External reference pricing versus price controls under endogenous product quality
Abstract
Motivated by the high prices of branded/patented pharmaceuticals in many parts of the world, this paper analyzes price regulations in a two-country (home and foreign) model where a single home firm serves both markets and its R&D investment determines product quality. We study two types of price regulations: direct price controls (PCs) and external reference pricing (ERP) under which the price that the firm is permitted to charge locally depends upon its price abroad. We show that although ERP undermines R&D incentives, its implementation can raise home welfare. However, home’s optimal ERP policy is too restrictive from a joint welfare perspective. Furthermore, if the foreign market is subject to a PC, home prefers ERP to a PC due to strategic considerations that come into play due to the international price linkage created by ERP.