The impact of the reference price system on the pharmaceutical market: A theoretical approach

This article analyses the impact of the reference price system on the price-setting strategies of the pharmaceutical firms and on the level of generic usage. This model is the first to take explicitly into account the impact of the reference price mechanism on the level of competition between brand-name and generic drugs and national pharmaceutical spending. We consider a duopolistic model with one firm producing the brand-name drug, whose patent has already expired, and the other producing the corresponding generic version. We work in a partial equilibrium framework where firms set prices sequentially and consumers face heterogeneous switching costs.We show that brand producers compensate the decline of profits by selling greater quantities instead of charging higher prices, thus fostering price competition in the pharmaceutical market. This result is a consequence of both the assumption of a vertically differentiated model and the introduction of the reference price system.