Question

QUESTION THREE [25]

3.1 “Patent laws, (which can last up to twenty years), in South Africa gives a pharmaceutical company monopoly power on the sale of any new medication that it discovers.” In terms of the above statement answer the following questions:

3.1.1 Discuss the profit maximisation position of the firm in the short-run and long-run whilst it is protected by the patent. (12)

3.1.2 Explain the change that occurs in terms of the market structure when the patent expires. (5)

3.1.3 Explain the profit maximising position of the new market structure in the short-run, in other words after the patent expires.

Answer 1

1) For a monopoly to maximise profit, it has to produce that quantity of output at which the Marginal Revenue = Marginal Cost. It can be best explained by the below graph--

In this graph, MC = Marginal Cost curve,

MR = Marginal Revenue Curve

AR = D = Average Revenue = Demand Curve

AC = Average Cost Curve

Qm and Pm is Maximum Quantity and Maximum price. for all quantites below or before Qm, we have MR > MC, thus there is scope for the monoly firm to increase their output to increase profit. for all Qty after Qm, we have MR < MC, which means our Cost is more than revenue hence losses, thus at the Qty Qm only, the Profit of the firm can be maximised, i.e. when MR = MC, and hence the price Pm. This is how the firm will maximise its best level of profit in short run.

In the long run, we know that it is covered by the Patent and hence no other firm can enter the market, it will be able to make supernormal profits, i.e. the profits which are much higher than normal profit, where in the grey shaded area in the graph, is the Supernormal profit, where the AR > AC at all the points in the grey area.(Profit = Revenue - Cost) .

Thus this is the profit maximisation strategy of a monopoly in the long run and short run.

2) When the Patent of the monopoly firm expires, new companies will enter the market, and hence now, there will be competition in place. Thus now, the monopoly cannot sell on the price it was selling before, now the price will be equal to the Marginal Cost. See the graph below--

MC remains constant when there is competition in market, cost doesn't change no matter what Qty of output is produced. Before the patent expiry, the firm was offering the product at a price higher than the MC, but now, after expiry of patent, to survive in the market, they have to sell at the price that is equal to MC, so as to breakeven and survive the competition.

3) Now in perfect competition, to maximise profit, the firm has to sell on the price where D=AR = MC, AR = Price in the perfect competiton. Before point P, MC < AR, hence more scope to increase the price, after point P, MC > AR, hnece losses, thus at point P, the profit of the firm will maximise.

Thanks :)