Economics is the study of how society decides what, how and for whom to produce
“Economics is the study of how society decides what, how and for whom to produce.” A market place is where buyers and sellers come together and reconcile their decisions on consumption and production by the adjustment of prices. Demand is the quantity that the buyers in a market place will purchase given a particular price. Supply is the quantity that sellers in a market place will produce given a particular price.
Ceteris paribus (all other things being equal) the demand will rise as the price falls. (figure 1) How much the price affects the demand is known as the elasticity. The more elastic a product is the more affect price change has on the demand.
Unfortunately, the world is not that simple and there has to be a willingness to demand. This can be influenced in a number of ways. Firstly, there is the price and availability of substitute products. For example, during the CJD scare the demand for beef fell and the demand for pork rose. Then there is the price and availability of complementary products. For example, if compact disc players halved in price but compact discs quadrupled in price then demand for compact disc players would fall, not rise.
There is also the consumer’s income to consider. As incomes rise the demand for certain goods will fall, (inferior goods) and the demand for other goods will rise, (superior goods). The price of those goods is not what influences the change in demand, the increase in income is. Finally there are the tastes and preferences of the consumers. Dropping the price of out of date technology, however drastic, will not increase demand. (i.e. the demand is inelastic for the duration of the trend or generation of technology.)
There also has to be a willingness to supply and as it is assumed that companies exist to make maximum profits the nature of costs play an important part. The costs a company incurs can be split into two basic categories, fixed and variable. Fixed costs being those that do not vary with output and variable costs being those that do. Fixed costs are therefore things like debts or rents that must be met regardless of production level. Whereas a variable cost would be labour or raw materials. The total cost is the sum of these two.
From figure 2 we see that as the output Q rises the average total cost falls at first but then levels off and then starts to rise again. This is known as the law of diminishing returns. Therefore, in order to maximise profits the company will aim to produce the quantity that occurs when the marginal cost (the addition to the total cost) of making one more unit is zero. This being the quantity at which the marginal revenue and marginal cost line cross.
If the price is less than P1 then the company is not covering its variable costs and they should not produce anything. An alternative in this circumstance could be to leave that market place and create a niche market, hopefully, on your own. If the price lies between P1 and P2 then the average variable costs are covered and some quantity of the fixed costs can be paid off whilst actually operating at a loss. Anything thing above P2 and the company will make a profit.
This only applies in the short run where the company cannot fully adjust to a change in conditions. In the long run there are only average cost, marginal cost and marginal revenue curves on figure 2 (i.e. sans AVC) and the decision to produce or not is made on whether the price will exceed P2 or not. Above P2 is profit and below it the company should not produce.
The falling and rising again of the long run average cost is due to economies of scale, where there are cost advantages to producing more because, for example, labour costs are not directly proportional to the output. However, as with the diminishing returns there are also diseconomies of scale. This is where increasing output increases costs. For example, in 1997 the BMA rejected the idea of super hospitals, where treatment would be concentrated in thousand bed facilities. It was thought that the diseconomy would start at about 500 bed facilities because a shortage of specialty capacity would be incurred and scheduling would become impossible.
In the case of Pfizer and its Erectile Dysfunction wonder drug Viagra we might begin to see the effects company tactics in a newly created oligopoly. Having held a licensed monopoly in this market through patent law, Pfizer are now facing competition from two other drugs, Levitra and Cialis. Having failed to prevent these products coming to market in the courts Pfizer need to reconsider their tactics.
Pfizer start this battle at several disadvantages. The first and most obvious of these is that the competition have not had to spend as much developing their substitutes as Pfizer did developing Viagra. They will not have to effectively create a market place as Pfizer did, as it is now very well established. Nor will the competition have to approach this market place as warily as Pfizer because of the taboo nature of the product and its function. However, Pfizer do have options open to them. They can; compete on price, compete on brand; leave the market place or merge with another firm to facilitate cost reduction.
Before they can compete on price Pfizer must first cover their costs. As we have seen in the short run it could be acceptable to make a loss so long as the variable costs are met. However, Pfizer manufacture more than one product and therefore the 17% of sales revenue ($12.5 billion this quarter) spent on research and development must be covered by the products that make it to market. In particular in Pfizer’s case was a product that was banned after getting to market that only recouped $55 million in revenue. This means that Pfizer can only cut the price of Viagra so far before it is not viable. Which is why one can pick up Levitra for $11.56 per pill to Viagra’s $12.00.
Viagra is an established brand, Pfizer spent $53 million promoting Viagra in 1999 alone. It would hard to find any adult who has not heard of Viagra or does not know what it does. There are few in any industry who can boast this kind of consumer knowledge of their brand. The most notable being Coke and Microsoft.. In order to convince people to shift to the other brands GSK and Bayer will have to convince the marketplace that their product is better. They have already done this through heavy advertising and recently won the sponsorship rights to the NFL for a number of years. Evidence suggests that Levitra and Cialis both work faster, for longer and with less side effects.
Pfizer’s actual strategy is to enter another market place with the same product. Thereby doing to others as has been done to them. That is, entering a marketplace without paying the entry costs that the current inhabitants did. And even more satisfying for Pfizer is that the chances are those incumbents will be GSK and Bayer.
They are entering Viagra into the oral drugs for the treatment of pulmonary arterial hypertension (PAH) market. This way they only have to foot the bill for the trials and very little in the way of innovation, scaling up, factories and infrastructure costs will be incurred. In this way they reduce their direct competition and in combination with the economies of scale and cost cutting they expect from their merger with Pharmacia will reduce the impact of the loss of their monopoly.