Product line extensions and distribution channels in pharmaceutical supply chain

In response to aggressive generic competition after the original drug’s patent expires, various original firms extend their product lines by introducing an authorized generic drug with both lower quality and cost, either via internal distribution or third-party distribution. In this paper, we develop a game-theoretic model to investigate the product line extension and distribution channel decisions for an original firm that has already sold an original drug and considers introducing an authorized generic drug to compete against the generic firm. We show that product line extension enables the original firm to leverage the value of drug differentiation by price discriminating the patients with heterogeneous preferences for quality, but it also leads to original drug’s profit loss caused by the internal cannibalization. Given an internal distribution channel, when the cost gap is not small for the internal cannibalization to be less aggressive, the original firm will extend the product line, which could surprisingly benefit the generic firm but harm the patients. In contrast, under a third-party distribution channel, the original firm always prefers to extend the product line by setting a low wholesale price, which always reduces the generic firm’s profit but increases the patient surplus. Finally, contrary to the conventional wisdom that a decentralized channel always harms the original firm compared with a centralized one due to the double marginalization, our results suggest that when the original drug has a small cost gap or a large quality gap relative to the generic drug, the original firm is better off with using the third-party distribution to introduce the authorized generic drug than the internal distribution, as it permits higher original drug’s profit due to alleviated internal cannibalization, although at the expense of lower authorized generic drug’s profit.