Market Structures: Competition and Monopoly: Question 8

Worked solution

Part (a): Calculating average cost

Average cost is total production cost divided by output. Using last year’s production cost and output (not the plant’s original $120,000,000 construction cost from seven years ago):

$\text{Average cost} = \frac{28\,000\,000}{40\,000\,000} = 0.70$

So Vaxora Pharma’s average cost of production last year was $0.70 per dose.

Part (b): Two barriers to entry

This scenario describes two separate barriers to entry:

• The exclusive 10-year government licence is a legal barrier. It directly forbids any other firm from manufacturing or selling this vaccine in Bellshire, regardless of how capable a rival firm might be.
• The $120,000,000 cost of building a plant of sufficient scale is a high start-up/capital-cost barrier. Few firms could raise this much investment, so it would continue to discourage entry even once the 10-year licence eventually expires.

Part (c): Economies of scale from large-scale production

Vaxora Pharma spreads the very high cost of its specialised plant over a large output of 40 000 000 doses, giving an average cost of just $0.70 per dose. A smaller rival firm producing far fewer doses from its own, smaller-scale plant would likely find its fixed and running costs spread over far less output, giving it a higher average cost per dose than Vaxora achieves. This ability to produce at a lower average cost through large-scale production is known as economies of scale, and it is a genuine potential advantage of Vaxora’s monopoly position.

Part (d): Discussion, does the health service benefit?

Possible benefit: Because Vaxora Pharma can produce at an average cost of only $0.70 per dose through economies of scale, in principle it could supply Bellshire’s health service more cheaply than several smaller, competing manufacturers, each facing higher average costs of their own.

Possible drawback: Despite this low average cost, Vaxora Pharma is charging $4.00 per dose, more than five times its $0.70 average cost of production. With no rival manufacturer for the health service to switch to or use to negotiate a lower price, Vaxora faces no competitive pressure to pass its low costs on through a lower price, and can instead keep the difference as extra profit.

Conclusion: The evidence in the scenario, a price of $4.00 sitting far above an average cost of $0.70, suggests that Vaxora’s economies of scale are benefiting Vaxora Pharma’s profit far more than they are benefiting Bellshire’s health service. Without a rival supplier to create competitive pressure on price, the health service is more likely to be paying an unnecessarily high price than enjoying the lower costs that Vaxora’s scale of production makes possible.

Final answers

• (a) Average cost $=$ $0.70 per dose.
• (b) The exclusive 10-year licence (a legal barrier) and the $120,000,000 plant construction cost (a high start-up-cost barrier).
• (c) Spreading costs over a very large output gives Vaxora a lower average cost than smaller rivals could achieve, economies of scale.
• (d) On balance, the health service is more likely to be paying an unnecessarily high price than benefiting from Vaxora’s lower potential costs, since no rival exists to force the saving to be passed on.