Question

1. A large pharmaceutical company recently acquired the exclusive rights of a drug, which is the only legally available drug that treats a chronic medical condition, and was produced by a number of small pharmaceutical companies prior to the acquisition.
   1. Please use the demand and supply graph to explain how this acquisition may change the price and quantity of this drug.
   2. Please explain how this acquisition might affect consumer’s surplus and producer’s surplus.
   3. Will your answers (in a and b) change if the demand elasticity is inelastic vs. elastic? Why or why not, please explain.   

Answer 1

So when a large company acquires the exclusive rights to production of a commodity earlier produced by multiple firms, the market structure has effectively shifted from being competitive to a monopoly. Earlier the industry was aggregation of all firms. Now the large company is itself the industry. Following are the changes occuring due to this.

a. Earlier, equilibrium was where industry's demand (as depicted by AR or average revenue curve) intersected the supply curve (as depicted by the MC or marginal cost curve of industry = horizontal summation of each firm's marginal cost curve). It was established at E1 as shown in the figure. Quantity was Q1 and price was P1 at equilibrium.

Post the acquisition, the firm is itself the industry. So it will establish equilbrium where it will maximise its profits i.e. where MC curve intersects the MR or marginal revenue curve or point E0 and this will lead to E2 being the point of price and output determination. So quantity in the market is Q2 and price is P2.

If we note the change, monopolist's price is higher than the competitive price and monopolist's output is lower than competitive output.

b. Consumer's surplus (CS) is the area below demand curve and producer's surplus (PS) is the area above supply curve.

Before acquisition, CS was equal to the area of PDE1P1 and PS was equal to the area of PSE1P1.

But post the acquisition, now that equilibrium quantity and price have changed, so have CS and PS. CS is equal to the area of PDE2P2, and PS is equal to the area of PSE0E2P2.

To note the change, there has been a reduction in CS by the area of P1P2E2E1. So consumer's surplus has declined. PS has changed by a reduction of area AE0E1 and addition of area P1P2E2A which has been transferred from the consumers.

Area E0E1E2 is the deadweight loss of this acquisition as that part has been lost entirely.

c. Yes, if demand was inelastic, the reduction in equilibrium quantity would be much greater as it is now and the increase in equilibrium price would also be much greater. This would be because when demand would be ineasltic, it would mean much steeper AR curve. So intersection between MR and MC curve would happen at a much higher point where not only would price be higher, even quantity would be much lesser.