Is EU competition policy an obstacle [610067]

Is EU competition policy an obstacle
to innovation and growth?
By Simon Tilford
Introduction
Free markets are not always efficient. Left to their own devices, firms will attempt to limit competition so
as to boost profits. Competition needs to be protected and promoted; it does not arise spontaneously.Independent competition policy is needed to ensure that firms are unable to earn monopoly profits by
preventing potential competitors from entering the market. In properly contested markets, firms must striveto be innovative and to maximise their pr oductivity if they are to flourish.
Although it is incomplete, the EU’s single market has done much to extend competition into many sectors
wher e monopolies had pr eviously ear ned excessive pr ofits. In the pr ocess, it has boosted the competitiveness
of Eur opean fir ms and deliver ed a much better deal for consumers. The Eur opean Commission deser ves far
more credit than it is given for facing down recalcitrant governments and for championing economic
openness against the pr otectionist instincts of many member -states.
The focus of this paper is on high-tech fir ms. Both competition law and intellectual property rights are
designed to pr omote innovation and economic ef ficiency . But they pull in dif ferent dir ections, at least
super ficially: competition policy seeks to maximise competition, while the granting of a patent pr ovides an
innovator with a temporary monopoly. High-tech companies need to benefit from the development of their
intellectual property, while newcomers need to be able to challenge incumbents and spur them to innovate.It is up to competition authorities to strike the right balance.
The Commission’s tough line against market abuse by dominant firms is undoubtedly the right one to take
in established, slow-growing industries characterised by a number of firms producing similar but competingproducts. But it is less clear that it is the right approach to take to companies in high-tech sectors. Forexample, high-tech firms often create whole new markets for products, which they inevitably dominate, atleast until a rival company comes along and challenges them. It is this temporary market power and theassociated profits that help justify heavy investment in research and development (R&D).
Critics of the Commission’s approach to dominant high-tech firms allege that if they are forced to share
their intellectual property with competitors, or are prevented from controlling the price at which theirproducts and services are sold, they will innovate less. This, in turn, will slow the development of new goods
and services and hence competition, to the detriment of consumers and broader economic performance.
Indeed, the EU has regularly been accused of failing to understand the nature of competition in thesemarkets, and of favouring the inter ests of ‘competitors’ rather than ‘competition’.
Europe’s future prosperity will depend to a large extent on its success in developing and sustaining successful
high-tech businesses. The r easons for Europe’s lack of innovation relative to the US are complex, as the EU
recognised when it launched the Lisbon agenda of economic reforms in 2000. An insufficiently skilledworkforce is one problem; others are fragmented markets and a lack of venture capital. But competitionpolicy can also influence the ability of firms to reap the rewards of investment in R&D. As such, it could
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have a bearing on Europe’s ability to produce and sustain big high-tech businesses. This paper will examine
this issue with r eference to the Microsoft case and the EU’s sectoral inquiry into the pharmaceuticals sector.
Defining competition
Technological progress and the diffusion of new technologies are essential for sustained economic growth.
But the EU’s record in recent years of bringing new innovations to market has been mixed. European firmsare still technological leaders in some sectors – such as mobile telephony – and share leadership in industriessuch as aerospace and pharmaceuticals. But the EU’s record in producing fast-growing high-tech businesses
is poor, certainly compared with the US, but also increasingly with Asia. In the past 40 years, five new high-tech US start-ups have made it into the list of the 100 biggest companies in the world (by marketcapitalisation): Microsoft, Sun Microsystems, Intel, Cisco and Oracle. No European firm has achieved such
growth over the same period. The one that comes closest is SAP, a German producer of business software.
There are plenty of small high-tech European firms. The problem is that very few of these small companies
grow into big businesses. One explanation is the lack of venture capital. There is no pan-Europeanequivalent of Nasdaq, the stock exchange for start-up companies established in 1971. All five of the US
firms mentioned above were listed and continue to float on Nasdaq. However, the fragmentation of EUmarkets, combined with still insufficient levels of competition in some sectors and under-investment in
human capital, are further reasons for Europe’s poor record of producing large, high-tech businesses.
Competition law may not be the most important explanation for Europe’s relative dearth of innovation, butit deserves more attention. After all, firms will only invest in R&D if they are confident that they will reap
the rewards of that investment. Competition policy can affect their ability to do so, and as such is far frombeing an esoteric concern.
There is no doubt that the European Commission’s directorate general (DG) for competition is driven by a
determination to ensure competitive markets. Indeed, it has done an enormous amount to open them up
across the EU, doggedly facing down protectionist pressures in member-states. It is worth remembering that
most EU countries have limited experience with independent competition authorities. In most member –
states, the setting-up of independent competition policies lagged behind the establishment of EUcompetition law . One notable exception was Germany, which established the Deutsches Kartellamt
(German Car tel Of fice) in 1957. By contrast, the US Sher man Act, which intr oduced federal laws forbidding
businesses fr om monopolising a market to ear n unfair pr ofits or r estrain fr ee trade, dates from 1890.
The Commission’ s appr oach to competition policy has traditionally been mor e mechanistic or
formalistic than that of its US counterpar ts. For example, if a pr oposed merger between two firms
would give the combined company a dominant market position, the Commission would decide against
it on competition grounds. It has placed little emphasis on analysing whether the proposed tie-up couldbe beneficial to consumers by, for example, allowing the merged company to exploit greater economiesof scale or other synergies. It simply deduced that a position of market dominance must lead to lesscompetition and hence anti-competitive behaviour. By contrast, the US authorities have always beenmore reluctant to intervene against dominant firms for fear of undermining innovation, and moretrustful of the markets to punish anti-competitive behaviour. They have tended to believe that if adominant firm exploits its position by overcharging its customers, other firms will enter the market insearch of a share of its ‘excess’ profits.
The Commission’s attitude partly reflects the influence of post-war German thinking. Because Germany was
the only major member-state that had developed an independent competition policy, its approach stronglyinformed EU competition law. German competition policy was driven by a determination to preventconcentrations of power , be they political or economic, and hence prevent any return to the monopolies and
cartels that dominated the economy under the Nazis. It was based on the belief that markets could only be
considered competitive where no firm could influence the price of its product. Although this wasconceptually pr oblematic even in the 1950s (most companies have some degree of market power), there is
little doubt that Germany’s determination to ensure markets were properly contested explains much of the
country’s post-war success. Whereas other EU countries, notably Britain and France, were seduced byindustrial policies that put the inter ests of producers first, Germany’s Cartel Office ensured such policies had
no place in Germany.
However, there were also more practical reasons for the Commission’s approach. The EU economy was
much less integrated than the US one, and firms therefore found it harder to enter new markets in the EU.Because markets wer e generally less competitive and mor e fragmented than in the US, ther e was less chance
that anti-competitive behaviour by fir ms would quickly be challenged by new competitors entering the

market. The task facing the EU’s competition authority was therefore more demanding than that
confr onting their US counterparts, and a more interventionist approach to competition policy was justified.
Reforms of EU competition policy
However, EU competition policy has undergone significant reform in recent years, with the Commission
modernising merger policy and reforming its interpretation of article 81 of the EC treaty, which deals with
cartels and restrictive vertical agreements.1This modernisation was the
Commission’s response to several developments: empirical work on what makes
a market competitive; a number of European Court of Justice rulings against theCommission; and the gradual liberalisation of many sectors across the EU,which has increased the likelihood that the market would punish anti-
competitive behaviour.
The Commission now applies more economic analysis when considering its decisions, studies the actual
effects of a proposed merger on the consumer, and accepts that in certain circumstances mergers can be goodfor competition. Certainly in the area of merger policy, it is unfair to accuse the Commission of putting the
interests of ‘competitors’ ahead of ‘competition’.
But one area where the Commission’s approach has not really evolved is its treatment of dominant firms.
Under article 82 of the EC treaty (which covers market abuse by dominant firms), they have a specialobligation to avoid behaviour which can ‘restrain, distort or hinder competition.’ This means that
commercial strategies that would be legal for firms that do not have a dominant market position are deemedunlawful when pursued by a firm that does. The Commission defines a dominant firm as one that controls
more than 50 per cent of the market for a particular product.
On the face of it, the Commission’s interpretation of article 82 looks to be robust and pro-competition.
How can market dominance possibly be in the interests of the consumer or competition? After all, unless
firms have to stay ahead of the competition, what incentive will they have to innovate? The Commission’ s
approach is undoubtedly the right one to take in established, slow-gr owing industries characterised by a
number of fir ms producing similar but competing products, such as manufacturers of cars or household
goods. The question, however , is what constitutes market power . For example, it is less clear that the
Commission is right wher e a fir m’s dominant position has come about thr ough heavy investment in R&D
and the accumulation of valuable intellectual pr operty. When applied to these companies, EU competition
policy may be less favourable to competition than its advocates believe.
An understanding of the nature of competition in high-tech industries needs to recognise the role of
temporary market power as a driver of innovation. Firms in high-tech industries with high R&D costs andhence exposure to risk, such as those in the pharmaceuticals and information and communicationtechnologies (ICT) sectors, often preside over a large share of the market for a particular product. This doesnot necessarily indicate a lack of competition. Many high-tech companies cannot help but have a dominantmarket position, because they have often created whole new markets for a product they have developed. Butmarket leadership in high-tech sectors tends to be short-lived compared with more mature industries. A newproduct from a rival firm can very quickly make the dominant technology redundant. The opportunity tocharge high prices – for a while at least – is often what drives companies in these sectors to innovate.
A high degree of market concentration and substantial profits should not necessarily be taken as a sign that
competition is failing. The profits of the dominant firm offset the losses of the many losers and act as anincentive for others to innovative and supplant the dominant technology. For its part, the incumbent usuallyhas to invest heavily to r etain its lead. Most economists believe this dynamic process drives innovation and
benefits the consumer. If firms are forced to share their intellectual property with competitors, or prevented
from controlling the price at which their products and services are sold, there is a risk that they will innovateless. This, in tur n, can slow the development of new goods and services and hence competition and
productivity growth, to the detriment of consumers.
In 2005, the Commission published a consultation paper which suggested that r eform of article 82 should
build on the reinterpretation of article 81, and lead to greater use of economic analysis to understand thenature of competition in markets for high-tech products, such as ICT and pharmaceuticals. The papersuggested that the Commission should look much more closely at whether the actions of a dominantcompany actually benefit consumers. For example, if consumers profit from the dominant firm’s economiesof scale or the ubiquity of its pr oduct, and if the dominant company cannot pr event potential competitors
from entering the market, this would make action against it much less likely . A mor e economic3
1 Vertical agreements are
arrangements between two or more
companies operating at dif ferent
levels of the production,
distribution or supply chain.

interpretation of article 82 would mean the Commission only intervening where a firm could disregard
customers and suppliers with impunity .
However, since the publication of the consultation paper the Commission has been reluctant to be drawn
on how its appr oach will evolve. Indeed, if the stance it has adopted in relation to the ICT and
pharmaceuticals industries is anything to go by, the likelihood of significant change in the interpretation of
this key aspect of competition policy appears to be receding.
The ICT and pharmaceuticals sectors are crucial to Europe’s economic growth prospects. It is of pivotal
importance that the right environment exists for investment in these technologies. Both are fast-growing,R&D-intensive industries, in which innovation can lead to huge new markets and rapid productivitygrowth. The development and efficient use of ICT and the growth of successful firms in this sector would
do much to help Europe close the gap in productivity with the US. While the diffusion of ICT across the
EU has accelerated in recent years, EU spending on ICT-related R&D is
running at a little over a third of US levels.
2In
1990, the global research-based pharmaceuticalindustry still invested roughly 30 per cent more in Europe than in the US.
Today it invests roughly 50 per cent more in the US than in Europe.
3If the
gradual erosion of the EU’s position in pharmaceuticals persists, the EU will bepoorly placed to profit from new industries, such as genomics,
nanotechnologies and cognitive and neuro-sciences.
The next two sections will look in more depth at the ICT and pharmaceuticals sectors, because it is here
that the tension between innovation and EU competition law is at its most stark. Both industries are very
competitive, but inevitably tend towards a high degree of market concentration. In the case ofpharmaceuticals, this is because of the financial costs of developing new medicines. Only a small proportion
of drugs under development ever reach the market, so firms have to be very big in order to sustain the
necessary investment in R&D. In both industries, firms are often creating whole new markets for their
products, which inevitably leads to some degr ee of market power . In addition,
there are power ful network ef fects at work in the ICT sector .
4It makes sense for
firms to agree on an industry standard, so that equipment and software are
compatible. However , this confers monopolies on the fir m that owns the patents
on the industr y standar d.
Information and communication technologies – just like any other industry?
Two of the most controversial issues in competition law today are the extent to which a dominant firm can
be compelled to share its intellectual property with competitors, and the right of a dominant company tobundle the sale of one product along with others. These tensions have been graphically illustrated in the caseof Microsoft, the supplier of over 90 per cent of the world’s computer operating systems (Windows).
Following a series of complaints by the firm’s competitors, the European Commission launched an
investigation into Microsoft’s commercial practices. In 2004 it imposed a record fine on the company forabusing its dominant position in the market for computer operating systems. The Commission ruled thatthe firm must share more technical information with rival makers of computer servers, to ensure that rivals’
server software works smoothly with Microsoft’s Windows software. TheCommission concluded that the company was attempting to exploit itsdominant market share in one market – computer operating systems – to cementits dominant position in the market for company servers. For the same reason,the Commission also demanded that Micr osoft offer a version of Windows
without a media player for playing and listening to music and videos
downloaded from the internet. The Commission’s decision was subsequentlyupheld by the EU’ s Court of First Instance (CFI) in September 2007 and cannot
be appealed to the European Court of Justice.
5
Suppor ters of the Commission’s tough line against Microsoft, such as the Free
Software Foundation, argue that the decision will lead to greater competition,which will benefit consumers and be a catalyst for more innovation in theindustry.
6They are dismissive of arguments suggesting that high-tech sectors
are different from other industries because of the importance of intellectualproperty, or that the ubiquity of Micr osoft’ s products could benefit consumers
and businesses. They allege that Micr osoft’ s contr ol of cr ucial intellectual pr operty entr enches its4
2 Main science and technology
indicators, OECD, 2008/1 edition. 3 Submission to the European
Commission in relation to the
pharmaceuticals sector inquiry,
European Federation ofPharmaceuticals Industries
Associations, June 2008.
4 Network ef fects mean that a
service becomes mor e valuable as
more people use it, thereby
encouraging ever mor e people to
adopt it.
5 The Court of First Instance was
created in 1989 and is attached to
the European Court of Justice. It
gives rulings on certain cases, particularly those brought by
private individuals, companies andsome or ganisations. It also deals
with competition law.
6 The Free Software Foundation
is a charity with a mission to pro-
mote computer user fr eedom and
to defend the rights of all free
softwar e users.

monopoly position and undermines innovation: Microsoft itself has little incentive to innovate because its
market shar e is guaranteed, whereas potential competitors have little incentive because they have no hope
of challenging Microsoft.
Critics of the EU action against Micr osoft, such as the US Association for Competitive Technology, maintain
that the firm is being punished for being successful. They argue that
compromising Microsoft’s intellectual property by forcing it to share withcompetitors will stunt innovation at the company and in potential competitors(who will innovate less for fear they will be unable to maintain control of their
intellectual property).
7The result, critics allege, will be weaker growth in
productivity and hence economic growth.
The Commission’s tough line against Microsoft is not motivated by protectionism or anti-US bias: most of
the firms that stand to gain from the EU’s action are also American ones. There is no reason to suspectMicrosoft would have been treated any differently had it been a European company. The reason why US
companies have been in the firing line is that US firms dominate the ICT sector. Rather than reflecting EUbias, the action against Microsoft has served to highlight how few major European firms are active in ICT.
It is not our purpose to judge the merits or otherwise of the EU’s case against Microsoft. It is, of course,
perfectly possible that Microsoft’s commercial strategy has been anti-
competitive, and that it has been exploiting its dominant position in one market
to thwart potential competitors, to the detriment of consumers and competition.Rather, we are interested in the Commission’s reasoning for the action it tookagainst the firm (and the justifications the CFI gave for upholding the
Commission’s action), and the implications for innovative businesses operatingin the EU.
8A number of the points that underpin the Commission’ s analysis and
the CFI’s judgement require clarification.
As it stands, the CFI’ s ruling appears to pr ovide a legal foundation for the
Commission to for ce a dominant company to shar e its intellectual pr operty with
its rivals.9In its r uling the CFI implies that a dominant company cannot refuse
to shar e its intellectual pr operty by citing the damage this could do to its
incentive to innovate. Y et it cannot be right to claim that ever y intellectual
property that potential rivals need in order to be able to challenge a dominant
company should be shar ed. If that wer e really the law , those assets that wer e most valuable would be the
ones that dominant fir ms would be for ced to shar e. It is puzzling that there is no meaningful analysis by the
Commission of the long-term effects on innovation and investment of a general requirement for dominant
firms to share intellectual property.
In industries such as ICT and pharmaceuticals, where R&D largely determines which firms are
competitive and which are not, a general obligation to share valuable intellectual property coulddiscourage innovation and ultimately damage competition. Once a firm has created valuable intellectualproperty that allows it to maintain a temporary monopoly, rivals will obviously have an interest inforcing it to share. But a dominant firm should be entitled to refuse to share its intellectual property ifthis is the fruit of significant investment. After all, the purpose of intellectual property rights is to rewardrisk-taking and spur innovation.
This issue was alluded to in the Commission’s 2005 draft paper on reform of article 82, but the Commission
has not subsequently clarified its position. In its ruling, the CFI does not spell out that companies shouldonly be for ced to share their intellectual property with competitors in truly extraordinary circumstances,
nor does it recognise that Microsoft is an extraordinary case. It is essential that the Commission moves
quickly to spell out its position. Otherwise, the accusation that it is more interested in protectingcompetitors than competition could star t to ring true.
The Commission also needs to indicate more clearly how the ubiquity of a company’s products could benefit
the consumer . For example, the Commission and CFI do not acknowledge the potentially positive power of
network effects in telecoms, computing and other digital industries. Standardisation around a dominantoperating system normally creates benefits for consumers, including greater availability of software writtenin standard computer code (which would not be developed in a fragmented market). Of course, suchnetwork effects confer monopolies on the makers or patent holders of the dominant technology. However,so long as consumers benefit and so long as bar riers to entr y into the industr y are relatively low , it is not
clear that inter vention by the competition authorities is war ranted. 5
7 The Association of Competitive
Technology is an international
organisation representing more than3000 small and mid-size
infor mation technology firms from
around the world.
8 The Court of Justice of the
European Communities, usuallycalled the European Court of Justice
(ECJ), is the highest court in the
EU. It has the ultimate say onmatters of EU law in order to
ensur e equal application across the
various member-states.
9 Robert O’Donoghue, ‘Microsoft
v. European Commission: sounds
good in theory but….’, Global
Competition Policy, September2007.

Instead of engaging in a period of reflection, there are signs that the Commission feels emboldened by its
success against Micr osoft. In the aftermath of the CFI ruling, the Competition Commissioner, Neelie Kroes,
called for a big fall in Microsoft’s market share: “You can’t draw a line and say
exactly 50 per cent is correct, but a significant drop in market share is what wewould like to see.” Mor eover, without naming Microsoft specifically,
Commissioner Kroes, came out very strongly in April 2008 in favour of open-
source software, arguing that no business shouldleave itself dependent on one software supplier.
10She even questioned the sense
of purchasing proprietary software.11The Commission appears to be going
beyond its remit – to set ground rules for competition – by seeking to determine
actual market outcomes.
The Microsoft case and the CFI’s ruling suggest that the Commission needs to employ more economic
analysis in its assessment of what makes for competitive markets in high-tech goods. It also suggests that
the Commission has little confidence in the power of markets to tame monopolies. This scepticism isjustifiable in mature industries, but not necessarily in high-tech sectors. It still shows little recognition thatmonopoly positions in these businesses are often transitory because entry barriers are low, and that taking
action against dominant high-tech firms could do more harm than good. The Commission appears ready torisk stunting innovation, and perhaps the economic efficiencies that would stem from network effects,
rather than accept a high degree of market dominance.
There is an urgent need for guidelines that clearly lay out the circumstances in which a dominant company
can be considered to have abused its market position and what action it can expect from the Commission.The established case law does not provide sufficient clarity. At present, intervention is largely being driven
by the complaints of competitors, but the interests of competitors are sometimes not the same as those ofconsumers. The Commission needs to r eaffirm that it is committed to taking a more economic approach in
this area, and clarify how it intends to enforce article 82. If laws are not clear or the nature of competition
misunderstood there is a risk that firms will not invest.
Pharmaceuticals: the wrong target?
EU-based fir ms ar e much mor e active players in the phar maceuticals industr y than in the ICT sector . Indeed,
European fir ms compete mor e successfully in this high-tech industr y than in any other , with France, Germany
and the UK home to some of the world’ s most successful pharmaceuticals
companies. But the futur e of the EU’ s resear ch-based phar maceuticals sector
cannot be taken for granted. T wenty years ago, Eur ope was the centr e of this
industry. Since then there has been a steady shift from Europe to the US. Between
1990 and 2005, spending on pharmaceuticals R&D in the US grew by 4.6 times;in Europe the figure was just 2.8. In 2005, North America accounted for 47 percent of world pharmaceuticals sales, compared with 30 per cent in Europe.
12
The reasons for this shift are complex, and include Europe’s eroding science base and popular attitudes
to new technologies. However, the main reason is the economic and regulatory framework in the EU.Pharmaceuticals prices are much higher in the US and the market for new innovative drugs is now muchbigger in the US than in the EU. According to market analysts IMS Health, the US market now accounts
for around two-thirds of the sales of medicines launched since 2001; the EUaccounts for barely a quarter.
13Drugs companies tend to do their R&D
where they do their clinical trials, which is in their biggest and mostprofitable markets.
Despite this loss of supremacy, the pharmaceuticals industry remains hugely important for Europe,
accounting for 15 per cent of private sector R&D in the EU. Indeed, successful R&D determines whetherpharmaceutical firms thrive or fail to a greater extent than in any other industry. Pharmaceuticals companies
argue that big profits are needed to fund research on a large range of potential products, most of which
never make it to market. They stress that they will only be able to maintain their current levels of investmentin R&D if they can satisfy their shar eholders that it will be sufficiently profitable. Shareholders are certainly
sceptical about the future profitability of the pharmaceuticals industry. Expected returns on shares inpharmaceuticals firms have declined steadily since the turn of the century, and until the onset of the financialcrisis their shares had underperformed the stock-market as a whole.
On Januar y 15
th2008 the Eur opean Commission announced a sectoral inquir y into the phar maceuticals
sector . It accompanied its move with a dawn raid on the of fices of a number of Eur opean and US6
10 Unlike commercial (proprietary)
software, open-source software canbe easily studied by other
programmers and improved upon.
11 Proprietary software is computer
software on which the producer has
set restrictions on use, private modi-
fication, copying, or republishing.
12 EFPIA submission to the
European Commission in relationto the phar maceuticals sector
inquiry, European Federation of
Pharmaceuticals IndustriesAssociations, June 2008.
13 ‘US prescription sales grew
3.8 per cent in 2007, to $186.5
billion’, IMS Health press release,March 2008.

pharmaceuticals companies. As evidence that the EU pharmaceuticals market is not working efficiently, the
Commission cited an alleged slowdown in the number of innovative medicines being br ought onto the
market and delays in the introduction of generic (and hence cheaper) alternatives to patented drugs. In
particular, the Commission stated that it wanted to determine whether agreements between pharmaceuticalsfirms were slowing the introduction of new medicines and whether firms were using patent disputes and so-
called ‘ever-greening’ (extending patent protection for existing medicines) and vexatious litigation to shut
generic drugs out of the market. The Commission noted that generic medicines account for 42 per cent ofthe EU market compared with 63 per cent in the US.
Although the Commission was at pains to stress that it had not drawn any conclusions about what, if any,
action would need to be taken to address the problems cited in the terms of the inquiry, this was the firsttime dawn raids have been used in an inquiry of this kind.
The terms of the inquiry are troubling, because they omit any mention of the impact that the structure of
the pharmaceuticals market could have on competition. There is no doubt this market is distorted, but a
major reason for this lies with member-state governments, rather than the firms themselves. EU member-states control prices of prescription medicines through extensive national regulation comprising controls on
prices or profits. In most EU countries, national regulatory bodies also effectively determine the demand fora particular drug because healthcare budgets are capped. Pharmaceuticals firms have very little pricing
power and very little scope to influence demand for their products. The market for pharmaceuticals in
Europe is not a competitive one, and as such it is questionable whether firms can be considered to be‘dominant’ if they control the market, or a large share of it for a particular treatment.
Faced with intense pressures to limit the growth in healthcare spending, the average prices paid for
medicines across the EU have been falling at a time of steep rises in the costs of R&D, squeezing theprofitability of sales in the EU. Moreover, prices paid for the same medicines vary hugely across the EU.
They tend to be lowest in member-states that do not have a research-based pharmaceuticals sector, such as
Spain and Italy. The Spanish and Italian governments do not have to balance the need to contain healthcare
spending with the need to ensur e that phar maceuticals fir ms have incentives to innovate, and ar e free to
concentrate on negotiating the lowest prices possible. They have little to lose fr om Eur opean fir ms shifting
their R&D out of the EU. The UK, Ger many, the Netherlands and Sweden are the high price countries. This
is no coincidence, as they (along with France) ar e the EU countries with significant r esear ch-based
pharmaceuticals industries, and they need to ensur e that the dr ugs companies have suf ficient incentives to
do R&D in the EU.
By omitting the str uctur e of the market fr om the terms of its inquiry, the Commission is effectively arguing
that these national regulatory regimes have no impact on the readiness of pharmaceuticals firms to develop
new medicines. The Commission does not recognise that dominant buyers could be exploiting theirposition; the focus is on alleged abuse of dominance on the part of the firms. But any market characterisedby a dominant buyer should cause the Commission as much concern as one dominated by a single supplier.Of course, the Commission can do little about the distortions created by national pricing regimes – it hasno competence in the area of healthcare – but it must at least recognise that the various national regulatoryframeworks can distort the market and that the prices paid for medicines influence the readiness of firms toinnovate and to supply particular markets. Pharmaceuticals companies will only introduce the medicines ifthey are confident it will be profitable.
An innovation strike?
The Commission’s inference that pharmaceuticals companies are engaged in some kind of innovation strike
and that they ar e purposely slowing the introduction of new drugs is puzzling. Unless the pharmaceuticals
firms bring new products onto the market they have little future. It is far from
clear that there has been a decline in innovation, if by that we mean a decline inthe number of dr ugs being brought onto the market.
14 But even if this had
occurred it would not necessarily reflect collusion between pharmaceuticalssuppliers. It is as likely to reflect the increased costs of developing drugs anddoubts on the par t of the companies that they will be able to charge sufficiently
high prices on EU markets to justify the investment.
There is little doubt that the rate of growth of R&D spending by pharmaceuticals companies in the EU
has slowed and that, combined with the increased costs of developing new medicines, this will lead to adecline in the number of innovative dr ugs being developed in the EU. But the principal r eason for the
weaker gr owth of R&D is the price the fir ms receive for the medicines, rather than a lack of competition7
14 Submission to the Eur opean
Commission in relation to the
pharmaceuticals sector inquiry,
European Federation of
Pharmaceuticals Industries
Associations, June 2008.

between firms. If innovative drugs are not coming onto the market it is likely to be because EU
gover nments are not paying sufficiently high prices for it to be worthwhile for pharmaceuticals companies
to supply the drugs or because national regulatory bodies are unwilling to give clearance to new drugs that
they decide they cannot afford.
The prices of patented drugs are much lower in the EU than the US. According to
a US Department of Commerce study published in 2004, the average price ofpatented medicines in the EU was little over half that in the US.
15Although the
figures are not strictly comparable (firms have to spend much more on marketing
medicines in the US than in the EU) there is no doubt that the pharmaceuticals firms are increasingly dependenton the US for profits. As mentioned earlier, the prices paid for patented drugs also vary widely across the EU.It is no coincidence that more new medicines are available in the US than the EU or that medicines become
available more quickly in higher price EU countries than in lower price ones. The Commission should
recognise how price controls could have an impact on the speed at which drugs come to market.
The Commission could be on stronger ground with its suspicion that the pharmaceuticals firms are
attempting to extend the lives of the patents on their existing drugs. But any assessment of whether or not
pharmaceuticals firms are engaged in ever-greening cannot be made in isolation, and must also recognisethe impact that national regulatory frameworks and pricing structures have on the incentives to develop and
introduce new drugs in the EU. If attempts to artificially prolong the lives of patents are a reaction to low
prices and other regulatory issues, punishing firms for it will further undermine the market environment forinnovation. The maintenance of prevailing price structures and national regulatory structures, combined
with a dilution of patent rights, risk upsetting the balance of incentives and could lead to an accelerateddecline in R&D spending in the EU.
Parallel trade and dual pricing
Parallel trade refers to wholesalers buying medicines in an EU market where prices are low, selling them in
another EU market wher e prices ar e high, and ear ning a pr ofit in the pr ocess. For example, the prices of
patented medicines ar e ver y low in Gr eece and Spain, which do not have r esear ch-based phar maceuticals
industries. GlaxoSmithKline, a British fir m, was found guilty by the Commission in 2004 of dual pricing.
It had r efused to supply a dr ug to Spanish wholesalers at the dr ug’s standar d price on the Spanish market,
instead demanding that the wholesalers pay prices similar to those in the EU markets to which the
wholesalers intended to r e-export the drugs.
In other markets, such as those for cars or other consumer goods, parallel trading has contributed to price
convergence across the EU, usually by forcing companies to lower prices, and helped to deepen the singlemarket. However, these are markets where prices are set by the companies. In the pharmaceuticals sector inEurope they are set by the governments; unlike car manufacturers, pharmaceuticals companies are ‘price-takers’ (they have to accept what public bodies are prepared to pay).
The Commission claims that a refusal to supply wholesalers in low price countries “interferes with the
commission’s objective of integrating domestic markets and restricts price competition for the company’sproducts”, and that “dual pricing cannot be justified on economic grounds since there is no evidence thatpartitioning the common market would encourage investment on innovation”.
16The Commission analysis
implies that there is a single EU market in pharmaceuticals and that thepharmaceuticals companies are responsible for partitioning it. But there is nosuch integrated EU market and no price competition for the firms to underminebecause prices are set by national bodies. This is the principal reason for the lackof integration in the phar maceuticals industry, not the actions of firms.
The Commission’s claim that its ruling against GlaxoSmithKline would impact
on innovation is also debatable. Even the W orld Health Organisation (WHO)
believes otherwise. According to the WHO, the current system of EU price
controls “has a direct effect on what medicines are produced by innovator
companies”.
17This is understood by the EU’ s High Level Pharmaceutical Forum, composed of the 27 EU
ministers responsible for the pharmaceuticals industry along with the Commissioner for Enterprise andIndustry, Günter Verheugen, and the Commissioner for Health, MarkosKyprianou. In its second progress report published in 2007, it argued thatmember-states needed to “create the right environment for price competition”and ensur e innovation by pr oviding fir ms with the “right signals to companies
on what innovations ar e expected and valued”.
18 8
15 US Depar tment of Commerce,
‘Pharmaceutical price controls inOECD countries’, October 2004.
16 Directorate General for
Competition, EuropeanCommission, ‘Sectoral inquir y into
the pharmaceuticals industry’,January 2008.
17 World Health Organisation,
‘Priority medicines for Europe and
the world’, November 2004.
18 ‘Guiding principles for good
practices implementing a pricing
and reimbursement policy’, Annex
A to the pharmaceutical forum
second pr ogress report, June 2007.

The ECJ ruled on the GlaxoSmithKline case on September 16th2008, with both sides claiming victory. The
Commission claimed that the r uling meant that firms refusing to supply would be breaking EU law. But the
ruling was more nuanced. The ECJ went some way to meeting the concerns of the research-based
pharmaceuticals firms, arguing that a firm should be able to be able to “counter in a reasonable andproportionate way” trade where a wholesaler was importing large quantities of a drug with a view to re-
exporting it to member-states where the price of the medicine was higher.
If the sectoral inquiry fails to take into account the issue of pricing structures when looking at parallel trade,
it will come to the wrong conclusions. It is far from clear that firms should be found guilty of abuse of
market dominance for refusing to supply wholesalers in low price markets, because the firms are pricetakers, and because prices in some member-states are set at artificially low levels. Very low prices mayprovide some short-term benefits to the Greek and Spanish taxpayers, but are too low to make investment
in new drugs worthwhile. If prices are too low in markets such as Spain and Greece, they have to be higher
elsewhere in order to ensure that firms have the incentive to develop new drugs. Essentially, low-pricedcountries are free-riders. If prices were bid down to the level of the lowest price market in the EU, the decline
of the EU pharmaceuticals industry would accelerate. The Commission’s reasoning appears to confuse lowprices with a competitive market. In the case of the pharmaceuticals sector, low prices mean that firms have
weaker incentives to develop the drugs to challenge the incumbent treatments.
Too few generics
There is no doubt that the share of the EU pharmaceuticals market accounted for by generic medicines is
too low in the EU. It is possible that pharmaceuticals firms are using patent practices to place obstacles inthe way of generic competitors. But any analysis of why the penetration of generics in the EU is lower thanin the US needs to consider the ways in which the segmented structure of the EU pharmaceuticals market
and the national pricing str uctures slow the introduction of generic alternatives to patented medicines. First,
many national markets are too small for it to be worthwhile for generic companies to enter them. Second,
there is again the issue of price. In countries where the prices for innovative drugs are low, penetration of
generics is low . For generics makers to consider it wor thwhile entering a market, ther e has to be a big
enough dif ference between the price of a patented dr ug and the price that will be paid for a generic
alternative. As noted earlier, this difference is much lower in the EU than the US, with the result that generics
makers have fewer incentives to enter EU markets.
Indeed, what the debate over generics shows is that the EU cur rently suffers the worst of both worlds: EU
countries ar e not paying enough to ensur e that the EU r emains a central base for phar maceuticals r esear ch,
but ar e not benefiting fr om cheaper generic alter natives as quickly as the US because their markets are not
attractive enough for generic manufacturers. Ironically, the countries that are essentially free-riding on the
health budgets of other member-states by paying artificially low prices – Spain, Italy and Greece – do worstwhen it comes to benefiting from cheaper generic alternatives. They might be paying low prices for patenteddrugs, but these financial benefits are offset by the fact that they make less use of generics.
The sectoral inquiry needs to consider how the EU can build a genuine single market in pharmaceuticals
products. A genuinely integrated market would be much more predictable for firms, who would not haveto contend with so many different regulatory structures and pricing regimes. It would also open the wayfor much more efficient use of generic medicines. The market penetration of generic medicines wouldimprove because companies would be selling into one large market rather than 27 segmented ones, andoperating according to one pricing regime.
Conclusion
Europe will not be able to compete in the global economy on the basis of its current specialisation in
medium-technology sectors, such as car manufacturing and electrical engineering. As was explicitlyrecognised in the EU’s Lisbon agenda of economic reforms launched in 2000, European countries need to
improve their record of developing high-tech businesses if they are to prosper. The reasons for Europe’s poor
record of innovation are complex, but one rather neglected factor is competition policy. Competition policyneeds to foster rather than deter high-tech innovation.
The rules of competition policy should apply to high-tech sectors, just as they do to all others. But EU
competition policy needs to take into account the special characteristics of high-tech industries as well asthe regulatory environments in which firm operate when deciding whether to take action against them forpursuing allegedly anti-competitive practices. The pr esence of a dominant company does not necessarily
point to an uncompetitive market.9

The very nature of competition in high-tech sectors creates barriers to entry and positions of market power.
High-tech fir ms often create whole new markets for products, which they inevitably dominate, at least until
a rival company comes along and challenges them. It is this temporary market power and the associated
profits that help justify their heavy investment in R&D. Forcing innovative companies to share theirintellectual pr operty in order to foster competition will lower prices in the short-term. But it will not
necessarily be in the interests of competition or the consumer in the longer-term if it undermines incentives
for companies to innovate and develop new products.
This paper looked at these issues with reference to the Commission’s action against Microsoft and its
sectoral inquiry into competition in the pharmaceuticals sector. The Commission’s position vis-à-visMicrosoft (along with that of the EU’s Court of First Instance), implies that a dominant company should beforced to share its intellectual property in order to enable other firms to compete with it. In a sector such
as ICT where firms compete by investing in R&D, this is problematic. Such a general requirement to share
the intellectual fruit of this investment threatens to weaken competition, not strengthen it, to the detrimentof consumers.
The Commission’s sectoral inquiry into the pharmaceuticals industry highlights the risks of basing
competition policy on an incomplete understanding of the nature of competition in a particular market.Pharmaceutical prices are set by the government or public healthcare body in each of the 27 member-states,
and often at levels that are too low to justify investment in innovation. Unless the EU can do something to
address the fragmented and unpredictable nature of the market for pharmaceuticals in Europe, it needs tobe careful about any action it takes against the pharmaceuticals firms for allegedly anti-competitive
practices. Taken in isolation, there is a risk that such action will further undermine R&D expenditure bypharmaceuticals firms in Europe.
Both the Micr osoft case and the sectoral inquiry into the pharmaceuticals industry suggest that the
Commission needs to employ more economic analysis in its assessment of what makes for competitive
markets in high-tech goods. It should provide greater clarity about what constitutes a dominant market
position, the cir cumstances in which a dominant company can be consider ed to have abused its market
position, and what action it can expect fr om the Commission. It needs to r ecognise that temporar y
monopoly positions in high-tech businesses ar e often inevitable and that taking action against dominant
high-tech fir ms can do mor e har m than good. If the r ules ar e not clear , or the natur e of competition is
misunderstood, innovation will suf fer.
#
Simon Tilford is chief economist at the Centre for European Reform.
November 200810
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