How Loyalty Discounts Between Firms Harm Competition When There Are Network Effects: FTC v. Surescripts

Exclusive contracts are vertical arrangements that restrict one or both parties to the contract from doing business with anyone else. These contracts may have pro-competitive benefits such as reducing costs and discouraging free riding. However, a firm may also use exclusive contracts to deny a rival sufficient scale to compete. Any analysis of the effects of exclusive contracts on competition must weigh the potential pro-competitive and anti-competitive effects.

When the market in question is two-sided (or multi-sided), the use of exclusive contracts can tip the scales toward the anti-competitive effects. Two-sided platforms connect two distinct groups of customers, allowing them to interact and create value for both sides. A key feature in many two-sided markets is indirect network effects where the value of the platform to customers on one side of the market is enhanced by participation of customers on the other side. A classic example is a credit card network. Cardholders value the network more when more merchants accept their card. Merchants value the network more when more cardholders carry the card. 

Because of indirect network effects, a new entrant must solve a “chicken-and-egg” problem and achieve a critical mass of customers on both sides of the platform. This is the only way to become a viable competitor to an incumbent platform.

Exclusive contracts can prevent rivals from obtaining that critical mass of new customers. Therefore, the use of exclusive contracts in two-sided markets between an incumbent platform and its customers may deny other platforms the scale needed to compete. This can make entry or expansion by a rival platform difficult or even impossible.

That is exactly what was alleged in FTC v. Surescripts.^[1]

How Can Loyalty Pricing Reduce Competition?

The economics literature that aligns closest to Surescripts’ conduct is Segal and Whinston (2000) that lays out a “divide and conquer” strategy where an incumbent pays for exclusivity by charging a low price to some customers that sign exclusives, while charging the monopoly price to non-signers. In that strategy, “each buyer that signs an exclusive creates an externality on all other buyers by reducing the likelihood that another supplier will enter.”^[2]

The effects of the “divide and conquer” strategy are amplified in two-sided markets with exclusives on both sides where a chicken-and-egg problem due to indirect network effects exacerbates the entry barrier.^[3] Intuitively, the existence of exclusive contracts on one side of a platform may affect a rival’s ability to sign up non-exclusive customers on the other side.^[4]

Even when contracts are not explicitly exclusive, the use of all-units discounts can lead to similar exclusionary effects. With all-units discounts, a customer receives a discount on all units it purchases once it exceeds a threshold level (or share) of transactions with a seller, not just the units beyond the threshold. As has been shown in the literature, these discounts can exclude smaller potential rivals.^[5] These rivals may be unable to compete for significant sales without also accounting for the loss of potentially large discounts if the customer’s sales fall below the threshold.

The FTC argued this was the effect of Surescripts’ contracts with its customers. While most of the contracts were not explicitly exclusive, most customers would lose all their discounts/incentives by multi-homing for even a small percentage of their transactions. In practice, this meant the contracts were de facto exclusive.

What is Surescripts’ Business?

Historically, after a visit to a doctor, a patient might be handed a prescription on a physical slip of paper that was then delivered to a pharmacy. The pharmacy would check the patient’s insurance coverage via phone or fax when filling the prescription and bill the patient the appropriate amount. Starting in the early 2000s, these transactions began to be completed electronically and Surescripts was one of the first platforms to facilitate those connections.

While Surescripts is engaged in many transactions, the case focused on two: “routing” and “eligibility.”^[6] Routing involves the transfer of prescription information from a prescriber via their electronic health record (EHR) software to a pharmacy.^[7] Eligibility involves the transfer of patient health insurance information from a pharmacy benefit manager (PBM) to a prescriber via their EHR.

There are many benefits from these transactions relative to traditional methods. For example, a prescriber can have available the formulary details for a patient’s plan at the point of care and prescription information can be transferred quickly and accurately to a pharmacy. The use of electronic routing and eligibility transactions grew quickly, partially due to federal incentive programs encouraging their use, and have now almost completely replaced traditional methods.^[8]

For routing and eligibility respectively, pharmacies and PBMs each pay Surescripts a fixed fee per transaction and Surescripts then sends a percentage of those fees to the EHR. While most of Surescripts’ contracts with pharmacies, PBMs, and EHRs were not nominally exclusive, they provided discounts and incentives if a customer used Surescripts for all or almost all transactions. As explained below, the FTC argued that these provisions made the contracts de facto exclusive and limited entry by rival platforms.

The following focuses on the routing transaction, but much of the analysis extends to the eligibility transaction.

How Did Surescripts Allegedly Keep Out Rivals?

According to the FTC’s complaint, Surescripts is alleged to have become a monopolist of electronic routing transactions by 2009.^[9] By that time, Surescripts had established connections to nearly all EHRs and pharmacies, making Surescripts an essential platform for all customers that required connections. The FTC’s complaint explained that, due to indirect network effects, the more pharmacies that connected, the greater the EHR’s demand for the Surescripts platform. Similarly, pharmacies value connecting to Surescripts more when more EHRs are connected. Those effects alone gave Surescripts an advantage over rival platforms as it was one of the first platforms to obtain significant connections (i.e., “critical mass”) on both sides of the network.

According to the FTC, Surescripts’ monopoly was maintained, at least in part, due to Surescripts’ “loyalty” contracts with EHRs and pharmacies. Pharmacies would receive a lower per-transaction price if they routed (generally) 100% of transactions via Surescripts. Similarly, an EHR would receive a higher percentage of that routing fee (an “incentive payment”) if it used Surescripts for 100% of its transactions. While these differences may only amount to a few cents per transaction, they are economically significant once multiplied by the millions of routing transactions that occur each year.^[10]

These all-units discounts made it very costly for most customers to use multiple platforms (i.e., multi-home) as routing even a small fraction of transactions over a rival platform would result in that customer potentially losing all discounts or incentives from Surescripts. As a result of the loyalty contracts, the FTC argued that Surescripts secured contracts with customers covering at least 95% of routing transactions.^[11]

The following section provides a quantitative example explaining how Surescripts’ loyalty contracts created a barrier for rival platforms. The basic premise is that for a rival to convince a customer to use its platform for even a small percentage of transactions, the rival would need to offer large discounts/subsidies to make up for the higher price/lower incentives on transactions the customer continued to route through Surescripts. Readers that prefer to skip the example (and a few calculations) can safely skip to the next section that discusses the outcome of the case.

Quantifying the Effects of Surescripts’ Contracts on Rivals

To understand the practical effects of Surescripts’ loyalty contracts on the ability of rival platforms to compete, consider the following stylized example.^[12] Suppose Surescripts has loyalty contracts covering 90% of transactions on both sides of the routing market (i.e., with EHRs and pharmacies). Further, suppose a rival platform offers connections to the remaining 10% on each side. Finally, suppose a pharmacy routes 100 transactions a day and pays Surescripts four cents per transaction if it is loyal and six cents per transaction otherwise.

The rival could approach the pharmacy loyal to Surescripts and offer the pharmacy 10 transactions from EHRs at a price, p^r. To accept, the pharmacy would need to factor in the higher price it would now pay on the 90 transactions it still routes through Surescripts. If loyal to Surescripts, the pharmacy would pay $4 (=$0.04*100) to Surescripts. If the pharmacy multi-homed, it would pay $5.40 (=$0.06*90) to Surescripts and p^r*10 to the rival platform. For the pharmacy to accept, p^r would need to be no more than $-0.14.^[13] I.e., the rival would need to pay the pharmacy to make it as well off as before.

The same type of analysis holds for the rival platform approaching an EHR. It would need to offer additional incentives to the EHR to make up for the incentives the EHR would lose from Surescripts. 

To avoid paying these subsidies, a rival could simply work with non-loyal customers on both sides of the transaction (i.e., the contestable demand). However, in our example, the existence of loyalty contracts on both sides of the platform makes the contestable demand very small. The rival could not compete for 10% of all transactions because some of the non-loyal pharmacies will still be transacting with loyal EHRs (and vice versa). In fact, the contestable demand is only 1% of the total transaction volume (i.e., (1-0.9)*(1-0.9) = 1%).^[14] Even if the shares of loyal customers were 50% on each side of the platform, the contestable demand is still only 25% of all transactions.

Therefore, the extent of foreclosure due to Surescripts’ contracts depends on the magnitude of the contestable demand and the difference between Surescripts’ loyal and non-loyal prices/incentives. While the actual numbers are not public, the FTC alleged the subsidies required to convince customers to multi-home would not be feasible for a rival platform. According to the FTC’s complaint, “Surescripts’s web of loyalty contracts prevented competitors from attaining the critical mass necessary to be a viable competitor in either routing or eligibility. Those effectively exclusive contracts foreclosed at least 70% of each market, eliminating multiple competitive attempts from other companies, such as Emdeon, that offered lower prices and greater innovation.”^[15]

What was the case outcome?

During litigation, Surescripts moved for full summary judgment on the FTC’s claims and the FTC moved for partial summary judgment on two issues: market definition and monopoly power.^[16] The FTC won on both its issues.^[17] On the monopoly power issue, the judge ruled Surescripts had a 95% share since 2010 in the relevant markets and, combined with the “chicken and egg” problem in two-sided markets, Surescripts has had monopoly power since that time. The judge deferred ruling on Surescripts’ motion on competitive effects but noted that “success on its motion was an uphill battle.”

Soon after, the parties agreed to a settlement that included several components.^[18] Surescripts was prohibited from using exclusivity or loyalty contracts requiring 50% or more of a customer’s transactions. It also was prohibited from including provisions in its contracts limiting the ability of customers to do business with Surescripts’ competitors or preventing rivals from competing with Surescripts.^[19]

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FTC v. Surescripts provides an illuminating example of the implications of exclusive contracts in two-sided markets. Due to the chicken-and-egg problem that affects all platforms, gaining a critical mass of customers can be challenging. The addition of loyalty contracts that are de facto exclusive can heighten entry barriers and limit competition from rival platforms.