Competition and the Reference Pricing Scheme for Pharmaceuticals

Abstract

In a pharmaceutical Reference Price Scheme (RPS), firms are free to set their prices, but the (insured) consumer pays only the difference between the Reference level (R) and the actual price of the drug, if this is higher than R. By introducing n (> 1) firms with in nite cross-price elasticity (i.e. generic drugs), we explore the effects of competition on the optimal pricing strategies under a RPS. A two-stage model repeated either once or an in nite number of times is presented: in the first stage firms compete or collude in prices and set R, while in the second they take R as exogenous. When stage 1 is competitive, the equilibrium in pure strategies exists and is efficient only if R does not depend on the price of the branded product. When generics collude, the way R is designed is crucial for both the stability of the cartel among generics and the collusive prices in equilibrium. It is shown that an optimally designed RPS must set R as a function only of the infinitely elastic side of the market and should provide the right incentives for cartel's deception.