South-Western College Publishing - Economics  
Wholesale Change in Drug Prices Likely
Subject

Comparative statics
Welfare loss

Topic Monopoly
Key Words Wholesale prices, Medicare, Medicaid, taxpayers, Justice Department, drug prices
News Story

Drug companies often set wholesale prices much higher than doctors, clinics, and other medical providers actually pay. The medical profession then bills federal and state health programs, such as Medicare and Medicaid, for the wholesale price. For example, doctors can charge Medicare $17 for a dose of leucovorin, a cancer treatment that actually costs them $2.75. This practice attracts doctors to the companies that manufacture such drugs.

Taxpayers may be paying more than a billion dollars more than they should. The Justice Department and state attorneys general are investigating. They have asked First Databank of San Bruno, California to provide drug price information to the states based on what is actually paid for drugs. Medical providers are expected to complain. They assert that the high charges are necessary to offset the miserly payments they receive from Medicare and Medicaid in other areas.

(Updated July 1, 2000)

Questions
1. Draw a diagram of the equilibrium of a monopolist drug company. Show the marginal cost, average total cost, average revenue, and demand curves. Mark the equilibrium price and quantity of the drug sold. Shade in the area representing profit.
  a) If the company begins to attract medical providers by establishing higher wholesale prices which the providers can then charge to federal and state medical programs, which curve will be affected? Illustrate.
  b) What will happen to the equilibrium price and output? Mark the new equilibrium on your diagram.
  c) What will happen to the amount of profit? Illustrate your answer.
  d) Why does it make sense for drug companies to employ this strategy?
2. The Justice Department and the state attorneys general are investigating. Explain why society is hurt by the actions of the drug companies with reference to your diagram and the following:
  a) The price of drugs
  b) Consumer surplus
  c) Deadweight loss
3. If the practice of charging unrealistic wholesale prices ceases, will allocative efficiency be improved? Explain your answer.

Source
Julie Appleby, "Drug Pricing Probed," USA Today, April 6, 2000.

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