This presentation by John Davies, Senior Vice President, Compass Lexecon, was made during the discussion “Excessive prices in pharmaceutical markets" held at the OECD Competition Open Day on 27 February 2019. More documents and presentations on this topic can be found at oe.cd/comp-open-day-19.

1. John Davies
27 February 2019
The economics of exploitative abuse in the
pharmaceuticals sector

2. COMPASS LEXECON 1
“UNITED BRANDS FRAMEWORK”
Is the company dominant
in a relevant market?
Is the difference between the
costs actually incurred and
the price actually charged
excessive?
Has a price been imposed which
is…
either unfair in
itself
or unfair when
compared to the price
of competing
products?
Market definition and dominance:
United Brands Limb 1: Price cost test:
United Brands Limb 2: Unfairness:

3. COMPASS LEXECON 2
“Is the company dominant in a relevant
market?”
Assessing exploitative abuse:
market definition and
dominance

4. COMPASS LEXECON 3
 Saudi Arabian oil is sold at
the “market price”, not at a
price reflecting its own cost
 Market price is set by higher
cost production
 Implication for excessive
pricing: ‘pricing up’ to a
higher-cost substitute
product should be OK.
 “It is apparent from the
above that the CMA clearly
gave some consideration to
the suitability of tablets as a
comparator. However, it is
not clear to us that it did so
in sufficient depth.” CAT
judgment Pfizer/Flynn
MARKET DEFINITION: PRODUCERS WITH VERY DIFFERENT COSTS
CAN BE IN THE SAME MARKET
Low demand
year: price = 60
High demand
year: price = 75
Source: CERA. 2008. Ratcheting Down: Oil and the Global Credit Crisis.

5. COMPASS LEXECON 4
 Again, possible problem of circular reasoning if ‘cost-based’ price
taken to indicate competitive price level.
 Are pharmaceutical firms dominant, given regulatory constraints?
 Require: “Very high and long-lasting barriers to entry” to
intervene:
– Without insuperable barriers to entry, new entrants can be expected
to compete high prices away
– NB: Gilo and Ezrachi critique of this must be taken seriously, but as an
empirical observation high prices do attract entry - e.g. Aspen Italy
– In a market with entry, assessing what the firm might have expected
at the time it set its prices can be very uncertain
DOMINANCE IN EXCESSIVE PRICING CASES

6. COMPASS LEXECON 5
Is the difference between the costs
actually incurred and the price actually
charged excessive?
Assessing exploitative abuse:
United Brands Limb 1 – excess
of price over cost

7. COMPASS LEXECON 6
 What is the right measure of cost to use?
 Short-run marginal cost almost certainly inappropriately low.
ASSESSING COST-PLUS: COST
 Particularly difficult when
dealing with a multi-
product firm, with joint or
common costs (indirect
operating costs and capital
costs). Or a firm serving
several jurisdictions. How
much to ‘allocate’ to the
product?

8. COMPASS LEXECON 7
 So: there is no reason for individual product prices to reflect an ‘equal’
allocation of indirect costs.
 However,
“―it is not appropriate, when deciding whether an undertaking has abused a
dominant position by charging excessive prices in a particular market, to take
into account the reasonableness or otherwise of its profits on other, unspecified,
markets comprised in some wider but undefined ’portfolio‘ unrelated to the
market in which dominance exists.”
Competition Appeal Tribunal, UK, NAPP Pharmaceutical
 Hard to know what to make of this argument. Businesses simply do not try to
achieve a similar margin on all of their products. If they had to do so :
 Some products, facing highly elastic demand, might not be able to support a higher margin
 Overall, the firm’s pricing would be inefficient and it might make losses
ASSESSING COST-PLUS: COST
ALLOCATING INDIRECT COSTS

9. COMPASS LEXECON 8
Has a price been imposed which is either
unfair in itself or unfair when compared
to the price of competing products?
Assessing exploitative abuse:
United Brands Limb 2 –
unfairness

10. COMPASS LEXECON 9
 “charging a price which is excessive because it has no reasonable relation to
the economic value of the product supplied [is] … an abuse.” ECJ, United
Brands
 But what is economic value? Economists usually use ‘value’ to mean the
amount a consumer might be prepared to pay for something. However, by
this definition, nothing can be priced excessively
 Is there an inherent value in a product? Economists used to debate this a lot.
IS THE EXCESS FAIR? THE QUESTION IS OFTEN POSED IN TERMS OF
‘ECONOMIC VALUE’
 Contra Marx, there is clearly no ‘inherent’
value in a product. It all depends on supply
and demand
 So the only sensible approach to assessing
‘value’ is to use comparators: the price of a
product in a reasonably competitive market

11. COMPASS LEXECON 10
 Some recent cases, especially in pharma, largely give up on
comparators and identify unfairness ‘in itself’
– Absence of specific reasons for price to exceed cost. “Having exercised its judgment with
a margin of appreciation, the CMA has concluded that there are no non-cost related
factors that would increase the economic value […] beyond Cost Plus.” (Phenytoin 5.261)
 But should firms be required to find ‘reasons’ to price above cost in a market economy?
– Size of excess is ‘in itself’ abusive. “ […] the excesses Pfizer has achieved on 25mg
capsules are sufficient to demonstrate that Pfizer’s Prices bear no reasonable relation to
the economic value of this capsule strength and are unfair in themselves and therefore
abusive.” (5.370)
 Loss of legal protection and certainty if 2-stage test is only about cost? CAT agreed.
 Cost to national health systems. “The Parties’ respective excessive prices have had an
adverse effect on the end customer, the NHS.” (Phenytoin, 1.43)
 But any price has an adverse effect on the end customer, excessive or not?
 None of these seem (to me) particularly convincing.
UNFAIR ‘IN ITSELF’?
DOES NOT SEEM (TO ME) TO MEAN ANYTHING MUCH

12. COMPASS LEXECON 11
 Market definition and dominance: avoid reliance on pricing
arguments, price > cost is not a “SSNIP” above competitive levels
 Check for high and long lasting barriers to entry
 If using a price-cost test:
– ensure that prices exceed any allocation of fixed and capital costs
– reflect information and expectations of the company at the time (do
not penalise good luck)
 ‘Value’ can be found only in market prices: put a lot of weight on
comparator pricing…
 … and conversely avoid finding that a price is excessive ‘in itself’
 Focus on remedying a cause, not penalising an effect
SO WHAT WOULD A ‘GOOD’ EXCESSIVE PRICING CASE LOOK LIKE?

13. COMPASS LEXECON 12
THANK YOU!
Jdavies@compasslexecon.com