In developing a vaccine for the SARS virus a pharmaceutical company incurs a ver

Question

In developing a vaccine for the SARS virus a pharmaceutical company incurs a very high fixed cost. The marginal cost of delivering the vaccine to patients, however, is negligible (consider it to be equal to zero). The pharmaceutical company holds the exclusive patent to the vaccine.

Question:
Suppose you have accurate information about the pharmaceutical company's fixed cost. How could you use price regulation of the pharmaceutical company, combined with a subsidy to the company to have the efficient quantity of the vaccine provided at the lowest cost to the government?

Explanation / Answer

Efficiency level of output and price is achieved by regulating the pharmacy company to produce the SARS virus drug at a price equal to MC. This will lead to potential losses to the firm in the short run and exit of the firm in the long run as the firm MC in this case is approximately zero.

So the regulators will protect the firm and the consumers by following the principle of 'fair return price' where the price is set at the point where the ATC cuts the demand curve. At this price the firms will break even and can earn normal profits. When we supply the drugs at P=ATC, the MR is always above the MC, this motivates the firms to supply unlimited quantity at that price.

And if the government feels that the P= ATC is also higher, it can subsidize some part of ATC in the form of tax holiday or rebate. This will reduce the price of the out put to the final consumer and at the same time compensates the firm with a subsidy to cover it losses.

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