The Cornell Queens Executive MBA

Managerial Economics and Industry Analysis MBUS 881/NCCB 505 Summary of Discussions Session 3 Bo Pazderka

Session 3 - Slide # 9
Q1: Economic functions of patents Motivation to invent Inducement to invest in commercialization Forced disclosure of information to benefit other potential inventors (this is a trade-off for the exclusive grant of monopoly)

Session 3 - Slide # 9 (cont.)

Q2: Negative consequences of patents Diffusion of innovation is slowed down (fewer consumers can afford the product as price rises) The patent monopoly creates deadweight welfare loss Research in areas protected by patents may be discouraged Inventors fear being sued for patent infringement Since the price of knowledge is increased to all users, research in related areas is more costly Tradeoff: In exchange for patent monopoly, the patentee must disclose detailed technical information
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Session 3 - Slide # 9 (cont.)

Q 3: Should generic competition be encouraged The annual cost of therapy with brand-name HIV/AIDS drugs is US$10,000-15,000; generic equivalents from Brazil cost US$3,000 and from India $350 Two cases currently before the courts in India: The Indian Patent Office denied an application by the Swiss pharmaceutical company Novartis for a formulation of a leukemia drug marketed elsewhere as Gleevec or Glivec, on the grounds that the new formulation does not improve efficiency. Two Indian courts confirmed the ruling; the case is currently (2013) before the Supreme Court of India (Globe and Mail, March 26, 2012) [second case on next slide]
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Session 3 - Slide # 9 (cont.)

The Indian patent controller issued a compulsory licence to allow the Indian generic firm Natco to produce anti-cancer drug Nexavar, patented by Bayer. Natcos cost: $173/month of therapy. Bayers cost: $5,500/month. The case is currently (2013) before the courts (Financial Times, October 2, 2012) Generic producers can produce high-quality drugs The TRIPS Agreement of 1994 allows compulsory licensing under specified circumstances: National emergency Public interest Public non-commercial use Abuse of patent by the patent holder
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Session 3 - Slide # 9 (cont.)

Key objection to generic competition: It reduces profits of research-oriented brand-name companies. Thus future R&D spending and flow of new drugs could be undermined However, there are barriers to generic entry: Authorized branded generics Regulatory delays Reason why brand-name companies also sell generic drugs: Increased profits through price discrimination in segmented markets (Chapter 5 of Course Notes)

Session 3 - Slide # 17
Q1: Has Microsoft stifled innovation or enhanced it? Judge Jackson found (November 1999) that Microsoft: Attempted to destroy Netscape Deliberately applied its market power to harm any firm that could compete against its core products Created a significant applications barrier to entry (although this is hard to interpret as a deliberate attempt to exclude competition) However, on the positive side Microsoft provided consistent platform, minimizing difficulties for average computer user Helped standardize user interface, etc.
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Session 3 - Slide # 17 (cont.)

Q2: Should Microsoft have been broken up? Judge Jackson argued (June 2000) that computer operating systems could be separate from applications Supporting argument: After the break-up of AT&T, new services were developed, long-distance rates reduced, innovation stimulated However, there are problematic aspects of breakup: With OS and Applications separate, no single entity would have incentives to promote integration No clear organizational lines for split exist Cost of corporate restructuring would be large

Session 3 - Slide # 17 (cont.)

Additional comments made in class discussion: Market restrictions created by Microsoft stimulated the development of open-source software. Microsoft thus unintentionally contributed to innovation Because of internal frictions among the various divisions within Microsoft, innovations made by one division are sometimes perceived as a threat by other divisions thus innovation is stifled This would suggest that breakup would be beneficial. However, some divisions are not profitable and would not survive on their own

Session 3 - Slide # 17 (cont.)

Additional comments made in class discussion (cont.): The standards developed by Microsoft became industry standards. This drives down costs, but also stifles innovation by other firms Standards raise barriers to entry The legal complexities in the software industry generate numerous lawsuits. The size of Microsofts legal department would place it among the largest law firms in the U.S.

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Session 3 - Slide # 26
Q 1: Incentives to advertise Brand-name company advertises the brand name (in this case, Tylenol) very little of the impact of its spending will spill over to other brands Generic company advertises the product in general, (in this case acetaminophen). The sales of all generic products will likely benefit they will enjoy a free ride on the spillovers of a single companys advertising spending

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Session 3 - Slide # 26 (cont.)

Q 2: Incentives for quality control Brand-name company has a greater incentive, since the potential damage to the value of the brand resulting from poor quality (product recalls, etc.) is very large Generic company has a lesser incentive, since the potential damage from poor quality dissipates among several producers of the same (generic) product

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Session 3 - Slide # 29
Q1: Using oligopoly theory to defend the oil companies Theory suggests that price competition in oligopoly sometimes degenerates into price war hence firms in such industries tend to avoid price competition and replace it with other forms (advertising, new products) Gasoline is a homogeneous product, and price differentials among competitors are difficult to sustain Gasoline price changes when they occur tend to be linked with changes in crude oil prices (and all oil companies are part of the same world market) Natural disasters, etc. play a role, and they tend to affect all competitors at the same time
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Session 3 - Slide # 29 (cont.)

Q2: Other industries (market) exhibiting identical prices: Sugar, cement, steel Q3: Can collusion be beneficial to society? Economists argue that price collusion (price fixing) is always damaging However, Agreements on standardization, rationalization of product lines, reduction of pollution, all-around reduction of advertising spending, etc. are beneficial [Competition (antitrust) authorities usually conduct a prior review and approval of such agreements]
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Session 3 - Slide # 29 (cont.)

Q 4: Ethical responsibility of managers Fiduciary duty of managers to maximize shareholder wealth assumes acting within the law this is also usually (but not always) ethical Business ethicists argue that managerial decisions should follow two fundamental values: Ordinary decency (honesty, fairness, respect for property rights) Distributive justice (aligning the distribution of benefits within the organization with contributions made by its members) Proponents of the corporate social responsibility (CSR) doctrine argue, in addition, that:
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Session 3 - Slide # 29 (cont.)

Q 4 (cont.) Business decisions should take account of stakeholders (other than shareholders) However, critics of the CSR doctrine emphasize the distinction between taking account of vs. being accountable to The employment contract between managers and owners contains a set of formal and direct rights and obligations making managers accountable to the owners (Reference: Course Notes, pp. 194-197)

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Session 3 - Slide # 33
Q 1: Cartel quota adjustments As demand conditions change, both the D curve and the MR curve shift, hence the total quantity optimal for the cartel changes The demand for OPEC oil may also be affected by the behaviour of non-OPEC oil producers A change in total quantity requires adjustment of quotas for each member (historically, Saudi Arabia acted as a shock absorber)

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Session 3 - Slide # 33 (cont.)

Q 2: Relevance of the MR = MC rule Application of this rule guarantees short-run profit maximization However, a very high price of oil encourages R&D in alternative sources of energy and energy conservation. Hence, long-run profit maximization may require a price PACTUAL < PSHORT-RUN PROFIT MAX. Some OPEC member countries have invested heavily in the Western industrialized economies it is in their interest to ensure that the rising price of oil does not cause an economic downturn

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