Market size and strategic interaction in pharmaceutical price regulation

We present a model of optimal regulation in the presence of spillover effects and asymmetric countries, and we use it to study strategic interaction among countries in pharmaceutical price regulation, where the spillovers result from innovation in drug development. Regulators' pricing decisions affect welfare both directly and indirectly, via firms' R&D policies. We characterize two types of equilibrium, depending on whether countries price at, or above, the minimum level the industry is willing to accept to serve the market. The combination of these two equilibria may imply a U‐shaped relationship between countries' pharmaceutical prices and relative market size. Using data for 83 cancer drugs across 23 OECD countries, our empirical analysis supports this hypothesis, with results being robust to correcting for the impact of confidential price discounts and a range of different model specifications. Our findings contribute to the academic debate about the relationship between prices and market size, as well as the policy debate about using supranational procurement policies to lower prices. In particular, we show that joint procurement can lower or raise prices according to the sizes of the domestic markets that join to create a single purchasing authority.