Dynamic Competition when Consumers Have Inertia: Evidence from Medicare Part D

When consumer choices have inertia, firms have incentives to use dynamic pricing by first reducing the price to build a large market share, and then by increasing prices. This strategy may reduce consumer welfare through increases in the prices for incumbents, while also changing the patterns of entry and exit in the market. Although the presence of inertia in health care markets has been well established, little is known about the welfare implications of dynamic pricing in these markets. In order to assess these implications, in this paper I develop and estimate a dynamic model of supply and demand for Medicare Part D prescription drug insurance plans, where multi-product firms consider consumer inertia in their decisions about premiums, offerings of new plans, and exit of plans. Using the model and the estimated parameters, I conduct counterfactual exercises where I explore the welfare effects of a policy that limits dynamic pricing by imposing fixed markups. I find that this policy, given the actual consumer inertia present in this market, would improve consumer welfare by 3.1%, through a reduction in premiums that is partially off-set by a reduction of entry into the market. When the same policy is implemented in a counterfactual scenario without inertia, it has a larger positive effect, increasing consumer welfare by 9.4% relative to the benchmark. This difference indicates that policies that limit dynamic pricing can be more effective in improving consumer welfare in markets with lower levels of consumer inertia, where they are less likely to harm market entry.