Brand Loyalty and Generic Competition

Facing generic competition, a brand-name drug company sometimes launches its own generic called an "authorized generic" (AG) through a third-party entity. If an authorized party transfers a substantial part of its profits to the brand-name drug company, the latter's total profit increases as a result and every branded drug that comes off the patent should have its AG version. However, in actual fact only a small proportion of branded drugs have AGs. To explain this puzzle, I develop a model that features switching costs due to the customer base a brand-name drug develops prior to generic entry. The model predicts that AGs are launched when switching costs to the generics are sufficiently low. I test this hypothess using prescription drug data and find strong support for it.