Daniel l. Rubinfeld

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Part Introduction: Markets and Prices Preliminaries SLR cameras .. Gasoline is another example. Regular and premium octane gasolines might be considered part of the same market because most consumers can use either. Diesel fuel, hovvever, is not part of this market because cars that use regular gasoline cannot use diesel fuel, and vice versa.~ Market definition is important for a number of reasons. A company, for example, must understand v\'ho its actual and potential competitors are for the various products it now sells or might sell in the future. It must also knov'\' the productcharacteristic boundaries and geographical boundaries of its market in order to be able to set price, determine advertising budgets, and make capital investment decisiQns. Market definition is likewise important for public-policy decisions. Should the go\'ernment allow a merger or acquisition involving companies that produce similar products, or should it challenge it The answer depends on the impact of that merger or acquisition on future competition and prices, and often this can be evaluated only by defining the market The development of a new drug by a pharmaceutical company is an expen- 1. siv~ venture. It begins with large expenditures on research and development, then requires various stages of laboratory and clinical testing, and, if the new drug is finally approved, marketing, production, and sales. At that point, the firm faces the important problem of determining the price of the new drug. Pricing depends on the preferences and medical needs of the consumers who 'will be buying the drug, the characteristics of the drug, and the number and characteristics of competing drugs. Pricing a new drug, therefore, requires a good Lmderstanding of the market in which it will be sold. In the pharmaceutical industry, market boundaries are sometimes easy to determine, and sometimes not so easy to determine. Markets are usually defined in terms of t!zerapeutic cl(lsses of drugs. For example, there is a market for (lntiulcer drugs that is very clearly defined. Until a few years ago, there were four competitors in the market: Tagamet (produced by Smithkline-Beecham), Zantac (produced by Glaxo), Axid (produced by Eli Lilly), and Pepcid (produced by Merck). All four drugs work in roughly the same way: They cause the stomach to produce less hydrochloric acid. They differ slightly in terms of their side effects and their interactions with other drugs that a patient might be taking, but in most cases they could be readily substituted for each other. s Another example of a clearly defined pharmaceutical market is the market for (lllticllOlesterol drugs. There are four major products in the market: Merck's Mevacor has about 50 percent of the market. Pravachol (Bristol-Myers-Squibb) and Zocor (also Merck) each have about 20 percent, and Lescol (Sandoz) about 10 percent TIlese drugs all do pretty much the same thing (reduce blood cholesterollevels) and work in pretty much the same way. While their side effects 4 How can we determine the extent of a market Since the market is where the price of a good is established, one approach focuses on market prices, We ask whether product prices in different eographic regions (or for different product types) are approximately the same, or whether they tend to move together. If either is the case, we place them in the same market.. For a more detailed discussion, see George J, Stigler and Robert A Sherwin, "The Extent of the !vlarket," JOHrnal of Law al/d Eeol/olllies 27 (October 1985): 555-85. . 5 As we will discuss in Example 101, more recently Prilosec entered the market, and by 1997 became the largest selling drug in the world, It is also an antiulcer drug, but works on a different biochemical mechanism and interactions differ somewhat, they are all close substitutes. Thus when Merck sets the price of Mevacor, it mu~t be concerned not only 'with the 'willingness of patients (and their insurance companies) to pay, b{lt also with the prices and characteristics of the three competing drugs. Likewise, a drug company that is considering whether to develop a new anticholesterol drug knows that if it commits itself to the inveshllent and succeeds, it will have to compete with the four existing drugs. The company can use this information to project its potential revenues from the ne'w drug, and thereby evaluate the inveshllent. Sometimes pharmaceutical market boundaries are more ambiguous. Consider painkillers, a category that includes aspirin, acetaminophen (sold under the brand name Tylenol but also sold generically), ibuprofen (sold under such brand names as Motrin and Advil, but also sold generically), naproxen (sold by prescription, but also sold over the COLmter by the brand name Aleve), and Voltaren (a more powerful prescription drug produced by Novartis). There are many types of painkillers, and some work better than others for certain types of pain (e.g., headaches, arthritis, muscle aches, etc.). Side effects likewise differ.. While some types of painkillers are used more frequently for certain symptoms or conditions, there is considerable spillover. For exarnple, depending on the severity of the pain and the pain tolerance of the patient, a toothache might be h'eated with any of the painkillers listed above. This substitutability makes the boundaries of the painkiller market difficult to define. We often want to compare the price of a good today with what it was in the past or is likely to be in the future. To make such a comparison meaningful, we need to measure prices relative to the overall price level.. In absolute terms, the price of a dozen eggs is many times higher today than it was 50 years ago. Relative to prices overall, however, it is actuallv lower. Therefore, we must be careful to correct for inflation when comparing prices across time. This means measuring prices in renl rather than nomin(ll terms. The nominal price of a good (sometimes called its "current-dollar" price) is just its absolute price. For example, the nominal price of a quart of milk was about 40 cents in 1970, about 65 cents in 1980, and about $1.05 in 1999. These are the prices you would have seen in supermarkets in those years. The real price of a good (sometimes called its "constant-dollar" price) is the price relative to an aggregate measure of prices. In other words, it is the price adjusted for inflation. The aggregate measure most often used is the Consumer Price Index (CPl). The CPI is calculated by the US Bureau of Labor Statistics and is published monthly. It records how the cost of a large market basket of goods purchased by a "typical" consumer in some base year changes over time. (Currently the base year is 1983.) Percentage changes in the CPI measure the rate of inflation in the economy6 " Because the market basket is fixed, the cpr can tend to Q\'erstate inflation. The reason is that when the prices of some goods rise substantially, consumers \\"ill shift some of their purchases to goods whose prices ha\'e not risen as much, and the cpr ignores this phenomenon. We will discuss this in Chapter 3 nominal price Absolute price of a good, unadjusted for infla tion" real price Price of a good relative to an aggregate measure of prices; price adjusted for inflation. Consumer Price Index Measure of the aggregate price leveL
12 Part 1 Introduction: Markets and Prices Preliminaries 3 After correcting for inflation, do we find that milk was more expensive in 1999 than in 19707 To find out, let's calculate the 1999 price of milk in terms of 1970 dollars. The CPI was 38.8 in 1970 and rose to about 167 in 1999 (There was considerable int1ation in the United States during the 1970s and early 1980s.) In 1970 dollars, the price of milk was 38.8 X 51.05 = 50.24 167 . In real terms, therefore, the price of milk \vas lower in 1999 than it was in 1970. Put another way, the nominal price of milk went up by about 162 percent, but the CPI went up 330 percent. Relative to the aggregate price level, milk prices fell, In this book, we will usually be concerned with real rather than nominal prices because consumer choices involve analyses of price comparisons. These relative prices can most easily be evaluated if there is a common basis of comparison. Stating all prices in real terms achieves this objective. Thus, even though we will often measure prices in dollars, we will be thinking in terms of the real purchasing power of those dollars. I n 1970, Grade A large eggs cost about 61 cents a dozen. In the same year, the average annual cost of a college education at a private four-year college, including room and board, was about $2,530. By 1998, the price of eggs had risen to $1.04 a dozen, and the average cost of a college education was $19,213. In real terms, were eggs more expensive in 1998 than in 1970 Had a college education become more expensive Table 1.1 shows the nominal price of eggs, the nominal cost of a college education, and the CPI for 1970-1998. (The CPI is based on 1983 = 100.) Also shown are the felll prices of eggs and a college education in 1970 dollars, calculated as follows: . . . r- CPI1970 . .. Rea I pnce ot eggs m 197:) = -~-- x nommal pnce m 1975 CPI 1975 R I . f . 1980 CPI 1970 . ea pnce 0 eggs m = --- X nomma I pnce . m . 1980 CPI 1980 and so forth. The table shmvs clearly that the real cost of a college education rose (by 81 percent) during this period, vdule the real cost of eggs fell (by 59 percent). It is these relative changes in prices that are important for the choices that consumers must make, not the fact that both eggs and college cost more in dollars today than they did in 1970. In the table, we calculated real prices in terms of 1970 dollars, but we could have just as easily calculated them in terms of dollars of some other base year. For example, suppose we want to calculate the real price of eggs in 1980 dollars. Then: Real price of eggs in 1975 = x nominal price in 1975 CPI 1975 R I . f . 1985 CPI 1980 . I . . ea pnce 0 eggs m = -~-- X nomma pnce m 1985 CPI 1985 and so forth. By going through the calculations, you can check to see that in terms of 1980 dollars, the real price of eggs was $1.30 in 1970, $1.18 in 1975, 84 cents in 1980, 61 cents in 1985, 64 cents in 1990, and 53 cents in 1998. You will also see that the percentage declines in real price are the same no matter wluch base year \·ve use. s Consumer Price Index Nominal Prices Grade A large eggs College education Real Prices ($1970) Grade A large eggs College education 1970 1975 1980 1985 1990 1998 38.8 53.8 82.4 107.6 130.7 163.0 $0.61 $0.77 $0.84 $0.80 $1.01 $1.04 2530 3403 4912 8156 12,800 19,213 $0.61 $0.56 $0.40 $0.29 $0.30 $0.25 2530 2454 2313 2941 3800 4573 The federal muumum wage-first instituted u11938 at a level of 25 cents per h~ur-has been increased periodically over the years. From 1981 through 1989, tor example, it was $3.35 an hour and was raised to $4.25 an hour in 1990. In 1996, after much deliberation and debate, Congress voted to raise the rnll1imum wage to $4.70 in 1996 and then to $5.15 in 1997 9 Figure 1.1 shows the minimum wage from 1938 through 1999, both in nominal terms and in 1996 constant dollars. Note that although the legislated muumum wage has steadily increased, in real terms the minimum waae o todav is 0 not very different from vl'llat it was U1 the 1950s. Nonetheless, the 1996 decision to increase the muumum wage was a difficult one. Although the higher minimum wage would provide a better standard of 7 Two good sources of data on the national economy are the Ecollolllic Report of the President and the Statistical Abstract of the Uilited States. Both are published annually and are a\'ailable from the US. Government Printing Office 8 You can get .World Wide Web data on the cost of a college education at ~nd on the pnce of eggs at L'ric'I'in:c: m",,[ c.".'" "ra , Some states also ha\'e mininmm "'ages that are higher than the federal minimum waae You can learn more about the minimum wage at this 'Web site: ',\ f-:CH. del! l~'J
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Daniel l. Rubinfeld

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