Working Paper: CEPR ID: DP8076
Authors: Maria Angeles De Frutos; Carmine Ornaghi; Georges Siotis
Abstract: We present a Hotelling model of price and advertising competition between prescription drugs that differ in quality/side e¤ects. Advertising results in the endogenous formation of two consumer groups: brand loyal and non-brand loyal ones. We show that advertising strategies are strategic substitutes, with the better quality drugs being the ones that are most advertised. This positive association stems from the higher rents that firms can extract from consumers whose brand loyalty is endogenously determined by promotional effort. The model's principal hypotheses on advertising and pricing strategies are taken to the data. The latter consists of product level data on price and quantities, product level advertising data as well as the qualitative information on drug quality contained in the Orange Book compiled by the Food and Drug Administration (FDA). The empirical results provide strong support to the model's predictions.
Keywords: advertising; market segmentation; pharmaceutical industry; product differentiation
JEL Codes: I11; L11; L13; L65; M37
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher quality drugs (L65) | Higher advertising expenditures (M37) |
| Higher advertising expenditures (M37) | Enhanced brand loyalty (M37) |
| Higher advertising expenditures (M37) | Higher prices (D49) |
| Higher quality drugs (L65) | Higher prices (D49) |
| Advertising expenditures of one firm (M37) | Decrease in advertising expenditures of rival firm (M37) |
| Advertising expenditures (M37) | Profits (D33) |
| Advertising (M38) | Investment in R&D for superior drug quality (O32) |