NBER WORKING PAPER SERIES

A PRIMER ON THE ECONOMICS OF PRESCRIPTION PHARMACEUTICAL PRICING IN HEALTH INSURANCE MARKETS Ernst R. Berndt Thomas G. McGuire Joseph P. Newhouse Working Paper 16879 http://www.nber.org/papers/w16879

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 March 2011

We have benefited from discussions with Richard G. Frank, Frank McCauley, Mark V. Pauly, Robert S. Pindyck and Fiona Scott Morton, but we are solely responsible for the views expressed herein. This research has not been sponsored. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. 2011 by Ernst R. Berndt, Thomas G. McGuire, and Joseph P. Newhouse. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is given to the source.

A Primer on the Economics of Prescription Pharmaceutical Pricing in Health Insurance Markets Ernst R. Berndt, Thomas G. McGuire, and Joseph P. Newhouse NBER Working Paper No. 16879 March 2011 JEL No. D4,I11,L12,L13,L65 ABSTRACT The pricing of medical products and services in the U.S. is notoriously complex. In health care, supply prices (those received by the manufacturer) are distinct from demand prices (those paid by the patient) due to health insurance. The insurer, in designing the benefit, decides what prices patients pay out-of-pocket for drugs and other products. In this primer we characterize cost and supply conditions in markets for generic and branded drugs, and apply basic tools of microeconomics to describe how an insurer, acting on behalf of its enrollees, would set demand prices for drugs. Importantly, we show how the market structure on the supply side, characterized alternatively by monopoly (unique brands), Bertrand differentiated product markets (therapeutic competition), and competition (generics), influences the insurers choices about demand prices. This perspective sheds light on the choice of coinsurance versus copayments, the structure of tiered formularies, and developments in the retail market.

Ernst R. Berndt MIT Sloan School of Management 100 Main Street, E62-518 Cambridge, MA 02142 and NBER eberndt@mit.edu Thomas G. McGuire Department of Health Care Policy Harvard Medical School 180 Longwood Avenue Boston, MA 02115-5899 mcguire@hcp.med.harvard.edu

Joseph P. Newhouse Division of Health Policy Research and Education Harvard University 180 Longwood Avenue Boston, MA 02115-5899 and NBER newhouse@hcp.med.harvard.edu

 APRIMERONTHEECONOMICSOFPRESCRIPTIONPHARMACEUTICALPRICING INHEALTHINSURANCEMARKETS ErnstR.Berndt,MITSloanSchoolofManagementandNBER ThomasG.McGuire,HarvardMedicalSchool JosephP.Newhouse,HarvardUniversityandNBER

I.

INTRODUCTION ThepricingofmedicalproductsandservicesintheU.S.isnotoriouslycomplex.This

entangledmazelikelyreflectsaconfluenceoffactors:lessthanuniversalinsurancecoverage; heterogeneousbuyingpowerofpublicandprivatepurchasers;federalregulationsfavoring somepublicpurchasers;thepresenceofvariouscoinsuranceandcopaymentschemes;the licensingandcertificationofprovidersandprescribers;andtheimpactofpatentprotectionand marketingexclusivityprovisions.Onerootcauseofthecomplexityistheintermediationof insuranceandotherthirdpartypayers.Supplypricesthosepaidtomanufacturersareset inmarketsorbynegotiation.Demandpricesthosepaidbypatientsatthetimetheybuy medicalservicesorproductsarespecifiedaspartoftheinsurancecontractforthegreat majorityoftheAmericanpopulationthathashealthcareanddruginsurance. Marketspushinsurerstosetdemandpricesinawaythatmaximizesthevalueof insurancetopotentialenrollees.Therearethustwosetsofinteractingforces,thoseoperating aroundsupplypricesandthoseoperatingarounddemandprices,thatdeterminewhatthe consumerpatientseesinahealthinsurancecontractwithrespecttomedicalservicesor products.Herewefocusoncoverageofprescriptiondrugs,anincreasinglyimportantshareof

healthcarefromthestandpointofbothbenefitsandcosts,andonethathasrecentlybeena mainareaofchangeinhealthinsurance. Someaspectsofdemandsidepricingforprescriptiondrugsaredifficulttounderstand, oratleastfitpoorlywithinstandardframeworksforstudyofhealthinsurance.Although pharmaceuticalsarenotmentionedexplicitly,readersoftheNovember21,2010Dilbertcomic stripmaywellhavethoughtthatDilbertcaricaturistScottAdamswasreferringto pharmaceuticalswhenheparodiedconfusopolypricing:1

Inthisprimerweprovideananalyticalframeworktohelpunraveltheconfusopoly pricingofprescriptionpharmaceuticals.2Textbooksinmicroeconomictheorytypically introduceperfectlycompetitivemarkets,thenconsiderthecaseofpuremonopolies,andfinally turntothemorecomplexdifferentiatedproductandoligopolymarketparadigms.Herewe followadifferentsequenceandbeginwiththedrugmarketcasethatapproximatesamonopoly aunique,patentprotectedpharmaceuticalproductthathasnoclosesubstitutes.Thenwe turntothemorecommoncaseofmanyproductswithpatentprotectionthatcompetewith imperfectsubstitutes.ForthiscaseweemploythetoolsofBertranddifferentiatedproduct

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pricing.Finally,wetakeupmarketsforgeneric,offpatentdrugs.Fromthepharmaceutical manufacturersviewthegenericmarketcanbecharacterizedasapproximatelycompetitive, butattheretaillevelthismarketsharessomeofthecharacteristicsofthemanufacturing marketwithimperfectsubstitutes.Inallcases,ourmainintentionistodescribehowthe supplysideofthemarketinfluenceshowaprofitmaximizinginsurersetscoverageforthese products.OuranalysisappliestotheAmericanmarket;regulationofsupplysidepricingis morecommoninothercountries,andtheconsequencesfordemandsidepricingthatwe deriveheremaynotreadilyapply. Ouranalysistriestoanswerthequestionofwhyexistingpricinginstitutionsand

arrangementshaveemerged;wedonotattempttobenormative.Normativeanalysesin economicsaretypicallybasedonmaximizingthewelfareofarepresentativeconsumer (consumerssurplus)plustheeconomicprofitsofthesupplier(producerssurplus).Demand curvesareacriticaltoolinsuchwelfareanalyses,sincewhenconsumersareinformedand makerationaldecisions,thedemandcurvecanbeinterpretedasamarginalbenefitschedule. Giventhemanycomplexitiesinhealthcareproductmarketsinvolvinginsuranceandmoral hazard,asymmetricinformation,patientheterogeneity,priceregulation,adverseselection,and physicianagencyissues,amongothers,inhealthcaredemandcurvesmaynotconveymarginal benefits. Weassumeinsurersmaximizeprofits,implyingthattheyseektolowerprocurement pricesfordrugsfortheircustomersgiventhedrugsonthemarketateachpointintime.3We assumeinsurersignoreanydynamicissuesofhowtheirdecisionsaffectincentivesfordrug

development.4SincetherearemanyinsurersintheU.S.market,thislatterassumptionisa weakone.5 Beforeturningtoouranalysis,wenotethattheproductionfunctionfornewdrugs involvessubstantialupfrontcostsforresearchandregulatoryapprovaltomarketthedrug; becauseweareconcernedwiththepricingofdrugsoncetheyreachthemarket,wetreatthese costsasfixedorsunk.Actualmanufacturingcostsformostsmallmoleculedrugstendtobe modest.Inadditiontothecostsofresearchandregulatoryapprovalandmanufacturing, manufacturersofbranddrugsalsoincursubstantialmarketingcosts,butthesedonotmuch varyformodestchangesinthequantityofdrugproduced.6 II. MARKETSFORDRUGSWITHNOCLOSESUBSTITUTES:THEMONOPOLYPARADIGM Webeginwiththemarketforatrulyuniquedrughavingnoclosesubstitutes,i.e.,a

monopolyproduct.Anydrugthatisamajorclinicaladvancewillfitthismodeluntila competitordrugappears.Forexample,forseveralyearsafterViagra(sildenafil)wasintroduced intheU.S.marketin1997,therewasnootherdrugapprovedfortreatmentoferectile dysfunction.AnotherexampleisGleevec(imatinibmesylate),launchedin2001byNovartis afterbeingapprovedbytheFDAforthetreatmentofararecancerpatientswithPhiladelphia chromosomepositivechronicmyeloidleukemia.ForseveralyearsGleevecremainedtheonly approveddrugintheU.S.forthatfrequentlyfatalcancer.Patentsmaintainedthemonopoly forbothofthesedrugs,andineachcasewecananalyzethemanufacturerspricingbehavior usingstandardpricetheory.Notably,eventhougheachdrugisauniqueproduct,itsdemand curveslopesdownward,i.e.,quantitydemandedincreaseswithreductionsinprice.Thereward ofsellingmoregivesevenamonopolistareasontolowerprice.Whenbuyingdrugsfroma
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monopolist,theinsurercanusethisincentivetorestrainmonopolypricing.Asabenchmark, wefirstconsiderthecasewithnodruginsurance,andthenintroducedrugbenefitinsurance withpatientcostsharing.Tokeepmatterssimple,wewillassumethateveryoneinthemarket isinsured.7Aswewillshow,theformofcostsharingemployedbytheinsureraffectspricing incentivesfacedbythemonopolist. Weillustratethiscasewithalinearinversedemandequationoftheform: p=abq,(1)

whereaandbareeachparametersgreaterthanzero,pisprice,andqisquantity.Our conclusions,however,donotdependonlinearity.Weholdfactorsotherthanqthataffectthe inversedemandcurveasfixed,andsubsumetheirimpactintheconstantterma.Lettotalcosts TCofproductionanddistributionbethesumofacomponentindependentofoutput,thefixed costc,andaconstantmarginalcost,d: TC=c+dq,wherec,d>0.(2)

Profitsequalrevenuesminuscosts, Profits=pqTC=(abq)qcdq=(ad)qbq2.(3) Choosingqsoastomaximizeprofitsyieldsthefirstorderconditionwheremarginalrevenue equalsmarginalcost: a2bq=d

whichcanbesolvedfortheprofitmaximizingq,denotedq*: q*=(ad)/2b.(4)

Substitutingthisq*intotheinversedemandfunction(1)yieldstheprofitmaximizingp, denotedp*,as
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p*=(a+d)/2.(5)

ThismonopolypricingsolutionisgraphedinFigure1. Althoughsomebrandeddrugsarepurchasedbypersonswithnoinsuranceorbythose

whoseinsurancedoesnotcoverthedruginquestion(e.g.,somepoliciesdonotcover lifestyledrugs),thevastmajorityofdrugpurchasesaremadeinconnectionwithsome insurance.In2009,only21%ofspendingonprescriptiondrugsintheUSwasoutofpocket, andmuchofthatrepresentedcostsharingbyinsuredconsumers.8Thereforewenowconsider pricinginthemonopolycasewithinsurance. Insurerssetdemandpricesinoneoftwoforms:asacoinsurancerate,inwhichthe consumerpaysafixedpercentageofthesupplyorprocurementprice,andasacopayment,in whichtheconsumerpaysafixeddollaramount,say$25,forasupplyofthedrugforagiven periodoftime,usuallyamonth.Ifthesupplypriceisfixed,atsay$100,a15%coinsuranceis equivalenttoa$15copayment.Ifthisisallthereweretothestory,thechoicebetweena coinsuranceformandcopaymentformwouldbeofnoconsequence.Aswewillshow, however,thechoicebetweencoinsuranceandcopaymentaffectshowthemanufacturersets supplyprice.Theinsurerandtheenrolleeswillthusfavoroneovertheother. Beginwiththecoinsuranceform.Denotetheconstantcoinsurancerateasi(0<i1);9 ifthepriceofthedrugisp,thepatientpaysip.Coinsuranceinflatesthedemandcurvefacing theseller.Apatientwillingtopay$20foracertainunitofthedrugisstillwillingtopay$20, implyingthepricethesellercanchargeis$20/iandstillsellthedrug.Thenewinversedemand forthemonopolydrugwithcoinsuranceis,whereI1=1/i:

P=I1(abQ)=ABQ,whereA=I1aandB=I1b.(6)
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AsseeninFigure2,relativetothenoinsurancecase,thiswithinsurancedemandcurvesimply rotatesclockwiseandupwardatthequantitydemanded,rotatingfromthequantitywherethe priceequalszero(comparewithFigure1),whichfromEqns.(1)and(6)iswhereq=a/bandQ =A/B=I1a/I1b=q.10TheslopeofthenewinversemarketdemandcurvebecomesB=I1b.At anygivenprice,demandislesselastic.Atthenewequilibriumwithcoinsurance(denotedwith capitalletters),fromEqn.(5)weseethat and P*/p*=(i1a+d)/(a+d).(8) Sincemarginalcostd>0andthecoinsurancerateis0<i1,theprofitmaximizingmonopoly pricewithcoinsurancewillbegreaterthanwithoutinsurance,i.e., 1<P*/p*<i1.(9) Therighthandsideinequalityrewrittenstatesthatthedemandpricefallswithcoinsurance(iP* <p*),implyingthatquantitydemandedgoesupwithcoinsurance.Thus,ingeneral,boththe supplypriceandthequantitydemandedincreaserelativetothenoinsurancecase,withthe divisionbetweenthetwodeterminedbytheinitialpositionsofthedemandandmarginalcost schedules.Notethatifianddarelow,(8)impliesthattheincreaseinthesupplypricecouldbe verylarge;asdgoestozero,theincreasefactorapproachesi1.Figure2illustratessuchacase. Considernowinsuranceintheformofrequiringthepatienttopayafixedcopayment P*=(A+d)/2=(i1a+d)/2(7)

(e.g.,$10permonthssupply)whenpurchasingthemonopolydrug.Theconsequencesofthis wouldbecatastrophicfortheinsurerandultimatelytheconsumerifthesuppliercouldset pricetomaximizeprofitsbecausetheresultingdrugpriceincreaseswouldtranslateinto

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increasedpremiums.Ifthedemandpriceisfixed,independentofsupplyprice,thesellercould setanypriceatall,andstillsellthequantitydemandedfrom(1)toaninsuredconsumer.(We ignorethepriceelasticityofthedemandforinsurance;theresultingpremiumfromveryhigh drugpricesmaymeantheinsurercannotbreakeven.)Inotherwords,fromthepointofview ofthemanufacturerofadrug,copaymentsputnoconstraintatallonmonopolyprices. Sincecoveragewithcoinsurancemaintainsalinkbetweensupplypriceanddemand

price,whereascoveragewithcopaymentsdoesnot,coinsurancepenalizesamonopolistwith lostsales,atleasttosomedegree,asthemonopolistraisesprice. Anotherformofcoverage,nottypicallyseenintheU.S.butobservedofteninother

countriesnotonlyforthemonopolydrugbutalsoforthecaseofcompetingdrugs,doeseven moretorestrainmanufacturerspriceincreases.Supposetheinsurerdeclaredthatitwould coveronly$xforeachprescriptionpurchasedbytheconsumer,nomatterwhatpricetheseller set,andthattheconsumerwouldneedtopaythebalance(thesupplypriceminustheinsurers contribution)whenpurchasingthedrug;thisiscalledreferencepricing,sincetheamountthe insureriswillingtocoverisoftenbasedonacomparisonwithpricesofthatdruginother countriesorotherdrugsinthesameclass.11Aslongastheinsurerspaymentisfixedatsome amount,themonopolistwillrecognizethatsupplypricesabovethatamountwillsimplymove consumersalongtheirdemandcurves,therebyreducingthequantitydemanded.Notethat withthisstrategyinthemonopolydrugcase,$xaresimplytransferredtothemonopolist,and thereisnoreductioninnetpricetotheconsumer.(Thesituationobviouslydifferswith competingdrugs.)

ItisinformativetoexaminecostsharingprovisionsofinsurersintheU.S.providing benefitstoMedicarePartDbeneficiaries.Insurerstypicallydistinguishspecialtydrugsfrom moreeverydaydrugs.Originallyspecialtydrugswereinjectableproteinsderivedthrough recombinantDNAtechnology.Today,however,specialtydrugsincludenotonlythosedrugs butalsodrugsthattreatpatientswithchronicandcomplexdiseases;theytypicallyrequire specialhandlingbypharmacists,providers,andpatients.AccordingtoMedco,alarge pharmacybenefitmanagement(PBM)company, Traditionally,specialtydrugstreatedrareconditionsaffectingfewpatients.Thespecial handling,administration,andpatientmonitoringrequirementscontributetotheircost, whichcanannuallyamounttotensofthousandsofdollarsforpatientsandtensof millionsofdollarsforplans.Inthelastdecade,specialtydrugshavebecomeavailableto treatabroaderrangeofillnesses.12 Forourpurposes,itisappropriatetothinkofspecialtydrugsasbeinguniquedrugshavingno closesubstitutes,i.e.,asproductsmarketedinpuremonopolymarkets. InFigure3wereproducemediancostsharingprovisionsinstandaloneMedicarePartD

prescriptiondrugplans,weightedbyenrollment,aspublishedbyMedPAC.(Thetimeseries beginsin2006becausethatwasthefirstyearofthePartDdruginsuranceinMedicare.)Asis seeninthebottomrowofFigure3,unlikethecaseforotherdrugswhichhavevarious copaymentsdependingontier(thereasonforwhichwecometonext),forspecialtydrugs thereisacoinsurancerate,aratethathasinfactincreasedfrom25%in2006to33%in2009. Notethatwitha33%coinsurancerate,relativetoanuninsuredmarket,theupperlimitonprice increasesbornebytheinsurer(andultimatelybythosewhopayinsurancepremiums)isa factorofthree.13Effectively,coinsurancegivesinsurerssomebargainingpoweroverprice,by shiftingpotentiallygreaterexposureatthemargintobeneficiariesthandoesafixed

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copayment.Incidentally,inthespecialtytier,unliketheotherthreetiersshowninFigure3, Medicaredoesnotallowbeneficiariestoappealforlowercostsharing;indeed,typicallydrugs onthespecialtytierrequirepriorauthorization.14Insum,theinsightfromeconomictheory thatinsurerschoosecoinsuranceforuniquemonopolyproductsappearstoapplytothemarket forspecialtypharmaceuticals.15 III. MARKETSWITHPATENTPROTECTEDSUBSTITUTEDRUGS:BERTRAND COMPETITION Adifferentandprevalentinsurancecontractariseswhenseveraldrugsthatarepartial

butnotperfectsubstitutescompetewithoneanotherwithinatherapeuticclass.Anexample ofsuchcompetitionwouldbetheclassofstatin(cholesterollowering)drugs.Althoughsome drugsinthisclasshavenowlosttheirpatentprotectionandaregeneric,forseveralyearsthere wereanumberofcompetingdrugs,eachofwhichhadpatentprotection.Moregenerally,even ifsomedrugsinaclassaregeneric,thisexampleappliestocompetitionbetweentwoormore drugsintheclasswhentheyarestillonpatent. WecastthissituationasaBertrandmodelofdifferentiatedproducts.16Specifically,we considertwocompetingproductsthatareonpatent,firstwithnoinsurance,andthenwith copaymentsandformularies.17TheBertrandmodelexplainswhyaninsurermaynotofferboth products,eventhoughbyexcludingaproduct,someenrolleeswillnotgettheirbestmatchin termsoftherapeuticoptionor,moreprecisely,willhavetopayanuninsuredpricetoobtain it. Supposethatfirm1manufacturesdrug1andfirm2manufacturesdrug2.For convenience,letmarginalproductioncostsbezero.Letthedemandfunctionsfrompatientsin
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thehealthplanfordrugs1and2beq1(p1,p2)andq2(p1,p2),respectively.Thegoodsare substitutessocrosspricetermsarepositive(e.g.,q1/p2>0),andownpriceeffectsare negative.Furthermore,weassumetheproductsdemandfunctionsaresymmetric. Considerpricingwithoutinsurance,assumingBertrandcompetitionbetweenfirms1 and2.Firm1maximizesprofit,1=p1q1(p1,p2)takingp2asgiven,andfirm2maximizes2= p2q2(p1,p2)takingp1asgiven.Wecandescribethebehaviorsofthetwofirmsintermsof reactionfunctions,andgraphtheminFigure4.p1(p2)describesthebestresponseorreaction functionofp1tochangesinp2,andp2(p1)issimilarlythereactionfunctionofp2tochangesin p1.Sincethegoodsaresubstitutesindemand,p1(p2)>0andp2(p1)>0.Afirmwouldnot wanttoraiseitspriceswithoutlimit,however,inresponsetoarivalsbehavior.Supposethe rivalfirm2setaveryhighprice,sufficientlyhighthatfirm1isineffectamonopolist.Inthe limitp1()=p1mwherep1misthemonopolypriceoffirm1;similarlyforfirm2.Sincesucha pricemaximizesamonopolistsprofit,thefirmwouldnotwanttoincreaseitspricefurther.We depictinFigure4boththemonopolypriceaswellastheBertrand(orNash)equilibrium, (p1b,p2b)wherep1b=p1(p2b)andp2b=p2(p1b).Competitionbetweenthesubstituteproducts reducespricesomewhatbelowthemonopolyprice,dependinginpartonhowsubstitutableare thetwodrugs.18 Nowintroducehealthinsurance.Iftherewerenoconnectionbetweenhealthinsurance coveragedecisionsandprocurementprices,thebestthingfortheinsuredgroupwouldbeto havebothproductsavailableintheplan;sincetheyaredifferentiated,oneproductworks betterforsomeenrollees,theotherproductworksbetterforothers.

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Suppose,though,thattheinsurerimplementedaformularyalongwithitscoverage decision.Theinsurancetakestheformofareductionintheoutofpocketpriceofacovered drugtoc(thecopayment),buttheinsurerstipulatesthatonlyoneofdrugs1or2willbe coveredandavailableatcopaymentc.Theotherdrugwillnotbecoveredsothatanyenrollee whowantstobuyitmustpaythefullmarketprice.Whymightaninsurer,intheinterestofits enrollees,coveronlyonedruginsteadoftwo?Toseethereason,considerhowBertrandprice competitionworksinthiscase. Thegametheoreticformulationisasfollows:Inthefirststage,theinsurerannounces thatitwillchooseonedrugandwillofferthatdrugtoitsenrolleesforcopaymentc.Thedrug chosenwillbetheonewhosemanufactureroffersthelowerprocurementprice.Theother drugwillnotbecoveredatall(willbeoffformulary).Next,inthesecondstage,firmsengage inBertrandpricecompetitionbysubmittingbindingbidssimultaneouslytotheinsurer.Finally, theinsurerchoosesadrugtobeontheformulary. Giventhecontractbeingofferedbytheinsurer,beingontheformularyoffersthe manufactureranadvantage.Itwillgainadditionalsalesatthesubsidizedpriceofcrelativeto theearlieruninsuredpriceofpb.Supposeweimaginefirm1weretobidapriceofp1b,the equilibriumintheoriginalBertrandcompetition.Firm2,byreducingitspricetojustbelowp1b, wouldgainalargeshareofsalesbytakingbusinessfromfirm1.Thus,p1bisnolongeran equilibriumprice,andeachfirm,anticipatingthissituation,willseektoundercuttheotherto obtaincoveragebytheinsurer.Specifically,eachfirmwillloweritspriceuntiltheprofitfrom

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theextrasalesfrombeingontheformularyislessthantheprofitafirmcanmakeifitsdrugis offtheformulary.Letthepricethatthewinningfirmbidsatthispointbepf. Assumefirm1isthefirmwiththelowbid,soconsumerspaycfordrug1.Thenew pricethatisoptimalforfirm2isthepointonitsreactionfunctionpnfcorrespondingtoaprice ofcfordrug1.Figure4showsthenewequilibriumpricesforconsumerswithfirm1winningas p(c,pnf),wherecisthecopayandpnfisfirm2soptimalpricegiventhatfirm1hasasupplyprice ofpfandademandprice(patientcopayment)ofc. Figure4showsthatinsuredconsumersfacelowerunitpricesforbothdrugsthanthey didwithnoinsurance.Moreover,focusingjustontheeffectofprocurementprices,overall consumerwelfarewouldhaveincreasedwithdruginsurance,sincethepremiumortaxes necessarytofinancetheinsuranceplustheoutofpocketspendingtobuytheoldbundleof drugsislessthantheamountconsumerswerespendingwithoutinsurance.Ifthiswerenotso, theformularywouldhavenoeconomicvalueandconsumerswouldnotbuyinsuranceofthis type.Afullaccountingoftheeffectofinsuranceoneconomicwelfare,however,wouldhaveto considertheloadingchargedbytheinsurer,theeffectonrisk,theeffectonfuturedrug developmentfromlowerrevenuesatdrugmanufacturers,spillovereffectsonnondrughealth careutilization,andanystaticwelfaregainsassumingdrugpricesmoveclosertothemarginal costofproduction,whichislowformostdrugs.19 Thisframeworkalsoleadstotwopredictionsandoneobservation.First,thecloserthe

degreeofsubstitutionbetweenthedrugs,thelowertheprocurementprice.Theintuitioncan beseenbyassumingtheoppositecase,thatthedrugsarehardlysubstitutableatall.Thenthe
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losingfirmdoesnotlosemanysalesbynotbeingchoseninthelimitnosalesatalland thereforeneitherfirmhasmuchincentivetooffertheinsureralowpriceandsupplyprice remainsneartheuninsuredprice. Second,thebetteristhecoverage,i.e.,thelowerisc,otherthingsequal,theloweris theprocurementprice.Theintuitionhereisthatthebetterthecoverage,themoreofthedrug willbedemandedandhencethegreaterthevalueofbeingthewinningfirm.Anotherwayto seethisisthatinthelimitingcaseascincreasesandapproachestheuninsuredprice,the additionalsalesgainedbythewinningfirmrelativetotheuninsuredcasegotozero. Notethattherewillgenerallybesomeconsumerswhowillrespondbesttoanon preferreddrugandforwhomtheonformularydrugsarenotgoodsubstitutes.Eventhis group,however,willpaylessthaninthenoinsurancecaseaslongasthereissomedegreeof substitutabilitybetweenthetwodrugs. InrealityinsurersusethemorecomplexpricingarrangementshowninFigure3,atiered

formularywithdifferentialpatientcopaymentstosteerpatientstowardtheinsurerspreferred drugs.Forexample,withinagiventherapeuticclassofmedicationsthathasanumberof reasonablysubstitutableproducts(e.g.,anticholesteroldrugs),theinsurerwilltypicallyputany genericdrugsonthelowesttier,andofferthegenericformulationtopatientswitharelatively lowrequiredcopayment,e.g.,$10fora30dayprescription.Thosebrandedproductsforwhich theinsurerhasnegotiatedapreferredlowerpricewithoneormoremanufacturersareplaced onasecondtier;theinsureroffersdrugsonthissecondtiertopatientswithahigherrequired copayment,e.g.,$25fora30dayprescription.Thosebrandedproductswithinthesame therapeuticclassforwhichtheinsurerhasbeenunabletonegotiateapreferableprice(perhaps

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thebrandmanufacturerrefusedtodeviatefromanodiscountedpricepolicy)arethenplaced onathirdtier;theinsureroffersdrugsonthisthirdtiertopatientswithanevenhigher requiredcopayment,e.g.,$50fora30dayprescription.20 TheBertrandcompetitionmodelexplainswhymanufacturersarewillingtooffer

discountsformorefavorabletierplacement.Althoughthemodelingbecomesmore complicated,thelogicofthisBertrandcompetitionframeworkwithjusttwodrugs,oneof whichisonformularyandoneofwhichisoffformularywithnocoverage,carriesoverto insurancebenefitdesignswithtwoormoretiers,withthewinningbidderhavingitsproduct placedonthelowestcopaymenttier. Thecopaymentstrategyisnotoptimalfortheinsurerinthemonopolydrugcase because,aspointedoutabove,coinsuranceratherthancopaymentachievestheminimum priceforconsumersintheaggregate,takingaccountofbothoutofpocketpaymentaswellas thepremiumortaxesnecessarytofinanceinsurance.Theuseofcoinsurance,however,also hasadownside:theconsumermustbearthe(oftenconsiderable)riskofoutofpocket paymentstousethedrug.Theoptimalinsurancecontractwillbalancethedualaimsof minimizingtheprocurementpriceofthedrugandtheamountofriskconsumersbear.21
AnthonyBarrueta,SeniorCounselforKaiserPermanente,alargehealthmaintenance organization,documentstherelevanceofouranalysesinarealworldcontext.Injointhearingsbefore theDepartmentofJusticeandtheFederalTradeCommission,henotedthatforuniquedrugs:

Underthesecircumstances,thereislittleopportunityforapurchaserto stimulatecompetitionamongmanufacturers.Manufacturersareroughlyfreeto setlaunchprices,theyrarelydiscountthoseprices,andpurchasersareprice takers.22

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Hecontrastedthiswiththecaseofseveralpatentprotecteddrugscompetingwitheachother inthesametherapeuticarea.Hecalledthisthecompetingmonopoly/oligopolystage,and describeditasfollows: Thisstagerepresentsthelionsshareofthemarketatanygiventime.Here, therearemultiplesimilardrugsonthemarket,allstillundermarketexclusivity protection.Dependingonhowsimilarthedrugsarethatis,howsubstitutable theyareforeachotherorganizedpurchasershavetheabilitytoeitherswitch patientsinamedicallyappropriatemanneramongthedrugs(ifthedrugsare highlysubstitutable)oratleaststartnewpatientsonapreferreddrug(ifthe drugsaresimilarlyeffective,butswitchingwouldbedisruptivetotherapy).In eithercase,thereisacompetitiveopportunitythatcanbetakenadvantageof. Thisistheareawhereformulariescanbeappliedforthegreatesteffecton overallcosts.23 Whennegotiatingwithaplanwithamultipletierformulary,ifthemanufacturerinsists

onahighdrugpriceitrisksbanishmenttothethirdtier,wherepatientshavethelargest copayment,ornotevenbeingontheformulary,inwhichcasetheconsumerpaystheentire priceoutofpocket.Offeringalowpricetotheplanbuysfavorableformularyplacement,with thelowerpatientcopaymentsincreasingthequantitydemandedofthedrug.Fromthe viewpointoftheinsurer,theabilitytoobtainlowernegotiatedpriceswilldependonhow crediblytheinsurercanmovemarketshareofdrugswithinthetherapeuticclassthrough physicianeducation,tieredpatientcopayments,andotherformularymanagementtools.24 Earlierwediscussedreferencepricingasawayofsharplyrestrictingamonopolists

marketpower,withtheinsurer(ratherthantheinsured)ineffectmakingthefixedcopayment, andthepatientsdemandpricenowbeingthevaryingbalancebetweenthesupplypriceand theinsurersfixedcontribution.Inanumberofcountries,whenthereareseveralcompeting differentiateddrugswithinthesametherapeuticclass,theinsurerwilldesignateoneparticular

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drug(usuallybutnotalwaysageneric)asthereferencedrug,andwilloffertopaynomore thanthesupplypriceofthatdrug,regardlessofwhichdruginthatclassisprescribed.Withthe consumerbeingresponsiblefortheentiregapbetweenthesupplypriceandtheinsurersfixed copayment(thevaryingdemandprice),referencepricingcanbecomeapowerfultool reducingmanufacturersmarketpowerindifferentiatedproductmarkets.25 IV. MARKETSFORGENERICDRUGS:THEPERFECTCOMPETITIONPARADIGM Underprovisionsofthe1984WaxmanHatchlegislation,priortothepatentexpiration

ofthebrandedinnovatorproductbutonlyafterthepassageoffiveyearssinceinitiallybeing approvedformarketingbytheU.S.FoodandDrugAdministration(FDA)(atimeperiod designateddataexclusivity),genericmanufacturerscansubmittotheFDAadossiercalledan AbbreviatedNewDrugApplication(ANDA).IntheANDAtheydocument,basedonclinical studies,thattheirproposeddrugformulationisbioequivalenttothepatentprotected innovatorbrandedproduct,andthattheirmanufacturingpracticescomplywithcertain regulations.SincetheimplementationofWaxmanHatch,thegenericapplicantneednot undertakeandrepeatcostlyclinicaltrialsdemonstratingsafetyandefficacyofthedrug. AfterreviewingtheANDA,theFDAcangrantatentativeapproval,withfullapproval becomingeffectiveonthedateofpatentexpirationorothermarketexclusivityprovisions.26In suchcases,onthedaythebrandedinnovatorsmarketexclusivityexpires,generic manufacturerscanmarkettheirapprovedproduct.Alternatively,genericmanufacturerscan choosetofiletheirANDAaftermarketexclusivityexpires,althoughthatwilldelaytheirentry intothemarket.Sincetheclinicalandadministrativecostsofestablishingbioequivalenceare relativelymodest(estimatedintherangeof$25million27),andawellknownregulatory
17

pathwayexists,barrierstoentryareminimal,andthuspriceschargedbygenericmanufacturers rapidlyfalltomarginalcost,consistentwithcompetitivemarkets.28 Theextentandimpactofgenericentryonaveragegenericpricesforthelargest25new

genericsenteringtheU.S.marketbetween2005and2009isillustratedinFigure5.29The numberofmonthssinceinitialgenericentryisplottedonthehorizontalaxis(uptoamaximum of40months),theaveragegenericprice(indexedto100attimeofinitialgenericlaunch)ison theleftverticalaxis,whilethenumberofgenericentrantsisontherightverticalaxis.Because notallgenericmoleculeshavebeenonthemarketforthefull40months,foreachmonthsince launchtheaverageiscomputedoverthenumberofmoleculeshavingbeenonthemarketat leastthatlengthoftime;thus,giventhechangingsamplecomposition,thetimetrendsince initiallaunchisnotcompletelysmooth. AsseeninFigure5,thegenericpriceindexfallstoalevelofabout78atmonthsix,with anaveragenumberofgenericentrantsbythattimeofseven.Bymonths12and24theaverage genericpriceindexfallstoabout50and23,respectively,andthenstabilizesataboutsixafter month25,evenastheaveragenumberofgenericmanufacturersgraduallyincreasestoabout 10,11and12,respectively. Averagedovermonths112and1324sinceinitialgenericentry,the20052009generic priceindexesare68and28,respectively.Thesepriceindexesaremuchlowerthanthe comparableannualyearoneandyeartwopriceindexvalues80and65reportedby GrabowskiandVernon[1992],basedon19841991majorgenericlaunches.Weinferthat genericentryandpricecompetitionfollowinglossofmarketexclusivityhasintensifiedoverthe lastquartercenturysincethe1984passageoftheWaxmanHatchlegislation.
18

Thisdepictionofgenericcompetitionfollowinglossofmarketexclusivityholdsinmost cases,withthreenotableexceptions.UnderWaxmanHatch,thefirstgenericmanufacturer thatsuccessfullyprevailsinchallengingthebrandinnovatorspatentclaimscanbegranted180 daysofexclusivityduringwhichtimenootherANDAholderforthatmolecule/strengthcan marketitsproduct.ThisiscalledaParagraphIVentry. WithnofurtherANDAentrypermittedforaperiodof180days,themarketforthat particularmolecule/strengthbecomesaduopoly,withthebrandedmanufacturerandthe singlegenericmanufacturerbeingthetwocompetitors.Duringthistimeperiod,thepriceof genericsisgenerallyonly1020%lessthanthatofthebrand,considerablyabovemarginalcost. Avariantofthisoccurswhenthebrandedmanufacturerentersintoanagreementwith agenericmanufacturerotherthanthesuccessfulParagraphIVentranttomarketthe molecule/strengthunderthebrandedproductsoriginalNewDrugApplication(ratherthanan ANDA)duringthe180dayexclusivityperiod.Thisiscalledauthorizedgenericentry,andit enablestheinnovatorbrandedcompanytocontinuepricingitsproductinanowtriopoly marketforupto180days,ratherthancedingallgenericsalestothesinglesuccessful ParagraphIVentrant.30Followingexpirationofthe180dayParagraphIVexclusivityperiod, genericentrytendstoberapidandsubstantial,withgenericpricesfallingsharply.Thisisseen inFigure5,whereaparticularlylargepricedropoccursduringmonthseven. Asecondexceptioninvolveswhatarecalledbrandedgenericsbrandedproducts frommanufacturersotherthantheoriginalinnovatorpatentholderenteringwithasimilar strength(orwithanoffpatentmoleculeincombinationwithothermolecules)therapeutic formulationbutbrandedwithotherthanthegenericname.Brandedgenericsseekto
19

differentiatethemselvesfromboththeoriginalpatentholderandothergenericentrants, relyingontheirhistoricreputationforhighqualitymanufacturing,andgenerallyattemptto chargepricesinbetweenthegenericandoriginalbrand.31Brandedgenericsweremore commoninthe1970sand1980s;overthelastfewdecadestheyhavetendednottobe particularlysuccessful,butaswediscussnext,inthefuturetheymayberejuvenatedinthe contextofbiosimilars. Athirdpotentialexceptiontogenericmarketsbeingcharacterizedascompetitivewith pricesclosetomarginalcostinvolvesbiologics.Unlikesmallmolecule,chemicallysynthesized pharmaceuticalsthatcanreadilybedescribedanalytically,largermolecule,oftenproteinbased biologicsarecomplex,andbecauseoftheirlargersize,theirsurfacescanfoldindifferentways, therebynotblockingreceptorsitesasuniformlyassynthesizedsmallmolecules.32 Derivedfromlivingorganisms,biologicscanchangeinunpredictableways,andare thereforemorechallengingandcostlytomanufacture.Importantly,characterizingthem analyticallyandestablishingbioequivalencebetweentheoriginalbiologicandanattempted followonbiologicentrantraisesdifficultscientificissuesandregulatorychallenges.Notably, section7001ofthe2010healthcarereformlegislation(thePatientProtectionandAffordable CareAct)establishedtheauthorityfortheFDAtolicensebiosimilarsandprovidedtheoriginal biologictwelveyearsofdataexclusivity(sevenmorethanforsmallmolecules).Becauseofthe greatermanufacturingcost,complexityandregulatoryuncertainty,however,itiswidely anticipatedthattheextentandspeedoffollowonbiologicentrysubsequenttolossofpatent protectionwillbeconsiderablylessthanhashistoricallybeenobservedwithchemically

20

synthesizedsmallmolecules.Hencethebrandedgenericorbiosimilarpricedeclineswilllikely becorrespondinglylessrapidandsteep,withpricesremainingabovemarginalcosts.33 Althoughanupstreamgenericdrugmanufacturereventuallyfacesanapproximately competitivemarket,perfectcompetitionmaynotprevailinthedownstreammarkets. Distributionofgenericdrugshasbeenfoundtobeespeciallyprofitableforbothpharmacy benefitmanagers(druginsurers)andretailoutlets.34Onecandidateexplanationismarket powerofpharmacybenefitmanagers(PBMs)andretailers.Infact,thePBMindustryis reasonablyconcentratedinthreelargefirms,ExpressScripts,Medco,andCaremark/CVS35,and theretailindustryisalsosomewhatconcentratedinlargechains.In2010Caremark/CVS, Walgreens,andRiteAidhadanestimated20,16and6percentofretailandmailordersalesin theUSmarketrespectively;WalMarthasanother6percent.36 Thesedata,however,likelyunderstatethemarketpowerthatthelargechainshavein theretailmarketforseveralreasons.First,thedenominatorforthemarketsharedatajust quotedincludesmailorderprescriptionsfromMedcoandExpressScripts,twofirmsthatdonot haveretailpharmaciesbuthave15percentofthetotalmarketbetweenthem.Thedataalso includesomespecialtypharmaceuticals,andthosedrugsaretypicallynotsoldatretail. Second,thesearenationaldata,butretailpharmacyisaquintessentiallocalmarket.Third,and perhapsmostimportantly,bothpublicandprivatepurchaserscontractingfordruginsurance willtypicallyrequirethatagivenpercentageofbeneficiariesbewithinacertaindistanceofan innetworkpharmacy(e.g.,90%ofthoseinsuredarewithinfivemilesofaninnetwork pharmacy).Thisconditiongivesthelargechainsanabilitytoextractdiscountsfromdrug

21

insurerswhosemarketistypicallyatleastastateifnotnationwide.(Somehealthinsurersare alsodruginsurers;otherscarveoutorsubcontractdruginsurancetoalargePBM.Some employerswillalsocontractthedruginsurancefortheiremployeestoaPBM.)Tothedegree thePBMsareearninggreaterrentsongenericdrugsbecauseofthecompetitiveconditionof thedownstreamproductmarketdescribedabove,thismarketpowerbecomesawayforthe retailchainstoextractsomeofthoserents.Thismarketpowermaybestartingtobreakdown, however,aswedescribebelow.

V. INSIGHTSGAINEDFROMTHESEMODELS

Familiartoolstakenfrombasicmicroeconomictheorytextbookscanunravelsomeof theelementsofconfusopolypricinginpharmaceuticalmarkets.Itisusefultoelaborateon someoftheinsightswehavegainedfromthesemodels. A. COPAYMENTSFORSELECTEDCOMPETINGDIFFERENTIATEDPRODUCTS Whenanumberofpatentprotecteddrugswithinthesametherapeuticclassare reasonablysubstitutable,theinsurercanstimulatepricecompetitionamongmanufacturersby offeringaformulary,coveringsome,butnotalldrugs,withtieredcopayments.Asseenin Figure3,forthemostpartthisiswhatMedicarePartDPrescriptionDrugPlansdo;in2009the mediancopaymentfortier1genericdrugswas$7foramonthssupply,fortier2preferred brandnamedrugsitwas$38,andfortier3nonpreferredbrandnamedrugs,itwas$75. Typically,asubsetofdrugsareonthepreferredbrandtier.Theinsurerincreasesitsbargaining powerbylimitingthenumberofpreferredbrands,andbyloweringthecopaymentforthe preferredtier.Eachofthesecontributetoitspowertomovemarketsharetothepreferred drug.TheUSVeteransAdministration,forexample,putsthisstrategytowork:intheanti

22

cholesterolandacidpreventingprotonpumpinhibitortherapeuticclasses,onlyonedrugison theformularyineachclass,andnootherdrugsarecovered.37Moreover,asdocumentedin DugganandScottMorton[2010]basedon20032006data,brandswithfewtherapeutic substitutesandhighsalestoPartDeligiblesdidnotexperiencethepricedeclinerelativeto trendevidencedbydrugswithseveralsubstitutes,trendsconsistentwiththeplansformularies stimulatingcompetitionandloweringprices. Whileintheoryinsurerscouldemploydollarequivalentdifferentialcoinsuranceratesin differentiateddrugproductmarkets,fixedcopaymentlevelshavetheadvantageof administrativesimplicityandtransparency,aswellasenablingconsumerstobudgetconfidently forneartermpharmaceuticalcosts.Furthermore,utilizingcoinsuranceratherthancopayments couldfacilitatedisclosureofinformationabouttheinsurersprocurementprices,information thattheinsurerand/orthemanufacturermaybereluctanttomakepublic. B. HOWMANYTHERAPEUTICCLASSESTODISTINGUISHONFORMULARY? OnaverageabouttwentynewdrugsareapprovedannuallybytheFDA.Since1960 about1000newdrugshavereceivedFDAapproval;oneestimateisthatfrom1945to2005, about1200newdrugshavebeenapprovedbytheFDA.38Thegreaterthenumberofdistinct therapeuticclassesthataformularydistinguishes,thesmallerthenumberofdistinct competitormoleculeswithineachclass;alternatively,thesmallerthenumberoftherapeutic classes,thegreaterthenumberofcompetitorswithineachclass.Thespecificationofthe boundariesofdistincttherapeuticclassesaffectsthenumberofmanufacturersthatcompete witheachotherwithinaclass,andthereforehasimplicationsfortheextentofprice competitionamongmanufacturers.In2009MedicarePartDdesignated146distinct
23

therapeuticclasses,whichwere(andare)determinedbytheUnitedStatesPharmacopeia ratherthantheinsurersofferingPartDinsuranceplans;allinsurersofferingPartDplansmust usethese146classes.39Inthecommercial(under65yearsofage)insurancemarketthereis considerableheterogeneityamongthenumberofclassesthatvariousinsurersuse,withsome havingmoreandothersfewerthanMedicarePartD. Moreover,MedicarerequiresinsurersofferingPartDplanstohaveatleasttwocovered productsin140therapeuticclasses,butitdesignatessixprotectedclassesinwhichdrugsare thoughtnottobeclosesubstitutesandthereforerequiresthatinsurersoffercoverageforall butoneofthedrugsineachofthesesixclasses.40Evenifaclasshasalargenumberofdrugs, anygivenpatientmayonlydowellononeorafewofthem.Examplesoftwosuchclasses, whicharetwoofthesixthatareprotectedbyMedicare,areantidepressantsand antipsychotics.Insuchcases,fromthevantageofpatientsthatrespondidiosyncratically,the drugsarenotverysubstitutable.Medicaresrequirementthatallbutonedrugintheclassbe ontheformulary,however,givesmanufacturersofpatentprotecteddrugsintheseclasses additionalmarketpower,enablingthemtopricesubstantiallyabovemarginalcost,without havingtoworryasmuchaboutpotentialBertranddifferentiatedproductspricecompetition.41 C. NEWPRICECOMPETITIONATTHERETAILLEVEL InrecentyearsgiantretailerWalMarthastakenseveralactionsthatmimicthe formularymodelinthecontextofretaildrugdistributionandcompetitionratherthandrug manufacture.Foralargenumberofgenericdrugs,WalMartannouncedin2008itwould charge$4fora30dayprescriptionand$9fora90dayprescription,whereasatthattime insuredconsumersgoingtochainssuchasCVS,RiteAid,andWalgreenstypicallyhadalarger
24

copay(asseeninFigure3,themediangenericcopayfora30dayprescriptioninaPartDplans in2009was$7).42Laterin2008WalMartalignedwithinsurerssuchasHumanaandemployers suchasCaterpillartoofferconsumersazerodrugcopaymentforgenericsatWalMart,whereas consumerswouldpayanormal$5copaymentiftheyfilledtheirprescriptionsatnonWalMart pharmacies.TheresultingincreasedvolumeatWalMartnotonlygaveitmorebargaining powervisvisgenericmanufacturers,butitalsobroughtfoottrafficintoitsstorestopurchase nondrugproducts. CompetitordrugretailchainWalgreensreacted,offering90dayprescriptionsfor $12.99,equivalentto30dayprescriptionsfor$4.33(plusanannualmembershipfee).43Finally, inlate2008thecombinedpharmacybenefitmanagementfirmCaremarkandretailchainCVS announcedanewHealthSavingsPlanthatletcustomersbuy90daysuppliesofover400 genericdrugsfor$9.99(plusa$10annualmembershipfee)eitherthroughitsmailorderorat itsretailsites,callingthischannelneutrality,andnotingthatithopedthatbyshiftingits90 daymailorderprescriptionstobepickedupatitsretailstores,itwouldbringcustomersinto thestore.ThesedevelopmentsdocumentthatBertrandpricecompetitionisaliveandgrowing intheretailprescriptiondrugstoremarketsegmentaswellasintheupstreammanufacturing marketforcompetingbrandedproducts.44 VI. FINALREMARKS Attheoutsetofthisprimerwenotedthatbecauseoftheimportanceofasymmetric information,principalagentissuesinvolvingphysicians,payersandpatients,alongwithmoral hazardandadverseselectioninhealthcaremarkets,ingeneralonecannotrelyonsimple demandtheorytomakenormativestatementsandevaluationsofhowwellhealthcaremarkets
25

areperforming.Putsimply,inhealthcarewecannotcrediblyassumethatrepresentative consumersarerationallymaximizingutilitysubjecttobudgetconstraints. Whileourinabilitytorelyonconventionalconsumerdemandtheorylimitsourabilityto makeunambiguouswelfarestatementsabouthowwellhealthcaremarketsareworking,wedo knowthatmarketdemandfunctionsexist,whatevertheirsources.Usingthosefunctionsalong withthefamiliarframeworksofcompetition,monopolyandBertranddifferentiatedproduct pricecompetition,wecanstillproductivelyemploymicroeconomictools,aswellastheoriesof firmsandmarkets,tohelpusbetterunderstandtheconfusopolyofpricingin biopharmaceuticalmarkets.

26

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Frank,RichardG.andJosephP.Newhouse[2007],"MendingtheMedicarePrescriptionDrug Benefit:ImprovingConsumerChoicesandRestructuringPurchasing",WashingtonDC:The BrookingsInstitution,HamiltonProjectDiscussionPaper200703,April. Frank,RichardG.andJosephP.Newhouse[2008],"ShouldDrugPricesBeNegotiatedUnder PartDofMedicare?AndIfSo,How?",HealthAffairs27(1):3343,January/February. Frank,RichardG.andDavidS.Salkever[1992],Pricing,PatentLossandtheMarketfor Pharmaceuticals,SouthernEconomicJournal59(2):165179,October. Frank,RichardG.andDavidS.Salkever[1997],GenericEntryandthePricingof Pharmaceuticals,JournalofEconomicsandManagementStrategy6(1):7590,Spring. Frueh,FelixW.,ShashiAmur,PadmajaMummaneni,RobertS.Epstein,RonaldE.Aubert,Teresa M.DeLuca,RobertR.Verbrugge,GilbertJ.BurckartandLawrenceJ.Lesko[2008], PharmacogenomicBiomarkerInformationinDrugLabelsApprovedbytheUnitedStatesFood andDrugAdministration:PrevalenceofRelatedDrugUse,Pharmacotherapy28(8):992998, August. Gaynor,Martin,DeborahHaasWilson,andWilliamB.Vogt[2000],AreInvisibleHandsGood Hands?MoralHazard,Competition,andtheSecondBestinHealthCareMarkets,Journalof PoliticalEconomy108(5):9921005,October. Glazer,Jacob,HaidenA.HuskampandThomasG.McGuire[2011],APrescriptionforDrug FormularyEvaluation,Boston,MA:HarvardMedicalSchool,DepartmentofHealthCare Policy,unpublished,February25. Goldman,DanaP.,GeoffreyF.Joyce,GrantLawless,WilliamH.CrownandVincentWilley [2006],"BenefitDesignandSpecialtyDrugUse",HealthAffairs25(5):131931, September/October. Grabowski,HenryG.[2008],"FollowonBiologics:DataExclusivityandtheBalanceBetween InnovationandCompetition",NatureReviews:DrugDiscovery7:47988,June, doi:10.1038/nrd2532. Grabowski,HenryG.,IainM.CockburnandGeniaLong[2006],"TheMarketforFollowOn Biologics:HowWillItEvolve?",HealthAffairs25(5):1. Grabowski,HenryG.andJohnM.Vernon[1992],BrandLoyalty,Entry,andPriceCompetition inPharmaceuticalsafterthe1984DrugAct,JournalofLawandEconomics35:331340, October.

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Grabowski,HenryG.andJohnM.Vernon[1996],LongerPatentsforIncreasedGeneric CompetitionintheUS:TheWaxmanHatchActafterOneDecade,Pharmacoeconomics10 Suppl2:110123. Kanavos,PanosandUweReinhardt[2003],ReferencePricingintheUnitedStates?,Health Affairs22(3):1630,May/June. Lakdawalla,DandSood,N.[2009]InnovationandtheWelfareEffectsofPublicDrug Insurance,JournalofPublicEconomics93:54148. MasColell,Andreu,MichaelD.Whinston,andJerryR.Green[1995],MicroeconomicTheory, NewYork:OxfordUniversityPress. Medco[2011],2010DrugTrendReport.Availableonlineatwww.medco.com;alsoavailableat www.drugtrend.com. Pauly,MarkV.[2010],InsuranceandDrugSpending,Philadelphia,PA:Universityof Pennsylvania,TheWhartonSchool,unpublishedmanuscript,December10.Forthcomingin PatriciaM.DanzonandSeanN.Nicholson,eds.,TheEconomicsoftheBiopharmaceutical Industry,Oxford,UK:OxfordUniversityPress,2011. Pindyck,RobertS.andDanielL.Rubinfeld[2009],Microeconomics,7thEdition,UpperSaddle River,NewJersey:PearsonPrenticeHall. Pollack,Andrew[2011],CouponsforPatients,butHigherBillsforInsurers,NewYorkTimes, January2.Availableonlineat http://www.nytimes.com/2011/01/02/business/02coupon.html?_r=1&pagewanted=print,last accessed10March2011. Reiffen,DavidE.andMichaelE.Ward[2005],"GenericDrugIndustryDynamics",Reviewof EconomicsandStatistics87(1):3749. Reiffen,DavidE.andMichaelE.Ward[2007],"'BrandedGenerics'AsAStrategytoLimit CannibalizationofPharmaceuticalMarkets",ManagerialandDecisionEconomics28:25165. Saha,Atanu,HenryG.Grabowski,HowardM.Birnbaum,PaulE.GreenbergandOdedBizan [2006],"GenericCompetitionintheU.S.PharmaceuticalIndustry",InternationalJournalofthe EconomicsofBusiness13(1):1538,February. Trusheim,MarkR.,MurrayL.AitkenandErnstR.Berndt[2010],CharacterizingMarketsfor BiopharmaceuticalInnovations:DoBiologicsDifferFromSmallMolecules?,ForumforHealth Economics&Policy,Manuscript1200,June,48pp.Availableonlineat http://www.bepress.com/fhep.
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WalMart[2010],$4PrescriptionsProgram,availableonlineat http://www.walmart.com/p/4PrescriptionsProgram/546834,lastaccessedMarch21,2010.

31

FIGURE1

32

FIGURE2

33

FIGURE3 CostSharingintheMedianMedicarePartDPlan

Source:MedicarePaymentAdvisoryCommission,March2009,Table48.Valuesweightedby enrollment.ValuesforMedicareAdvantagePrescriptionDrugplansaresimilar.

34

FIGURE4
BertrandPriceCompetition

P2

Themonopolypricepm

P2m P2b

Bertrandequilibrium,noformulary,pb Bertrandequilibrium,with Drug1onformulary

P2nf

P2 P1

P1 P2

P1b P1m

P1

35

FIGURE5
AverageGenericPriceandNumberofGeneric ManufacturersFollowingInitialGenericEntry, Top25NewGenerics20052009
120.0 16
(Indexed to 100 at Month 0)

14

12 80.0 10

60.0
Generic Pricing

6 40.0 4 20.0 2

0.0

Months (After Generic Launch)

Number of Generic Manufacturers

100.0

Source:BerndtandAitken[2010],Figure3.

36

ENDNOTES
1 Availableonlineathttp://www.dilbert.com/strips/comic/20101121/,lastaccessedFebruary7,2011. Itisworthnotingthatinhis1997bookTheDilbertFuture(HarperCollins,June1,1997,ISBN07522 11617)ScottAdamsfirstdefinedconfusopolyasAgroupofcompanieswithsimilarproducts,who intentionallyconfusecustomersinsteadofcompetingonprice.(p.159).Examplesofindustriesin whichconfusopoliesexist(accordingtoAdams)includetelephoneservice,insurance,mortgageloans, banking,financialservicesandretailelectricitymarkets(butnothealthcareorpharmaceuticals).For furtherdiscussionandreferences(includinganeconomicanalysisofpricinginderegulatedenergy marketsinAustraliabyJoshuaGans),seehttp://en.wikipedia.org/wiki/The_Dilbert_Future,last accessedMarch10,2011. 2 Thisprimerbuildsonourpreviouswritings,inparticularonBerndtandNewhouse[2010,2011],Berndt andAitken[2010,2011],BerndtandFrank[2007],FrankandNewhouse[2007,2008],Frank[2001]and Berndt[2002]. 3 Inaformalanalysis,Gaynor,HaasWilsonandVogt[2000]showthatalowerprocurementpriceisin theinterestoftheinsurerpressuredbycompetitiontomaximizeutilityofenrollees,andintheinterest ofsocialwelfare.Inotherwords,higherprocurementpricesarenotausefulantidoteto overconsumptioncausedbymoralhazardininsurancecoverage. 4 LakdawallaandSood(2009)pointoutthatthepresenceofaninsurerallowsforsupplypricesfornew drugstobemaintainedathighlevelsexceedingmarginalproductioncosttoencourageinnovation,but demandpricestobesetlowtoencourageefficientconsumption.Socialandprivatebenefitsandcosts ofdruginsurancearealsoconsideredinGlazer,HuskampandMcGuire[2011]. 5 EveniftherewereamonopolydruginsurerintheU.S.,drugresearchanddevelopmentdecisionsare takenwiththeworldmarketinmind,andtheU.S.istypicallyslightlylessthanhalfthatmarket. 6 Clearlyifthemarketsfortwodifferentmoleculesareofmarkedlydifferentsize,however,marketing costswillvary.Becausemarginalproductioncostistypicallylow,themarginalrevenuefromselling anothertabletorcapsuleisnearlyallprofit.Hence,incentivestoinvestheavilyinmarketingare substantial,somethingforwhichpharmaceuticalmanufacturersarenotorious.Notethatmarketing costsareinthenatureofacapitalgood,sincethemanufacturerisinvestinginthefuturereturnsof establishingabrandname.Americanaccountingconventionstreatsuchcostsasacurrentperiod expense,whichinflatesaccountingprofitsonassetsrelativetoeconomicprofits.SeeBerndt[2002]for furtherdiscussionandreferences. 7 Thedemandfromthosewithoutinsurancecansimplybeincorporatedintothemarketdemandcurve. 8 See http://www.cms.gov/NationalHealthExpendData/02_NationalHealthAccountsHistorical.asp#TopOfPage. 9 Thecaseoffullcoveragewithcoinsuranceorcopayment(zerocontributionbytheinsured)putsno restraintonmonopolypricing,andwedisregardthispolarcase. 10 Notethattheimplicitassumptionhereisthatconsumerssaturationwhenthedrugisfree(priceof zero)isunchangedwithandwithoutcoinsurance,sothattheintersectionofthedemandcurvewiththe horizontalaxisisunaffected.Whileintuitivelyplausible,onecouldenvisagesituationswhereaninsurer providedinsureesinformationconcerningbenefitsoftakingdrugsthatanuninsuredconsumerdidnot receive(e.g.,inanefforttoincreasecompliancewithtakingprescribedmedicationsandlowerhospital andphysicianspending),sothatunderinsuranceitispossiblethatatazeropricethequantityutilized wouldbegreaterthanunderthenoinsurancescenario. 11 KanavosandReinhardt[2003]. 12 Medco[2011],p.23.

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 Thefactorofthreeapplieswithzeromarginalproductioncosts,butunlikeotherdrugs,production costsforspecialtydrugsaretypicallynontrivial,diminishingthefactorbywhichcoinsuranceraisesthe profitmaximizingprice. 14 ForfurtherdiscussionofthetreatmentofspecialtydrugsintheMedicarePartDprogram,see Duggan,HealyandScottMorton[2008]. 15 Forfurtherdiscussionofspecialtydrugsanddruginsurancebenefitdesign,seeGoldman,Joyce, Lawlessetal.[2006].Issuesregardingfactorsaffectingoptimalcoinsuranceratesforpreventionandfor treatmentareconsideredbyEllisandManning[2007]. 16 TextbooktreatmentsofBertrandcompetitionarefoundin,forexample,MasColell,Whinstonand Green[1995,ch.12]andPindyckandRubinfeld[2009,ch.12]. 17 Asweshow,copayments,combinedwiththeabilitytochoosesuppliersaspartofaformulary,givean insurertheabilitytoinfluenceprocurementprices.Analysisofthealternativeofcoinsuranceaddsno furtherinsights. 18 Duggan,HealyandScottMorton[2008]. 19 Glazer,HuskampandMcGuire[2011]discusswelfareimplicationsofprescriptiondruginsurancein greaterdetail. 20 Recentlysomemanufacturersofproductsplacedonthethirdcopaymentorcoinsurancetierhave attemptedtocountertheinsurersformularyplacementoftheirproductbyprovidingconsumerswith couponsthatreduceandperhapseveneliminatethepatientsdifferentialcopaymentsbetweentiers; see,forexample,Pollack[2011]. 21 Forfurtherdiscussionofeconomicissuesunderlyingoptimalinsuranceinthecontextofprescription drugs,seePauly[2010]andGlazer,HuskampandMcGuire[2011]. 22 Barrueta[2003]. 23 Ibid. 24 Berndt[2002],FrankandNewhouse[2007,2008],Duggan,HealyandScottMorton[2008]andDuggan andScottMorton[2010]. 25 AninterestingresearchquestionwouldbetocomparethepropertiesoftheEuropeanbased approach,referencepricing,totheUSbasedapproach,formulariesandtiering. 26 Theseothermarketexclusivityprovisionsinclude,forexample,sixmonthsofadditionalmarket exclusivitybeyondpatentexpirationforundertakingcertainclinicalinvestigationsinvolvingpediatric populations. 27 See,forexample,ReiffenandWard[2005]andSaha,Grabowski,Birnbaum,GreenbergandBizan [2006]. 28 Wedonotdiscusstheinnovatorsoptimalpricingstrategyfollowinglossofpatentprotectionand genericentry.Thissituationhasbeenconsideredby,amongothers,FrankandSalkever[1992,1996], Cook[1998]andBerndt[2002]. 29 TakenfromBerndtandAitken[2011],Figure3. 30 Forfurtherdiscussionofauthorizedgenericentryissues,seeBerndt,Mortimer,Bhattacharjya,Parece andTuttle[2007],andFederalTradeCommission[2009a]. 31 ReiffenandWard[2007]. 32 Foracomparisonofsmallmoleculesandbiologicspostlaunch,seeTrusheim,AitkenandBerndt [2010]. 33 See,forexample,Grabowski,CockburnandLong[2006],Grabowski[2008]andFederalTrade Commission[2009b]. 34 See,forexample,GrabowskiandVernon[1992]andDrugChannels[2007a,b;2008a]. 35 BerndtandNewhouse[2010,2011].
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 SeeThe201011EconomicReportonRetailandSpecialtyPharmacies, www.PembrokeConsulting.com,Exhibit2,p.8,LargestU.S.PharmaciesRankedbyTotalPrescription Revenues,2010E(retailandmailorderfacilities). 37 BerndtandNewhouse[2011]. 38 Frueh,Amur,Mummanenietal.[2008]. 39 Duggan,HealyandScottMorton[2008]. 40 Thesixclassesareantidepressants,antipsychotics,anticonvulsants,immunosuppressants,anti retroviralsandantineoplasticagents. 41 MedicarealsoplacedrestrictionsthatthePDPmustcoveratleastonedrugineachFormularyKeyDug TypeClass(FKDT),whichisafinercategorythantherapeuticclasstypicallycontainingonlyoneortwo brands;seeDugganandScottMorton[2010]fordetails. 42 WalMart[2010]. 43 Fordiscussionandextensivereferences,seeDrugChannels[2007a,b;2008a,b,c,d]andBerndt Newhouse[2010,2011]. 44 ButseeAbelsonandSinger[2011]fordiscussionofmorerecentdevelop0ments.
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