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A pharmaceutical company can produce each pill of a new drug at a constant marginal cost given by MC = 5. Note that since the marginal cost is constant, then the average cost of producing pills is also 5. Inverse demand for the pills is given by P = 25 – Q and the company’s marginal revenue curve is thus given by MR = 25 – 2Q.
a) Suppose the company initially has market power and acts as a monopolist. How many pills will the company sell and what price will it charge consumers?
b) What are the consumer and producer surpluses when the company prices as a monopolist?
c) Suppose the government mandates that the company can only sell the pills at marginal cost (i.e. at P = 5). How many pills will the company sell?
d) What are the consumer and producer surpluses once the government mandate is in place?
e) Does the government pricing mandate satisfy the Kaldor-Hicks Criterion relative to the
status quo? Is the government pricing mandate Pareto superior to the status quo? (Use changes in consumer and producer surplus as your measures of the value of the policy to these agents.)
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