Suppose the demand and supply curves for prescription drugs are given below: Qd

Question

Suppose the demand and supply curves for prescription drugs are given below:

Qd = 600 -P

Qs = 2P

a. What is the competitive equilibrium price and quantity?

The government decides to put a price cap of P = 100 on prescription drugs.

b. What is the new quantity sold? Calculate the deadweight loss associated with the price ceiling, assuming that all prescription drugs are sold to the highest valued users under the price cap scenario.

Suppose instead that the government decides to subsidize prescription drugs. If the government subsidizes demanders by 150 per unit for every prescription filled, show that the new equilibrium price paid by demanders will be P = 100.

c. What is the new equilibrium supply price? Calculate the deadweight loss associated with the subsidy.

Explanation / Answer

a. What is the competitive equilibrium price and quantity?

Use the fact that competitive equilibrium has Qd = Qs

600 – P = 2P

P* = $200 and Q* = 400

b. The government decides to put a price cap of P = 100 on prescription drugs. This makes the price fixed at 100 and it cannot be increased beyond this level. New quantity at P = 100 is Q* = 2*100 = 200. Deadweight loss = 0.5*(500 – 100)*(400 – 200) = 40000

c) Now that subsidy is $150 given to buyers, demand becomes Qd = 600 – (P – 150) or Qd = 750 – P

New equilibrium price received by sellers

750 – P = 2P

P* = 250

Price paid by buyers net of subsidy = 250 – 150 = $100. Quantity with subsidy = 2*250 = 500 units

The deadweight loss associated with the subsidy is captured by

DWL = 0.5*(250 – 100)*(500 – 400) = $7500.

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