Innovation has long been viewed as a critical driver of economic growth. To increase innovation incentives, policymakers have used changes to the level of competition as a key tool. These policy tools have ranged from providing protections to firms that successfully innovate through patent protection (e.g. Hall (2018)) to laws and regulations aimed at increasing the number of innovative firms through increased competition (e.g. Lo and Thakor (2015), Thakor and Lo (forthcoming)).
But the relationship between competition and innovation is not clear-cut (Aghion et al. 2005). While measures such as limiting competition through greater patent protection may encourage more innovation by firms seeking to reap monopoly profits, incumbent firms with existing products under such protection may not feel the need to innovate further if they can already rely on guaranteed revenues. As a result, understanding the interaction between these forces is crucial for determining the effect of policies aimed at increasing innovation by changing the degree of competition in a market.
Legal mechanisms to maintain market power in the pharmaceutical industry
In our study, we shed light on a legal mechanism through which innovative firms may maintain their market power, and its ramifications for innovation and policies that seek to increase innovation through competition (Li et al. 2021). We do so in the setting of the pharmaceutical industry – an important sector in the economy that focuses on developing innovative products through its research and development (R&D) investments. This setting also provides data that permit us to explore innovation activity using actual drug clinical trial actions, rather than relying solely on measures of patents, which many have noted may not accurately reflect innovation activity (van Pottelsberghe de la Potterie and de Rassenfosse (2008), Freilich (2019)).
In this industry, firms that are first to pass clinical trials and obtain US Food and Drug Administration (FDA) approval for their products enjoy marketing exclusivity for a number of years (typically three to seven years), during which no other firm can directly compete against that drug. But after marketing exclusivity expires, other firms may enter the market by launching generic versions of the specific drug (through a process called Paragraph IV filing). Figure 1 depicts the timeline of this process.
Figure 1 The timeline of generic drug entry
To continue their monopoly over marketed drugs, incumbent pharmaceutical firms regularly enter ‘pay-for-delay’ agreements (also known as ‘reverse payments’) with generic manufacturers that seek to enter the market, whereby the generic firm agrees to delay product launch in exchange for a cash amount. These agreements effectively provide a tool through which incumbent firms can reduce the competition that they face.
How do such agreements affect innovation?
We utilise detailed data on public pharmaceutical firms and their drug development portfolios from 2005 to 2016 to examine the impact of this legal mechanism on innovation. We first construct a company-specific measure of the amount of competition that each incumbent pharmaceutical firm faces through Paragraph IV generic drug entry filings. We show that unconditionally over our sample period, incumbent firms responded to potential entry from direct competitors by reducing their innovation activities: they initiated a smaller number of new drug trials.
At first glance, these results seem to reinforce the notion that increased competition dampens innovation incentives. But we then show that the ability of incumbent firms to enter into pay-for-delay agreements affects these incentives. Pay-for-delay agreements were a commonly used strategy in the 2000s (e.g. Bulow (2004)). In the early 2010s, the Federal Trade Commission (FTC) argued that pay-for-delay agreements enabled firms to share a monopolistic market profit. This eventually led to a landmark Supreme Court decision in the FTC vs Actavis case in 2013, in which the Supreme Court held that the commission could litigate pay-for-delay agreements under antitrust law. The decision was arguably unexpected, since prior to the ruling, both the District Court and Eleventh Circuit Court dismissed the Federal Trade Commission’s claims, while the final Supreme Court decision was split five-to-three.
Since the ruling, the commission has aggressively and successfully targeted pay-for-delay agreements. Pharma firms now incur a substantial increase in legal risk stemming from antitrust enforcement if they have engaged in pay-for-delay agreements after this ruling. Figure 2 shows how pay-for-delay agreements dropped sharply after the ruling. In the years leading up to 2013, the number of pay-for-delay settlements showed a strong increasing trend, but after 2013 this trend reverses itself. For example, in 2015, there were only seven settlements with first filers (the first generic company to file for Paragraph IV entry) – the lowest number since 2006.
Figure 2 Pay-for-delay settlements over time
Note: This figure plots the trend of pay-for-delay settlements around the decision of FTC v. Actavis (dashed line).
We use the FTC vs Actavis ruling as a shock to the ability of firms to engage in pay-for-delay agreements to protect the profits of drugs whose period of Federal Drug Administration marketing exclusivity has expired. First, we find that the previous negative relationship between competition and innovation reverses itself in the period following the ruling. In response to increased generic entry, incumbent firms increase their number of new drug trial initiations. In additional empirical tests, we find that incumbent firms that were more exposed to the ruling (i.e. had a greater number of drugs with marketing exclusivity expiring in the years after the ruling) subsequently increased their innovation activities following the ruling. They initiated more new drug trials, reduced their suspensions of ongoing drug trials, and issued more valuable patents.
Overall, our evidence suggests that the ability of incumbent firms to maintain their market power via pay-for-delay agreements has a strong influence on how these firms innovate in response to competition. In particular, the use of these agreements seems to have reduced innovation incentives for firms. Exposed firms increased their innovation when such agreements became more legally tenuous.
The net effects on innovation
While our main results show that restricting the ability of incumbent firms to engage in pay-for-delay agreements seemed to increase their innovation incentives in the face of competition, the aggregate effects are not clear-cut a priori. For example, increased innovative activity on the part of incumbents may serve as a deterrent to potential (non-generic) entrants, as it may be more difficult to compete against the incumbent’s increased efforts. Furthermore, a diminished ability to protect monopoly power may weaken the incentives of firms that innovate to gain that monopoly power.
We explore the overall impact on innovations by examining effects at the drug therapeutic category level. We find an overall decrease in suspensions as well as an increase in new trial initiations by incumbent firms exposed to competition risk by the Supreme Court ruling. But we also find that the enhanced ability of generic producers to enter an area may dampen entry into the area by new firms. This suggests that the ability of incumbent firms to stave off generic competition has implications not only for the decision to innovate by incumbents but also for the decision to innovate by new (non-generic) potential innovators. Our results shed new light on the reasons why the effect of antitrust policy on innovation is not clear-cut and imply that the effects of optimal policy related to antitrust law on innovation will be nuanced.
In conclusion, our results provide evidence for a complex effect of competition on innovation. This has implications for the use of antitrust law to promote innovation, suggesting that policymakers must take a nuanced approach to regulation aimed at influencing competition. If the regulatory goal is to stimulate innovation, then it may not be enough to enact laws and regulations that increase competition. Rather, the encouragement of increased competition should be accompanied by initiatives that limit the contracting options for incumbents to nullify the regulatory attempt to elevate competition. Only when this is done does greater competition stimulate innovation.
Aghion, P, N Bloom, R Blundell, R Griffith and P Howitt (2005), "Competition and innovation: An inverted-U relationship", The Quarterly Journal of Economics 120(2): 701-728.
Bulow, J (2004), “The Gaming of Pharmaceutical Patents”, Innovation Policy and the Economy 4: 145-187.
Van Pottelsberghe de la Potterie, B and G de Rassenfosse (2008), "Policymakers and the R&D-patent relationship", VoxEU.org, 01 June.https://voxeu.org/article/policy-productivity-and-patents
Freilich, J (2019), "Prophetic patents", UC Davis Law Review 53: 663.
Hall, B H (2018), "Innovative Startup Firms and the Patent System", VoxEU.org, 19 July.
Li, X, A W Lo and R T Thakor (2021), “Paying off the Competition: Market Power and Innovation Incentives”, NBER Working Paper 28964.
Lo, A W and R T Thakor (2015), "Competition and R&D: Evidence from biopharma", VoxEU.org, 24 March.
Thakor, R T and A W Lo (forthcoming), "Competition and R&D Financing: Evidence from the Biopharmaceutical Industry", Journal of Financial and Quantitative Analysis.