Abstract

This paper builds upon prior work on vertical interactions in the drug supply chain in the United States. There is limited research to date seeking to model these vertical relationships, particularly in the presence of generic substitute availability. We begin with a model based on Conti et al. (2021), where two branded drug manufacturers compete for preferred formulary placement by offering rebates to a monopolist pharmacy benefit manager (PBM), and add a generic drug whose price is non-negotiable. Additionally, we allow for consumer heterogeneity in terms of willingness to sacrifice perceived quality in exchange for cost savings when deciding between a branded or generic drug. We show that an equilibrium exists whereby the PBM sets the copayment for the generic drug higher than that of the preferred brand in exchange for higher rebates and examine how the incentives produced by the formulary contest may lead PBMs to discourage generic uptake.