Competition in the pharmaceutical industry: how do quality differences shape advertising strategies?

We present a Hotelling model of price and advertising competition between prescription drugs that differ in quality/side effects. Advertising results in the endogenous formation of two consumer groups: brand loyal and non-brand loyal ones. We show that advertising strategies are strategic substitutes, with the better quality drugs being the ones that are most advertised. This positive association stems from the higher rents that firms can extract from consumers whose brand loyalty is endogenously determined by promotional effort. The model's principal hypotheses on advertising and pricing strategies are taken to the data. The latter consists of product level data on price and quantities, product level advertising data as well as the qualitative information on drug quality contained in the Orange Book compiled by the Food and Drug Administration (FDA). The empirical results provide strong support to the model's predictions.