Isn't Competition Grand?: Wal-Mart, Drugs, and Antitrust

Josh Wright —  25 October 2006

Fred Tung highlights Wal-Mart’s new strategy of selling a month’s supply of 300 different generics for $4, noting that Target will match Wal-Mart’s prices but Walgreens and CVS will not. Isn’t competition grand? Well, not everyone is convinced that low prices for consumers is a good thing.

Unsurprisingly, for instance, this strategy has not gone over well with smaller pharmacies who have much to lose from increased competition. A BNA Health Care Report (HT: David Fischer) notes that “community” pharmacists are planning to ask state AGs to investigate whether Wal-Mart’s $4 generic program is designed to avoid state predatory pricing laws. John Rector, the senior VP and general counsel of the National Community Pharmacists Association, accused Wal-Mart of introducing the program in states (now expanded to 14) without predatory pricing laws.

Wal-Mart has been a popular issue for legal scholars, see e.g., this symposium at UConn, Thom’s post on outsourcing, and this post from Gordon Smith which mentions in passing that a JLR search of Wal-Mart produces 5799 documents!  While I realize that Wal-Mart “the phenomenon” provides fodder for legal discussion across many areas of substantive law, the antitrust issue seems to be picking up traction. The above-mentioned symposium, for instance, includes a panel entitled “Breaking Up the Big Box: Trade Regulation and Wal-Mart.”

I have written in this space before about the unconvincing antitrust case against Wal-Mart. This suit against generics appears to fall in the same category as the general lament against competition and low prices appearing in Barry C. Lynn’s essay in Harper Magazine (to which I respond in this post): “Breaking the Chain: The Antitrust Case Against Wal-Mart,”

“to defend Wal-Mart for its low prices is to claim that the most perfect form of economic organization more closely resembles the Soviet Union in 1950 than 20th century America. It is to celebrate rationalization to the point of complete irrationality.”

The notion that low prices can form the basis of any reasonable argument for an antitrust attack on Wal-Mart is laughable. Of course, antitrust does allow for the remote possibility that predatory pricing strategies allow a firm to use low prices to drive out rivals and recoup monopoly profits in the future. But such consumer welfare losses are not only generally unlikely, but especially improbable in a retail segment characterized negligible barriers to entry and consistently low profit margins. Further, the empirical contradicts this theory at every turn. For instance, Jerry Hausman and Ephraim Leibtag’s econometric analysis of the impact of Wal-Mary entry on consumer welfare suggests that Wal-Mart brings enormous gains to consumers.

At the end of the day, these complaints are transparent. They are not about consumers. They are not about protecting competition. And they are certainly not about efficiency. These are complaints about the competitive process itself. My response to Lynn’s call to arms to use federal antitrust law to level an attack on Wal-Mart designed to equalize distribution chain bargaining power seems equally applicable to private actions under state antitrust law against low priced generics:

The antitrust attack against the retailer that has been a boon to consumers is incredibly misguided because it invokes the wrong tool (antitrust law) to engineer a market structure that will certainly harm consumers without any meaningful benefits. The Antitrust Feds ought to leave Wal-Mart to its consumer welfare increasing ways and focus on endeavors that are more likely to help consumers than hurt them.

11 responses to Isn't Competition Grand?: Wal-Mart, Drugs, and Antitrust

  1. 

    Elizabeth: No, the profit margins are low for retailers. Let me know if you are interested enough in proof of this to have me send you data.

    Wrt barriers to entry, I suspect we are applying definitions. Without getting into Bain v. Stigler definitional debates on BTE, these guys are not earning supra-competitive profits (see above point, maybe you will need me to send proof). I suspect you are thinking that capital costs to build a store are an antitrust BTE. I don’t think so.

    Finally, selling loss leaders and increasing sales on products where the retailer earns a higher margin (markup over the wholesale price it pays the manufacturer) say nothing about profit margins of the store as a whole. Of course, supermarkets and other multi-product retailers sell products with low margins, high-margins, and sometimes at a loss. But profit margins for retailers are low, and have been consistently low over time as concentration has increased.

  2. 
    Elizabeth Nowicki 27 October 2006 at 8:12 am

    “My point is that it the conditions for predatory pricing simply do not exist in the retail industry where there are low barriers to entry and consistently low profit margins”
    Two things:
    1. Low profit margins? I did not think so. Matter of fact, I thought the margins went the OTHER way. No?
    2. Low barriers to entry? No. Maybe we are defining how to assess the barriers differently? What are you thinking of?
    3. I have never taught antitrust in my life (though I have published on it), so I might be totally wrong, but. . . I have vague vague recollections that parties often take a loss on products to get the consumer in the store to spend on high margin products. I cannot remember, though, if that creates a antitrust issue. I thought it did, but you (Josh) are the antitrust guru. I defer to you.

  3. 
    John L. Davidson 27 October 2006 at 6:46 am

    Josh.

    Please go back and re-read my post, for I believe you rushed thru for you misstate my point.

    I did not say that antitrust policy should focus on the issues I raised. I specifically said that it had already been shown to be of limited usefulness in that regard.

    That’s why I suggested that new thinking and research should be undertaken into entirely different issues—for example, why are community pharmacies and bankers unable to come up with new business models and change to meet the competition from wal-marts?

    Having 30 years experience in bank regulation I could make a hell of an anecdotal argument that Wal-Marts “won” principally due to the lack of riskless capital for community pharmacies.

    If you are a small local business, borrowing money on a personal signature and facing the loss of one’s home and future on an attempt to compete with Wal-Marts is a very risking adventure, one that few people would rationally undertake, especially since the people running Wal-Marts face no personal risk whatsoever.

    In my view, Wal-Marts won, in terms of path dependence, once it became a public company. At that point the fight was no longer a fair one.

    If one looks at the case study in this light, one immediately sees that other factors can offer insights. For example, I believe it took wal-marts a long time to get into California. An explanation might have been that California has anti-deficiency legislation so local retailers could put up more of a fight.

    In sum, there are many factors that could account for Wal-Marts. Any objective observer would could that the country is worse off because of Wal-Marts, but the reasons I believe have nothing to do with what Wal-Marts did or is now doing but instead have to do with legal failings and institutional failings on the part of others.

    Said differently, stop listening to stock brokers touting a stock and start observing and considering other explanations.

  4. 

    Thanks for the comments all! A few quick responses:

    Elizabeth: Yes is the answer to your questions. Of course, I never claimed otherwise. In fact, as I mentioned in the post, predatory pricing is certainly an antitrust issue. My point is that it the conditions for predatory pricing simply do not exist in the retail industry where there are low barriers to entry and consistently low profit margins.

    Thom & David: The issue of PBMs negotiating down discounts from manufacturers is one that is analogous to the ability of supermarkets to negotiate discounts from product manufacturers. It is important, however, to distinguish this ability of a retailer facing a downward sloping demand curve to extract such discounts by “selling” its consumer base to manufacturers or promoting one product or another from monopsony power. All supermarkets have this power. So does Wal-Mart. This point is not made to “correct” either of you. It is just an observation I thought I would add to the discussion.

    John L Davidson: The notion that antitrust policy should focus on “changes that need to be made” because there are losers in the competitive process is, indeed, non-conventional thinking. The same complaints were made by small firms with high cost structures in the early days of antitrust. The ideas that antitrust ought to be used to equalize income distribution and protect small businesses are not wrong because they are unconventional — unconventional is great — they have been rejected because they are without economic basis or empirical support.

  5. 

    David–

    You may be absolutely right that Walgreens and CVS could match Wal-Mart’s prices on generics without pricing below their own costs. If that’s the case (and it probably is), then they ought to lose business to Wal-Mart.

    As I noted, the weak link in my alternative theory is the claim that Wal-Mart and Target have more influence over prescribing decisions than do Walgreens and CVS. Obviously, they do not have the same power held by HMOs and PBMs (and it was that power that explained the differential pricing in the Brand Name Prescription Drugs case).

    I have no idea what sort of insurance plans Wal-Mart negotiates for its employees. It’s plausible, though, that it dictates some treatment outcomes, and it may specify that doctors treating its insureds must prescribe one drug over another (e.g. Paxil over Prozac). If it does this sort of thing (and I would not be at all surprised — the company is constantly looking for ways to cut costs), then it has a pretty powerful bargaining tool: it can ensure that its employees (it has 1.8 million — not all are insured, of course) use one drug over another.

    In theory, Walgreens could exercise similar control, but my guess is that it would be less likely to do so. It’s not as aggressive a cost-cutter, and it has only 163,000 employees (so its cost-savings wouldn’t be that great).

    Again — I’m just positing a theory. I admittedly don’t know the facts about the degree to which Wal-Mart manages its employees’ health care. I was just trying to come up with an explanation — besides predation (which seems very unlikely) and the pharmacy chains’ insistence on supracompetitive prices — for Walgreens’ and CVS’s failure to meet the Wal-Mart discount.

  6. 

    Tracked a cite down, and the PBM is Medco. See http://www.thejournalnews.com/apps/pbcs.dll/article?AID=/20061013/BUSINESS01/610130338/1066.

    In regards to Thom’s comment, generics – although less expensive to consumers – are more profitable for the seller (Wal-Mart, CVS, etc.) than brand name drugs. Thus, the price can be lowered quite a lot before it becomes unprofitable. (As to Thom’s formulary theory, I think that would apply to HMO’s and PBMs who do control the formularies (such as Medco). But retailers do not control formularies. I am not sure how Target and Wal-Mart would “control the health insurance” of someone, much less “many more” someones than CVS and Walgreen’s. Could you elaborate?)

    Although simplistic, Wal-Mart and Target (and Medco) are doing well financially; CVS and Rite Aid and Walgreen’s are all in trouble. Wal-Mart can afford the risk of lowering prices on generic drugs; it can sustain the lower profits on the generics (assuming it does result in lower profits).

    But while it is possible that – as Elizabeth Nowicki comments – Wal-Mart plans on lowering prices, driving the competition out and then raising prices, I think this very unlikely here. First, I am not aware that Wal-Mart has done this in the past. Wal-Mart is famous (or infamous) for entering new towns and driving local retailers out of business because its goods are cheaper. But I am not aware of Wal-Mart then raising its prices. (If this did happen, the antitrust laws would provide a remedy.)

    Second, Wal-Mart is a smart business and it wants to make money. It probably calculated that it can do this because it believes that consumers will buy more of its other products at Wal-Mart or because it believes it will make up for the “lost” profit with increased volume (or a combination of both). Given that Wal-Mart has traditionally made its money via volume, my guess is that it believes that it can make more money by lowering the price and increasing sales.

  7. 
    John L. Davidson 26 October 2006 at 3:18 pm

    Wal-Mart’s is symptom, not a disease. One can only hope than rather than tending toward political grandstanding, someone in the legal academic world would ask the right question—which really has very broad application—and this why are are institutions like banks and business schools wholly failing to provide community” pharmacists with the tools—cash, and networks—and the skills to change, adopt, and continue to be viable with the twin benefits of choice for consumers and opportunity and income equality for broader segments of our society.

    Said differently, I look at Wal-Marts and do not see success by Wal-Marts. I see failure by those who compete with Wal-marts.

    I am reminded by a reprint in the current HBReview on marketing that pointed out that railroads missed the point when they say themselves only as railroad companies, not transportation companies.

    I guess, in part, I am wondering why, since the strenths and limits of antitrust are so apparent, why don’t we have real new scholarship into why did the loosers, loose to Wal-marts and what changes need to be made?

    This is a separate quetion from whether Wal-Marts now has abusive market power, which it does.

    Alternatively, give the shape and distribution of gross income in the country, it is also possible to argue that Wal-Marts is the direct result of our income policies which have for 30 years driven down income for 99% of America. Literally, we have driven shoppers into the hands of Wal-Marts. Said, differently, there is a real chicken, egg problem with just saying that it’s all due to the skill of Wal-Marts.

    If real incomes for the bottom 99% of Americans had risen the last 30 years, who knows.

    I recall well the writing of Thurow who pointed out that if you are a barber and you want to get $500 for haircut, then you need to open your shop in a wealthy, productive community where the incomes are high.

    The current Atlantic Monthly has a great way to start looking at this question —maps of where college grads are living today. Wal-Marts is not in those markets.

    This are just questions, not arguments, meant to challenge the too conventionl thinking of this “blog”

  8. 

    Great post, Josh. I wonder why Walgreens and CVS won’t meet the discounts. One theory is predation: Wal-Mart is pricing below cost, and Walgreens and CVS simply cannot afford to engage in a price war with a predator. As you note, that theory’s pretty implausible because recoupment would be nearly impossible in an industry (retail pharmaceutical drug sales) with negligible barriers to entry and a formidable competitor (Target) that will not be driven out of business.

    So what’s going on? Why won’t Walgreens and CVS meet these consumer-friendly discounts? I think there are two possible answers, both of which would exonerate Wal-Mart. First, the pharmacy chains may just be refusing to give up margin on generic drugs. If that’s the case, then they deserve to lose business to Wal-Mart. Any antitrust intervention that would protect their right to charge supracompetitive prices would be perverse.

    A second theory is that Wal-Mart and Target have lower costs than Walgreens and CVS and can thus charge a price that’s above their own costs (i.e., non-predatory) but below the pharmacy chains’ costs. So why might that be the case? One possibility is scale efficiencies — Wal-Mart and Target are bigger and can therefore take advantage of various economies of scale not available to Walgreens and CVS. Perhaps, but I doubt it. Walgreens and CVS are pretty darn huge.

    Another possibility is that Wal-Mart and Target are better able to negotiate discounts from drug manufacturers. My guess — and it’s admittedly a guess — is that this is what’s going on.

    So why would drug manufacturers give greater discounts to Wal-Mart and Target than to Walgreens and CVS? The famous In re Brand Name Prescription Drugs case suggests an answer. In that case, retail pharmacies alleged that the drug manufacturers had conspired to deny discounts to retail pharmacies while providing such discounts to managed care organizations such as HMOs. The evidence of “agreement” was a remarkably parallel pattern of giving discounts to HMOs but denying them to retail pharmacies. As it turns out, there was a good reason for each drug manufacturer, acting unilaterally, to treat HMOs more favorably than retail pharmacies: HMOs control doctors, can dictate prescribing decisions, and can thus “move market share” from one brand name prescription drug (e.g., Paxil) to another (e.g., Prozac). Retail pharmacies, by contrast, have no control over prescribing decisions and thus cannot “reward” a discount by favoring one drug over another.

    (Readers interested in this case should read Judge Posner’s opinion here.)

    So here’s my theory: Wal-Mart and Target control the health insurance of many more folks than Walgreens and CVS. They can dictate, for their insureds, which prescription drugs get prescribed. (In other words, they can posit “formularies” that favor certain drugs over their competitors.) Wal-Mart and Target therefore have greater ability than Walgreens and CVS to move market share from one drug to another. Accordingly, when they ask the drug manufacturers for a discount, they’re more likely to get it. This means their costs for drugs will be lower. And because they have lower costs, they can under-cut Walgreens and CVS without pricing below cost.

    OK — it’s just a theory. The weak link is probably my claim that Wal-Mart and Target can control prescribing decisions for lots of people. I don’t know that that’s the case, but it wouldn’t surprise me if Wal-Mart had negotiated insurance plans for its gazillions of employees that gave it some control over doctors’ prescribing decisions.

  9. 
    Elizabeth Nowicki 26 October 2006 at 9:35 am

    Josh, wait a minute. Maybe I need to go back and re-read your post, or maybe I need to take Micro/Macroecon again, but I thought lowering prices, driving competition out of business, and then raising prices as essentially a monopolist (or oligopolist) was indeed a problem of the competition/economics/antitrust. No?

  10. 

    I do not have a cite handy, but I recall reading that one or more major Pharmacy Benefit Managers, have reduced its (their) price(s) for generic drugs in response to Wal-Mart’s move. Given that an ever-increasing number of people purchase their drugs via PBM mail-order, this should help an even larger number of individuals reduce their spending on generic drugs. It is also, of course, further evidence that competition in this market is alive and well (and, I would argue, evidence that the best response to Wal-Mart’s move is to compete not to push a lawsuit).

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  1. TRUTH ON THE MARKET » Obama on Wal-Mart - November 29, 2006

    [...] Of course, if it were not, Wal-mart’s hypothetical (and dubious) strategy to earn monopoly rents through reducing labor costs would be easily undone by rival seizing a profitable entry opportunity to compete with Wal-Mart on price and increase wages! The other argument could be that Wal-Mart is refusing to increase prices and generate revenues which could be applied to increased wages. Nonsense again. This implies that Wal-Mart would be better off by increasing prices but refuses to do so, i.e. our daunting monopolist is not maximizing profits. And let me preempt Elizabeth’s question (see, e.g. the comments to this post on Wal-Mart’s drug plan) … No, this is not a claim about predatory pricing, i.e. low prices now associated with losses recouped by monopoly profits later. Rather, this is a claim that the monopolist’s profit-maximizing strategy is to offer low prices in order to not be able to afford higher wages. [...]