The Relative Importance of Actual and
Potential Competition: Empirical Evidence
From the Pharmaceuticals Market
Mats A. Bergmany and Niklas Rudholmz
y
Department of Economics,
Uppsala University, Box 513,
SE-751 20 Uppsala, Sweden
z
Department of Economics,
Umeå University
SE-901 87 Umeå, Sweden
March 2003
Abstract
We study actual and potential competition and other factors that determine price paths of brand-name drugs in the Swedish pharmaceuticals market. The results indicate that the price of the incumbent
product is lowered by potential competition, entry of (additional)
generics, and the introduction of a so-called reference-price system.
We also identify a ”ratchet” e¤ect, through which price regulation
makes entry-deterring limit-pricing credible.
Key Words: Potential competition, patent expiration, limit pricing,
contestable markets.
JEL classi…cation: L65, I11
1
Introduction
Potential competition is a central concept in economics, although perhaps
less in focus today than it was during the early days of the theories of contestable markets and limit pricing. Despite the importance of the concept as
a tool for economic analysis in various situations, e.g., for competition policy
analysis, the strength of potential competition relative to actual competition has been the subject of relatively few empirical studies. The existing
studies are concentrated in the airline industry. In the present article, we
study potential competition in the pharmaceutical market. We propose the
use of patent expiration dates as events that marks the onset of potential
competition, while generic entry mark the onset of actual competition.
The pharmaceutical market is a natural candidate for studies of the e¤ect
of patent expiration. The fact that drug prices in many countries are regulated suggests a further bene…t from studying this market. Price regulation
allows the incumbent to commit to a price, because it creates a ”ratchet”
e¤ect. If a price is reduced, it may not be possible to increase the price again
unless this can be justi…ed by increased input costs. This is true at least for
the Swedish pharmaceuticals market, where prices are e¤ectively regulated.
(See below.) Thus, the pharmaceutical market provides an example of a
market where commitment to entry deterrence is credible.
Because of its regulatory structure, the Swedish pharmaceutical market
provides an interesting setting in which to test the e¤ect of potential competition when commitment to a low price is possible. The purpose of this
article is to study the pricing behavior of brand-name drug manufacturers
when facing potential, as well as actual, competition by generic substitutes.
The hypothesis we want to test is that potential competition, which is assumed to become e¤ective upon patent expiration, has a signi…cant e¤ect on
the price of such drugs.
Our results show that prices fall in response to potential entry (i.e., at
patent expiration), as well as in response to actual entry. The e¤ect of the
onset of potential competition is of the same order of magnitude as the e¤ect
of one additional entrant, a 5-8 per cent reduction in price. In line with our
expectations, the e¤ect of potential competition is the largest in relatively
small markets.
Section 2 demonstrates, by way of a linear example, how price regulation
creates a mechanism by which an incumbent that faces potential competition can reduce prices to an entry-deterring level (i.e., to the limit price).
1
Section 3 presents the data, the estimation techniques and the results from
the empirical analysis. The main results are summarized in section 4.
Related literature
According to the contestable-market hypothesis (Baumol et al, 1982),
an incumbent monopoly …rm is sometimes completely unable to exploit its
monopoly position, even if the market is characterized by increasing returns
to scale. That is, in order to prevent entry, the incumbent must charge prices
equal to average costs. The conditions for this to hold are that the product is
homogenous, that there are no sunk entry or exit costs and, most critically,
that the price charged by the incumbent is …xed for a longer period than it
takes a rival …rm to enter and capture the whole market.
Another theory of potential competition is the limit-pricing theory (Bain,
1949, Sylos-Labini, 1962, and Modigliani, 1958). This holds that the incumbent …rm can prevent entry - or slow entry down - by setting a ”limit price”,
and then earn supra-competitive pro…ts. The limit-pricing theory comes in
a number of versions, although the classical version of the theory posits that
the incumbent …rm commits to a ”limit quantity”, such that the residual demand is insu¢cient for the potential entrant to break even. The incumbent
can charge the ”limit price” corresponding to the limit quantity and earn
higher-than-normal pro…ts.
Under the assumptions of the contestable-market hypothesis, no rents
can be extracted from an incumbency position. Under the assumptions of
the limit-pricing theory, on the other hand, the incumbency position can
yield relatively large pro…ts. The reason for this discrepancy is that while
the contestable-market hypothesis is essentially a two-period model of price
competition, the limit-pricing theory (in its classical version) is a two-period
model of quantity competition. Being the …rst mover in a game of quantity
competition (or, more generally, strategic substitutes) is advantageous, while
being the …rst mover in a game of price competition (strategic complements)
is disadvantageous (or at least not advantageous).
The contestable-market hypothesis has been criticized for being based on
unreasonable assumptions - i.e., that the entrant can enter more rapidly than
the incumbent can change its price. The logical weakness of the (classical)
limit-pricing theory is that once entry has occurred, it may be pro…table for
the incumbent to raise the price. Therefore, the entrant may have reason
to believe that the threat of a low limit price is not credible. This, in turn,
suggests that holding down prices may not be e¤ective in preventing entry.
2
Spence (1977) and Dixit (1981) solve the inconsistency by assuming that the
incumbent can sink costs by building capacity, which will lower the future
marginal cost of production. This introduces a post-investment asymmetry
between the incumbent and the entrants, which the former bene…ts from.
Milgrom and Roberts (1982) address the weaknesses of the theory by modelling the competition between the incumbent and the entrant as a game of
incomplete information. The incumbent can then use a low price to signal
low marginal costs and in that way deter entry.
Gilbert (1989) and Bergman (2002) survey theoretical, empirical and experimental studies of potential competition. Most experimental studies suggest that it is actual competition, rather than potential competition, that
a¤ects prices and pro…ts. The persistency of high pro…t levels in concentrated industries points in the same direction, as do a number of studies of
pricing in the airline industry. However, other empirical evidence suggest
that potential competition can sometimes be e¤ective.
There are a large number of studies concerning the e¤ect of generic entry on original-drug prices, as well as on the determinants of generic entry
in the pharmaceuticals industry. The results indicate that entry by generic
substitutes usually lowers the price of brand-name products, and that the
most important factor in explaining entry is the expected pro…ts of the potential entrants. 1 Ellison and Ellison (2000) show how marketing, product
proliferation and pricing strategies a¤ect entry by generic substitutes. They
…nd that prices increase (relative to a pharmaceutical price index) during
the …nal years of patent protection. After the patent has expired, prices fall
for the group of pharmaceuticals where entry is predicted to be likely, and
continue to rise for pharmaceuticals where the probability of entry is low or
medium high.
Generic competition in the Swedish pharmaceuticals market
Generic entry is de…ned as the introduction of a new pharmaceutical
drug sharing the same seven …gure ATC-code (as de…ned by the Swedish
Medical Products Agency, SMPA) as a brand-name drug sold in the Swedish
pharmaceuticals market. Generic manufacturers are the producers of such
pharmaceuticals.
1
See, for example, Caves et al. (1991), Suh et al. (1999), Ferrándiz (1999) and Aronsson
et al. (2001), all of whom have studied the impact of generic competition on brand-name
prices and/or market shares. In addition, Scott Morton (1999), Rudholm (2001) and
Ekelund (2000) focused on the determinants of entry of generic products.
3
In Sweden (and in the European Union) it is possible for the generic manufacturers to use some of the original manufacturers’ documentation, instead
of having to create all documentation themselves. In particular, an applicant
for a license to sell a new generic drug does not have to produce pharmacological and toxicological studies, if it can be shown that the new pharmaceutical
is equivalent to another pharmaceutical product that has been approved for
sale in Sweden or in another member country of the European Union, and if
it is presently sold in Sweden. 2 The goal of the SMPA is that the handling
of an application to sell a new generic drug should be completed within 210
days, although this goal has not been reached persistently.3
Formally, both generic and original manufacturer can set prices freely.
However, in order for the patients’ costs to be reimbursed, the Swedish National Social Insurance Board must accept the prices set by the …rms. Hence,
the Social Insurance Board’s role as gatekeeper of the reimbursement system
in practice gives it the power to regulate prices.4 In addition, a so-called
reference-price system was introduced in 1993. The system limits the reimbursement to patients who purchase pharmaceuticals to 110 percent of the
price of the least-cost identical generic alternative. Similar systems have been
introduced in several other countries, including Germany.
2
Another way of achieving this is to use references to published scienti…c literature
to prove that the pharmaceutical has a well established medical use, with acknowledged
e¤ects, and a reasonable margin of safety. The procedures described above follow the
SMPA rules 1995:8 and 1993:14. The preceding rules, found in the National Board of
Health and Welfare Code of Statutes 1980:90, states that the generic manufacturer must
present studies concerning the bioavailability and tolerability of the generic substitute.
3
In 1999, the SMPA reported that the average time for handling an application for
approval of a generic drug was 252 days, and that 40% of the applications were handled
within the goal of 210 days.
4
If a manufacturer of a pharmaceutical product wants to increase the price of the product, he/she must also motivate why the SNIB should accept the price increase. This is
clearly stated in the SNIB code of statutes (1996:31, 1992:20). Before 1992, price regulations were upheld by a law (SFS 1981:49), which stated that in order for a pharmaceutical
to be reimbursed, price negotiations had to be conducted with the SNIB. Informal contacts with employees at the SNIB con…rm that price increases are only allowed if the
manufacturer can provide good reasons, such as cost increases, for the new price.
4
2
Credible limit pricing under price regulation: a linear example
In this section we show with a simple linear model how an ability to commit
not to increase prices provides the incumbent with a mechanism for entry
deterrence. The incumbent sets a limit price, i.e., a price that is low enough
that entry is just prevented. Without a credible commitment not to increase
the price and in the absence of informational asymmetries, the incumbent
cannot deter entry by reducing price. Whether entry occurs or not depends
only on the post-entry pro…t opportunities in the market and the entry costs.
Hence, in that situation, there is no point in reducing prices in advance of
entry and prices will fall if and when entry occurs. In other words, there will
be no e¤ect on prices of potential competition, but there will be an e¤ect of
actual competition. Conversely, if entry deterrence occurs, there will be an
e¤ect of potential competition.
Before analyzing the di¤erentiated-products price-competition case, which
we will focus on, consider the case of static price competition and homogenous products, with constant marginal costs and a …xed entry cost. If the
incumbent cannot commit to a price, there will be no entry. This is so because Bertrand competition will follow upon entry, so that the …xed costs of
entry cannot be recouped. Predicting this, the incumbent has no incentive
to lower the price in advance of entry. Hence the incumbent will set the
monopoly price. In such a setting, there is no advantage in being able to
commit to a …xed price or to a maximum price, since the monopoly pro…t
can be obtained without making a commitment. On the contrary, if the incumbent has to commit to a price, while the entrant can chose a price after
observing the incumbent’s price, as assumed in the contestable-market hypothesis, prices will be forced down to average costs, but there will still be
no entry.
Using the same set-up, but assuming di¤erentiated products, these extreme results no longer hold. Without commitment prices will remain above
marginal costs after entry and, for some parameter values, the entry cost
can be recouped and there will be entry in equilibrium. To see this, let the
demand for product j = 1; 2 be given by:
qj = 1 ¡ pj + ¯p¡j
5
(1)
for 0 < p¡j · 1 and:
qj = 1 ¡ p j + ¯
(2)
¼2 = p2(1 ¡ p2 + ¯p1 ) ¡ f
(3)
for p¡j > 1, where pj denotes the price of product j and where 0 · ¯ · 1,
and ¡j = 2 if j = 1 and vice versa. The parameter ¯ represents the degree
of di¤erentiation, with ¯ = 0 representing di¤erentiated products and ¯ = 1
representing relatively undi¤erentiated products.5 Assume also that qj = 0
if pj > 1. Let the marginal cost be normalized to zero. Then the pro…t for
…rm 2, the entrant, is given by:
where f is the …xed cost of entry, and correspondingly for …rm 1, although
without the entry cost. From the …rst-order conditions, the accommodation
equilibrium (i.e., when the incumbent does not engage in entry-deterring
activities), will be given by:
1
pacc
=
(4)
j
2¡¯
qacc
=
j
1
2¡¯
¼acc
=
1
1
(2 ¡ ¯)2
¼acc
=
2
1
¡f
(2 ¡ ¯)2
for j = 1; 2: Note that if f > 1=(2 ¡ ¯)2, entry will be blockaded.
However, if the incumbent can commit not to increase its price above a
certain level, the incumbent may have an incentive to deter entry for lower
values of f. The pro…t of the entrant, as a function of p1, is given by:
1
¼2 = (1 + ¯p1)2 ¡ f
(5)
4
Setting ¼2 = 0, we see that the (highest) entry-deterring price is:
p
2 f ¡1
det
p1 =
(6)
¯
5 Restricting ¯ to lie between 0 and 1 simpli…es the analysis, by ensuring an interior
solution, so that our equilibrium solution will always be described by the expressions given
in the text.
6
Pro…t under entry deterrence is given by:
p
µ
¶
q
2 f ¡1
det
¼1 =
(1 + ¯)¯ ¡ (2 f ¡ 1)
¯2
(7)
Letting ¼1det = ¼1acc, we can solve for the critical f , above which entry deterrence is pro…table (up until f = 1=(2 ¡ ¯)2 ). The numerical expression is not
very enlightening, so it is not shown here. Instead, the incumbent’s optimal
price (after patent expiration and, possibly, entry) for ¯ = 0:5, as a function
of f, is calculated6 ;
8
>
<
if
f < 0: 36
p2=3
p1(f ) = > 4 f ¡ 2 if 0: 36 · f · 0: 44
:
0:75
if
0: 44 < f
(Entry accommodated)
(Entry deterred)
(Entry blockaded)
In this example, entry deterrence will occur in the interval [0: 36; 0: 44], within
which prices will fall when potential competition becomes possible, i.e., at
patent expiration. In the high end of the interval, prices will fall relatively
little,while in the lower end, prices will fall relatively much. For entry costs
below the lower end of the interval, entry will be accommodated. Hence,
for su¢ciently low entry costs, the incumbent’s price will not respond to
patent expiration (potential competition), but it will respond to generic entry
(actual competition). For su¢ciently high entry costs (above the upper end
of the interval), entry will be blockaded, prices will not respond to patent
expiration and there will be no generic entry.
This simple example demonstrates that price regulation can create a
”ratchet” e¤ect, which in turn can make an entry-deterring limit-price credible.
3
3.1
The empirical analysis
Data
All data have been provided by the SMPA. The medical substances come from
7 out of the 14 existing di¤erent …elds of use, as de…ned by the SMPA. The 18
pharmaceutical substances in our sample result in a dataset consisting of 1184
observations. Data refer to prices and quantities sold, each quarter, for the
6 Before patent expiration, the optimal price will be equal to the monopoly price which
is 0:75 in this example.
7
package size with the largest recorded sales volume for each substance. This
results in an unbalanced data panel covering, at most, the years 1972 to 1996.
The price series have been de‡ated using the consumer-price index, with 1990
as the base year, and then normalized to 100 in that year. The recalculation
to index series makes it possible to interpret the results in percentage terms.
The average quarterly revenue (de‡ated using the consumer price index, but
not normalized to 100 in the year 1990) for each of the substances, measured
in SEK (Swedish crowns) is presented in Table 1, along with some additional
descriptive statistics.7
Table 1. Product and market characteristics.
Substance
Cimetedine
Sukralfate
Etacrynic Acid
Atenolol
Pindolol
Azapropazone
Diklofenac
Naproxen
Piroxicam
Sulindac
Lorazepam
Oxazepam
Clomipramine
Lofepramine
Maprotiline
Miaserine
Protriptyline
Dipivefrin
Brand
Entry
(date)
810911
831111
661214
780127
740301
780127
811218
810206
851108
821022
800125
660516
730525
790406
770223
900202
660623
880916
Patent
Exp.
(date)
790118
870220
840303
811021
840329
850112
890827
900825
800920
761205
850405
800702
891012
Gen.
Entry
(date)
831111
860613
881028
870213
871211
870918
930618
860626
910426
910426
940128
920527
Geni
1996
(No)
4
1
0
4
2
0
1
5
1
0
0
2
1
0
2
2
0
1
Average
Revenue
(SEK/q)
602 500
207 000
2 500
897 500
134 500
5 500
427 500
330 500
60 000
161 000
50 500
195 500
75 500
103 000
60 000
35 500
2 500
70 000
Pat.
time
(q)
0
0
30
36
40
15
9
16
15
31
3
0
14
24
0
0
34
5
ATC
Code
A02B
A02B
C03C
C07A
C07A
M01A
M01A
M01A
M01A
M01A
N05B
N05B
N06A
N06A
N06A
N06A
N06A
S01E
In the regressions below, we use the number of generic brands active in
the market in each quarter, while Table 1 above report the number of generics
active in the …rst quarter of 1996.
7
Some additional summary statistics for the dependent and independent variables are
presented in the Appendix, see Table A2.
8
All pharmaceuticals in Table 1 are single-substance pharmaceuticals, with
a sales volume exceeding 100 packages each quarter after entry, which lost
patent protection during the period 1972-1990 and which belong to one of the
seven selected …elds of use. This selection is motivated by problems of obtaining reliable data regarding patent expiration dates for those pharmaceuticals
that are a mixture of several di¤erent medical substances. The information about patent times has been obtained from the Swedish Patent and
Registration O¢ce. These data describe the patent times for the chemical
substance used in the di¤erent pharmaceuticals. The brand-name manufacturer could thus have other patents concerning, for example, manufacturing
procedures. Therefore, our data on the time of patent expiration need not
be a perfect measure of the actual date generic entry was allowed. However,
the assumption that the chemical-substance patent is the relevant one guaranteeing market exclusivity has been used in earlier studies, e.g. Caves et al.
(1991). Note also that for …ve of the substances, the patent regarding the
chemical substance used had already expired at the time when the pharmaceutical product in question was introduced into the Swedish pharmaceuticals
market.
3.2
Estimation results
We want to test the hypotheses that prices respond to the introduction of
potential competition, i.e. to patent expiration, as well as to actual competition. To do that, we use the following model of the price of brand-name
product i at time t8 ;
pit = ®i + °1(SIZEit¡1 ¤ DP ATi ) + °2DP ATi + ° 3DREF
+° 4GENit + °5(GEN93 ¤ DREF ) + °6T REND + "it
(8)
where ®i is a product-speci…c intercept and (SIZEit¡1 ¤ DP ATi) measures
any market-size e¤ects at the time of patent expiration. DP ATit is a dummy
8
The theoretical model presented above applies to individual substances (or pharmaceutical products), whereas equation (8) is designed for estimation by means of panel data.
It was not possible to estimate a price equation for each individual substance, as the time
series are relatively short (at least in some cases), and the price of certain pharmaceutical
products do not change very often.
9
variable taking the value 1 after patent expiration for substance i: This variable will be used to measure the e¤ects of potential competition on brandname product prices. DREF is a dummy variable taking the value one
after the introduction of the Swedish reference-price system in 1993. GENit
represents the number of generic competitors active in market i at time t:
An interaction term, (GEN93¤DREF ), is included in order to investigate
if the e¤ect of the introduction of the reference price system is di¤erent
for substances which faced generic competition at that time. The variable
GEN93 takes the value 1 for those substances that faced generic competition
when the system was introduced. This might be expected to be important,
since before the reference-price system was introduced, generic copies were
often priced as low as around half the price of the original. When the system
was introduced, patients would then have to pay a large fraction of the price
of the original, unless the original manufacturer lowered the price to 110 per
cent of the least-cost generic alternative. However, generic manufacturers
that entered the market after the system had been introduced were likely to
choose prices just a little below those of the original manufacturer, since the
original manufacturer would otherwise probably lower its price immediately.
Finally, the T REN D variable has been included to capture any remaining
price trend after de‡ating the price series.
We also estimate a model where the variable GENit is replaced by a
dummy variable re‡ecting the presence of the …rst generic competitor, DGEN1it ,
and three other dummy variables re‡ecting entries with two, three or four
(or more) generic entrants. This is done to investigate if the e¤ect of the
…rst generic entrant di¤ers from the e¤ects of additional entrants. The price
equation can then be written;
pit = ®i + °1 (SIZEit¡1 ¤ DP ATi ) + °2DP ATi + °3DREF + ´1DGEN1it
+´2 DGEN2it + ´3 DGEN3it + ´4DGEN4it + °5(GEN 93 ¤ DREF )
(9)
+°6T REND + "it
Both models were estimated with the statistical software STATA, which
contains estimation procedures designed to correct for the e¤ect of unbalanced panel data. We used Newey-West (1987) standard errors designed to
correct for both autocorrelation and heteroskedasticity, as there were some
indications of serial correlation (see Appendix). The estimation results are
10
presented in Table 2 below (except for the substance-speci…c …xed e¤ects
which have been suppressed in order to save space).
The model using the number of generic competitors, GENit , indicate that
additional generic competitors lower the price of the incumbent as expected.
The results suggest that one additional competitor lowers the price by about
8 per cent on average. The parameter estimates corresponding to equation
(9) are not signi…cant for the …rst three generic entrants, although the point
estimates are negative for one and three generic competitors. When there
are four (or more) competitors, price is estimated to be reduced about 40
per cent.
Table 2. Estimation results.
Variable (Parameter)
Equation 1 Equation 2
SIZEit¡1 ¤ DP ATi (°1)
0.0042
0.0039
(4.96)
(4.59)
DP ATi (°2)
-8.06
-5.39
(-3.64)
(-2.12)
DREF (°3)
-1.15
-0.015
(-0.58)
(-0.01)
GENit (°4)
-7.65
(-7.10)
DGEN1it (´1 )
-3.52
(-1.42)
DGEN2it (´2 )
0.42
(0.18)
DGEN3it (´2 )
-15.01
(-1.84)
DGEN4it (´2 )
-39.92
(-7.84)
GEN93 ¤ DREF (°5)
-14.25
-15.56
(-5.15)
(-5.80)
T REND(°6 )
-0.76
-0.85
(-17.18)
(-18.80)
2
R
0.52
0.53
Note: Newey-West t-values are given within parentheses.
The dummy-variable parameter representing patent expiration is negative and signi…cant in both models. We interpret this result to mean that
potential competition forces small brand-name producers to lower their price
11
by between 5 and 8 per cent. Because the e¤ect of the interaction between
size and patent expiration is found to be positive, the price of large brandname products is estimated to fall less. In fact, using the mean sales volume,
the estimated total e¤ect on the original price is close to zero.9 This is consistent with the simple model of Section 2. Assuming that entry costs are
independent of the market size, entry is likely to occur for large products,
irrespective of any reasonable price reduction, while for small products, a
modest price reduction may deter entry. For very small products, we again
expect no e¤ect of patent expiration, since entry is likely to be blockaded (in
the sense described in Section 2). However, our empirical analysis includes
only products with sales above a certain threshold.
If the observed price e¤ects stem from attempts by the original manufacturers to deter entry, we would expect the number of entrants to be
in‡uenced by the original’s price. In fact, of the two brand-name drugs that
had attracted four or more generic competitors in the …rst quarter of 1996
and which had lost patent protection during the period under study, neither
had its price lowered at patent expiration. The substances are Atenolol and
Naproxen. The nominal price of these products were actually raised at the
time of patent expiration. In contrast, there are three substances, the price
of which were lowered by more than 10 percent at the time of patent expiration: Clomipramine, Lorazepam and Dipivefrin. All of these substances had
one or less generic competitors in the …rst quarter of 1996, the last quarter in
this study. Hence, it seems that the …rms that adopted an aggressive pricing
policy at the time of patent expiration experienced less generic competition
than those who were more acquiescent. 10
The di¤erences between pharmaceuticals regarding generic competition
probably also depend on the type of pharmaceuticals. Cimetedine is used
in the treatment of gastric ulcer, Atenolol is used in the treatment of heart
disease and Naproxen is used to treat arthritis. Note also that these pharma9
Note that the sales distribution is skewed to the right. Hence the median is smaller
than the mean and therefore original prices are estimated to fall for median sales values.
10
Scott-Morton (1999) used several di¤erent model speci…cations to predict the number
of potential entrants and compared these predictions to the actual number of generic
entrants. However, as Scott-Morton notes in her paper, even the least restrictive approach
clearly misses potential entrants who do not enter the market at all. In our setting this
problem is augmented by the fact that several, if not most, entries are from ”outside”
generic …rms not included in such speci…cations. Thus, we do not attempt to make any
such comparisons in this paper.
12
ceuticals all have high revenues compared to the rest of the pharmaceuticals
in our sample. Bae (1997) reports that these substances have a below average
entry delay. That is, the times to generic entry are shorter for the substances
mentioned above than for the average substance in his study. This could
be interpreted as an indication that these substances are considered to be
relatively attractive by generic manufacturers in the U.S. market as well.
We …nd no signi…cant e¤ect of the introduction of the Swedish referenceprice system, except for products which already faced generic competition at
the introduction of the system (through the interaction-term e¤ect, measured
by °5). In those cases, prices fell on average 14 or 15 per cent, according to
the two estimates. Aronsson et al. (2001) found that the prices of original
drugs facing generic competition fell dramatically when the reference-price
system was introduced. In this study we are able to qualify that result: The
introduction of the reference-price system mainly lowered the prices of those
incumbent products which already faced generic competition. It appears that
no similar e¤ect exists for later generic entrants. These results are consistent
with what one would expect. Before the system was introduced, generic entrants typically set prices far below the original, without capturing more than
a relatively small fraction of the market. When the system was introduced,
the original manufacturers were forced to lower their prices to a level close
to that of the generics, in order for patients to be fully reimbursed. However,
after the system had been introduced, generic entrants had incentives to set
prices just a little below the incumbents’ prices.
4
Summary and discussion
Given the importance attributed to potential competition in many situations, it is surprising that the e¤ectiveness of potential competition has not
been extensively studied in industries other than the airline industry. In
particular, the expiration of patents in the pharmaceutical industry provides
a natural experiment to test the e¤ect of potential competition, while the
generic entry that often occurs also allows us to study the additional e¤ect
of actual competition.
One feature of the Swedish pharmaceuticals market is that the original
manufacturer normally is not allowed to increase prices. This gives the original manufacturer a commitment device. A low ”limit price” will be a credible
commitment not to increase prices upon entry; hence entry can be deterred.
13
Therefore, we would expect prices to be reduced at patent expiration, at least
in some markets. Of course, this mechanism will only come to play if the
price regulation is relatively weak. If the price were already, because of the
regulation, low enough for entry to be unpro…table, the incumbent …rm need
not reduce its price further. However, in most pharmaceuticals markets, this
appears not to be the case.
Our results indicate that the price of the incumbent product is lowered signi…cantly by potential competition, if the quarterly sales are not
too large. In addition, brand-name pharmaceutical prices are lowered by
entry of generic substitutes. The introduction of the reference-price system
lowered the price of those original products that already, at the time of the
introduction of the system, faced actual competition. However, we …nd no
e¤ect on the prices of originals whose patents have expired after the system
was introduced.
The estimated e¤ect of potential competition - that prices fall between
5 and 8 per cent for small products as potential competition is introduced
- is larger in our study than in most studies of potential competition in the
airline industry. In our study and for such products, potential competition
(from all potential rivals combined) is estimated to be about as e¤ective as
one additional actual competitor. In the airline studies, the price e¤ect of
an actual competitor was in one study found to be three to ten times larger
than the e¤ect of a potential competitor (Morrison and Whinston, 1987).
However, for originals with higher sales volumes, we estimate the e¤ect of
patent expiration to be signi…cantly lower.
5
Acknowledgments
The authors would like to thank Thomas Aronsson, Runar Brännlund, Magnus Johannesson, Jonas Nordström, Johan Stennek and seminar participants
at the universities of Gothenburg and Umeå, at the Research Institute of Industrial Economics and at the Stockholm School of Economics for helpful
comments and suggestions. Research funding from HSFR and the Swedish
Competition Authority is also gratefully acknowledged.
14
6
Appendix
Autocorrelation coe¢cients
The partial11 autocorrelation coe¢cients, ½, and their associated standard
errors are presented in Table A1 for the …rst 16 lags of the residual from the
least squares estimates for equations (8) and (9). The results show that there
is some autocorrelation mainly in the …rst two lags of the residual. However,
the autocorrelation coe¢cients rapidly decline after the two …rst lags. As the
serial correlation decline as the number of lags increases, and as the number
of time periods for each substance is quite large, least squares estimates are
still consistent and unbiased, but ine¢cient. Thus, the use of a Newey-West
(1987) covariance matrix is appropriate in order to come to terms with this
problem.
Table A1. Autocorrelation coe¢cients
Model 1
Model 2
½
s.e
½
s.e.
"t¡1
0.51 0.16
0.51
0.16
"t¡2
0.25 0.13
0.23
0.12
"t¡3
0.03 0.07
0.03
0.07
"t¡4
0.17 0.08
0.18
0.08
"t¡5 -0.03 0.04
-0.05
0.05
"t¡6 -0.03 0.03
-0.03
0.04
"t¡7 -0.06 0.04
-0.05
0.04
"t¡8
0.06 0.04
0.06
0.04
"t¡9 -0.08 0.06
-0.07
0.05
"t¡10 -0.15 0.13
-0.14
0.05
"t¡11 0.06 0.08
0.05
0.09
"t¡12 0.10 0.06
0.10
0.06
"t¡13 -0.06 0.03
-0.07
0.04
"t¡14 0.03 0.04
0.02
0.04
"t¡15 -0.03 0.03
-0.02
0.03
"t¡16 0.01 0.02
0.02
0.02
Summary statistics
In Table A2 below, means and standard deviations are presented for the
variables used in the estimation of equation (8). Note that the SIZE*DPAT
1 1 I.e.,
controlling for independent variables and other lag lengths of the residual.
15
measure has been calculated using the o¢cial SMPA statistics which report
the number of sold packages by the hundred. Although the measures are
somewhat di¤erent, in order to be comparable in any way to the average
revenue reported in Table 1 above, the …gures reported below have to be
multiplied by 100.
In addition, one can easily verify the accuracy of the mean for the reference price system dummy variable, DREF. As the reference price system was
introduced in the …rst quarter of 1993 (i.e. 12 quarters before the last observations in our data) multiplying DREF by T should give a result of 12 (except
for rounding errors). Taking Cimetidine as an example, 57 ¤ 0:21 = 11:97.
Repeating this for all substances will give the same result.
16
Table A2. Summary statistics
Substance
PRICE
Cimetedine
128.91
(62.51)
107.25
(17.91)
115.22
(24.24)
108.10
(35.42)
110.29
(27.96)
129.15
(32.06)
107.03
(22.87)
102.62
(401.60)
95.21
(19.23)
111.45
(21.95)
110.18
(22.50)
121.84
(35.99)
117.05
(17.12)
100.82
(9.26)
113.37
(17.39)
88.51
(6.26)
118.98
(28.23)
92.11
(13.51)
Sukralfate
Etacrynic acid
Atenolol
Pindolol
Azapropazone
Diklofenac
Naproxen
Piroxicam
Sulindac
Lorazepam
Oxazepam
Clomipramine
Lofepramine
Maprotiline
Miaserine
Protriptyline
Diprivefrin
SIZE
*DPAT
6784.72
(5579.12)
2026.46
(658.47)
16.56
(11.24)
4693.95
(5541.21)
621.54
(648.77)
39.39
(43.01)
3397.28
(1969.06)
4824.67
(3522.17)
507.72
(402.54)
451.13
(564.90)
507.98
(189.99)
1982.80
(988.07)
957.81
(784.70)
903.01
(712.57)
665.46
(171.11)
404.95
(118.51)
11.98
(10.10)
706.75
(335.54)
DPAT
DREF
GEN
1.00
(0.00)
1.00
(0.00)
0.71
(0.46)
0.50
(0.50)
0.55
(0.50)
0.79
(0.41)
0.84
(0.37)
0.73
(0.45)
0.63
(0.49)
0.42
(0.50)
0.95
(0.21)
1.00
(0.00)
0.85
(0.36)
0.66
(0.48)
1.00
(0.0)
1.00
(0.00)
0.65
(0.48)
0.86
(0.35)
0.21
(0.41)
0.24
(0.43)
0.13
(0.33)
0.17
(0.38)
0.14
(0.35)
0.17
(0.38)
0.21
(0.41)
0.20
(0.40)
0.29
(0.46)
0.23
(0.42)
0.19
(0.39)
0.13
(0.33)
0.13
(0.34)
0.18
(0.39)
0.16
(0.37)
0.50
(0.51)
0.13
(0.33)
0.41
(0.50)
2.79
(1.26)
0.80
(0.41)
0.00
(0.00)
1.50
1.88
0.82
(0.99)
0.00
(0.00)
0.59
(0.50)
2.40
(0.40)
0.27
(0.45)
0.00
(0.00)
0.00
(0.00)
0.74
(0.93)
0.21
(0.41)
0.00
(0.00)
0.47
(0.83)
0.54
(0.83)
0.00
(0.00)
0.52
(0.51)
17
GEN93
*DREF
0.21
(0.41)
0.24
(0.43)
0.00
(0.00)
0.17
(0.38)
0.14
(0.35)
0.00
(0.00)
0.21
(0.41)
0.20
(0.40)
0.00
(0.00)
0.00
(0.00)
0.00
(0.00)
0.13
(0.33)
0.13
(0.34)
0.00
(0.00)
0.16
(0.37)
0.00
(0.00)
0.00
(0.00)
0.41
(0.50)
T
57
49
96
72
88
72
56
60
41
53
64
96
91
65
75
24
96
29
7
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19