Read the question carefully, to make sure you are answering that question and not a different one. Since I give partial credit, try to write at least something on each question.
One thing I noticed in this test was how useful diagrams are for people just learning economics. Verbal explanations are fine for answers-- better even, ideally-- but it is easier to go wrong in a verbal explanation than if you have to draw out a diagram that shows what is happening. If you have to draw the diagram, you at least realize that you are confused and probably wrong, whereas writing out the words does not reveal logical problems so well.
(a) (0, 5, or 10 points) If the FDA's job really tried to "maximize potential benefits patients receive", what would its rate of false negatives be, and what policy would it use? Why is this incompatible with the second goal, to "minimize risks due to the products"?
Answer. It would have a zero rate of false negatives, because it would approve all drugs. Then patients would get all the benefits possible. This would naturally increase the number of dangerous drugs too, and costs of drug use would increase drastically.
(b) (0, 5, or 10 points) What form or forms of market failure justifies making Oxycontin available only by a doctor's prescription?
Answer. Asymmetric information would be the most important market failure. People do not know which drugs are appropriate for them, and the doctor, with better information, can tell them. Paternalism plays a role in this, since even without regulation people could consult doctors. There may also be negative externalities associated with Oxycontin, since someone who becomes addicted may thereby distress his friends and relatives.
(c) (0, 5, or 10 points) How will the drug market's consumer and producer surplus and total surplus change if Teva and Endo get their FDA approvals and win their patent cases against Purdue Pharma?
Answer. PS falls, CS rises, and total surplus goes up. PS falls because the price falls, and CS rises for the same reason. Total surplus increases because the initial price was the monopoly price, which leads to an output too small to maximize value.
Note that although the producer surplus of Teva and Endo rises, it rises by less than the surplus of Purdue Pharma falls, since the market price falls.
Several test-takers failed to answer what happened to total surplus.
Answer. In the free market, the price would be such that the marginal cost of production equalled the marginal benefit of the least-valuing buyer. The government subsidy drives the price lower, because firms make money from the subsidy even if the price is below their marginal cost. This means that consumers with lower marginal benefits buy too, though, and the marginal benefit to these consumers is less than the marginal cost to the producers. Since marginal benefit is less than marginal cost, negative value is created.
Some test-takers thought that this was a question about a natural monopoly being subsidized. This is wrong for three reasons. First, health care is not a natural monopoly. Second, if it were, there would be market failure immediately, which the question says there is not. Third, if the industry were a natural monopoly, a subsidy could actually increase value rather than reducing it. When there exists one distortion in the market (the natural monopoly) a second distortion (the subsidy) can undo the first.
Answer. The problem is not size by itself, but the incentives of government officials and company officials. The effectiveness of a company's employees can be measured by their effect on profits, a relatively clear measure. It is not so clear whether a government employee--especially a manager-- has been effective. Also, a company is monitored by stock market analysts, who are quick to point out inefficiences, which then show up in the stock price and are therefore apparent to the stockholders who control the firm. Voters, on the other hand, may not be able to detect ineffectiveness of their elected officials. Moreover, even if stockholders fail to react to poor management, poor management creates a profit opportunity for anybody who can buy enough stock to control the firm. This takeover possibility means that a bad manager is highly vulnerable. Takeovers are not possible in government. Elections are highly competitive, but it is hard for one person or organization to capture much of the benefits of changing the management.
The part of this most often missed was the importance of takeovers. The most common big mistake was to just restate the question instead of answering it. To say, "Because government are more inefficient and subject to government failure" is not an answer.
It was also common to give a list of problems government have, such as lobbying by special interests, without explaining why a corporation would not have the same problem. Plenty of people lobby corporations too-- indeed, that is what supplier sales reps do for a living.
A few people said that CEO's could be fired, and that was an advantage of corporations. Elected officials can be fired too, though, and in practice are fired (that is, defeated for re-election) much more often than CEO's.
(a) (0, 10, or 20 points) Explain why the quality of refrigerators might well stay the same, or even rise.
Answer. The seller will definitely make buyers worse off, but he has two dimensions in which to do so: higher price and lower quality. One or the other will happen. It might be, however, that consumers value quality so much that the best seller strategy is to increase the quality, but to increase the price even more. If the company can create a big gap between benefit to consumers and cost of production by increasing quality it will do so, since it can capture that benefit by increasing the price.
Economies of scale are irrelevant. Even if they do exist, that just means the monopolist can produce refrigerators more cheaply, not that he has more of a reason to produce a high quality.
(b) (0, 10, or 20 points) Explain why the monopolist will choose an efficient
level of quality.
Answer. The monopolist will maximize value by his choice of quality because his aim is to maximize his own profits. If his quality choice was not efficient, that means he could make consumers better off without hurting himself. But in that case, he could change the quality to make them better off-- but change the price too, so that he captures the increased benefit.
(a) (0, 5, or 10 points) What is the competitive equilibrium price and quantity?
Answer. P=20 and Q=40. The marginal cost equals 20 there.
(b) (0, 5, or 10 points) What output maximizes total value in society?
Answer. The efficient output is where the marginal benefit of 20 equals the marginal social cost of 20, so that the marginal private cost is 16. Thus, we need Q=2*16 = 32.
(c) (0, 5, or 10 points) What kind of a pollution tax would enable the market to reach the value-maximizing output without further government regulation?
Answer. A tax of 4, equal to the externality. If on the seller, the seller would sell at P=20, but retain only 16, and so produce only 32.
(d) (0, 5, or 10 points) Should the tax be imposed on the buyers in this market, or on the sellers?
Answer. It doesn't matter. The effect is the same either way. If it is on the sellers they will sell at a price of 20, retaining 16 after paying the tax. If it is on the buyers, they will pay no more than a price of 16, because they know they will have to pay an additional 4 to the government.
(a) (0, 5, or 10 points) What are two examples of natural monopolies, one with prices regulated by the government, one with prices not regulated?
Answer. Electricity distribution is regulated, but city newspaper sales are not. Both are natural monopolies because there are big economies of scale.
(b) (0, 5, or 10 points) What is the economic justification for price regulation of natural monopolies?
Answer. If the price were not regulated, it would be at the high, monopoly price. As a result, output would be less than the value-maximizing level and there would be missed sales to people who would value the good at more than its production cost.
(c) (0, 5, or 10 points) What is the ratchet effect?
Answer. The ratchet effect is that although a firm can keep any cost savings it achieves in the short run, at the next rate hearing the government will reduce the price it can charge accordingly, and it will lose the profit from its cost saving.
(d) (0, 5, or 10 points) Show using a diagram how growth of demand over time might convert an industry from being a natural monopoly to being competitive.
Answer. In the diagram, the cost curve is U-shaped, but initially the demand curve cuts it where it is downward sloping. When demand shifts out, there becomes room for several firms to operate at the bottom of their cost curves.
... he quotes a passage from an advocate of the suppression of intemperance, of which the following is a sample:- "If anything invades my social rights, certainly the traffic in strong drink does. It invades my primary right of security by constantly creating and stimulating social disorder." Upon this Mr. Mill observes:-Explain how value maximization "ascribes to all mankind a vested interest in each other's moral, intellectual, and even physical perfection, to be defined by each according to his own standard". Answer. Suppose Smith cares about Jones's moral perfection, and would pay $100 if Jones were to stop drinking whisky. Value maximization says that the outcome should be that Jones stops drinking whisky, whether that is attained by government regulation or by a deal between Smith and Jones. Mill, on the other hand, denies that the interest of Smith in Jones's behavior has any relevance to political or social decisions.A theory of "social rights," the like of which probably never before found its way into distinct language, being nothing short of this, that it is the absolute social right of every individual that every other individual should act in every respect precisely as he ought, that whosoever fails thereof in the smallest violates my social right and entitles me to demand from the Legislature the removal of the grievance. So monstrous a principle is far more dangerous than any single violation of liberty. ... The doctrine ascribes to all mankind a vested interest in each other's moral, intellectual, and even physical perfection, to be defined by each according to his own standard. ( http://www.rasmusen.org/g406/21b_Stephen.htm)
A number of people were confused and thought that it was {\it Mill} who "ascribes to all mankind a vested interest in each other's moral, intellectual, and even physical perfection." No-- Mill is attacking that view, as you will see if you read carefully above. That confusion was not relevant to answering the question here, but I mention it anyway.
(a) (0, 5, or 10 points) Judge Taft says that before the Sherman Act was passed, contracts in restraint of trade were not enforceable under the common law. Why did that make forming an effective cartel more difficult?
Answer. Without legal enforcement, it was easier to cheat on the cartel by breaking the agreement and offering lower prices to customers.
(b) (0, 5, or 10 points) Why could an association of firms violate the anti- trust law even if they had no more than 30% percent of the pipe capacity in America and did not operate in every state?
Answer. The association might have all the capacity in one region, and pipe is expensive to transport. Also, the Sherman Act says it unlawful to conspire to restrain trade, whether or not the conspiracy could be successful.
(c) (0, 5, or 10 points) Justice Parker was concerned about abuses "from corporations who are perpetually laboring for exclusive advantages in trade, and to reduce it into as few hands as possible." What abuses are those? What is wrong with using contracts to reduce the number of companies competing with each other?
Answer. The main abuse is that the companies will use the contracts to raise prices and restrain output, reducing the value of trade and creating the usual triangle loss.
FDA Approves Generic OxyContin
By ANNA WILDE MATHEWS
and LEILA ABBOUD
Staff
Reporters of THE WALL STREET
JOURNAL
March 24, 2004; Page A3
In a closely watched test case for how regulators will handle the risks posed by potent opioid painkillers, the Food and Drug Administration approved the first generic versions of the controversial drug OxyContin.
The approval came with an agreement by the two generic-drug makers to create programs to reduce the risk of abuse and diversion onto the "street" market. The FDA said those "risk-management plans" would be consistent with measures taken by Purdue Pharma LP, the maker of branded OxyContin, which put additional safeguards into place after widespread abuse of the drug opened the company up to criticism as well as lawsuits.
Peter J. Pitts, the FDA's associate commissioner for external relations, said the agency didn't believe that the availability of generic versions would increase demand for the drug, based on the pattern with past generic introductions. Mr. Pitts said the generic versions may cut the cost for legitimate patients. "FDA's job is to maximize potential benefits patients receive and minimize risks due to the products," he said.
Law-enforcement officials have long been concerned about the potential for a bigger, cheaper, less well-controlled supply once versions of OxyContin are marketed by multiple companies. OxyContin has become a high-profile example of the risks posed by powerful painkillers. Originally approved in 1995, it had a special mechanism that allowed the painkiller, chemically known as extended-release oxycodone hydrochloride, to be released gradually over many hours for management of severe pain. But by crushing the pill and snorting or injecting the powder, abusers found they could get all the effects of the drug at once, for a potent high.
Teva Pharmaceutical Industries Ltd. and Endo Pharmaceuticals Holdings Inc., the two generic companies that got FDA go-ahead, declined to immediately comment on their abuse-prevention safeguards. Because both companies are still locked in a legal battle over patents with closely held Purdue Pharma, it isn't clear when they might actually begin selling their cheaper versions. The generic companies said it was too early to talk about pricing.
OxyContin's sales rose to $1.9 billion last year, from $1.6 billion in 2002, according to data from IMS Health. Including OxyContin, sales of narcotic painkillers were $5.6 billion last year, up 20% from the year before, and 127% from 1999, according to IMS Health, a market research company.
The debate over control of such powerful drugs is ramping up because of an expected flood of new painkiller products. Among those in the pipeline are asthma-style inhalers that could administer morphine and fentanyl, a synthetic opioid. Johnson & Johnson, which makes the Duragesic fentanyl patch, has said it hopes to sell other painkilling patches.
The FDA is already moving to push companies to create proactive anti-abuse plans for all new potent painkillers. But as it moves forward, the agency is trying to strike a delicate balance. Many researchers and pain doctors argue that patients with severe pain often don't get the drugs they need. One major 1998 study of 13,625 nursing-home cancer patients found that more than a quarter of those who suffered daily pain got no analgesic at all. Moreover, pain doctors have complained that aggressive law-enforcement efforts may discourage legitimate prescriptions for patients who need potent opioids, which are narcotic drugs with effects similar to those of drugs derived from opium.
On the other side, law-enforcement officials have said they need tough measures to avoid abuse and addiction and trafficking.
About 1.9 million people had at some point used OxyContin without a medical need, according to a 2002 federal study on abuse of prescription painkillers, which also found that an estimated 29.6 million people had at some point used painkillers without a medical need.
The Bush administration recently announced a major crackdown on abuse of prescription drugs, particularly highly addictive painkillers. The Drug Enforcement Administration in the past has called for limits on the distribution of potent and easily abused drugs to certain pharmacies or physicians. But the FDA has never limited any opioid to certain pharmacies, and agency officials say they don't have the authority to block certain physicians from prescribing a drug.
As the problems of OxyContin abuse became more evident, Purdue several years ago began putting in place a number of measures designed to reduce abuse of OxyContin. The program's measures include a national system that is supposed to help track diversion with the goal of informing law enforcement officials of signs of problems. The company also conducts education efforts among doctors and community officials, and offers tools to limit diversion such as special prescription pads for doctors.
Still, it can be hard to accurately gauge the effects of such programs, partly because it is difficult to measure the extent of abuse.
Purdue has said it believes its program to be effective. In fact, the company filed a petition with the FDA asking the agency to ensure that generic makers have abuse-reduction programs similar to its effort.
"If you don't have a risk management program and you flood the market with generic oxycodone formulations, that seems to us like asking for trouble," said a Purdue spokesman. "It seems to us it should be an even playing field, and all companies should be held to the same standard."
Purdue is now seeking FDA approval for a new time-release painkiller, Palladone, but it has fought hard in court to retain the exclusivity of its major product. Endo won its first round of litigation in January when a judge in the Southern District of New York invalidated Purdue's patent because, the court found, the company misled federal patent regulators in obtaining it.
Purdue has filed an appeal in that case, which could take a year or more. Endo could decide to launch its generic product before then, but would face paying steep damages if the higher court overturned the ruling. Bill Newbould, a spokesman for Endo, said the company hasn't yet decided when it plans to launch its generic.
Teva has a patent litigation case pending in the same court and before the same judge for a different dosage. That trial hasn't yet begun, but Teva could choose to launch its product before the other appeal is settled. A spokesman for Teva said no such decision has yet been made.
Write to Anna Wilde Mathews at anna.mathews@wsj.com 1 and Leila Abboud at leila.abboud@wsj.com 2
No. 498
Circuit Court of Appeals, Sixth Circuit
85 F. 271; 1898 U.S. App. LEXIS 2157
February 8, 1898
PRIOR HISTORY: [**1]
Appeal from the Circuit Court of the United States for the Eastern District of Tennessee.
COUNSEL: J. H. Bible and Edward B. Whitney, for the United States.
Frank Spurlock, for appellees.
OPINIONBY: TAFT
OPINION: [*278] Before HARLAN, Circuit Justice, and TAFT and LURTON, Circuit Judges.
TAFT, Circuit Judge, delivered the opinion of the court.
The first section of the act of congress entitled "An act to protect trade and commerce against unlawful restraints and monopolies," passed July 2, 1890 (26 Stat. 209), declares illegal "every contract, combination in the form of trust or otherwise or conspiracy in restraint of trade or commerce among the several states or with foreign nations." The second section makes it a misdemeanor for any person to monopoize, or attempt to monopolize, or combine or conspire with others to monopolize, any part of the trade or commerce among the several states. The fourth section of the act gives the circuit courts of the United States jurisdiction to hear and determine proceedings in equity brought by the district attorneys of the United States under the direction of the attorney general to restrain violations of the act.
Two questions are presented [**2] in this case for our decision: First. Was the association of the defendants a contract, combination, or conspiracy in restraint of trade, as the terms are to be understood in the act? Second. Was the trade thus restrained trade between the states?
The contention on behalf of defendants is that the association would have been valid at common law, and that the federal anti- trust law was not intended to reach any agreements that were not void and unenforceable at common law. It might be a sufficient answer to this contention to point to the decision of the supreme court of the United States un U.S. v. Trans-Missouri Freight Ass'n, 166 U.S. 290, 17 Sup. Ct. 540, in which it was held that contracts in restraint of interstate transportation were within the statute, whether the restraints would be regarded as reasonable at common law or not. It is suggested, however, that that case related to a quasi public employment necessarily under public control, and affecting public interests, and that a less stringent rule of construction applies to contracts restricting parties in sales of merchandise, which is purely a private business, having in it no element of a public or quasi public character. [**3] Whether or not there is substance in such a distinction, -- a question we do not decide, -- it is certain that, if the contract of association which bound the defendants was void and unenforceable at the common law because in restraint of [*279] trade, it is within the inhibition of the statute if the trade it restrained was interstate. Contracts that were in unreasonable restraint of trade at common law were not unlawful in the sense of being criminal, or giving rise to a civil action for damages in favor of one prejudicially affected thereby, but were simply void, and were not enforced by the courts. Mogul Steamship Co. v. McGregor, Gow & Co., [1892] App. Cas. 25; Hornby v. Close, L.R. 2 Q.B. 153; Lord Campbell, C.J., in Hilton v. Eckersley, 6 El. & Bl. 47, 66; Hannen, J., in Farrer v. Close, L.R. 4 Q.B. 602, 612. The effect of the act of 1890 is to render such contracts unlawful in an affirmative or positive sense, and punishable as a misdemeanor, and to create a right of civil action for damages in favor of those injuried thereby, and a civil remedy by injunction in favor of both private persons and the public against the execution of such contracts and the maintenance [**4] of such trade restraints.
The argument for defendants is that their contract of association was not, and could not be, a monopoly, because their aggregate tonnage capacity did not exceed 30 per cent. of the total tonnage capacity of the country; that the restraints upon the members of the association, if restraints they could be called, did not embrace all the states, and were not unlimited in space; that such partial restraints were justified and upheld at common law if reasonable, and only proportioned to the necessary protection of the parties; that in this case the partial restraints were reasonable, because without them each member would be subjected to ruinous competition by the other, and did not exceed in degree of stringency or scope what was necessary to protect the parties in securing prices for their product that were fair and reasonable to themselves and the public; that competition was not stifled by the association because the prices fixed by it had to be fixed with reference to the very active competition of pipe companies which were not members of the association, and which had more than double the defendants' capacity; that in this way the association only modified [**5] and restrained the evils of ruinous competition, while the public had all the benefit from competition which public policy demanded.
From early times it was the policy of Englishmen to encourage trade in England, and to discourage those voluntary restraints which tradesmen were often induced to impose on themselves by contract. Courts recognized this public policy by refusing to enforce stipulations of this character. The objections to such restraints were mainly two. One was that by such contracts a man disabled himself from earning a livelihood with the risk of becoming a public charge, and deprived the community of the benefit of his labor. The other was that such restraints tended to give to the covenantee, the beneficiary of such restraints, a monopoly of the trade, from which he had thus excluded one competitor, and by the same means might exclude others.
Chief Justice Parker, in 1711, in the leading case of Mitchel v. Reynolds, 1 P. Wms. 181, 190, stated these objections as follows:
"First. The mischief which may arise from them (1) to the party by the loss of his livelihood and the subsistence of his family; (2) to the public by depriving it of an useful member. [**6] Another reason is the great abuses these voluntary restraints are liable to; as, for instance, from corporations who are perpetually laboring for exclusive advantages in trade, and to reduce it into as few hands as possible."