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Chapter 10

  1. 1. PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Monopoly CHAPTER 1© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  2. 2. What Is a Monopoly? • Monopoly –A market in which only one firm sells a product with no close substitutes –The single firm that sells in that market • “No close substitutes” –Deciding whether a market or firm is a monopoly • Depends on the how easy it is for consumers to substitute the products of other sellers 2 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  3. 3. How Monopolies Arise • Barriers to entry –Something causing other firms to stay out of the market • Rather than enter and compete with firms already there –Economies of scale –Legal barriers –Network externalities 3 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  4. 4. Economies of scale • Economies of scale –Firm’s long-run average cost curve slopes downward • The more output the firm produces, the lower will be its cost per unit • Natural monopoly –Arises due to economies of scale • A single firm can produce for the entire market at lower cost than could two or more firms 4 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  5. 5. Figure Cost per unit would be even higher with three firms (each operating at point C). Since a single firm could produce at lower cost than two or more firms, this market tends naturally toward monopoly. A Natural Monopoly 5 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Dollars Articles of Clothing per Day LRATC $15 12 5 A C B 100 150 300 In the figure, the typical firm has an LRATC curve as shown, with economies of scale through an output level of 300, which is assumed to be the maximum market quantity. A single firm could serve the market at a cost of $5 per unit, operating at point A. Two firms splitting this market would each produce 150 units, with each operating at point B on its LRATC curve. Cost per unit would be $12, higher than with just one firm.
  6. 6. Legal Barriers • Legal barriers –Protection of intellectual property • Literary, artistic, and musical works, as well as scientific inventions • For a limited period of time – Enjoy a monopoly and earn economic profit • Patents • Copyright –Government franchise 6 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  7. 7. Legal Barriers • Patents –A temporary grant of monopoly rights over a new product or scientific discovery –20 years • Copyright –A grant of exclusive rights to sell a literary, musical, or artistic work –At least 70 years 7 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  8. 8. Table Largest Patent Infringement Awards 8 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1
  9. 9. Legal Barriers • Government franchise –A government-granted right to be the sole seller of a product or service –Any other firm that enters the market will be prosecuted –The U.S. Postal Service 9 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  10. 10. Legal Barriers • Governments grant franchises –When they think the market is a natural monopoly –To serve the public interest by ensuring that there are no competitors that would cause cost per unit to rise –The seller must submit to either government ownership and control or government regulation over its prices and profits 10 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  11. 11. Network externalities • Network externalities –Additional benefits enjoyed by all users of a good or service because others use it as well –Joining a large network is more beneficial than joining a small network –Market for computer operating systems –Social networking sites 11 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  12. 12. Monopoly Behavior • Goal of a monopoly –To earn the highest profit possible • A monopolist faces constraints –Production costs constraints • Technology • Prices of inputs –Price constraints • Faces a given market demand curve • Tradeoff: the more it charges for its product, the fewer units it will be able to sell 12 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  13. 13. Monopoly Behavior • Single-price monopoly –A monopoly firm that is limited to charging the same price for each unit of output sold • Price discrimination –Charging different prices to different consumers • Based on differences in the prices consumers are willing to pay 13 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  14. 14. Monopoly Behavior • Monopoly pricing OR output decision –One decision –Once the firm determines its output level, it has also determined its price –Once the firm determines its price, it has also determined its output level –Downward-sloping demand curve • The lower the price, the higher the quantity 14 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  15. 15. Table Demand and Revenue at Patty’s Pool 15 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2
  16. 16. Figure When a firm faces a downward-sloping demand curve, marginal revenue (MR) is less than price, and the MR curve lies below the demand curve. For example, moving from point A to point B, output rises from 3 to 4 units, while price falls from $10 to $9. For this move, total revenue rises from $30 to $36, so marginal revenue (plotted at point C) is only $6— less than the new price of $9. Demand and Marginal Revenue for Patty’s Pool 16 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Dollars Quantity 9654321 87 13 0 1 2 3 -2 -1 9 8 7 6 5 4 10 11 12 Demand MR B A C
  17. 17. Monopoly Behavior • Downward-sloping demand curve –Marginal revenue is less than the price of output –Marginal revenue curve lies below the demand curve • Profit maximization –Produce the quantity where MC = MR and the MC curve crosses the MR curve from below –The price is found on the demand curve 17 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  18. 18. Figure Like any firm, the monopolist maximizes profit by producing where MC equals MR. Here, that quantity is 50 thousand units. The price charged ($100) is read off the demand curve. It is the highest price at which the monopolist can sell the profit- maximizing level of output. Monopoly Price and Output Determination 18 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Dollars Thousands of Subscribers Serviced per Month $100 50 D1 MR1 E MC
  19. 19. Monopoly Behavior • Monopoly –A firm with market power; a price setter • Market power –The ability of a seller to raise price without losing all demand for the product being sold • Price setter –A firm (with market power) that selects its price rather than accepting the market price as a given 19 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  20. 20. Figure The monopoly in this figure is earning a profit. At the profit maximizing output level (50 thousand), profit per unit is equal to the difference between price ($100) and ATC ($70). Total profit is equal to profit per unit multiplied by the number of units, or $30 × 50,000 = $1,500,000, represented by the blue shaded rectangle. A Monopoly Earning Profit 20 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Dollars Thousands of Subscribers Serviced per Month D1 MC Total Profit MR1 ATC 50 $100 $70 E
  21. 21. Monopoly Behavior • Profit per unit = P – ATC • A monopoly earns a profit –Whenever P > ATC • Total profit at the best output level –The area of a rectangle • Height = distance between P and ATC • Width = level of output 21 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  22. 22. Figure A Monopoly Suffering a Loss 22 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 The monopoly in this figure is suffering a loss. At the profit maximizing output level (50 thousand), the loss per unit is equal to the difference between price ($100) and ATC ($125). The total loss is equal to loss per unit multiplied by the number of units, or $25 × 50,000 = $1,250,000, represented by the pink shaded rectangle. Dollars Thousands of Subscribers Serviced per Month D1 MC Total Loss MR1 ATC 50 $100 $125 E AVC
  23. 23. Monopoly Behavior • Loss per unit = ATC – P • A monopoly suffers a loss –Whenever P < ATC • Total loss at the best output level –The area of a rectangle • Height = distance between ATC and P • Width = level of output 23 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  24. 24. Equilibrium in Monopoly Markets • Equilibrium –When the only firm in the market, the monopoly firm, is maximizing its profit • Short run equilibrium –At the output level where MR = MC • Profit, if P > ATC • Loss, if P < ATC • Shut down, if P < AVC 24 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  25. 25. Equilibrium in Monopoly Markets • The shutdown rule –Should accurately predict the behavior of most privately owned and operated monopolies –If a monopoly operates under a government franchise or regulation • And produces a vital service • The government may not allow it to shut down 25 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  26. 26. Equilibrium in Monopoly Markets • Long run equilibrium –Monopolies may earn economic profit –A privately owned, unregulated monopoly • Suffering an economic loss in the long run • Will exit the industry 26 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  27. 27. Equilibrium in Monopoly Markets • Comparing monopoly to perfect competition –All else equal –A monopoly market will have a higher price and lower output than a perfectly competitive market 27 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  28. 28. Figure Comparing Monopoly and Perfect Competition (a, b) 28 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Price per unit Quantity of output (a) Competitive market Dollars per unit Quantity of output (b) Competitive firm $10 d=MR ATC MC 1,000 E $10 S D 100,000 E 1. In this competitive market of 100 firms, equilibrium price is $10 . . . 2. and each firm produces 1,000 units, where P=MC. 3. When a monopoly takes over, the old market supply curve . . .
  29. 29. Figure Comparing Monopoly and Perfect Competition (c) 29 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Price per unit Quantity of output (c) Monopoly $10 MC D 100,000 E 4. becomes the monopoly's MC curve. MR 60,000 F $15 5. The monopoly produces where MR=MC, 6. with a higher price and lower market output than under perfect competition
  30. 30. Equilibrium in Monopoly Markets • An important proviso –Comparing monopoly and perfect competition • Price is higher and output is lower under monopoly • If all else is equal 30 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  31. 31. Equilibrium in Monopoly Markets • Monopolization of a competitive industry leads to two opposing effects –Higher prices and lower output • For any given technology of production –Lower prices and higher output • Because of changes in technology of production –Ultimate effect on price and quantity depends on which effect is stronger 31 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  32. 32. Equilibrium in Monopoly Markets • Government and monopoly profit –Monopolies often exist with government permission –Monopoly’s total profit may be less than that predicted by the analysis • Government regulation • Rent-seeking activity 32 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  33. 33. Equilibrium in Monopoly Markets • Government regulation (government franchise) –The monopoly must accept government regulation, often including the requirement that it submit its prices to a public commission for approval –Keeps economic profit at zero 33 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  34. 34. Equilibrium in Monopoly Markets • Rent-seeking activity –Any costly action a firm undertakes to establish or maintain its monopoly status –Time and money spent lobbying legislators and the public for favorable policies • Reduce a monopoly’s profit • Economic rent –Any earnings beyond the minimum needed in order for a good or service to be produced 34 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  35. 35. What Happens When Things Change? • An increase in demand, a monopolist will: –Produce more output –Charge a higher price –Earn a larger profit • A decrease in demand, a monopolist will: –Reduce output –Charge a lower price –Earn a smaller profit 35 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  36. 36. Figure Panel (a) shows Zillion-Channel in equilibrium. It is providing 50 thousand units of cable TV service at a price of $100 per month. Panel (b) shows the same firm following an increase in demand from D1 to D2. With the increased demand, MR is higher at each level of output. In the new equilibrium, Zillion- Channel is charging a higher price ($125), providing more TV service (75 thousand units), and earning a larger profit. A Change in Demand 36 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Dollars Thousands of Subscribers Serviced per Month $100 D1 MR1 E MC 50 (a) Dollars Thousands of Subscribers Serviced per Month $100 D1 MR1 E MC 50 (b) D2 MR2 75 F $125
  37. 37. What Happens When Things Change? • A cost-saving technological advance –A monopoly will pass to consumers only part of the benefits from a cost-saving technological change –Monopoly’s profits will be higher • Costs increase –A monopoly will pass only part of a cost increase on to consumers in the form of a higher price –Monopoly’s profits will be lower 37 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  38. 38. Figure A cost-saving technological advance shifts the monopolist’s marginal cost curve down, from MC1 to MC2. Consumers gain because the price falls, but the drop in price is less than the drop in marginal cost. The monopoly gains because its profit is greater. A Cost-Saving Technological Change 38 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Dollars Thousands of Subscribers Serviced per Month $90 MC1 D1 MR1 50 E $100 MC2 60 H
  39. 39. Price Discrimination • Price discrimination –Charging different prices to different customers for reasons other than differences in cost • But a price-discriminating monopoly –Divides its customers into different categories based on their willingness to pay for the good 39 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  40. 40. Price Discrimination • Requirements –Market power • Downward-sloping demand curve • Price setter –Identifying willingness to pay • Difficult –Prevention of resale • More difficult for goods 40 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  41. 41. Price Discrimination • Effects of price discrimination –Firm: higher profits –Higher price for some consumers • Above the price they would pay under a single-price policy –Lower price for some consumers • Below the price they would pay under a single-price policy 41 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  42. 42. Figure Panel (a) shows a single-price monopolist, selling 30 dolls per day at $25 each and earning a profit of $450 per day, as shown by the blue shaded rectangle. Two Kinds of Price Discrimination (a) 42 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Dollars per Doll Number of Dolls per Day DMR MC=ATC$10 30 $25
  43. 43. Figure In panel (b), she price discriminates by charging a higher price of $35 for 10 dolls per day, while still charging $25 for the remaining 20 dolls. Profit increases by $100 per day, the area of the dark-shaded rectangle. Two Kinds of Price Discrimination (b) 43 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Dollars per Doll Number of Dolls per Day D MC=ATC$10 10 MR 30 $25 $35
  44. 44. Figure Panel (c) shows a different type of price discrimination: charging the original $25 on the first 30 dolls, and a lower price on just 10 additional dolls, bringing her total output to 40. Compared to panel (a), her profit in panel (c) rises by $100 per day—the area of the dark-shaded rectangle. Two Kinds of Price Discrimination (c) 44 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Dollars per Doll Number of Dolls per Day D MC=ATC$10 $25 40 MR 30 $20
  45. 45. Price Discrimination • Perfect price discrimination –Charging each customer the most he or she would be willing to pay for each unit purchased –Marginal revenue = price of the additional unit sold • Firm’s MR curve is the same as its demand curve –Higher profit • At the expense of consumers 45 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  46. 46. Figure The single-price monopolist sells 30 dolls per day at $25 each. With a constant ATC of $10, she earns a profit of $450 per day, as shown by the blue rectangle in panel (a). However, if she can charge each customer the maximum the customer is willing to pay, shown by the height of the demand curve, then her MR curve is the demand curve she faces. In panel (b), she would sell 60 dolls ,where MC = P at point J. Her profit would increase to the area of triangle HBJ. Perfect Price Discrimination 46 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Dollars per Doll Number of Dolls per Day Dollars per Doll Number of Dolls per Day D MC=ATC$10 MR E 30 $25 MR curve before price discrimination MC=ATC $10 30 $25 D and MR 60 MR curve with perfect price discrimination B H J (a) Single price (b) Perfect price discrimination
  47. 47. Price Discrimination • A price discriminating firm –Facing separate market demand curves in different markets (A, B, C, etc. . .) –Should choose its prices and output levels –So that marginal revenue in each market is equal to its marginal cost of production: MRA = MRB = MRC = . . . = MC 47 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  48. 48. Figure No-Choice Airlines is able to separate travelers into two different types: Business travelers in panel (a) and students in panel (b). In each market, it sells the profit-maximizing number of tickets at which marginal revenue is equal to marginal cost, and it charges the price on the demand curve for that number of tickets. Because the demand curves are different, so are the marginal revenue curves, so price and output will differ in each market. In panel (a), for business travelers, MR = MC at 50 tickets, and No- Choice charges $140. In panel (b), for students, MR = MC at 60 tickets, and No-Choice charges $70. How a Price-Discriminating Monopoly Sets Prices in Multiple Markets 48 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 Dollars per Ticket Number of Round Trip Tickets (b) StudentsDollars per Ticket Number of Round Trip Tickets (a) Business Travelers D MC$40 MR E 50 $140 A MC$40 MR 60 $70 D $200 20 F
  49. 49. Price Discrimination • Price discrimination in everyday life –It can be practiced by any firm that satisfies the three requirements –Mail-in rebates –Coupons –Sales –College tuition 49 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  50. 50. Why Americans Pay for the World’s Pharmaceuticals • Pharmaceutical industry –We want new and better drugs • Help cure or manage more diseases • Fewer side effects –We also want drugs to be inexpensive • Total research and development (R&D) cost –For each marketable new drug –Is in the hundreds of millions of dollars 50 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  51. 51. Why Americans Pay for the World’s Pharmaceuticals • New drugs are costly to develop • More than 10 years to get a profitable drug to market • A fraction of those that make it most of the way down the road are deemed safe and effective enough to get government approval for sale • Incentives for the industry –Internationally recognized patents to the companies that discover new drugs 51 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  52. 52. Why Americans Pay for the World’s Pharmaceuticals • United States funds the bulk of world’s R&D expenditures for new drugs –Only Americans pay the higher monopoly price for the new drugs • Directly pay full price (without health insurance) • Indirectly – Higher premiums charged by insurance companies – Higher tax payments to cover government- supported medical care 52 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  53. 53. Why Americans Pay for the World’s Pharmaceuticals • Those outside the U.S. –Pay the much lower prices • Their governments negotiate with the pharmaceutical companies 1. How has this lopsided pricing system come about? 2. What are the consequences? 3. Will it continue? 53 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  54. 54. Pfycor’s New Drug • Pfycor, Inc. –Holds the patent on a new drug –Two markets drug: the U.S. and Europe –Assumptions • Identical demand curves • MC = ATC = constant –Can price discriminate –Maximize profits: MRUS = MREUROPE = MC • Same price in each market 54 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  55. 55. Figure The two panels illustrate the situation for a monopoly selling a drug in two markets with identical demand curves: The U.S. in panel (a), and Europe in panel (b). In each market, the monopoly sells the profit-maximizing output level at which marginal revenue is equal to marginal cost, and charges a price given by the demand curve at that output level. With identical demand and marginal revenue curves in the U.S. and Europe, the monopoly will sell the same output (70 million doses) and charge the same price ($2.25 per dose) in each market. Production cost is $0.50 per dose, so total revenue exceeds production cost by ($2.25 − $0.50) × 70 million = $122.5 million in each market (the area of the blue shaded rectangles), for a total of $245 million. Monopoly Pricing in Two Identical Markets 55 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Dollars per Dose Millions of Doses per Year (b) EuropeDollars per Dose Millions of Doses per Year (a) U.S. DUS MC$0.50 MC$0.50 $2.25 DEUROPE MR 70 $2.25 A B MR 70
  56. 56. Asymmetrical Pricing from Government Bargaining • In developed countries –Pharmaceutical companies must negotiate a price with the government • Governments: strong bargaining position –Can refuse access to their markets entirely –As long as the price is greater than the production cost, the firm will still want to sell the drug in their country 56 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  57. 57. Asymmetrical Pricing from Government Bargaining • Pharmaceutical companies: some bargaining power –If it refuses to sell at a low price, European patients will not be able to get the drug • Unless they buy it in the U.S. market at the high monopoly price 57 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  58. 58. Asymmetrical Pricing from Government Bargaining • U.S. –Monopoly pricing (higher price) • Europe –Lower bargained price (slightly above production cost) –Lower profit 58 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  59. 59. Figure As in the previous figure, a monopolist sells a drug in the United States in panel (a), and Europe in panel (b), and both markets have the same demand and marginal revenue curves. But in panel (b), European governments negotiate a lower price per dose of $0.75. Additional revenue from each dose sold in Europe is now $0.75, so that is the new (constant) marginal revenue in Europe. With marginal revenue greater than production cost, the monopoly will sell all that Europeans will buy at $0.75 per dose, which is 130 million doses. Production cost is still $0.50 per dose, so in Europe, total revenue exceeds production cost by ($0.75 − $0.50) × 130 million = $32.5 million. Meanwhile, in panel (a) for the U.S., nothing has changed, so price remains at $2.25. In the U.S., total revenue continues to exceed production cost by ($2.25 − $0.50) × 70 million = $122.5 million. Europe now contributes less to R&D expenses and profit ($32.5 million) than does the U.S. ($122.5 million). Monopoly Pricing with Bargaining in One Market 59 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 Dollars per Dose Millions of Doses per Year (b) Europe Dollars per Dose Millions of Doses per Year (a) U.S. DUS MC$0.50 MC$0.50 $2.25 DEUROPE MR 70 $2.25 A B MR 70 $0.75 E 130
  60. 60. Asymmetrical Pricing from Government Bargaining • Will Pfycor continue to develop new drugs? –Yes . . . If the profit earned from both markets is enough to cover Pfycor’s expected R&D expenses • And provide sufficient profit to compensate its owners for risking their funds 60 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  61. 61. Asymmetrical Pricing from Government Bargaining • Consequences for Americans –Americans pay disproportionately to develop them • Both Americans and Europeans enjoy the benefits of new drugs –Pfycor will choose not to develop some new drugs with especially high R&D costs 61 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  62. 62. Threats to Asymmetrical Pricing • U.S. consumers –Purchase medications from other countries over the Internet • At prices substantially below U.S. prices • Parallel trade –The resale of a product to consumers in another a country without the manufacturer’s consent 62 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  63. 63. Threats to Asymmetrical Pricing • U.S. legislators –Want to force down U.S. drug prices –Like to repeal the 1987 law that prohibits importing pharmaceuticals from other countries without the manufacturer’s consent –Want to empower Medicare to negotiate lower drug prices • Medicaid and the Department of Veteran’s Affairs can negotiate drug prices 63 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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