POPULATION CHARACTERISTICS AND PRICE DISPERSION IN THE MARKET FOR PRESCRIPTION DRUGS

I. INTRODUCTION Prescription drugs are almost ideal examples of homogeneous commodities. A patient can fill her prescription at any pharmacy she chooses and expect to obtain exactly the same medicine. A priori, therefore, it would seem that if any commodity obeyed the law of one price then a prescription drug would be that commodity. That is not the case. Using data from two townships in up-state New York, Sorensen (2000) provided compelling evidence that the prices of individual drugs varied substantially among pharmacies within each of the two communities. The extent of price dispersion differed among individual drugs in ways that were consistent with the predictions of models that explain price dispersion on the basis of costly consumer search. Price dispersion among homogeneous goods is not unique. Other studies have examined the determinants of price dispersion in the markets for gasoline (Adams 1997), water (Yoskowitz 2002), automobiles (Dahlby and West 1986; Goldberg and Verboven 2001), grocery products (Aalto-Setala 2003), mutual funds (Hortacsu and Syverson 2004), Internet and retail sales of books and CDs (Brynjolfsson and Smith 2000), and several different products (Pratt, Wise, and Zeckhauser 1979). They have also generally concluded that prices in those markets vary in ways that cannot be accounted for solely by heterogeneity in product attributes with respect to physical characteristics, space, time, or, in cross-country studies, government regulation. In addition, apparent violations of the law of one price have been observed in commodity markets for agricultural products and raw materials that are relatively homogeneous with respect to their physical characteristics (see. e.g., Goodwin, Grennes, and Wohlgenant 1990). However, Sorensen's study of pharmaceutical drugs is of particular interest because he examines prices in two clearly defined markets for commodities that are physically identical. He finds that search costs, measured by the frequency of drug purchases, affect the amount of price dispersion. Models of price dispersion based on costly search for information by consumers seem to provide plausible alternative explanations, especially as many prescription drugs are not widely used and their prices are not commonly known by buyers. As Sorensen observes, his empirical analysis of the effects of search costs is incomplete in at least one important respect. Sorensen's data were for only two geographically adjacent markets (less than 30 miles apart). Thus, he could not investigate the effects of characteristics of the communities being served by the pharmacies in those markets. In this article, we address the question, "who searches for the lowest drug prices?" Research by Talukdar (2008) and Morton, Zettelmeyer, and Silva-Risso (2003) show a link between consumer search characteristics and retail and Internet pricing. Thus, search characteristics for consumer groups may be very different across drug markets as well. For example, the proportions of the elderly and the poor in a population served by a market may affect the amount of search in that market because of differences in opportunity costs of time and expected benefits from search. We expand upon previous research to examine market characteristics that affect price dispersion among prescription drugs. Our analysis of consumer search characteristics is particularly relevant to the current policy debate concerning healthcare reform, changes to Medicare, and insurance coverage through the workplace. We examine price dispersion for pharmaceutical drugs in five geographically isolated markets in Montana using data obtained from a cross-section survey, administered by the authors on the pricing of 75 different drugs by individual pharmacies. The five markets are a minimum of 80 miles apart from one another and have distinctly different demographic and other socioeconomic characteristics. The new data set permits a more extensive evaluation of the effects of search and population characteristics on price dispersion. …