A Dynamic Oligopoly Structural Model for the Prescription Drug Market after Patent Expiration

Abstract

Motivated by the slow diffusion of generic drugs and the increase in prices of brand-name drugs after generic entry, I incorporate consumer learning and consumer heterogeneity into an empirical dynamic oligopoly model. In the model, firms choose prices to maximize their expected total discounted profits. Moreover, generic firms make their entry decisions before patent expiration. The entry time of generics depends on the FDA random approval process. I apply this model to the market of clonidine. The parameters of the model are estimated and calibrated. The model replicates the stylized facts fairly well. I confirm that consumer heterogeneity in price sensitivity plays an important role in explaining the brand-name pricing pattern. I also apply the model to examine the impact of a policy experiment, which shortens the expected approval time for generics. Although this experiment brings generics to the market sooner, it also reduces the number of generic entrants as the likelihood of entering a crowded market in the early periods increases. Given the change in magnitude of the policy parameter, the experiment improves the rate of learning, and lowers the equilibrium generic prices throughout the period. However, it hardly raises the overall welfare.

Keywords: Dynamic Oligopoly, Prescription Drugs, Brand-name Drugs, Generic Drugs, Patent Expiration, Consumer Learning, Consumer Heterogeneity

JEL Classification: C73, D43, D83, L13, L65