Interestingly, increasing the mean upstream experience of rivals by one unit raises a firm’s vertical integration probability by more than three times the amount caused by increasing the firm’s own upstream experience by one unit. This suggests that the magnitude of bandwagon effects in the generics industry is quite substantial. The number of potential upstream-only entrants, which was found to affect downstream payoffs positively, has a significantly negative coefficient in the vertical integration equation. The estimated marginal effects also indicate that increasing the number of potential upstream suppliers significantly lowers a firm’s probability of vertically integrating. This finding can be interpreted as follows: when the number of potential unintegrated upstream entrants is large so that a lower degree of vertical integration is expected to hold in equilibrium, each downstream entrant has a lower incentive to vertically integrate. This provides additional support to the view that firms’ vertical integration decisions are strategic complements. The main finding from the econometric analysis is that vertical integration decisions in the generics industry exhibit bandwagon effects: a firm’s incentive to vertically integrate is higher if it expects a greater prevalence of vertical integration among its rivals. What could be the cause of such strategic complementarity? One possible explanation is that the strategic complementarity of vertical integration is caused by foreclosure effects in the post-entry market.
Imagine a market where the foreclosure effects of vertical integration are severe relative to its efficiency effects. In such a market, an unintegrated downstream entrant earns a low profit when many of its rivals are vertically integrated, clone rack but it gains a high incremental profit by choosing to vertically integrate. On the other hand, when few of its rivals are vertically integrated, the firm’s incremental profit from integrating is likely to be small. By comparison, when foreclosure effects are weak relative to efficiency effects, the firm’s incremental profit from vertical integration is likely to be larger when fewer of its rivals are integrated . Another possibility is that firms in the industry learn from others about the benefits of vertical integration, as suggested by Rosengren and Meehan . The performance of a vertical integrated entrant in one market may inform others in the industry about the hitherto unknown benefits of vertical integration, and influence their actions in future markets. The existence of such learning spillovers would cause vertically integrated entry to become more prevalent over time; it would also create correlation between individual firms’ probability of vertical integration and their rivals’ upstream experience levels. However, while such inter-firm learning effects cannot be ruled out entirely, they are unlikely to be driving the estimated positive impact that rivals’ mean upstream experience has on the probability of vertical integration. This is because the year dummy variables in the vertical integration equation are expected to pick up any learning spillover effects that exist.
Turning to the marginal effects of the year dummies, we find that the probability of vertical integration was significantly higher in 2001 and 2002. The rising trend during the first half of the observation period is consistent with the existence of learning spillovers. Somewhat puzzling is the decreasing trend during the second half. One possible explanation is that some of the vertically integrated entries in the former period were caused by fad behavior, which declined in importance during the latter period. The US generic pharmaceutical industry has experienced a wave of vertical integration since the late 1990s. Industry reports suggest that this pattern may be associated with the increase in paragraph IV patent challenges that followed key court decisions in 1998. The 180-day market exclusivity given to the first generic entrant to file a patent challenge has turned the entry process in some generic drug markets into a race to be first; vertical integration may provide an advantage to the participants of the race by promoting investments aimed at the early development of active pharmaceutical ingredients . Another cause of the vertical merger wave suggested by industry reports is the existence of bandwagon effects: the rising degree of vertical integration in newly opening markets may have motivated firms to become vertically integrated themselves. This paper employs simple theoretical models to demonstrate the validity of these two explanations and to derive empirical tests. In the context of a simultaneous-move vertical integration game such as the one seen generally in the generics industry, the existence of bandwagon effects is equivalent to the strategic complementarity of vertical integration decisions.
The theoretical model in Section 2.3.1 shows that under strategic complementarity, a firm’s probability of vertical integration increases as its rivals’ cost of integration decreases. This result leads naturally to a simple test of bandwagon effects. The other model, presented in Section 2.3.2, shows that vertical integration enables firms to develop their APIs early during a patent challenge, increasing their chances of winning first-to-file status, when API supply contracts are incomplete and payment terms are determined through ex post bargaining. This prediction can be tested by seeing if markets characterized by paragraph IV certification are more likely to attract vertically integrated entrants. The two tests are applied to data on 85 generic drug markets that opened up during 1999-2005, using a trivariate probit model that accounts for selection and endogeneity. The coefficient estimate for the paragraph IV indicator variable shows that vertical integration probabilities are higher in paragraph IV markets as the theory suggests, but the marginal effect evaluated at representative values of the covariates is not significantly different from zero. Thus, the hypothesis that vertical integration facilitates relationship-specific non-contractible investments is only partially supported by the data. The past upstream entry experience of a downstream entrant is found to have a significantly positive impact on its probability of vertical integration. This suggests that upstream experience lowers the cost of vertical integration. We also find that the mean upstream experience of rivals has a significantly positive effect on a firm’s vertical integration probability. These two results combined indicate that vertical integration decisions are strategic complements – in other words, bandwagon effects are likely to exist. There are several possible sources of bandwagon effects. One possibility is that vertical integration generates foreclosure effects in the post-entry market, which, according to Buehler and Schmutzler , give rise to the strategic complementarity of vertical integration decisions. There is some empirical evidence to support the existence of foreclosure effects: the number of potential unintegrated upstream entrants has a positive effect on downstream payoffs but its effect on the returns to vertical integration is negative, which suggests that unintegrated downstream en-trants are better off if the market is less vertically integrated. Another candidate for the source of bandwagon effects is inter-firm learning about the benefits of vertical integration. The marginal effects of the year dummy variables provide some indication of inter-firm informational spillovers. However, hydroponic shelves learning effects are unlikely to be behind the estimated positive relationship between a firm’s probability of vertical integration and its rivals’ upstream experience levels. The effect of vertical integration on market outcomes such as prices and product quality in the final goods market can be either positive or negative. For instance, an increase in the level of vertical integration can lead to higher prices or lower prices in the downstream market, depending on the underlying demand and cost function parameters . This is because vertical integration has countervailing effects. One is to decrease the integrating firm’s costs – for instance, through the elimination of double marginalization or the facilitation of non-contractible investments. Such efficiency effects tend to lead to lower final good prices or higher product quality.
Another effect is to foreclose unintegrated rivals’ access to upstream suppliers or downstream buyers. Such foreclosure practices often lead to higher prices or lower quality for the final good. Finally, vertical integration can deter or facilitate entry by unintegrated firms, or induce them to become vertically integrated themselves. In other words, vertical integration can affect market outcomes by influencing the market structure formation process. As this discussion suggests, the link between vertical integration and market outcomes is quite complicated. For this reason, modern analyses on the effects of vertical integration tend to be conducted on an industry-by-industry basis. This paper presents a novel method for empirically examining vertical integration in an individual industry. It is based on a game theoretic model of simultaneous entry into an oligopolistic market consisting of an upstream segment and a downstream segment. The players of the game are potential entrants who can enter into one of the vertical segments or both. After they make entry and investment decisions, competition occurs within the post-entry market structure and profits are realized. Firms’ entry decisions are based on their expectations of post-entry profits, which in turn are affected by the entry decisions of others. Put another way, potential entrants form profit expectations according to the vertical market structure they expect in the entry equilibrium, as well as the position they foresee for themselves within that market structure. It is assumed that po- tential entrants are heterogeneous in observable ways and that the entry game is one of complete information. The econometric model is designed for application to a dataset consisting of multiple markets where vertical entry patterns are observed. The entry patterns are interpreted as outcomes of the vertical entry game. The object of estimation is the set of firm-level post-entry payoff equations corresponding to three different categories of entry: downstream-only, upstream-only, and vertically integrated. Potential entrants choose the entry category, or action, that yields the highest profit net of entry costs. Each payoff equation contains as arguments variables that describe the actions of other potential entrants. They represent rival effects – the effect of upstream, downstream, and vertically integrated rival entry on profits. While such estimates provide direct measures of inter-firm effects, they can also be used as indirect evidence on the effect of vertical integration on market outcomes. Like Chapter 2, the dataset used in this chapter comes from the US generic pharmaceutical industry. It covers multiple markets, each defined by a distinct pharmaceutical product. The upstream segment of each market supplies the active pharmaceutical ingredient while the downstream segment processes the API into finished formulations such as tablets and injectables. For each market, we observe multiple firms entering the two vertical segments – some of them into both segments – when patents and other exclusivities that protect the original product expire and generic entry becomes possible. From the estimated parameters of the vertical entry game, I find that vertical integration between a pair of firms has a significantly positive effect on independent downstream rivals. This suggests that vertical integration has a substantial efficiency effect that spills over to other firms in the downstream segment. Another finding is that in markets containing two upstream units and one downstream unit, backward integration by the downstream monopolist significantly reduces the profit of the unintegrated upstream firm. This is consistent with the existence of efficiency effects due to vertical integration; the independent upstream firm’s profit falls if it must contend with a tougher rival. The parameter estimates are used to simulate the effect of a hypothetical policy that bans vertically integrated entry. I find that while the ban tends to increase the number of upstream entrants, it tends to reduce the number of downstream entrants. Even though competition in the upstream segment is increased as a result, the lower efficiency of unintegrated suppliers or the existence of double marginalization problems leads to less entry in the downstream segment. This suggests that vertical integration has an entry-promoting effect in the generic drug industry. We cannot observe the effect of the policy on other market outcomes such as prices. However, the finding that vertical integration has significant efficiency effects as well as entry-promoting effects leads us to conclude that banning vertically integrated entry has an adverse effect on market performance. The remainder of the chapter is structured as follows. Section 3.2 explains how this study fits into the empirical industrial organization literature on vertical integration and that on market entry. To my knowledge, this is the first empirical paper to exploit an entry game structure in order to analyze the effects of vertical integration. In Section 3.3, I describe the process of vertical market structure formation in the generic pharmaceutical industry.