Hitotsubashi University
Institute of Innovation Research

Brand Royalty and Generic Competition

Jiangyun(Yunyun) Wan

IIR Working Paper WP#16-01

Jan. 2016

Institute of Innovation Research
Hitotsubashi University
Tokyo, Japan
http://www.iir.hit-u.ac.jp

Brand Loyalty and Generic Competition
Yunyun Wan⇤

Abstract
Facing generic competition, a brand-name drug company sometimes launches its
own generic called an “authorized generic” (AG) through a third-party entity. If an
authorized party transfers a substantial part of its profits to the brand-name drug
company, the latter’s total profit increases as a result and every branded drug thatcomes o↵ the patent should have its AG version. However, in actual fact only a small
proportion of branded drugs have AGs. To explain this puzzle, I develop a model thatfeatures switching costs due to the customer base a brand-name drug develops prior
to generic entry. The model predicts that AGs are launched when switching costs to
the generics are sufficiently low. I test this hypothess using prescription drug data andfind strong support for it.

Keywords: brand loyalty, authorized generics, generic entry, customer base, switchingcost
JEL Classification Numbers: L13, L20, I11⇤

Institute of Innovation Research, Hitotsubashi University

1

1

Introduction
When facing generic competition, brand-name drug companies sometimes launch theirown generic drugs. Such generics, to be distinguished from ordinary generics, are called“authorized generics” (AGs). Authorized generics contain exactly the same ingredients as
the brand-name drugs and even come o↵ the same production lines. However, they are soldby third-party entities in the generic category and hence they directly compete with thebrand-name drugs like any other generics. This gives rise to the puzzle: why brand-namedrug companies use such a strategy? One popular answer is product di↵erentiation. But
product di↵erentiation is a preemptive strategy to deter entry (e.g. Schmalensee (1978)),
whereas AGs are launched almost simultaneously with generic entry. The entry deterrence
hypothesis does not seem apt.
Another possible explanation is in terms of divisionalization due to Baye et al. (1996),
who show that in Cournot oligopoly a firm can always increase total profit by splitting itself
into two autonomous entities. Thus, a launch of an authorized drug makes business sense if
the authorized generic distributer acts as an autonomous entity but agrees to transfer a largepart of its profit to the brand-name drug manufacturer. But if such a “divisionalization”
strategy is profitable, we should observe brand-name drug companies launching AGs without
fail whenever they face generic competition. In actual fact, however, only a small number ofo↵-patent brand-name drugs have ever had AGs.1 This fact gives rise to the second puzzle:
if divisionalization is profitable, why don’t brand-name drug companies launch authorized
generics against every generic entry?
In this paper I intend to explain these puzzles. In doing so, I maintain the assumptionthat consumers are well aware that generics are bioequivalent to (i.e., just as e↵ective andsafe as) the branded drug. However, the same drug never treats every patient equally wellbecause the same illness a↵ects individuals di↵erently and make them react di↵erently to1This is according to the AG list prepared by FDA (U. S. Food and Drug Administration). http://www.fda.gov/AboutFDA/CentersOffices/OfficeofMedicalProductsandTobacco/CDER/ucm126391.htm

2the same drug. In such cases patients learn the efficacy of a drug through personal uses andexperiences; that is, as they keep using the drug, they continuously Baysian-update theirbeliefs in the efficacy of the drug. Thus, although all drugs, the brand-name and generics,
are equally efficacious on average, personal experiences determine the actual efficacy of the
drug for each patient. In such cases, the brand-name drug is distinguishable from generics
in that patients have used the former long before the generics are introduced. That is, thebrand-name drug enjoys a customer base at the time of generic entry.
In this paper, I place the customer base at center stage of my analysis and analyze
its implications using the notion of switching costs popularized by a series of papers byKlemperer(Klemperer, 1987). More specifically, I first build an analytical model, which
predicts that the brand-name drug company launches an authorized generic when consumers
have sufficiently low switching costs to the generic. I then develop an econometric model totest this hypothesis and find strong empirical support for it.
My analytical model has two periods and two firms; the brand-name drug company andthe generic drug company. In the first period the brand-name drug company markets its
patented drug as a monopoly. In the second period, patent expiration allows the genericdrug producer to enter the market and engage in Cournot competition with the incumbent.
The Cournot assumption simplifies the analysis by eschewing mixed-strategy equilibria. As
explicated above, customers who bought the brand-name drug in the first period have developed affinities towards it, thereby forming the customer base for the incumbent. I assume
that the brand-name company can influence the size of its customer base but cannot a↵ect
the switching cost per se, which comes to patients through experiences. In other words, I
treat the switching cost as a key parameter of this model.
I next extend the model to allow the brand-name company to launch an authorized genericin period 2. As is the case, it is assumed that the authorized drug is marketed by a third
party, which competes as an autonomous entity. Consumers regard all three drugs (brandname, generic and authorized generic) as homogeneous. However, consumers constituting3

the customer base incur the switching cost when switch to either kind of generics. Finally,
I assume that there are more than one firm which want to market the authorized generic sothat the brand-name drug manufacturer can make a take-it-or-leave-it o↵er to capture all
the profit from AG sales.
A comparison of the two versions of the model yields the key result that answers the
puzzle with which this paper began: a brand-name drug manufacturer is more likely tolaunch an authorized generic, the smaller the switching cost from its brand-name drug tothe generics. This result has the following intuitive explanation. In the standard Cournot
game, a launch of an AG has only the divisionalization e↵ect, which is profitable to thebrand-name drug company, as shown by Baye et al. (1996). However, in the presence ofthe customer base, a launch of an AG lowers the generic prices and lures consumers fromthe customer base to the generics. I call this potential erosion to the customer base thecannibalization e↵ect. In short, then, a decision whether to launch an AG hinges on thebalance between the divisionalization e↵ect which is beneficial to the brand-name drug, andthe cannibalization e↵ect, which is harmful to the firm.
When the switching cost is sufficiently high, consumers do not switch so easily, so theincumbent can build a larger customer base to better position itself against generic entry.
With a large customer base, however, a price decrease due to a launch of an AG results in alarge revenue loss; that is, there is a large cannibalization e↵ect. Therefore, the brand-namedrug company prefers to defend the customer base instead of launching an AG to attract
new customers. Even if the switching cost is somewhat smaller so that some consumer baseerosion is inevitable, the brand-name drug company may still refrain from launching an
AG to avoid further customer base erosion. In contrast, if the switching cost is sufficiently
small, the incumbent is unable to defend the customer base that is erodible and subject todefection. However, the small switching cost also implies a significantly weak cannibalizatione↵ect relative to the divisionalization e↵ect, so the brand-name drug company launches an
AG. Thus, my model answers the puzzle with which began this paper: an AG is more likely to4

be launched when the switching cost from the brand-name drug to the generics is sufficiently
low.
In the second half of this paper I empirically test the above hypothesis using the datacollected from the FDA website. In doing so it is of utmost importance to specify what
constitutes the switching costs in the present context. To that end, note that most drugs do
not miraculously cure fatal illnesses. Rather, they reduce probabilities of death by relieving
symptoms such as pain or anxiety or by altering clinical measurements - reducing cholesterolor blood pressure, for example. The point is that the true efficacy of drugs is difficult toascertain even for scientists.2 In a word, drugs are, to a certain extent, credence goods. As
such, consumers tend to rely on personal experiences to gain confidence in the drugs theytake. Such confidence - or aversion to alternative drugs - grows if they use the same drugs
repeatedly. In this respect, brand-name drug manufacturers have the first-mover advantage
over generic entrants because consumers have been using the brand-name drugs before thegenerics enter. This confidence in the brand-name drugs consumers have developed serves as
the switching cost, i.e., the benefit a consumer must give up when switching to the generics.
When generics become available, the longer a brand-name drug have marketed, the more
confidence in its efficacy the consumers have gained through repeated uses. which means thehigher switching cost they would like to pay to switch to a generic. Therefore, the length oftime that a brand-name drug has been marketed before generics can be used as a proxy forthe consumers’ switching cost.
I now relate my work to the literature. There is a literature that examines the e↵ects of
AGs on non-authorized generic entry. For example, FTC’s 2009 report shows that launchof an AG lowers generic prices and revenues, and it goes on to speculate that threats of
AGs may even prompt a collusive agreement between the generic and the brand-name drug
manufacturer, delivering a double whammy to consumers in the form of deferment of generic2

According to FDA’s special report, From Test Tube to Patient : Improving Health Through Human
Drugs.

5

entry and non-marketing of AGs.3 Rei↵en and Ward (2005) finds a similar result; launch of
an AG reduces the number of potential generic entrants in the future. In contrast, however,Berndt et al. (2007) show that despite reduced expected gains due to launch of an AG ,there remain sufficient incentives for generic entry. Studying German data, Appelt (2010)
even goes further to claim that introduction of AGs has no e↵ect on the number of genericentrants, and concludes that entry deterrence is not a rationale for launching of AGs. Chen
(2007) examines the legal issues arising from AGs, and calls for a legislative reform of the
Hatch-Waxman Act.
In contrast to all these papers focusing on the e↵ects of AGs on generic entry, the literature examining the incentives to launch AGs is rather scanty. My paper is an attempt to fillthis lacuna in the literature. Further, my analysis can shed light on some recent empiricalfindings. For example, Appelt (2010) empirically identifies earning generic profits as theprimary motive for launch of AGs. This can be interpreted as the divisionalization e↵ect.
My analysis may also be useful in explaining the empirical finding of Berndt et al. (2007)
that the brand name drugs with higher pre-generic revenues are more likely to have AGs. I
can show using my model that, for a given switching cost, the incumbent is more likely tolaunch an AG if the market is larger. The intuition is that an increase in demand (intercept)
expands the divisionalization e↵ect relative to the cannibalization e↵ect; that is, it raises the
combined profit from the brand-name drug and the AG by a greater magnitude than the
profit from brand-name drug sale alone. Thus, if the pre-generic revenues are interpreted
as a proxy of the market size, my model provides an explanation for the empirical result ofBerndt et al. (2007).
The remainder of this paper is organized in 5 sections. Section 2 presents a two-period
model of Cournot oligopoly, in which launch of an AG is ruled out. Section 3 extends theabove model to allow for launch of an AG through a third party. Section 4 I compares
the two models and shows that launch of an AG is profitable to the incumbent only when3

Authorized Generics:
An Interim Report of the Federal Trade Commission,
http://www.ftc.gov/reports/authorized-generics-interim-report-federal-trade-commission

6

2009.

the switching cost is sufficiently small. Section 5 presents an empirical model to test the
hypothesis and discuss my empirical findings. Section 6 concludes the paper.

2Competition Without Authorized Generics
This section presents the basic two-period model, where launching an AG is not an

option. The model has the following structure. In period 1 the incumbent is a monopolythat produces the patented brand-name drug. The patent expires at the end of period 1,
allowing for generic entry. I assume that in period 2 the incumbent and the entrant engage
in Cournot competition. On the demand side there is a fixed measure of consumers wholive two periods. They buy at most a unit of the branded drug in period 1. Consumers’
demands vary, giving rise to a negatively-sloping demand curve, which I assume is linear
and is written p = m

Q, where m is demand intercept and Q is quantity demanded. Let

B denote the number of customers who actually bought the brand name drug in period 1.
These consumers like the branded rug and are willing to pay the premium s > 0 over thegeneric. I assume s to be exogenous and let it serve as a measure of the switching cost.
In period 2, the two firms play a Cournot game and consumers buy at most one unit ofeither the brand name dug or the generic. I assume that consumers regard the two drugs ashomogeneous. Thus, I can write the demand function facing the generic firm as p = m g b,
where g and b denote the quantities of output set by the brand name company and the genericcompany, respectively. As for the incumbent, thanks to the premium-paying customer baseB, it faces the two-part demand:p2 (b) =8>><m + s
>
>
:m

b

b

g

g

if b  B
if b > B

which is discontinuous at output b = B. This shows that, if the incumbent serves its customer
base only, it can keep the price above the generic price due to the switching cost (s), but if7

wants to attract new customers, then it has to lower the price to match the generic price.
To keep things simple, I further assume identical unit costs of production across firms andset it equal to zero, which is without loss of generality under linear demands. With theseassumptions, the generic firm’s profit is written ⇡g = (mbg)g. As for the incumbent,

the demand function derived above implies the following profit function, depending on thevalue of B; Therefore, the incumbent’s profit is also discontinuous at b = B and given by

⇡b =

8
>
>
>
(m + s>>><(m + s
>
>
>
>
>
>
:(m b

b

g)b

if b < BBg)B

if b = Bg)b

if b > B

Note that the profit function is discontinuous at b = B.In Figure 1 the curve to the left ofpoint B displays the profit from the customer base only⇡(b, s, g) = (m + s

b

g)b,

while the one to the right of B corresponds to the profit⇡(b, g) = (m

b

g)b.

Now I solve the model for subgame-perfect Nash equilibrium. Beginning with the second
period competition, maximizing the generic firm’s profit above yields the familiar bestresponse function g(b) = (mb)/2. To obtain the incumbent’s best-response function,

define the key quantities: b̄(g) = arg max (m + sbg)b and b(g) = arg max (m

b

g)b,

and write the corresponding maximum profits as ⇡¯ (b̄, s, g) and ⇡(b, g). Define next thequantity b̂(g) implicitly by⇡(b̂, s, g) = (m + s

8b̂g) = ⇡(b, g).

It is obvious that for given gb̂(g) < b(g) < b̄(g).
In the linear case we have,b̄(g) = (m + sb(g) = (m

g)/2

g)/2

b̂(g) = (m + sgps(2m + s2g))/2

Now, as g increases, the profit functions ⇡(b, s) and ⇡(b) shift down, giving rise to thefollowing three cases, depending on the location of point B.
Case 1: g is relatively small such that B  b̂(g). Then b(g) is the incumbent’s best response
to gCase 2: g takes on an intermediate value so that b̂(g) < B < b(g) . Then the incumbent’s
best response is B.
Case 3: g is large so that b̄(g)B. In this case its best response is b̄(g).

These three cases are displayed in Figures 1 - 3.

Figure 1: g is relatively small so that B  b̂(g)9Figure 2: g is intermediate so that b̂(g) < B < b̄(g)Figure 3: g is large so that b̄(g)  B
Accordingly, the incumbent’s best-respond function has three segmentsb(g) =

8
>
>
>
(m
>
>
>
<

g)/2

B
>
>
>
>
>
>
:(m + sif g  m

2B

p
2 sB,

if g 2 (m2Bp
2 sB, mg)/2 if gm

2B + s),2B + s.

Figure 4 depicts the incumbent’s best-response function. Note that it is discontinuous atp
g = m 2B 2 sB. Accordingly, we can write the incumbent’s equilibrium second-period10Figure 4: The incumbent’s best-response function

profit as

8
>
>
>
m2 /9
if B 2 (0, B̂2 ]>>><⇡b = (m B + 2s)B/2 if B 2 (B̂1 , (m + 2s)/3)
>
>
>
>
>
>
:(m + 2s)2 /9
if B 2 [(m + 2s)/3, 1)
p2

where B̂1 ⌘ 3m+8s 49 4s +3ms and B̂2 ⌘ 2m+3sp

9s2 +12ms.
6

Since B̂1 < B̂2 , if B 2 [B̂1 , B̂2 ],there are two equilibria, one on the vertical segment of the best response function, the otheron the lower segment of it. There is apparently the equilibrium selection issue; however, insearch of the subgame-perfect equilibrium I focus on the one that yields the greater total
profit to the incumbent.
Having computed the equilibrium profits in period 1, I am ready to move to period 1, in
which the incumbent chooses output B to maximize the sum of profits in both periods (weignore discounting):

⇡b =

8
>
>
>
m2 /9
>
>
>
<

if B 2 (0, B̂2 ](m B + 2s)B/2 if B 2 (B̂1 , (m + 2s)/3)
>
>
>
>
>
>
:(m + 2s)2 /9
if B 2 [(m + 2s)/3, m)
11

2.1

Local maxima

Since the total profit function is not continuous, I first derive the optimal B in each caseand then determine the global optimum.
Case 1: B 2 (0, B̂2 ]In this case, B has no e↵ect on the incumbent’s period 2 profit. The unconstrained
optimum occurs at B = m/2. As B̂2 < m/2, the constraint on B is binding. Therefore,
the optimal B is B̂2 , and the maximum profit is ⇧(B̂2 ).
Case 2: B 2 (B̂, (m + 2s)/3)
The unconstrained optimum occurs at B2 = 3m+2s, which is greater than B̂1 . If
6s > m/2, then B2 < (m + 2s)/3, and hence B2 is the interior solution, with the
maximum profit ⇧( 3m+2s); On the other hand, if s  m/2, B2 exceeds the upper limit
6of the range of B so there is no optimum (B = (m + 2s)/3 is the supremum).
Case 3: B 2 [(m + 2s)/3, m)
The unconstrained optimum occurs at B3 = m2 . To find out if B3 is an interior solution,
I compare B3 with the lower bound, m+2s
. If s  m/4, B3
3(m+2s)/3, and so B3 is theinterior solution, with the maximum profit ⇧(m/2). If s > m/4, B3 < (m + 2s)/3, andtherefore B3 is not an interior solution. Therefore, the maximum profit is ⇧((m+2s)/3).
The next lemma summarizes the main findings:
Lemma 1
1. When B 2 (0, B̂2 ], the local maxima is ⇧(B̂2 ).
2. When B 2 [B̂1 ,m + 2s), the local maximum is ⇧( 3m+2s) if s > m/2; otherwise, there
6
3

is no maximum.
3. When B 2 [ m+2s
, m), the local maximum is ⇧(m/2) if s  m/4, or ⇧((m + 2s)/3)3otherwise.
12

2.2

Global maxima

So far we identified the local maxima in the three disjoint intervals of the incumbent’s
feasible set. We now turn to the global maxima for the incumbent.
m
1. If s  , the local maxima are ⇧(B̂2 ) and ⇧(m/2). Computation shows that ⇧(B̂2 ) <4mm
m + 2s⇧( ), so the global optimum occurs at B =and b =. The incumbent’s
223mequilibrium total profit is ⇧( ).
2m m
2. If s 2 ( , ], the local maxima are ⇧(B̂2 ) and ⇧((m+2s)/3). A calculation establishes
4 2
m + 2sm + 2sthat ⇧(B̂2 ) < ⇧(). So the global maximum occurs at B =and b =
3
3
m + 2sm + 2s. The equilibrium total profit is ⇧().
33m
3. If s 2 ( , m), the local maxima are ⇧(B̂2 ), ⇧( 3m+2s) and ⇧((m+2s)/3). Computation
62
3m + 2sshows that ⇧() exceeds the other two. Hence, the equilibrium outputs are
6
3m + 2s
3m + 2s
3m + 2sB=
and b =
, and its total profit is ⇧().
66
6These results are summarized in
Proposition 1 The equilibrium customer base is given by

B=

8
>
>
>
m/2
>
>
>
<

s 2 (0, m/4],(m + 2s)/3
>
>
>
>
>
>
:(3m + 2s)/6s 2 (m/4, m/2],s 2 (m/2, m).

The following results are immediate consequences of Proposition 1
Proposition 2(A) when s 2 (0, m/4] , the brand-name firm sells less than its customer base in the second
period;13

(B) when s 2 (m/4, m) , the brand-name firm holds on to its customer base in the second
period;From Proposition 2, we can see that the brand-name drug is never sold to new customers
in the second period. This implies that those who bought the brand-name drug in the first
period are willing to pay the premium over the generic, which reflects the switching cost.
This is consistent with the fact that in the real world the brand-name drugs are always priced
higher than their generic counterparts.

3

Competition with the authorized genericIn this section we allow the incumbent to launch an AG through a third party in period

2. The firm distributing the AG is autonomous and competes fully with the brand-namedrug company and the generic firm. I assume that the incumbent makes a take-it-or-leave-ito↵er to the management of the AG firm and receives all the profit from AG sales through acontractual agreement with the AG supplier. This increases the total profit in the standard
Cournot model and is called the divisionalization e↵ect as noted earlier.
The model is similar to the one developed in the preceding section. In the first period
the incumbent chooses the quantity B. In the second period, it competes now with twogeneric firms. Let a denote the quantity of the authorized generic supplied, and b and g
the quantities of the brand-name drug and the generic drug supplied in the second period,
respectively. With this notation the brand-name company faces the inverse demand function:

p2 =

8
>
>
<m + s
>
>
:m

b

b

a

a

g

14

g

(b  B),(b > B).

Note that the demand function is discontinuous at output b = B. Therefore, the incumbent’s
profit is also discontinuous at b = B:

⇡b =

8
>
>
>
(m + s>>><(m + s
>
>
>
>
>
>
:(m b

b

a

g)b

(b < B),

B

a

g)B

(b = B),ag)b(b > B).

The incumbent’s best response function can be written asb(a, g) =

8
>
m
>
>
>
>
>
<

a
2

B
>
>
>
>
>
>
:m + sgag2

a+g m

2B

p
2 sB,

a + g 2 (m2Bp
2 sB, ma+g

2B + s.

m

2B + s),Without the customer base, the generic faces the demand

and maximizes the profit ⇡g = (mp2 = mbbg)g. The best response function is given byag(b, a) =

m

a

b
2

g

a

Similarly, the authorized generic faces the symmetric demand

and maximizes the profit ⇡a = (mp2 = mbbg)a, obtaining the best responseaa(b, g) =

m

15

a

b
2

g

g

As in the previous case without the AG, the incumbent has three distinct best-response
functions, depending on B, and hence there are three possible equilibria. Below I calculate,the incumbent’s equilibrium profits for each possibility.

⇡b =

8
>
>
m2
>
>
16
>
>
<

B 2 (0, B̃2 ],B(m B+3s)

3
>
>
>
>
>
> (m+3s)2:B 2 [B̃1 , m+3s),
4
B 2 [ m+3s
, m).
4

16

⇣

⌘

p

Calculation shows that if 1/8 2m + 9s 3 s(4m + 9s)

B

⇣
⌘
p
1/4 m + 2s 2 s(m + s) , there are two equilibria, one is (B, 1/3(m B), 1/3(m B)),⇣⌘p
the other is (m/4, m/4, m/4).
Let B̃1 ⌘ 1/8 2m + 9s 3 s(4m + 9s) and⇣⌘p
B̃2 ⌘ 1/4 m + 2s 2 s(m + s) .
With the AG the equilibrium profits for the authorized drug manufacturer are:

⇡a =

8
>
>
m2
>
>
16
>
>
<

B 2 (0, B̃2 ],(m B)2B 2 [B̃1 , m+3s
),
4

9
>
>
>
>
>
2
>
: (m s)B 2 [ m+3s
, m).
4

16

In the first period, the brand-name firm’s profit is (mB)B so the incumbent’s total

profits (including the profit for AG sales) are:
8
>
>
>
(m
>
>
>
<
⇧AG = (m
>
>
>
>
>
>
:(m

2

B)B + m8

B 2 (0, B̃2 ],B)B + B(m 3B+3s) + (m 9B)
2B)B + (m16s) + (m+3s)
16

2

2

B 2 [B̃1 , m+3s),
4
B 2 [ m+3s
, m).
4

The incumbent chooses B to maximize ⇧AG . I consider the three cases seriatim.
Case 1: B 2 (0, B̃2 ]In this case, since the choice of B will not a↵ect the incumbent’s profit in the second
16period, the unconstrained optimum is B = m/2. However, since m/2 > B̃2 , the constraint on B is binding. Hence, B̃2 maximizes the total profit, yielding the maximized
profit ⇧AG (B̃2 ).
Case 2: B 2 [B̃1 , m+3s)
4
In this case the unconstrained optimum is B2 = 10m+9s> B̃1 . Further, if s  3m,
22
5
B2 exceeds the upper bound on B and hence there is no optimum (the supremum is
B = (m + 3s)/4. If s > 3m
, B2 < m+3s
, and hence the incumbent choose B2 , with the
54
maximum profit ⇧AG ( 10m+9s).
22Case 3: B 2 [ m+3s
, m)
4
In this case the unconstrained optimum is B = m2 . However, m/2(m + 3s)/4 ifmand only if s  m/3. Hence, when s  , the constraint is not binding, and the3mmaximized profit is ⇧AG ( 2 ); otherwise, the constraint is binding and the maximized
profit is ⇧AG ( m+3s
).
4

3.1

Global Maxima

The results from the preceding section are the following:
1. When B 2 (0, B̃2 ], the local maximum equals ⇧AG (B̃2 ).
2. When B 2 [B̃1 ,m + 3s
10m + 9s), there is a local maximum, ⇧AG (), if s > 3m/5.
422

3. When B 2 [ m+3s
, m), there is a local maximum, ⇧AG ( m2 ), if s  m3 ; there is a local
4mmaximum, ⇧AG ( m+3s), if s 2 ( , m).
4
3
As we can see, the local maxima depend on the switching cost, and hence so does theglobal maximum. I compute the following:m, the local maxima are ⇧AG (B̃2 ) and ⇧AG ( m2 ). Computation shows that
3m
⇧AG ( 2 ) > ⇧AG (B̃2 ), so the global optimum occurs at B = m2 and b = m+3s
. The
3

1. When s incumbent’s equilibrium total profit is ⇧AG ( m2 ).
17

2. When s 2 ( m3 , 3m], the incumbent will compare ⇧AG (B̃2 ) and ⇧AG ( m+3s). A calculation
5
4
shows that ⇧AG ((m + 3s)/4) > ⇧AG (B̃2 ), so the global maximum occurs at B = m+3s
4and b = m+3s
. The equilibrium total profit is ⇧AG ( m+3s
).
4
4
3m
, m], the incumbent will compare ⇧AG (B̃2 ), ⇧AG ( 10m+9s
) and
22
5
⇧AG ( m+3s). A calculation shows that ⇧AG ( 10m+9s) is greater than the other two.
422

3. When s 2 (Hence, the equilibrium outputs are B = 10m+9s
and b = 10m+9s, and the total profit is22
22⇧AG ( 10m+9s).
22
Proposition 3 If the incumbent launches an AG, the equilibrium customer base is given byB=

4Comparisons

8
>
>
>
m/2
>
>
>
<

s 2 (0, m/3],(m + 3s)/4
>
>
>
>
>
>
:(10m + 9s)/22

s 2 (m/3, 3m/5],
s 2 (3m/5, m).

In this section we compare the incumbent’s profit in two regimes at various values ofs. First, for s 2 (0, m4 ], the incumbent’s profit is ⇧( m2 ) without an AG and ⇧AG ( m2 ) with
an AG. Calculations show that when s 2 (0, 0.077m), ⇧( m2 ) < ⇧AG ( m2 ), meaning thatlaunching an AG will be more profitable for the incumbent. However, when s 2 [0.077m, m4 ],mm⇧( ) ⇧AG ( ), so launching a AG is less profitable.
2
2
m m
m
When s 2 ( , ], the incumbent’s profits are ⇧( m+2s
) without an AG, and ⇧AG ( )34 32
m + 2swith an AG. It can be shown that ⇧() is the greater and hence the incumbent will not3
launch AG if the switching cost is within this range. In all other values of s the incumbent
receives greater profits if it does not launch an AG. To conclude, the incumbent launches an
AG only when the switching cost is sufficiently small, namely, if s < 0.077m.
Proposition 4 The incumbent launches an AG only when s < 0.077m.

18This result contrasts sharply with the standard result from Cournot oligopoly. There, anoligopolist can increase total profits by setting up an autonomous company that competes
with the parent company; see Baye et al. (1996). This fact also lies at the heart of theso-called horizontal merger puzzle; see first formulated by Salant et al. (1983).
Proposition 4 leads to the following empirically testable hypothesis.
Hypothesis 1 The brand-name company is more likely to launch an AG when the switching
cost is relatively low.
In the next section we test this hypothesis.

5

Empirical investigations

5.1

Data

In this section we empirically test the hypotheses presented at the end of the preceding
section. To that end, I use the dataset I collected on all the brand-name drugs that haveexperienced generic penetration from the beginning of 2001 till the beginning of 2003.
This data set was constructed by combining information from three di↵erent resourceson the FDA website. The first resource is the First Generics list.4 First Generics are“those drug products that have never been approved before as generic drug products andare new generic products to the marketplace”. From this list, I obtained the information
about all the first generics approved from 2001 to 2003, including the generic names and thedates that they were approved for marketing. Then I used the name of the generics to findout the corresponding brand-name drugs in the Orange Book.5 The Orange Book lists all
the brand-name drugs and their generic counterparts, including the names, the dosage and4

http://www.fda.gov/Drugs/DevelopmentApprovalProcess/HowDrugsareDevelopedandApproved/
DrugandBiologicApprovalReports/ANDAGenericDrugApprovals/ucm050527.htm
The address may be subject to change.
5

http://www.accessdata.fda.gov/scripts/cder/ob/eclink.cfm

19dosage forms, and the marketing approval dates. After the corresponding brand-name drugs
are determined, I used the Authorized Generics List6 to find out if these brand-name drug
companies had ever launched authorized generics.
I conjecture that the switching cost from the brand-name drugs to the generics mainly
comes from two factors, “unwilling to switch” and “unable to switch”. “Unwillingness toswitch” to a generic means that a consumer feels a mental and psychological attachment tothe brand-name drug. I measure the degrees of consumer “attachment” by the length of time
during which there were no other drugs than the brand-name drugs on the markets, that is,
the length of time between the date a brand-name drug was approved and the date its first
generic was approved. As is mentioned in the introduction, drugs are credence goods. It
takes time for consumers to develop affinities to drugs. Drugs for acute conditions may have
immediate curing e↵ects. However, the same conditions often recur over time, requiring theconsumer to take the same drug (since the brand-name drug is the only drug available ofits kind before generic entry) repeatedly. Each additional use can make the consumer feel
more confident about the the drug’s efficacy. Similarly, for chronic illnesses, a longer-term
continual use of a brand-name drug may give a consumer a better understanding of its e↵ects
on her health. As these cases imply, the longer the brand-name drug has been marketed,the greater the degree of confidence a consumer has in its efficacy. As a consequence, thelength of time the brand-name drug has been marketed can serve as a proxy for the consumer
switching costs.
Unfortunately, however, the time before generic entry cannot be used to measure the“mental and psychological attachment” to OTC drugs, which are previous prescription drugs
that have been made available over the counter after long marketing periods with establishedsafety records. From the pre-generic marketing time, we only know how long the OTC version
had been on the market before the first generic OTC enters. We do not know, however, how
6

http://www.fda.gov/AboutFDA/CentersOffices/OfficeofMedicalProductsandTobacco/CDER/
ucm126391.htm
The address may be subject to change.

20

long the prescription version had existed on the market, at home or abroad, before the OTC
version first appeared. For this reason, my data set comprises only the data for prescription
drugs.
The other factor defining a consumer switching cost is the consumer’s “inability toswitch”. Inability to switch means that a consumer has limited freedom to choose amongdi↵erent versions (the brand-name version or the generic substitutes) of the drug. I consider
that all the drugs fall into two categories: “Hospital Use” and “Home use”. “Hospital Use”
drugs are used administered in hospitals, mainly provided by caregivers, during surgery or
medical tests. On the other hand, “Home Use” drugs are those patients administer themselves at home, for example, tablets to be taken orally, and cream to be applied on the skin.
Usually patients who take “Hospital Use” drugs face less choice. First, those who receive
hospital treatments are more likely to be in emergency, and therefore take whatever drugs
they are given. Second, their choices are limited by the hospital’s pharmacy: it is possiblethat the hospital does not carry the drugs they want to switch to. Third, treatments provided by a caregiver usually involve fairly complex procedures and hence, given the limited
knowledge, patients are more likely to leave the choice of drugs up to their doctors. In
contrast, patients who take “Home Use” drugs have more options. With prescriptions, they
can go to pharmacies they like best or even to online pharmacies, and can choose between
the brand-name drug and the generic substitute. For this reason, “Home Use” drugs shouldhave lower switching costs relative to “Hospital Use” drugs.
To decide which drugs are for “Hospital Use” and which are for “Home Use” is not aneasy task, however. To do that, I looked up each drug online to determine its uses, and I thenused the following criteria for classifications. Drugs used in surgery, or for other treatments
mainly practiced by caregivers, injection, for example, are considered “Hospital Use” drugs;
otherwise they are considered for “Home Use”. For example, Ultane (inhalation liquid)
is an anesthesia used before surgery. Therefore it is classified as a “Hospital Use” drug.
Similarly, Rimso-50 (intraversical solution) is used for bladder instillation, which I classify

21

as a “Hospital Use” drug, though some patients might practice bladder instillation at home.
Sometimes, the “dosage forms” can be useful to determine drugs’ uses. For example, Amicar
is used to control bleeding during or after a surgery. While Amicar Injection is grouped
as “Hospital Use”, Amicar Tablet is grouped as “Home Use”. Compared to injections,tablets are taken orally and require a longer time before taking e↵ect, so they should not be
used to treat serious bleeding problems or used in emergencies, like during a surgery. The
instruction of Amicar Tablets further implies that they should only be used to treat mild
bleeding problems after a surgery, like dental surgery, which can be practiced by patients on
their own in a less urgent situation.7
Table 1 below summaries the characteristics of the three variables in my dataset.
ag
inpmono month

Count
202
202
202

Mean
.282
.198
141.018

s.d.
.451
.399
70.564Min0021.767Max
1
1
256.433

Table 1: Summary results
The dataset has 202 observations. ag, a dummy variable, denotes brand-name firm’s
decision on launching AG, 1 for “launch”, 0 for “not launch”. The mean of ag is 0.282,
showing that out of the 202 brand-name drugs about 28.2% has launched AG. “inp”, anotherdummy variable, 1 for “Hospital Use”, 0 for “Home Use”, denotes whether a drug is taken intreatments mainly practiced at hospital. This variable is intended to represent consumers’“easiness to switch”. The mean of “inp” shows that, out of the 202 drugs, 19.8% are mademainly for “Hospital Use”. “mono month”, measured in months, denotes the length ofbrand-name drug marketing periods before generic entry. This variable captures consumers’
unwillingness to switch (brand loyalty). The mean of mono month is about 12 years (1417“For the treatment of acute bleeding syndromes due to elevated fibrinolytic activity, it is suggested that 5
AMICAR 1000 mg Tablets or 10 AMICAR 500 mg Tablets (5 g) or 4 teaspoonfuls of AMICAR Oral Solution(5 g) be administered during the first hour of treatment, followed by a continuing rate of 1 AMICAR 1000
mg Tablet or 2 AMICAR 500 mg Tablets (1 g) or 1 teaspoonful of AMICAR Oral Solution (1.25 g) per hour.
This method of treatment would ordinarily be continued for about 8 hours or until the bleeding situation
has been controlled.” https://dailymed.nlm.nih.gov/dailymed/archives/fdaDrugInfo.cfm?archiveid=5242

22

months), which is consistent with the fact that the average brand-name marketing time before
generic entry is 12 to 13 years.8 The row of mono month suggests substantial variations in
the length of pre-generic marketing time across di↵erent brand-name drugs.

5.2

Methodology

I assume whether or not a brand-name company launches an authorized generic is related
to the switching cost its consumers has to pay to switch to a new drug. I treat the decision
to launch an authorized generic as a binary variable, Yi , which equals 1 if brand-name drug
i launches an authorized generic, and 0 if it does not. A probit model is built to analyze
the determinants of such decisions. The probability of launching an authorized generic isdefined as:
Pr(Yi = 1 | Xi , "i ) = (Xi + "i )where Xi , a vector of regressors, contains observed factors that explain the decision of launching authorized generics, while "i , with " ⇠ N (0, 1), is an error term, which captures the e↵ectof unobserved factors on such decisions, andis a vector of coefficients to be estimated.

is the CDF of the standard normal distribution.

5.3

Results

In my probit regressions, the dependent variable, “ag”, is 1 whenever an authorized generic is launched for brand-name drug i.

The independent variables are “ln-mono month” (log-linearized “mono month”) and “inp”. As I have mentioned in section
5.1, “mono month”, denoting the length of pre-generic marketing period of brand-namedrug i, is a continuous variable, and hence so is its log-linearized version “lnmono month”.
“inp” is a dummy variable, which equals 1 when drug i is made mainly for “Hospital Use”
and 0 otherwise. Table 2 shows the regression results:
8

According to the New Medicine Timeline in Mossingho↵ (1999).

23

ag
inp
lnmono month

Coefficient
-.769
-.341

Std. Err.
.293
.139

P >z
.007
.015

Table 2: Estimation results : regress
The coefficient of the variable “inp” is negative, which means that, if a drug is mademainly for ?Hospital Use?, the brand-name company would be less likely to launch an authorized generic. The coefficient of the variable “lnmono month” is negative, implying that,
if a brand-name drug has a longer pre-generic marketing period, the brand-name company
would be less likely to launch an authorized generic. The results are significant as thep-values are less than the cutting value 0.05.
A brand-name drug company launches an authorized generic at a lower price to to attract
consumers who would not buy brand-name drugs. For “Hospital Use” drugs, consumers do
not have much freedom to choose as their choices are usually made by the doctors. It isreasonable to assume that doctors are relatively less sensitive to price changes than patients.
Therefore for hospital-use drugs, brand-name firms are more likely to influence the doctors
to stay with their brand-name drugs instead of lowering prices to compete with generics.
In contrast, for “Home Use” drugs, consumers have more freedom to choose from, andtherefore the strategy to launch an AG is more important in competition with generics.
However, launching an AG leads erodes the brand-name drug’s customer base as a lower pricetempts some customers in the base to switch to the generics. This dilemma can be resolved
if the brand-name companies can figure out how much more the higher-end customers would
like to pay for the brand-name drugs. The results of my test show that the length of the
pre-generic marketing periods of the brand-name drugs may serve as a good proxy for the“how much more”. If consumers have longer experiences with the brand-name drugs, theywould value them considerably more (than generic substitutes). In this situation, the brandname firm might find it more profitable to exploit the higher end customers, and hence isless likely to launch an AG. In contrast, if consumers have relatively short experiences withthe brand name drug, they would not value the brand-name drugs as much (more than the24generic substitutes), and hence a brand-name firm is more likely to launch an AG to compete
for the lower-end customers with the generic firm.

6Concluding remarks
When there is generic competition the brand-name company sometimes (but not always)

launches an generic version of its brand-name drug, called an authorized generic, througha third party. Launch of an AG is justifiable in terms of “divisionalization” but then AGs
should be launched virtually for all brand-name drugs that come o↵ the patent. In actual
fact, however, only a small percentage of such drugs have the AGs. In this paper I address
this puzzle. To that end, I develop a two-period model in which the incumbent develops acustomer base as a monopoly in the first period and readies itself for generic competition in
the second period.
My main finding is that a brand-name company launches an authorized generic only whenusers of the branded drug have sufficiently low switching cost. When the switching cost is
high, the incumbent sells more than the the profit-maximizing quantity to develop a larger
customer base. If the switching cost is low, however, the customer bases is more vulnerable
to price competition and hence instead of building a large customer base and defending it,
the brand-name company launches an AG and resorts to the divisionalization tactic to steal
lower end customers from the generic entrant. To test my main finding econometrically I
then build a probit model. The regression result gives significant support for my hypothesis.

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