MONOPOLY DRUGS VERSUS GENERIC DRUGS CASE STUDY QUESTIONS (1) What is the importance of the case...

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"MONOPOLY DRUGS VERSUS GENERIC DRUGS" CASE STUDY QUESTIONS (1) What is the importance of the case study (titled "Monopoly drugs versus generic drugs") to consumers, producers and government? In your view which of these three economic agents is affected most by the issues discussed in this case study and why? (3.5 marks) (2) From your own point of view or personal experience would you consider "brand-name drugs" and "generic drugs" as perfect substitutes? Why? (1.5 marks) Source: Mankiw (2018) MONOPOLY DRUGS VERSUS GENERIC DRUGS According to our analysis, prices are determined differently in monopolized markets and competitive markets. A natural place to test this theory is the market for pharmaceutical drugs because this market takes on both market structures. When a firm discovers a new drug, pat- ent laws give the firm a monopoly on the sale of that drug. But eventually, the firm's patent runs out, and any company can make and sell the drug. At that time, the market switches from being monopolistic to being competitive. CASE STUDY What should happen to the price of a drug when the patent runs out? Figure 6 shows the market for a typical drug. In this figure, the marginal cost of producing the drug is constant. (This is approximately true for many drugs.) During the life of the patent, the monopoly firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost and charging a price well above mar- ginal cost. But when the patent runs out, the profit from making the drug should encourage new firms to enter the market. As the market becomes more competi- tive, the price should fall to equal marginal cost. Experience is, in fact, consistent with our theory. When the patent on a drug expires, other companies quickly enter and begin selling generic products that are chemically identical to the former monopolist's brand-name product. Just as our analysis predicts, the price of the competitively produced generic drug is well below the price that the monopolist was charging. The expiration of a patent, however, does not cause the monopolist to lose all of its market power. Some consumers remain loyal to the brand-name drug, per- haps out of fear that the new generic drugs are not actually the same as the drug they have been using for years. As a result, the former monopolist can continue to charge a price above the price charged by its new competitors. For example, one of the most widely used antidepressants is the drug fluoxetine, which is taken by millions of Americans. Because the patent on this drug expired in 2001, a consumer today has the choice between the original drug, sold under the FIGURE 6 The Market for Drugs When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, which is well above the marginal cost of making the drug. When the patent on a drug runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost. Costs and Revenue Price during patent life Price after patent expires 0 Monopoly quantity Marginal revenue Competitive quantity Demand Marginal cost Quantity brand name Prozac, and a generic version of the same medicine. Prozac sells for about three times the price of generic fluoxetine. This price differential can persist because some consumers are not convinced that the two pills are perfect substitutes. ● "MONOPOLY DRUGS VERSUS GENERIC DRUGS" CASE STUDY QUESTIONS (1) What is the importance of the case study (titled "Monopoly drugs versus generic drugs") to consumers, producers and government? In your view which of these three economic agents is affected most by the issues discussed in this case study and why? (3.5 marks) (2) From your own point of view or personal experience would you consider "brand-name drugs" and "generic drugs" as perfect substitutes? Why? (1.5 marks) Source: Mankiw (2018) MONOPOLY DRUGS VERSUS GENERIC DRUGS According to our analysis, prices are determined differently in monopolized markets and competitive markets. A natural place to test this theory is the market for pharmaceutical drugs because this market takes on both market structures. When a firm discovers a new drug, pat- ent laws give the firm a monopoly on the sale of that drug. But eventually, the firm's patent runs out, and any company can make and sell the drug. At that time, the market switches from being monopolistic to being competitive. CASE STUDY What should happen to the price of a drug when the patent runs out? Figure 6 shows the market for a typical drug. In this figure, the marginal cost of producing the drug is constant. (This is approximately true for many drugs.) During the life of the patent, the monopoly firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost and charging a price well above mar- ginal cost. But when the patent runs out, the profit from making the drug should encourage new firms to enter the market. As the market becomes more competi- tive, the price should fall to equal marginal cost. Experience is, in fact, consistent with our theory. When the patent on a drug expires, other companies quickly enter and begin selling generic products that are chemically identical to the former monopolist's brand-name product. Just as our analysis predicts, the price of the competitively produced generic drug is well below the price that the monopolist was charging. The expiration of a patent, however, does not cause the monopolist to lose all of its market power. Some consumers remain loyal to the brand-name drug, per- haps out of fear that the new generic drugs are not actually the same as the drug they have been using for years. As a result, the former monopolist can continue to charge a price above the price charged by its new competitors. For example, one of the most widely used antidepressants is the drug fluoxetine, which is taken by millions of Americans. Because the patent on this drug expired in 2001, a consumer today has the choice between the original drug, sold under the FIGURE 6 The Market for Drugs When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, which is well above the marginal cost of making the drug. When the patent on a drug runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost. Costs and Revenue Price during patent life Price after patent expires 0 Monopoly quantity Marginal revenue Competitive quantity Demand Marginal cost Quantity brand name Prozac, and a generic version of the same medicine. Prozac sells for about three times the price of generic fluoxetine. This price differential can persist because some consumers are not convinced that the two pills are perfect substitutes. ●