CDAE 61 Assignment 9
30 points
1. Read Pfizer and Other Drug Makers Report Higher Profits under 'readings' – 'assignments'. A
big issue in the news today is skyrocketing health care costs. A big part of the problem is the
high cost of pharmaceuticals, which cost twice as much in the US as in most other countries in
the world. The pharmaceutical industry makes a higher accounting profit than almost any other
legal business that exists, and has for years.
a. What do you think is the relationship between unusually high accounting profits and economic
profits? Why? The high accounting profits most likely reflect higher economic profits. The cost
of manufacturing pharmaceuticals is low relative to the cost of inventing them. Returns to capital
(machines) are part of accounting profits, but are probably not that important relative to the costs
of labor (scientists). Costs of labor do not enter into accounting profits. Pharmaceutical
companies make their profits from patents. Pharmaceutical companies therefore earn monopoly
profits, which are above and beyond normal profits (i.e. they are economic profits).
If profits in the Pharmaceutical business are so high, why do we not see more firms entering the
market—i.e. what are the barriers to entry, if there are any?
Patents are a legal barrier that prevent new firms from entering the market to produce existing
drugs. It also takes a lot of research to produce new drugs, a lot of expense to test them, and a
long time to turn research into a patented medicine. This means there are high start up costs (i.e.
high capital investments) and long delays before realizing profits, a significant barrier to new
entry
b. One solution to high costs being discussed is to import the drugs from other countries, and
resell them here (pretty bizarre actually, because in many cases we will be re-importing drugs
exported by American companies for a lower price than those companies sell them for here).
Draw a graph depicting the market supply and demand curve for drugs in the US. The
intersection of supply and demand determines price. Alongside this graph, draw another of an
individual firm’s MC and ATC costs curves. Extend the price line from the first graph to the
second (see figure below). On the second graph, shade in the portion that depicts economic
profit. (If you have trouble with this, look at the lecture notes, or Chapter 8 from Frank and
Bernanke). Now show the impact of increasing drug imports from other countries, depicted as a
shift in the market supply curve (for this sake of this assignment, assume that the imports would
be from different firms, so that firms here could not simply export less to those countries we’d be
importing from). What impact will this have on firm profits? You may draw this as a new
figure, or simply indicate the shift on your existing figure.
The top two figures show supply and demand in the domestic market for drugs. Because drug
companies have a monopoly on drugs, and there are substantial barriers to entering the market,
the supply curve does not equal the marginal cost curve, and the drug company (the firm in the
figure on the right) makes substantial profits as indicated by the shaded area. On the bottom
figures, SI shows the impacts of drug imports from other countries—they increase supplies. This
lowers the price of drugs, reducing domestic output and eliminating profits as shown in the lower
right hand figure. This is actually a very simplified story, as the drug companies license drug
production in foreign countries as well.
2. Another big issue in the news is the spread of Wal-Mart. Read the article on Wal-Mart under
‘Readings’—“California Voters Reject Wal-Mart.”
a. From what you have learned about the invisible hand, do you think the clothing stores in
Inglewood are making an economic profit? Why or why not? The clothing stores in Inglewood
are unlikely to be making an economic profit. If they were, new firms (stores) would open up,
which would drive profits down to zero. Draw the market supply and demand curves for
clothing stores in Inglewood before the arrival of Wal-Mart, and another graph depicting the MC
and ATC curves along with price that shows only normal profit. This graph will be similar to
that for question 1.
b. Now draw a third graph that shows the MC and ATC curves for Wal-Mart, along with the
price at which Wal-Mart sells its goods. Show the impact of a new Wal-Mart on the market
supply curve for clothes, and on prices. Again, you can depict this as a shift in the supply curve.
Show the impact of this on economic profits for the local stores. If Wal-Mart comes in to
Inglewood, what will happen to supply? What impact will this have on profits? How will the
local stores respond?
Wal-Mart has lower MC and ATC than the local stores. There MC and ATC curves are shown
on the far right. When Wal-Mart comes into town, it will shift the supply curve out to the right
(SWM) and drive prices down. Since the local stores were not making any economic profit, they
will now start making a negative economic profit. In the long run, they will shut down, leaving
only Wal-Mart.
c. Look over the Wal-Mart web site on sustainability at
http://walmartstores.com/GlobalWMStoresWeb/navigate.do?catg=345. Wal-Mart is such
a big player in the retailing industry that they can really change how things are done. For
example, if Wal-Mart decided that we should re-use glass standardized bottles (e.g. all
beer and soda comes in the same type of bottle) instead of recycling them (which would
save enormous amounts of energy), it would make it cost effective for all of industry to
follow. Considering this info, What are the pros and cons of a new Wal-Mart? Where do
you come down on the Wal-Mart issue?
Wal-Mart provides goods at cheaper prices, which benefits poor people in the short run, but
closes down local businesses and in many cases leads to a net loss of jobs, increasing the number
of poor people in the long run. Wal-Mart jobs are often lower paying than the ones they close
down. Wal-Mart also imports the vast majority of what it sells, increasing the foreign trade
deficit, and shifting jobs abroad. Most Wal-Marts are large, one story box stores outside of town,
promoting urban sprawl, decay of the urban center, automobile dependency, etc. etc. Wal-Mart
also puts downward pressure on prices, and may therefore stimulate greater efficiency on the part
of existing stores. It also rakes in huge profits for owners and shareholders.
Personally, I’m very impressed with their statements on sustainability. Right now a lot of the
green movement is driven by the moderately affluent, who in general do not lead very sustainable
lifestyles. However, Wal-Mart also promotes consumerism in a huge way, which is a big part of
the problem.