Higher Prices from Entry: Pricing of Brand-Name Drugs

When a new firm enters a market and starts selling a spatially-differentiated product, the prices of existing products may rise due to a better match between consumers and products. Entry may have three unusual effects. First, the new price is above the monopoly price if the two firms collude and may be above the monopoly price even if the firms play Bertrand. Second, the Bertrand and collusive price may be identical. Third, prices, combined profits, and consumer surplus may all rise with entry. Consistent with our theory, the real prices of some anti-ulcer drugs rose as new products entered the market. Higher Prices from Entry: Pricing of Brand-Name Drugs When a new firm starts marketing a product that is spatially differentiated from existing products, the price of existing products may rise regardless of whether the firms collude. We assume that a brand’s location in product space is exogenously determined, and the firm’s only choice variable is price. Using a spatial model, we show that the effect of entry on price depends on how close together products are located in characteristic space. To illustrate this logic, we suppose that a firm enters a market that previously had one firm. If the new product is located at the same point in characteristic space as the original one, the two goods are perfect substitutes so that price must fall if the firms act noncooperatively. If the new product is located so far from the original one that no consumer is interested in buying both products, entry does not affect the original product’s price. Suppose, however, that the two products are located near enough each other that they compete for the same customers but are not perfect substitutes. The original monopoly kept its price down to attract consumers who are located relatively far from its product in characteristic space. Some of these distant customers prefer the new product, which has characteristics closer to their ideal than does the original product. After entry, the original firm has less of an incentive to lower its price to attract consumers for whom its product is a relatively poor match, so it raises its price and sells to only consumers located near its product in characteristic space whose demand is relatively inelastic. Entry may have three unusual effects. First, the new price is above the monopoly price if the two firms collude and may be above the monopoly price even if the firms play Bertrand. Second, the Bertrand and collusive price may be identical. Third, prices, combined profits, and consumer surplus may all rise with entry. Consumers are located closer on average to their ideal product in the new equilibrium than in the original one, which compensates for the higher price. We examine the implications of our model for pricing of brand-name prescription drugs, a market that has been subjected recently to much media and regulatory scrutiny. For example, President Clinton, observing that an index of drug prices rose nearly six times faster than general inflation over roughly the last decade called for a National Health Board to investigate "unreasonable" drug prices. Apparently many politicians believe that the rapid prescription drug price increases reflect increasing monopoly or collusive behavior. Our model offers an alternative explanation, which is consistent with either collusive or noncollusive behavior by firms. As our model requires, location of brand-name drugs in characteristic space is exogenous because it is very difficult for the firm to develop a drug with specific properties. Frequently drugs have unattended side-effects or must be taken more frequently than patients prefer. We examine the largest prescription pharmaceutical market, antiulcer drugs. We show that unexpected price increases occur when new drugs enter that are dissimilar from original drugs. Our explanation for price increases upon entry is different from the familiar story in the 1 "Clinton’s Health Plan; Drug Companies Feeling Pressure of Clinton’s Plan to Keep Their Prices Down," New York Times, September 30, 1993, p.22. 2 Our explanation is only part of the explanation for these rapid price increases. Some other explanations for the relatively rapid rise in the indexes of pharmaceutical prices concern changes in quality or biases in the sampling procedures for new goods. See Berndt, Griliches, and Rosett (1993), Griliches and Cockburn (1994), and Suslow (1995). 2 pharmaceutical literature (e. g., Caves, Hurwitz, and Whinston, 1991) that contends that brandname manufacturers raise their prices to price discriminate when generics enter the market. In that explanation, when manufacturers of generic pharmaceuticals are allowed to sell a clone of a previously proprietary drug, they sell at a price far below that of the original. Although pricesensitive consumers switch to the generics, the brand-conscious consumers who continue to buy the brand-name drug are charged a higher price than they paid originally. Despite this price discrimination, the average market price (across name brands and generics) is likely to fall (Frank and Salkever, 1992, p. 24). In contrast, in our model of competition between differentiated proprietary drugs, the prices of all products may rise with entry. Section I presents the basic spatial differentiation model. We then compare equilibria under various market structures: monopoly in Section II and duopoly in Section III, where we analyze Betrand and collusive outcomes. In Section IV, we present empirical evidence in support of the theory using data from the anti-ulcer drug market in the mid-1980’s. A brief concluding section follows. I. The Basic Model Our analysis and presentation of the basic spatial-differentiation model is based on Salop (1979). For simplicity, suppose that products differ in only one characteristic (e. g., soft drinks range from not sweet to sweet). Products are located in this one-dimensional characteristic space, which is represented as a line (Hotelling, 1939) or a circle (Salop, 1979) of unit length. Firms cannot change their location, t, but can choose their price. Customers are located uniformly 3 We assume that firms are located so far from the end points of any line segment that endpoint considerations can be ignored. 3 along the line segment. For simplicity, each consumer buys one unit. The ideal product of a customer located at t̂ is a product located at the same point along the line. The utility a consumer located at t̂ gets from a product located at t is (1) U (t̂, t ) u c t̂ t , where u is the utility from the consumer’s preferred product, |t̂ t| is the distance product t is from the customer’s preferred product t̂, and c is the rate (transportation cost) at which a deviation from the optimal location lowers the consumer’s pleasure. Because this utility function reflects constant marginal disutility as one moves away from t̂ in this metric, the utility function is symmetric around t̂. A consumer has zero utility if the product is located at t = t̂ ± u/c. Each consumer attempts to maximize consumer surplus, U(t̂, t) p, which is the difference between the consumer’s utility from consuming a product located at t and the price. The consumer purchases the best buy, which is the product with the greatest surplus (the best combination of price and location). Instead of buying one of the products in this market, a consumer buys an outside good if it is a better buy in the sense that it gives more pleasure for a given amount of money. If the product is a prescription anti-ulcer drug, then antacids, surgery, antibiotics, or stress-reduction therapies are outside goods. Let the best outside good give the consumer a surplus of uo. The consumer only buys a unit of the best-buy product i, if its surplus exceeds uo: (2) max i [U (t̂ , ti ) pi ] ≥ uo ,