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2017-04-07
Pharmaceutical Pricing: The Effects of Patent
Expiration and Generic Competition
Robertson, Marina
http://hdl.handle.net/10456/42681
All materials in the Allegheny College DSpace Repository are subject to college policies and Title 17
of the U.S. Code.
ECONOMICS 620
Allegheny College
Meadville, Pennsylvania
16335
Pharmaceutical Pricing: The Effects of Patent Expiration and
Generic Competition
Marina Robertson
7 April 2017
i
Pharmaceutical Pricing: The Effects of Patent Expiration and Generic
Competition
By:
Marina Robertson
Submitted to the Department of Economics:
Project Advisor: Tomas Nonnenmacher
Second Reader: Hyun Woong Park
April 7, 2017
I hereby recognize and pledge to fulfill my responsibilities as defined in the Honor Code and to
maintain the integrity of both myself and the College as a whole.
Marina Robertson
ii
Table of Contents
List of Figures ............................................................................................................................................... iii
List of Tables ................................................................................................................................................ iv
Abstract ......................................................................................................................................................... v
Chapter 1: Introduction ................................................................................................................................ 1
Chapter 2: Theory ......................................................................................................................................... 4
Chapter 3: Empirical Analysis ...................................................................................................................... 15
Chapter 4: Case Study ................................................................................................................................. 23
Chapter 5: Conclusion ................................................................................................................................. 33
References .................................................................................................................................................. 37
About the Author ........................................................................................................................................ 39
iii
List of Figures
Figure 2.1 ...................................................................................................................................................... 9
Figure 4.1 .................................................................................................................................................... 25
Figure 4.2 .................................................................................................................................................... 28
Figure 4.3 .................................................................................................................................................... 30
iv
List of Tables
Table 3.1: Real Branded Price Regressions ................................................................................................. 18
Table 3.2: Real Generic Price Regressions .................................................................................................. 21
v
Abstract
The pharmaceutical industry consistently prices branded drug well in excess of generic drugs.
Generic drugs are produced as perfect substitutes for the branded drug counterparts, yet additional
factors are in place that allow these branded and generic drug prices to diverge. The use of patents to
protect a branded drug provide monopoly power to that manufacturing firm for the given time period.
Adopting a theory of an imperfectly segmented market, it is the case that consumers have varying levels
of price sensitivity allowing for branded prices to continue to maintain prices even with generic
competition. Branded firms are price makers following patent expiration because they retain price
insensitive consumers who perceive the branded drug as being different and superior to the generic
substitutes. This paper examines data on pharmaceutical prices of branded and generic drugs following
patent expiration and generic entry using a regression model to analyze these effects. The case study of
three drug markets show real life examples of how drug prices change with generic competition. While
some drugs follow the trend found in the regression analysis, others differ based on strategies embraced
by their manufacturers. The results of this study, like others in this academic area, lead to a question of
whether pharmaceutical pricing policies require reform.
1
Chapter 1: Introduction
As of 2015, branded drugs made up 73.3% of total prescription drug revenues in the United
States while branded generics counted for 10.7% and unbranded generics for 16%. Despite the fact that
the vast majority of revenues are being made by branded drugs, they only accounted for 11.3% of the
total drug prescriptions being dispensed in the United States in 2015, compared to unbranded generics
which accounted for 83.4%. Branded generics were the least dispensed, making up only 5.3% of total
drug prescriptions (IMS Health, 2017). These figures illustrate the immense differences in pricing of
branded and generic drugs. The pharmaceutical industry is crucial in the benefits it provides to
consumers but unique in the qualities that allow prices to be in excess of those in a perfectly
competitive market. Pharmaceutical regulations are designed to increase competition to control prices
while simultaneously increasing innovation. The use of patents in this industry acts as a reward for
innovation, allowing drug manufacturers to set monopoly prices during the period of patent coverage as
a way to recover the sunk costs of research. Regulations such as the Hatch-Waxman Act of 1984 sought
to keep the patent system in place but to make it easier for competition to exist in the market following
patent expiration.
Little is known, however, about the post-patent competitive process: the speed and fullness
with which competitive entry then erodes patent-protected monopoly rents and eliminates the
associated deadweight losses. Although the patent on an innovative drug expires on a specific
date, the drug's trademark lives on as the vehicle for maintaining the innovator's goodwill and
possibly delaying or impeding subsequent competition (Caves, Whinston, Hurwitz, Pakes, &
Temin, 1991, p. 2).
Caves, et al. aptly describe the uncertainty that follows a drug’s patent expiring. While it might be
expected that generics will enter the market and compete with the original, or branded drug, we see
2
that patent benefits and the first mover advantage prevent the branded drug from directly competing
with the generics. The goal of the research presented in this paper is to explain what happens to prices
in the pharmaceutical industry following patent expiration with the entrance of generic competitors.
What I find is that general branded prices continue to increase following generic entrance and patent
expiration, but there are extenuating circumstances where this is not the case.
My findings support a theory of an imperfectly segmented market, consistent with the findings
of previous researchers. In a highly regarded study by Frank and Salkever, they describe this
segmentation in the following way:
One segment (consisting largely of hospitals, HMOs and Medicaid patients) is sensitive to
differences between brand-name and generic prices, while the other (mainly comprised of
individuals purchasing drugs in a retail outlet based on prescriptions from office-based
physicians), is not sensitive to these price differences (1992, p. 166).
This difference in levels of price sensitivity leads to a market where branded drugs are able to take
advantage of the price insensitive consumer and maintain high and increasing prices while generics are
forced to lower their prices.
Chapter 2 provides background on the pharmaceutical industry and theory behind pricing. It
examines the use of patents in the industry and the supply and demand aspects that differentiate
pharmaceuticals from other industries. The chapter presents the monopoly pricing model that firms
operate under during their patent protected period. Given this model, the expectation is that prices for
branded drugs will drop as the market shifts from monopolistic to oligopolistic and eventually to perfect
competition. Because this is often not the case for pharmaceuticals, the chapter gives theory behind
when and why prices would not follow these trends.
3
Chapter 3 gives an empirical analysis of drug prices using a review of prior studies. The
regressions in the chapter come from a study done by Regan, examining prices of drugs that came off
patent sometime between the years of 1998 and 2002. The findings of this study are consistent with
theories presented in Chapter 2 as well as findings of prior researchers.
Chapter 4 is a case study of different drug markets. It examines actual price trends in the market
for ADHD drugs, specifically for Ritalin, the prescription sleep aid market, and antidepressants. The
purpose of this chapter is to show that drug prices will not always follow a certain trend. While some of
these drug prices are consistent with trends found in the empirical analysis, others have unique pricing
strategies, such as those used by Ambien manufacturers.
4
Chapter 2: Theory
Introduction
The pharmaceutical industry bears the characteristics of a complex and often controversial
industry. While it is abundantly clear that pharmaceuticals are necessary goods for many people, there
is a common debate about how they are priced. It sometimes seems like pharmaceutical firms are
jumping through hoops to find a way to keep increasing prices. There are unique supply and demand
features in this industry such as third-party payers’ effect on consumer demand and the difference
between physicians and pharmacies demand, as well barriers to entry on supply such as government
regulations and patents. While the patents are in effect they allow for legal monopolies, which in turn
means launch prices for drugs will be higher than costs, as described by monopoly pricing theory. After
these patents expire we expect to see bioequivalent generics enter the market and increase
competition, driving down the prices to those of a perfectly competitive market. Due to many
complexities of the pharmaceutical industry we often do not see pricing trends that follow these
economic pricing models. Firms often undertake strategic pricing strategies or find ways to single out
the price insensitive sector of the market in order to keep prices high. What this creates is inconsistent
trends in drug prices.
Market Structure: Supply and Demand
The demand for pharmaceuticals is unlike many other industries because it is affected not only
by the final consumer’s demand but by prescribers and pharmacists as well. It is often assumed in
economics that the consumer behaves rationally, and this is likely to be the case for final consumers of a
drug who desire the best treatment at the lowest cost. However, rational behavior on the part of
physicians and pharmacists is not necessarily providing the cheapest prescription to consumers.
Physicians do not always try to prescribe the medication that will be of the best monetary value to their
5
patients often because of lack of complete information or ease of sticking to what they already know.
Because a brand name drug is around well before any other potential competitors enter the market,
physicians are likely more familiar with that drug and may continue to prescribe even if there are more
affordable generic substitutes in the market. Branded drug manufacturers often spend their time and
money trying to persuade physicians to prescribe their drug. This may give the physician a sense of
complete information about the given branded drug while not knowing exactly how well the generics
are replicas of the original. This is also due to the fact that many physicians are not actively aware of
drug prices because they are only responsible for prescribing the drug which will then be paid for at the
pharmacy. The demand is slightly different for drugs being dispensed in hospitals because they are often
more concerned with cost minimization. Hospitals often have formularies of the drugs that are trusted
and available to be prescribed, and contractually they are able to prescribe the generic substitute unless
specifically stated by the physician (Caves, Whinston, Hurwitz, Pakes, & Temin, 1991, p. 4-8). This means
they are going to prescribe the generic substitute unless otherwise specified as a way to keep hospital
pharmacy costs lower.
Ultimate consumer demand is affected by the presence of third party payers and information
costs. Third-party payers are best described as “an entity (other than the patient or the health care
provider) that reimburses and manages health care expenses” (Medical Dictionary, 2009). Many people
in the United States have some form of health insurance whether it is from a private insurance
company, a government program such as Medicare or Medicaid, or an employer. The presence of these
third-party payers can misrepresent retail prices to consumers and force the industry to diverge from
the expected perfect competition pricing for the generic market. Many of these third-party payers base
their reimbursements on the average wholesale price (AWP) of a drug. “The AWP is reported by generic
producers themselves”, allowing for price manipulation for the benefit of the producing company
(Alpert, Duggan, & Hellerstein, 2013). How this works is they will price in excess of the actual price in
6
order to produce a larger reimbursement to the pharmacy. While it seems apparent that pharmacies
benefit from this pricing because it increases their profits, it is also desirable to the generic producing
company because it can increase their market share due to the fact pharmacies will have more to gain
from providing that specific generic substitute over all others (Alpert, Duggan, & Hellerstein, 2013).
Third-party payers distort consumer demand because it makes it more difficult to get accurate pricing
information, consumers only pay a fraction of real prices, and may be restricted to purchasing only the
drugs covered by their unique plan.
On the supply side of the pharmaceutical industry, it is common to see few competitors for
many drug markets, despite the overall large number of firms in the industry. This can be attributed to
the fact that many of the active chemical entities that are used to produce a certain drug are typically
small scale. This indicates that potential entrants to the market can be relatively high. Producers of
generic substitute drugs do face the costs of receiving FDA approval, but these are generally not enough
to dissuade firms from entering the market. The ability to compete is a factor in this market because
larger firms can have the advantage of brand recognition. A large firm that has produced originator
drugs before their name is more recognizable to the general public can often acquire more market share
than the small generic production firms when they choose to produce generic substitutes. These drugs
are often referred to as branded generics (Caves, Whinston, Hurwitz, Pakes, & Temin, 1991, p. 8-11).
Overall for the supply side, patents create the largest barriers to entry and are discussed in further detail
in the proceeding section.
Patents
The pharmaceutical industry has some unique features that enable high launch prices in
comparison to other industries, one of these being the use of patents. Patents in general are used as a
way to give exclusive rights to the originators of a new invention or innovation. For the pharmaceutical
7
industry patents have been commonplace to protect the rights to produce a new drug. What this
produces is a legal monopoly. The societal hope is that patents will increase the incentive to innovate
and continue research and development. The result however makes it seem that companies use patents
as a way to price high in order to cover some of these costs of research and development. Economically
speaking research and development costs are sunk costs and should not be taken into account when
determining the price for a good.
Patents have a controversial history because it is difficult to measure their effect on innovation.
Amendments to patent law have been implemented over the years with the intentions of improving the
patent system in the pharmaceutical industry as a whole. The Hatch-Waxman Act was passed in 1984
and “eliminated the requirement of socially wasteful duplicative testing by generic entrants, and
granted drug innovators some restoration of the effective lives of their patents” (Caves, Whinston,
Hurwitz, Pakes, & Temin, 1991, p. 10). Prior to this act it was not uncommon for pharmaceutical
manufacturers to see a substantial delay between the time that a drug is given patent protection and
when it is actually able to be placed on the market. It was also harder for generic drugs to enter the
market at this time because they were required to undergo the same approval process as the originator
drugs. The Hatch-Waxman Act made it significantly easier for generic substitutes to enter the market by
imposing the use of Abbreviated New Drug Applications (ANDA), which required generics to only prove
their bioequivalence to the originator. While this amendment may lower prices in the long run because
it is easier to increase competition, it grants longer patent lives which can allow a firm to be profitable
longer and develop a stronger first-mover advantage (Caves, Whinston, Hurwitz, Pakes, & Temin, 1991,
p. 10).
Monopoly Pricing Theory
8
The use of patents in the pharmaceutical industry leads the existence of legal monopolies. These
legal monopolies give pharmaceutical firms the ability to set higher prices given the fact that
monopolistic firms are price-makers rather than price-takers. In a perfectly competitive market a firm
must adhere to the market price of a good in order to remain competitive with the other firms, meaning
their marginal revenue is equal to the market price. A firm in this type of market will set price equal to
the marginal costs of what they are producing (P=MC). A monopolistic firm is different in the fact that
they have more individual control over the price of the good because they are the sole seller of that
good, therefore demand is more inelastic. In a monopoly with a linear demand function, the marginal
revenue (MR) declines at a rate twice as fast as the demand (D). Figure 2.1 shows an example of this
relationship. A firm in any market maximizes its profits by selling the quantity where marginal revenue is
equal to marginal cost (MR=MC), in this case Qm. In a monopoly, the price will be set given this
determined quantity, Qm, and the level of market demand that that quantity. This leads monopolistic
firms to set a price at Pm higher than that of a competitive market, shown on the graph as Pc. Producing
at this level creates an economic deadweight loss (DWL) because the firm is not supplying at the socially
optimal level, meaning that prices are in excess of marginal costs in a monopoly. This pricing reduces
buyer surplus while increasing supplier surplus.
9
Figure 2.1
P
MC
DWL
Pm
Pc
D
Qm
MR
Q
Since pharmaceutical firms have patents, meaning exclusive rights to produce a specific drug,
we expect them to follow this model of pricing. This will allow pharmaceutical firms to sell a lower
quantity of goods at a higher price. Patents have only a limited effective period, therefore when they
expire we expect the market to become competitive if barriers to entry are low enough. In theory, firms
will desire to enter this market because the originator firms were seeing high profits, and the earliest
firms to enter after patent expiration expect to see some level of profits. In a perfectly competitive
market economic profits will eventually equal zero so we would expect firms to enter the market until
this is the case. Based on Figure 2.1 we would expect a reduction in the price level for a drug after
generic entry to eventually drop from Pm to Pc.
In many instances there are multiple branded drugs that are used to treat the same condition.
While these drugs must be in some way differentiated, they can be substitutes for one another in
certain cases. When there are multiple branded drugs available on a given market, we might expect
10
them to compete with one another and for that to bring prices down. However most studies have not
confirmed this result. Because these drugs must have slightly different formulas, the way they work will
not be exactly the same. In the case of the prescription sleep aid market, there are multiple branded
drugs, but some consumers might prefer the drug that starts working immediately while others want
one that lasts longer. Although having these additional branded drugs enter the market often decreases
market share, it does not typically correspond to any decrease in price (Shapiro, 2016). The prices of
these branded drugs are then able to continue to rise as they are viewed as superior goods in
comparison to their generic counterparts.
Pricing Strategies
In depth empirical examinations of the pharmaceutical industry have proven that prices often
do not follow the expectation of economic pricing theories. While it is almost guaranteed that the
launch prices of an originator drug will be substantially higher than marginal costs as described in
monopoly pricing theory, the pricing structures tend to vary following patent expiration. Prices can
depend on what the drug treats, its level of innovation and effectiveness, and the type of market that
drug faces.
Price Maintenance
Companies seek to maximize their profits as much as possible. While patents will give a
company monopoly power for a set period of time, that power will eventually run out. Because of this
limit, companies have found ways to maintain market share after their patent expires. One way
pharmaceutical manufacturing companies can do this is by patent manipulation, or strategic entry delay.
This is when a firm with a current patent on a drug produces a reformulation of that drug and then
introduces the reformulation just prior to patent expiration. It could be a reformulation in the way the
drug is administered or potentially a new extended time release version of the original drug. This
11
practice is referred to as strategic entry delay because companies strategize on the most efficient time
to release the newly formulated drug in order to keep market share within their company. By releasing
just before patent expiration they expect the new drug to compete with the generic substitutes of the
original. If they decide to release the reformulated drug a few years before patent expiration, that drug
is only going to be competing with the original drug. Along “with the Hatch-Waxman Act of 1984, the
FDA included an unchallengeable exclusivity period for newly approved drugs, independent of patents”
(Shapiro, 2016), meaning these reformulations receive some of the same benefits as having a patent on
the drug. Because other firms cannot produce a generic substitute of the reformulated drug during the
period of exclusivity it gives the originator company the upper hand. The reformulated drug will then
have no perfect competitors and therefore demand for it will be more inelastic and prices can remain
higher than the generic substitutes for the original drug (Shapiro, 2016). Reformulations are just one
form of patent extension that allows a firm to have extended exclusivity. Firms can affectively extend
their patent protection if they discover a new treatment or use for a drug they developed, allowing
them to corner a different market. An additional strategy drug manufacturer’s employ is the creation of
combination drugs. For example, a drug used to treat schizophrenia, called Zyprexa, was combined with
the generic fluoxetine, used for treating depression. The combination of these drugs was used to treat
bipolar depression and patented by the manufacturer of Zyprexa (Cunningham & Spruill, 2005).
Strategies like these are used by firms to maintain share of a market or to enter into a new market.
Having extended patent protection is way for firms to increase their revenues and receive additional
recognition.
Market Segments and Demand Elasticity
Prices of pharmaceuticals, like pricing for most goods, rely heavily on the level of consumer
demand elasticity. When products have more inelastic demand, meaning it is difficult or unlikely for
consumers to switch to a similar good, they can be priced higher. Pharmaceutical firms take advantage
12
of this as best they can, for example if a drug is developed that has no competitors for a certain
treatment use, the demand will be very inelastic because consumers with the condition that the drug
treats will have no other option but to pay whatever the given price is as long as they can afford it. This
allows for companies to make large profits until there is enough competition in the market for that drug
to drive prices down. What tends to actually occur however, is that pharmaceutical companies that are
drug originators can sometimes find ways to take advantage of asymmetric information of consumers to
target a group of consumers with inelastic demand. This can be achieved by observing the off-patent
market type for a given drug.
There are three main types of market categorizations that can describe how consumers perceive
a pharmaceutical market with generic competition. The first is an undifferentiated market. In an
undifferentiated market consumers are viewed has having the same level of demand for a certain
product. More specific to the pharmaceutical industry, it can be described as a market where consumers
perceive the originator drug to be exactly the same as its generic substitutes. This means that the
originator drug has developed no level of brand loyalty or a first-mover advantage. Consumers also have
complete information about the safety and effectiveness of the generic substitutes on the market. Given
this type of market, prices should follow the patterns of a market shifting to perfect competition,
meaning as more firms enter prices will decrease until economic profits are zero. Eventually the
originator and its generic substitutes will be priced the same. An undifferentiated market is sometimes
uncommon to see because many industries benefit from first-mover advantages.
The second market categorization is a perfectly segmented market, meaning there are two
distinct market segments. This happens when “an originator is perceived as completely different from
its competitors by some customers” (Suh, Manning, Schondelmeyer, & Hadsall, 2000, p. 533). Those
who believe the originator is not equivalent to the generics have price inelastic demand. This allows for
13
the originator to keep charging higher prices while the generics compete only with each other and have
lower, more competitive, prices.
The third market type is an imperfectly segmented market. In this case “off-patented drugs are
only slightly differentiated and are very close substitutes” (Suh, Manning, Schondelmeyer, & Hadsall,
2000, p. 534). When generics enter the market price trends will diverge. As more of these generic
substitutes enter the market their prices will continue to drop. Consumers will initially have varying
levels of incomplete information causing some to switch to the generic drug faster than others.
Eventually this market will diverge into two sectors, the consumers with incomplete information about
the effectiveness of the generics will have inelastic demand for the originator, and the consumers who
now perceive the generics as a perfect substitute for the originator. This allows an originator company
to target the consumers who continue to have inelastic demand and therefore they can keep prices
higher than those of the generics (Suh, Manning, Schondelmeyer, & Hadsall, 2000, p. 534).
Conclusion
Pharmaceutical firms have continuously found ways to manipulate their prices after patent
expiration to make profits in excess of a perfectly competitive market. This chapter has highlighted
some of the most important features of the pharmaceutical industry and some commonly used pricing
strategies. Overall prices will depend on the level of competition, meaning the number of firms in the
industry, the number of years since patent expiration and elasticity of demand for the generic compared
to the originator. Using this information I am able to examine empirical analyses of pricing trends in this
industry after patent expiration. The following chapters will give concrete evidence that these trends
exist and some case study examples of when firms will choose which pricing strategy. The general
consensus is that pharmaceuticals are overpriced and firms are taking advantage of consumers in need. I
14
will highlight some of the flaws in the system such as the patent system and incomplete information of
the ultimate consumer as well as the prescribing physicians.
15
Chapter 3: Empirical Analysis
Introduction
The topic of pharmaceutical pricing is one that countless economists have attempted to explain.
There is no simple explanation to why drug prices behave the way they do. Economists have created and
recreated regressions in order to examine the trend of rising prices of pharmaceuticals, especially
branded drugs. Given the theories and pricing strategies described in the first chapter, this chapter
presents the empirical evidence of these theories in real life. The regressions shown in this chapter use
data to show the effects of generic competition following patent expiration on drug prices. The findings
of this chapter support an imperfectly segmented market theory.
Background
In the years following the Hatch-Waxman Act of 1984, many economists took an interest in
studying the effects of the legislation. They were looking to see whether the goals of easier generic
entry and restoration of patent life were actually being attained. This led economists such as Caves
(1991), Grabowski and Vernon (1992), and Frank and Salkever (1992) to study drug pricing. While these
studies are highly regarded, they are becoming dated. Grabowski and Vernon studied 18 major drugs
between the 1983 and 1987. Their work supports my hypothesis, which is that branded drug prices will
increase with generic competitors in the market. Studies such as theirs have shown that in the
pharmaceutical industry price competition does in fact exist, but it is concentrated in only the generic
market (Regan, 2003, p. 20).
This concept of market segmentation has been regarded as a driving force in the ability to price
pharmaceuticals. In 1992 Frank and Salkever used this model to examine pricing trends and found them
to be consistent with the Stackleberg model. In this model the manufacturer of the branded drug acts as
the price leader and benefits from the first mover advantage, forcing the generic manufacturers to
16
accept the price as given. Because they are restricted by their need to compete with other generic firms
they are unable to maintain prices as high as the branded price (Regan, 2003, p. 21).
Data
A more recent example of these models in the pharmaceutical industry includes “18 branded
drugs that lost their patent sometime between February 1998 and February 2002” (Regan, 2003, p. 22).
It also includes their generic competition that followed patent expiration, and both the branded and
generic drugs were observed in one month intervals. The data needed to compile this type of study is
not easy to come by, and there are complications due to the complexity of the pharmaceutical industry.
The data for this study started with a collection of drugs that went off patent between 1998 and 2002,
which were found in a cross-reference of the FDA’s Electronic Orange Book and annual tables presented
in the journal Med Ad News. Regan’s study follows the work of previous researchers in that she excludes
drugs that are injectables and infusibles on the basis that these types of drugs are typically only used in
hospitals. Drugs that changed to over-the-counter status were also eliminated because they no longer
required a prescription. The therapeutic equivalence of all the chosen drugs was tested, using the TE
Codes as defined by the FDA’s Electronic Orange Book, to prove that all the generics were in fact
adequate substitutes for the branded counterparts. The pricing and prescription data comes from NDC
Health and is classified as one of three types of payments: cash, Medicaid and third party payments.
After all drugs were considered there were 18 left that met all the requirements for the study, treating a
variety of different ailments (Regan, 2003, p. 23-25).
Because there is not readily accessible price data at the pill level, Regan used total prescription
count and dollars to construct a different measure of price. Using the total prescription dollars could
cause measurement error because the number of pills to a prescription can vary. Given that all 18 drugs
considered in her study treat chronic conditions, the number of pills prescribed each month is expected
17
to be consistent. For the regression analysis the dependent variable is the price per prescription. The
average wholesale price of a prescription, either branded or generic, is constructed using the data on
payments in cash, from Medicaid, and by third party payers. The independent variables included in the
regressions measure generic competition and method of payment. The variable NUMGEN is the number
of generic entrants in the market. It should be noted that on average there are 4.7 generics per branded
drug in the market for the given time period of this data set. The variable CASH followed by a subscript
(b) for brand name drugs and (g) for generic, is “the percentage share of the total prescription dollars
that were paid for in cash” (Regan, 2003, p. 29), those paid for by Medicaid are represented by the
variable (MEDb,g). Because panel data are necessary to study changes in price, a two-way fixed effects
approach was adopted; this is consistent with the regression method used by Frank and Salkever (1992).
Using this approach, the equilibrium branded price can be approximated by:
Pb(it) = αi + αt + λ1NUMGENit + βXb(it) + εb(it),
(3.1)
where i represents the drug, t is the time period, Xb are the other branded explanatory variables, and εb
is the error term. If there are measurement errors among the regressor a fixed-effects model is one way
to compensate. The two-way model includes time effects, making it suitable for this type of panel data.
For these specific data it is assumed “that the measurement error varies across, but not within, each
drug… Thus, this drug specific measurement error gets picked up in the fixed-effects (i.e., the unique
constant term αi (δi)) for each drug”. Similarly, the regression equation for the equilibrium generic price
is given as:
Pg(it) = δi + δt + θ1NUMGENit + θ2Pb(it) + γXg(it) + εg(it),
where Xg are generic explanatory variables, and εg is the error term.
Regression Results
(3.2)
18
Table 3.1: Real Branded Price Regressions
Dependent Variable:
CASHb
Real Pb
(1)
1.657
(8.351)***
-
MEDb
-
NUMGEN
Constant
R2
nobs.
-
-
-
81.934
(86.539)***
Real Pb
(2)
1.49
(8.299)***
-1.781
(-8.085)***
-0.309
(-2.203)**
108.063
(32.466)***
Real Cash Pb
(3)
0.882
(6.203)***
-
Real Medicaid Pb Real Third Party Pb
(4)
(5)
1.733
1.775
(7.257)***
(8.079)***
-
69.614
(102.607)***
79.013
(69.356)***
84.409
(84.409)***
0.997
0.997
0.997
0.995
0.996
339
339
339
339
339
(t-values)
***=significant at the 1% level for a 2 tailed t-test
**=significant at the 5% level for a 2 tailed t-test
*=significant at the 10% level for a 2 tailed t-test
Table 3.1 Regression from Regan, T. L. (2003). Microeconomic essays on market entry, optimal education,
and measured experience
The set of regressions shown in Table 3.1 focus on the explanatory variables’ impacts on the real
branded price (Pb) per prescription. The dependent variable specific to columns (1) and (2) is the real
average branded price. Column (1) examines simply the generic competition in the market, using
NUMGEN as the only variable besides the constant. Given the previous research on this subject, we
would expect the coefficient of NUMGEN to be positive. This is because previous research has shown
that when there are more generics entering the market, the price sensitive consumers will switch to the
cheaper generic substitute while the price insensitive market segment will continue to buy the branded
drug, even at a higher price. In this case an additional generic entrant to the market is expected to
increase the average price of the brand name drug by $1.66. This result is statistically significant at the
1% level. Column (2) explores how the payment type for the branded drug and generic entrants affect
average branded prices. The variables CASHb and MEDb are used relative to third party payments. Both
of these variables are significant and have a negative effect on the real average price of the branded
19
drug. Including these variables in the regression slightly decreases the effect of the variable NUMGEN,
which now corresponds to a $1.49 increase in the average branded price.
The next three columns of the regression, (3), (4), and (5), focus on price discrimination using
the information on type of payment. This creates three different dependent variables that represent the
real price per branded prescription given cash payments, Medicaid payments, and third party payments.
Each of these regressions rely solely on the number of generic entrants to the market, or NUMGEN. For
regressions 3-5 the variable NUMGEN is significant and positive in all instances. What is represented by
these regressions is that the real branded price based on Medicaid payments is about equal to the price
based on third party payments with an additional generic entrant, with impacts of $1.73 and $1.78
respectively. The biggest difference in impact lies in the regression in column (3) and shows that an
additional generic entrant is expected to increase the real branded price based on cash payments by
$.88. This effect is much smaller than the effect from Medicaid and third party payments on average
price per branded prescription.
These five regressions on real price per branded prescription illustrate a common factor. They
show that the number of generic entrants into a market has a significant positive effect on the price of
the branded prescription, meaning that as generic competition increases so does the average branded
drug price. For the data used in this regression, the branded drugs made up 43 percent of the
prescriptions filled but 47 percent of the actuals dollars spent on these prescriptions. This statistic alone
makes it evident that branded drug prices are significantly higher than generic prices. These results are
consistent with the findings of other studies, for example the study by Suh, Manning, Schondelmeyer,
and Hadsall, published in 2000. The drugs examined in Suh, Manning, Schondelmeyer, and Hadsall’s
research were significantly more dated than those used in the regression above but all were developed
sometime after the Hatch-Waxman Act in 1984, meaning they should yield similar results. Their study
was able to examine drug prices from four years before patent expiration until four years after and
20
presented some initial findings even prior to their regressions. They observed a trend in branded drug
sales dropping approximately 12% in dollars but 31% in quantity purchased four years after patent
expiration. Total dollars sales and quantity are clearly dropping for branded drugs following patent
expiration, meaning the price-sensitive market segment is switching to the more cost efficient
substitute: a generic. However we see that while significantly lower quantities of the branded drugs
were being sold after patent expiration, the dollar sales are still high in comparison, meaning the priceinsensitive consumers are willing to pay more to get the originator drug. This is consistent with their
theory of the pharmaceutical industry behaving as an imperfectly segmented market (Suh, Manning,
Schondelmeyer, & Hadsall, 2000, p. 537).
The regressions examining real average generic price use the same data as the regressions in
Table 3.1. The difference in constructing these regressions is that the variable NUMGEN has been
changed now into a dummy variable, DNUMGEN, which is equal to “1” when there are more than one
generic entrants, otherwise it is “0”. The Bertrand model of price competition can be used when
describing oligopolistic markets in the short-run. This model is a good fit for the generic drug market
given the model’s assumptions. It is used for firms who are producing goods that are perfect substitutes
to one another, which is the case for generic drugs. The model also assumes that firms will compete
through setting price and that price will be driven to the marginal cost of production, meaning that the
actual number of firms in the market do not matter so long as there are at least 2. For these reasons
using the dummy variable, DNUMGEN, is in alignment with the Bertrand model (Regan, 2003, p. 38).
21
Table 3.2: Real Generic Price Regressions
Dependent Variable:
Real Pg
(1)
-8.135
(-3.976)***
-0.022
(-0.199)
-
Real Pg
(2)
-7.261
(-3.529)***
-0.074
(-0.670)
-
Real Medicaid Pb
-
-
Real Third Party Pb
-
-
CASHg
-
MEDg
77.839
(7.828)***
0.208
(-1.499)
0.336
(2.525)**
76.016
(7.669)***
0.979
339
0.979
339
DNUMGEN
Real Pb
Real Cash Pb
Constant
2
R
nobs.
Real Cash Pg
(3)
-3.625
(1.475)
-
Real Medicaid Pg Real Third Party Pg
(4)
(5)
-16.508
-3.718
(-2.544)**
(-1.579)
-
-0.172
(-0.630)
0.252
(1.421)
-0.125
(-0.848)
-
1.719
(2.400)**
-0.158
(-0.337)
-0.201
(-0.514)
-
-0.590
(-2.278)**
0.132
(0.773)
0.042
-0.296
-
-
-
-
62.281
(4.448)***
-12.102
(-0.326)
102.996
(7.729)***
0.955
337
0.862
337
0.979
339
(t-values)
***=significant at the 1% level for a 2 tailed t-test
**=significant at the 5% level for a 2 tailed t-test
*=significant at the 10% level for a 2 tailed t-test
Table 3.2: Regression from Regan, T. L. (2003). Microeconomic essays on market entry, optimal education,
and measured experience
Table 3.2 gives five regressions similar to those in Table 3.1 but instead the dependent variables
are related to the real average generic prices and again include breakdowns based on the three different
payment types. The most important regressor to notice here is DNUMGEN. Columns (1) and (2) of Table
3.2 show DNUMGEN being negative and statistically significant. These two regressions are similar but
column (2) includes the independent variables of the percentage share of dollars spent in cash for
prescriptions and well as dollars paid by Medicaid. These two columns show that the effect of
competition in the generic market (meaning more than one firm manufacturing a generic) is somewhere
between an $8.14 and $7.26 decrease on the average generic price. The average price for a generic
prescription in this data set is $70.25, showing that this is a considerably large price decrease (Regan,
2003, p. 30). Columns 3-5 for the most part are not a significant to explaining pricing differences by
22
payment type. Column (4) however does show that generic competition has a significant and negative
effect on Medicaid pricing of generics. Having more than one generic substitute on the market
corresponds to a $16.51 decrease in the Medicaid price of that drug.
Conclusion
The numerous studies on the subject of generic competition and drug prices show that prices
for the branded drug do in fact increase after patent expiration. However not every study is exactly the
same, and the degree to which generic competition affects prices cannot be taken as guaranteed in any
case. The evidence does in fact support the notion that prices of branded drugs are very unlikely to drop
following patent expiration when there are generics on the market. In a highly regarded analysis of
pharmaceutical pricing, Frank and Salkever concluded that “none of the studies suggests strong name
brand price reductions in response to generic entry” (1992, p. 174). This is in accordance with the
analysis presented in this chapter and shows branded manufacturers as dominant firms in the
Stackelberg model.
The trends we see in the pricing of generics do follow what economists would expect of an
increasingly competitive market. The Bertrand model appears to be a good descriptor of this type of
market. As expected, research has proven that generic prices decrease when there is other generic
competition. The unique preferences of consumers driving these pricing differences shows different
levels of price-sensitivity. This leads to an imperfectly segmented market where incomplete information
and other restrictions allow some consumers to remain price-insensitive to the point where increases in
the branded drug prices do not deter them.
23
Chapter 4: Case Study
Introduction
The empirical analysis presented in Chapter 3 shows a trend that is common for branded drugs
and their generic competitors in the years following patent expiration. In the examination of actual drug
prices however, it is not rare to find drugs that do not follow this trend of increased branded drug prices
or decreasing generic prices. This chapter examines real examples of three different drug markets and
provides some insight on why their pricing trends vary by drug and treatment, and gives concrete
examples of pricing strategies described in Chapter 2.
ADHD Market
The drug market for the treatment of Attention Deficit Hyperactivity Disorder (ADHD), with the
use of psychostimulants, has grown at an almost shocking rate. “Between 1990 and 1996,
psychostimulant consumption increased 37% nationwide, while the number of patients diagnosed with
the disorder grew from around 900,000 to approximately 3 million. In 2000, the total sales of ADHD
drugs in the U.S. were about $1 billion, and by 2003 had surpassed $2.2 billion (in constant 2000
dollars)” (Bokhari & Fournier, 2013). This rapid growth prompted drug manufacturers to enter the
market either with generic versions or new formulas or new effects, such as extended release. Some of
the more well-known branded drugs include Ritalin, Adderall, and Concerta. While all of these drugs are
intended to treat ADHD, they have unique qualities that differentiate them from the others. Concerta is
known for its extended release formula, lasting 12 hours in most people. As soon as Concerta entered
the market in 2000 it was a major success. It went from a 4.7% market share of all ADHD drugs to 26.1%
share. Seeing this success, in 2001 Adderall launched a new extended release version of their drug that
quickly captured the market, shifting Adderall’s market share from their original formula to the new
24
extended release drug, Adderall XR (Bokhari & Fournier, 2013). Reformulations like these often have an
effect on the price and market share of the original branded drug as well as the new reformulation.
The price and market share data for this study comes from NDCHealth's proprietary Source
Territory Manager® data files for the years 1999–2003. This data set offers total number of pills
dispensed and total dollar sales for multiple ADHD drugs during the given years. The NDC data are at the
retail sales level so the price can be thought of as an average transaction price, including the final price
paid by consumers and insurance companies, rather than just the copayment of the consumer. These
pricing data allow me to analyze trends and examine how well these trends follow those presented in
the regressions in Chapter 3.
Given the data from Bokhari & Fournier, I chose to first focus on Ritalin, Adderall, and Concerta,
as well as any generic substitutes for those drugs because these have the highest market shares. These
drugs are differentiated in few specific ways. The molecules of Ritalin and Concerta are both classified as
methylphenidates while Adderall is classified as having mixed amphetamine salt based molecules.
Certain molecular structures are more effective in treating some people, while being less effective on
others. These drugs are also differentiated by their release. Ritalin, Adderall and their generic
counterparts are all immediate release drugs designed to last for four hours, whereas Concerta is in a
catergory of its own. It uses the Osmotic Release Oral System (OROS) technology and is made to last for
up to 12 hours (Bokhari & Fournier, 2013). This shows that while these drugs all treat ADHD they are by
no means perfect substitutes for one another. For the sake of having the most complete analysis given
this data set, I chose to focus mainly on Ritalin and Ritalin SR compared to their generic counterparts.
Figure 4.2 provides a visual representation of the pricing trends of these drugs between 1999
and 2003. Ritalin SR is a reformulation of Ritalin. While it is still classified as a methylphenidate, the new
formula is immediate-acting and extended release (8 hours). Ritalin SR is consistently the highest priced
25
of these four drugs in the given time period. The generic Ritalin SR, or generic MPH-ER, is less expensive
than both of the branded drugs but more expensive than the generic Ritalin, or MPH-IR. Figure 4.1
shows some clear trends in the pricing of these drugs. In the first year of the data set the difference in
price between Ritalin and generic MPH-IR is about equal to the difference in price of Ritalin SR and
generic MPH-ER ($10.31 and $11.27 respectively). The same is true for the price difference in 2003, the
end of the study. The difference between the IR drugs is $21.50, while the difference in the ER drugs is
$26.11. This growth in the price difference is consistent with the empirical analysis findings, showing
that branded prices are increasing while generic prices decrease. On average, the price of generic Ritalin
dropped by $1.74 every year. For all four of these drugs the market share decreased significantly over
the given time period, and market shares for these generics were consistently higher than those for the
branded drugs between 1999 and 2003.
Figure 4.1: Ritalin vs Generic Prices
Ritalin
Ritalin SR
Gen Ritalin
2000
2001
Gen Ritalin SR
75
AVERAGE PRICE PER GRAM
70
65
60
55
50
45
40
35
30
1999
2002
2003
Figure 4.1: Ritalin vs Generic Prices. Data from Bokhari, F. A., & Fournier, G. M. (2013, June). Entry in the
ADHD drugs market: Welfare impact of generics and me-too's. The Journal of Industrial Economics, 61(2),
339-392.
26
This study of ADHD drugs does not show as large of a price change as the empirical study
suggested. The market for ADHD drugs however is rather large and while the only perfect substitutes for
a branded drug is its generic counterpart, most ADHD drugs can act as substitutes for one another. This
is pretty clear given how significant the drop in market share is for all four of the drugs discussed above.
The generic Ritalin had almost 29% of the market share in 1999 but only 2.6% by 2003. With Concerta
coming to the market in 2000 and Adderall XR in 2001 it appears that many people who were taking a
form of Ritalin switched to one of the newer drugs. What is clear from this study is that even when a
branded drug is rapidly losing market share it still takes the strategy of raising prices. From 2002 to 2003
the price of Ritalin SR increased over $6.
Sleep Aid Market
Prescription sleep aids are used to treat individuals with insomnia and other sleep problems.
The CDC reports that 4% of adults over the age of 20 use sleep aids regularly, and that percentage tends
to increase with age (Prescription Sleep Aid Use Among Adults: United States 2005–2010, 2013). There
are multiple branded drugs in this market, but Ambien was the first non-benzodiazepine used to treat
sleep disorders and is the most popular sleep aid. Ambien was released in 1992 by Sanofi-Aventis, and
the patent expired in 2007. Generic entry occurred almost immediately after patent expiration. What
sets Ambien apart from other prescription sleep aids is that it released a reformulation of the drug,
Ambien CR, in 2005, two years prior to patent expiration. The new version has the same molecules as
the original, but it releases them more slowly. The FDA granted Ambien CR market exclusivity until the
end of 2008, although generics did not enter until late 2010 (Shapiro, 2016).
Prices for these drugs come from CMS and are the average price that Medicaid pays per
prescription. This has previously been considered a good indicator of retail drug prices, but it does not
take into account rebates given to insurance companies from drug manufacturers as some price data
27
measure. Prices in this case may be slightly over-stated, however the changes in price are still accurate.
With the CMS data, “the average prices of Ambien in each of 2004, 2005 and 2006 are $93, $101, and
$111… the prices of Ambien CR in each of 2006, 2007 and 2008 are $104, $113, and $126” (Shapiro,
2016). Prices for both of these drugs are consistently rising over the given periods. Ambien prices here
are seen rising pretty rapidly right before its patent expiration. After the patent expired in 2007 the
average price of Ambien dropped over $60, leading to an increase in utilization of this drug. These price
trends are represented in Figure 4.2. Despite the major drop in Ambien prices, Ambien CR prices
continue to increase. Following the Ambien patent expiration, Ambien CR was the newest and most
innovative branded drug on the market. Since Sanofi-Aventis was the manufacturer for both of these
drugs they were able to cut the price of Ambien drastically in an attempt to increase its market share,
while simultaneously increasing the price of Ambien CR and advertising it as the most advanced sleep
aid on the market. This allowed Ambien CR to take a hold of the price-insensitive consumers who
perceived the product as superior to others, while Sanofi-Aventis also benefitted financially from the
price-sensitive consumers who switched to Ambien after its price drop. Figure 4.2 shows that Ambien CR
prices were constantly lower than Lunesta, whose chemical formula remains in the body longer and is
perhaps the most similar to Ambien CR out of all the sleep aids.
28
Figure 4.2: Average Price of Sleep Aids over Time
This strategy used here by the manufacturers of Ambien is referred to as strategic entry delay,
described in Chapter 2. Pharmaceutical manufacturers will release a reformulated version of their drug
before the original patent expires in order to maintain a hold on the market even when generics enter.
These reformulations typically enter the market two years before patent expiration, and while the new
version of the drug could be significantly more efficient, companies will not release the reformulations
until it will make them the most profit in the long-run (Shapiro, 2016). Because pharmaceuticals can
potentially save lives, we always want to see new innovations and improvements that will benefit the
consumer. This strategy of delaying entry has some additional benefits to the consumer but it seems
unethical on the manufacturing side to wait to release a drug that could potentially really improve
people’s lives. In Ambien’s case, this strategy lead Sanofi-Aventis to drop the price in order to compete
with generics. While this is what is expected for a market following patent expiration, it is only the case
typically in an undifferentiated market. Given the empirical evidence, we see that the pharmaceutical
29
industry is typically an imperfectly segmented market. This is reflected in the consistently increasing
prices of Ambien CR.
Antidepressants
Similar to the ADHD drug market, the market for antidepressants has grown at an incredible
pace. The total number of prescriptions between 1991 and 2005 grew 380%, reaching 32.72 million in
2005. In the same time period, total expenditures increased rapidly until 2004, and in 2005 they saw a
decline of $270 million from the previous year. It was around this time that certain antidepressants were
coming off patent, allowing generics to enter. Most of these generics entered at significantly lower
prices, leading to this drop in total expenditures. Pricing in the antidepressant market is interesting
because we see different drugs and their generic competitors having dissimilar price trends (Chen, et al.,
2008).
Antidepressants have three different subclasses: Selective Serotonin Reuptake Inhibitors (SSRIs),
Tricyclic Antidepressants (TCAs), and Other Antidepressants. TCAs were some of the first treatments for
depression that were prescribed, and most were created in order to treat a different mental health
disorder, such as OCD. Because these antidepressants have been around for so long, they all have
generic competitors. SSRIs have grown steadily in popularity and tend to treat a wide variety of
psychiatric disorders, from eating disorders, to PTSD, to anxiety disorders. The subclass Other
Antidepressants has been increasing in market share from 1991 to 2005. Many of these serve other
purposes such as treatment of seasonal affective disorder (Chen, et al., 2008).
Chen’s data comes from the Centers for Medicare & Medicaid Services (CMS) and covers
antidepressants from 1991 to 2005. Like the last study, the per-prescription cost may not contain
information on rebates so it might not be completely accurate but is still the most complete data source
available. This bias is also not a major problem because pricing trends should be about the same. Figure
30
4.3 represents the pricing trends of the Other Antidepressants subclass from the years of 1991 to 2005.
The medications shown in this figure are the most often prescribe antidepressants from the given
subclass. This category consists of both generics and branded drugs. Branded drugs are indicated with a
registered trademark symbol, for example Cymbalta®. The additional agents indicated on the graph
show pricing trends in less commonly prescribed Other Antidepressants. The majority of these
additional agents are branded drugs. The Other Antidepressants subclass saw the largest average price
per prescription increase during the given period. On average these prescriptions cost $17 in 1991 and
increased to $70 by 2005. SSRIs saw a steep increase in price, follow by a slight decline after the FDA
announced that SSRIs could lead to a higher risk of suicide. On the other hand, TCAs an average
decreased in price per prescription. This is likely due to their decreased popularity and the availability of
many less expensive generics on the market (Chen, et al., 2008).
Figure 4.3: Payment per prescription for Other Antidepressants by quarter in Medicaid
31
Examining the price trends based per prescription payments shown in Figure 4.3 shows that
branded prices are significantly higher than generic prices. The three branded drugs shown, Wellbutrin,
Effexor, and Cymbalta, are all consistently more expensive then the generic competitors. The additional
agents included in the graph are at the bottom end of these branded prices, likely because most of the
drugs in this category are branded antidepressants. In comparison the generic drug trazodone was
constantly the lowest priced, with prices decreasing from 1991 to 2005. The case of the generic
bupropion is unique. Figure 4.3 shows prices steadily decreasing until around the end of 2003 where
they saw a rapid spike. In 2000 there were only two generic manufacturers of bupropion and the
average price per prescription was $51.40. By 2005, there was additional competition for bupropion
with 8 generic manufactures, but the price was now $69.70 on average for a prescription. As the
empirical study from Chapter 3 has shown, as well as many accredited researchers on this subject, it is
very uncommon to see an increase in the price of generics, especially when competition is increasing.
Bupropion is the generic of Wellbutrin, and around the time of this price increase researchers
discovered that bupropion and Wellbutrin had additional treatment possibilities aside from treating
depression. This is likely indicating that demand for the drug was growing faster than competition and
pushed the prices up (Chen, et al., 2008).
Chen, et al. also studied pricing trends of SSRIs during their period of expanding popularity.
While branded drugs and generics were both entering the market between 1991 and 2005, it was not
enough to bring branded prices down. With the growing demand for SSRIs prices were able to
continuously increase for branded drugs. Chen, et al. found that “the price of a prescription for
Prozac® increased by 157% ($60.25 in 1991 quarter 1 to $154.61 in 2005 quarter 4; significantly higher
than the increase in the producer price index)” (2008). While Prozac’s price increase was larger than
many other branded drugs, some other SSRIs saw increases in price from around 75% to 100%. On the
contrary, generic prices consistently decreased as competition increased. When some of the first
32
generics entered the market they were priced about $20 less per prescription than their branded
counterparts. However by the end of the period in question, prices had dropped almost $80 per
prescription for the generic fluoxetine.
Conclusion
Pharmaceutical pricing is a tricky subject given the complexities of the market, as shown by
these three case studies. When looking at Ritalin and its competitors in the ADHD market we see that
the general pricing trends found in the study by Regan were followed, just not to the extent that the
regression coefficients suggested. Prices for generics only declined slightly whereas branded prices rose
very slowly. In the sleep aid study, the strategic entry delay allowed Ambien manufacturers to take
advantage of an opportunity to increase their revenues. By introducing Ambien CR they were able to
drop the price of Ambien and capture two sides of the market, the price sensitive and the price
insensitive. The study of antidepressants showed that drug preferences can change when there is more
complete information, such as the case for SSRIs when they were found to be linked to suicidal thoughts
or tendencies, and the shift away from TCAs. Drug prices can be very responsive to changes in demand,
meaning that the evidence presented in the empirical study does not hold true to every pricing situation
but is a good indicator for a typical market.
33
Chapter 5: Conclusion
The results of this and many other studies is that there is a branded-generic price divergence.
Branded drugs are able to either maintain or increase prices, whereas generic prices decrease as
competition increases. While branded drug prices typically increase following patent expiration, their
market shares significantly decrease. A year after patent expiration, Frank and Salkever (1992), and
Regan (2003) report an average of 5 generic competitors, and Regan reports that generics have 60%
market share, which only increases as years since patent expiration increases. Although generics are
competitive in this market, they are only competitive with each other in terms of pricing. The HatchWaxman Act was designed to increase generic competition. While this seems to have happened,
generics have not yet been able to significantly compete with branded drugs, rendering the regulation
as being effective in use but not having the desired effects on branded prices.
The intricacies of the pharmaceutical industry prove that there is always room for further
research. The majority of studies on pharmaceutical pricing following patent expiration and generic
entry were done not long after the Hatch-Waxman Act went into effect in 1984. While this research
made a significant impact in how we understand pharmaceutical pricing, it is becoming dated and there
is a general feeling among most Americans that pharmaceuticals are priced well above what they should
be. Politicians have spent years attempting to address this issue, and it is possible that there will be
changing pricing regulations on pharmaceuticals in the future. In just the past few years, certain
pharmaceutical companies have introduced massive price hikes, seemingly out of nowhere. In 2015, a
drug Daraprim, sometimes used by transplant or AIDS patients, experience a 5000% spike in price. The
drug was selling for only $1 a pill in 2009, but when the rights were sold to CorePharma, the price
increased to $13.50. Only six years later the rights were sold again, this time to Turing. The CEO then
made the decision to raise to price to a shocking $750 a pill. The drug has been on the market over 60
years and patent expiration occurred long ago (Long, 2016). Daraprim is not the only recent example of
34
major drug price hikes. In 2016 there was a similar case where pharmaceutical firm Mylan increased the
price of EpiPen almost 500% in five years (CBS News, 2017). Drugs like these can be life or death if
certain individuals are not able to access them. The outrage comes in the fact that these drugs were
previously affordable. I suspect that this will be an area for research in the next few years. There is a
potential for addition regulations to be put in place as a way of preventing this type of behavior.
Some economists have speculated about the impact of advertising on drug prices and market
share, but most studies have been inconclusive on whether this has a significant impact. It is apparent
that the benefit to advertising is brand recognition. Caves, Whinston, and Hurwitz (1991) remarked that
they saw an overall decline in branded advertisements once the first generic became approved to enter
the market. In percentages they found “the first approved generic producing a fall of 20 per cent and
additional entrants up to ten producing additional declines of 60 per cent” (Frank & Salkever, 1992, p.
174), referring to these decreases in advertising. It seems from the few studies done on the subject of
advertising and generic entrants that advertising’s main purpose in the pharmaceutical industry is to get
consumers familiar with the drug before the patent expires, in the hopes that those consumers feel they
have complete information about the drug and therefore will remain price insensitive. Whether or not
this strategy holds true requires further research.
When examining the pharmaceutical industry and health care in general, the topic of consumer
welfare often arises. Price hikes and strategic entry delay, along with other tactics used by
pharmaceutical firms, can have a negative impact on consumer welfare. Strategic entry delay can cause
a firm to delay release of a potentially life-saving drug innovation. While it benefits firms in the sense
that it increases their profits, consumers would ideally like to see drug innovations as soon as they are
deemed safe and beneficial. The pharmaceutical industry is tricky in this sense. Consumers desire to see
new or improved drugs as frequently as possible; they want to know that high drug prices can be
justified by substantial improvements in benefits to the user. Pharmaceutical firms are operating as all
35
other firms do, by seeking to maximize profits. This is where the patent system has run into some
criticism. Michele Boldrin and David K. Levine have analyzed the patent system and came to the
following conclusion about the use of patents:
there is no empirical evidence that they serve to increase innovation and productivity, unless
productivity is identified with the number of patents awarded—which, as evidence shows, has
no correlation with measured productivity (2013, p. 3).
Boldrin and Levine take the stance that the patent system should be abolished due to its many
shortcomings based on a few key points.
Patents in the pharmaceutical industry are often considered a way to make up for sunk costs of
research and development. In economics sunk costs are not meant to be considered when pricing a
good or service. However because the pharmaceutical industry is vital to consumer wellbeing, some feel
that a protected monopoly period is a justifiable means to improve innovation. Boldrin and Levine
mention the concept of first-mover advantage, saying that it is stronger than many suspect. After a
study of drug markets in India, it was concluded that it takes on average four years for a substitute drug
to come on market (2013, p. 13). This could be enough time for certain firms to recover some sunk costs
of their research and development. Boldrin and Levine speculate about possible ways to reform the
current system. One method they suggest is to make Stage II and Stage III clinical trials a public good,
financed by the National Institutes of Health. Because these clinical trials make up the majority of
development costs for a drug (about 80% of these costs), having legislation require their funding as a
public good could significantly lower drug costs (Boldrin & Levine, 2013, p. 13).
My study, like others, has presented a question of what is ethical behavior on the part of
pharmaceutical manufacturers. Their use of pricing strategies may produce the most profit but have a
negative effect on consumer welfare. This, coupled with the shortcomings of the current patent system,
36
allows pharmaceutical manufacturers to have what could be considered too much control over drug
prices. In this current system, the drugs with the highest potential to save lives are often being priced
the highest (Boldrin & Levine, 2013, p. 13). This is not a reflection of actual drug costs to the
manufacturer; producers take advantage of the inelastic demand for these drugs to raise prices. When
there is a potential for these drugs to be affordable to consumers, it seems unethical that firms are
pricing them way out of reach by the average individual.
37
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Perspectives, 27(1), 3-22.
Caves, R. E., Whinston, M. D., Hurwitz, M. A., Pakes, A., & Temin, P. (1991). Patent Expiration, Entry, and
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About the Author
Marina Robertson is an Economics major and a French minor at Allegheny College where she
volunteers on campus and works as tutor throughout the school year. She grew up in Bainbridge, Ohio,
outside of Cleveland. In her free time Marina enjoys doing yoga and anything involving the outdoors.
After graduation she will work at UPMC in the Financial Management Rotational program in Pittsburgh
Pennsylvania. She plans to pursue her Master of Business Administration at graduate school in the near
future.