Innovation-and-Learning-Adjusted Price Indexes for Prescription Drugs

Abstract

In general, prescription drugs have an unobservable quality prior to consumption, which is called an 'experience characteristic'. Consumers learn these experience characteristics from both consumption experience and advertising exposure. Based on the Bayesian learning process of experience characteristics and the characteristics approach to demand functions, this paper proposes innovation-and-learning-adjusted price indexes for prescription drugs. This structural approach not only resolves the quality adjustment of new molecules but also avoids arbitrary assumptions on the link-in of generic drugs to the originator branded drug. The suggested price indexes are applied to the data for antidepressant drugs during the years 1980-1995. We have found; (i) the average annual growth rate of the focal price index is about -9.5%, which suggests that the existing price indexes for prescription drugs may seriously overstate the rate of inflation in arapidly growing market with the entry of innovative products; and (ii) consumers' learning about experience characteristics were substantial especially after active generic entry in 1986 and the entry of Prozac in 1988.