Answer to Question #242163 in Microeconomics for bila

Question

The Pharmaceutical Benefits Scheme subsidises the price of prescription medications. Demand for prescription drugs is inelastic due to the lack of close substitutes, while supply is relatively elastic.

a Use a supply and demand graph to illustrate the equilibrium in the market for prescription medications without a subsidy.

b On the same graph show the effects of a $10 per prescription subsidy paid to drug companies. What happens to the equilibrium quantity?

c Do buyers or sellers benefit the most from the subsidy? Explain your answer.

d The government, noticing that drug companies are unpopular, decides to pay the $10 subsidy to consumers instead. What effect does this change in policy have on the price paid by consumers, the price received by drug companies, and the size of the prescription drug market? Explain your answer

Answer 1

Solution:

a.). The supply and demand graph for prescription medications without a subsidy is as follows:

The equilibrium point before subsidy is at point E₀, the market price is P₀ and the market quantity is Q₀.

 

b.). The effect of a $10 per prescription subsidy paid to drug companies will shift the supply curve to the right (vertically downwards by the amount of the subsidy) and thus lower the equilibrium price in the market and increase the equilibrium quantity. The supply curve will shift from S₀ to S_1. The new equilibrium point will be E₁, the new equilibrium price will be P₁ and the new equilibrium quantity will be Q₁ as displayed on the same graph.

 

c.). Buyers will benefit more from this subsidy than sellers. This is because of the inelastic demand curve. The more inelastic the demand curve, the more the benefit for buyers as a large percentage of the subsidy will be passed onto consumers through a lower market price.

 

d.). This change in policy will benefit the consumers by offsetting higher prices charged to them. As such, they will be able to pay lower prices for commodities. Drug companies will receive low prices for the commodities since they will not be benefitting from the consumer subsidy. As such, they will charge high prices for the commodities and benefit from the higher margins received. The market for prescription drugs will be affected negatively due to a reduction in drugs supply. This is because the producers aren’t being motivated or compensated to produce more drugs and supply in the market.