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INNOVATION, BRAND-LOYALTY AND GENERIC COMPETITION IN PHARMACEUTICAL MARKETS Fernando Antoñanzas Roberto Rodríguez Ibeas Carmelo INNOVATION, BRAND-LOYALTY AND GENERIC COMPETITION IN PHARMACEUTICAL MARKETS Fernando Antoñanzas Roberto Rodríguez Ibeas Carmelo Juárez Castelló (Universidad de La Rioja)

Introduction New drugs differ in their degree of innovation Innovation: new chemical ingredient with Introduction New drugs differ in their degree of innovation Innovation: new chemical ingredient with pharmacological action for a disease without (or unsatisfactory) treatment. (Large investments in R&D and high degree of uncertainty) Alternatively, pharmaceutical firms may opt for minor developments of existing chemical entities (Low R&D expenditures and uncertainty)

Most of the new drugs are not based on really new chemical active principles. Most of the new drugs are not based on really new chemical active principles. (Grabowski and Wang 2006: 115 out of 919 between 1982 and 2003, worldwide); in Spain, in 2004, 35 out of 782 new registered specialities were based on new chemical elements. Drug industry seems to have opted for the strategy of developing minor innovations.

Goals Theoretical model to analyze how a brand-name drug manufacturer with a patent close Goals Theoretical model to analyze how a brand-name drug manufacturer with a patent close to expiration decides the degree of product differentiation through innovation before it faces generic competition. Characterize equilibrium prices and optimal level of innovation Analyze how changes in brand loyalty affects equilibrium prices and level of innovation We focus on minor innovations with low (or no) uncertainty.

Relevant literature Empirical literature Relevance of R&D: Di. Masi et al (2003) JHE Market Relevant literature Empirical literature Relevance of R&D: Di. Masi et al (2003) JHE Market regulation (reference pricing) and R&D activities: Danzon-Chao (2002) Journal of Law and Economics, Zweifel. Crivelli (1996) Journal of Regulatory Economics, Vernon (2005) Health Economics. Market regulation and drug prices: Brekke et al (2007) JHE, Cabrales (2003) WP, Kyle (2007) Review of Economics and Statistics, López-Casasnovas-Puig-Junoy (2000) Health Policy

Theoretical literature Frank-Salkever (1992) Southern Economic Journal: Effect of generic competition on the prices Theoretical literature Frank-Salkever (1992) Southern Economic Journal: Effect of generic competition on the prices of off-patent drugs Lexchin (2004) Health Policy Königbauer (2006) (2007) JHE: Advertisement and prescribing behaviour

The Model Duopolistic model of vertical product differentiation Firm 1: It produces a brand-name The Model Duopolistic model of vertical product differentiation Firm 1: It produces a brand-name drug whose patent is close to expiration Firm 2: It produces a generic drug Consumers: Patients with the same illness that can be treated con either of the two drugs. They are indexed by θ, the degree of illness, that is uniformly distributed in [0, 1]. Each consumer is assumed to buy, at most, one unit of the product.

 Physicians: They observe θ and decide which drug to prescribe. Perceived quality of Physicians: They observe θ and decide which drug to prescribe. Perceived quality of the drug from firm i by all physicians: Si = fi + ki, where fi denote the physical attributes and ki the innovative attributes. It is assumed that f 1 = f 2 = f =1 ; k 1 = k y k 2 = 0. Firm 1 can produce the innovative attribute k ε [0, 1] at a cost C(k) with C’>0 C’’≥ 0. A proportion of physicians ε (0, 1) takes only into account the innovative attribute, and prescribe the drug from firm 1; the remaining (1 - ) takes into account the prices and the quality of the drugs when prescribing.

 Patients’ net utility: 1) 2) All physicians prescribe as long as the net Patients’ net utility: 1) 2) All physicians prescribe as long as the net utility is non-negative. Two-stage Game: In the first stage, firm 1 chooses the level of innovation k (R&D effort leads to a deterministic k). In the second stage, both firms choose their prices, with firm 1 acting as a Stackelberg leader, to maximize profits. Goal: characterize the subgame perfect equilibrium

Indifferent patients Patient indifferent between both drugs Patient indifferent between the generic and not Indifferent patients Patient indifferent between both drugs Patient indifferent between the generic and not buying Patient indifferent between brandname and not buying

The demand functions Firm 1 Firm 2 The demand functions Firm 1 Firm 2

(Patient is better-off with the generic drug, but the physicians prescribes the brand-name drug) (Patient is better-off with the generic drug, but the physicians prescribes the brand-name drug) A proportion Firm 1 0 Firm 1 1 A proportion (1 - ) Firm 2 (Patient is better-off with the generic drug)

Equilibrium prices Low values of and high values of k: firm 1 prefers to Equilibrium prices Low values of and high values of k: firm 1 prefers to compete for the price-sensitive physicians. It chooses a price such that some of them prescribe its product. Product differentiation is relatively large, softening price competition. As grows, the minimum level of innovation that firm. 1 needs to find it profitable to compete for these physicians is higher. For low levels of innovation, product differentiation is not large enough, and firm 1 exploits the loyal physicians.

First stage: Optimal level of innovation We assume that C (k)= 0. 5 ck First stage: Optimal level of innovation We assume that C (k)= 0. 5 ck 2, con c<0, 5 For , k*( ) = 1 for all : the optimal level of innovation is the maximum feasible value, regardless of the level of brand-loyalty. Product differentiation is maximal.

For larger values of c, there is a threshold value for brand-loyalty such that For larger values of c, there is a threshold value for brand-loyalty such that for values below the threshold maximal product differentiation is optimal: K=1 (fig 1). For high values of brand-loyalty, firm 1 reduces the level of innovation.

For low values of , the optimal level of innvovation is below 1, and For low values of , the optimal level of innvovation is below 1, and it grows with brand-loyalty. For high values of , the optimal level of innvovation is also below 1, and it decreases with brand-loyalty. For intermediate values of brand-loyalty, the optimal level of innovation is 1.

When decreases, firm 1 increases the level of innovation and the price. Higher prices When decreases, firm 1 increases the level of innovation and the price. Higher prices compensate larger innovation costs. However, for low values of , the lower brand-loyalty, the lower the optimal level of innovation.

Welfare analysis Social welfare = treated patients’ net surplus + firms’ profits – innovation Welfare analysis Social welfare = treated patients’ net surplus + firms’ profits – innovation costs = treated patients’ gross surplus – innovation costs Result: The level of innovation that maximizes social welfare is, at least, as high as the level of innovation chosen by the firm

Public policy implications Promotion of generics: Reduction in If the proportion of loyal physicians Public policy implications Promotion of generics: Reduction in If the proportion of loyal physicians is sufficiently high, policies that reduce brandloyalty are unambiguously desirable as they increase social welfare. These policies can be counterproductive when the proportion of brand-loyal physicians is relatively low. In this case, they induce less innovation and may lower welfare.

Conclusions For high levels of innovation and brand-loyalty, it is optimal for firm 1 Conclusions For high levels of innovation and brand-loyalty, it is optimal for firm 1 to compete for price-sensitive physicians. For low values of innovation and brand-loyalty, firm 1 prefers to charge the monopoly price and sell only to loyal physicians. Innovation: It can be lower if brand-loyalty decreases.