67 4. Reference Pricing versus Medical Savings Accounts 4.1. Introduction Health care expenses are uncertain. Many illnesses and accidents seldom happen and seemingly at random, but when they occur, the costs can be so high that they may be ruinous to households. To protect against this, most people prefer to pay a regular premium for the certainty of health insurance to the risk of getting sick and having to pay a large medical bill. However, since insured individuals cover only a small fraction, e.g. a proportional co-payment, of the medical expenditure, prices lose their steering effect. The smaller the patients’ out-of-pocket share of their medical costs is, the more demand becomes inelastic – in? uencing not only the decision of whether to consume health care services or not, but also the choice between different treatment alternatives. This is especially a serious problem in the pharmaceutical sector because, due to huge research and development costs, manufacturers are granted temporary market power with patent protection.52 By using this exclusive market position to build-up a high reputation and brand-awareness, even after the patent expires the ? rst-mover advantage gives the innovator continuing price-setting power (Frank and Salkever 1992). The cost-driving concurrence of supply-side price setting power and price-inelastic demand has provoked policy makers throughout the industrialised world to establish complex regulatory frameworks. As the pioneer in implementing this type of policy, Germany’s Statutory Health Insurance System (SHI) introduced reference pricing (RP) in 1989. Many countries followed, e.g. the Netherlands, Denmark, Sweden, Spain, Belgium and Italy as well as Australia, British Columbia (Canada) and New Zealand (Brekke et al. 2005). They all have the common aim of containing public pharmaceutical spending by means of reducing moral hazard effects and enhancing generic competition. Nevertheless, RP can only be an inferior substitute for free-market price competition because patients’ co-payments do not re? ect drug prices, but only their distance to an arbitrary determined indemnity tariff. On the contrary, Medical Saving Accounts (MSAs), i.e. individual accounts in which insurants are obliged to make deposits for medical expenses, enable competition on the basis of market prices. Transferring expenditure responsibility to the patients strengthens not only cost consciousness, but makes demand more elastic and thus reduces moral hazard welfare losses. The main purpose of this chapter is to compare the impact of RP and MSAs on competition and price-setting strategies of pharmaceutical manufacturers. To accomplish this, we use a vertical product differentiation model with two ? rms: one brandname drug producer whose patent has already expired and one generic competitor. 52 For the relevancy of R&D in the pharmaceutical market see e.g. Grabowski and Vernon (1994). 68 Assuming ? rst mover advantage, we play a Stackelberg game with the brand-name producer as price leader and the generic competitor as price follower. We will ? nd that both RP and MSAs are adequate frameworks to improve competition compared to simple proportional co-payment arrangements, but prices as well as manufacturer surpluses will be persistently lower under MSAs. Combined with serious classi? cation problems which come up with RP, our results clearly suggest a system of MSAs as the superior control instrument. The chapter is structured as follows: section 4.2 gives a short introduction into generic competition, which is the basis for RP and MSAs. In sections 4.3 and 4.4, functionality and empirical experiences of the two control-instruments are presented. Subsequently, in section 4.5 we start with the economic analysis. Extending a simple vertically differentiated duopoly model, we deduce equilibrium conditions and compare the respective impact of RP and MSAs on manufacturers’ price-setting behaviour, competition and surpluses. Section 4.6 compares the model results. Based on these results, in section 4.7 a reform proposal is given. Finally, section 4.8 draws the conclusions. 4.2. Generic Competition Once a pharmaceutical patent expires, generic replacement drugs may enter the market. Generics are exact copies of original branded drugs and contain the same active chemical ingredients. The existence of those perfect substitutes and the negligibly small economies of scale in the production of pharmaceuticals (Caves et al. 1991) lead to the expectation that the generic entry would take away the possibility of monopoly rents of brand-name incumbents. Prices should decrease to marginal costs. However, empiric studies of the US-market show a different picture:53 Contrary to expectations, Grabowski and Vernon (1992) revealed that prices for the 18 high sales-volume branded drugs they investigated increased by an average of 7 % one year after and 11 % two years after generic entry.54 At the same time, prices for generics signi? cantly decreased and were on average 35 % lower than their initial entry price after two years. Grabowski and Vernon’s descriptive results were proved by Frank and Salkever (1997), who used an econometric model to test a sample of 32 drugs which lost patent protection during the early to mid-1980s. They found evidence that brand-name prices increase, whereas generic prices strongly decrease after the 53 We refer to the US-market because it is widely unregulated and thus generic competition is not distorted due to speci? c public control instruments. In the US, the pharmaceutical sector is mainly characterised by market-driven controls through private health care insurers using managed care drug bene? t programs (see Danzon 1997). 54 The phenomenon that branded drug producers increase prices as a response to generic entry is called “Generic Competition Paradox”. The thinking is that demand is divided into two segments: price insensitive (“loyal”) and price sensitive (“non-loyal”) consumers. Since the generic drugs capture the non-loyal patients, manufacturers of brand-name drugs raise their prices in the price insensitive segment (Frank and Salkever 1992).