International Society for New Institutional Economics Vertical Integration Trends in the Bulgarian Pharmaceutical Sector: A Case Study Tamara Todorova Department of Economics American University in Bulgaria International Society for New Institutional Economics Iceland, June 2007 Tamara Todorova, American University in Bulgaria Iceland, June 2007

1. Literature Review: Empirical Studies Monteverde and Teece (1982) Masten (1984) Lilien (1979) Anderson and Schmittlein (1984) Anderson (1985) John and Weitz (1988) Muris, Scheffman and Spiller (1992) Tamara Todorova, American University in Bulgaria Iceland, June 2007

2. Conceptual Framework Asset specificity * site specificity * physical asset specificity * human asset specificity * dedicated assets * brand name capital Uncertainty and bounded rationality Opportunism Tamara Todorova, American University in Bulgaria Iceland, June 2007

Table 1. Choice of market versus firm contracting Asset Specificity Low High Opportunism Market Firm Table 1. Choice of market versus firm contracting Tamara Todorova, American University in Bulgaria Iceland, June 2007

4. The Bulgarian Pharmaceutical Sector Consumer preferences Profitability and nature of distribution Types of pharmacy chains Major drug manufacturers - Actavis - Sopharma - Chaika Pharma Tamara Todorova, American University in Bulgaria Iceland, June 2007

4. The Bulgarian Pharmaceutical Sector Legal regulations EU requirements Violations of good commercial practices Tamara Todorova, American University in Bulgaria Iceland, June 2007

Drug Manufacturer Wholesaler Retailing Sopharma Sopharma Trading Yes, through Sanita Franchise Actavis Hygia No, attempted through Mareshki Pharmacies Chaika Pharma Commercial League Yes, through Exemplary Pharmacies and Pharmatel, attempted Sofia Pharmacies Table 2. Vertically integrated structures in the Bulgarian pharmaceutical sector Tamara Todorova, American University in Bulgaria Iceland, June 2007

5. Vertical Integration Drives High transaction costs for drug manufacturers Low consumer trust – fake or banned drugs High degree of opportunism on the part of distributors Quality problems Long distribution channels Asset specificity Tamara Todorova, American University in Bulgaria Iceland, June 2007

Asset specificity favors own production Asset specificity favors own production. The more specific the drug and the greater the investment in brand name, the greater the likelihood of internalization. Tamara Todorova, American University in Bulgaria Iceland, June 2007

Branded drugs are expected to be sold predominantly through integrated (own) outlets, while generic drugs through non-integrated outlets. Tamara Todorova, American University in Bulgaria Iceland, June 2007

6. Potential for Empirical Research = profit margin (unit profit) of the th drug; = 1 if branded drug, 0 if generic; = unit costs of producing the th drug. Tamara Todorova, American University in Bulgaria Iceland, June 2007

profit is likely to be higher with branded drugs, greater profitability of own production with higher asset specificity. higher costs are expected to reduce profit; combined effect of production and transaction costs. an interaction term coefficient that leads to a slope dummy; profits would also fall if branded drugs incur higher costs. Tamara Todorova, American University in Bulgaria Iceland, June 2007

profit margin falls with sales. = sales of the th drug profit margin falls with sales. Tamara Todorova, American University in Bulgaria Iceland, June 2007

Table 3. Contingency table generic drug specific drug non-integrated sales (independent retailers) vertical integration (own pharmacies) Table 3. Contingency table Tamara Todorova, American University in Bulgaria Iceland, June 2007

advertising spent on the th drug 1 if the pharmaceutical manufacturer is vertically integrated with a pharmacy, 0 otherwise; 1 if the drug carries the brand name of the manufacturer, 0 if it is generic; advertising spent on the th drug Tamara Todorova, American University in Bulgaria Iceland, June 2007

specificity of drugs drives forward integration in the Bulgarian pharmaceutical sector; higher advertising expenditures represent greater investment in brand-name capital and imply greater tendency for forward integration of drug manufacturers with pharmacies. Tamara Todorova, American University in Bulgaria Iceland, June 2007

7. Discussion High transaction costs drive vertical mergers of drug manufacturers with distributors. Common ownership guarantees common supply, common advertising, low cost and low prices of medicines. Firms achieve full control over financial flows and pricing strategies. Tamara Todorova, American University in Bulgaria Iceland, June 2007

Better advertising, special handling of products. Forward integration is important for products that need coordination of marketing and distribution. Better advertising, special handling of products. Drugs are sophisticated products that require information, special demonstration or proper display. Greater efficiency and cost savings. Tamara Todorova, American University in Bulgaria Iceland, June 2007

The major driving force behind vertical mergers between drug manufacturers and distributors seem to be asset specificity of drugs and the sizable transaction costs faced by producers in a low-trust transition economy such as Bulgaria. Tamara Todorova, American University in Bulgaria Iceland, June 2007