Question

1. Drawing on the five forces model, explain why the pharmaceutical industry has historically been a very profitable industry.

2. After 2002, the profitability of the industry, measured by ROIC, started to decline. Why do you think this occurred?

Answer 1

Ans 1: The rivalry among existing firms is low. Generic drugs have a high rivalry; however, patented drugs rivalry is low since other companies can’t manufacture the medicines that are patented. Availability of substitutes are fairly low, generic drugs may be available but not in all cases. Bargaining power of suppliers is low. Good manufacturers have their own research and development facilities. Bargaining power of buyers is low for patented drugs, buyers don’t have any other option. The threat of new entrants is low. Opening a new drug company requires huge capital investment. The pharmaceutical industry does not have much restraining in the path of existing companies according to the five forces model which is why this industry has been profitable historically.

Ans 2: The decline in profitability of the industry is mainly because of a drug that is structurally very similar to already known drugs or ‘me-too drug’. These drugs are cheaper and less risky to develop since the market is already aware of the side effects and effectiveness of the drugs. “From 1998 to 2003, 487 drugs were approved by the FDA, and of those 379 (78%) were classified by the FDA as having similar qualities to those already on the market” (Nussenblatt, 2010). These drugs initiated price wars in the market leading to a reduction in the profitability of the companies.