The relative impact of actual and potential rivalry on firm profitability in pharmaceutical industry.docx
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Therelativeimpactofactualandpotentialrivalryonfirmprofitabilityinpharmaceuticalindustry
Therelativeimpactofactualandpotentialrivalryonfirmprofitabilityinthepharmaceuticalindustry
KarelCool, Lars-HendrikRoller, BenoitLeleux. StrategicManagementJournal. Chichester:
Jan1999. Vol. 20, Iss. 1; pg. 1
[Headnote]
Keywords:
potentialcompetition;drugindustry;industryprofitability;marketshare;rivalry
[Headnote]
ThispaperestimatestheeffectsofactualandpotentialrivalryonprofitabilityoffirmsintheU.S.pharmaceuticalindustryduringthe20-yearperiod1963-82.Theresultsshowthatduringthe1960sactualrivalryamongthesampledfirmsdidnotmateriallyaffectfirmprofitability,butthatduringthe1970scompetitionamongincumbentshadanincreasinglyadverseeffectontheirprofitability.Theresultsalsoshowthatpotentialcompetitionsignificantlyreduceddrugfirms'profitabilityduringtheentire20-yearperiod.Copyright(C)1999JohnWiley&Sons,Ltd.
(ProQuestInformationandLearning:
...denotesformulaeomitted.)
INTRODUCTION
PotentialcompetitionasalimitingforceontheexploitationofmarketpowerhasbeenrecognizedatleastsinceBain(1956).Sincethen,numerousstudiesonfirmperformancehavestressedtheabilityofpotentialentrytolimittheexploitationofmarketpower(seeGilbert,1989,forasurvey).Thedynamiclimitpricingliterature,forinstance,explicitlyaccountsforfirmstoearntemporaryexcessprofitswherebypotentialcompetitionlimitsmarketpowerbutnotasmuchasactualcompetition.
Potentialcompetitionasadeterminantofindustryandfirmprofitswasgiventhesameimportanceasactualcompetitioninthetheoryoftheperfectlycontestablemarket(seeBaumol,Panzar,andWillig,1982).Byassumingthatentryandexistcostsarenonexistent,theyshowedthatincumbentfirmscannotexercisemarketpower.Furtherdevelopmentscastdoubtonthisassertion,however.Forexample,SchwartzandReynolds(1983)showedthattheforceofpotentialcompetitionisseverelyweakenedifthereisasmalldeviationfromtheassumptionof'hit-and-run'conditions,i.e.,iftherearesomesunkentryorexitcosts.Thatis,whenmarketsareonly'imperfectly'contestable,itbecomesanempiricalquestionastohoweffectiveandpredictivethetheoryofperfectcontestabilityis.
Empiricalstudiesofmarketpowerhavegenerallyconcludedthatpotentialcompetitionindeedlimitsmarketpower(seeGilbert,1989).Inmostofthesestudies,however,potentialcompetitionhasbeenmeasuredthroughobservedentryorexit.1Thisverylikelyleadstoanunderestimationoftheeffectofpotentialcompetitionsincethetheorypredictsthatthemerethreatofentryshouldreducemarketpower.
Thepresentpaperproposesmeasuresofbothactualandpotentialrivalryandstudiestheimpactofbothtypesofcompetitiononprofitabilityinoneparticularsetting:
theU.S.pharmaceuticalindustryintheperiod1963-82.ThepharmaceuticalindustryhasoftenbeenthesubjectofallegationsconcerningmonopolisticpricingandwastefulR&Dactivity.Attheheartofthedebateisthequestionofwhethertheindustryiscompetitiveandofwhetherdrugfirmsareearningexcessiverents.ThenextsectionofthepaperbrieflydescribesthemajorevolutionsintheU.S.pharmaceuticalindustrywhichmayhavehadanimpactontheeffectsofactualandpotentialrivalry.Thesectionthereafterdefinesthevariousmeasuresusedintheeconometricanalysisanddescribesthedata.Inthethirdsection,theregressionresultsareinterpreted.Conclusionsaredrawninthefinalpart.
RIVALRYINTHEU.S.DRUGINDUSTRY
ProbablythemostsignificantregulatorychangeintheU.S.drugindustryinthepostwarperiodwasthe1962Amendmentstothe1938Food,DrugsandCosmeticsAct.Thisregulationdramaticallyincreasedregulatoryoversight:
firmswererequiredtoshowefficacyinadditiontosafetyforexistingandnewdrugs;preclinicaltestingwassubstantiallyexpanded;anewphasewasintroducedinthedrugapprovalprocess-theInvestigationalNewDrug(IND);laboratorypracticesandmanufacturingrulesweremademorestringent,etc.Thisaddeduptoalongerandmoreexpensiveapprovalprocess.2
Didthesechangesmateriallyaffectactualandpotentialrivalryandtheireffectonfirmprofitability?
Beforedevelopingmeasuresandconductingtests,wefirstpresentsomeargumentsandfactsontheindustryintheperiod1963-82.Thesehelpusformulateourconjectures.
Actualrivalry
Ifthereisintenserivalryamongdrugfirms,oneexpectsintensepricecompetitionamongequivalent(andsubstitute)productsofdifferentcompetitors.Alternatively,apresenceofdifferentpricesforequivalentproductswithdifferentbrandsislikelytoindicaterestraintsonpricecompetition.Further,iffirmsfocusoninnovationratherthanpricecompetition,oneexpectstoseeahighrateofproductintroductions.Whatdoindicatorsintheperiod1963-82suggestabouttheseformsofcompetition?
Table1givesthefour-firmandeight-firmconcentrationratiosfortheentireprescriptiondrugmarket.TheaverageC-4is26percentwithastandarddeviationof1.3percent,whiletheaverageC-8is43.4percentwithastandarddeviationof1.1percent.Restraintsonpricecompetitionmaybeexpectedespeciallyinmarketsthatarehighlyconcentrated.Atfirstglance,theconcentrationfiguresarenothighenoughtocausesignificantconcernregarding(tacit)pricearrangements.Neitheristhereatrendtowardsincreasingconcentration.
Productsofdifferenttherapeuticclassesarerarelysubstitutes,however.Therefore,concentrationisbettermeasuredatthetherapeuticclasslevel.3Table2liststheC-4andC-8ratiosforthevarioussegmentsinrepresentativeyears.ItisclearthattheaverageC-4isquiteabithigherwhenmeasuredatthesegmentlevel:
between44percentand49percent.ThesameistruefortheC-8ratio.Thisrangesbetween57percentand68percent.Thatis,arelativelysmallnumberoffirmsonaveragecontrolthesalesinthevariousproductgroups.Alsonoticeableisthataveragesegmentconcentrationincreasedinthefirstdecadefollowingthe1962Amendmentsbutdroppedagainintheseconddecade.Thismaysuggestthatconditionsforpriceagreementsweremorefavorableinthefirstdecadethaninthesecond.4
Wemayalsocomparepricesofequivalentdrugstoevaluatetowhatextenttherewaspricecompetition.Thefollowingexampleisatypicalcaseofdrugpricingintheperiodimmediatelyfollowingtheregulatorychangesof1962.Antibioticswasoneofthemarketswherepatentshadexpiredfirstandwheremultisourcearrangementsexisted.5By1973,MilanLaboratoriesmanufacturederythromicinforSherry,SmithKline,Squibb,Pfizer,Parke-Davis(WarnerLambert)andWyeth(AmericanHomeProducts).Sherry'swholesalepricefor100250mgtabletsofthisantibioticwas$5.70.Squibb'swholesalepricefortheidenticalproductwas$11.83(Brooke,1975:
15).Abbott,whichalsomanufacturedthisproduct,wasthemostexpensivesupplierat$12.96.Abbott,however,alsorealizedthegreatestsales,soldthelargestnumberofunitsandhadthemostprescriptions.BondandLean(1977)similarlyobservedforothertherapeuticcategories(antianginalsandoraldiuretics)inthefirst10yearsfollowingthe1962Amendmentsthatthereweresignificantpricedifferencesamongequivalentdrugs,thatthefirstentrantintoasegmentoftenhadthelargestsales,thehighestprice,thelowestpromotionexpensesandthehighestmargins.
Thehighconcentrationatthetherapeuticclasslevelisnotsufficientevidencetoconcludethatthereisanabsenceofrivalry,however.Ahighlevelofconcentrationmaymasksignificantproductinnovation.Figure1showstheintroductionintheUnitedStatesofnewchemicalentities(genuineinnovations)andofallnewdrugs(includingimitationdrugs,multisourcedrugsmarketedunderdifferentbrands,etc.).ThedataaregiveninTable3.
Thegraphshowsthat,particularlyfromtheearlytomid-1970sonward,firmslaunchedanincreasinglylargenumberofdrugsand,thus,thatrivalryonthebasisofproductintroductionsincreased.GiventhedecreasingratioofNCEsto-alldrugs,thedataalsosuggestthetypeofproductcompetition:
imitationratherthanrivalrybasedongenuineinnovations.
Inaddition,fromthe1970sonwards,someimportantregulatorychangeswerepassedtopromoterivalry.StateAnti-Substitutionlawsprohibitingpharmacistsfromdispensingagenericallyequivalentandlessexpensivedrugwererepealedinagrowingnumberofstates.By1972,onlytwostateshadrepealedtheirlaws.Thisincreasedto10by1975,32by1977and46by1979.Further,theMaximumAllowableCost(MAC)programwhichdeterminesmaximumreimbursementratesformultisourcedrugstohealthcareprograms(e.g.,Medicaid,Medicare)wasinitiatedin1975.Thedrugsthatfellundertheprogramgrewsteadilyinthesecondhalfofthe1970s,addingfurthertothegrowingpricepressures.Inaddition,agrowingnumberofhospitalsintroduced'formularies'whichidentifiedthedrugsthatcouldbeusedwithinthehospital.6Assubstitutionofbrandedproductsforlessexpensivegenericequivalentswaswidelypracticedwithinhospitals,thisputanotherpressureondrugpricing(seeHurwitzandCaves,1988).
Judgingfromtheincreaseintherateofgenericprescriptions,regulatorsmadeheadwayintheircrusadeforpricecompetition(seeTable3).In1963,thepercentageofgenericprescriptionsstoodat5.3percent.Thishadalmosttripledby1982(14.1%).AsshownbyHurwitzandCaves(1988),genericdrugfirmserodedtheshareofthepatentedproducts,especiallyasincumbentshadthetendencytocutbackont