The anticompetitive nature of brand-name firm introduction of generics before patent expiration.
Recently, brand-name pharmaceutical companies have begun to adopt a strategy of producing a generic version of their patented brand-name drug before the expiration of the patent ("preexpiration") and to contract to supply the generic past the patent expiration date.(1) This approach is most likely a response to the growing group of large purchasers that are sensitive to price due to cost containment and other financial pressures.(2) Indeed, once brand-name name manufacturers lose patent protection for their product, virtually complete substitution from the brand-name form of the drug to the generic may occur. Thus, if the return from the drug can or is thought to be maximized by introduction of a generic form preexpiration, brand-name firms will engage in this strategy and sacrifice short-term profits for long-term gain.(3)
However, this preexpiration introduction of and contracting for generics by branch-name manufactuters may represent anticompetitive actions on the part of these manufacturers. This strategy allows brand-name firms to increase profits at the expense of generic firm competition and may deter potential generic manufacturers from entering and effectively competing in the generic drug market.
Below, several theories that may apply to the anticompetitive nature of brand-name manufacturers' actions are discussed. First, I provide a brief overview on predatory pricing and then apply these concepts to a discussion of brand-name generic introduction preexpiration. Then I discuss other economic theories (first-mover advantages, entry lags, raising rivals' costs) and their application to brand-name generics introduction. I then conclude the article and offer some potential solutions that may level the playing field between brand-name firms and potential generics manufacturers in the generic drug market.
II. Predatory pricing
The majority rule for predatory pricing is based on a standard articulated by Areeda and Turner.(4) In an idealized market consisting of n competitors with n > 1, "a firm which drives out or excludes its rivals by selling at unremunerative prices is not competing on the merits, but engaging in behavior that may properly be called predatory."(5)
Unremunerative prices are generally those at which the firm incurs a loss, i.e., the price received for the sale of the product is less than the marginal cost of making it.(6) However, recognizing the administrative difficulties in assessing marginal cost, Areeda & Turner articulate a pricing structure standard that roughly estimates the presumptive legality or illegality of a price: "(A) A price at or above reasonably anticipated average variable cost should be presumed lawful. (B) A price below reasonably anticipated average variable cost should be conclusively presumed unlawful."(7)
A basic condition for the Areeda & Turner standard to apply is that there must be some "sacrifice" in net revenues for predation to exist.(8) Hence, for predatory pricing to be rational for a firm, the potential predator must have "(1) greater financial staying power than his rivals, and (2) a very substantial prospect that the losses he incurs in the predatory campaign will be exceeded by the profits to be earned after his rivals have been destroyed."(9)
However, there may be some weaknesses associated with this standard. First, the Areeda & Turner standard may not be able to encompass markets other than the idealized manufacturing industries assumed by the authors, for example, industries with minimal marginal costs such as the computer software industry. Further, although past commentators have argued that predatory activity by firms is not rational,(10) there may be other bases for predatory behavior not encompassed by the classic theory. More recent economic analysis has in fact pointed to circumstances where predation may be rational. For example, dominant firms may predate in order to deter future competitors or to deter current competitors in, other markets where the predator sells. This conception originates from the predator wishing to show an aggressive stance against future competition. In the alternative, a dominant firm may simply have a deeper pocket than its competitors on the basis of differential access to capital. Finally, "some economic models have shown that a dominant firm may use pricing in an effort to convince (`signal') actual and potential rivals that it has lower costs (which may not actually be the case) and hence that they would be better off in some other market."(11) These commentators also argue that the goal of the predator is not necessarily the full elimination of the rival competitors from the market as is assumed in the classic predation theory. Indeed, dominant firms may gain a significant benefit "marely by convincing their rivals to act in a less competitive manner - that is, `disciplining' them. Successful discipline consists of using any of the above strategies in order to modify the response function of rivals - neither forcing them from the market nor requiring complete cooperation."(12)
Others have also indicted that the classic predator god of rival firm destruction may not represent the actual market endpoint desired by the rational predator. Predatory pricing may occur simply as a result of a dominant firm's attempts to "discourage" prospective rivals rather than any attempt to destroy them.(13) The effect of variations in pricing of the dominant firm, then, is to strategically "discourage" and "signal" fringe and current rival competitors that the dominant firm will be aggresive in its reactions within the market over time.(14) Thus, the firm's price as compared with the average variable or marginal cost is less relevant than the strategic rationale for setting price, especially if that strategic rationale is for the purpose of deterring entry.(15) Thus, the question is squarely set: Should antitrust policy allow responsive pricing of dominant firms who are faced with the possibility of entry of new competitors and evaluate such pricing simply on the basis of the Areeda & Turner test? Williamson views these "price and ouput responses of a contingent kind - now it's there, now it isn't, depending on whether an entrant has appeared or vanished - as inherently suspect."(16)
This view advocates that the fundamental predatory pricing inquiry requires an analysis of the dynamic actions of a firm, particularly if it is attempting to indicate to present and future competitors that it will act (e.g., set price) appropriately to discourage competition. This latter activity and the incentive structure created by it is then anticompetitive.
Thus, there appears to be some support for the notion that predatory pricing activities by firms may result from strategic games being played by dominant firms in an attempt to limit fringe or other rivals' price and production activities rather than to completely eliminate competition. Theoretically, price as a tool is important, but its relation to the average variable or marginal cost level (i.e., that level required to eliminate rivals, the majority standard) may be less important than the price required to provide decreased incentives for potential rivals to enter this market and/or compete. This concept will be significant in the brand-name pharmaceutical context.
B. Illustrative cases
The debate over using average variable or marginal cost pricing as the sole indicator of predatory pricing versus allowing for prices higher than this level when assessing predation has also been illustrated in the courts. The frequently cited cases on the matter are William Inglis & Sons Baking Co. v. ITT Continental Baking Co.,(17) which held that prices above average variable or marginal cost can be held to be predatory, and Barry Wright Corp. v. ITT Grinnell Corp.(18) where the First Circuit rejected the Ninth Circuit Inglis test and held that prices must be below average variable or marginal cost to be predatory.(19)
In Inglis, a family-owned bakery (Inglis) manufactured and distributed breads and rolls in northern California; it competed with a national bakery (Continental). Both sold their products under a "private" label (i.e., on behalf of a specific customer using an exclusive name held by the contractor) and an "advetised" label (i.e., a national brand name available to all retail customers).(20) The significance of the private versus advertised distinction was that private labels were typically sold locally at a lower price than advertised brands and hence at a lower profit. Inglis alleged that Continental attempted to eliminate competition and create a monopoly in the northern California market for wholesale bread by charging discriminatory and below-cost prices for its private label bread. Inglis claimed that through a strategy of predatory pricing, Continental attempted to eliminate independent local wholesalers (like Inglis) who were not as financially able to endure a price war. The trial court, after a $5 million jury verdict for the plaintiff Inglis, granted a defendant motion for judgment notwithstanding the verdict in part and a new trial. On appeal, the Ninth Circuit held, inter alia, that because the evidence raised a jury issue as to whether Continental's prices were predatory and since damages could not be assessed without a determination of liability, a new trial was required.
The Ninth Circuit took the opportunity to fully consider the requirements for a predatory monopolization or attempted monopolization claim under section 2 of the Sherman Act.(21) The court indicated that there must be "(1) specific intent to control prices or destroy competition in some part of commerce; (2) predatory or anticompetitive, conduct directed to accomplishing the unlawful purpose; and (3) a dangerous probability of success."(22)
The finding of intent is flexible and does not appear to require a smoking gun. The court indicated that "the existence of specific intent may be established not only by direct evidence of unlawful design, but by circumnstantial evidence, principally of illegal conduct.... This court has made it clear that the nature of such conduct varies with the conditions of the market and the characteristics of the defendant."(23) Further, the court quoted Posner favorably, acknowledging the reality that sophisticated participants in business will not leave a "documentary trail of improper intent."(24) Intent, however, can also be found from the conduct of the alleged monopolizer; the fundamental inquiry is what a rational actor would believe the effect of its conduct to be. The court indicated that:
[o]ur approach to proof of intent through use of conduct is to focus on what a rational firm would have expected its prices to accomplish. . . . Predatory pricing may be proved by examining the relationship between the defendant's prices and costs. But such proof must tend to show that the anticipated benefit of the prices, at the time they were set, depended on their anticipated destructive effect upon the competition and the consequent enhanced market position of the defendant.(25)
The "dangerous probability of success" requirement may be inferred "either (1) from direct evidence of specific intent plus proof of conduct directed to accomplishing the unlawful design, or (2) from evidence of conduct alone, provided the conduct is also the sort from which specific intent can be inferred."(26) The market power of the alleged monopolizer is also considered: "[plroof of market power in the defendant may be relevant in establishing the requisite unreasonable conduct. . . . Such proof may also be relevant, as some cases seem to establish, because it may serve as sufficient direct proof of dangerous probability of success."(27)
Thus conduct can be used as a signal of both improper intent and a dangerous probability of success.(28) However, conduct as an independent requirement must fall into one of two categories: "either (1) conduct forming the basis for a substantial claim of restraint of trade, or (2) conduct that is clearly threatening to competition or clearly exclusionary."(29) Generally, the court indicated that conduct of an alleged monopolizer must, in the end, be such that "its anticipated benefits were dependent upon its tendency to discipline or eliminate competition and thereby enhance the firm's long term ability to reap the benefit of monopoly power."(30) Because such conduct is not "true competition," and "it makes sense only because it eliminates competition," and since it "does not enhance the quality or attractiveness of the product, reduce its cost [of production], or alter the demand function that all competitors confront,"(31) it will be held to be anticompetitive.
Further, the court indicated its discordance with the average variable or marginal cost standard for determining predatory pricing. The court indicated that although some occasions of pricing below average variable or marginal cost could be anticompetitive, the court would not follow the Areeda & Turner standard blindly.(32) The court explicitly indicated that a price above average variable or marginal cost could be considered predatory:(33)
[a]lthough pricing below average total cost and above average variable cost is not inherently predatory, it does not follow that such prices are never predatory. Predation exists when the justification of these prices is based, not on their effectiveness in minimizing losses, but on their tendency to eliminate rivals and create a market structure enabling the seller to recoup his losses.(34) never predatory. Predation exists when the justification of these prices is based, not on their effectiveness in minimizing losses, but on thier tendency to eliminate rivals and create a market structure enabling the seller to recoup his losses.(34)
Thus, the court held that to establish predatory pricing, a plaintiff must demonstrate that the anticipated benefits of the alleged monopolizer's price depended on its tendency to discipline or eliminate competition subsequently improving the alleged monopolizer's long-term ability to "reap the benefits of monopoly power."(35)
However, as indicated above, the First Circuit has not followed Inglis and has accepted the majority rule based on the classic Areeda & Turner standard for determining predation. In Barry Wright, a purchaser (Grinnell) of mechanical snubbers attempted to develop alternative sources for its needs; the supplier of Grinnell's snubbers (Pacific) was the dominant firm in the market. Grinnell tried to assist an alternate manufacturer (Barry Wright) to produce snubbers for it. During the interim, Grinnell continued to purchase snubbers from Pacific at its standard 20% discount from list price. Pacific, noting that Grinnell was purchasing less than its anticipated requirements, offered Grinnell additional discounts to obtain more of its business. Grinnell initially did not accept the greater discounts; however, when it became clear that Barry Wright would not meet production deadlines, Grinnell purchased its snubbers from Pacific at the additional discount rate. Barry Wright ultimately failed in its attempts to enter into the snubber business and brought suit against Pacific for predatory pricing as illustrated by the additional discount rates. Although Pacific's prices were undisputedly above average variable and marginal Cost,(36) Barry Wright urged the court to adopt the Ninth Circuit test and consider the pricing schedule under that standard.
The court rejected Barry Wright's invitation. The court acknowledged that it is sometimes rational for a firm to engage in predatory pricing; the firm may do so "if it knows (1) that it can cut prices deeply enough to outlast and to drive away all competitors, and (2) that it can then raise prices high enough to recoup lost profits (and then some) before new competitors again enter the market."(37) However, the court indicated that the Ninth Circuit test should not be adopted because of the combined effect of the following considerations:
[a] price cut that ends up with a price exceeding total cost - in all likelihood a cut made by a firm with market power - is almost certainly moving price in the "right" direction (towards the level that would be set in a competitive marketplace). . . .
[paragraph] the scope of the Ninth Circuit test is vague [because it could include, for example, limit pricing and all instances of a firm not increasing, prices]. . . . [and]l
[paragraph] [it would be difficult to] distinguish in any particular case between a firm that is cutting price to "discipline" or to displace a rival and one cutting price "better to compete."(38)
Thus, the court held that the Sherman Act did not consider prices that exceeded average variable and marginal costs to be predatory.
C. Application to brand-name manufacturer preexpiration
introduction of generics
It is difficult to apply the classic Areeda & Turner standard to the practice of introducing generics preexpiration by brand-name manufacturers with supply contracts that extend past the patent expiration date. Fundamentally, the classic predatory pricing scenario requires competitive activity occurring with the number of firms in the market greater than one. In this case, at the outset there is no competition: a monopoly exists in product market (i.e., only one firm is in the "market").39 Thus, simple application of the average variable cost standard to this "market" is arguably inappropriate.
The prohibition against predation has as its rationale the prevention of a dominant firm from reducing its prices to unfairly eliminate competitors(40) and subsequently gaining a profit surplus that it otherwise would not have had but for the price reduction and competition elimination. But introduction of a generic drug preexpiration by a brand-name manufacturer would in fact allow a dominant firm to eliminate competitors and gain a surplus of profit it otherwise would not have had but for the introduction. This can occur as follows:
1. The brand-name manufacturer has reduced the price for its product: It has begun selling its brand-name product, for which it can charge monopoly prices, for generic (i.e., substantially lower) prices.
2. The price decrease is for the purpose of eliminating competitors: The introduction of generics when monopoly profits are available is an attempt by brand-name manufacturers to discourage entry or discipline potential and/or future competitors in the post-patent expiration (i.e., generic) market.
3. The action produces a surplus that the brand-name manufacturer otherwise would not have had: Fundamentally, without the introduction of a generic version by the brand-name firm, the only source of income post-patent expiration from the product would be sales of the brand-name product; but due to the much cheaper costs to purchasers associated with generic drugs, it would be expected that a certain X percentage of that market would substitute to the cheaper generic form post-patent expiration. Without a brand-name generic, the brand-name manufacturer would have no part of X; however, with a brand-name generic, the brand-name firm retains some portion of X and the profits derived therefrom. But the previous analysis assumes that there is no entry deterrence effect by generic introduction preexpiration. Relaxing this somewhat unrealistic assumption and allowing for entry deterrence, X will be further reduced (i.e., transferred to the brand-name manufacturer(41)) resulting in additional surplus not obtained without such action. In addition, importantly, if the brand-name manufacturer obtains exclusive contracts with purchasers preexpiration that apply post-patent expiration, there will be a reduction of purchaser demand in the generic drug market due to brand-name preemption of the market and thus a further reduction of X (which again is transferred to the brand-name firm).
4. Resulting prices will be higher but for the preexpiration introduction: By introducing and contracting to supply a generic form of a brand-name drug, the brand-name firm has locked-in a price for its generic product that retains effectiveness past the patent expiration date. This price will be higher than what generic manufacturers could offer (but lower than the brand-name form's price) since the brand-name manufacturer still maintains monopoly power over the drug at introduction (i.e., preexpiration); and further, because the contract price is locked-in before generic manufacturers can be allowed to compete (again, preexpiration), even if a purchaser wished to switch to the lower-priced generic manufacturer's product, it could not without breaching its contract with the brand-name manufacturer.(42)
Thus preexpiration generic introduction by brand-name manufacturers can reasonably be seen to result in increased prices for these products post-patent expiration and thus may represent anticompetitive action.
It is also rational for brand-name pharmaceutical firms to engage in such behavior. Because brand-name manufacturers have "greater financial staying power"(43) than generic manufacturers and because firms would not engage in this activity if they did not believe that they have "a very substantial prospect that the losses . . .will be exceeded by the profits,"(44) they have an incentive, assuming no prohibition, to act in this predatory fashion. Simply put, in markets where generics can easily enter, brand-name firms through preexpiration generic introduction forego short-term monopoly profits for long-term generic market power and profits. However, the policy behind prohibiting predatory behavior would seem to apply readily to these brand-name firm activities.
Similarly, other theoretical conditions provide incentives for predatory action by pharmaceutical firms in the situation at hand. Because of the substantial increase in the production of generic drugs after the Drug Price Competition and Patent Term Restoration Act,(45) brand-name pharmaceutical manufacturers have seen their market shares shrink drastically; in addition, with managed care and third-party payors increasingly sensitive to drug prices, generic drugs have been heavily favored over brand-name products. The rational action for brand-name manufacturers faced with such eroding market share post-patent expiration thus would include taking predatory actions by exploiting their strengths, i.e., preexpiration monopoly power and large capital resources.
Thus, a brand-name manufacturer may attempt to deter competitors by signaling early (i.e., preexpiration) through its own generic introduction that it will be aggressive in maintaining its market share. The introduction of brand-name generics hence creates an important factor for potential generic manufacturers to consider when determining which generic market to enter.(46) Further, this factor in combination with the "deep pocket" that brandname manufacturers are perceived to have would serve to give potential generic manufacturers the incentive to relocate their intended drug targets to markets without these high cost obstacles.(47) These factors put into substantial relief the resultant effect on competition: because of the preexpiration introduction of brand-name generics and the credible threat of brand-name protectionism backed by its superior capital resources, competition is harmed due to the flight of fringe competitors to other, non-brandname preempted markets.(48) However, if this practice is allowed to continue and many or all brand-name manufacturers utilize the preexpiration generics strategy, potential generics manufacturers may be dissuaded from entering into the market at all. Further exacerbating this problem would be the reduction in the market for the generic product due to brand-name manufacturer contracts preexpiration whose term lasts past the patent expiration date. Because generic manufacturers will perceive that the initial market for their product is substantially reduced (i.e., locked-up by brand-name firm contracts), and under typical conditions of smaller, less stable generic manufacturer capital resources, the resulting market may simply not be large enough for generic manufacturers to rationally enter into and effectively compete; thus they will be further deterred from entering into a drug market where there is a brand-name generic.
In terms of the relevant case law, application to the pharmaceutical situation also suffers from a lack of baseline competition. However, the general policy principles of Inglis and Barry Wright are consistent with the contention that the brand-name manufacturers are engaging in predatory activities.
Recall that in Inglis, conduct is the keystone to a predatory monopolization or attempted monopolization claim. Intent focuses on what a "rational firm would have expected its prices to accomplish . . . the anticipated benefit of the prices at the time they were set . . . their destructive effect upon the competition and the [alleged predator's] consequent enhanced market position. . . ."(49) Brand-name manufacturers as rational actors surely would not lower their prices during a monopolistic position without some expected future benefit. It is likely that the brand-name manufacturers act rationally and lower their price through the production of generics so as to maintain their market share ;nd deter future competitors.(50) Clearly the anticipated benefit would be to foreclose competition: by contracting to supply their product postpatent expiration, the brand-name manufacturer locks in both price and demand for the product.(51) This results in the "destructive effect" of reduced generic drug competition post-patent expiration and higher prices (and greater profits) received by the brand-name firm.(52)
Similarly, these brand-name manufacturers have a quite dangerous probability of success.(53) Because of their dominance in the market preexpiration (both in terms of their monopoly power and their large capital resources as compared with future potential generic drug manufacturers), the brand-name manufacturers have ample ability to design a strategy that signals potential competitors of their intention to protect their chosen share of the generic product market. Further, because the actions of the brand-name firms (e.g., introducing generics, setting/changing its pricing structure, and forming exclusive contractual agreements structured to their needs) all can occur before the generic manufacturers have the right to enter into the market, the brand-name firm strategy and its intended effects may already be fully implemented by the time generic manufacturers can attempt to react in the market. Thus, generic manufacturers with this information would have a rational incentive to aim for other markets precisely fulfilling the competitive reduction goal of the predator's strategy.
The brand-name manufacturer's conduct also appears to be "clearly threatening to competition or clearly exclusionary."(54) Again, as noted above, the brand-name firm's preexpiration conduct attempts to eliminate or reduce competition through a reduction in product price. It excludes competitors and raises prices by contracting past the patent's expiration date. The foregone monopoly profits are for the purpose of deterring competitors from entering into the market; it is rational for the firm to engage in this behavior because the firm will obtain surplus profits in excess of what they would have had but for the preexpiration predatory activities. Certainly, the conduct of the brand-name manufacturers "does not enhance the quality or attractiveness of the product, reduce its cost [of production], or alter the demand function that all competitors confront."(55) Finally, because Inglis does not have a bright line requirement regarding average variable or marginal cost and the focus of the inquiry is if "the justification of these prices is based . . . on their tendency to eliminate rivals and create a market structure enabling the seller to recoup his losses"(56) brand-name manufacturers who introduce generics and contract for their provision post-patent expiration appear to be engaging in predatory, and hence anticompetitive, activity.
Barry Wright, following the Areeda & Turner standard, has similar difficulties in application as indicated in the theoretical discussion of the Areeda & Tuner standard above due to the lack of competition (i.e., n = 1).(57) The rationale analysis for the Areeda & Turner standard may be applicable; but brand-name manufacturers would not likely be considered acting predatorily if the average variable or marginal cost pricing standard is rigidly adhered to since it would be expected that their generic product price would be above this amount. However, note that the standard of average variable or marginal cost in the classic predation case is based upon the "unremunerativeness" of pricing below such levels; rational actors will only price at below such levels (i.e., they will only "invest"(58) these funds) in expectation of future returns due to a reduction of future competition. In addition, in a mature, inelastic market, marginal cost represents the price at which maximum profit is obtained; thus setting price below marginal cost raises suspicion because it decreases the firm's profits.(59) Similarly, in the brand-name generics case, in a monopoly market maximum profit is gained at monopoly prices; rational firms will only price below this level (again "investing" these funds) in expectation of future returns as a result of a reduction of future competition. Thus, brand-name firm pricing below monopoly prices preexpiration should also raise suspicions regarding underlying firm rationales.
The practice of brand-name manufacturers introducing their own generic forms preexpiration can be seen to be economically predatory. Because of the unique nature of the monopolistic status of the brand-name firm, rigid application of classic predatory theory is inappropriate. However, the rationales for predation as well as more recent economic assertions that predation is rational under certain circumstances indicate that brand-name firms are engaging in, and have the incentive to engage in, predatory pricing. The Ninth Circuit test also appears to indicate that brandname firms are acting predatorily. However, the First Circuit test, i.e., the Areeda & Turner standard, may be less supportive. But because of the monopoly status of the brand-name manufacturer, the policy behind the Areeda & Turner standard may indicate that since these firms are sacrificing (monopoly) profits, their actions should raise suspicions regarding their competitive strategies and may in fact support the contention that these firms are acting predatorily.
III. Other economic theories
A. First-mover advantages
A first-mover advantage is a competitive advantage realized by a firm due to lead time in introducing its product before others.(60) Classically, the first mover, by beating competitors to market, enjoys a period of monopoly not legally protected but nevertheless valuable.(61) A key first-mover advantage is the ability of the first mover to make binding commitments to adversely affect the potential profitability of competitors.(62)
Brand-name drug manufacturers have been seen to fit neatly within a first-mover advantage analysis. In the pharmaceutical industry, "first movers have natural product differentiation advantages that permit them to charge high prices and retain substantial market shares."(63) However, first-mover advantages also accrue when generics are allowed to enter the market. It has been empirically shown that in cases where the brand-name manufacturer does not introduce a generic form of its drug, generic manufacturers who enter first obtain large shares of that drug market; indeed, "[a]n examination of the market leaders in our sample [of generics manufacturers] indicates that for virtually all products, the market leader is an early entrant."(64)
Applying these concepts to the situation where a brand-name manufacturer introduces a generic form of its product preexpiration and contracts to supply the product past the patent expiration date, it is clear that the innovation evidenced by the patent would give the firm a well-earned first-mover advantage during the patent period for the brand-name drug. Because the brand-name manufacturer was the first to "win" the competition for innovation in the specified drug market, the firm was "rewarded" with exclusive patent protection over the product, antitrust considerations notwithstanding.
However, when the brand-name manufacturer introduces a generic preexpiration, it not only exhibits a first-mover advantage in the generic market:(65) it also exhibits an "only-mover advantage" there. Because generics manufacturers cannot compete during the brand-name generic introduction and thus cannot obtain or even vie for a first-mover advantage themselves, it is unlikely when considering the empirical evidence on generic entry that they will ever have an opportunity to become the market leader or obtain significant market share. Thus, if the brand-name firm has a monopoly (and thus the first-mover advantage) in a brand-name drug market, when that firm credibly commits itself to a generic introduction strategy such that it obtains the first- (and only-) mover advantage, given that effective entry by a potential generic manufacturer is less profitable for "late" entrants as indicated by empirical data, then these potential entrants considering entry into that market would, after observation of the firm's selected and committed-to strategy, rationally choose not to enter.(66) The result is a significant reduction in competition due to the brand-name manufacturer's only-mover advantage in the generic drug market when it introduces its generic preexpiration.
B. Entry lags
Entry lags have been defined as "the period between the time when a monopolistic price increase is implemented and the time when profitable price constraining entry has been completed."(67) Entry lags into markets are significant when considering competition because they may "allow established firms to profitably raise prices above competitive levels for a substantial period of time before entry forces prices back to competitive levels."(68) Thus, there will be a transfer of surplus from consumers to producers during the lag period before effective competitor entry.
Entry lags apply to the brand-name firms introducing generics preexpiration and contracting for their supply at this time but having the contractual term extend past the patent expiration date. When brand-name manufacturers sell generics at some price greater than marginal cost and contract with purchasers past the patent expiration date, these firms will be transferring wealth away from consumers during the post-patent expiration period (recall, they have full rights to all surplus preexpiration) until effective generic manufacturer entry and product competition dissipates the lag created by (1) the first- (only-) mover advantage and (2) the contracting period that the brand-name firm has locked in preexpiration with purchasers. However, this conclusion assumes that there will be sufficient incentives to induce generic manufacturer entry and an opportunity to compete on price. In fact, there are strong incentives for a potential generics competitor to steer clear from the market with the brand-name supplier of generic goods as discussed previously;(69) further, because the price has been locked in preexpiration by the brand-name firm, only through breach can the purchaser substitute from the brand-name generic to the generic manufacturer product.(70) Each of these factors results in a further reduction in competition. Thus, the unilateral creation of an entry lag by brand-name manufacturer generic Introduction preexpiration can significantly reduce future competition in the generic drug market.
In addition, an economist with the Federal Trade Commission's Bureau of Economics has identified three circumstances when entry lags may be anticompetitive by deterring entry due to asymmetries between monopolistic firms and potential entrants. They are:
(1) when entry lags increase over time and entry costs per unit of time do not change, today's potential entrant may face higher costs than incumbents faced when they entered;
(2) when entry lags are long and sunk costs are a function of the length of the entry period, entrants may face sizable sunk costs that can deter entry, and
(3) when entry lags are long and cannot be shortened cost effectively, Incumbents may have credible strategic responses that can deter entry.(71)
When entry lags increase over time, this may represent a barrier to entry since the potential competitor may experience costs that the initial monopolist did not.(72) This can be seen as an "entry fee," that the potential competitor "must pay, but that established firms did not have to pay.(73) However, this increase in costs alone may not be anticompetitive if market conditions require additional investments to produce a product similar to that of the monopolist. But when the monopolist itself creates that extra cost to be borne by potential competitors to obtain market share, there is significant concern of anticompetitive conduct. In the case at hand, when the brand-name firm introduces a generic and contracts for supplying it past the patent expiration date, it has created costs for potential competitors in the generic market. Because these costs must be made up in some fashion, it is most likely that the generic manufacturer would need to increase the relative price of its product to recoup this entry fee. With this in mind, the generic manufacturer can either exit the market (or never enter it), reducing competition in that fashion, or it can attempt to remain in the market but charge the higher price due to the entry fee, also an undesirable competitive result. Thus, the ability of the brand-name manufacturer to contract past the date of patent expiration can be seen to be anticompetitive from an entry lag perspective.
Similarly, in this situation there is a potential for deterrence of entry due to a relatively high minimum efficient scale with respect to market demand.(74) Again, because of the brand-name firm's contracting for supplying purchasers post-patent expiration, the costs associated with attempted entry will be large relative to the smaller market demand for the generic product. Furthermore, in addition to costs created by the brand-name firm, the sunk costs In capital equipment, preparations for and actual Food and Drug Administration inspections, personnel, etc., add to the tally of entry costs for a potentially preempted market. Because of the cumulation of these significant costs relative to a reduced demand, a generic manufacturer may rationally choose not to enter into the brand-name manufacturer market, however, if many or all manufacturers adopt this strategy, as indicated previously, there may be very little incentive to access the generic market at all.
In addition, recall that when longer entry lags indicate large sunk costs, these entry lags may enable established firms to adopt strategies that cause entrants to alter their entry strategies, perhaps leading to exit or to entry into a different market niche that is less threatening to the incumbents' profitability."(75) This also applies to the situation at hand. Because a brand-name manufacturer can define the entry lag by its timing of the introduction of its generic as many months (or years) preexpiration it wishes, it has significant control over whether the generic manufacturer will enter into the particular market or change to another where it will not directly compete with the brand-name firm. Indeed, it would seem that control over this timing element of preexpiration generic Introduction can itself define whether a generic firm will have the incentive to compete in the particular brand-name market.(76)
Thus the presence of brand-name firm-defined entry lags appears to indicate that the market is not "self-policing" (77) from a competition point of view. Brand-name firms can increase their profit surplus by transferring wealth away from consumers when they contract preexpiration to supply their generic product past the patent expiration date. Further, brand-name firm actions can give potential generic manufacturer competitors the strong incentive not to enter into the market through creating costs for these potential entrants and raising the minimum efficient work scale relative to market demand. Finally, control of entry lag time by brand-name firms can significantly alter potential entrants strategies and incentives that may lead to exit from the market or the decision not to enter at all.
C. Raising rivals' costs
The concept of raising rivals, cost (RRC) is based upon a model of antitrust that "prohibits exclusion among competitors or exclusion of rivals where such conduct enables a firm profitably to raise or maintain price above the competitive level."(78) Note that a firm that utilizes a strategy of RRC may obtain greater returns cf. a classic predatory pricing approach. This occurs because the RRC predator as an initial condition does not need to incur short-term losses. By raising its competitor's prices while minimizing any cost increases to itself, the RRC predator can force the competitor's price above market (or above the predator's own).(79) Further, an RRC strategy can be successful even if the competitors do not exit the market. Economic theory predicts that as a firm's marginal costs increase, it will respond by decreasing output. If an RRC predator Increases the costs to all its competitors, the relative decrease in output by these competitors will decrease supply. At that point the RRC predator can either maintain output but increase its profit due to the increased price or expand output partially or fully to make up for competitor decreased output and thus further increase market share.(80) Note further that the RRC predator need not possess market power (i.e., being able to raise market price by restricting its own output), instead, the focus is on forcing competitors to decrease their output.(81)
In terms of brand-name introduction of generics, there are certain basic characteristics of the generic drug market that are required to make an RRC predator strategy potentially profitable. If the generic drug market in question has the following characteristics:
"1. the brand-name firm has the ability to raise some of its rivals' costs in a manner that raises the cost of the marginal industry production;
"2. a sufficiently inelastic market demand for the product; and
"3. a sufficiently small increase in the brand-name firm's average costs as a result of the cost-raising action;"
then RRC can be profitable for the brand-name firm.(82) These characteristics would appear to apply to the generic drug market. First, the brand-name firm has the ability to raise the cost of industry marginal production. By contracting preexpiration, the brand-name firm has increased the cost for all potential generic manufacturers in obtaining demand for their product through preexpiration contracting thus raising the costs for those wishing to enter the generic market post-patent expiration. Second, it appears also that there is inelastic demand in this market, indeed, because of the substitution effects and high level of price competition within the generic drug market, there has been significant entry and competition between generic drug manufacturers as well as brand-name firms (through the latter's use of the preexpiration Introduction strategy). Finally, there may be little if any increase in the brand-name firm's average costs as a result of the cost-raising action. Because the contracts are with purchasers who have already dealt with the brand-name firm and these purchasers represent most of the purchasers generally because of the firm's exclusive rights over the product preexpiration,(83) contracting past the patent expiration date would be relatively simple and involve very small costs as compared with generic manufacturer costs in attempting to secure purchasers around these contracts without any preexisting relationship.
The baseline market conditions thus allow the RRC strategy to be readily applied to the generic drug market under consideration. When the brand-name manufacturer during the preexpiration period contracts with purchasers to buy brand-name generics postpatent expiration, the brand-name firms have raised the potential generic manufacturers' costs of entry and hence have hampered their ability to sell to the generic drug market. Since the potential generic manufacturer must overcome the cost of previous brandname contracting that extends past the patent term, this gives these fringe competitors the incentive either not to enter into this market or to limit their output due to the brand-name firm's preexpiration lock-up of demand. Both of these results raise prices and lower effective competition.
An important consequence of this scheme is that the brand-name firm's output does not fall as a result of the increased costs of the generic manufacturers. The brand-name firm, if it was producing at capacity preexpiration, continues to produce at capacity. But because. the generic firms either do not enter or enter producing a lower output, the brand-name firm increases its relative post-patent expiration market share without having to recoup borne costs under a classic predatory scenario.
In addition, the increase in costs to the generic manufacturer increases the brand-name manufacturer's inframarginal rents in the generic drug market.(84) Because the brand-name firm's profit is a function of the difference between market price and its average costs, any producer whose average costs stay the same while the relative market price increases will obtain an increase in profits from that increase in price. Thus, in this situation, the brand-name firm has two sources of excess surplus. First, the brand-name firm gains surplus from lock-up of demand preexpiration: the price of the product to purchasers preexpiration would be expected to be above marginal cost due to the brand-name firm's monopolistic position, by contracting preexpiration for sale of the product post-patent expiration, the cost to these purchasers post-patent expiration will still be above marginal cost and therefore the brand-name firm gains a post-patent expiration surplus. But further, the cost to potential competitors of obtaining purchasers is also raised, forcing their marginal costs and thus their prices higher. Thus, the brand-name firm gains additional surplus from this market via a relative increase in price while their costs remain constant. Hence the brand-name firm under these conditions gains an increase in inframarginal rents.(85) In comparison, without these RRC actions, post-patent expiration, without any increase in generic manufacturer's costs and a level playing field on which all generic drug manufacturers (including the brand-name firm) begin competition together (i.e., no preexpiration contracting), the relative price at equilibrium would be expected to be the marginal cost of drug production. Thus, RRC predation serves to make the price of the generic drug higher than it would have been postpatent expiration without predatory actions by the brand-name firm, and thus serves to increase inframarginal rents accrued to the brand-name firm in the generic drug market.(86)
The RRC strategy appears to allow brand-name manufacturers to decrease competition within the generic drug market through preexpiration contracting that lasts past the patent expiration date. Not only does this strategy give potential market entrants a decreased incentive to enter into the market, it potentially allows brand-name firms to increase their market share, increase price relative to the marginal cost of generic drug production,(87) and increase surplus through an increase in inframarginal rents, all at the expense of generic firm competition.
IV. Summary and concluding comments
Brand-name firm introduction of generic forms of their drug and contracting terms that supply this generic version past the date of patent expiration may have significant anticompetitive effects. It first appears that engaging in some form of predatory pricing is rational for the brand-name firm. The price-sensitive market for drugs continues to increase over whatever "price-insensitive" market there existed before the universal focus on cost-containment.(88) As well, economic justifications of predation that do not require complete elimination of brand-name rivals also support the rationality of engaging in predation and bring into question the validity of a bright line pricing level. Further, the common average variable or marginal cost standard articulated by Areeda & Turner, although the majority standard, may be less applicable to this case because of the preexpiration exclusivity rights of the brand-name firm. However, the policy behind the standard may Indicate that brand-name firms are acting anticompetitively. Particularly, since the brand-name "investment" preexpiration results in (1) incentives for potential generic competitors not to enter the brand-name generic market., (2) prices that remain greater than marginal cost post-patent expiration; and (3) brand-name surplus gained at the expense of generic firm competition, there is a significant argument that the brand-name manufacturer is behaving predatorily.
Similarly, direct application of the case law is problematic because of the lack of initial competition in the brand-name drug market. However, Inglis, which does not have a bright line average variable or marginal cost cutoff, would seem to support the contention that brand-name firms are acting predatorily. Barry Wright, well within the traditional average variable or marginal cost standard, may not support the idea of brand-name firm predation on a cost basis. However, the policy of the rule indicates that there should be suspicions raised regarding the nature of the brand-name firm's actions.
Other theories also support the anticompetitiveness of the brand-name firm practice. Although first-mover advantages are reasonable as a compensation for innovation, only-mover advantages that extend past the legislatively mandated endpoint protect a competitor in a market never intended by the legislative mandate. The generic market should be free from advantages intended for the brand-name market. Further, entry lags under the control of brand-name firms could also be used to the detriment of potential generics manufacturers, giving them an incentive to exit or never enter into the brand-name drug generic market. Because the generic firm will necessarily need to overcome both only-mover advantages and preexpiration contracts made by brand-name firms that extend post-patent expiration, the brand-name firm controls costs that are to be borne by generic firms. By wielding this power to raise potential entrants' costs, the brand-name firm is attempting to limit competition. Further, the generic prices charged will remain at the level dictated by the brand-name firm preexpiration; generic firms have no ability to compete with these prices because they have no right to bid for the business at the time of the contract. Thus prices remain relatively high post-patent expiration and surplus is transferred away from the consumer to the brand-name manufacturer compared with a situation where all generics manufacturers were to compete in the same market under the same starting conditions.
Finally, the RRC anticompetitive strategy provides another description of the brand-name firm's activities. Through preexpiration contracting and the timing thereof, the brand-name firm can significantly induce a potential generics manufacturing firm to either relocate its efforts into other markets, exit the generics manufacturing market generally, or reduce output. These results can be accomplished with little or no short-term loss as would be required in the classic predation theory. Successful adoption of the RRC strategy by brand-name firms leads to market share increases, price increases relative to marginal cost, and infra-marginal rent increases.
Potential solutions to this problem necessarily require some leveling of the playing field in the generic drug market. One solution could be to require licensing of the brand-name product to generic firms preexpiration if the brand-name manufacturer began production arid sale of a generic form of the drug. This would provide the advantage of bringing lower prices for the drug (theoretically approaching marginal cost) during the patent period. However, significant administrative concerns need to be addressed. One major concern would be the terms under which the the brand-name firm would license the product to the generic manufacturer. Royalties could be used, but there are significant monitoring costs associated with this arrangement. Lump-sum payments could be required; but generic firms undergoing manufacturing start up would be expected to have minimal excess capital available for this purpose. Further, brand-name firms would most likely object to a forced licensing arrangement because of the loss of exclusivity rights based on the patent.(90) Thus, although possible, licensing of the patented drug may present insurmountable transactions costs that would need to be recouped in the market leading to potentially higher prices and efficiency losses.
Another possibility is to require all brand-name generics contracts to end on the date of patent expiration. This would allow brand-name firms to maintain their exclusivity rights and profits during the patent term but also allow all generics manufacturing firms to begin their competitive efforts at a similar time. Thus, if a brand-name firm wished to reduce price through introduction of a generic, the consumer would obtain the benefit of the lower price preexpiration as under the current regime. Certainly, this activity would lead some preexpiration purchasers to continue buying from the brand-name firm post-patent expiration. But it would not preclude other generics manufacturers from entering and competing for purchaser business after the patent expiration date and would substantially reduce the RRC effect of preexpiration contracts. This would also prevent any implied threats of decreased supply preexpiration due to the brand-name firm's monopoly position at the contracting time.(91) Of course, there are administrative concerns here as well, for example, how can the contracting activities of the brand-name firm and its purchasers be monitored so that no preexpiration contracting extends past the patent expiration date? However, because generics firms themselves will have an incentive to monitor potential purchasers and the brand-name firm, and the test is a bright line one, there may be greater potential for this solution than one that relies on some determination of an equitable licensing agreement and encroachment on a constitutionally mandated exclusivity right.
Although this work covers some of the major economic theories applicable to brand-name manufacturer behavior in the generics market, this by no means excludes more colorful applications of legal doctrine that may be fruitful.(92) However, regardless of what legal theory is utilized, it would appear that there needs to be some adjustment of the incentive structure in the generic drug market so that the generics industry is not overcome by brandname firms on the basis of their use of patent protection to leverage post-patent expiration markets and thus preclude competition.
Overall, after the term of the patent is complete, level competition on the basis of product price, quality, and service should be the rule in the generic drug market. Otherwise, we jeopardize the societal benefits that result from innovative firms entering the market under the belief that they have an equal chance of winning at the competitive game.
(1) See Catherine Yang, The Drugmakers Versus the Trustbusters, Business Week, Sept. 5, 1994, at 67 (noting that Upjohn, Syntex, Ciba-Geigy, and Bristol Myers-Squibb have adopted this brand-name generics strate). (2) See, e.g., D. Green, Drug Groups Fear Falls from the top Financial Times, Apr. 6, 1995, at 23 (indicating that price competition and patent expiration are driving mnufacturers' margins down); T.M. Burton & S.D. Moore, Hoechst in Talks to Acquire All of Marion for $7.1 Billion, Wall St. J., Mar. 1, 1995, at A3 (indicating that HMOs and other price-conscious purchasers are dominating the U.S. market and that brand-name firms must grow to reduce costs to compete in face of demands for large price discounts as well as use strategies such as specialized managed care sales forces); S.D. Moore & E. Tanouye, Innovation Fails to Shield Glaxo in HMO World, Wall ST. J., Jan. 25, 1995, at B 1 (outlining how price discounts have reduced sales of the brand-name drug Zantac due to large discount buyers and generic competition); T.M. Burton, Marion Merrell, Already on the Block, Is Good Bet to Be Next Drug Maker to Go, Wall St. J., Jan. 24, 1995, at A6 (indicating the general trend of HMOs and hospital chain mergers creating giant purchasers of health care resulting in drug firms attempting consolidation as a response); G. Anders, Rx for Sales: Managed Health Care Jeopardizes Outlook for Drug 'Detailers', Wall St. J., Sept 10, 1993, at A1 (noting that sales forces for brand-name firms are being reduced as a cost-cutting strategy in the face of large purchaser demand for discounts). See also S.D. Moore, Glaxo Posts Strong Earnings, Unveils Plan for U.S. Venture, Wam St. J. Eur., Feb. 13, 1994, at 5, where health maintenance organizations are reported to be discussing paying drug companies on a capitated basis to shift the risk of increased cost from the buyers to the sellers of pharmaceuticals. The brand-name firm introduction of generics is consistent with other strategies aimed at positioning these fams to be players in the price-sensitive public and private markets. For example, SmithKline Beecham, Merck, and Eli Lilly have all spent billions of dollars in acquiring pharmaceutical benefits firms for the purpose of directly marketing to large public and private cost@sensitive purchasers. See T. Jackson & D. Green, SmithKline Pays $2.3 Billion for U.S. Drug Wholesaler, Financial Times, May 4, 1994, at 1; Merck's 6 billion acquisition of Medco Containment Services will buy close contact with pharmaceutical plans serving 33 million lives, Health News Daily, July 29, 1993, at 1; T.M. Burton & E. Tanouye, Eli Lilly to Buy McKesson Unit for $4 Billion, Managed Care Wk., July 18, 1994, at 1. These acquisitions have resulted in 80%-90% of the actively managed drug benefit market with these three drug manufacturers. See Bryan L. Walser, Pharmaceutical Cost Containment and Quality Assurance. Trends in Out-patient Utilization Review Programs and Pharmaceutical Benefits Management 78a (1994). Other companies have taken creative steps to maintain use of brand-name pharmaccuticals. Roche has begun a partnership with Henry Ford Health System (HFMS) (a vertically-integrated managed care system) that commits HFHS to identify, utilizing a drug-utilization review system, those physicians who inappropriately utilize the brand-name drug Rocephin twice daily versus the appropriate, cost-effective use of once daily administration. In exchange, Roche will then target these physicians and attempt to change their practice behavior so that they utilize the drug only once daily. Under this arrangement, Roche will be liable for much of the excess costs generated by inappropriate Rocephin use; however, according to HFHS, the partnership has the potential to lead to more appropriate Rocephin use, an increase in sales for Roche, and possible cost savings for HFHS. See Walser, supra, at 81. (3) Firms will have rational basis for this strategy. This can be shown schematically as follows; given the following:
[Graphical Data Omitted]
The area ABDO represents the profit over time, that, will be obtained by the brand-name firm during the patent protection period. When the patent expires (Patent Expiration in the figure), profits drop drastically; schematically they are represented here to be a step function that reduces to zero. However, if the firm introduces a generic form of its drug prepatent expiration (Generic Introduction in the figure), then the firm's profits over time will be represented as AWXZO. Thus, if WBCX is estimated to be less than CDZ, then firms will wish to introduce generic forms of their brand-name drug prepatent expiration. (4) 3 P. Areeda & D. Turner, Antitrust Law [sub-sections] 710-722 (1978). (5) Id. at 150. (6) Note that this price level could be considered anticompetitive even if the seller would incur greater losses if it charged a higher price or if it stopped production. Id. (7) Id. at 153-54. (8) Id. at 151. (9) Id. (10) See John McGee, Predatory Price Cutting: The Standard Oil (N.J.) Case, 1 J.L. & Econ. 137 (1958) (arguing that a larger firm engaged in attemptcd predation will incur losses proportionally larger than its target, that in order to benefit from predation a firm must enjoy entry barriers post-predation, and that without these barriers a fim can never earn above-competitive profits to make up for previous losses, together make predatory action not rational). (11) The Antitrust Revolution 151 (John E. Kwoka, Jr. & Lawrence J. White, eds., 2d ed. 1994). (12) Id. at 152. (13) Oliver E. Williamson, Predatory Pricing: A Strategic and Welfare Analysis, 87 Yale L.J. 284 (1977) ("Predatory pricing . . . may be directed less at destroying extant rivals than at discouraging prospective rivals."). Id. at 287. (14) Indeed, if a dominant firm can respond aggressively to a threat of entry, it can signal that "it intends to react vigorously to entry in later time periods or different geographic regions, [and thus] discounted future gains may more than offset sacrifices of current profit. Signaling . . . is plainly strategic behavior [whose effects are dynamic]. Areeda and Turner nevertheless model the predatory pricing issue mainly in static terms." Id. (footnote omitted). (15) Id. at 290. ("Marginal cost pricing . . . [and] temporary price cuts to marginal cost levels may be warranted by business exigencies other than strategic responses to entry . . . . Both of these practices, however, must be distinguished from the temporary cutting of prices to marginal cost levels for the strategic purpose of deterring entry.") Id. (16) Id. at 291-92. (17) William Inglis & Sons Baking Co. v. ITT Continental Baking Co., 668 F.2d 1014 (9th Cir. 1981), cert. denied, 459 U.S. 825 (1982). (18) Barry Wright Corp. v. ITT Grinnell Corp., 724 F.2d 227 (1st Cir. 1983). (19) Many circuit courts have addressed these issues. See, e.g., Langenderfer v. Johnson Co., 729 F.2d 1050 (6th Cir. 1984) (following Inglis test); Transamerica Computer Co. v. I.B.M. Corp., 698 F.2d 1377 (9th Cir. 1983) (extending Inglis and holding that pricing above average total costs may be deemed predatory upon clear and convincing proof of predatory intent); D&S Redi-Mix v. Sierra Redi-Mix, 692 F.2d 1245 (9th Cir. 1982) (accepting the Inglis standard and rejecting the "simple Areeda & Turner formula"). Id. at 1247. See also McGahee v. Northern Propane Gas, 858 F.2d 1487 (11th Cir. 1988), (accepting the majority Areeda & Turner predatory pricing model as in Barry Wright); Henry v. Chloride, 809 F.2d 1334 (8th Cir. 1987) (concurring with the Barry Wright standard but maintaining the possibility of utilizing the Inglis standard as to who bears the burden of proof); Northeastern Telephone Co. v. AT&T, 651 F.2d 76 (2d Cir. 1981) cert. denied, 455 U.S. 943 (1982) (adhering to the Areeda S. Turner standard and holding prices above average variable cost conclusively legitimate and those below conclusively predatory). The Federal Trade Commission apparently adheres to the Areeda & Turner standard; see International Telephone & Tele graph Corp., 3 Trade Reg. Rep. (CCH) [paragraph] 22,188 (July 25, 1984). (20) 668 F.2d at 1024. (21) 15 U.C.A. [sections] 2. (22) 668 F.2d at 1027. (23) Id. (24) "A firm of executiyes sensitized to antitrust problems will not leave any documentary trail of improper intent. . . . Any doctrine that relies upon proof of intent is going to be applied erratically at best." Id. at 1028, n.6 (quoting R. Posner, Antitrust Law - An Economic Perspective 189 - 90 (1976)). (25) Id. at 1034 (citations omitted). (26) Id. at 1029 (citations omitted). (27) Id. (28) "[T]he first element [of a monopolization claim], specific intent to control prices or exclude competition, may be inferred from certain types of conduct. The third element, dangerous probability of success, also is often dependent on proof of conduct." Id. at 1030. (29) Id. at 1029 n.11. (30) Id. at 1030. (31) Id. (32) "The [Areeda & Turner standard] has its critics to whom the creators have responded and even revised some portions of their theory. Courts that have adopted the Areeda-Turner test have not done so unqualifiedly. We are no exception." Id. at 1032. (33)"`[W]e do not foreclose the possibility that a monopolist who reduces prices to some point above marginal or average variable costs might still be held to have engaged in a predatory act because of other aspects of its conduct.'" Id. at 1033 (quoting California Computer Products, Inc. v. IBM Corp., 613 F.2d 727, 743 (9th Cir. 1979) (citations omitted)). (34) Id. at 1035. (35) Id. The court also indicated that although there was no explicit requirement for the alleged monopolizer to price below average or marginal cost, pricing should play a role in the burden of proof: "If the defendant's prices were below average total costs but above average variable cost, the plaintiff bears the burden of showing defendant's price was predatory. If, however, the plaintiff proves that the defendant's prices were below average variable cost, the plaintiff has established a prima facie case of predatory pricing and the burden shifts to the defendant to prove that the prices were justified. . . ." Id. at 1035-36. (36) "Here we have a price that exceeds both 'average cost' and 'incremental cost' - that exceeds cost however plausibly measured." 724 F.2d at 233. (37) Id. at 236. (38) Id. at 234. (39) Note also that the monopoly that exists currently is a constitutionally mandated one. See U.S. Const., art. 1, [subsections] 8, cl. 8, "The Congress shall have Power. . .To promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries."), not one as a result of illegal activity nor one resulting from superior business acumen, either of the latter two at least a possible result of previous competition. (40) That is, not on the basis of product quality, efficiency, business acumen, etc. (41) This transfer will be on two levels; first, the absolute magnitude of X will be decreased and transferred to the brand-name manufacturer; as well, the relative proportion of X will be higher for the brand-name manufacturer. (42) Here I am assuming that breach is not rational. However, even if it were rational, the "competition" between brand-name generics and generic manufacturer generics would not be on the basis of quality, lower cost, business acumen, or other recognized competitive bases. Further, the breaching purchaser would necessarily need to recoup damage payments in the market thus increasing prices to consumers. (43) See supra note 9 and accompanying text. (44) Id. (45) See Henry G. Grabowski & John M. Vernon, Brand Loyalty, Entry, and Price Competition in Pharmaceuticals After the 1984 Drug Act, 35 J. L. & Econ. 331 (1992) (Act reduced clinical testing costs significantly for generic manufacturers leading to large increases in generic firm entry). The Act itself is P.L. 98-417, 98 Stat. 1585 (1984). (46) That is, "they would be better off in some other market." Supra note 11. (47) But even outside of deterring potential competitors from entering its market, brand-name manufacturers may only be attempting to "discipline" generic manufacturers. By introducing generic forms of brand-name drugs, brand-name manufacturers can alter the generic manufacturer's response curve so as to not expand production to the level at which they previously would have but for the brand-name introduction. Thus, the overall market output would be lower and thus the price higher than otherwise would have been the case. (48) Supra note 11. (49) 668 F.2d at 1034 (citations omitted). (50) See, e.g., supra sections II.A., II.C. discussing the brand-name manufacturer's rational incentive to predate. (51) Fifty percent has been noted to be a potentially significant level of demand to be locked in. See 724 F.2d at 237. (52) See, e.g., supra section II.C. discussing resulting increased prices from brand-name manufacturer's contracting preexpiration past the patent expiration date. (53) Recall that "market power in the defendant may be relevant in establishing the requisite unreasonable conduct. . .because it may serve as sufficient direct proof of dangerous probability of success." Supra note 26. (54) 668 F.2d at 1029 n. 11; see also 724 F.2d at 237. (55) 668 F.2d at 1030. (56) Id. at 1035. (57) See supra section II.C. (58) "The central feature of the entry deterring strategy is that the industry invests now in some form of capital, and that investment reduces the prospects of a potential entrant and hence the probability of entry. The investment can be plant and equipment and the capital capacity. A. Michael Spence, Entry, Capacity, Investment and Oligopolistic Pricing, 8 Bell J. Econ. 534 (1977). The preexpiration contract can be added as a similar t e of investment. (59) Above this level, price-sensitive purchasers go to other sellers and below this level, cost is not recovered for the sold product. (60) See Oliver Williamson, Markets and Hierarchies: Analysis and Antitrust Implications 216 (1975). (61) Alone, the prospect of being first to market can provide incentives for innovation apart from any ability to patent. See, e.g., Ralph S. Brown, Design Protection: An Overview, 34 UCLA L. Rev. 1341 (1987) (discussing the creation of industrial and furniture designs for which exclusive protections are usually unavailable). (62) See S. Salop, Strategic Entry Deterrence, 69 Am. Econ. Rev. Papers & Proc. 335 (1979). (63) F.M. Scherer & David Ross, Industrial Market Structure and Economic Performance 592 (3d ed. 1990). (64) Grabowski & Vernon, supra note 45, at 346 (citations omitted). (65) As opposed to the brand-name market, where it has earned firstmover advantage and been rewarded by the patent for the brand-name drug. (66) See Richard J. Gilbert & David M. G. Newbury, Uncertain Innovation and the Persistence of Monopoly: Comment, 74 Am. Econ. Rev. 238 (1984). This choice by the fringe competitors occurs whether competition is deterministic or stochastic. Id. (67) John C. Hilke & Philip B. Nelson, The Economics of Entry Lags: A Theoretical and Empirical Overview, 61 Atitrust L.J. 365, 367 (1993) (citations omitted). (68) Id. at 369. (69) See, e.g., supra section II.C. for a discussion of inhibition of generic manufacturer entry. (70) See supra note 42 and accompanying text. (71) Hilke & Nelson, supra note 67, at 370. Hilke is the economist with the Federal Trade Commission. (72) For example, new entrants may have built a reputation for quality, service, and/for delivery equal to or greater than current market participants. Id. at 368. (73) Id at 371. (74) Id. at 371-72. (75) Id. at 372 (citation omitted). (76) Further, simply the threat that a brand-name firm could enter as an only-mover preexpiration may make potential generic drug manufacturers consider other potentially less threatening markets. Thus, simple signaling at strategic points preexpiration may deter generic firm entry into the post-patent expiration market, even if the brand-name firm does not enter as long as its threat is credible. (77) Hilke & Nelson, supra note 67, at 385. (78) ABA Antitrust Section: Monograph No. 18, Nonprice Predation Under Section 2 of the Sherman Act 8 (1991). (79) Id. at 9. The exceedingly clear example given by the ABA Antitrust Section regarding raising competitors costs (and thus prices) is the following: "the cost [an RRC predator incurs] of burning down a rival's plant would presumably be dwarfed by the costs the rival would be forced to bear to rebuild it." Id. (80) Id. Note that in both situations, market share and profits rise. When maintaining output, market share increases due to competitors decrease in output, when expanding output, each additional marginal unit produced until the brand-name firm's marginal cost reaches the higher price results in a profit that adds to that obtained preexpansion. (81) "[I]n RRC predation, the predator increases the victim's costs by raising the price of some scarce critical input needed by the victim, causing the victim to reduce its output. Such a strategy does not necessarily require that the RRC predator price inconsistently with short-run profit maximization, or that it incur losses in the short run, or that it ... be able to raise price by restricting its own output. Because RRC predation does not require behavior that is inconsistent with short-run profit maximization or a recoupment theory, it does not share some of the basic analytical inconsistencies of predatory pricing." David T. Scheffman, The Application of Raising Rivals' Costs Theory to Antitrust, 37 Antitrust Bull., 187, 188-89 (1992). (82) Id. at 189-90. (83) That is, all purchasers who wish to obtain the product preexpiration must o to the only source for it - the brand-name manufacturer; thus it is likely that all purchasers of the drug, would already have established relationships with the brand-name firm. (84) Scheffman, supra note 81, at 193. (85) This result does not assume that the RRC strategy results in prices greater than that contracted for preexpiration by the brand-name firm. To determine if there is any inframarginal gain one must compare the resultant price to that which would be charged in the absence of any RRC strategy in the residual demand market (recall that the bulk of the demand is locked up due to the preexpiration contracts). Thus, if the RRC predator raises its competitor's costs, and hence the "industry" (i.e., residual demand market) price, it gains inframarginal rents compared to a situation where the brand-name firm could only charge marginal cost due to generic firm (unencumbered) entry. The appropriate comparisons recognize the discrete markets - the locked-up market (where the brand-name firm obtains surplus because of its preexpiration price above marginal cost) and the post-patent expiration residual market (where the brand-name firm obtains additional surplus by raising competitors costs). (86) It should be noted that if the brand-name manufacturer has no capacity limit and its constant cost of production is B, if it has raised the potential generic manufacturer's cost such that its constant cost of production results in some price C, where C > B, the brand-name manufacturer can raise its price to just below C and still not induce entry by the potential generic firm. (87) See id. (88) "[W]hen generic substitutes exist, the world of drug buyers consists of two quite different groups - those who are price sensitive and those who are not." F. M. Scherer, Pricing, Profits, and Technological Progress in the Pharmaceutical Industry, 7 J. Econ. Perspec. 97 (1993). The price-sensitive market has always been large; in 1984, public and third-party payors with an interest in cost-minimization accounted for 82% of hospital drug reimbursements. Since 1984 the increased penetration of managed care and focus on cost-containment has increased this percentage and placed a great deal of downward pressure on outpatient drug prices as well. See, e.g., Suzanne Oliver, We're Making Good Business, Forbes, Dec. 19, 1994, at 187 (indicating that managed care institutions, insurers, and employers have become aggressive in their negotiations for drug price discounts). (89) This condition raises a tying possibility. The implicit threat when a brand-name firm approaches its purchasers with its own brand-name generic and a contract that lasts post-patent expiration is that if the contract for the generics is not agreed to, there may be an inconvenient decrease in supply for the drug preexpiration. Thus, the purchaser may be in a position of duress and required to accept contracts with the brand-name manufacturer for supply post-patent expiration even if the purchaser knows that it could get a much cheaper generic from an outside manufacturer in the post-patent expiration period. (90) This may also reduce incentives for innovation. (91) See supra note 89. Thus, purchasers have the unfettered incentive to purchase on the basis of price, assuming minimal product differences, and thus consumer price will approach marginal cost. (92) For example, the patent misuse doctrine, although usually applied only as an affirmative defense in cases of patent infringement, may be an interesting approach. The doctrine of patent misuse has been described as "an equitable concept designed to prevent a patent owner from using the patent in a manner contrary to public policy." USM Corp. v. SPS Technologies, Inc., 694, F.2d 505, 510 (7th Cir. 1982), cert. denied, 462 U.S. 1107 (1983) (citing Morton Salt Co. v. G.S. Suppiger Co., 314 U.S. 488 (1942)). Although the situation under discussion here does not focus on the usual pecuniary conditions of licensing a product or quid pro quo for a grant thereof, it does focus on the use of a portion of the patent - the term limit of patent protection. The fundamental policy question is: Is the use of a patent by a patent holder, through preemptive contracting preexpiration extending past the patent expiration date, a misuse of a patent? If the policy of the patent laws is to grant exclusive rights and powers until the patent expiration date and no more, clearly this would be an abuse of the patent; however, if the patent laws are designed to allow patent holders all rights and powers that can be accomplished during the patent protection period, including actions that extend protections past the patent expiration date, then the activity should not be prohibited under patent misuse doctrine analysis. Thus, perhaps encouraging several generic manufacturers to begin production and sale of their products preexpiration (hence infringing on the patent) would serve as an interesting test case.
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|Author:||Liang, Bryan A.|
|Date:||Sep 22, 1996|
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