The effect of generic competition on prescription to over-the-counter switching

While it is generally accepted that the decision to switch a drug from the prescription market to the over-the-counter (OTC) market is based on an optimization problem that firms are solving, no attempts have been made to formalize the problem. The purpose of this article is to present a model of prescription to OTC switching that helps explain the role of potential generic competition in a firm's decision to switch. In particular, we examine what market conditions are necessary for the threat of generic competition to induce switching.

The model is game-theoretic, played between an incumbent firm and a potential generic entrant, and is solved for its subgame perfect equilibrium. The incumbent first decides whether to apply to the FDA to switch to the OTC market. If the incumbent declines, then the potential generic entrant has the opportunity to apply for the switch. The FDA then accepts or rejects the application, and the generic chooses whether to enter the market.

In equilibrium, when applying to switch is costless, switching occurs if the probability that the application will be approved by the FDA is strictly positive and the OTC market is characterized by first-mover advantages. Adding a cost to the application process places restrictions on the probability of FDA approval to offset the cost of applying. The probability of approval must be sufficiently high to offset the cost of the application.

The model shows that switching from the prescription to OTC market may occur as a response to potential generic competition. Firms switch because they know that if they do not, a generic may initiate a switch and become the first mover in the OTC market.