Partly to prevent such situations, the FDA requires originator firms to provide information on the patents covering new drugs as part of their NDA filings. Typically, originators provide information on all relevant patents except for those that only claim manufacturing processes. Once an NDA is approved, a list of patents that are associated with the new drug is published in a FDA publica-tion called “Approved Drug Products with Therapeutic Equivalence and Evaluations”, commonly known as the Orange Book.5 The Orange Book is used by generic companies to learn about the existence and duration of originator patents in every drug market that they contemplate for entry. Prior to 1984, generic firms seeking marketing approval had to provide the FDA with the same type of information as originator firms, including data on clinical trials conducted on a large number of patients. As a result of the substantial entry costs that this entailed, entry by generic companies was limited: in 1984, roughly 150 drug markets were estimated to have been lacking generic entrants despite the expiration of patents . The Drug Price Competition and Patent Restoration Act of 1984, also known as the HatchWaxman Amendments, drastically changed the process of generic entry. Most significantly, generic companies were exempted from submitting complete NDAs.6 Instead, a generic entrant could file an Abbreviated New Drug Application , which replaces full-scale clinical trial results with data on bio-equivalence. Bioe-quivalence tests, vertical farming equipment suppliers which compare generic and originator drugs in the way that the active ingredient is absorbed into the bloodstream of healthy subjects, are much smaller in scale and far cheaper to conduct than conventional clinical trials.
When the FDA reviews an ANDA for a generic product, its decision is based on the bio-equivalence test results as well as the clinical trial results contained in the originator product’s NDA. The introduction of the ANDA system implied a huge reduction in product development costs, and generic entry surged after the mid-1980s; the volume-based share of generic drugs rose from 19 percent in 1984 to 51 percent in 2002, increasing further to 74 percent in 2009 . ANDAs are prepared by downstream finished formulation manufacturers and submitted to the FDA some time before they plan to enter the generic market. In the case of a drug containing a new chemical entity, the earliest possible date for filing an ANDA is four years after the approval of the originator’s NDA , but typical filing dates are later. If a generic firm plans to enter after all patents listed in the Orange Book have expired, it begins the ANDA filing process two to three years before the patent expiration date . This reflects the expected time it takes the FDA to review an ANDA; the median approval time was 16.3 months in 2005, increasing in recent years to reach 26.7 months in 2009 .7When unexpired patents are listed in the Orange Book at the time of ANDA filing, the generic firm must make a certification regarding each patent. The firm either indicates that it will wait until the patent expires to enter, or certifies that the patent is invalid or not infringed by its product. The first option is called a paragraph III certification and the latter is called a paragraph IV certification, named after corresponding passages in section 505 of the Federal Food, Drug, and Cosmetic Act. By filing an ANDA containing a paragraph IV certification, a generic firm preemptively counters any patent infringement claims that it expects from the originator. The FDA cannot give full approval to an ANDA until all patents listed in the Orange Book have expired or have been determined to be invalid or not infringed; a tentative approval, which does not permit the ANDA applicant to enter, can be issued in the mean time.
The filing of an ANDA by a generic firm is not publicized by the FDA until the latter announces a tentative or full approval. Therefore, generic firms generally do not observe their rivals preparing and filing ANDAs in real time. The preparation of an ANDA involves the development of the generic drug product by the applicant, who uses it to conduct bio-equivalence tests.8 A physical sample of the product is submitted to the FDA along with documents pertaining to bio-equivalence and quality. An important part of generic product development is the sourcing of APIs. Here, the ANDA applicant faces a make-or-buy decision. If the firm has a plant equipped with specialized machinery such as chemical reactors, it can choose to produce its own API. If the ANDA applicant decides to buy its API from outside, it must find a supplier from among the many manufacturers located around the world. There is no centralized market for generic APIs, but international trade shows such as the Convention on Pharmaceutical Ingredients and Intermediates provide regular opportunities for buyers and suppliers to gather and transact. Once the API is obtained, the downstream firm develops the finished formulation and prepares documentation for the ANDA. The ANDA documents, which are used by the FDA to evaluate the safety and efficacy of the generic product, must convey detailed information regarding the manufacture of the API to the agency. When the API is purchased from outside, the required information must be supplied by the upstream manufacturer. Basic information on the processes used for synthesizing the API is usually shared between the seller and buyer, but there remain trade secrets – such as the optimal conditions for chemical reaction – that the upstream firm may be unwilling to fully disclose to the downstream buyer. This is because the buyer might misuse the trade secrets by divulging them to other upstream firms who are willing to supply the API at a lower price. To address such concerns among API manufacturers, and to maximize the quantity and quality of API-related information that reaches the FDA, the agency uses a system of Drug Master Files . DMFs are dossiers, prepared by individual manufacturers, that contain information on manufacturing processes and product quality for APIs.
By submitting the DMF directly to the FDA rather than to its downstream customer, the API manufacturer is able to convey all relevant information to the regulatory agency without risking the misuse of its trade secrets . Unlike ANDAs, the identities of submitted DMFs are published upon receipt by the FDA.10 If an ANDA applicant buys APIs from outside, it notifies the FDA about the source of the ingredient by referring to the serial number of a specific DMF. At the same time, the applicant contacts the DMF holder, who in turn informs the FDA that the ANDA applicant is authorized to refer to its DMF. In this way, the FDA reviewer knows where to find the API-related information for each ANDA. It is possible for the ANDA applicant to reference multiple DMFs at the time of filing, and for a single DMF to be referenced by multiple ANDAs. On the other hand, adding new DMF reference numbers after filing the ANDA is time-consuming. According to the Federal Trade Commission , it takes around eighteen months for an ANDA applicant to switch its API supplier by adding a new DMF reference. It would appear that a vertically integrated entrant has less of an incentive to use the DMF system than an unintegrated upstream firm. To the extent that the vertically integrated firm produces API exclusively for in-house use, grow light shelves concerns about the expropriation of trade secrets do not arise. In reality, however, many DMFs are filed by vertically integrated firms. One reason for this is that such firms often sell APIs to unintegrated downstream firms even if they are competing in the same market. For instance, Teva, a large Israeli generic drug company who is present in many US generic markets as a vertically integrated producer, sold 32 percent of its API output in 2008 to outside buyers . Another reason is that generic companies often file separate ANDAs for multiple formulations containing the same API. By submitting a DMF to the FDA, an integrated firm can avoid the burden of including the same API information in multiple ANDAs. While one cannot rule out the possibility that vertically integrated firms sometimes refrain from submitting DMFs, the above discussion suggests that a DMF submission is a good indicator of upstream entry by both vertically integrated and unintegrated entrants. A final note regarding DMFs addresses the possibility that a DMF submission does not necessarily imply entry into the API market. As Stafford suggests, some API manufacturers may file a DMF to attract the attention of potential buyers, but may not begin actual product development for the US market until buyer interest is confirmed. Such cases do appear to exist, but the practice is counterproductive for two reasons. First, a spurious DMF that is not backed by an actual product, while creating little real business for the firm, can be potentially damaging for an API manufacturer’s reputation. Second, changing the content of an already-submitted DMF is time-consuming and requires notification to downstream customers . Thus, it seems safe to assume that a DMF submission by a relatively established API manufacturer indicates upstream market entry. In order to motivate the subsequent empirical analysis, I present a stylized description of the vertical market structure formation process in the generic industry.
The process varies depending on whether or not a patent challenge is involved. I first consider the situation without patent challenges, and discuss the case involving patent challenges next. When all generic entrants decide to wait until the expiration of originator patents , the vertical market structure of a given generic drug market is formed through a simultaneous entry game. Potential entrants simultaneously choose their actions from the following four alternatives: unintegrated downstream entry, unintegrated upstream entry, vertically integrated entry, and no entry. A firm’s ANDA filing is not observed by the other players until the FDA announces its approval. This unobservability allows us to assume that firms make their downstream entry decisions simultaneously . On the other hand, an entrant’s submission of a DMF becomes observable when the FDA posts that information on its website. This creates the possibility that some firms choose their actions after observing the upstream entry decisions of other firms. However, since upstream manufacturers tend to submit DMFs later in the product development process, when they are already capable of producing the API on a commercial scale, it is reasonable to assume that upstream entry decisions are made simultaneously with downstream decisions. Once the identities of the market entrants are fixed, we can envision a matching process where downstream manufacturing units are matched with upstream units. The matching process is not observed, because data from the FDA do not tell us which ANDAs refer to which DMFs.14 Afterthe matches are realized, firms invest in product development and document preparation. Upstream units develop their APIs and submit DMFs to the FDA, while downstream units develop finished formulations and file their ANDAs.15 Downstream generic manufacturers market their products to consumers after the FDA approves their ANDAs and all patents and data exclusivities belonging to the originator expire. The payoffs of individual firms are realized when each downstream firm’s revenue is split between itself and its upstream supplier, in the form of payment for APIs. When entry into a generic drug market involves a paragraph IV patent challenge, the process of market structure formation can no longer be described as a simultaneous entry game. There are two reasons for this. First, there is no fixed date when generic firms begin to enter, due to the uncertain nature of patent litigation outcomes. Second, there exist regulatory rules that reward the first generic firm to initiate a successful patent challenge against the originator. This causes potential entrants to compete to become the first patent challenger. The system of rewarding patent challenges was introduced in 1984 as part of the HatchWaxman Amendments. The rationale for providing such an incentive to generic firms is that the outcome of a successful patent challenge – the invalidation of a patent or a finding of non-infringement – is a public good . Suppose that one generic firm invests in research and spends time and money on litigation to invalidate an originator patent listed in the Orange Book.