Prescription drugs play an increasingly significant role in the Canadian healthcare system. Drug spending accounts for a considerable share of total healthcare expenditure and continues to be one of the fastest growing expenditure components in Canada. But, drug manufacturers’ price setting behaviours are not well understood in the literature. I develop a framework of oligopoly theory with two-dimension product differentiation based on a synthesis of the literature on the institutional history and development of the Canadian pharmaceutical system. I find that: (1) The differentiation in perceived quality between brand-name and generic drugs can explain the generic competition paradox. The degree of the product differentiation can be pivotal in shaping the brand-name drug manufacturers’ price setting behaviours in response to the shift in patients’ preference and changes in government policies. (2) Copay and generic drug price-cap policies are commonly adopted by the Canadian public drug plans to contain drug reimbursement cost. Policy-makers should use caution when applying these policies in combination or separately in order to reach the intended outcomes. (3) The generic drug price-cap can elicit competition among brand-name drug manufacturers, but it may need coordinated regulations on patented drug prices. Without full coordination among major stakeholders and across jurisdictions, the benefits of lowered drug prices for some can become additional costs for others. I innovatively adopt the multilevel model to analyze the pharmaceutical market structure and evaluate the net effect of the generic competition paradox. The empirical research on the drug price dynamics is consistent with the predictions of the previously developed theory. I find that: (1) More generic substitutes in a drug molecule are associated with a net effect of increases in drug prices, after other contextual variables are properly controlled for. (2) More therapeutic substitutes do not have a net effect of lowering drug prices. (3) When a generic substitution policy is in place, the studied brand-name drugs maintain net price premiums over their generic substitutes. But, the net price premiums in the case when there is a generic substitution policy are lower than those where there is no such policy.