3) In this question we examine rivalry and strategic trade policy in the pharma market. Suppose that predicted demand in the United States for a new “blockbuster” drug is P=150 – 0.5Qd (quantity is measured in millions of units).
a) Suppose that a US producer is the first to develop the drug and can produce at a (constant) marginal cost of $10. Suppose in addition that the US firm faces no competition. What is the equilibrium price and quantity in the United States market? Compute consumer surplus and profits. You may assume that fixed development costs are $500 million.
b) Now suppose that Swiss firm can develop a substitute drug. They can produce at the same marginal cost of $10 after incurring fixed development costs of $500 million if they choose to begin production. Will they find it profitable to enter the market? (Assume that if two producers begin competing, they drive price to marginal cost and that there is no appreciable Swiss market for the drug).
c) Now suppose that the Swiss government provides a production subsidy of $2 per unit produced. Will the Swiss firm enter the market? If the Swiss firm enters the market, will the U.S. firm find it profitable to continue producing. What limit does the threat of competition from the U.S. firm place on the price that Swiss firms can charge? Compute the price in the U.S. market, and the output levels of the U.S. and Swiss firms. Compute the profits for the U.S. and Swiss firms and consumer surplus in the U.S. market. What is the cost to the Swiss government? Compare world welfare (the sum of the producer profits, consumer surplus, and government revenue/expense) to that found in a.
d) Now suppose that the U.S. government provides a subsidy of $2 per unit produced to offset the Swiss subsidy. Which firms will be in the market? What will be the price in the U.S. market? What will be the level of profits for the U.S. and Swiss producers combined? What will be the cost to the US and Swiss governments combined? Compute consumer surplus and compare world welfare to that found in a and c. In answering this part of the question, assume that both U.S. and Swiss producers have already incurred their fixed costs so that they will not be relevant for the decision of whether or not to produce.
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