Question

2. Assume a pharmaceutical company invented a drug that is more effective in treating (or at least life extending) blood cancers and managed to obtain a patent on the drug making the company the sole provider of this blood cancer drug in the market for the next 30 years. Assume in the long-run (i.e.,in 30 years) as the patent expires, given a perfectly elastic long-run supply in the long-run, the competitive price becomes Pc, which also represents the industry’s marginal cost (MC) and average cost (AC). Assume a typical downward sloping market demand curve and the corresponding marginal revenue curve likely to prevail in a market characterized by monopoly. (20points-each part 5 points)

a) Draw a diagram with P on the y-axis and Q on the x-axis for the market for this drug. Draw the demand curve and the corresponding marginal revenue curve. Show the industry (i.e. firm in the short-run) MC=AC=Pc (long-run competitive price) on the diagram. Show the long-run competitive quantity (Qc) on the diagram.

b) Show the monopolistic firm’s profit maximizing output level (Qm) and the corresponding price level (Pm) on the diagram drawn in part a. Show the area that represents the welfare loss from monopoly on the diagram drawn in part a. Explain why this area represents welfare loss.

c) Assume the government established a maximum price of Pr where Pm>Pr>Pc. Show the Qr, the output produced under this government regulation, on the diagram drawn in part a. Assuming no complications in interventions as in government failure, would this price control help reduce welfare loss? Why or why not?

d) Is there still welfare loss under price regulation with a price of Pr? If no, explain why not. If yes, show the area of welfare loss on the diagram drawn in part a and compare welfare loss under Pr to welfare loss under Pm.

Answer 1

a. The long run competitive equilibrium is given by P=MC and the competitive price and quantity are shown below in the diagram.

b. The monopolist equilibrium is determined at MR=MC. monopolist profit maximizing price,P_m and quantity,Q_m are shown in the diagram below. The welfare loss due to monopoly is shown by the area of triangle abc. This is because monopolist sells less quantity at a higher price as compared to the perfect competition.

c. When government sets the price ceiling at P_r, the corresponding output is Q_r. This price control helps to reduce the welfare loss by area abed. This is because the P_r is lower than than P_m, while Q_r is higher than Q_m. Thus, consumers are now getting more quantity of drugs at a lower price.

d. Even after price regulation,there is still welfare loss of area of triangle dec as shown in figure. This is because P_r is still higher than P_c and Q_r is lower than Q_c. Thus, consumers are paying more price for lesser quantity,resulting in loss of consumer surplus. At the competitive equilibrium,there is no welfare loss.