Maine has passed a law allowing the state to negotiate with drug suppliers on behalf of more than 300,000 residents who do not have insurance coverage for prescription drugs. The objective is to obtain lower prices similar to those obtained by other large buyers. If prices do not fall in three years, the state can impose price controls.

The Pharmaceutical Research and Manufacturers of America have sued the state, alleging that the law is unconstitutional because it conflicts with the federal Medicaid program and regulates transactions outside the state. The Maine Human Services Commissioner observed that the association is concerned that the Maine law will be copied elsewhere.

(Updated September 1, 2000)

1. Draw a diagram showing the monopoly equilibrium of a drug producer. Include the demand and marginal revenue curves, and the average total and marginal cost curves.

a) Where there are many individual consumers, is the firm a price-taker or a price-maker? Why?
b) If consumers were to be represented by the state, how would your answer change?
c) How would prices be determined?
d) What is the lowest price that would exist in the long run, assuming the same output were produced? Mark this price on your diagram.

2. Suppose that price controls are imposed.

a) On a new diagram of the drug monopoly, show how an effective price control would affect price, output and profit.
b) What would be the benefits and the costs for consumers?
c) What would be the advantages and disadvantages for producers?
d) What would be the pros and cons for society in general?