Question

how are hollywood and the pharmaceutical industry similar in terms of their marginal cost curves?

Answer 1

We assume that firms wish to maximize profits. This requires that production be economically efficient; that is, the method used produces any given output for the least possible total cost.

Production opportunities, ways of combining inputs to change output, differ according to the length of time considered. The short run is a period of insufficient length to change the input level of factors such as capital equipment and plant; these factors are called fixed factors. Production and cost in the short run is governed by the Law of Diminishing Returns, which states that after a certain level of input of the variable factor, each additional unit of the variable factor, employed in conjunction with a fixed quantity of another factor, adds less to total product or output than the previous unit. This law explains why short-run marginal cost, the change in total cost for a one-unit change in output, increases after a certain output level. Given the relationship between marginal and average costs, the law is also the reason for the increasing portion of the U-shaped average variable cost and average total cost curves usually drawn. The long run is a period of sufficient length that all factors of production are variable, but the state of technology is given. In the long run, the factor mix selected will be that which results in the last dollar spent on each input yielding the same addition to total output. The optimal mix thus depends on relative factor prices, as well as factor productivity (indicated by the marginal product). It is the price of switches and routers relative to lines that explains why the Internet uses packet switching rather than circuit networks. Economies of scope exist if the total cost of producing two (or more) products within the same firm is less than producing them separately in two (or more) nonrelated firms. This occurs when products are jointly produced or where there are factors that are shared by the processes used to make different products. This explains why most studios produce both movies and television programs. Economies of scope provide a motive for many mergers, such as that between AT&T and TCI, between companies making different products.

A learning curve may apply in the long run. As the cumulative output of a company increases, on the job learning may occur, and the average cost decreases as a consequence. Such learning benefits are no doubt significant for new media products, such as computer animation and the development of computer games.

A transaction (the exchange of a good or service) bears costs whether the transaction is made through the market or within an organization. We noted a general trend away from internal transactions to market transactions. Hollywood studios provide an example. The trend to market transactions is largely a result of the improvements in communications technology that have stimulated the movement of many business-to-business transactions to the Internet.

The very long run is a period during which the technological possibilities available to the firm change. Technological change results from the invention, the act of creating something new, and innovation, the development of an idea into a new production technique or new product. A comparison of the consumer electronic products available now compared to what was available in 1950 illustrates the importance of technological change. Conventional pharmaceutical companies have a specific business strategy. They usually stay unprofitable for decades until their drugs are approved by the Food and Drug Administration to enter the market. Then they start to raise their drug price gradually at a rate above inflation every year. For instance, according to Deutsche Bank, Merck and Pfizer raised list prices an average of 13 percent in 2014 and 8 percent until the third quarter this year. At last, they will spend about 15 to 20 percent of sales on research and development for new drugs.

However, this model has been recently disturbed by some new players, namely Valeant Pharmaceuticals International and Turing Pharmaceuticals. For one thing, Valeant has been notorious for repeatedly buying up existing drugs and raising prices aggressively. In 2015, Valeant raised prices on its brand-name drugs an average of 66 percent, about five times as much as its closest industry peers.

Meanwhile, the company has been cautious about developing new drugs, devoting only 3 percent of its sales on research and development. For another, Turning Pharmaceutical went a step further. It acquired Daraprim, a 62-year-old drug to treat parasitic infection, in August and abruptly increased its price from $13.50 to $750 per tablet. Martin Shkreli, the founder, and CEO of Turing claimed they would use the extra profit to develop better treatments for toxoplasmosis with fewer side effects. Protests against these pharmaceutical companies emerged nationwide by insurance co companies emerged nationwide by insurance companies, lawmakers, and patients. Some presidential candidates also seized on the issue. Hillary Clinton called for efforts to control “price gouging” after a public outcry over the actions of Turing Pharmaceuticals. Senator Bernie Sanders also sent a letter to Turing, demanding information on the price hike. To address public outrage, Valeant and Turing defended themselves, saying that some old neglected drugs sell for far less than newer drugs for the same diseases.

Furthermore, list prices are typically not what Medicaid and some hospitals pay after discounts and rebates are negotiated, so the impacts of the price spike are exaggerated.