Market Structure and Firms' Strategies — Pharmaceuticals, Tesla, Aldi

Case

Extract 3: Excessive pharmaceutical drug prices in the US

Excessive drug prices are the single biggest category of healthcare overspending in the US. And unlike almost every other product, pharmaceutical drug prices continue to rapidly rise over time. Health and Human Services estimates that over the next decade, pharmaceutical drug prices will rise 6.3 percent each year, while other healthcare costs will rise 5.5 percent. Basic economic principles suggest that pharmaceutical drug prices should be going down because manufacturing volumes are increasing, and little new research and development (R&D) is being conducted. Yet, a simple market research on existing pharmaceutical drug prices proves otherwise.

After accounting for the costs of all R&D amounting to roughly $80 billion a year, pharmaceutical companies had $40 billion more from the top 20 pharmaceutical drugs alone, most of which went straight to profits instead of research. The remaining money goes to sales and advertising. Amongst the few largest pharmaceutical companies which command more than three quarters of the market for pharmaceutical drugs, only one spends more on research than on marketing its products.

Pharmaceutical companies tend to say they are unique in needing to spend a higher proportion of their capital on research than almost any other industry. But of all the companies in the world, the one that invests the most in R&D is not a pharmaceutical company. It’s Amazon. The online retailer spends about $20 billion a year on R&D, despite being renowned for both low prices and low profits.

However, the price of pharmaceutical drugs should not be determined by their research costs. Instead, it is determined by their value in preventing and treating disease. Exorbitant drug prices have two bad effects. First, high costs mean that lots of patients are unable to take their medications. Second, the high pharmaceutical drug prices distort research priorities, emphasising financial gains and not health gains.

Source: The Atlantic, 23 March 2019

Extract 4: Price secrecy and discrimination

In an eight-day policy forum where health ministers define the goals for the World Health Organisation for 2020, the hottest topic is the high price of new medicines. Confidential price discounts allow manufacturers to charge different payers different prices. If final prices negotiated confidentially reflect each health system’s ability to pay, such a pricing scheme would allow manufacturers to serve more markets than might be possible with more transparent pricing. Secretive negotiations, however, are just as likely to result in the lowest prices for countries with the greatest negotiating power. Indeed, there is evidence that list prices of some medications are higher in absolute terms and as a percentage of average income, in low and middle income countries than in high income countries. Secrecy makes it virtually impossible to guard against such inequity in final pricing, but allows plenty of opportunity for corruption.

In February the Italian health minister, Giulia Grillo, published a draft resolution on drug pricing. It calls for international action to improve the transparency of prices. Drug firms are not pleased. They argue that greater price transparency will mean that poor countries will no longer get good deals, because firms will not want to undermine their ability to extract high prices from wealthier states.

Extract 1: Tesla could go to India

Tesla and its founder and CEO Elon Musk are focused on building out factories around the world to complement its Fremont, California, electric vehicle plant where the company started. The EV maker spent over $1 billion in the past quarter including on new factories in Texas and Germany. Tesla thinks it can reach 20 million vehicles by 2030 — replacing 1% of the global fleet of passenger cars per year. One question more Tesla watchers have been asking is when India will become part of that global EV revolution. India has a large population, and an analyst contends India is and will remain a high priority for Tesla, pointing to EV demand and population growth in India as indicative of a massive market.

Source: CNBC, 22 October 2020

Extract 2: Aldi may drop prices to compete with Tesco’s new budget venture Jack’s

Low-cost supermarket chain Aldi “will never be beaten on price” and could even drop them in response to Tesco’s new low-cost venture Jack’s. UK and Ireland chief executive Giles Hurley said Aldi welcomes competition from new players such as Jack’s, adding: “If we need to reduce retail prices we will.” Tesco’s plan to open 10 to 15 Jack’s stores over the next six months pales in comparison to Aldi’s decision to add 400 new stores by 2025, bringing its total to 1,200. Aldi said it will hire 20,000 new members of staff to fuel its expansion. Britain’s fifth largest supermarket grew sales by 16.4% year-on-year to £10.2bn in the UK and Ireland last year, growing more than five times faster than the overall grocery market. Operating profit grew 26% to £266m.

Source: CityA.M., 01 October 2018

Extra practice stimulus. Ride-hailing startup Gojek started increasing its trip fares in Singapore at the end of March 2022. Following Gojek’s announcement, larger firms like Grab and ComfortDelGro announced similar moves. This came on the back of rising fuel prices in Singapore and increasing ridership due to the loosening of pandemic restrictions.

Questions

Q1. Discuss which market structure best describes the characteristics of the pharmaceutical drugs market in the US. (discuss, [8])

Q2 (i). Define price discrimination and identify the conditions necessary for price discrimination to take place. (define/identify, [2])

Q2 (ii). Explain one challenge to a pharmaceutical firm in undertaking price discrimination. (explain, [2])

Q3. Extract 1 discussed the potential expansion of Tesla into India. With the aid of a diagram, explain one possible reason why its profits might increase due to this expansion. (explain, [3])

Q4. Extract 2 states that low-cost supermarket chain Aldi ‘will never be beaten on price’. With the aid of a diagram, explain how the strategy of opening many more stores than Tesco enabled Aldi and Lidl to increase their price competitiveness. (explain, [4])

Extra 1(a). Explain how barriers to entry impact a firm’s ability to retain excess profits in the long run. (explain, [10])

Extra 1(b). Discuss whether the rise in trip fares by the ride-hailing firms is due to collusion or other factors mentioned above. (discuss, [15])

Answers

Q1 — discuss [8].

Scope. The question turns on classifying the pharmaceutical drugs market against the four market structures; the realistic candidates are oligopoly and monopoly. Stand: the market is best described as oligopolistic.

The market is oligopolistic. On the number and size of firms, Extract 3 states that a few large companies “command more than three quarters of the market”. Each therefore holds a large market share and a high degree of price-setting power — the defining feature of an oligopoly, where a few dominant firms each hold a significant share. On the nature of the product, the heavy spending on “research and marketing” is real and artificial product differentiation, which only differentiated structures (oligopoly, monopolistic competition) have any incentive to undertake. The scale of that spending — “$80 billion” on R&D annually — can be financed only by firms able to retain supernormal profit in the long run, which a high barrier to entry protects. Both features point to oligopoly.

The market could be monopolistic. The “exorbitant prices” charged even where “little R&D is conducted” reflect a great degree of price-setting power. This is sustained by high barriers to entry: drug development is slow and costly, and a successful firm can erect legal barriers such as patents, preventing rivals from producing the same drug. A firm that is the sole producer of a particular drug holds a monopoly over that specific drug.

Judgement. The market is best described as oligopolistic. A true monopoly has a concentration ratio approaching 100% and little incentive to spend on product differentiation; the “$80 billion” R&D spend is inconsistent with that. Furthermore, anti-competitive laws in most jurisdictions deter the formation of a true industry-wide monopoly, even if patents confer monopoly power over individual drugs. The industry as a whole is therefore oligopolistic, with monopoly elements at the level of individual patented drugs.

Q2 (i) — define/identify [2].

Reproduce the canonical definition of price discrimination: charging different consumers different prices for the same good for reasons not attributable to cost differences. The conditions for it to take place are (1) price-setting power / market power; (2) the ability to separate markets and prevent seepage (resale from the low-priced to the high-priced market); and (3) groups with different price elasticities of demand.

Q2 (ii) — explain [2].

A challenge is best framed as one of the three conditions failing. Theoretically a firm charges the more price-inelastic market (here, richer countries) a higher price and the more elastic market a lower price. But Extract 4 shows richer countries also have “the greatest negotiating power” to demand a lower price — so the firm may be unable to charge them the higher price the elasticity ranking implies, defeating the discrimination. Alternatively, if “greater price transparency” is mandated, the firm can no longer prevent seepage: buyers will all source from the lowest-priced state, so the separation condition fails.

Q3 — explain [3].

This part is worked in prose; its diagrammatic content is a market-structure cost/revenue figure outside the 9570 diagram set (see scope note below).

A cost reason: expanding into India raises Tesla’s scale of production and output, allowing it to reap greater internal economies of scale — for instance, spreading fixed costs over a larger output — so unit costs of production fall. With revenue unchanged, lower costs raise profit. Alternatively, a revenue reason: Extract 1’s “EV demand and population growth” indicating “a massive market” implies that entering India raises demand for Tesla’s vehicles, raising total revenue and hence profit. Either the cost channel (lower average cost) or the revenue channel (higher demand) suffices to explain a rise in profit.

Q4 — explain [4].

This part is worked in prose; its diagrammatic content is a market-structure cost/revenue figure outside the 9570 diagram set (see scope note below).

“Opening many more stores” represents the expansion of Aldi and Lidl, raising output and so unlocking greater internal economies of scale — the fall in long-run average cost a firm enjoys as it increases its own output. These include marketing economies (buying inputs in bulk strengthens the firm’s hand in negotiating supplier discounts, lowering input prices) and technical economies through the specialisation of labour: with “20,000 new members of staff”, workers can specialise and become more productive, cutting unit cost. Because these chains can produce at a lower average cost than smaller rivals such as Jack’s, they can sustain a lower price while remaining viable — translating the cost advantage into greater price competitiveness, consistent with Aldi’s claim that it “will never be beaten on price”.

Extra 1(a) — explain [10].

Definition. Barriers to entry are obstacles that prevent new firms from entering a market. Scope: this answer explains how two barriers — internal economies of scale and legal barriers — allow an incumbent to retain excess (supernormal) profit in the long run.

Internal economies of scale as a barrier. Where internal economies of scale are limited, a potential entrant can capture nearly all available cost savings by raising output only slightly. This makes entry attractive whenever incumbents earn supernormal profit; entry raises supply, erodes incumbents’ demand and price, and competes their supernormal profit away to normal profit in the long run. Conversely, where economies of scale are significant — typically because of high fixed capital costs — an entrant must reach a large output to match the incumbent’s average cost. An incumbent already at large scale is more price-competitive, deterring entrants, so it retains its market share and supernormal profit in the long run.

Legal barriers. With no legal barriers such as patents or copyrights, rivals can copy an incumbent’s intellectual property and enter without incurring its R&D cost, eroding the incumbent’s share to normal profit in the long run. With patents or copyrights in place, an entrant must fund its own R&D, raising its fixed costs and deterring entry — so the incumbent retains its market share and supernormal profit. A pharmaceutical firm patenting a new cure, for instance, prevents rivals from free-riding and protects its long-run profit. (Brand loyalty, statutory barriers and high sunk costs work similarly.)

Extra 1(b) — discuss [15].

Definition. Collusion occurs when firms cooperate to fix price or output, either formally (a cartel) or tacitly (price leadership) — see non-price strategies. Scope: whether the fare rise is due to collusion or to rising fuel prices. Stand: it is more likely due to rising fuel prices.

Collusion as the cause. Ride-hailing is an oligopoly: a few firms, each with significant market share and mutually interdependent. Competitive oligopolies exhibit price rigidity — no firm wants to raise price (rivals do not follow, so it loses share) or cut price (rivals match, so revenue falls). A simultaneous fare rise across firms is consistent instead with tacit collusion via price leadership: a leader raises price and the others match. If Gojek, Grab and ComfortDelGro are colluding tacitly, Gojek’s increase would be followed by its rivals — exactly the pattern observed.

Rising input prices as the cause. Alternatively, the fare rise reflects higher fuel prices. Fuel is a key input to ride-hailing, so a rise in fuel prices raises the firms’ variable cost of production. As marginal and average costs rise, profit-maximising firms producing where MC = MR raise their price — here, trip fares rise. The common timing across firms then reflects a common cost shock, not coordination.

Judgement. The rise is more likely driven by fuel prices. Price leadership is usually led by the firm with the largest share, yet here it was the smaller firm Gojek that moved first, with the larger Grab and ComfortDelGro following — inconsistent with classic price leadership. Moreover, fuel is a large share of ride-hailing variable cost, so a fuel-price spike compresses margins enough to compel a fare rise across all firms simultaneously. (One could argue the reverse: cooperative oligopolies exhibit price rigidity, and firms earning long-run supernormal profit could absorb a fuel-cost rise without raising fares — so a coordinated rise might still signal collusion. On balance, the common cost shock is the more parsimonious explanation.)

Note: in the original worksheet the input-cost analysis in 1(b) and the profit/price-competitiveness analyses in Q3, Q4 and 1(a) were supported by firm-level cost/revenue (AR/MR/AC/MC) diagrams. Those market-structure equilibrium diagrams are outside the 9570 syllabus and are therefore presented as prose here.