ECON101: Principles of Microeconomics (2021.A.01)

Generic prescription drugs are essentially identical substitutes for more expensive brand-name prescription drugs. Since the passage of the Drug Competition and Patent Term Restoration Act of 1984 (commonly referred to as the Hatch-Waxman Act) made it easier for manufacturers to enter the market for generic drugs, the generic drug industry has taken off. Generic drugs represented 19% of the prescription drug industry in 1984 and today represent more than two-thirds of the industry. U.S. generic sales were $29 billion in 1995 and soared to $176 billion in 2009. In 2009, the average price of a branded prescription was $155 compared to $40 for a generic prescription.

A study by David Reiffen and Michael R. Ward published in 2005 showed that entry into the generic drug industry has been the key to this price differential. As shown in the table, when there are one to three manufacturers selling generic copies of a given branded drug, the ratio of the generic price to the branded price is about 83%. The ratio falls to 76% when there are four to six competitors, 72.1% when there are seven to nine competitors, 69% when there are ten competitors, and 68% when there are eleven or more competitors.

They also found that the extent to which prices approach competitive levels depends on the potential revenue in the market for a drug. So long as markets are sufficiently large, entry of generic competitors leads to prices that are close to marginal cost (i.e., at near-competitive pricing levels).

The generic drug industry is largely characterized by the attributes of a perfectly competitive market. Competitors have good information about the product and sell identical products. The 1984 legislation eased entry into this market. And as the model of perfect competition predicts, entry has driven prices down, benefiting consumers to the tune of tens of billions of dollars each year.

Table 9.1 Price Comparison of Generic and Branded Drugs, by Number of Competitors