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“Downsize and distribute”: Why profit-driven purpose damages innovation

By Brendan Maton

Photo by Louis Reed on Unsplash

A recent critique of the pharmaceutical industry suggested that bosses of the big drug companies ought to be paid according to genuine medical breakthroughs rather than the share price of the enterprise.

The paper, The People’s Prescription, co-authored by the UCL Institute for Innovation and Public Purpose (IIPP), references a recent study by the German Institute for Quality and Efficiency in Healthcare, which found that more than half so-called new treatments made no proven added benefit*.

Which begs two, related questions: what are drug companies such as Pfizer or Johnson & Johnson doing, if not producing new medicines? And if they don’t produce that many breakthroughs, then why do their leaders earn so much? In 2015, an eye-watering $431m was paid to just three people at Gilead Sciences.

Will Lazonick, professor of economics at University of Massachusetts Lowell, has done as much as anyone to answer these questions. In a nutshell, he says that pharma companies, like so many others, have become “downsize and distribute” operations. Their leaders’ prime focus is to extract money, both for themselves and for shareholders.

Lazonick rejects the companies’ defence that they spend loads on research and development to discover new cures, by contrasting how much more they spend on buying back shares to inflate the share price and issuing dividends, ie. cash, to the remaining shareholders.

Lazonick calls this behaviour financialisation. It is not exclusive to the pharmaceutical industry. Nevertheless, those who believe the purpose of a company is to make money may nevertheless be scratching their heads at this point. What is wrong in the world of business with making money or paying some of it to shareholders? Lazonick’s response is that financialisation is at odds with sustainable prosperity. The latter recognises the contribution made by employees of a firm whereas financialisation tries wherever possible to outsource staff, downsize the workforce or treat them at best as a drag on profits.

Second, sustainable prosperity recognises that much of a firm’s value comes from the public institutions around it, including schools which has given employees (mostly) free education, the judicial system which protects rights, the health system that restores poorly employees to health^, and so. Financialisation, on the other hand, knows the value of all these freebies but doesn’t want to contribute to them by paying fair taxes — or indeed by lowering prices on essential medicines.

Financialisation has become a dominant way of thinking in several countries such as the US and the UK. Greed is good, not just for the top brass at pharmaceutical companies but their peers elsewhere, the big investors who back them and their agents. While the wealth of the top 0.001% has rocketed, however, middling income in the US has stayed the same for four decades. This layer of society includes the doctors and nurses who administer medicine, the middle-ranking staff of big business itself; teachers, lawyers, engineers and surveyors in walks of life unconnected to financialisation.

Lazonick’s criticism is not social, political or ethical, however much it may chime so with others. His arguments are rooted in economics and industrial management, his area of specialisation for fifty years. Lazonick contends that those who champion Wall Street (investors) over Main Street (business) have neither a theory of the innovative enterprise nor an idea of how value is created in business (value and money are not synonymous). For Lazonick, Wall St investors — he prefers to call them savers — have nothing to do with value creation.

Instead, he posits three precepts to corporate innovation: a strategy in order to manage the uncertainty that comes with innovation. A collaborative organisation that nurtures staff at all levels to promote companywide learning. And finance in recognition of the fact that innovation rarely pays out on day one.

Lazonick’s criticism of Big Pharma is in part because they don’t seem too concerned if innovation — as evidenced by new medicine — tails off. This ought to be a case of pouring more into research and development: the attendant uncertainty around outputs is what managers are there to manage. Then there is the second precept, which is a communicative, open, collaborative organisation. Is the culture right for facilitating useful discoveries?

In Lazonick’s theory, finance is vital to pay for labour, equipment and overheads. But the tail is wagging the dog if companies put the interests of financiers ahead of the firm’s. Because shareholders can buy and sell at will, Lazonick sees little of the commitment enterprises need from their financiers. But instead, we have reached a pattern of corporate behaviour where companies do whatever they can to push the share price higher to please shareholders. Hence, Lazonick’s description as “downsize and distribute.”

He is too old and experienced to assume companies can be relentlessly innovative or that they should get it right. Most don’t most of the time. Regarding research and development, he notes that this only applies to certain types of industry, less than half of all big corporations.

But these are the conditions in which the world of business finds itself. None justify the kind of egregious behaviour which sees companies borrow money from one set of financiers in order to pay dividends to another. There has never been any economic justification, according to Lazonick, for maximising shareholder value. It has become prevalent in corporate thinking and business schools, nevertheless, and one crucial cause has been the incentives for senior executives, the point on which this article began.

Over ten years from 2006 to 2015, the average percentage of total compensation awarded in stock or stock options to US Pharma’s biggest earners was almost 83%†.

While they own such an outsize interest in a rising share price, it is evident why chief execs themselves would not prioritise medical research or more balanced pay for all staff, or higher taxes.

But with a need for fairly priced medicine, innovative cures and corporations which respect their social responsibilities, it may be evident why lots of folk beyond Wall Street would call for the incentives of Big Pharma’s bosses to be recast.

Will Lazonick is professor of economics at University of Massachusetts Lowell and recently presented a lecture as part of of our Rethinking Capitalism undergraduate module on “The firm, competition and the sources of productivity growth”. These lectures will be released weekly to the public. Follow us on YouTube for more or check this page weekly.

Sign up to the UCL Institute for Innovation and Public Purpose’s mailing list to hear about our latest research, news and events. You can also follow us on Twitter: @IIPP_UCL.

*Data from the German Institute for Quality and Efficiency in Health Care (IQWiG) presented by Dr Beate Wieseler at the conference Access to Medicines in the Baltics, 13 October 2017)

^In his recent IIPP lecture, Lazonick notes that US employees and employers make decisions based on healthcare because of the cost, ie the necessity of private medical insurance distorts employment practices unlike in those countries where healthcare is free

†US Pharma’s Financialized Business Model, Institute for New Economic Thinking, July 2017, Lazonick et al

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UCL Institute for Innovation and Public Purpose

UCL Institute for Innovation and Public Purpose

Changing how public value is imagined, practiced and evaluated to tackle societal challenges | Director: Mariana Mazzucato | Deputy Director: Rainer Kattel