Pharmaceutical Markets, Competition and Regulation
LBS Regulation Initiative Workshop 29 October 1999
Geoffrey Horton
Introduction
It is almost universally accepted that, in general, competitive markets are by far the most efficient means of providing goods and services. The command economies of Eastern Europe and elsewhere have demonstrated how wasteful other systems can be. Within Western economies market liberalisation has increased efficiency. Privatisation and deregulation in the United Kingdom have resulted in cost savings and lower prices. Regulation is not as powerful as market forces. In the gas and electricity markets, for example, when supply was competitively available to some (larger) customers but still monopolistically provided under price control to others, prices in the free market were lower than in the regulated sector (to an extent not explicable by customer size).
Regulation may however be required as a response to market failure. The question then is whether the perceived market failure warrants the particular regulatory response. In the UK medicines market, the scheme that regulates the supply side, the Pharmaceutical Price Regulation Scheme (PPRS), has just been renegotiated by the industry and the Department of Health. It constitutes a significant deregulation of the supply side and there is a commitment by the Government to review the scheme holistically, in the context of many new demand side factors (mostly introduced this year), with a view to examining the potential for further deregulation of price and profit controls.
This paper examines the rationale for regulating the UK medicines market. It considers the scope for further deregulation, and compares the process established for medicines with developments in the regulation of other industries.
Developments in the regulation of other industries
Most utility regulators have a duty to promote competition in their industries. They can then deregulate in response to the emergence of sufficient levels of effective competition. Overall, the trend is away from general price and profit control and towards a reliance on competition as the best means of protecting and promoting the interests of consumers.
Electricity and gas supply, for example, used to be monopolies but are now open to entry. The electricity regulator wants competition to replace price control. In OFFER (1998) he says, "Customers are best protected by competition. In considering whether price restraints should continue beyond March 2000, and if so over which set of customers, it will be necessary to look ahead, at the prospective state of competition over the next few years. Price restraints can prevent, restrict or distort competition. In considering the interests of customers today, it is important not to undermine the protection of customers' interests tomorrow. In doing so, and in making decisions about price restraints, it will be important to take account of the feedback between continued price restraints and competition."
In telecommunications too, competition has become increasingly important. DTI (1998) says of the sector "As competition increases further, there should be less need for price controls and the regulatory structure should evolve to reflect the increasing role of competition in safeguarding the consumer interest. The last retail price control package agreed with BT removed price controls from all areas of the business market and several areas of the residential market. Overall, the proportion of BT's revenues covered by the price cap has been reduced from 66% to 24%. The current rate of development of competition for telecommunications means that the retail price cap ending in 2001 could be the last."
Market power is the main reason for economic regulation and competition legislation. For example, the 1998 Competition Act (and the Articles of the Treaty of Rome on which it is based) contain two prohibitions, on:
Chapter I Agreements to restrict competition
Chapter II Abuse of a dominant position.
The supporting guidelines to the Act (Office of Fair Trading, 1999), explain that "the assessment of market power is necessary under both Chapter I and Chapter II of the Act" since, to contravene it, an agreement must have an appreciable effect on competition or dominance must be established.
As the guidelines also say "Market power exists when undertakings are able consistently and profitably to charge higher prices than if they faced effective competition". A dominant position is abused mainly by pricing above the level that would obtain in a competitive market and producing and selling a smaller quantity of output. This can often be done to greatest effect by "price discrimination" - setting different prices.
The essence of market power is the ability to raise price above competitive levels without losing sales as customers switch to other products to an extent which makes the price rise futile. Other forms of abuse, such as predatory pricing, are normally means to secure or retain a dominant position in order to set prices above competitive levels.
Response to market power in utilities has become more sophisticated. Where market power is an unavoidable feature, it is answered by price control and other forms of regulation, such as of quality of service. This is the case with energy distribution and transmission (as opposed to production or supply), which involves the use of a natural monopoly of wires or pipelines. It is also the practice with the natural monopoly of water supply, although even here work is in hand to attempt to separate potentially competitive production and supply from the monopoly of carriage in pipes.
Where market power is a risk, it is answered by monitoring, the encouragement of competition, and resort to competition law to prevent particular abuses. There is no price control of the production of energy (gas from the North Sea or electricity from power stations) and its supply to customers is being gradually freed from price control. The yardstick for doing so is the extent to which competition is present. In telecommunications also price control is being withdrawn and regulation increasingly relies on general competition measures. Other industries, such as bus transport, are subject to competitive market forces and are investigated by the Director General of Fair Trading if there is reason to suspect an abuse of market power.
Increasing competition and the relaxation of price control have been linked with greater reliance on general competition legislation. In telecommunications the regulator acted in advance of the 1998 Competition Act. The price control package which removed substantial areas of BT's business from price control also introduced the two Treaty of Rome prohibitions, listed in section 2 above, into BT's licence. The Director General of Telecommunications said in OFTEL (1997) that "The price control proposals cannot stand without OFTEL having the parallel powers it needs to police anti-competitive behaviour. OFTEL therefore has no choice but to proceed with its present proposals for the introduction of the Fair Trading conditions into BT's and other significant licences. If, however, the government subsequently proceeds to introduce both Articles 85 and 86 into UK competition law relating to telecommunications the Fair Trading condition would be redundant and OFTEL would remove it from the licences." The Articles have now been introduced and regulators will be able to resort to them from March 2000.
The UK medicines market is regulated in a different way from the industries mentioned above (see Section 3 below) but the rationale for economic regulation is similar to that in these industries. It is worth examining the regulation of the medicines market in the light of these developments.
Rationale for Regulation in Pharmaceuticals
The UK medicines market is defined by three key characteristics, which distinguish it in many ways from most private consumer markets:
Governments throughout the world have traditionally viewed supply side regulation of the medicines market as necessary in order to contain the growth in their drugs bills, which they fear would become unmanageable if the industry and its supply of medicines were not regulated. This has rested on two key assumptions, which are thought to stem from the special characteristics listed above.
Assumption 1: the demand side of the market (mainly prescribers in primary care) is too weak to prevent suppliers exploiting their market power. The demand side is considered weak because the responsibility for prescribing medicines has traditionally rested with doctors who have little financial incentive or professional obligation to prescribe in a cost-conscious, efficient manner.
Assumption 2: there is little competition between suppliers within individual markets (namely, therapeutic markets, i.e. drugs with similar actions designed to deal with particular conditions). Moreover, this lack of competition, re-enforced by patents, confers considerable market power.
It is feared that these factors reduce the price elasticity of demand for drugs and so confer market power on drug producers. In short, it is feared that an uncompetitive supply side is able to exploit a weak demand side.
Anything that reduces responsiveness to price increases market power and it is the combination of these factors which is used to justify regulation. The demand factors in assumption 1 are not deemed sufficient by themselves to introduce measures to counteract market power at the supply end, since the PPRS applies only to in-patent medicines but the demand factors are present also in the purchase of generic medicines. In practice, physicians are well-informed purchasers compared with those in many other markets and they are subject to institutional pressures to contain costs.
Similarly, the supply factors in assumption 2 are unlikely to be decisive. Intellectual property is of prime importance in the industry and protected by patent. Patents confer a degree of market power. This is not a sufficient reason for acting because patents are designed to confer market power to reward investment in knowledge. A problem only arises if the rewards achieved from the market power are excessive. Where trade (or "parallel import") is restricted this is a consideration for each country separately. In using their market power owners of patents are likely to wish to follow the textbook example of the "discriminating monopolist" and price differently in markets which can be separated, depending on the demand conditions within each market. However, if the reward generated by the patent is reasonable, price discrimination is likely to increase output and produce a higher level of welfare than a situation where price discrimination is not possible. "Ramsey pricing", an optimal mark-up above marginal cost, may result. The familiar theory originates from Ramsey (1927) and was elucidated by Robinson (1933). Tirole (1988) provides a recent textbook exposition.
Description of Regulation in Pharmaceuticals
There are three basic types of regulation in pharmaceuticals:
Although the first two affects the last, as do arrangements for funding, pricing, and accountability within the NHS, it is the PPRS with which this article is chiefly concerned.
The sale of medicines to the NHS is regulated by the Pharmaceutical Price Regulation Scheme, (PPRS) - a direct descendant of a scheme set up in 1957 after wartime price controls had been removed. The scheme is renegotiated every five years and has just been renegotiated, with the new version commencing on 1st October.
The PPRS has objectives which are similar to the standard set for utility regulators (of ensuring reasonable demand is met, enabling suppliers to finance their activities, promoting competition, and protecting consumers as regards price and quality) but they are expressed differently, contain overtones of UK industry sponsorship, and are limited to the interests only of the NHS as a customer.
The scheme is voluntary, though the new scheme is subject to statutory powers in the event of non-compliance. The new scheme is the result of almost a year of negotiations between the Government and the industry, represented by its trade association, the ABPI (the Association of the British Pharmaceutical Industry).
The PPRS prevents rises in the price of existing products (and, at times of review, may cause reductions in their price). In contrast to the practice in most of Western Europe, it allows new products to be priced as companies wish.
However, this is subject to a measure of the company's profits remaining within a certain bound. If profits exceed a reference level by more than 40%, the excess must be paid to the Department of Health. If they fall below the reference level by more than 50% (or are likely to do so) the company may raise prices.
The reference profit level is a 21% return on the historic cost value of capital employed in production for sale to the NHS. In calculating profits for the purpose of the scheme, the costs that are deducted from revenues are not necessarily those that are actually incurred. In the cases of costs of administration, research and development, sales promotion, information, and distribution these are fixed amounts calculated as a percentage of sales (sometimes plus fixed amounts or fixed amounts per product), but the percentages and amounts are sometimes set individually for each company.
With the exception of some capital items such as stocks, which may be estimated on the basis of sales etc., capital assets are as in company accounts and allocated to NHS sales either by a fixed historical ratio or pro rata to sales or manufacturing costs.
There are significant features of the new scheme. Companies that fail to comply with the scheme will be subject to a statutory scheme, contained in the Health Act 1999, which allows the Secretary of State to control prices and profits directly. There are specific allowances for research and development and for sales promotion. Companies must reduce the price of their products by 4.5% (though they can differentially reduce prices so that the total effect is equivalent to a general reduction of 4.5%). No price increase may occur before 1st January 2001, though price increases after that will depend on the company's assessment under the PPRS.
The scheme, like its predecessors and regulation in other industries, has costs. Price or profits controls may reduce competition by setting a "marker" price that the industry follows. Less efficient firms may be able to stay in business. There are also more specific problems connected with the scheme.
The new PPRS agreement makes arrangement for regular monitoring of the extent and effectiveness of competition in the UK medicines market. The Department of Health and the ABPI will agree a series of indicators for assessing this, with a view to using them in reviewing the market at the time of the mid-term review of the new scheme, in 2002. This review will involve consideration of the degree to which the market can be further deregulated, in the light of evidence that competition is removing the need for the existing level of control.
4. Assessing the degree of competition
The standard approach used to assess competition is to see whether any firm, or group of firms acting jointly, is dominant; mainly (but not exclusively) by seeing if it has a market share above a certain figure. The European Court has stated that dominance can be presumed in the absence of evidence to the contrary if an undertaking has a market share persistently above 50% but the Director General of Fair Trading considers individual dominance unlikely with a market share below 40%.
An important question is therefore what is the market - e.g. pharmaceuticals, the therapy class, or the individual in-patent medicine. This is addressed by the "hypothetical monopolist test", which says that a product or group of products constitutes a separate market if, in an imaginary world where one firm produced them all, that firm could maximise profits by raising the price above competitive levels. This analysis relies on consideration of price elasticities and the potential for substitution. Assuming that marginal cost does not change significantly for small variations in output, profits will be maximised by price rises if the ratio of price to the difference between price and marginal cost exceeds the absolute value of the price elasticity. If marginal cost is very low, this will be true for elasticities of demand between 0 and -1.
Assessing the degree of competition therefore involves attempting to assess the degree of price elasticity. This is standardly done by:
Messrs. Towse and Williams, among others, have been working in this area.
A priori reasons suggesting a development of competition in the UK medicines market
There have been developments on both supply and demand sides. On the supply side, improvements in technology have made it faster and cheaper to bring products to market to challenge existing products, on price and/or quality.
The demand side has also changed considerably in recent years, with prescribers being made increasingly aware of the cost and quality of different treatments. This will be further affected as the Government's reforms of the NHS become established (they officially came into being on 1st April of this year). GPs will no longer be grouped in practices of typically 4-6 GPs. Instead all GPs and practices will be part of Primary Care Groups (PCGs), covering populations of approximately 100,000 people.
PCGs will have an overall cash limit to their budget, which is designed to encourage strong 'corporate' PCG-level policy and monitoring of prescribing, so as to improve efficiency, economy and effectiveness. Prescribers will have more direct access to sources of information about the cost and clinical effectiveness of medicines. Developments in IT will assist this, encouraging doctors to follow best practice. GPs will be subject to overall cash-limited budgets for all their work. Before 1st April there were distinct drug budgets, which meant that drugs would only considered in terms of the costs imposed not the savings made elsewhere (as, for example, medicines may remove the need for expensive hospital treatment).
All these factors mean that the UK medicines market is establishing itself as a market with many of the key characteristics shared by other markets, which are being deregulated and becoming more competitive. Patents now confer more limited market power with new, often better and cheaper, products coming to market within a year or two of the first. In addition, prescribers are aware of and responsive to these developments. The regulation of the market needs to be reviewed in the light of these developments and on the basis of a more accurate and detailed assessment.
Conclusions and way forward
Economic regulation is a response to market failure. Its main concern is the containment of market power. Where that market power is inevitable it must be met by control of prices (or profits). Where market power can be reduced, for example by encouraging greater response of demand to price, competition is likely to be a better safeguard and regulatory intervention can be limited to correcting and deterring abuses of market power rather than attempting to set prices as a substitute for competition.
The new PPRS is an improvement on the previous scheme, in improving the incentives for investing in the development and supply of innovative medicines to the NHS. However, the rationale for the scheme and its mechanisms has not been established adequately, by, for example, any explicit reference to the issue of market power and the potential for its abuse. Moreover, in contrast to most other regulated markets, there is no vision for the development of the medicines market and its regulation. The process established for monitoring and analysing the medicines market, with a view to reviewing it in 2002, means that there is an opportunity to establish such a vision - one based on competition and deregulation - and have the regulator and the industry work together towards its achievement.
REFERENCES
DTI (1998), A Fair Deal for Consumers: Modernising the Framework for Utility Regulation, Department of Trade and Industry
OFFER (1998), Reviews of Public Electricity Suppliers 1998 to 2000: Price Controls and Competition Consultation Paper
OFFER (1992), Review of Economic Purchasing, December 1992
OFTEL (1996), Pricing of Telecommunication Services from 1997, Statement June 1996
Ramsey F. (1927), A Contribution to the Theory of Taxation, Economic Journal vol.37, pp 47-61
Robinson J. (1933), The Economics of Imperfect Competition, Macmillan.
Office of Fair Trading (1999), The Competition Act 1998 - guidelines issued by the Office of Fair Trading, the Office of Electricity Regulation, the Office of Telecommunications, the Office of the Rail Regulator, the Office for the Regulation of Electricity and Gas for Northern Ireland, the Office of Water Services, and the Office of Gas Supply; OFT 400-418
Tirole J. (1988), The Theory of Industrial Organisation, MIT
See, for example, OFFER (1992) p12.
Licensing requirements (for drugs, physicians and pharmacists) also confer some market power
Robinson even uses the health sector as an example. "It may happen, for example, that a railway would not be built, or a country doctor would not set up in practice, if discrimination were forbidden".
Where the sales to capital ratio exceeds 3. 5, the profit level is a 4% return on sales.
Comprising of 20% of total home NHS turnover, for assessing profits, or 17% for assessing price increases, plus, in either case, an additional 0.25% for each in-patent active molecule with a home NHS turnover of £500,000 or more, to a maximum of 12 such molecules.
See OFT 1999.
Case C62/86, AKZO Chemie BV v Commission (1993) 5 CLMR 215.