The Added Value of the Plural Form. Evidence from Dutch Pharmacy Chains

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1 The Added Value of the Plural Form Evidence from Dutch Pharmacy Chains

2 TITLE CHAPTER NYENRODE BUSINESS UNIVERSITEIT The Added Value of the Plural Form Evidence from Dutch Pharmacy Chains Proefschrift ter verkrijging van het doctoraat aan de Nyenrode Business Universiteit op gezag van de Rector Magnificus, prof. dr. E.A. de Groot en volgens besluit van het College voor Promoties. De openbare verdediging zal plaatsvinden op dinsdag juni 008 des namiddags om vier uur precies door Rosalie M. Aldewereld-Duijvis geboren op april 9 te Zaanstad

3 TITLE CHAPTER Leescommissie Acknowledgements Promotores: Overige leden : Co-promotor: Prof. dr. H.R. Commandeur Prof. dr. E. Peelen Dr. F. Langerak Prof. dr. ir. A.K. Hajdasinski Prof. dr. R. Huijsman Prof. dr. H.S.J. Robben Prof. dr. ir. C.A.G.M. van Montfort Writing a doctoral thesis is something that I never imagined myself doing. I actually believed it to be boring and something for nerds. After my graduation I wanted to work in business. My graduation thesis was my first real encounter with science. I wrote this thesis, which was part of somebody else s Ph.D. research, at Nyenrode Business Universiteit. During the process of writing, I realized that science was not so boring after all! I actually considered it to be very challenging. I liked to try to get to the core of things and to crack my brains. Contrary to expectations I therefore decided to conduct my own Ph.D. research. The Ph.D. period has appeared to be a very valuable and interesting one; a period in which I have been given the opportunity to develop myself further, intellectually as well as personally. Despite all positive things it has not always been an easy period for me. Many times, I have seriously considered quitting. Luckily, I haven t. The completion of this doctoral thesis would not have been possible without the help of many people. I am deeply indebted to them all and I would like to take this opportunity to thank them. First of all, I want to thank my supervisors, Harry Commandeur, Ed Peelen, and Kees van Montfort, for their guidance during the project. Each of them has contributed in a different and very valuable way. Harry was involved from the very beginning. Whenever I was lost, he pointed me in the right direction. I very much appreciate his unconditional support and belief in my research. Ed s ability to quickly point out cause and effect were very important in analyzing my data. He pushed me when I really needed to be pushed. Without his focus on the bigger picture, my thesis would not have been finished yet. Finally, Kees was a great help to me in the statistical analysis. I don t know how I would have completed this analysis without his guidance. Second, I want to thank the members of the promotion committee. I am grateful for their valuable suggestions and comments. Special thanks go to Henry Robben, who was very helpful in constructing my conceptual frameworks. My gratitude also goes to the pharmacists that participated in the pre-test of the survey and all interviewees. Of these interviewees, Peter de Jong from Kring-apotheek deserves special thanks. I also want to thank my former thesis student, Bert Hendriks. His knowledge of the pharmacy sector has been very useful to me. Furthermore, I want to thank Robert van der Zwart. Without him I wouldn t have started this Ph.D. research in the first place. Third, I have received great support from my colleague, friend, and former roommate, Mr. Reddy. He has always been there to exchange ideas, to talk about other things than

4 TITLE CHAPTER research, or to calm me down with some wise words. Vijay, thank you and I miss having you as a roommate. I am looking forward to your defense! I also want to thank my other roommate, Mr. Zaka. With such great sense of humor, you will definitely be able to win the heart of your own blonde bombshell! I am also very thankful to my parents, whose support I could have not done without. Whenever the end seemed beyond reach, they were there to listen and to offer an encouraging word. Last, but certainly not least, I want to thank Jelle, who stood by me throughout the entire process. Thank you for being so patient with a girlfriend (and now wife) who always felt the need and the pressure to finish her Ph.D! I know it was difficult to understand that the difference between a two-week and three-week holiday was not just that I would finish my Ph.D. a week later. I hope that the three of us will enjoy a lot of three-week holidays and weekends away in the future! Rosalie Aldewereld-Duijvis Table of contents Chapter Introduction to the research questions Chapter Introduction to the research questions. Introduction.... Research questions.... Research methodology.... Objectives.... Limitations of of the thesis thesis.... Outline of of the thesis... Chapter Theoretical framework: Plural Plural governance 8. Introduction Characteristics Introduction of governance structures Firms Characteristics governance of choice: governance Either-or structures Chain Firms organizations governance governance choice: Either-or choice: Franchise or company- owned outlets..... Firms Chain governance organizations choice: governance And-and... choice: Franchise or company-owned outlets.. Structure-Conduct-Performance... Firms governance choice: And-and.. Conclusions Structure-Conduct-Performance.... Conclusions Chapter Empirical setting: The Dutch pharmacy sector 8 Chapter. Introduction Empirical...8 setting: The Dutch pharmacy sector. Pharmaceutical care policy in the Netherlands Introduction Controlling drug expenditure Pharmaceutical The role of care health policy insurers the in Netherlands pharmaceutical care market 0. Sector.. Analysis... Controlling drug expenditure..... Suppliers The role of health insurers in the pharmaceutical care market.. Sector New Analysis entrants Substitutes Suppliers.... Buyers New entrants.... Competitive Substitutes rivalry. Situation.. in Buyers other countries.... Conclusions.. Competitive...8 rivalry. Situation in other countries. Chapter Conclusions Research methodology and results: Case study 0 9. Introduction...0 Chapter. Case study method... Research methodology and results: Case study.. Why a case study?... Introduction Case study design.. Dutch Case plural study pharmacy method chains.... Unit.. growth... Why a case study?

5 VIII TITLE table of contents 8 9 table of contents CHAPTER IX..... Constraints Case study on design unit growth.. Dutch Plural plural dynamics: pharmacy Speeding chains up the unit growth process.. Local Unit responsiveness growth Pharmacies Constraints limited on unit local growth responsiveness Local Plural responsiveness: dynamics: Speeding Franchise up pharmacies the unit growth vs. company-owned process pharmacies Local responsiveness Plural Pharmacies dynamics: limited Achieving local higher responsiveness levels of local responsiveness 0. Creating.. uniformity Local responsiveness:... Franchise pharmacies vs. company-owned.. Generating pharmacies ideas.... Plural Plural dynamics: Generating Achieving more higher ideas levels and of more local varied responsiveness ideas 8... Creating Testing uniformity and evaluating ideas Plural Generating dynamics: ideas A more thorough testing process Decision-making Plural dynamics: Generating more ideas and more varied ideas.... Plural Testing dynamics: and evaluating Persuading ideas franchisees and pre-decision learning Implementation Plural dynamics: A more thorough testing process..8.. Plural Decision-making dynamics: Persuading franchisees and post-decision learning. Maintaining.. Plural uniformity...8 dynamics: Persuading franchisees and pre-decision learning.... Plural Implementation dynamics: Achieving higher levels of uniformity 80.8 Conclusions..8 Plural...8 dynamics: Persuading franchisees and post-decision learning. Maintaining uniformity 9 Chapter.. Conceptual Plural dynamics: framework Achieving and hypotheses higher levels of uniformity 8.8. Introduction Conclusions...8. Structural characteristics: Franchise pharmacies vs. company- owned pharmacies..8 Chapter. Conceptual Conceptual frameworks...8 and hypotheses.. Conceptual framework : Local responsiveness 8... Introduction Conceptual framework : Generating ideas Structural Conceptual characteristics: framework Franchise : Testing pharmacies ideas 90 vs. company-owned.. pharmacies Conceptual framework : Decision-making 9... Conceptual Conceptual frameworks framework : Implementation 9. Conduct:.. Franchise Conceptual pharmacies framework vs. : company-owned Local responsiveness pharmacies...9. Performance:.. Conceptual Plural pharmacy framework chains : Generating vs. pure pharmacy ideas chains Performance:.. Conceptual Plural chain framework pharmacies : Testing vs. pure ideas chain pharmacies Conclusions.. Conceptual...99 framework : Decision-making 8.. Conceptual framework : Implementation 8. Chapter Conduct: Research Franchise methodology: pharmacies Survey vs. company-owned 0 pharmacies 8.. Introduction Performance:...0 Plural pharmacy chains vs. pure pharmacy chains 89.. Why Performance: a survey?...0 Plural chain pharmacies vs. pure chain pharmacies 9.. Sampling Conclusions frame Pretest...0 Chapter. Data collection...0 Research methodology: Survey. Structure of the survey Scales...0 Introduction 9. Why a survey? 9..8 Conclusions Sampling frame Pretest 9. Chapter Data collection Research results: Survey Introduction Structure of...0 the survey 9.. Correspondence Scales between the observed and the actual distribution The Conclusions measurement model: Confirmatory factor analysis Construct validity 0 Chapter. Structural characteristics: Research results: Franchise Survey pharmacies vs. company- owned pharmacies. The structural model Introduction Assessing overall structural model fit Correspondence Local responsiveness: between the Relationships observed and among the actual structure, distribution conduct, and performance The measurement model: Confirmatory factor analysis.... Testing Construct hypotheses validity Structural Generating characteristics: ideas: Relationships Franchise pharmacies among structure, vs. company-owned conduct, and performance. 0 pharmacies.. The structural Testing hypotheses model Testing Assessing ideas: overall Relationships structural among model structure, fit conduct, and performance Local responsiveness: Relationships among structure, conduct, and Testing performance hypotheses Decision-making: Testing hypotheses Relationships among structure, conduct, and performance Generating ideas: Relationships among structure, conduct, and Testing performance hypotheses..0.. Implementation: Testing hypotheses Relationships among structure, conduct, and performance.. Testing ideas: Relationships among structure, conduct, and.. Testing performance hypotheses. Conduct:.. Franchise Testing hypotheses pharmacies vs. company-owned pharmacies.... Performance:..8 Decision-making: Plural pharmacy Relationships chains vs. pure among pharmacy structure, chains... conduct, and.8 Performance: performance Plural chain pharmacies vs. pure chain pharmacies Conclusions..9 Testing...0 hypotheses..0 Implementation: Relationships among structure, conduct, and Chapter 8 Conclusions, performance contribution, and suggestions for further research 9 8. Introduction.. Testing... hypotheses Answering Conduct: research Franchise question pharmacies... vs. company-owned pharmacies. 8. Answering Performance: research Plural question pharmacy and chains... vs. pure pharmacy chains Performance: Local responsiveness: Plural chain pharmacies Relationships vs. pure among chain structure, pharmacies conduct, and performance Conclusions 8.. Generating ideas: Relationships among structure, conduct, and performance Chapter Conclusions, contribution, and suggestions for further research Testing ideas: Relationships among structure, conduct, and performance 8. 0 Introduction Answering Decision-making: research question Relationships among structure, conduct, and performance 8. Answering research questions,, and

6 XTITLE table of contents 0 CHAPTER CHAPTER Implementation: Local responsiveness: Relationships Relationships among structure, among structure, conduct, conduct, and performance and performance Conduct: Generating Franchise ideas: pharmacies Relationships vs. among company-owned structure, conduct, pharmacies and 8.. Performance: performance Plural pharmacy chains vs. pure pharmacy chains Performance: Testing ideas: Plural Relationships chain pharmacies among vs. structure, pure chains conduct, pharmacies and 8. Contribution performance to science and practice Scientific Decision-making: contribution Relationships among structure, conduct, and 8.. Practical performance contribution 8. Limitations 8.. Implementation: and suggestions for Relationships further research... among structure, conduct, and performance References Conduct: Franchise pharmacies vs. company-owned pharmacies 8.. Performance: Plural pharmacy chains vs. pure pharmacy chains 0 Appendix 8..8 A List Performance: of people interviewed Plural chain pharmacies 8 vs. pure chains pharmacies 8. Contribution to science and practice Appendix 8.. B Cover Scientific letter contribution and survey Practical contribution 8. Appendix Limitations C Descriptive and suggestions statistics for further 98 research 9 References Appendix D Test statistics of multi-item constructs 0 Appendix A E Removed List of people items interviewed 0 Appendix Nederlandse B samenvatting Cover letter 0 and survey Appendix C Appendix D Appendix E Descriptive statistics Test statistics of multi-item constructs Removed items Nederlandse samenvatting Curriculum vitae Chapter Introduction to the research questions. Introduction Most empirical work on governance decisions focuses on explaining firms choice among governance structures. These works consider this choice as a function of circumstances. Under certain circumstances, one governance structure does better than another. As the circumstances vary, so do the governance structures that are observed. Nevertheless, in practice very different governance structures often exist side by side. Many retail chain organizations, for example, use both franchise and company-owned outlets (i.e. outlets that are owned by the chain operator). Well known retail chains active in different industries such as Albert Heijn, McDonald s, Etos, and Benetton all have franchise outlets as well as their own outlets. Also in other marketing settings, firms use different governance structures simultaneously. For example, firms often make and buy parts (Heide, 00); alternatively, they sometimes use a direct sales force and third party distributors (Anderson and Schmittlein, 98). In the literature the simultaneous use of different governance structures for the same function is referred to as the plural form (Bradach and Eccles, 989). The first explanations concerning the use of the plural form have been limited to specific conditions. For instance, according to Brickley and Dark (98), the combination of franchise and company-owned outlets within a system is based on monitoring costs. As company-owned outlets incur higher monitoring costs, they are located near company headquarters, while as franchise outlets incur lower monitoring costs, franchising occurs in more distant locations. Some researchers have started to shed the assumption that one particular governance structure is obviously superior under certain conditions. Rather than (just) the product of micro level conditions, they argue that the plural form is the product of the synergistic potential of different governance structures. The synergistic benefits of the plural form have been highlighted by a number of research works (e.g. Bradach and Eccles, 989; Dant et al., 99; Lafontaine and Kaufmann, 99) and then have been further developed and empirically validated by Bradach (99, 99). In his exploratory research, Bradach studied how restaurant chains use a plural form to better meet their key strategic objectives (e.g. uniformity and local responsiveness). He As As described described by by Heide Heide (00), (00), the the term term plural plural form form is is used used somewhat somewhat differently differently by by researchers. researchers. Cannon Cannon et et al. al. (000), (000), for for example, example, define define a plural plural form form as as a mixture mixture of of different different control control mechanisms mechanisms used used for for a single single exchange. exchange. Bradach Bradach (99), (99), on on the the other other hand, hand, considers considers a plural plural form form to to be be a combination combination of of distinct distinct governance governance structures. structures. Bradach Bradach and and Eccles Eccles (989) (989) allude allude to to both both uses uses of of the the term. term. In In this this thesis thesis we we adopt adopt Bradach s Bradach s use use of of the the term. term.

7 TITLE chapter i n t r o d u c t i o n t o t h e r e s e a r c h q u e s t i o n s CHAPTER explained that differences in the organization and management of franchise and companyowned restaurants can cause certain processes, which he calls plural dynamics, across these restaurants. For instance, due to their stronger financial incentives, franchisees are motivated to search for revenue enhancing ideas, which can be used later in companyowned restaurants. According to Bradach, these plural dynamics enable operators of plural restaurant chains to better meet their strategic objectives. Hence, he predicts that plural chains outperform pure chains (i.e. chains that consist only of franchise outlets or companyowned outlets). After Bradach, a number of scholars have conducted empirical research on the synergistic benefits of the plural form. For instance, Cliquet and Croizean (00) studied the advantages of having both franchise and company-owned outlets for cosmetic chain organizations, and Lewin (99) examined the implications of a mixture of franchise and company-owned outlets for innovation within restaurant chains. Some other scholars have studied the benefits of the plural form outside the context of franchising systems. For example, in the context of industrial purchasing, Heide (00) investigated whether firms can better manage information asymmetry problems by augmenting market relationships with internal organization. In this thesis we investigate the benefits of the plural form for Dutch pharmacy chains. In the Netherlands the pharmacy sector has been characterized by considerable consolidation in the past years. Approximately 9% of the Dutch community pharmacies are currently part of a chain organization. The reasons for this chain development are diverse. For example, since 999, it has become considerably easier for non-pharmacists to exploit pharmacies in the Netherlands. In reaction to this measure, various parties, particularly pharmaceutical wholesalers, have started to acquire pharmacies. The measures imposed by the Dutch government to control the expenditure on pharmaceutical aid have also played an important role in the development of pharmacy chains. These measures have caused the margins of pharmacies to be under increasing pressure. In combination with uncertainty about future measures, this has made many pharmacies to opt for the security of a large organization. Dutch pharmacies chains are organized in different ways. Two chains use a mix of franchise and company-owned pharmacies. Other pharmacy chains consist either of franchise pharmacies or of company-owned pharmacies. Operators of these chains often In the Netherlands prescription drugs are dispensed by community pharmacies, hospital pharmacies, and dispensing doctors (i.e. general practitioners that usually cover rural areas). Only community pharmacies are part of chain organizations. Therefore, whenever we use the term pharmacy in this thesis, we mean a community pharmacy. Dutch pharmacy chains make use of business format franchising. This is a form of franchising in which the franchisee operates under a complete business format that is structured by the franchisor. This format includes, for example, trade names, trademarks, operating methods, marketing techniques, and the franchisor s knowhow. consider extending their chains with company-owned pharmacies respectively franchise pharmacies. In this thesis we base our work on Bradach s qualitative research (99, 99). We examine to what extent his findings with respect to the benefits of the plural form can be applied to the Dutch pharmacy sector. In addition, we investigate whether the plural form offers any other benefits in this sector. Broadening Bradach s work to other retail sectors will create a more complete understanding of the added value of the plural form. To study the benefits of the plural form, we make use of the Structure-Conduct-Performance (SCP) paradigm. Rather than adopting an industry (meso) perspective in using the SCP paradigm, we adopt a pharmacy chain/pharmacy (micro) perspective. After Bradach, we start by examining how operators of pharmacy chains have structured their relationship with franchise and company-owned outlets. Cliquet and Croizean (00) have also investigated the applicability of Bradach s findings to another sector (i.e. the cosmetic sector). Rather than beginning with the how question, they, however, only studied why cosmetic chains make use of the plural form. We believe that the how question is essential in fully understanding the dynamics that exist within plural pharmacy chains, and in understanding why these dynamics are similar to or different from those identified by Bradach in the restaurant sector. In addition to studying the structural characteristics of franchise and company-owned pharmacies, we examine the relationship that exists between these characteristics and the conduct (behavior) of pharmacies within the chain organization. More specifically, we study pharmacies conduct with respect to the chain s strategic objectives. As described by Bradach (99), differences in the structural characteristics of franchise and companyowned restaurants cause these restaurants to make distinctive contributions to the chain s strategic objectives. In combination, these contributions of franchise and company-owned restaurants lead to certain plural dynamics. That is, the contribution of franchise restaurants sometimes positively affects the contribution of company-owned restaurants and vice versa. On the other hand, franchise and company-owned restaurants both make specific contributions that are not made by the other. After Bradach, we examine the plural dynamics that arise when franchise and company-owned pharmacies are used concurrently. Finally, similar to Sorenson and Sorenson (00) and Srinivasan (00), we study the performance implications of the plural form. A distinction is made between two types of performance: the performance of chain operators (i.e. the effectiveness of chain operators in achieving their strategic objectives and their contribution to the performance of pharmacies through products and services) and the performance of pharmacies (i.e. financial and nonfinancial performance). We examine the indirect effect of conduct on pharmacy performance (via chain operator performance) and the direct effect. By investigating pharmacy performance, we can determine whether pharmacies benefit from being part of a plural chain. Thus, whether plural dynamics lead to enhanced pharmacy performance.

8 TITLE TITLE chapter i n t r o d u c t i o n t o t h e r e s e a r c h q u e s t i o n s CHAPTER. Research questions As noted earlier, we start our empirical research by examining how operators of pharmacy chains structure their relationship with franchise and company-owned pharmacies. Hence, we pose the following research question: R How do operators of pharmacy chains structure their relationship with franchise and company-owned pharmacies? Once we have analyzed the structural characteristics of franchise and company-owned pharmacies, the next step in this thesis is, as described, to determine the link between these characteristics and the conduct of pharmacies within the chain organization. We examine the contribution of franchise and company-owned pharmacies to the chain s strategic objectives, the differences in their contribution, and the plural dynamics that result from these differences. Our second research question is as follows: R What is the effect of the way in which chain operators structure their relationship with pharmacies on the conduct of pharmacies within the chain organization? The final step is to investigate the link between the conduct of pharmacies and performance. As described, we study the indirect effect of conduct on pharmacy performance (through chain operator performance) and the direct effect. In addition to the link between conduct and performance, we also investigate the differences in the performance of operators of plural pharmacy chains and those of pure pharmacy chains, and the differences in the performance of pharmacies of plural chains and those of pure chains. We have formulated the following two research questions: R What is the effect of the conduct of pharmacies on the performance of chain operators, and what is the effect of this performance on the performance of pharmacies? R What is the effect of the conduct of pharmacies on their performance?. Research methodology In this thesis we combine different research methods, that is, literature research and different types of empirical research. In our literature research, we draw a link between theory on the plural form and several related theories (e.g. Transaction Cost Economics and the Resource-Based View of the Firm). The empirical data in this thesis is gathered through both qualitative and quantitative research. The first part of the empirical research consists of a case study. This case study is conducted among pharmacy chains that have adopted the plural form. The objective of the case study is to examine the relationships between the structural characteristics of franchise and company-owned pharmacies, their contribution to the chain s strategic objectives, the plural dynamics, and the way in which these dynamics enable plural pharmacy chains to better meet their strategic objectives. The second part of the research consists of a survey. The survey is not sent to the operators of pharmacy chains but to their pharmacies (both pharmacies of plural chains and of pure chains). In conducting the survey, we thus take a pharmacy-level focus rather than a chain operator-level focus. This is due to three reasons. First, by taking a pharmacy-level focus, we create a more indepth insight into pharmacies structural characteristics, their behavior, their performance, and the relationship between these variables. Second, it allows us to test whether the chain operator s view (that we determine by means of the case study) corresponds with pharmacists view. Pharmacists may, for example, perceive their relationship with the chain operator to be structured differently from what is assumed by the chain operator. Third, a practical reason is that the number of Dutch pharmacy chains is simply not sufficient to make statistical inferences on the chain operator-level.. Objectives This thesis has both scientific and practical objectives. Scientific objectives:. Providing detailed insight into the benefits of the plural form in the pharmacy sector and the realization of these benefits, and demonstrating why and to what extent these benefits are similar to or different from those identified by Bradach (99, 99) in the restaurant sector.. Presenting statistical evidence on the relationship among the structural characteristics of pharmacies, their contribution to the chain s strategic objectives, the plural dynamics, and the performance of pharmacies. To the best of our knowledge, these relationships have not previously been statistically investigated. Studies on these relationships have only taken a qualitative approach (Bradach, 99, 99). Studies on the plural form that have taken a statistical approach have either investigated the effect of certain conditions such as incumbency/lock in problems and performance ambiguity (Dutta et al., 99) and the firm s recognition of the synergistic benefits of the plural form (Dant and Kaufmann, 00) on the mix of governance structures, or they have investigated the effect of a mix of governance structures on intangible firm value (Srinivasan, 00) or firm performance (Sorenson and Sorenson, 00), thereby making theoretical assumptions about the benefits of the plural form. Only Heide (00) investigated the relationship between the mix of governance

9 TITLE chapter i n t r o d u c t i o n t o t h e r e s e a r c h q u e s t i o n s CHAPTER structures and the dynamics between these structures, but thereby he focused, as noted earlier, on solving information asymmetry problems and not on meeting strategic objectives.. Providing insight into the differences between pharmacies of plural chains and pharmacies of pure chains. In his study Bradach (99, 99) only examined plural restaurant chains, thereby making assumptions about pure restaurant chains. By also including pharmacies of pure chains in our survey sampling frame, we can compare the conduct and performance of these pharmacies with that of pharmacies of plural chains. Ultimately, such a comparison is needed to ascertain whether differences indeed exist between these two types of pharmacies. Practical objective:. Assisting the operators of Dutch pharmacy chains in making optimal use of the plural form and in increasing the performance of their pharmacies.. Limitations of the thesis This research is characterized by two different limitations.. We only focus on pharmacy chains and not on other retail chains in this thesis. This allows us to deepen our theoretical understanding of the plural form phenomenon. Such a deepening is necessary because theory on this phenomenon is only emerging. governance structures. In the second part, we delineate a number of theories that treat the choice of governance in either-or terms. Moreover, we discuss research that treats the choice of governance in and-and rather than in either-or terms, and we elaborate on the Structure-Conduct-Performance paradigm. Chapter explores the empirical setting of this thesis: the Dutch pharmacy sector. To fully understand the movements that take place within this sector, we start by describing the pharmaceutical care policy in the Netherlands. Subsequently, we analyze the structure of the pharmacy sector. This analysis is essential as it enables us to create a better insight into the behavior of pharmacies. Chapter reports on the findings of the case study. We start this chapter by elaborating on the case study method. Next, we discuss the key strategic objectives of pharmacy chains. For each of these strategic objectives, we explain how certain dynamics across franchise pharmacies, company-owned pharmacies, and the chain operator do lead plural pharmacy chains to be more effective in meeting them. Chapter presents five different conceptual frameworks and related hypotheses. These conceptual frameworks link structure, conduct, and performance to each other and are based on theory and the results of the case study. Moreover, hypotheses are presented regarding the differences in the structural characteristics and conduct of franchise and company-owned pharmacies and regarding the differences in the performance of plural and pure pharmacy chains and the performance of plural chain and pure chain pharmacies. Chapter elaborates on the second research method that is used in this thesis: the survey method. Subsequently, chapter reports on the results of the survey. Through the use of Structural Equation Modeling, we test the hypothesized relationships among structure, conduct, and performance. Furthermore, we test the hypotheses regarding the differences in structure, conduct, and performance that have been formulated in chapter. Finally, chapter 8 discusses the major findings, delineates the scientific and practical contribution of the research, describes the limitations, and suggests an agenda for further research.. In this thesis we only investigate Dutch pharmacy chains and do not consider foreign pharmacy chains. The reason for this is that country specific characteristics are also expected to play a role in understanding the behavior of pharmacies and thus in understanding the benefits of the plural form within the pharmacy sector. In the Netherlands the pharmaceutical care policy is different from that in other countries. As we will explain in chapter of this thesis, the pharmaceutical care policy has a severe impact on the structure of the Dutch pharmacy sector. This structure in turn is likely to influence the way in which pharmacies behave.. Outline of the thesis This thesis consists of eight different chapters. Chapter presents the theoretical framework. The first part of this chapter focuses on governance structures and the differences between the structural characteristics of franchise and company-owned

10 TITLE TITLE 8 8 Chapter Theoretical framework: Plural governance. Introduction Interfirm transactions can be managed by different governance structures. In the literature a broad range of governance structures have been identified. This broad range is often categorized into three basic types of structures: () markets, () hierarchies, () and hybrids. In market governance firms interact with each other at arm s length across a nameless, faceless market. To mediate their transactions, they rely on market-determined prices (Barney, 00). In hierarchical governance, on the other hand, external transactions are brought within the boundaries of the firm. Hierarchy rather than price is relied upon to control transactions. Finally, hybrid governance is traditionally viewed as a wide class of structures that combine characteristics of market and hierarchical governance. Examples of hybrid governance are R&D partnerships, franchising, and joint ventures. In the literature different definitions have been provided to the term governance structure. Williamson and Ouchi (98), for example, have defined it as a mode of organizing transactions. This is, however, a rather broad definition. Yin and Zajac (00) have delineated a governance structure as an organization design that incorporates systems of incentives, decision-making, and operational control. This is a more precise definition as it specifies the characteristics of the concept. According to Yin and Zajac, franchise (i.e. hybrid governance) and company-owned (i.e. hierarchical governance) governance structures differ significantly from each other with respect to these characteristics. The structure of this chapter is as follows. In paragraph. we describe the differences in the characteristics of governance structures. More specifically, as the focus of this thesis is on franchise and company-owned governance structures, we delineate the degree to which these structures differ from each other with respect to their characteristics. In the third paragraph, we broaden our focus to governance structures in general. We describe two theories that are often used in existing literature to explain firms choice among governance structures: Transaction Cost Economics and the Resource-Based View of the Firm. In the fourth paragraph, we narrow our focus once again to franchise and company-owned structures. We delineate two theories that explain the choice of chain organizations between franchise and company-owned governance structures: the agency cost theory and the ownership redirection theory. In paragraph. we describe research works that treat the choice of governance structure in and-and terms rather than in either-or terms. In the last paragraph, we provide an explanation of the Structure-Conduct-Performance paradigm.

11 CHAPTER CHAPTER chapter theoretical TITLE framework: plural governance 0. Characteristics of governance structures As described by Yin and Zajac (00), franchise and company-owned governance structures differ from each other with regard to incentives, decision-making, and operational control. Incentives Managers in company-owned outlets (i.e. company managers) have weaker financial incentives than franchisees. Company managers, who may have some incentive compensation, mainly receive fixed salaries (Brickley and Dark, 98). Franchisees rewards, on the other hand, are determined by the financial performance of their outlet(s). Except for a fixed or variable fee, franchisees appropriate the net income of their outlet(s). Because their compensation is more incentive-based than that of company managers, franchisees concern about the business is greater. They are motivated to maximize outlet sales through the effective management and promotion of the franchise concept (Carney and Gedajlovic, 99). Decision-making The decision-making structure that characterizes a dyadic relationship can be described in terms of three dimensions: () centralization, () formalization, and () participation (e.g. Dwyer and Welsh, 98). Franchise and company-owned outlets differ considerably from each other with respect to these dimensions. Centralization is the degree to which the power to make and implement decisions within the dyadic relationship is concentrated at one vertical level (John and Reve, 98). Company managers are employees and have little decision-making power. The decisionmaking authority resides with the chain operator. Franchisees, on the other hand, enjoy far more independence in this respect. This is at odds with the franchise contract, which seems to create the functional equivalent of the employee relationship (Bradach, 99). In practice, however, the character of the chain operator-franchisee relationship is often different from the terms of the contract. Contractual disagreements are rarely litigated. A reason for this is that it is difficult for the chain operator to win in court against a franchisee. Bradach (99) quotes a CEO of a restaurant chain who explained why: It is by no means clear who would win in litigation. The big company picking on the small entrepreneurs does usually not play well in front of the juries. Formalization is the degree to which decision-making is regulated by explicit rules and procedures (Dwyer and Welsh, 98). In case of franchising, the degree of formalization is high (Kneppers-Heynert, 988). Chain operators draw up many rules and procedures for franchise outlets. In franchise contracts and especially in operating manuals, chain operators explicitly describe in what way franchisees must exploit their outlets. The relationship between the chain operator and company-owned outlets is characterized by even more rules and procedures. The rules and procedures described in operating manuals also apply to company-owned outlets. Moreover, they have to obey rules with respect to budgets, targets, and reporting. Participation in dyadic decision-making is the degree of input to decisions (Hage and Aiken, 9), including ideas generation, decision-making involvement, and goal formulation (Dwyer and Oh, 988). Although the differences between franchise and company-owned outlets with respect to participation are not described as such in the extant literature, some authors do implicitly address them. For example, Bradach (99) describes that in the franchise arrangement decisions are often made through face-to-face interactions between the chain operator s executives and franchisees, while in the company arrangement these decisions are made centrally. Similarly, Yin and Zajac (00) quote an executive director of a large restaurant chain who noted that franchisees typically have much more access to people who make decisions than company managers, and that the latter ones have little input. In summary, franchisees do thus experience more participation in decisionmaking than company managers Operational control Company-owned outlets are subject to more operational control from the chain operator than franchise outlets. The greater operational flexibility of franchise outlets is evident, for example, in a wider span of control. The field staff responsible for franchise outlets supervises a larger number of outlets than the staff responsible for company-owned outlets. In addition, mechanisms to reinforce compliance with the chain operator are used less frequently and less intensively for franchise outlets than for company-owned outlets (Bradach, 99). The difference in operational control between franchise and companyowned outlets is caused by the difference in incentives. Company managers have weak incentives and therefore pose a risk of shirking (Brickley and Dark, 98). Operational control is necessary in order to prevent these managers from reducing their efforts. In contrast, franchisees demonstrate a higher level of self-management due to their strong incentives. Hence, the need for operational control is much smaller in their case. In In addition addition to to these these three three dimensions dimensions of of decision-making decision-making structures, structures, Dwyer Dwyer and and Welsh Welsh distinguish distinguish a fourth fourth dimension: dimension: specialization specialization (i.e. (i.e. the the amount amount of of task task differentiation). differentiation). No No differences differences exist exist among among franchise franchise and and company-owned company-owned outlets outlets with with respect respect to to this this dimension. dimension. Both Both types types of of outlets outlets display display the the same same level level of of specialization, specialization, as as they they carry carry out out the the same same functions. functions. As As this this thesis thesis focuses focuses on on the the differences differences between between franchise franchise and and company-owned company-owned outlets, outlets, we we leave leave this this dimension dimension out out of of consideration. consideration.. Firms governance choice: Either-or Most current work on governance decisions has studied firms choice among governance structures: why do firms make or buy a part (Monteverde and Teece, 98), utilize direct

12 CHAPTER chapter theoretical TITLE framework: plural governance versus indirect channels of distribution (John and Weitz, 988), or select a direct or third party sales force (Anderson and Schmittlein, 98). Two theories have been used to explain the choice among governance structures: Transaction Cost Economics and the Resource- Based View of the Firm. Transaction Cost Economics Transaction Cost Economics (TCE) has received the most attention in scientific literature. TCE s central claim is that transactions will be managed by a governance structure that minimizes the costs involved in carrying out the transaction (e.g. negotiation and monitoring costs). TCE is based on two assumptions concerning human nature: bounded rationality and opportunism. The essence of bounded rationality is that human actors face constraints on their cognitive capabilities. Although human actors intend to behave rationally, these cognitive constraints prevent them from doing so (Simon, 9). Opportunism, on the other hand, is defined as self-interest seeking with guile (Williamson, 98). TCE further maintains that there are three dimensions with respect to how transactions differ. The first dimension is asset specificity, which refers to the extent to which the assets used in support of a particular transaction are specialized or non-redeployable. The second dimension is uncertainty. TCE distinguishes two types of uncertainty (Williamson, 98). The first type of uncertainty, environmental uncertainty, refers to the condition of being unable to anticipate unforeseen contingencies in the product-market environment of the firm, while the second type of uncertainty, behavioral uncertainty, refers to the difficulties associated with assessing the contractual performance of transaction parties. Finally, the third dimension of transactions is frequency, which concerns the number of times transaction parties engage in exchange with one another. According to TCE, the interaction between the two characteristics of human nature and these dimensions of transactions cause certain contracting problems (Speklé, 00). For instance, given opportunism, asset specificity creates a safeguarding problem. If a firm invests in specific assets, it experiences a lock-in effect. Its transaction partner may opportunistically exploit this situation by demanding various kinds of concessions from the firm. To prevent this from happening, the firm is forced to design expensive safeguards. Another example is that under the assumption of bounded rationality, behavioral uncertainty gives rise to a performance evaluation problem. Because of constraints on the rationality of human actors, non-compliance to contracts may remain undetected. To avoid this, a firm must closely evaluate the contractual performance of its transaction partners. The more elaborate a governance structure, the better it can deal with these contracting problems and thus the better it can economize on the associated transaction costs. If minimizing transaction costs were the only goal, hierarchical governance would always be chosen over non-hierarchical governance. However, the more elaborate a governance structure, the more costly it is. Therefore, TCE predicts that if a transaction is exposed to minor contracting problems, market governance will be the most efficient means to mediate the transaction. The costs of organizing the transaction within a firm (i.e. bureaucratic costs) would exceed the costs of conducting the transaction within the market. If a transaction is confronted with major contracting problems, however, hierarchical governance will minimize the costs associated with overcoming these problems. Finally, if the contracting problems to which a transaction is exposed are moderate, hybrid governance will be preferred to both market and hierarchical governance. On the one hand, this type of governance is more elaborate than market governance and therefore better able to economize on the transaction costs associated with overcoming these moderate problems. On the other hand, adopting hybrid governance is less costly than adopting hierarchical governance. The Resource-Based View of the Firm Another theory that has been used by some scholars to explain firms choice among governance structures is the Resource-Based View of the Firm (RBV) (e.g. Chi, 99; Conner and Prahalad, 99; Madhok, 00). Whereas TCE posits that exchange conditions determine the choice of governance structure, the RBV posits that a firm s relative resources determine this choice. Resources are defined as all assets, capabilities, organizational process, firm attributes, information, knowledge, and so forth that are controlled by a firm and that enable the firm to conceive of and implement strategies that improve its efficiency and effectiveness (Barney, 99). The RBV s domain of interest is the search for competitive advantage rather than the search for the most efficient governance structure (Madhok, 00). According to RBV logic, resources are at the center of a firm s competitive advantage. There are two basic assumptions underlying the RBV (Barney, 99). The first assumption is that firms are considered bundles of resources (Penrose, 98) and that these resources are heterogeneously distributed across firms. No two firms have had the same set of experiences, acquired the same assets and skills, or built the same organization culture (Collis and Montgomery, 99). The second assumption is that resources may not be perfectly mobile across firms. That is because they either may be very costly to copy or inelastic in supply. If a firm s resources are heterogeneous, imperfectly mobile, and if they enable the firm to exploit opportunities or neutralize threats, then they are considered as potential sources of (sustained) competitive advantage (Barney, 00). As described above, the RBV considers resource differences among firms a very important determinant in making governance choices (Barney, 00). According to RBV logic, if a firm possesses resources and capabilities which enable it to carry out a certain activity in a superior manner vis-à-vis other firms, the firm will internalize this activity (i.e. adopt hierarchical governance). However, if another firm possesses these superior resources, the firm will engage in market exchange (or it will acquire the other firm). Finally, if the focal firm possesses some but not all of the needed resources, a common response will be to

13 CHAPTER chapter theoretical TITLE framework: plural governance combine resources with an external firm (Combs and Ketchen, 999) using, for example, a joint venture.. Chain organizations governance choice: Franchise or companyowned outlets Two streams of research related to TCE and the RBV specifically focus on chain organizations governance choice between franchise and company-owned outlets: the agency cost theory and the ownership redirection theory. The agency cost theory The agency cost theory, which is closely related to TCE, argues that agency problems determine a chain organization s choice between franchise and company-owned outlets. Of these agency problems, shirking has received the most attention (Brickley and Dark, 98; Norton, 988; Rubin, 98). As described above, managers in company-owned outlets pose a greater risk of shirking and therefore need more monitoring. To curb monitoring costs, agency cost theory claims that company-owned outlets are observed in locations where the cost of monitoring is low, while franchise outlets are observed where the cost of monitoring is high. The distance between an outlet and corporate monitoring offices is often used as an indicator of the extent of monitoring costs (Brickley and Dark, 98). On the other hand, franchising also gives rise to two agency problems (Brickley et al., 99). The first problem is the potential for free riding. Because franchisees appropriate the net income of their outlet(s), they have incentives to reduce quality if the gains from such activities can be internalized and the costs externalized (Carney and Gedajlovic, 99). The danger of free riding is greatest at outlets where the number of repeat customers is low (e.g. outlets that are located along the highway). In that case the cost of reduced quality is born primarily by other outlets that lose the customer s patronage and by the franchisor whose trademark will be less valuable. Alternatively, the cost savings from providing lower quality go directly to the given franchisee (Brickley et al., 99). Consequently, the agency cost theory predicts that outlets that serve a large proportion of non-repeat customers are owned by chain organizations. The second agency problem inherent to franchising is inefficient risk-bearing. As franchisees have a large part of their wealth tied up in a single outlet, they are forced to consider the full risk of undertaking investments (Brickley and Dark, 98). Therefore, franchisees are likely to make less optimal investment decisions than decision-makers who have a more diversified investment portfolio. For example, local advertising campaigns have spillover effects on other outlets that are part of the system. Such spillovers mean that individual franchisees will not appropriate the full return of their investment. As a result, such investments may be foregone by franchisees and be left to others (Carney and Gedajlovic, 99). To facilitate optimal investment decisions, it is argued that when outlets are geographically concentrated and thus when spillovers are more common, the outlets should be collectively owned and operated (Carney and Gedajlovic, 99). In short, while franchising economizes upon monitoring costs, it involves other agency costs. The monitoring benefits of franchising must be traded-off against these other costs. It is this trade-off which leads organizations to own and franchise outlets in a discriminating way (Carney and Gedajlovic, 99). The ownership redirection theory The ownership redirection theory, which is couched in the RBV, claims that the choice between franchise and company-owned outlets is determined by the phase in the chain organization s life cycle and is thus transitory in nature. To penetrate the market as widely and as rapidly as possible, chain organizations rely mainly upon franchising early in their life cycle. That is because franchisees provide three essential resources that chain operators lack in this phase: capital, information about the desirability of particular locations and knowledge of local conditions, and skilled management (Oxenfeldt and Kelly, 98-99). If the franchise system is successful, these resources are expected in time to become more directly available to the chain operator. That is to say, the chain operator now experiences positive cash flows, accumulates and develops its own information bases (because of its intimate contact with franchisees), and the supply of managerial talent becomes more readily available. Moreover, once chain organizations have attained their desired size, they become more concerned with operational efficiency and the development and maintenance of an overall image (Oxenfeldt and Kelly, 98-99). As both objectives can best be attained through tight control, free of resource constraints, franchise systems will evolve into large company-owned chains. Only low-performing outlets in rural areas as well as outlets in new market territories where the chain operator has little local market expertise and where it is attempting to establish another critical mass of outlets will be franchised (Carney and Gedajlovic, 99).. Firms governance choice: And-and The theories described above are all based on the assumption that firms make mutually exclusive choices concerning governance structures as one governance structure does better than another under certain circumstances. Both TCE and agency cost theory search for variations in environmental circumstances to explain firms choice of governance structure. The unit of analysis in these theories is the individual transaction or outlet. The RBV and the ownership redirection theory, on the other hand, look for differences in firms resources to explain this choice. The unit of analysis in these theories is the firm rather than the individual transaction or outlet.

14 CHAPTER chapter theoretical TITLE framework: plural governance Although these theories definitely have merit, their assumption that firms make mutually exclusive choices among governance structures keeps us from understanding certain phenomena that we observe. For example, as opposed to agency cost theory logic, franchise and company-owned outlets are often located together in practice. In addition, contrary to the ownership redirection theory argument, many chain organizations continue to have a large number of franchise outlets when they grow. These phenomena can only be understood if we discard the assumption that firms make such mutually exclusive choices. In an influential article, Bradach and Eccles (989) criticized the traditional make-or-buy principle. They invoke the concept of tapered integration (Harrigan, 98) to argue that firms often purposely combine distinct governance structures for the same function. In their view this combination of governance structures (what they refer to as the plural form ) enables firms to reap certain synergistic benefits that are unavailable if only one ideal governance structure is used. That is, the existence of one governance structure complements and benefits the management of the other structure and vice versa. The benefits of a combination of governance structures have been highlighted by several research works. For example, Harrigan (98) described that firms that are backward or forward integrated and that rely on outsiders for a portion of their supplies or distribution, can monitor the R&D developments of the outsiders, reduce vulnerability to strikes and shortages within their systems, and examine the products of competitors, while enjoying the lower costs and greater advantages (and profit margins) of vertical integration. In the context of franchising systems, Bradach and Eccles (989) explained that franchisees may spot new ways of enhancing efficiency which then can be employed in company-owned outlets. In the same way, company-owned outlets may provide more information that enables firms to negotiate with and control franchise outlets effectively. Dant et al. (99) also identified some of the synergistic benefits specific to franchising systems. For instance, franchisees can be a source of innovative products and business ideas for future growth, while company-owned outlets may serve as efficient laboratories for market testing of new ideas before these ideas are promoted to franchisees. Bradach (99, 99) has probably contributed the most to the existing knowledge of the synergistic benefits of the plural form. As described in chapter, he studied how restaurant chains use franchise and company-owned outlets to better meet their strategic objectives. Bradach identified four different strategic objectives of restaurant chains: unit growth (i.e. growth in the number of outlets), maintaining uniformity, local responsiveness, and system wide adaptation (i.e. the way threats to and opportunities for a chain as a whole are translated into action). In the beginning of this chapter, we explained that franchise and company-owned outlets differ considerably from each other with respect to the way in which their relationship with the chain operator is structured. According to Bradach, these As described in chapter, Bradach and Eccles (989) refer to the plural form both as a combination of governance structures (e.g. markets and firms) and a combination of control mechanisms (i.e. price, authority, and trust). differences in structural characteristics give rise to certain plural dynamics between the chain operator and franchise and company-owned restaurants. For example, by implementing new standards in company-owned restaurants, a chain operator shows its commitment to these standards, which makes it easier to persuade franchisees to implement them as well. Or, for example, following Dant et al. (99), Bradach considers franchisees to be an important source of innovative product and business ideas in contrast to company managers. According to Bradach, such plural dynamics enable restaurant chains that have adopted the plural form to better meet their strategic objectives. Hence, his central claim is that plural chains outperform pure chains.. Structure-Conduct-Performance As described in chapter, we make use of the Structure-Conduct-Performance (SCP) paradigm in this thesis to study the benefits of the plural form. The SCP paradigm has been developed by Mason (99, 99) and Bain (99) and is one of the major approaches to the study of industrial organization. The basic premise of the SCP paradigm is that structure affects conduct, which in turn affects performance. The term structure in this paradigm refers to the structure of an industry, measured by such factors as the number of buyers and sellers, vertical integration and entry barriers. Conduct, on the other hand, refers to the behavior of firms in the industry, including pricing strategies, product differentiation, and research and development. Finally, performance refers to the success of the industry in producing benefits for consumers (Carlton and Perloff, 000) and is captured by such factors as profitability, price-cost margin, and innovation rate. As noted earlier, rather than adopting an industry (meso) perspective, we adopt a pharmacy chain/pharmacy (micro) perspective in applying the SCP paradigm.. Conclusions In this chapter we have provided an overview of the structural characteristics of franchise and company-owned governance structures and the theories that are used to explain a firm s governance choice. Most of these theories treat this choice in either-or terms. That is, one structure is considered to do better than another under certain circumstances. TCE and the agency cost theory both argue that variations in environmental circumstances determine the choice of governance structure. In contrast, the RBV and the ownership redirection theory contend that a firm s relative resources determine this choice. Notwithstanding the value of these theories, we often see in practice that firms use different governance structures under similar conditions. To understand why, some authors have rejected the assumption that firms make mutually exclusive choices among governance structures. Rather, they treat the choice of governance structure in and-and terms. They argue that firms often deliberately combine different governance structures as this enables them to

15 TITLE TITLE CHAPTER chapter reap certain synergistic benefits that are unavailable if only one ideal governance structure is used. Chapter Empirical setting: The Dutch pharmacy sector. Introduction The empirical setting of this thesis is the Dutch pharmacy sector. The pharmacy sector is part of the pharmaceutical care market. The demand side of this market is structured differently than in other markets. This is due to a separation among enjoying, deciding, and paying. Because of this separation, the function of price as a value indicator diminishes. Not consumers but physicians are the decision-makers. Consumers have little knowledge about drugs and therefore physicians decide on the amount, type, and brand of a drug. Physicians usually base this decision on the quality of the drug rather than on its price. Furthermore, health insurers are usually the ones to pay for the drug. As consumers are insured for the costs of most drugs, they are not directly confronted with drug prices and hence are price-insensitive. The pharmaceutical care market is also different from most other markets in that it is characterized by considerable government regulation. As the absence of the price mechanism leads to an imbalance between demand and supply, the Dutch government regularly intervenes in the pharmaceutical care market. These interventions have considerable consequences for Dutch pharmacies. Figure. on the next page depicts the main players in the pharmacy sector and their interrelationships. The government is not part of the value chain but has a considerable influence on the money flows and the goods/services flows within this chain. Health insurers also have an influence on these flows (as will be described in paragraph..) and are part of the value chain at the same time. In this chapter we conduct a two-level analysis of the pharmaceutical care market. First, at the highest level of aggregation, we start by analyzing the pharmaceutical care policy in the Netherlands. In paragraph. we describe the ways in which the Dutch government tries to control the expenditure on drugs, and subsequently we delineate the growing importance of health insurers in the pharmaceutical care market. This analysis of the Dutch pharmaceutical care policy is necessary as it enables us to understand the structure of the pharmacy sector. Only by understanding this structure, we are fully able to explain the behavior of pharmacies. In paragraph., at a lower level of aggregation, we examine the A separation separation among among enjoying, enjoying, paying, paying, and and deciding deciding only only exists exists for for prescription prescription drugs drugs and and not not for for so-called so-called OTC OTC (Over (Over the the Counter) Counter) drugs. drugs. Unlike Unlike prescription prescription drugs, drugs, OTC OTC drugs drugs are are available available to to consumers consumers without without a prescription prescription and and are are not not reimbursed reimbursed by by the the health health insurer. insurer. They They are are sold sold by by both both pharmacies pharmacies and and drugstores. drugstores. On On average, average, only only % % of of pharmacies pharmacies revenues revenues come come from from OTC OTC drugs. drugs. Therefore, Therefore, this this chapter chapter will will focus focus on on pharmacies pharmacies as as suppliers suppliers of of prescription prescription drugs. drugs.

16 0 9 CHAPTER chapter empirical TITLE setting: the dutch pharmacy sector 0 structure of the pharmacy sector. Finally, in paragraph. we briefly describe the situation in the pharmacy sector in Germany as well as the United States and compare it to the situation in the Netherlands. Figure. Main players in the pharmacy sector and their interrelationships Government/ Health insurers Physicians pharmaceutical aid, the Ministry of VWS also continued implementing measures to directly control the costs of pharmaceutical aid. In 00, the expenditure on extramural pharmaceutical aid was. billion in the Netherlands (Vektis, 00), which was.% of the total expenditure on health care (CBS, 00). Although the costs of pharmaceutical aid do not form the largest cost category within health care 8, the rapid increase in these costs has been an important cause for the increase in the total expenditure on health care. From 00 to 00, the expenditure on pharmaceutical aid increased with 0.% (Vektis, 00). This increase was due to factors such as the growth and ageing of the Dutch population, the shift of care from the hospital to the home, and the shift in consumption towards newer, usually more expensive medicines (SFK, 00)... Controlling drug expenditure Manufacturers Wholesalers Pharmacies Patients Flow of goods and/or services Flow of money Influence Health insurers The data in this chapter has been gathered through desk research. Because the pharmaceutical care market is characterized by a complex web of rules and regulations and thus not very transparent, it was difficult to provide a good overview of this market.. Pharmaceutical care policy in the Netherlands The Dutch pharmaceutical care policy is based on the principle of safe and affordable pharmaceutical care that is accessible to everyone. This policy is implemented by the Ministry of Health, Welfare, and Sport (Volksgezondheid, Welzijn en Sport, VWS). In the 80s, the Ministry of VWS tried to guarantee the affordability of pharmaceutical aid mainly by policies of regulation. In the 90s, the focus of the Ministry of VWS shifted more to introducing competitive elements in the pharmaceutical care market. This is not to say that the Ministry pursued a model of pure competition. Rather, to guarantee the affordability of pharmaceutical care, policy reforms were aimed at introducing a system of regulated competition (Westerhout, 00). To stimulate competition in the pharmaceutical care market, the Ministry of VWS took two different measures. First, it removed some of the barriers that kept new parties from entering the pharmaceutical care market. Second, it provided a greater responsibility to health insurers. To ensure the affordability of To regulate the expenditure on drugs, the Ministry of VWS has implemented three important measures in the past years: the Drug Prices Act, the Health Care Tariffs Act, and the Drug Reimbursement System. Drug Prices Act In 99, the Drug Prices Act (Wet Geneesmiddelenprijzen, WGP) was introduced. The act focuses on the list prices of pharmaceutical manufacturers. List prices are the officially registered purchase prices of drugs. They are determined by manufacturers. The WGP stipulates that manufacturers list prices cannot exceed the average prices of the same drugs in Belgium, France, Germany, and the UK. As a consequence of this act, drug prices have decreased substantially. Health Care Tariffs Act The Health Care Tariffs Act (Wet Tarieven Gezondheidszorg, WTG) was implemented by the Ministry of VWS in This act determines the maximum price that pharmacies may charge consumers or their health insurers. The maximum price is made up of two components: a fixed fee and a purchase fee (SFK, 00). Pharmacies are allowed to charge a fixed fee for each prescription. This fee is a reimbursement for the operating costs of pharmacies and is independent of the price and the quantity of the drug. In 00, the fixed fee was.0. The purchase fee, on the other hand, directly remunerates pharmacies for the drugs they dispense. This fee is in principle based on the list prices of manufacturers. Due to cutbacks, the Ministry of VWS decided to reduce the fixed fee in 99. To earn back the difference, pharmacies were stimulated to negotiate with manufacturers and 8 9 Extramural means not through the hospital. Hospital care forms the largest cost category within health care. In 00, the WTG was replaced by the Healthcare Market Regulation Act (Wet Marktordening Gezondheidszorg, WMG).

17 CHAPTER chapter empirical TITLE setting: the dutch pharmacy sector wholesalers for purchase benefits 0. In the past years, these purchase benefits have been the subject of considerable political debate. The Ministry of VWS considers the purchase benefits too high. Pharmacies, on the other hand, claim that purchase benefits are an indispensable element in financing their practice, as the fixed fee lags behind operating costs (SFK, 00). To skim the purchase benefits of pharmacies and to fight margin competition, the Ministry of VWS has taken a number of measures. In 998, the Ministry of VWS introduced the so-called clawback. This measure obliged pharmacies to grant consumers or health insurers a discount of % on the list prices of manufacturers. In 999, the Ministry of VWS reached a three-year agreement with the Royal Dutch Pharmaceutical Society (Koninklijke Maatschappij ter Bevordering der Pharmacie, KNMP) to adjust the clawback. For the period , the clawback was increased from % to.8% (to a maximum of.80 per prescription). In exchange for this adjustment of the clawback, the fixed fee was gradually increased from.08 to.00 in this period. In 00, the then minister of VWS (De Geus) announced another revision of the clawback. A distinction was made between single-source drugs (drugs that are produced by one manufacturer, usually patented drugs) and multi-source drugs (drugs that are produced by more than one manufacturer). As pharmacies are able to negotiate higher price discounts on multi-source drugs, a clawback of 0% was imposed on the list prices of these drugs and a clawback of 9% on the list prices of single-source drugs. Because many pharmacies feared that the revised clawback would get them into serious financial trouble, the case was brought before court. A few months after its introduction the judge ruled the revised clawback invalid. To reach a solution for the impasse, the Ministry of VWS began negotiations with the KNMP, the Dutch Health Insurers (Zorgverzekeraars Nederland, ZN), and the Trade Organization of the Generic Drug Industry Netherlands (Bond van de Generieke Geneesmiddelenindustrie Nederland, BOGIN). In 00, it entered into a covenant with these parties. The covenant consisted of two main components. First, the prices that pharmacies pass on to consumers and health insurers for generic drugs would decrease with an average of 0% below manufacturers list prices (including the clawback of.8%). Second, pharmacists and health insurers would commit themselves to make optimal use of 0 These purchase benefits are the result of the differences between the list prices and the cost prices of manufacturers. To be able to provide large purchase benefits, manufacturers try to set their list prices as high as possible. Competition between manufacturers is thus not based on price but on margin. The overall discount on generic drugs (multi-source drugs) is estimated to vary from 0% to %. In comparison, it is estimated to vary from % to 0% for branded drugs (ABN AMRO, 00). Branded drugs can both be single-source and multi-source drugs. If the patent on a branded drug expires and other pharmaceutical manufacturers start producing the drug also, it changes from a single-source drug into a multisource one. In that case the discount on the branded drug is likely to increase. the availability of cheaper (generic) drugs. In 00, the covenant was extended and the association of innovative drug manufacturers, Nefarma, also agreed to the covenant. In addition to the rules of the 00 covenant, it was decided that the prices of patented drugs for which generic substitutes were available would decrease with an average of 0% or that compensating price reductions would be implemented within the single-source segment. In exchange for this, Nefarma set the condition that the Ministry of VWS would not sharpen the Drug Reimbursement System (see below) during the term of the covenant (SFK, 00). For the period 00-00, the agreements made within the 00 covenant were extended. Drug Reimbursement System The Ministry of VWS launched the Drug Reimbursement System (Geneesmiddelenvergoedingssysteem, GVS) in 99. This act determines whether and to what extent drugs are reimbursed to consumers. Drugs that are eligible for reimbursement and that are considered inter-replaceable are clustered. Per cluster a reimbursement limit is set. Drugs that are eligible for reimbursement but have a unique therapeutic value (and thus cannot be clustered) are fully reimbursed. In case the reimbursement limit is lower than the list price of the manufacturer, the price difference is made up by the consumer. To prevent co-payments and thus to prevent possible loss of market share, pharmaceutical manufacturers usually do not set their list prices above the reimbursement limit. A disadvantage of the GVS is that manufacturers who could price their drugs below the reimbursement limit (e.g. manufacturers of generic drugs) often match their list prices to the reimbursement limit. This means that the prices of these drugs are pushed up artificially. Future measures After 00, when the covenant would expire, the Ministry of VWS was planning to modernize the GVS. To safeguard the price reductions that were realized through the covenant, the reimbursement limits would be recalculated based on a lower price level. In addition, the Ministry of VWS planned to introduce a modular tariff system for pharmacies. This modular tariff would consist of two parts: a standard tariff and a tariff for so-called plus modules. The standard tariff would be based on a number of activities that pharmacies minimally have to undertake (e.g. monitoring the correctness of the medication). For additional activities (so-called plus modules), pharmacies and health insurers would be able to make agreements with each other (e.g. screening of patient groups). The modular tariff would provide health insurers more possibilities to influence the behavior of pharmacies, and it would make better use of pharmacies expertise as care providers. In addition, it would enable pharmacies to distinguish themselves from each other. The modular tariff would replace the fixed fee that pharmacies currently receive and was expected to lead to a The share of generic drug dispensing has increased from 9% in 00 to % in 00 (Vektis, 00). This enables these manufacturers to provide large discounts to pharmacies and thus to generate large sales.

18 CHAPTER chapter empirical TITLE setting: the dutch pharmacy sector better coverage of pharmacies operating costs. In exchange for this, pharmacies would be required to renounce their purchase benefits. It has been announced recently that the modular tariff system will not be introduced after all in 008. Instead, the Ministry of VWS has reached an agreement with the KNMP and the BOGIN that the prices of generic drugs will be lowered by another 0%. The system of purchase benefits will remain intact. This agreement has a duration of two years. What they have not been able to do for years, they are not able to do now either: to transform the drug market in a more or less normal market (FD, 00). One of the reasons for not implementing the modular tariff system and not abolishing the system of purchase benefits is that the Ministry of VWS has a large budget deficit. The agreement will realize an immediate savings of 0 million in 008 and another savings of million in 009 (FD, 00)... The role of health insurers in the pharmaceutical care market Since 000, the policy of the Ministry of VWS has been aimed at providing health insurers a leading role in the pharmaceutical care market. The reason for this policy is that the Ministry of VWS considers health insurers best able to control the costs of pharmaceutical aid. Health insurers are budget responsible for these costs and therefore have incentives to control them. In addition, they are the only independent party between care providers (supply) and the insured (demand). As a consequence of the enhanced responsibility of health insurers, the Ministry of VWS decided to take a step backward. It would restrict itself to setting limiting conditions and to overseeing the quality and the accessibility of pharmaceutical care. To equip health insurers for their leading role, the Ministry of VWS developed an extensive program of measures aimed at deregulation and instrumentation in 000. These measures can roughly be divided in two groups. One group included measures that increase health insurers influence on prescribing and dispensing drugs. An example of a proposed measure was the introduction of the modular tariff system. The other group included measures that increase health insurers influence on the prices and reimbursement of drugs. An example of a measure that was proposed was the gradual dismantlement of the GVS. By abolishing the reimbursement limits, health insurers would be given the possibility to negotiate with pharmaceutical manufacturers about drug prices, which was supposed to lead to greater price competition. Another proposed measure, that did not fit into one of these two groups of measures, was the abolishment of article 9 of the Medicines Act (Wet op de Geneesmiddelenvoorziening, WOG). Article 9 stipulates that pharmacists may only practice pharmacy in one pharmacy. By abolishing this article, competition was expected to increase as it would become more attractive for new parties to enter the pharmacy market. As there would not be an obligation anymore to have a different pharmacist in each pharmacy, the flexibility of these parties would increase. Despite the plans of the Ministry of VWS, health insurers did not really manage to fulfill their intended role. This was due to several (related) reasons. First, the program of measures aimed at regulation and instrumentation was only partially implemented. Some of the measures still await their implementation, while other measures were not implemented due to changes in policy views. For example, as described above, the Ministry of VWS decided not to introduce the modular tariff system. After a storm of protests, the Ministry of VWS further decided not to abolish article 9. Personal contact between pharmacists and patients was considered to be too important. Second, although the Ministry of VWS announced to reduce its involvement in the pharmaceutical care market, it continued to intervene directly in practice. The introduction of the revised clawback and the covenant are examples of such interventions. In combination with the fact that not all proposed deregulation and instrumentation measures were implemented, this left little room for health insurers to maneuver. Third, most health insurers were not yet internally equipped so as to fulfill a leading role in the pharmaceutical care market. Fourth, health insurers did not have the full confidence of all parties within the pharmaceutical care market. Some parties were skeptical about the ability of health insurers to perform a leading role and sometimes simply refused to cooperate with them. It seems as if health insurers are slowly enhancing their grip on the pharmaceutical care market though. For example, to manage the costs of drugs, a number of health insurers jointly started the so-called preference policy in 00. Based on this policy, health insurers designate drugs per GVS cluster that are reimbursed. Per cluster only those drugs are reimbursed that have a price within a % range of the lowest priced drug. Health insurers conduct the preference policy jointly as this enables them to guarantee the manufacturers of designated drugs a substantial market. The preference policy currently only applies to three GVS clusters. The objective of the preference policy is to create more price competition among pharmaceutical manufacturers. So far, however, this policy has hardly resulted in any price reductions. At the start of the preference policy, only one manufacturer (Merck) reduced its price marginally (one eurocent below the lowest cluster price). Besides Merck, no other manufacturers lowered their price. The preference policy caused all generic drugs to become preferential as the prices of these drugs already fell within the % range. All branded drugs became non-preferential. As a consequence, the market share of branded drugs decreased by approximately a third with the health insurers participating in the preference policy (Vektis, 00). The introduction of the new Health Insurance Act in 00 has been the most important reason for health insurers to achieve a stronger position in the pharmaceutical care market. Under this new act, it is in principle compulsory for everyone to have a standard health insurance package. Until 00, only those people with incomes below the maximum wage

19 CHAPTER chapter empirical TITLE setting: the dutch pharmacy sector level were required to be insured under the Social Health Insurance Act (i.e. Ziekenfondswet). People with higher incomes could either take out private insurance or no insurance at all. Under the new act, people can insure care that is not covered by the standard package through supplementary packages. For the standard health insurance package, individual health insurers are obligated to accept everyone under the same conditions. Risk selection is thus prohibited. The introduction of the new act has led to enhanced competition among health insurers. This is due to several reasons. First of all, it has become easier for people to change insurer. Before 00, it was difficult for many people to switch to another insurer due to risk selection, compulsory participation in social health insurance plans, and mandatory collective contracts (Ministry of VWS, 00). Nowadays everyone is allowed to switch once a year. Second, people have more reason to change insurer than before. Until 00, limited premium differences existed among insurers. The introduction of the new act has led, however, to a true price war among insurers, which has resulted in much lower nominal premiums than expected. Next to the greater premium differences, people also simply have more to choose from than before. They can choose among different types of policies (see below) and different own risks. For people who were previously insured under the Social Health Insurance Act, it has further become possible to choose a collective contract (and a corresponding premium discount). This in combination with the fact that it has become easier to switch, has led to a significant migration of people to different insurers. In 00, approximately 8% of Dutch citizens changed to another insurance company (NZa, 00). Third, the new health insurance system is only operated by private health insurance companies (the social health insurance funds have become private companies). These private health insurance companies can make profits and can pay dividends to shareholders. Under the new act, health insurers no longer have to enter into a contract with every care provider. This means that health insurers can refuse to sign contracts with those care providers that are considered to provide insufficient quality or to charge high prices. This ability provides health insurers with a stronger position versus care providers and stimulates competition among these providers. To increase their purchasing power towards care providers (and to increase internal efficiency), there has been a massive wave of mergers among health insurers after the introduction of the new act. Almost 90% of the market is controlled by six large insurance firms at this moment (Schut, 00). To get people to switch from non-contracted care providers to contracted ones, health insurers offer a socalled in-kind policy. Based on this policy, the health insurer fully reimburses the insured for care received from contracted care providers. The health insurer pays the bill directly to Approximately two-third of the Dutch population was insured for health care through a social health insurance fund, while one-third was privately insured. Despite the abolishment of the contracting obligation, health insurers have limited room to maneuver in purchasing care at this moment. Prices are still regulated for the most part. Price competition is only allowed for physiotherapy and for a small part of hospital care. the care provider. If the insured prefers to go to a non-contracted care provider, he may not receive full reimbursement. In addition, health insurers offer a so-called restitution policy. In this case the insured is free to choose a care provider but has to pay the bill himself and then apply to the health insurer for reimbursement. A reimbursement policy is generally more expensive than an in-kind policy. In 99, the contracting obligation was already abolished for pharmacies. Nevertheless, health insurers have hardly used this freedom. Over the years health insurers have made higher demands upon pharmacies though. Since 00, pharmacies have, for example, been required to hand in a quality plan annually. In this quality plan, pharmacies have to describe their objectives with respect to the quality and the efficiency of the care they provide. The introduction of the Health Insurance Act has not caused health insurers to be selective in contracting pharmacies either. That is because health insurers fear reputation loss and losing customers if these customers can no longer go to their trusted care providers. In the future, however, health insurers are expected to be more selective. For a number of years, some health insurers have experimented with so-called preferred pharmacies with which they conclude favorable contracts. To stimulate people to visit these preferred pharmacies, health insurers use financial (e.g. a bonus) and qualitative impulses (e.g. extra service) (Boonen and Schut, 00).. Sector Analysis The different policy reforms and cost controlling measures of the Ministry of VWS have had a large impact on the market relations within the pharmacy sector. To analyze the structure of the pharmacy sector, we make use of Porter s five forces framework (Porter, 99). This framework is derived from the SCP paradigm and consists of five different forces: power of suppliers, threat of new entrants, threat of substitutes, power of buyers, and competitive rivalry... Suppliers Pharmacies are supplied by three different parties: pharmaceutical manufacturers, pharmaceutical wholesalers, and physicians. Pharmaceutical manufacturers The power of pharmaceutical manufacturers has been strongly affected by the government s substitution policy. To curb the rising expenditure on pharmaceutical aid, the Ministry of VWS agreed with the LHV to stimulate the prescription of drugs by their generic name in 99. If a general practitioner prescribes a drug by its generic name, a pharmacist is free to decide whether or not to dispense a branded drug or to substitute it for

20 8 CHAPTER chapter empirical TITLE setting: the dutch pharmacy sector 8 9 a cheaper generic version. As noted earlier, the discounts provided on generic drugs are often much higher than those provided on branded drugs, which makes generic substitution financially appealing to pharmacies. Health insurers also make agreements with pharmacists on target percentages for generic substitution. If pharmaceutical manufacturers produce unique branded drugs for which no generic copies are available (because they are protected by patents), they have much more power. Branded drugs are, however, hardly truly unique anymore because of the widespread introduction of so-called me-too drugs. Pharmaceutical wholesalers In the early 90s, there were actually only three pharmaceutical wholesalers in the Netherlands. Currently, however, numerous other (small) wholesalers exist. There are four major wholesalers though. OPG is the largest, with a market share of approximately 9%. Thereafter come Interpharm (%), Brocacef (8%), and Mosadex (%) (Kempen & Co, 00). Both Interpharm and Brocacef have been acquired by foreign pharmaceutical wholesalers. In 000, Interpharm was sold to Alliance Unichem (UK), which recently merged with the drugstore retailer Boots. Brocacef was purchased by Phoenix (Germany) in 00. In the past years, the profit margins of pharmaceutical wholesalers have been under severe pressure. This has been due to the stronger competition between wholesalers and to the various measures imposed by the Ministry of VWS. Although none of these measures has been directly aimed at wholesalers, they have been subject to increasing margin pressure from both pharmaceutical manufacturers and pharmacies as intermediaries. To cope with decreasing margins, wholesalers have broadened the scope of their business. Large wholesalers, for instance, have started to provide a wider array of services to their pharmacies (e.g. floor plan designs, stock management systems, advice on acquiring pharmacies, multiple deliveries per day, etc.). This way they can distinguish themselves from smaller wholesalers. This higher service level has, however, also led to higher overhead costs, which in turn has caused large wholesalers to provide lower discounts on generic and parallel imported drugs 8. Pharmacies therefore often purchased these drugs from smaller wholesalers in the past, while they acquired the rest of their assortment from a large wholesaler. To prevent pharmacies from doing this, most large wholesalers have started to provide an overall discount percentage on pharmacies entire assortment rather than a discount percentage per product. This has led to more one-on-one relationships between large wholesalers and pharmacies. exploit pharmacies. As pharmacies realize relatively large profit margins, wholesalers shifted their attention from backward to forward integration. They started to acquire pharmacies. This also enabled wholesalers to strengthen their grip on the distribution chain. A disadvantage of acquisition is that the goodwill prices of pharmacies are very high 9 and acquisition thus involves a large capital investment. Acquisition is, however, still often preferred by wholesalers to internal development because pharmacies generally have a very loyal customer base. Once registered at a pharmacy, people usually remain customer until they move 0. A reason for this is that most people are simply not aware of the fact that they have a free choice. It appeared from research that more than half of the people incorrectly believed that the choice of pharmacy was determined by the health insurer or the general practitioner. Because people do not switch pharmacies, it is often difficult for newly opened pharmacies to establish a customer base. Recently, however, some wholesalers have slowly started to open pharmacies. They often do this in so-called AHOED s or health care centers. The disadvantage of internal development is overcome this way. That is, the close presence of other care providers in AHOED s and health care centers guarantees pharmacies a continuing stream of customers. Except for Mosadex, all major wholesalers have acquired Dutch pharmacies. Table. depicts the number of pharmacies that each wholesaler approximately owned in 00 (ASKA, 00) and the names of the company-owned chains. Also shown in this table is the wholesaler Celesio (Germany). This company has also acquired Dutch pharmacies but is not active in the Dutch market as a wholesaler. OPG, Alliance Boots, and Celesio in principle maintain full ownership over their Dutch pharmacies. Phoenix, on the other hand, allows pharmacists to purchase a majority share in their pharmacies after a couple of years. Dutch wholesalers have not just moved forward through vertical integration but also through franchise formulas for pharmacies. Around 990, OPG, Interpharm, and Brocacef each set up a franchise formula. By means of these franchise formulas, the wholesalers tried to distinguish themselves from one another. By delivering added value, they hoped to create a stronger bond with affiliated pharmacies. In 00, OPG disposed of its franchise formula. This was, amongst other reasons, due to the fact that it was difficult to convince pharmacists of the added value of a franchise formula. In 00, OPG introduced a formula for its own pharmacies. This formula has been adopted by the first independent pharmacy recently. Service Apotheek is a franchise formula which has been set up by pharmacists rather than by wholesalers. In 00, the Service Apotheek formula was sold to Mosadex. Dutch wholesalers have also begun to vertically integrate. Initially, they were integrated backward in the production of generic drugs. This activity, however, appeared not profitable enough. Since 999, it has become considerably easier for non-pharmacists to 8 Me-too drugs are patented drugs that differ slightly from breakthrough drugs. OPG, Interpharm, and Brocacef. Parallel imported drugs are drugs that are imported from low-price countries. 9 0 The goodwill is estimated to range from.0 to. times the annual turnover. In 00, the turnover of an average pharmacy was,8,000 (SFK, 00). It is estimated that less than % of the Dutch population switches pharmacies annually. An AHOED is a new construction in which a pharmacy is located together with general practitioners in one building. In a health care center, a pharmacy is not just situated together with general practitioners but also with other health care providers such as dentists and physiotherapists.

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