Abstract
To control Medicaid's increasing expenditure on reimbursement of outpatient prescription drugs, the Omnibus Budget Reconciliation Act of 1990 included a rebate program that featured a most favored customer (MFC) clause. This clause guarantees that Medicaid pays the minimum price o¤ered in the market (minimum price provisioning or MPP) or a proportion of the average manufacturer price (average price provisioning or APP). We characterize the optimal pricing strategy of a third-degree price discriminating monopolist in response to the imposition of MPP or APP rules. Among our findings are conditions under which these rules result in higher prices charged in all markets. We also examine the e¤ects of these rules on aggregate demand for the drug and on social welfare. In general, these rules may change aggregate demand and social welfare in either direction. We are able to provide some useful su¢ cient conditions. For example, imposing MPP increases social welfare if it results in higher aggregate demand.