Our paper provides evidence for what we consider a surprising outcome: in the case of the new prescription drug program for Medicare enrollees, moving consumers from cash-paying status to membership in an insured group lowers optimal prices for branded prescription drugs below what they otherwise would be. This is surprising because the standard effect of insurance is to create inelastic demand and therefore elicit higher prices from a seller with market power (Duggan and Scott Morton 2006). However, the insurers that we study bundle insurance with a formulary and other mechanisms to create elastic demand. An individual consumer typically does not know which drugs are acceptable therapeutic substitutes; the consumer’s physician typically has poor knowledge of prices, especially negotiated prices; and any one consumer is too small a share of demand to negotiate with a pharmaceutical company. A prescription drug plan can potentially surmount all three hurdles.
Our evidence leads us to conclude that the formulary and other mechanisms perform the special role of allowing buyers to move market share among drugs with patent protection, thereby raising cross-price elasticities and lowering purchase prices (or reducing price increases) for branded drugs. This result contrasts with the common intuition that an uninsured consumer, paying at the margin for her own purchases, is the best tool with which to create competition in the market and impose pricing discipline on sellers. Certainly, this reasoning is at least part of the rationale behind many current policies in health care such as tax-free health care savings accounts (R. Glenn Hubbard, John F. Cogan, and Daniel P. Kessler 2005). Our evidence suggests that this picture is incomplete; for maximum effect, the consumer also needs to be part of a group that can substitute one provider for another.