Two Puzzles Resolved: Of the Schumpeter-Arrow Stalemate and Pharmaceutical Innovation Markets

• Author: Michael A. Carrier
• Position: Michael A. Carrier: Professor, Rutgers University School of Law-Camden
• Pages: 01

Michael A. Carrier: Professor, Rutgers University School of Law-Camden. I would like to thank Jon Baker, Herb Hovenkamp, Mark Janis, Mark Lemley, and participants in the AALS 2007 Annual Meeting joint session on Antitrust and Intellectual Property and the Iowa Innovation, Business, and Law Colloquium for helpful comments. I also would like to thank Summer Davis, Justin Pentz, Neena Verma, and especially Sean Neafsey for excellent research assistance. Copyright 2007 Michael A. Carrier.

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Introduction

One of the most heated discussions in economic circles in recent years has concerned the relationship between market structure and innovation. After a half-century of debate and innumerable studies, the overwhelming consensus is that there is no clear answer to the question. The diametrically opposed positions of Joseph Schumpeter (favoring concentration) and Kenneth Arrow (favoring competition) both garner support in unending bouts of hand-wringing.

This Article offers at least a partial solution to this puzzle. By closely parsing the economic studies, I isolate several factors that determine the ideal market structure for innovation in specific industries. In particular, I find that competition and size are each important for pharmaceutical innovation.

This nuanced approach promises to pay dividends in the context of "innovation markets," one of the most criticized concepts in antitrust law. Such markets are unique in that they consist not of actual products, but of the research and development ("R&D") directed toward new products. Perhaps because of their novelty, critics have leveled numerous attacks against such markets:¹

* Innovation is speculative and includes unidentifiable market participants;

* Innovation markets are not needed because conduct can be challenged at a later time;

* The relationship between R&D and innovation is unclear; and

* The market structure most conducive to innovation is unclear.

The approach I offer in this Article addresses these concerns. It also promises to have immediate practical consequences. The antitrust enforcement agencies, for example, have recently been hamstrung by disagreement on innovation markets. In the proposed 2004 merger between Genzyme and Novazyme, the two companies researching Pompe disease (a fatal condition affecting young children), the Federal Trade Commission ("FTC") split 3-1-1 on the question of whether to challenge the merger. In a statement accompanying the majority decision not to challenge the merger, Chairman Timothy Muris refused to "adopt[] [a] presumption[] [of anticompetitive harm] without economic foundation . . . [which] would constitute a major step backward in antitrust law."² In contrast, Page 397 Commissioner Mozelle Thompson's dissent highlighted the dangers of a merger to monopoly.³

The common-sense concern about a merger between the two most advanced firms in a market explains not only the dissent in the Genzyme case, but also the FTC's eight challenges to mergers (all since 1990) in innovation markets in the pharmaceutical industry. Common sense, however, is not economic foundation, particularly when the relationship between market structure and innovation is as disputed as it is. This Article at last offers the economic foundation that has been missing from innovation-market analysis.

Part I begins by defining innovation markets. It then articulates the most fundamental critiques that have been leveled against the markets. Finally, it rebuts these critiques by emphasizing the realities of the pharmaceutical industry. It explains that

* The high barriers to entry from patents and a lengthy Food and Drug Administration ("FDA") regulatory process allow the relevant innovators to be identified;

* The conduct cannot be challenged at a later time because it is difficult, if not impossible, to observe a lack of innovation in the product market; and

* The question of which market structure is most conducive to innovation can be answered in the pharmaceutical industry.

Part II then focuses on the crucial inquiry involving market structure and innovation. It first articulates the positions of Schumpeter and Arrow. Next, it extracts the most important factors from the economic studies in the past half-century. Applying these factors, this Part finds that the resources needed to survive the lengthy FDA regulatory process demonstrate the importance of size in the industry. But the presence of patents, product innovation, and technological opportunity shows the significance of competition for pharmaceutical innovation. This finding confirms the propriety of antitrust enforcement in innovation markets.

Part III proposes a new five-part test for the agencies to apply to innovation markets. First, the agencies must show that the merger would lead to significant concentration among firms reasonably likely to reach the market. Second, they must offer a theory that the merging firms will suppress innovation. Third, the firms can rebut the prima facie case of concentration by showing that another firm is likely to reach the market. Page 398 Fourth, in a narrow range of cases, the merging firms can proffer an efficiencies defense. Fifth, a "Schumpeterian" defense can be offered by small firms that would not otherwise be able to navigate the regulatory process.

The test improves upon the current analysis in several ways. It replaces the current ad hoc approach with a comprehensive framework based on the Merger Guidelines. And it breaks new ground in considering not just the number of firms in R&D, but also their respective stages of FDA review. Given the wildly varying odds of success in reaching the market from the preclinical stage and each of the clinical stages, it is indefensible to continue to neglect this factor.

Part IV presents the results of nine case studies from the past two decades-eight cases challenged and one not challenged by the FTC. These cases are important because they constitute nearly all of the innovation- market cases. In fact, there have been only two challenges outside this arena.⁴ In addition, because these matters have all been settled by consent decree, (1) the relevant analysis has taken place not in the courts but in the agencies, and (2) discussion about the cases has, until now, been limited to the facts alleged in the agency complaints.

My empirical analysis examines the treatment of particular conditions before the merger, the number of participants, the merging firms' (and rivals') stage of FDA review, and the state of the market today. It concludes that five of the nine cases were justified but that the remaining four should not have been challenged.

Going forward, application of my test promises to make innovation- market analysis more comprehensive and predictable and to incorporate a more realistic assessment of pharmaceutical development hurdles. By preventing unnecessary challenges, it seeks to ensure the most effective use of limited government resources. And by increasing the odds that certain products will reach the market, it promises to promote innovation.

In short, the debates concerning innovation markets and the relationship between market structure and innovation present some of the most challenging issues in economics and antitrust. By closely parsing the economic studies and conducting the first empirical analysis of innovation- market mergers in the pharmaceutical industry, this Article begins to solve two crucial, interrelated puzzles.

I Innovation Markets

A Theory

The concept of innovation markets burst into attention (at least of scholars and the government agencies) in 1995. In that year, the antitrust Page 399 enforcement agencies-the U.S. Department of Justice ("DOJ") and FTC- promulgated Intellectual Property ("IP") Guidelines. The most controversial aspect of the Guidelines was the creation of an innovation market, which was defined as

A[] . . . market [that] consists of the research and development directed to particular new or improved goods or processes, and the close substitutes for that research and development.⁵

"The close substitutes," the Guidelines continued, were "research and development efforts, technologies, and goods that significantly constrain the exercise of market power with respect to the relevant research and development . . . ."⁶ The agencies promised that they would "delineate an innovation market only when the capabilities to engage in the relevant research and development [could] be associated with specialized assets or characteristics of specific firms."⁷

The theory behind innovation markets is that a merger between the...