Wednesday, January 16, 2013

The Substitution Effect for Pharmaceutical Drugs

The New York Times has an interesting article on how coupons for pharmaceutical drugs for patients can result in higher costs to health insurance firms.  Here is how it works.  Suppose there are two substitute drugs, one is a high priced brand name and the other is a lower priced generic.  If the health insurance company has a tiered pricing system for their customers for these two drugs where customers pay a higher co-payment for the brand name drug and a lower co-payment for the lower priced generic.  As I show in class this is to minimize the health insures expenses for prescription drugs.

Suppose the brand name pharmaceutical company provides the customer with a coupon where the co-payment for the brand name drug so that it is similar to the co-payment for the generic drug.  If they are the same and customers prefer the brand to the generic, then customers will choose the brand name drug, resulting in higher costs to the health insurance company.  This is exactly what has happened.

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