In the economist’s sense, the demand for a product is effective demand, that is, the amount consumers are willing to buy at a given price and over a given period of time (Nellis & Parker, 1992). The law of demand is that ‘the quant of a good demanded per period of time will fall as the price rises and rise as the price falls, other things being equal’ (Sloman & Sutcliffe, 2001). The determinants of demand are price of the product, tastes, the number and price of substitute goods, etc. The changes of these factors influence the demand curve shifting, except price of the product. In demand theory, there are three key concepts: elasticity, marginal revenue (MR) and average revenue (AR). Elasticity measures the responsiveness of quantity of product with changing of price of product and other factors (e.g. the price of substitute). Their relationships are shown in Figure.2. According to demand theory, the demand curve is also the average avenue curve. The slope of demand curve is twice as large as that of marginal revenue curve. The demand in AB is elastic (i.e. decreasing price leads to increasing total revenue), in BD is inelastic (i.e. decreasing price leads to decreasing total revenue), and on B is unit elasticity (i.e. decreasing price makes total revenue constant). When the demand curve shifts to right, the elasticity of demand at the same price will decrease. In addition, when MR equals to zero, the total revenue is maximum.
In market operating, only with analyzing the demand curve and cost curve together, managers can correctly anticipate the changing of environments. As shown in Figure.3, the profit reaches maximum amount at point c (i.e. the intersection of MR and MC curves) (Mckenzie & Lee, 2003). The reason is that when MC is bigger than MR after point c, every additional unit produced will lead to a decrease of profit. The maximum profit, therefore, is the area of rectangle P1abATC1 as shown in shadow. According to this theory, managers can arrange relative production and price to adapt changes of demand. For example, if any determinants result in shifting demand curve to right, managers could enlarge production from Q1 to Q2 and increase price from P1 to P2. Thus, the firm will arrive at another profit maximum level (i.e. the area of rectangle P2ABATC2).
In addition, if demand curve is below ATC curve and above AVC curve (shown in Figure.4), the firm can not obtain any profits because total revenue (i.e. the area of rectangle OP1bQ1) is less than total cost (i.e. the area of rectangle OATC1aQ1). The area of rectangle P1baATC1 is the loss. Under this circumstance, there are two choices for managers: first, because the firm will suffer a greater loss if it shuts down than if it operates, it can keep operating and minimize the loss until the firm is able to extricate itself from its fixed cost. Second, the firm can shift the demand curve to right by advertising until the demand curve is above the ATC curve, and then obtain profits.
In long run, firm may invest on fixed assets, such as high productive equipments or new plants, to decrease its average total cost as shown in Figure 5. The important point is that by spreading the higher cost of additional plant and equipment over a larger output level and by declining unavoidable excess capacity of resources, the firm can reduce the average cost of production to achieve economies of scale. When its long run marginal cost goes beyond its long run average total cost, the firm will encounter diseconomies of scale and its average total cost will increase again. However, not all firms experience economies and diseconomies of scale at the same level of production. As a natural monopolist, it may expand its economies of scale as far as its output levels go beyond the level required by the effective market so that it dominates production of market (Mckenzie & Lee, 2003).
Viagra, the most popular erectile dysfunction (ED) drug, has occupied about 85% market shares in US ED market since its birth in 1998 ( Pfizer Inc Third-Quarter 2003 Performance Report), and will has global annual sales of $1.5bn in 2003 (Teacher, 2003). These figures demonstrate that Viagra has become a magnate in this market. However, a new competitive drug, Levitra from GSK and Bayer, entered this market recently. Just in the third quarter, Levitra has obtained about $145m in the US market. Therefore, with Levitra’s entry, the structure of this market has been changing.
To institute a correct competitive strategy, it is necessary to analyze actions of competitors at first. Levitra, as a new entrant in ED market, faces a problem on returning its high R&D expenses. Typically, pharmaceutical companies invest 15% of sales value in R&D (Reuters Business Insight). Considering years of researching Levitra, the figure of the expense is amazing. As a result, Levitra’s cost structure in short run is illustrated like figure 4. Its demand curve is above its average variable cost curve and below its average total cost, which states that Levitra’s total revenue in short run is less than its total cost. Thus, the sole way for Bayer and GSK to overcome this problem is to shift its demand curve to right by advertising or other promotion methods. Furthermore, according to the demand and cost theory, change of price does not lead to shifting demand curve in short run. That may explain why the price of Levitra ($129 per 10 pills) is slightly below the price of Viagra ($139 per 10 pills) (sources from & ). Therefore, the main marketing strategy of Levitra is features differentiation by advertising that Levitra can take effect within 25mins more rapidly than Viagra does and last longer (about 24hours) (sources from ).
Facing such aggressive strategy, Viagra must find an effective strategy to keep its leader status in ED market. Because Viagra has dominated this market for five years, it has diluted its fixed cost into production. That is to say that Viagra has entered into economies of scale. Namely, its average total cost is lower than new entrants’. Comparison of demand and cost between Viagra and Levitra is illustrated in Figure 6. Viagra’s marginal cost curve (MCV) is on the right of Levitra’s marginal curve (MCL), which means that the quantity of Viagra (Q2) is higher than that of Levitra (Q1) at the same price (P1). At this time, Levitra has a loss (area of rectangle abP1ATC2) and Viagra has a profit (area of rectangle ABATC1P1). If the whole demand of ED market is constant (i.e. no unexploited demands), Viagra will loss its market shares (i.e. left shifting of DV) when Levitra expand its market shares by promotion (i.e. right shifting of DL). Under this circumstance, the best way for Viagra is to launch price war. Because of its dominance of cost, Viagra will take back its market shares and compel Levitra to withdraw this market. However, the reality is that there are a large number of unexploited market demands—the sale of ED drugs will reach $6bn globally within six or seven years (Teacher, 2003). In addition, because both Pfizer and Bayer are magnates in pharmaceutical industry, it is impossible for Pfizer to drive its competitors out of this booming market only by price war. Therefore, the appropriate competitive strategy in short run for Pfizer is: first, Pfizer need to analyze strengths and weaknesses between the two drugs. Then, as response, Pfizer should launch more aggressive promotion methods (e.g. advertising its product features, bonus) to expand its market shares not only from its competitors’ market shares, but also from unexploited market segments. At this term, it could be acceptable to give up equilibrium between profit and cost, because the decrease of profit can be compensated in the long run. In long run, Pfizer should invest on plants, equipments and R&D in time to content increase of demands. Then, because its average total cost decreases again, Pfizer can take more profit from increase of demand in the former term.
To sum up, demand and cost theory, as an important part in microeconomics, can help managers make correct decision in marketing and production management. In the application of this theory, it should be noticed to integrate the short run analysis and long run analysis according to profit-maximizing principle.
(1748 words)
References:
Mckenzie, R.B. & Lee, D.R. (2003) Microeconomics for MBAs. On the Internet. URL:
Nellis, J. G & Parker, D. (1992) The Essence of Business Economics. Hemel Hemsptead: Pretice Hall International ( UK) Ltd.
Pfizer Inc Third-Quarter 2003 Performance Report. On the Internet. URL:
Sloman, J. &Scutclitte, M. (2001) Economics for Business, 2nd edition. Essex: Pearson Education Limited.
Reuters Business Insight (1998) The Pharmaceutical Marketplace in The 21st Century. On the Internet. URL:
Teacher, D. (2003) GSK and Bayer’s Orange Pill Challenges Viagra. On the Internet. URL: html
