Skip Navigation

How Increased Competition from Generic Drugs Has Affected Prices and Returns in the Pharmaceutical Industry July 1998

Besides its primary effect of reducing the returns from marketing innovator drugs, generic entry can also have a small positive effect on the incentive to innovate. Economists have shown that a monopolist can have a tendency to "rest on his laurels."⁽¹⁾ Monopolists may have little incentive to research and develop new products that will compete directly with their currently marketed products--a phenomenon referred to as the replacement effect. When a cash flow model of the expected returns from marketing an innovative product incorporates that effect, it shows that in a few cases, the net impact of generic entry on a monopolist's incentives to innovate could be close to zero (although in general one would expect returns to decline). In those cases, generic entry may reduce the size of the replacement effect almost as much as it reduces the present discounted value of the returns from marketing an innovation.

Whether the reduced replacement effect significantly offsets the direct decline in returns caused by generic competition will depend on how much of the current product's market is being replaced and the timing of that replacement. The reduction in the replacement effect is more likely to be an important factor when the product being replaced is within a few years of patent expiration. That implies that when pharmaceutical companies invest in developing new drugs in therapeutic classes in which they are already market leaders, the rise in generic competition may not lower their incentive to innovate as much as the Congressional Budget Office's (CBO's) calculation of the returns from marketing a drug (presented in Chapter 4 ) would appear to indicate.

Still, only a limited number of cases exist in which the reduced replacement effect could be strong enough to nearly offset the direct decline in returns because of generic competition. Although companies do continue to develop drugs in therapeutic areas where they are market leaders, they also invest in therapeutic areas where few treatments exist. And it is in precisely those areas--where patients may benefit the most from a new drug--that the offsetting replacement effect is not present at all.

As Box D-1 shows, the profit stream from innovating is equal to the present discounted value of the returns from marketing the innovation, offset by any decline in the present discounted value of the profit stream from the currently marketed product (that decline, shown in brackets in the box, represents the replacement effect). Generic entry reduces the present discounted value of the returns from marketing the innovation (by an average of $27 million in 1990 dollars, according to CBO's analysis) but is offset somewhat by a decrease in the replacement effect.
 

That relationship can be expressed mathematically, as follows. Assuming that:

t = number of years a product has been on the market

t_g = year of generic entry

T = number of years of product life

h = year in the life of the currently marketed product when a new, competing product is introduced by the monopolist

= share of the current product's market that is absorbed by the new product

= monopolist's profits in year t with no generic entry

= monopolist's profits in year t with generic entry

= if t < t_g; if t > t_g

V^M = profit stream generated from introducing a new product after the current product has been on the market for h years, in the absence of generic competition following patent expiration

V^G = profit stream generated from introducing a new product after the current product has been on the market for h years, with generic entry in year t_g

It is assumed that the functions and are the same for the product that is currently on the market as for the new one. Those functions could be thought of as the average profits generated from marketing a new drug t years after market introduction. In the absence of generic entry, the change in the profit stream from introducing a new product after the current one has had h years on the market is equal to:
 

The first term equals the present discounted value of the profits from the innovation. The second term equals the decline in the present discounted value of the profit stream of the currently marketed product after the innovation is introduced (the replacement effect). After accounting for generic entry, the profit stream from innovation becomes:
 

The first two terms are equal to the present discounted value of the profits from the innovation. The second term accounts for lower postpatent revenues when generic entry occurs. Together, those equations imply that the effect of generic entry on the returns from marketing an innovation can be expressed as:
 

The first term in that combined equation equals the fall in the present discounted value of the profit stream from the innovation because of generic entry starting in year t_g. The second term equals the loss in the future profit stream from the currently marketed product because its sales volume declines after the more innovative product is introduced. The amount by which V^M exceeds V^G is diminished by the change in the replacement effect.

Note that using present discounted values diminishes the first term more than the second term. The effect of generic entry on the current profit stream is diminished because it occurs at the end of a drug's product life. But the change in the replacement effect under generic entry occurs sooner, as reflected by discounting by t - h years rather than by t years. Suppose that h = 10, so that a new product is introduced after the monopolist's current product has been on the market for 10 years. The model used in this study estimates that the effect of generic entry on the present discounted value of profits, when discounted back only to year 10, is more than twice the value when discounted back to year 0. If more than half of the current product's market is absorbed by the new product ( > 0.5), the change in the replacement effect would completely offset the first term. The change in the replacement effect is largest when the currently marketed product approaches patent expiration.

1. Jean Tirole, The Theory of Industrial Organization (Cambridge: MIT Press, 1988), p. 392, quoting Kenneth J. Arrow. Although manufacturers of brand-name drugs usually do not have a pure monopoly, the analysis still applies to innovation in this industry.

---