A Simple Model of Pharmaceutical Price Dynamics

Branded pharmaceutical firms use price and promotional strategy to manage public knowledge about their drugs. We propose a dynamic theory of pharmaceutical pricing and conduct an exploratory empirical analysis inspired by the theory. Our theory predicts a pattern of increasing prices and decreasing promotional activities over a drug’s life cycle. Prices are kept low and advertising levels high early in the life cycle in order to build public knowledge about the drug. As knowledge grows, prices rise and advertising falls. If the management of this stock is important enough, this tendency of prices to rise can overwhelm the price‐decreasing effect of entry by generic competitors late in the drug life cycle. We argue that our theory of price dynamics explains empirical regularities in this industry.