ABSTRACT
This chapter examines the structure and regulation of the pharmaceutical industry. It describes measures of competition, barriers to entry, and regulation of the industry by the Food and Drug Administration. It also studies drugs through a health production function that depends on both drugs and other medical inputs to illustrate the potential for substitutability. It shows how demand for a drug is affected by changes in its price, insurance deductibles and copayments, and by technological improvements in its effect on health.
The chapter then turns to drug pricing and profits gained through standard models of monopoly profit maximization and price discrimination. The reader learns that a firm’s investment in research and development (R&D) is closely linked to its pricing and profit potential, and a variant of net present value analysis generates predictions about R&D.
Cost-containment strategies for high drug prices include multiple tiered copayment schemes that encourage generic substitution; drug formularies that restrict patients’ choices; and the use of firms known as pharmacy benefit managers to manage commercial insurers’ drug plans. The chapter closes by examining new drugs, showing that they often have relatively high prices, but tend to reduce overall health care spending.
