Innovation, loyalty and generic competition in pharmaceutical markets

We analyze how a manufacturer with a brand-name drug close to patent expiration decides to launch a product-line extension (an upgrade through innovation) before it faces generic competition. There are two types of physicians: loyal physicians always prescribe first the product-line extension and then either the off-patent drug or a generic drug while the non-loyal ones prescribe taking into account the prices of the drugs. We consider a two-stage game. In the first stage, the incumbent firm decides the level of innovation. In the second-stage, all firms decide sequentially their prices, with the incumbent firm acting as a Stackelberg leader. We find two equilibria in the pricing-decision game. For relatively large levels of innovation, the incumbent firm competes for the price-sensitive physicians. However, for low levels of innovation, the incumbent firm prefers to exploit the loyal physicians and to charge the monopoly price. The equilibrium level of innovation exhibits an inverted U-shaped behaviour with respect to the degree of loyalty.