Some time ago I wrote about a paper of mine (Hünermund et al., 2015) in which my coauthors and me develop a model to explain the occurrence of industry shakeouts. Shakeouts are a phenomenon which we encounter frequently in new industries. At one point in time, a large number of relatively small firms, previously operating in a market, becomes unsustainable. Within a short period of time a lot of firms exit and, eventually, the industry becomes dominated by a few large players. Our model explains this frequently observed pattern by technological factors that change over the lifespan of an industry. Cost advantages — because of more efficient production technologies — allow a few firm to take over and squeeze all others out of the market.
We also have a nice empirical application for our model which I did not present so far. The US penicillin industry experienced a shakeout in the 1950s. In 1952, a peak number of 30 firms where active in the business. The number of active firms decreased by more than 40% until 1960 and by around 70% until the mid 1980s. Figure 1 tells you the reason for this drastic development. Over the course of time, scientific progress in penicillin production was so substantial that, even after a severe exit wave, the few remaining firms were able to meet increasing demands for antibiotics.
But I’m going to start from the beginning. Penicillin was discovered in 1928 by Alexander Fleming. By accident, he found some bacteria cultures, with which he was experimenting, contaminated by a fungus. Interestingly, the colonies immediately surrounding the contaminated parts were destroyed. After some further experiments, he concluded that the fungus, which was from the Penecillium genus, produced a substance that proved to be effective against certain types of bacteria.
The medical potential of this new substance, called penicillin, was realized soon. The only problem was to produce sufficiently large amounts of it. In the early days, the fungus was cultivated in a petri dish filled with a production medium based on yeast extract. This procedure resulted in yield rates of around 1.2 microgram per milliliter of production broth. To treat a severe medical case though, an amount of around 300 milligram per day was necessary. It’s no surprise that penicillin was nearly unaffordable at that time.
The history of penicillin is a perfect example for the important difference between the invention of a new product and its commercialization. Progress in the production process was only modest during the 1930s. With the beginning of World War II, the need for antibiotic drugs was higher than ever. However, the British wartime economy was unable to provide the necessary resources to develop penicillin production on an industrial scale. This step was made in the United States. During the 1940s, the US government promoted an extensive research program on antibiotics combining scientific efforts at various universities and research institutes with research by private pharma companies such as Pfizer and Merck.
Only these concerted actions made the huge increases in yield rates possible that you see in Figure 1. Note, by the way, that the figure has a logarithmic scale on the y-axis. The red regression line (from 1950 onwards) thus depicts an exponential growth of yield rates which were doubling circa every seven years. Major innovations, for example, were achieved in the composition of the production medium. Specialized equipment also made is possible to produce penicillin in large production vessels which was far superior to the surface growth of the fungus in the early years.
The most substantial improvements in yield rates, however, were achieved by developing new substrains of the Penecillium mold through selective breeding. With the help of the US army, scientists conducted a worldwide search for the most promising variants of the fungus. Funnily enough though, the by-far most productive strain, which was the parent for a whole family of high-yielding strains, was found “right around the corner”, on a moldy cantaloupe at a market in Illinois. By the 1970s, penicillin and new variants of it, suitable for different kinds of diseases, were a mass product that was saving millions of lives.
Our data only go until the mid 1980s. But the topic of antibiotics is more topical than ever. Increased resistance of microbial organisms against existing drugs poses a serious threat to our medical system. It’s kind of sarcastic that the same mechanism of artificial selection, which allowed the tremendous progress in the production of antibiotics, nowadays renders more and more treatments ineffective against bacterial infections. At the same time, R&D in the field of antibiotics seems to become less and less profitable for private firms. A drug which you can buy for 20 euros in every pharmacy and take for 10 days is not exactly a blockbuster business. Therefore, the US government reacted by establishing public procurement programs to substitute missing private incentives with public demand. In Europe, there is a large Joint Programming Iniative concerned with subsidizing research related to antimicrobial resistance. We face a dilemma here. Private incentives for R&D, in the form of increased prices for new forms of antibiotics, will only become stronger when increased resistance will have rendered existing drugs ineffective. We better not let it come so far.
Hünermund, P., Schmidt-Dengler, P. and Y. Takahashi (2014): “Entry and Shakeout in Dynamic Oligopoly,” ZEW Discussion Paper No. 14-116.