Thailand Law Journal 2009 Spring Issue 1 Volume 12

Meanwhile, there exist international agencies, like the World Health Organization, World Bank, and United Nations Development Programme, explicitly mandated to model and address the dynamics of challenging third-world markets by collaborating with governments and operating in the interests of civil society. As well, government research divisions like the National Institute of Health in the U.S., Medical Research Council in the U.K., and the Central Drug Research Institute in India, conduct basic research aimed at understanding disease with the objective of inducing private firms to apply this research through drug development activities. [FN16] Despite public investment in drug discovery, development, and distribution activities, private firms have typically been loathe to leverage public resources toward profitable ends. First, the transaction costs associated with external cooperation of any sort are prohibitive. Second, profitability in this industry has typically hinged upon vertical integration of private firms. Since public organizations do not offer low transaction costs or the possibility of vertical integration, for-profit companies typically do not perceive public-private collaborative opportunities as profitable.

In fact, collaboration of any sort is perceived as risky for pharmaceutical firms. In many industries, the presence of very large firms is explained by the tendency of companies to exploit internal economies of scale and scope. [FN17] In the pharmaceutical industry, the tendency toward large firm size is explained by economies of scale through sharing of fixed costs, economies of scope arising from the opportunity to share knowledge across program boundaries, and the enhanced ability to absorb internal and external spillovers. [FN18] In those cases where collaboration is undertaken, acquisition is often sought as well. A recent study of 2,163 alliances between pharmaceutical and biotechnology firms in the US and Europe demonstrates that the top twenty pharmaceutical companies prefer to undertake alliances with biotech firms with an emphasis on acquiring the whole firm or parts of it with all knowledge, tacit and explicit, embodied within the transaction. [FN19]

Collaboration is generally unpopular due to the high transaction costs associated with sharing knowledge in such a high-risk industry. [FN20] Since both parties to a pharmaceutical collaboration explicitly seek the cross-fertilization of ideas within the interaction, and the parties typically compete in the same sector, collaboration presents the increased likelihood of usurpation of knowledge in the pursuit of profit. For this reason, firms typically seek to internalize and thus capture all value created within the organizational unit.

All three factors influencing transactions costs, articulated by Williamson, are at play in the pharmaceutical arena. Williamson identifies uncertainty, asset specificity, and frequency of interaction associated with collaboration as the chief modulators of transactional desirability outside the firm. [FN21]

a. Uncertainty

Though the drug development process appears sequential, as it proceeds from target and lead discovery, to preclinical development, clinical development, and manufacturing scale-up, the process is, in fact, iterative. [FN22] Consequently, there is great uncertainty and risk of failure associated with contracting out particular steps in the research and development process, with the likelihood of a dead end being greater than the likelihood of continuing beyond the external contract. To be sure, internally-managed pharmaceutical projects are also high-risk. However, the reciprocal interdependence of drug development tasks requires a high degree of integration best addressed through internal organization. [FN23]

b. Asset Specificity

Asset specificity refers to the relative lack of transferability of assets intended for use in a given transaction to other uses. [FN24] Highly specific assets represent sunk costs that have relatively little value beyond their use in the context of a specific transaction. However, by virtue of a highly specific asset's predictability of use, contracting for use of the asset is relatively standard.

Assets used in drug development transactions are highly unspecific, as the outcomes associated with their use are unpredictable. In the past thirty years, the drug development process has progressed from almost entirely random, with large volumes of synthetic compounds being run against targets to determine biological activity, to largely rational, with in silico computerized models and x-ray crystallography of proteins helping to determine the optimal properties of potential leads for given targets. [FN25]

However, despite a move toward rational drug design, today's processes are a mixture of both calculation and serendipity. For this reason, contractual specification of assets in order to quantify the ex post value captured by both parties is next to impossible. Valuing contributions in pharmaceutical transactions is a severe hurdle in the way of effective negotiation between parties, and its difficulty militates toward the vertically-integrated pharmaceutical organizational form. [FN26]

c. Frequency

Lastly, the discovery of a new active compound which is safe and effective requires the close multidisciplinary collaboration of chemists, biologists, pharmacologists, biochemists, and clinicians in constant communication with one another. [FN27] Within one organization, this cross-disciplinary contact can most easily be facilitated through organizational structure and strategy at the very top levels. However, even if two entities with strong innovative cultures collaborate on a project, the architecture is not in place for interaction between both organizations. The problem of asset specificity will necessarily encroach upon the need for frequency of contact, as firms will only want to contribute the knowledge necessary for the individual project. This sort of attitude is antithetical to the innovative process as a whole. Thus, frequency of interaction between all disciplinary contingencies to a transaction is a barrier to collaborative innovation.

These problems of uncertainty, asset specificity, and frequency are exacerbated due to the dichotomous objectives and cultures characteristic of private firms and public organizations. Whereas private firms are normally motivated by the pursuit of profit, public organizations undertake objectives for which market failure is most probable. [FN28] Therefore, with respect to a particular line of research, public researchers will be content once discovery has been generated and before costly patent attainment activities are undertaken. On the private side, private firms will be frustrated by the inclinations of researchers to disseminate information regarding discoveries early in the process while the private partner seeks to protect the discovery. [FN29]

The divergent goals of public and private organizations have the tendency to yield divergent cultures-with private attention to efficiency and public attention to the explicit humanitarian attainment of the public good. [FN30] Many private firms perceive capitalism as itself an engine for innovation. The private sector sees itself as making new life-saving products possible and spurring creative individuals to do their best-efficiently and productively. On the other hand, the public sector is seen as bureaucratic, inefficient, and wasteful of limited resources. It is seen as inherently incapable of generating constant innovation, but by its heavy-handed interventions is able to stifle efficient enterprise through excessive taxation, complex regulation, price and profit control, or unfair subsidized competition. [FN31] By not recognizing or even understanding the potential of the public sector, important pharmaceutical players are ill-equipped to leverage its resources.

[FN16]. S. Nwaka & R.G. Ridley, “Virtual drug discovery and development for neglected diseases through public-private partnerships” (2003) 2 Nature Reviews in Drug Discovery. 919-928.

[FN17]. A. Chandler, Scale and Scope, (Cambridge, MA: The MIT Press. 1990).

[FN18]. R. Henderson & I. Cockburn, “Scale, Scope, and Spillovers: The Determinants of Research Productivity in the Pharmaceutical Industry” (1993) NBER Working Paper Series, Working Paper No. 4466.

[FN19]. Andrew Jungmittag et al, Changing Innovation in the Pharmaceutical Industry: Globalization and New Ways of Drug Development, (Springer-Verlag, 2000) at 84.

[FN20]. F. Tapon & C. Cadsby, “Optimal Organization of Research” (1996) 31(3) Journal of Economic Behavior & Organization 381-399.

[FN21]. Oliver E. Williamson, The Economic Institutions of Capitalism, (New York: Free Press, 1985).

[FN22]. See, Figure 1.

[FN23]. J.D. Thompson, Organizations in Action (New York: McGraw Hill, 1967), 54-56.

[FN24]. Raisa B. Deber, “Delivering Health-Care Services: Public, Not-for-Profit, or Private?” (2002) Commission on the Future of Health Care in Canada, Discussion Paper No. 17 at 11.

[FN25]. H. Giersiefen, R. Hilgenfeld & A. Hillisch, “Modern Methods of Drug Discovery: An Introduction” in Alexander Hillisch & Rolf Hilgenfeld, eds. Modern Methods of Drug Discovery (Birkhauser, 2003) at 1-18.

[FN26]. H. Kettler & K. White, Valuing Industry Contributions to Public-Private Partnerships for Health Product Development (Geneva: Initiative on Public-Private Partnerships for Health, 2003).

[FN27]. Tapon, supra note 19.

[FN28]. R. Coase, The Firm, the Market, and the Law, (Chicago: University of Chicago Press, 1988).

[FN29]. Stuart R. Walker, ed., Creating the Right Environment for Drug Discovery (London: Quay Publishing, 1991) at 78.

[FN30]. Michael R. Reich, “Introduction: Public-Private Partnerships for Public Health” in Michael Reich, ed., Public-Private Partnerships for Public Health (Cambridge: Harvard University Press, 2002) at 1-18.

[FN31]. W. Muraskin, “The Last Years of the CVI and the Birth of the GAVI” in Michael Reich, ed., Public-Private Partnerships for Public Health (Cambridge: Harvard University Press, 2002) at 116.

This article is published with the kind permission of Nathaniel Lipkus. The article originally appeared in Michigan State University Journal of Medicine & Law, Spring 2006 issue.