Question

Bayer is a large German pharmaceutical company that was founded in the 19th century. It is perhaps best known as the company that introduced Aspirin.

It is the 1970s, and you are a consultant of the executives at Bayer, who are trying to decide what avenues of research to prioritize. The executives have recently learned about the discovery in Japan of a very potent antibacterial compound called norfloxacin. Bayer scientists claim that they have theories on how to substantially improve on the discovery by the Japanese scientists, to the point where the product they hope to develop would easily outsell norfloxacin and revolutionize the market for antibiotics. An antibiotic so effective would be lifechanging and lifesaving all over the world, as bacterial infections are painful, debilitating, and in many cases deadly. However, the decision is not so simple.

Putting a drug on the market involves substantial costs: the cost of the research to discover the compound (from millions to tens or hundreds of millions), the cost of clinical trials (each of three phases may be hundreds of millions), and the cost of regulatory approval (the FDA again charges millions as a fee for getting approval). Estimates of the average cost range from hundreds of millions to billions of dollars. The marginal cost of producing a drug, by contrast, is substantially lower.

Now, consider Bayer’s problem. Suppose that if it invests, the cost to get the drug from the scientists’ brains to FDA approval is $1 billion. However, once the drug is discovered and information about it published (as is required), other companies can easily produce it without incurring the $1 billion research and development (R&D) cost. These companies would still incur the marginal cost of production, but would effectively have no fixed costs.

1. Show the cost structure and break-even point of Bayer, including whatever curves are necessary to show this.

2. Bayer knows that an American company, Barr Pharmaceuticals, will likely produce a generic version of the drug as soon as Bayer’s results are released. On a second graph beside the Bayer graph, show the cost structure and break-even point of Barr Pharmaceuticals as compared to that of Bayer, including whatever curves are necessary to show this.

3. In addition to Barr Pharmaceuticals, there are many other potential entrants into the generic antibiotic market. What will the long-run price of the drug be, if this is the case? Show the location of the long-run price on your cost structure graph from the previous question.

4. From a business point of view, would you recommend Bayer to invest? Characterize the consumer and producer surpluses as a consequence of your recommendation.

This isn’t quite how the pharmaceutical market works in real-life. Bayer will actually be able to apply for a document that make it illegal for companies like Barr Pharmaceuticals to produce the drug—this document is a patent. With the ability to prevent Barr from producing, Bayer will effectively have a monopoly on the new antibiotic once it discovers it.

5. Return to your diagram of Bayer’s cost structure and add consumer demand. Assume that at least part of the demand curve lies above Bayer’s ATC curve. Indicate the range of prices/quantities for which Bayer can make a profit. (Add any other curves that are necessary to show this).

Given that the patent system exists, Bayer decides to go ahead with the research. Congratulations, your company has just discovered ciprofloxacin, 2 to 10 times as strong as norfloxacin, and one of the most widely prescribed antibiotics in the world!

6. Indicate the profit maximizing price/quantity for Bayer, and shade in the consumer and producer surpluses if Bayer maximizes its profit.

7. Shade in the deadweight loss.

8. Now, suppose Bayer sells the medicine directly to consumers and can charge a different price on every transaction it makes (this is called pure price discrimination). If it is able to do this, indicate the consumer surplus, producer surplus, and deadweight loss on your graph.

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Answer 1

Part 6,7,8 are graphically answered in Part 5