molecular biology revolution made the role of public policy in shaping the industry even more important. The revolution was initially based in the uni- versities, and the size and strength of the American commitment to health-related research ensured that U.S. universities were at the frontier of the new science. But public policy also proved very important in shaping the ways in which the new science affected the pharmaceutical industry. The industry used molecular biol- ogy in two forms as a new process technology in making large molecular weight drugs and as a new research tool in searching for more conventional, small mo- lecular weight drugs. The vast majority of drugs prescribed today are "small" molecular weight drugs relatively small, simple molecules that can be synthe- sized in a test tube and that often can be taken orally. "Large" molecular weight drugs, are much, much larger. They usually cannot be directly synthesized but must be "grown" or "expressed" and cannot usually be taken orally. The first trajectory was, at least initially, unambiguously competence de- stroying and was most effectively exploited by new entrants. In the United States an institutional environment that not only supported universities in making the fundamental breakthroughs necessary to exploit the new science but also sup- ported their translation into small, flexible, aggressively funded new firms led to the birth of an entire industry segment, the biotechnology firms. At the same time the second trajectory the adoption of the tools of biotech- nology as search tools proved to be competence destroying for those pharma- ceutical firms that had not fully made the transition to "science-based" or "ratio

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PHARMACEUTICALS AND BIOTECHNOLOGY 365 nal" drug discovery. It thus reinforced the dominance of the large scientifically based firms, a large majority of which were located in the United States and which owed much of their success to the U.S. public policy regimes of the 1970s and 1980s. The remainder of this chapter expands on this argument. We begin by dis- cussing the evolution of drug discovery research technology and the role of pub- lic policy in shaping U.S. success prior to the molecular biology revolution. We suggest that a number of public policies played instrumental roles in building an American industry that was among the strongest in the world. The third section lays the foundation for a discussion of the impact of public policy on the industry in the wake of the revolution in molecular biology. We suggest that molecular biology as a process technology "biotechnology" was competence destroying for the vast majority of established firms, while molecular biology used as a research tool was competence enhancing for those firms that had already made a transition to science driven, or more "rational" drug discovery. Further, we describe the ways in which the revolution shaped the evolution of the industry across the world, focusing particularly on the ways in which response in the U.S. was very different, and in many ways much more effective, than responses in Europe and Japan. Finally, we discuss the role of public policy in shaping this differential response. We suggest (as have many before us) that public policy was instrumental in laying the foundations for the explosion of vibrant "new biotechnology firms" that characterized the American response to "biotechnol- ogy." We also suggest that the ability of many of the established American firms to respond effectively to the challenges of the new science was predicated on skills that they had developed during the previous era, skills developed partly in response to an environment largely shaped by American public policy. THE PHARMACEUTICAL INDUSTRY BEFORE THE MOLECULAR BIOLOGY REVOLUTION The history of the pharmaceutical industry can be usefully divided into three major epochs. The first, corresponding roughly to the period 1850-1945, was one in which little new drug development occurred and in which the minimal research that was conducted was based on relatively primitive methods. The large-scale development of penicillin during World War II marked the emergence of the second period of the industry's evolution. This period was characterized by the institution of formalized in-house R&D programs and relatively rapid rates of new drug introduction. During the early part of the period the industry relied largely on so-called "random" screening as a method for finding new drugs, but in the 1970s the industry began a transition to "guided" drug discovery or "drug development by design," a research methodology that drew heavily on advances in molecular biochemistry, pharmacology, and enzymology. The third epoch of the industry had its roots in the 1970s but did not begin to flower until quite

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366 U.S. INDUSTRYIN2000 recently as the use of the tools of genetic engineering in the production and dis- covery of new drugs has come to be more widely dispersed. Understanding the evolution of the industry in the first two periods is impor- tant because their history illustrates the role public policy played in shaping the industry and because both the industrial and institutional structure of the industry and the organizational capabilities of individual firms were molded during these early periods. Early History By almost any measure pharmaceuticals is a classic high-technology or science-based, industry. Yet drugs are as old as antiquity. For example, the Ebers Papyrus lists 811 prescriptions used in Egypt in 550 B.C. Eighteenth cen- tury France and Germany had pharmacies where pharmacists working in well- equipped laboratories produced therapeutic ingredients of known identity and purity on a small scale. Mass production of drugs dates back to 1813, when J.B. Trommsdof opened the first specialized pharmaceutical plant in Germany. Dur- ing the first half of the nineteenth century, however, standardized medicines for treating specific conditions were virtually nonexistent. A patient instead would be given a customized prescription that would be formulated at the local phar- macy by hand. The birth of the modern pharmaceutical industry can be traced to the mid- nineteenth century with the emergence of Germany and Switzerland as leaders of the new synthetic dye industry. This was due in part to the strength of German universities in organic chemistry and in part to Basel's proximity to the leading silk and textile regions of Germany and France. During the 1880s dyestuffs and other organic chemicals were discovered to have medicinal effects, such as antiception. It was thus initially Swiss and German chemical companies such as Ciba and Sandoz, Bayer and Hoescht, leveraging their technical competencies in organic chemistry and dyestuffs, that began to manufacture drugs, usually based on synthetic dyes, later in the nineteenth century. For example, the German com- pany Bayer was the first to produce salicylic acid (aspirin) in 1883. Mass production of pharmaceuticals also began in the United States and the United Kingdom in the later part of the nineteenth century, but the pattern of development was quite different from that of Germany and Switzerland. Whereas Swiss and German pharmaceutical activities tended to emerge within larger chemical-producing enterprises, the United States and the United Kingdom wit- nessed the birth of specialized pharmaceutical producers such as Wyeth (later American Home Products), Eli Lilly, Pfizer, Warner-Lambert, and Burroughs- Wellcome. Up until World War I German companies dominated the industry, producing approximately 80 percent of the world's pharmaceutical output. In the early years the pharmaceutical industry was not tightly linked to for- mal science. Until the 1930s, when sulfonamide was discovered, drug companies

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PHARMACEUTICALS AND BIOTECHNOLOGY 367 undertook little formal research. Most new drugs were based on existing organic chemicals or were derived from natural sources such as herbs, and little formal testing was done to ensure either safety or efficacy. Harold Clymer, who joined SmithKline in 1939, noted: [Y]ou can judge the magnitude of [SmithKline's] R&D at that time by the fact I was told I would have to consider the position temporary since they had already hired two people within the previous year for their laboratory and were not sure that the business would warrant the continued expenditure. World War II and wartime needs for antibiotics marked the drug industry's transition to an it&D-intensive business. Alexander Fleming discovered penicil- lin and its antibiotic properties in 1928. Throughout the 1930s, however, it was produced only in laboratory-scale quantities and was used almost exclusively for experimental purposes. With the outbreak of World War II, the U.S. government organized a massive research and production effort that focused on commercial production techniques and chemical structure analysis. More than 20 companies, several universities, and the Department of Agriculture took part. Pfizer, which had production experience in fermentation, developed a deep-tank fermentation process for producing large quantities of penicillin. This system led to major gains in productivity and, more important, laid out an architecture for the process and created a framework in which future improvements could took place. The commercialization of penicillin marked a watershed in the industry's development. Due partially to the technical experience and organizational capa- bilities accumulated through the intense wartime effort to develop penicillin, as well as to the recognition that drug development could be highly profitable, phar- maceutical companies embarked on a period of massive investment in R&D and built large-scale internal R&D capabilities. At the same time there was a very significant shift in the institutional structure surrounding the industry. Whereas before the war public support for health-related research had been quite modest, after the war it boomed to unprecedented levels, helping to set the stage for a period of great prosperity. Golden Age for the Industry: 1950-1990 The period from 1950 to 1990 was a golden age for the pharmaceutical in- dustry, as the industry in general, and particularly the major U.S. players, firms such as Merck, Eli Lilly, Bristol-Myers, and Pfizer, grew rapidly and profitably. R&D spending literally exploded and with them came a steady flow of new drugs. Drug innovation was a highly profitable activity during most of this period. Statman (1983), for example, estimated that accounting rates of return on new drugs introduced between 1954 and 1978 averaged 20.9 percent (compared to a cost of capital of 10.7 percent). Between 1982 and 1992, firms in the industry grew at an average annual rate of 18 percent.

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368 U.S. INDUSTRYIN2000 Several factors supported the industry's high average level of innovation and economic performance. One was the sheer magnitude of both the research oppor- tunities and the unmet needs. In the early postwar years, there were many physi- cal ailments and diseases for which no drugs existed. In every major therapeutic category, from pain killers and anti-inflammatories to cardiovascular and central nervous system products, pharmaceutical companies faced an almost completely open field. Before the discovery of penicillin, very few drugs effectively cured diseases. Faced with such a "target-rich" environment but very little detailed knowl- edge of the biological underpinnings of specific diseases, pharmaceutical compa- nies invented an approach to research now referred to as "random screening." Under this approach, natural and chemically derived compounds are randomly screened in test tube experiments and laboratory animals for potential therapeutic activity. Pharmaceutical companies maintained enormous "libraries" of chemi- cal compounds and added to their collections by searching for new compounds in places such as swamps, streams, and soil samples. Thousands, if not tens of thousands, of compounds might be subjected to multiple screens before research- ers honed in on a promising substance. Serendipity played a key role because the "mechanism of action" of most drugs, the specific biochemical and molecular pathways that were responsible for their therapeutic effect, was generally not well understood. Typically, researchers had to rely on the use of animal models as screens. For example, researchers injected compounds into hypertensive rats or dogs to explore the degree to which they reduced blood pressure. Under this regime it was not uncommon for companies to discover a drug to treat one dis- ease while searching for a treatment for another. Although random screening may seem inefficient, it worked extremely well for many years and continues to be widely employed. Several hundred chemical entities were introduced in the 1950s and 1960s, and several important classes of drug were discovered in this way, including a number of important diuretics, all of the early vasodilators, and several centrally acting agents, including reserpine and guanethidine. In the early 1970s, the industry also began to benefit more directly from the explosion in public funding for health-related research that followed the war. Between 1970 and 1995, for example, support for the National Institutes of Health (NIH), the agency through which the vast majority of federal support for health- related research is channeled, increased nearly 200 percent in real terms, to over $8.8 billion a year or 36 percent of the federal nondefense research budget, an amount roughly equal to the total research expenditure of all the U.S. pharmaceu- tical firms (Figure 1~. Before the 1970s publicly funded research was probably most important to the industry as a source of knowledge about the etiology of disease. From the middle 1970s on, however, substantial advances in physiology, pharmacology, enzymology, and cell biology the vast majority stemming from publicly funded

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PHARMACEUTICALS AND BIOTECHNOLOGY 10.00 8.00 6.00 4.00 2.00 0.00 369 Nominal I Deflated - - ~_ ~' ~' T ~ 1970 1975 1980 1985 1990 1995 Year FIGURE 1 NIH total appropriations (billions of dollars). research led to enormous progress in understanding the mechanism of action of some existing drugs and the biochemical and molecular roots of many diseases. This new knowledge made it possible to design significantly more sophisticated screens. By 1972, for example, the structure of the renin angiotensive cascade, one of the systems within the body responsible for the regulation of blood pres- sure, had been clarified by publicly funded researchers, and by 1975 several com- panies had drawn on this research in designing screens for hypertensive drugs (Henderson and Cockburn, 1994~. These firms could replace ranks of hyperten- sive rats with precisely defined chemical reactions. Instead of requesting "some- thing that will lower blood pressure in rats," pharmacologists could request "something that inhibits the action of the angiotensin 2 converting enzyme." In turn, the more sensitive screens made it possible to screen a wider range of compounds. Before the late 1970s, for example, it was difficult to screen the natural products of fermentation, a potent source of new antibiotics, in whole animal models. The compounds were available in such small quantities or trig- gered such complex mixtures of reactions in living animals that it was difficult to evaluate their effectiveness. The use of enzyme systems as screens made it much easier to evaluate these kinds of compounds. It also triggered a "virtuous cycle" in that the availability of drugs whose mechanisms of action were well known made possible significant advances in the medical understanding of the natural history of several key diseases, advances that in turn opened up new targets and opportunities for drug therapy (Gambardella, 1995; Maxwell and Eckhardt,1990~. The industry's increasing reliance on advances in fundamental science dra- matically increased the importance of public sector research in shaping industry productivity. Publicly funded research was important for several reasons. First, it provided the "raw knowledge" that undergirded many key discoveries. Table 1 illustrates the increasingly close relationship between the public and private sec- tors during the period. It summarizes detailed case histories of the discovery and development of 21 drugs identified by two leading industry experts as "having had the most impact upon therapeutic practice" between 1965 and 1992. Only 5

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PHARMACEUTICALS AND BIOTECHNOLOGY 371 of these drugs, or 24 percent, were developed with essentially no input from the public sector. These data suggest that public sector research has become more important to the private sector over time. Table 1 groups the drugs into three classes according to the research strategy by which they were discovered: those discovered by "random screening," those discovered by "mechanism-based screening," and those discovered through fun- damental scientific advances. Broadly speaking, the degree of reliance on the public sector for the initial insight increases across the three groups, and as the industry has moved to a greater reliance on the second and third approaches, so too has the role of the public sector increased. The public sector was also impor- tant in providing highly trained employees for the private sector and in helping to sustain a "research ethos" within those private firms that aggressively embraced the new techniques and that was highly productive. Efforts to measure the rate of return to public research have been very con- tentious and dogged by a variety of difficult practical and conceptual problems (Griliches, 1994; Ward and Dranove, 1995~. However in a recent study Cockburn and Henderson (1998) suggest that differences in the effectiveness with which pharmaceutical firms access the upstream pool of knowledge created by public science correspond to differences in research productivity of as much as 30 per- cent. Zucker et al. (forthcoming) find very similar results in their study of the role of the public sector in supporting the growth of the newly founded biotech- nology firms. Although any estimate of this type must be treated with great caution, these results are consistent with the hypothesis that public sector research has been critically important to the industry's health. Most intriguingly from a public policy perspective, these authors found that a firm's connectedness to the public sector, measured by the coauthorship of scientific papers across institutional boundaries, is closely related to several other factors that enhance the productiv- ity of privately funded pharmaceutical research. These include the number of "star scientists" employed by the firm and the degree to which the firm uses a researcher' s reputation among his or her peers as a criterion for promotion.3 These results are consistent with the hypothesis that the ability to take advantage of knowledge generated in the public sector requires investment in a complex set of activities that taken together change the nature of private sector research. Thus they raise the possibility that the ways in which public research is conducted may be as important as the level of public funding. Despite their apparent importance, these new research techniques were not uniformly adopted across the industry. For any particular firm, the shift in the technology of drug research from "random screening" to one of "guided" discov- ery or "drug discovery by design" depended critically on the ability to take ad 3 The use of coauthoring behavior to measure connectedness to the public sector was pioneered by Zucker et al. (1997) in their study of the emergence of new biotechnology firms.

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372 U.S. INDUSTRYIN2000 vantage of publicly generated knowledge (Cockburn and Henderson, 1996; Gambardella, 1995) and of economies of scope within the firm (Henderson and Cockburn, 1996~. Smaller firms, those farther from the centers of public re- search, and those that were most successful with the older techniques of rational drug discovery appear to have been much slower to adopt the new techniques than were their rivals (Cockburn et al.,1998; Gambardella, 1995; Henderson and Cockburn, 1994~. There was also significant geographical variation in adoption. The larger firms in the United States, the United Kingdom, and Switzerland were among the pioneers of the new technology, but Japanese and other European firms have been slow in responding to the opportunities afforded by the new science. In general, although the pharmaceutical industry is global in nature, companies from the United States, Switzerland, Germany, and the United King- dom have dominated in the postwar period. French and Italian firms have not played major international roles. Japan is the second largest pharmaceutical mar- ket in the world and is dominated by local firms, largely for regulatory reasons; but Japanese firms have to date been conspicuously absent from the global indus- try. Only Takeda ranks among the top 20 pharmaceutical firms in the world, and until relatively recently the innovative performance of Japanese pharmaceutical firms has been weak compared with their U.S. and European competitors. INSTITUTIONAL ENVIRONMENTS Institutional forces have shaped the industry in the "pre-biotechnology world," providing powerful inducements to innovation. From its inception, the evolution of the pharmaceutical industry has been tightly linked to the structure of national institutions. The pharmaceutical industry emerged in Switzerland and Germany in part, because of strong university research and training in the rel- evant scientific areas. German universities in the nineteenth century were leaders in organic chemistry, and Basel, the center of the Swiss pharmaceutical industry, was the home of the country's oldest university, long a center for medicinal and chemical study. In the United States the government's massive wartime invest- ment in the development of penicillin profoundly altered the evolution of Ameri- can industry. In the postwar era, the institutional arrangements in four key areas, the public support of basic research, intellectual property protection, procedures for product testing and approval, and pricing and reimbursement policies, have strongly influenced both the process of innovation directly and the economic returns, and thus the incentives, for undertaking such innovation. Public Support for Health-Related Research Nearly every government in the developed world supports publicly funded health-related research, but countries vary significantly in both the level of sup- port offered and in the ways in which it is spent. As reviewed earlier, public

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PHARMACEUTICALS AND BIOTECHNOLOGY 373 spending on health-related research in the United States is now the second larg- est item in the federal research budget after defense and is roughly equivalent to the research budget of the entire U.S. pharmaceutical industry. Both qualitative and quantitative evidence suggests that this spending has had a significant effect on the productivity of those large U.S. firms that were able to take advantage of it (Cockburn and Henderson, 1998; Maxwell and Eckhardt, 1990; Ward and Dranove, 1995~. Public funding of biomedical research also increased dramatically in Europe in the postwar period, although the United Kingdom spent considerably less than Germany or France, and total spending did not approach American levels (Table 2~. Moreover, the institutional structure of biomedical research in continental Europe evolved quite differently from its evolution in the United States and the United Kingdom, creating an environment in which science is far less integrated with medical practice. Science does not in general confer the same status within the medical profes- sion in continental Europe as it does in the United Kingdom or the United States. Traditionally the medical profession has had less scientific preparation than is common in either the United States or the United Kingdom, and medical training and practice have focused less on scientific methods per se than on the ability to use the results of research. Moreover doctorates in the relevant scientific disci- plines have been far less professionally oriented. Historically the incentives to engage in patient care at the expense of research have been very high. France and TABLE 2 Breakdown of National Expenditures on Academic and Related Research by Main Field, 1987a Expenditure (1987 million dollars) U.K. FRG France Netherlands U.S. Japan Averageb Engineering 436 505 359 112 1966 809 14.3% 15.6% 12.5% 11.2% 11.7% 13.2% 21.6% Physical sciences 565 1015 955 208 2325 543 21.2% 20.2% 25.1% 29.7% 21.7% 15.6% 14.5% Life sciences 864 1483 1116 313 7285 1261 36.3% 30.9% 36.7% 34.7% 32.7% 48.9% 33.7% Social sciences 187 210 146 99 754 145 6.0% 6.7% 5.2% 4.6% 10.4% 5.1% 3.9% Arts and humanities 184 251 218 83 411 358 6.8% 6.6% 6.2% 6.8% 8.6% 2.8% 9.6% Other 562 573 418 143 2163 620 15.6% 20.1% 14.2% 13.0% 14.9% 14.5% 16.6% Total 2,798 4,037 3,212 958 14,904 3,736 Expenditure data are based on OECD "purchasing power parities" for 1987 calculated in early 1989. bThis represents an unweighted average for the six countries (i.e., national figures have not been weighted to take into account the differing size of countries). Source: Irvine et al. (1990, p. 219).

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388 U.S. INDUSTRYIN2000 NATIONAL SYSTEMS OF INNOVATION: HOW DID PUBLIC POLICY MATTER? This brief description of the impact of the revolution in molecular biology on the pharmaceutical industry highlights the diversity of responses across the world and suggests several "stylized facts" to be explored in examining the relationship between "national systems of innovation," or the entire set of public policies and institutional constraints that shaped the evolution of any particular firm and the evolution of the industry across the world. First, why was the use of molecular biology as a production tool pioneered in the United States by small, newly founded firms, in Japan by firms diversifying into the industry from other fields, and in Europe largely by established pharmaceutical firms? Why did new en- trants play a much smaller role in the European context? Second, did national systems of innovation play a role in shaping the diffusion of the use of molecular biology as a research tool? This technology was pioneered by established phar- maceutical firms in almost every case, yet its rate of adoption varied widely across the world. The Evolution of "Biotechnology" Why the small, independently funded biotechnology start-up was initially an American phenomenon is an old question and a much discussed one. One of the reasons that it cannot be answered definitively is that the answer is to a large degree overdetermined; many factors were clearly at play, almost any one of which may have been sufficient. As the discussion has already suggested, the use of molecular biology as a production technology was a competence-destroying innovation for the vast majority of the established pharmaceutical firms. In the United States a combination of factors allowed small, newly founded firms to take advantage of the opportunity this created. These factors included a favorable financial climate, strong intellectual property protection, a scientific and medical establishment that could supplement the necessarily limited competencies of the new firms, a regulatory climate that did not restrict genetic experimentation, and, perhaps most importantly, a combination of a very strong local scientific base and academic norms that permitted the rapid translation of academic results into com- petitive enterprises. In Europe, apart from the United Kingdom, and in Japan many of these factors were not in place, and it was left to larger firms to exploit the new technology. A Strong Scientific Base and Academic Norms The majority of the American biotechnology start-ups were tightly linked to university departments, and the very strong state of American academic molecu- lar biology clearly played an important role in facilitating the wave of start-ups that characterized the 1 980s (Zucker et al. forthcoming). The strength of the local science base may also be responsible within Europe for the relative British ad

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PHARMACEUTICALS AND BIOTECHNOLOGY 389 vantage and the relative German and French delay. Similarly, the weakness of Japanese industry may partially reflect the weakness of Japanese science. There seems to be little question about the superiority of the American and British sci- entific systems in the field of molecular biology, and it is tempting to suggest that the strength of the local science base explains much of the regional differences in the speed with which molecular biology was exploited as a tool for the production of large molecular weight drugs. Although this explanation might seem unsatisfying to the degree that aca- demic science is rapidly published and thus, in principle, rapidly available across the world, the American lead appears to have been particularly important because the exploitation of biotechnology in the early years required the mastery of a considerable body of tacit knowledge that could not be easily acquired from the literature (Zucker et al., 1997; Pisano, 1996~. Geographic proximity probability facilitated the transmission of this kind of tacit knowledge (Jaffe et al., 1993~. In the case of biotechnology, however, several authors have suggested that the U.S. start-ups were not simply the result of geographic proximity (Zucker et al., 1997~. These authors have suggested that the flexibility of the American academic sys- tem, the high mobility characteristic of the scientific labor market, and, in gen- eral, the social, institutional, and legal context that made it relatively straightfor- ward for leading academic scientists to become deeply involved with commercial firms were also major factors in the health of the new industry. The willingness to exploit the results of academic research commercially also distinguishes the U.S. environment from that in either Europe or Japan. This willingness has been strengthened since the late 1970s and the passage of the Bayh-Dole Act (see below), and the resulting role of universities as seedbeds of entrepreneurship has probably also been extremely important in the take-off the biotechnology industry. In contrast, links between the academy and industry, especially the relatively free exchange of personnel, appear to have been much weaker in Europe and Japan. Indeed, the efforts of several European governments were targeted pre- cisely toward strengthening industry-university collaboration, and it has been ar- gued that the rigidities of the research system of continental Europe and the large role played in France and Germany by the public, nonacademic institutions have significantly hindered the development of biotechnology in those countries. That these kinds of factors, as distinct from the strength of the science base per se, were absolutely critical to the wave of new entry in biotechnology that occurred in America in the early 1980s is given further credibility by the rate at which the use of molecular biology diffused across the world. Access to Capital It is commonly believed that lack of venture capital restricted the start-up activity of biotechnology firms outside the United States. Clearly, venture capi

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390 U.S. INDUSTRYIN2000 tat, a largely American institution, played an enormous role in fueling the growth of the new biotechnology-based firms. Prospective start-ups in Europe, however, appear to have had many other sources of funds, usually through government programs. The results of several surveys also suggest that financial constraints did not constitute a significant obstacle for the founding of new biotechnology firms in Europe (Ernst and Young, 1995; MERIT, 1996; SERD, 1996~. In addition, although venture capital played a critical role in the founding of U.S. biotechnology firms, collaborations between the new firms and the larger, more established firms provided a potentially even more important source of capi- tal. Why did prospective European or Japanese biotechnology start-ups not turn to established pharmaceutical firms as a source of capital? A plausible explana- tion focuses on the market for know-how in biotechnology. The evolution of that market created many opportunities for European and Japanese companies to col- laborate with U.S. biotechnology firms. Although some U.S.-based new firms, such as Amgen, Biogen, Chiron, Genentech, and Genzyme, pursued a strategy of vertical integration from research through marketing in the U.S. market, most firms' strategies emphasized licensing product rights outside the U.S. to foreign partners. Thus to an even greater extent than many established U.S. pharmaceu- tical firms, European and Japanese firms were well positioned as partners for U.S. new biotechnology firms. Given the plethora of new U.S. firms in search of capital, European and Japanese firms interested in commercializing biotechnol- ogy had little incentive to invest in local biotechnology firms. Even in the ab- sence of other institutional barriers to entrepreneurial ventures, start-ups in Eu- rope or Japan might have been crowded out by the large number of U.S.-based firms anxious to trade non-U.S. marketing rights for capital. Intellectual Property Rights The establishment of clearly defined property rights also played a major role in making possible the explosion of new firm foundings in the United States, because the new firms, by definition, had few complementary assets that would have enabled them to appropriate returns from the new science in the absence of strong patent rights (Teece, 1986~. In the early years of biotechnology, considerable confusion surrounded the conditions under which patents could be obtained. In the first place, research in genetic engineering was on the borderline between basic and applied science. Much of it was conducted in universities or otherwise publicly funded, and the degree to which it was appropriate to patent the results of such research became the subject of bitter debate. Millstein and Kohler's groundbreaking discovery, hybridoma technology, was never patented, while Stanford University filed a patent for Boyer and Cohen's process in 1974. Boyer and Cohen renounced their own rights to the patent, but nevertheless they were strongly criticized for having being instrumental in patenting what many observers considered to be a basic

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PHARMACEUTICALS AND BIOTECHNOLOGY 391 technology. Similarly a growing tension emerged between publishing research results versus patenting them. The norms of the scientific community and the search for professional recognition had long stressed rapid publication, but patent laws prohibited the granting of a patent to an already published discovery (Merton, 1973; Kenney, 1986~. In the second place the law surrounding the possibility of patenting life-formats and procedures relating to the modification of life-forms was not defined. This issue involved a variety of problems, but it essentially boiled down, first, to whether living things could be patented at all and, second, to the scope of the claims that could be granted to such a patent (Merges and Nelson, 1994). These hurdles were gradually overcome. In 1980 Congress passed the Patent and Trademark Amendments of 1980 (Public Law 96-517~. Also known as the Bayh-Dole Act, this law gave universities, and other nonprofit institutions and small businesses, the right to retain the property rights to inventions deriving from federally funded research. In 1984 Congress expanded the rights of univer- sities further, by removing certain restrictions contained in Bayh-Dole regarding the kinds of inventions that universities could own and the right of universities to assign their property rights to other parties. In 1980 the U.S. Supreme Court ruled in favor of granting patent protection to living things (Diamond v. Chakrabarty); the case involved a scientist working for General Electric who had induced genetic modifications on a Pseudomonas bacterium that enhanced its ability to break down oil. In the same year the second reformulation of the Cohen and Boyer patent for the recombinant DNA process was approved. In subsequent years, a number of patents were granted establishing the right for very broad claims (Merges and Nelson, 1994~. Finally, a one-year grace period was intro- duced for filing a patent after publication of the invention. It is often stressed that the lack of adequate patent protection was a major obstacle to the development of the biotechnology industry in Europe.8 First, the grace period available in the United States is not available in Europe; any discov- ery that has been published is not patentable. Second, the interpretation has pre- vailed that naturally occurring entities, whether cloned or uncloned, cannot be patented. As a consequence, the scope for broad claims on patents is greatly reduced, and usually process rather than product patents are granted. In 1994 the European Parliament rejected a draft directive from the European Commission that attempted to strengthen the protection offered to biotechnology. Although it is clear that stronger intellectual property protection is not unam- biguously advantageous, as the controversy surrounding NIH's decision to seek patents for human gene sequences clearly illustrated, in the early days of the industry, the United States probably reaped an advantage from its relatively stronger regime. ~ See, for instance, Ernst and Young (1995).

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392 Regulatory Climate U.S. INDUSTRYIN2000 Although public opposition to genetic engineering was a significant phe- nomenon in the United States in the earliest years of the industry, it has quickly become less important, and in general the regulatory climate has been a favorable one (Kenney, 19861. In Europe, however, opposition to genetic engineering re- search by the "Green" parties is often cited as an important factor hindering the development of biotechnology, especially in Germany and other Northern Euro- pean countries, and public opposition to biotechnology is said to have been a factor behind the decision of some European companies to establish research laboratories in the United States. The Use of Molecular Biology as a Research Tool Explaining variations in the rate of adoption of molecular biology as a re- search tool across the regions of the world is, in contrast, rather more difficult. In general the techniques were adopted first by the large, globally oriented U.S., British, and Swiss firms. Adoption by the other European firms, and by the Japanese, appears to have been a much slower process. At first glance the relative strength of the local science base and the degree to which university research was connected to the industrial community appears to be as important an explanation here as it was in understanding the case of the diffusion of "biotechnology." Science in Japan and mainland Europe was argu- ably not as advanced as it was in the United States and Britain, a factor that slowed the adoption of the new techniques. Unfortunately this explanation is made much less plausible by the Swiss case. The Swiss companies established strong connections with the U.S. scientific system, suggesting that geographic proximity played a much less important role in the diffusion of molecular biology as a research tool. A second possible explanation is that diffusion was shaped by the relative size and structure of the various national pharmaceutical industries. Henderson and Cockburn (1996) have shown that between 1960 and 1990 there were signifi- cant returns to size in pharmaceutical research, and that since 1975 these returns have come primarily from the exploitation of economies of scope. They interpret this finding as suggesting that the effective adoption of the techniques of guided search and more rational drug design placed a premium on the ability to integrate knowledge within the firm and thus that the larger, more experienced firms may have been at a significant advantage in the exploitation of the new techniques. To the degree that those firms that had already adopted the techniques of "rational" drug discovery were at a significant advantage in adopting molecular biology as a research tool, the pre-existence of a strong national pharmaceutical industry with some large internationalized companies may have been a fundamental prerequi- site for the rapid adoption of molecular biology as a tool for product screening

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PHARMACEUTICALS AND BIOTECHNOLOGY 393 and design. The U.S. pharmaceutical industry has traditionally been internation- ally oriented and, at least since the early 1980s, open to international competition in the domestic market. But in many European countries, such as France and Italy, the pharmaceutical industry was highly fragmented into relatively small companies engaged essentially in the marketing of licensed products and in the development of minor products for the domestic markets. Although size or global reach may have been a necessary condition, the fail- ure of the largest German and Japanese firms to adopt these techniques suggests that it was not sufficient. The largest Japanese and German firms were arguably as international and as large as the Swiss. The most plausible explanation is that institutional variables, particularly the stringency of the regulatory environment and the nature of patent regime, were also important. As mentioned earlier, there is now widespread recognition that the introduction of the Kefauver-Harris Amendments had a significant impact in inducing a deep transformation of the U.S. pharmaceutical industry, particularly through raising the cost and complexity of R&D. Partly as a result many U.S. firms were forced to upgrade their scientific capability. Similarly the two European countries, the United Kingdom and Switzerland, whose leading firms did move more rapidly to adopt the new techniques appear to have actively encouraged a "harsher" competitive environment. The British sys- tem encouraged the entry of highly skilled foreign pharmaceutical firms, espe- cially the American and the Swiss, and a stringent regulatory environment also facilitated a more rapid trend toward the adoption by British companies of institu- tional practices typical of the American and Swiss companies in particular, product strategies based on high-priced patented molecules, strong links with universities, and aggressive marketing strategies focused on local doctors. The resulting change in the competitive environment in the home market induced British firms to pursue strategies that moved away from fragmenting innovative efforts into numerous minor products toward concentration on a few important products that could diffuse widely into the global market. By the 1970s the ensu- ing transformations of British firms had led to their increasing expansion into the world markets. Lacy Glenn Thomas (1994) has suggested that the slowness with which the majority of the European firms, apart from British and Swiss firms, adopted the techniques of guided drug discovery reflected much weaker competitive pres- sures in their domestic markets. The Japanese experience also looks in many respects like that pursued in Europe outside Switzerland and the United King- dom. In Japan legal and regulatory policies combined to frame a very "soft" competitive environment that appears to have seriously slowed the adoption of modern techniques by the Japanese pharmaceutical industry. As a result of the combination of patent laws, the policies surrounding drug licensing, and the drug reimbursement regime, Japanese pharmaceutical firms had little incentive to de- velop world-class product development capabilities, and in general they concen

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394 U.S. INDUSTRYIN2000 bated on finding novel processes for making existing foreign or domestically originated molecules (Mitchell et al., 1995~. Moreover, Japanese firms were pro- tected from foreign competition and simultaneously had strong incentives to li- cense products that had been approved overseas. Under this regime the predomi- nant technology strategy for Japanese pharmaceutical companies became the identification of promising foreign products to license. Mitchell et al. (1995) have noted that some of these institutional factors are beginning to change and that these changes are starting to have effects on the R&D strategies and capabilities of some but not all firms participating in the Japanese pharmaceutical sector. After 1967 foreign-originated products required clinical testing in Japan before they could be approved for sale. After 1976 drug products could be patented. After 1981 pricing policy was changed so that prices for established drugs are reviewed periodically and compared with prices of newer drugs. Together these factors have combined to increase the incentives for origi- nal research. Recent evidence suggests that the share of new chemical entities approved in the United States that originate in Japan has increased substantially, from 4 percent in the 1970s to around 25 percent in 1988 (Mitchell et al., 1995~. Nevertheless, because they lack a history of strong internal R&D, it is taking time for Japanese pharmaceutical companies to develop world class research capabili- ties. Strong domestic competition, the existence of appropriate incentive mecha- nisms toward aggressive R&D strategies, and integration into the world markets thus appear to be important explanatory variables in analyzing variations in the diffusion of the new technologies in drug screening and design across regions. Note, however, that they appear to say little about variations in diffusion across Arms. Most of the firms that rapidly adopted the new techniques were large multi- national or global companies, with a strong presence, at least as far research is concerned, in the United States and generally on the international markets. Zucker and Darby (1997) present some evidence that size alone is a reasonable predictor of adoption, at least in the United States. We suspect that this correlation reflects the fact that adoption is highly correlated with the degree to which firms have made the transition to guided drug discovery. By and large these were larger firms that had early developed a taste for science and that were able to build and sustain tight links to the public research community (Gambardella, 1995~. Here institutional factors appear to have been a necessary but not sufficient condition. To the extent that the adoption of the new techniques also involved the successful adoption of particular, academic-like forms of organization of research within companies (Henderson, 1994), and this process was in turn influenced by the proximity and availability of first-rate scientific research in universities, it was much easier for American and to a lesser extent British firms to adopt them. From this perspective, it is tempting to suggest that the origin of the Ameri- can advantage in the use of biotechnology as a research tool as well as a process

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PHARMACEUTICALS AND BIOTECHNOLOGY 395 technique lies in the comparatively closer integration between industry and the academic community, compared with other countries. One might also speculate that this closer integration resulted in some degree from the strong scientific base of the American medical culture and from the adoption of tight scientific proce- dures in clinical trials. Through this mechanism, American companies might have come to develop earlier and stronger relationships with the biomedical com- munity and with molecular biologists in particular. Segregation of the research system from both medical practice and from close contact with commercial firms (as in France and possibly in Germany) has been highlighted as a major factor hindering the transition to molecular biology in these two countries (see, for in- stance, Thomas, 1994~. CONCLUSION Public policy plays a crucial role in shaping private sector productivity in many modern economies. The case of the pharmaceutical industry provides a particularly intriguing window into this process and into the importance of na- tional systems of innovation in shaping industrial structure (Nelson, 1992~. Before the revolution in molecular biology, the U.S. pharmaceutical industry was shaped by public policy choices in a number of areas. Strong support for the life sciences provided both highly trained employees and a steady stream of knowledge that was a critical input to the industry. A tough regulatory environ- ment and an intellectual property regime together increased the returns to funda- mental innovation and further combined to create a cohort of large, diversified, highly skilled firms able to manage the transition from random to science-guided discovery effectively. The revolution in molecular biology further reinforced the power of public policy in shaping the industry. In the first place, the revolution's extraordinary dependence on fundamental science meant that the large commitment the United States made to public funding became even more important. But the importance of public policy extends far beyond the simple provision of funding for research. In the case of biotechnology, or the use of molecular biology as a production technique, advances in basic science rendered obsolete several of the core com- petencies of existing firms, particularly those related to process development and manufacturing. In the United States, institutional flexibility on a wide range of dimensions led to the formation of specialized biotechnology firms that could provide these competencies and bridge the gap between basic university research, on the one hand, and clinical development of drugs on the other. Thus the new biotechnology-based firms were, in many ways, an institutional, or public policy- shaped, response to the technical opportunities created by new scientific know- how. The case of biotechnology as a research tool presents a different but comple- mentary picture. This trajectory was born within the confines of established phar

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396 U.S. INDUSTRYIN2000 maceutical firms, and institutional factors appear to played a "necessary" rather than "sufficient" role in its diffusion. Pharmaceutical firms adopted biotechnol- ogy as a research tool as a way to use molecular biology to enhance the value and productivity of their existing assets and competencies, and in this sense biotech- nology tools were "competence enhancing." But they were only competence enhancing for some pharmaceutical firms those that were already oriented to- ward "high science" research and already firmly embedded in the global scien- tific community. Thus this case is one of existing institutional arrangements and structures shaping, rather than creating, the path of technical change. Forces facilitating institutional flexibility and responsiveness played a less prominent role in this domain, which may help to explain why Swiss and British firms have joined U.S. firms as leaders in the application of molecular biology to small mol- ecule discovery. We hesitate to draw any hard and fast conclusions about how public policy might best be shaped in the future to support the health of the industry. But this brief historical overview does raise several intriguing questions. First, it high- lights the extraordinarily important role of publicly funded science in supporting the industry. Most important from a policy perspective, perhaps, it highlights the fact that the ways in which this research is conducted may be as important as the level to which it is funded. The published results of publicly funded research are, with some lag, widely diffused across the world, and this kind of "output" clearly had an important impact on the industry. But our discussion suggests American industry was able to gain extraordinary benefits from this research because of the fluid nature of the boundary between public and private research institutions in the field. In the case of the larger, more established firms, this led to the creation of several exceptionally creative and flexible research organizations that were heavily influenced by the norms of "open" science. In the case of biotechnology, it led to the foundation of an extraordinary number of new firms whose energy and creativity has been the envy of the world. To the extent that efforts to realize a direct return on public investments in research lead to a weakening of the cul- ture and incentives of "open science," our results are consistent with the hypoth- esis that the productivity of the whole system of biomedical research may suffer. REFERENCES Arora, A., and A. Gambardella. (1990). "Complementarily and external linkage: the strategies of the large firms in biotechnology." Journal of Industrial Economics 37(4):361-379. Barbanfi, P., A. Gambardella, and L. Orsenigo. (1998). "The evolution of the forms of organization of innovative activities in biotechnology." Forthcoming in Biotechnology/International Journal of Technology Management. Bienz-Tadmore, B., P. Decerbo, G. Tadmore, and L. Lasagna. (1992). "Biopharmaceuticals and con- ventional drugs: Clinical Success Rates." Bio/Technology 10:521-525. Burstall, M.L. (1985). "The Community's pharmaceutical industry," Bruxelles: Commission of the European Communities.

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