Evergreening and Operational Risk Under Price Competition

Abstract

"Evergreening" is a strategy wherein an innovative pharmaceutical fi rm introduces an upgrade of its current product when the patent on this product expires. The upgrade is introduced with a new patent and is designed to counter competition from generic manufacturers that seek to imitate the firm's existing product. However, this process is fraught with uncertainty because the upgrade is subject to stringent guidelines and faces approval risk. Thus, an incumbent fi rm has to make an upfront production capacity investment without clarity on whether the upgrade will reach the market. This uncertainty may also affect the capacity investment of a competing manufacturer who introduces a generic version of the incumbent's existing product but whose market demand depends on the success or failure of the upgrade. We analyze a game where capacity investment occurs before uncertainty resolution and fi rms compete on prices thereafter. We find that the incumbent will always continue to o ffer its older product even if the upgrade succeeds. Further, it can never deter entry by investing in excess capacity. We fi nd that the incumbent is less likely to invest in evergreening as the intensity of competition in the generic market increases. We also fi nd that the incumbent firm is more likely to invest in evergreening if the entrant faces a capacity constraint than when the entrant does not. Further, we characterize outcomes for a social planner in terms of social surplus and market coverage, by incorporating the risk-return trade-off that the incumbent faces in terms of level of product improvement versus the upgrade success probability. We show that incremental evergreening may be socially optimal when the innovative firm's capacity investment is taken into account, contrary to the prevalent view of regulators who seek to curtail incremental evergreening.