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PROFESSOR: Once again
to put this in the
context of where we are.
We're talking about
producer theory.
And we're talking
about how firms
decide how much to produce.
We started with a perfect
competition, and that nailed
down the fact that with under
perfect competition we got the
zero profit long run perfectly
elastic supply curve.
We then, last time, talked
about monopoly as another
extreme and talked about how
monopolists choose both their
price and their quantity.
They set margin around or equal
to marginal cost. That
gives them a quantity.
And then they choose the price
off the demand curve and how
that leads to profits and how
that leads to monopolists
producing less than the
competitive level.
And we also ended by talking
about a perfectly price
discriminating monopolist, one
that can actually charge each
consumer their willingness to
pay and therefore, absorb all
the social surplus.
Now, I want to come back and
start, this morning, by
talking again about price
discrimination and realizing
that, in some sense, we know
that there's no such thing as
perfect price discrimination.
There's no monopolist out there
charging us literally
exactly what we're
willing to pay.
But there are lots of examples
of price discrimination in the
real world.
And sometimes they're
kind of obvious.
Sometimes they're not.
But what they all have in common
is the notion of trying
to find some signal of our
willingness to pay and using
that to set the price.
So instead of being like our
original monopolist, just
setting one price.
Monopolists are forever trying
to find some signal, some
underlying signal of our
willingness to pay and using
that to set the price.
OK.
So for example, a classic
example we know is airlines.
OK.
What airlines do--
Airlines charge you more, for
example, if you book your
ticket the last minute.
And the notion of course-- or
towards the last minute.
At the very last minute they may
end up charging you less.
But as you get close to the date
when you want to leave,
the price goes up.
The notion, of course, is that
who is going to buy tickets
close to the date they want to
leave. It's largely going to
be business people, not
the vacation traveler.
The vacation traveler is
going to plan ahead
and buy far in advance.
The one that's going to buy a
week before is the business
person who just got a
meeting scheduled.
Business people are going to
be less price sensitive.
They're going to have a higher
willingness to pay.
They've got to get
to the meeting.
They're not paying anyway.
The company's paying.
And they're just to
do what they need
to get to the meeting.
So that's a less price
sensitive population.
So that's the population
you want to hit
with a higher price.
So you want to price up tickets
that you buy towards
the end because those are more
likely to be the people who
are least price sensitive.
So let's ask another question.
Somebody tell me why do movie
theaters charge less for
matinees than for
movies at night?
Why do movie theaters
charge less?
If you go see the first movie
of the day-- and you guys
probably don't anymore.
But when you were
kids you did.
And when I take my take
my kids, I do.
And that afternoon matinee
movie costs less.
Why is that?
Yeah.
Anyone want to take
a chance at that?
And related to it, you can
also ask the question.
Why do restaurants have
early bird specials?
Why, when you go to restaurant,
often will they
charge you less if you go there
in the early hours as
opposed to later?
So what's going on with that?
Someone tell me.
Yeah.
AUDIENCE: They're not
using up all their
seats in the afternoon.
So they might as well
lower the price.
PROFESSOR: In the afternoon
they're not.
Although the truth is, a lot
of the time they're--
If you look at a movie theater
today, it's almost never full,
except for like the opening
night of a very popular movie.
So that's part of it.
But let's talk about
the demand side.
What else is special about
the type of people?
Why don't you go on what's
special about the type of
people who want to see movies or
go to restaurants at those
different times?
They're not willing
to pay as much.
PROFESSOR: Yeah, they're
basically people with a lot of
free time on their hands.
Right?
The people who are going out
to dinner early, the people
who see movies in the afternoon,
these are people
who are unemployed or
have little kids.
And they're just looking
to kill time.
And so basically, these
are people who
are willing to shop.
These are people who are going
to say look, I've got to fill
in some time.
I don't have to go right now.
I can go any time.
So I'm going to be more
price sensitive.
The people who are going to
dinner later, who are going
out to the movie at night,
they're working all day.
They have no choice.
They have to see the
movie at night.
Or they're in school all day.
They have to see the
movie at night.
They're less price elastic.
So that's why you want
to set the movie
price higher at night.
Alternatively, another
reason could be--
One signal of willingness to
pay is price sensitivity.
What's another signal?
It's going to be income.
Who's going to be seeing the
movies during the day and
going to the dinner early?
It's elderly individuals and
families with small kids who
are the most resource
strapped.
People who have plenty
of disposable income
are going at night.
They're working.
They're young.
They're singles and
young couples.
They work all day or are
in school all day.
They go at night.
They have more disposable
income.
The people going during the
day are the elders and the
people with young kids who have
less disposable income.
And as a result they're going
to be more price sensitive.
So you want to charge
them a lower price.
So that's another example
of price discrimination.
OK, why does Disney World charge
you less if you live in
the area than if you do not.
This is true fact.
Disney World charges you less if
you're from Orlando than if
you're not from Orlando.
Why is that?
Someone tell me.
Yeah.
AUDIENCE: I think the Disney
can go any time.
So you might as well you
might as well take
them to other places.
PROFESSOR: I mean, basically
the idea is look, if I just
spent a grand on a plane ticket
to take my kids to
Orlando to Disney World, I'm not
going to kvetch over $10
either way, getting in
or not getting in.
But if I live in the area,
I may or may not go.
I can go to a park, instead.
I can go do something
else, instead.
It's just one of many
choices for me.
The point is, having paid the
fixed cost of getting to
Orlando, I'm going to be much
less price sensitive about
getting into the park than other
people who live there,
who have lots of
other choices.
Likewise, having paid the money
to get there, I have
shown I have more disposable
income because I paid the
money to get there.
I've shown I have enough
disposable income that I'm
willing to drop money on a plane
ticket to take my kids
to Disney World.
So I'm going to have
more income that we
are willing to pay.
OK, so basically the point
is companies are
forever doing this.
The ultimate example was,
briefly, Amazon.com started
pricing by IP address.
For a while, it was a
controversy over Amazon
started literally charging,
getting people's IP addresses
and literally adjusting prices
based on saying, oh, this
person is from a university
library.
University libraries aren't
price sensitive.
We'll charge them
more, et cetera.
That got shut down.
But that was the ultimate form
of trying to be price
discriminatory.
That was as close as we'll
come to perfect price
discrimination.
The point is, in general, people
with market power,
people that set the price above
marginal cost will in
general be looking for parties
which are high income and low
elasticity to which they can
charge a higher price.
Yeah.
AUDIENCE: Another example, like
MIT, they actually ask
for your income statement.
And then, based on that, they
give you their price.
PROFESSOR: Well, see that's
very interesting.
That's very interesting.
MIT--
What's tricky about that is--
Is that about exploiting
price sensitivity?
Or is that about equity?
That's a bit harder because
MIT could claim--
And probably, actually,
it's true.
They're not doing it.
Because the truth is,
MIT could charge
whatever they want.
They'd still fill the class.
Right?
So it's not really about--
I think in MIT's case, it's
not really about price
sensitivity.
It's about income redistribution
and some notion
of making sure low income
people can come and
afford to be here.
But that is a good point.
The difficulty with empirical
economics is often,
correlation versus causation.
The same fact can have many
different descriptions, many
different explanations.
OK?
So just wanted to give you some
brief examples to think
about the fact that we see
price discrimination in
reality all the time.
Nonetheless, we do our classic
monopoly model.
We assume there's one price.
And the truth is the one price
monopolist is probably closer
to the truth than the perfectly
price discriminating
monopolist. But the truth, as
often in this course, is going
to be somewhere in between.
OK, questions about that.
What I want to focus on
primarily, for this lecture,
is where do monopolies
come from.
How do monopolies arrive?
How do we end up in this
situation, where instead of
many firms competing to sell
a good, we only have one?
And there's basically two
sources of monopolies, two
sources that give birth to
monopolies in modern societies.
The first source is
cost advantages.
The first source is
cost advantages.
Some markets come with natural
cost advantages, natural
reasons why there's a
benefit to being one
player in the market.
So for example, it could be
that there's, essentially,
only one usable input.
So let's say there's a
rock quarry in town.
You've got to get rocks from.
And there's just one
rock quarry.
And rocks are really expensive
to transport.
So basically, if you live in
that town, the person who owns
that rock quarry is going to be
the monopolist. No one else
is really going to compete
because it would cost them so
much to transport rocks
from another
quarry in another town.
OK?
Basically, the point is.
Sometimes, there are
these fixed costs.
And whoever has paid the fixed
cost has an enormous natural
advantage over other
players, over other
entrants to the markets.
And we call those natural
monopolies.
Natural monopolies--
Natural monopoly is a firm where
for all the relevant
quantities over any relevant
range, the average cost for
one firm is always below the
average cost of a new entrant.
The average cost for the one
firm that's in the market is
already always going to be below
the average cost for any
new entrant.
And that is going to be true
in markets with very large
fixed costs and very small
marginal costs.
A natural monopoly will occur
when there's very large fixed
cost and very small marginal
cost. In that case, what we'll
see is average cost is
always declining.
Natural monopolies arise
when average
cost is always declining.
If average cost is always
declining, it's never going to
make sense for another entrant
to come in the market.
And an example we
could think of--
The best example I could think
is like a water utility, the
folks who deliver water
to our houses.
The fixed costs of delivering
water are enormous.
You've got to lay the pipe
to deliver the water
all through the town.
Those are enormous
fixed costs.
The marginal costs
are trivial.
I mean, water is cheap.
You get the water.
You send it through the pipes.
OK?
It would never make sense to
have two companies deliver
water throughout the town.
It wouldn't make sense to have
another company come in, rip
up the roads, lay a competing
set of pipes all through the
town to compete.
It just wouldn't make sense
because those fixed costs are
so huge relative to the
marginal costs.
They could never make money.
That first company--
If a second company came in and
threatened to do that, the
first company could always keep
the price low enough that
that second company could never
recover their fixed costs.
Because the first company has
already paid the fixed cost,
they're already in.
A second company could
never come in and
cover those fixed costs.
So if we see figure 15-1.
Here's an example of a firm,
of a water utility, low
marginal cost. There was a
high fixed cost. So the
initial average costs
are very high.
But the average costs are
declining constantly because
the marginal costs are low,
relative to fixed costs.
OK?
So if demand for the good goes
up, over some relevant range--
If demand gets to be infinite,
it may make sense to lay
another set of pipes.
You know, the first set of pipes
may get overwhelmed.
But as long as demand can be met
by the set of pipes that's
been laid, there's absolutely no
reason for another firm to
enter this market.
If another firm ever threatened
to do so, the first
firm would just lower price and
say, look, you're going to
have to spend so much money
putting that set of pipes in
through town you'll never
be able to make it up.
Because having laid those
set of pipes--
Remember what the shut
down condition is.
As long as that first firm can
charge price greater than
marginal, can charge price above
average variable cost,
which is marginal cost
in this case.
As long as that firm can charge
price above marginal
cost, it will always
stay in business.
And that second firm can't make
any money at a price near
the marginal cost because they
can't cover their fixed cost.
So they'll essentially
chase them out.
So essentially, the fact that
they've had that set of pipes
already laid down gives them a
threat, a credible threat,
that that second firm
cannot enter.
Thus, we call natural monopolies
are places where
other firms face barriers
to entry.
Natural monopolies are where
there are barriers to entry,
where other firms cannot enter
because they'd have to pay
those enormous fixed costs.
And it would never make economic
sense to do so.
OK.
And in that case, you're going
to get a monopoly.
And we call it a natural
monopoly because, in some
sense, the monopoly is the
right thing to do.
It is actually economically
efficient for there to be only
one provider of water
in the town.
That's the economically
efficient outcome.
It is economically inefficient
to pay a second set of those
enormous fixed costs.
Now, then you say, well what
about the fact that monopolist
will under produce water,
charge too much.
We'll get to that in a minute.
But when there's natural
monopolies, the goods should
be delivered by a monopoly.
That's the right thing to do.
But there's a second reason why
monopolies arise, which is
a little more pernicious, which
is government actions.
Sometimes monopolies are
unnatural and created by the
government.
So a classic example is when
governments actually decide
that they're going to deliver
a good and only they'll
deliver the good, like
the postal service.
When a government decides look,
we are just going to
deliver this good.
We're just going to have
the postal service.
And for many, many years, if you
wanted to send a package
from one place to another, you
had to do it through the
postal service.
Well, it turned out
of course, that
wasn't a natural monopoly.
As we know through the growth of
FedEx and others, there was
actually quite a good distance
to compete in that market.
And eventually, those other
folks delivering packages came
in and competed in
that market.
And in fact, in the US, it's
very rare to have a government
provided good, a purely
government provided good.
It's very rare.
Historically, it wasn't.
And in many other parts of
the world, it's not.
In many other parts of the
world, governments run the
banks, the airlines,
all utilities.
So in many other parts of the
world, governments will
actually set up these
monopolies
through government action.
And basically, that is something
which is not done
much in the US but
done elsewhere.
Now however, one place we do set
up monopolies in the US,
which is pretty important,
is through
the issuing of patents.
If you invent, say a new drug,
and you patent it.
You then have the exclusive
right to sell that chemical
compound for 17 years.
So if you come up with some new
chemical compound to treat
whatever, you have the exclusive
right to market that
chemical compound
for 17 years.
That is a government sanctioned
monopoly.
Now, is that a good thing
or a bad thing?
Are patents--
The government has just
created a monopoly.
Could someone tell me why that
might be actually a good thing
for the government to do?
Yeah.
AUDIENCE: Schumpeter talks about
how it's a way to cause
innovation.
Because no one would put that
many dollars into drug
research, if they weren't
going to be
able to make money.
Because the marginal cost was
so low that other people--
The cost of establishing a
pharmaceutical company
[UNINTELLIGIBLE]
is really low.
So other people would come
and cut out all their
profits that they had.
PROFESSOR: Exactly, if you put
all these resources into
inventing a drug, it's not
like laying pipes.
Once you invented it, someone
could just copy it the next
day and produce it at the
same cost you can.
So why would you ever do that?
Why would you, as someone who,
even if you cared about the
benefits to the world, still
want to make some money.
Why would you spend billions
and millions of dollars
inventing these new drugs?
If the next day, someone
else can just say,
that's a great idea.
I'll produce that for $0.47 a
pill, just like you will.
And you won't make
any money off it.
And you'll have lost all this
money you invested.
So the argument for patents is
you want an incentive for
innovation, which suggests
there's a trade-off here.
On the one hand, you want an
incentive for innovation.
On the other hand, once you
create this monopoly, they can
charge outrageous prices.
There is a drug.
There are drugs.
Genzyme is very big company
started here in Massachusetts.
And the whole reason they exist
is to create drugs for
very, very rare diseases.
Diseases that strike like
100,000 people a
year but are deadly.
Like Gaucher's disease is a
famous example of this one.
So they create these drugs.
They put billions of dollars
into research,
create these drugs.
And then, having created them
and gotten a patent, charge
like $100,000 a year
to use the drugs.
Drugs that cost, you know,
$500 a year to produce.
Now on the one hand, if these
drugs didn't exist,
people would die.
These are literally
lifesaving drugs.
These are people who used to
die, who now live because of
these drugs.
And these drugs never would have
been invented if Genzyme
couldn't have made some
money off them.
On the other hand, you've got
a product which costs $500 a
year to make, and they're
charging $100,000 a year to
people to use.
And in particular, when it
comes to drugs like for
treating AIDS in the developed
world where people cannot--
There's no way they can afford
that kind of money.
That's a problem.
Yeah.
AUDIENCE: But aren't you not
only paying for them to
produce the drug but
paying for all the
research that went into--
PROFESSOR: Exactly,
that's right.
You're paying for all
the research.
That's why they never
would have
invented it if they couldn't.
So you're paying for
the research.
They also take home a nice,
hefty profit at
the end of the day.
But that is true.
You are also paying for the
research that goes into that.
And people wouldn't put
that money up front.
That research is funded
by investors.
And investors would not invest
in Genzyme and give them money
to do research if they weren't
going to get a return.
So if Genzyme--
Of that $99,500 Genzyme makes
on that Gaucher's disease
drug, most of it is going back
to pay the people who funded
the research.
But a healthy chunk is not.
A healthy chunk is market
power monopoly profit.
Yeah.
AUDIENCE: Could the government
then have subsidies for some
types of licensing to ensure
that the consumers are not
affected because everyone
cannot afford the
drug without it.
PROFESSOR: I'm going to come
to that in a second.
Now actually, let me just hold
that thought for a second
because I want to actually show
you how we think about
whether patent is a
good idea or not.
So let's go to figure 15-2.
I just want to, sort of, show
you how what you guys seem to
understand intuitively, we can
illustrate in the kind of
graphs we've been using.
Once again, we want to think
about going back and forth
between the intuition and the
graphical and mathematical
aspects of this stuff.
So here we have a monopolist.
Imagine that you have a good
where the original demand
curve is D1.
A good where the original demand
curve is D1 and the
original consumer surplus is
that dotted area C plus 1 plus
that slashed triangle.
So it's based on the area above
the competitive price PC
under the demand curve D1.
So you have a good.
It's some drug, which
people like.
And there's some
demand for it.
And it's produced competitively
at a price PC
with the consumer surplus
of that triangle.
Now, let's say a monopolist
comes along and says, we can
make this drug way better.
We could make a much better
drug, but we're going to need
a patent for it.
Well, two things happen.
On the one hand, the demand
curve shifts way out.
Now you've got something which
people value a lot more.
They're much more willing to
pay for this better drug.
OK?
And that's the benefit.
That's the innovation
effect on demand.
On the other hand, the
price goes up to the
monopolist's price.
Where marginal revenue equals
marginal cost, they're going
to produce at Q sub m and charge
a higher price P sub m.
Whereas, if this is a perfectly
competitive firm,
they produce much more, where D2
hits the marginal cost and
consumer surplus would
be much larger.
So the trade off is, on the
one hand, you end up here.
In this case I've drawn, you end
up with a larger consumer
surplus, even with monopoly.
But you could imagine drawing
the same graph, in the case
where consumer surplus falls.
You can imagine demand doesn't
go up that much.
But the monopolist gets
the monopoly price.
And you could imagine drawing
this triangle such that the
new consumer surplus triangle
is smaller than the old
consumer surplus triangle.
OK?
So it's not obvious which
way this goes.
You have two effects.
On the one hand, you have the
effect that demand shifts out.
That creates a potential for
more social surplus.
On the other hand, you have the
case that the monopolist
artificially prices too high.
That causes a reduction
in social surplus.
In this case, the former
dominated the latter.
But I hope you can see you can
draw this in cases where that
wouldn't be true.
And that's the tricky
thing with patents.
It's going to depend.
If you're patenting something
which is really demand
increasing, that's great.
But if you're patenting
something which is just a
copycat of something that exists
and all you're doing is
turning a competitive market--
In the limit, imagine I
somehow snookered the
government into giving me a
patent for something which
literally does no more
than what's existed.
But somehow I could fool--
In that case, have to do a
little more or people wouldn't
buy it, just a little more
than what existed.
It wouldn't increase
demand much.
But I would then have these
monopoly rents.
OK?
So that's basically the trade
off with patents.
All right, question
about that.
Now, let me move on then
and talk about--
The question was
raised about--
Well, couldn't the government
do something about this, in
terms of trying to address
this problem.
And we just talked about the
government as bad guy in
creating this problem.
Although, it's not necessarily
a problem
in the case of patents.
But there's also the role of
government as potential good
guy, which is can the government
help in this case
of natural monopoly?
So natural monopoly, we've got
this awkward situation where
clearly a monopoly
makes sense.
It doesn't make sense to have
competitive people delivering
water in town.
But once you've got one person
delivering water, they'll
charge you a fortune for it,
well above marginal cost. And
that's inefficient.
That lowers social surplus
relative to the optimal level
of provision.
So can the government
solve this problem?
Could the government, for
example, come in and say look,
we recognize there's
a natural monopoly.
We recognize that you, Rubrico,
are the only company
that makes sense to
deliver water.
But we are going to regulate you
in a way to maximize the
social surplus, given that
natural monopoly.
So to see that, let's
go to the highly
complicated figure 15-3.
OK, we'll have to walk
through this slowly.
It's a lot of stuff going
on here at once.
OK?
15-3.
We're back to the usual curves
we were using last time.
The demand curve is P
equals 24 minus Q.
The cost curve is 12
plus Q squared.
So the marginal cost
is just 2Q.
The competitive outcome was
to produce eight units
at a price of 16.
The monopoly outcome was
to produce six units
at a price of 18.
OK?
And you ended up with the
monopolist causing a
deadweight loss of C plus E.
That was where we were last
time in this example.
And let's say this was
a natural monopoly.
So that's why there's
a monopolist there.
Now, what if the government came
in and mandated that the
monopolist can charge no more
than the competitive price?
Let's say the government
knew what the
competitive price was.
The government says,
look, I took 14.01.
I see this graph.
I know the competitive
price is 16.
So I'm going to say,
monopolist--
You're the monopolist.
You go ahead.
And no one else can
deliver water.
It makes sense for
you to do it.
But I'm going to regulate that
you cannot charge consumers a
price above 16.
What you can see in that case,
is the government will turn
the monopolist from a price
maker to a price taker.
And in doing so, the government
will undo the
poisoning effect we talked about
last time and cause the
monopolist to behave as if it
was a competitive firm.
So to see that, we have to ask,
well what's the marginal
revenue curve now for the
monopolist, given this
government mandate that it can
charge no more than 16?
Well, the marginal revenue
curve, up to the point it
sells six, is the old marginal
revenue curve.
So we're working down this
marginal revenue curve.
And up to that point, where
marginal revenue intersects
marginal cost, that's the
marginal revenue curve.
And that's where the monopolist
would stop.
But the problem is the
monopolist isn't actually able
to charge more than 16.
So now, if it's charging 16,
now it asks itself well,
should I produce that
seventh unit.
Remember last time
we did the math.
The monopolist should not
produce the seventh unit.
Because last time we showed
that, because of that
poisoning effect, profits would
fall if it produced that
seventh unit.
But now it's not true because
now it's only charging 16.
So if it's charging 16, and if
it produces that seventh unit,
it's still going to charge 16.
The poisoning effect
has gone away.
There's no more poisoning
effect.
There's no loss to producing the
seventh unit because the
most it can get is 16.
It would like to price
it much higher.
It can't.
Since the most it can price at
is 16 he says, well gee, then
there's no poisoning effect.
I might as well produce at
the competitive level.
And basically, what you can
see is if you tell the
monopolist they can't charge
more than the competitive
price, then they will produce
at the competitive level.
And you'll end up at that
competitive outcome, even with
a monopolist, because that will
be the profit maximizing
thing for the monopolist
to do.
So sounds like we've got a
pretty good solution here.
Right?
If there's a natural monopoly,
we just come in and say you
can't charge more than the
competitive price.
So in theory, government
can fix this.
We've been talking about
government as a bad guy.
Here's government
as a good guy.
Government can come
in and fix this.
What's the problem with that?
What's the problem, in practice,
with carrying out
what I just laid out
here in theory?
Yeah.
AUDIENCE: How does the
government know what the
competitive price is?
PROFESSOR: How does the
government know what the
competitive price is?
How does the government know
what these curves look like?
Now, let's think about
both curves.
OK, first the government
needs to know--
If it wants to know the
competitive price, it's got to
know the demand curve and
the supply curve.
Well the demand curve, in
principle, the government
could learn.
The government could go out and
survey people and get a
sense of kind of, could collect
some data, could run
some experiments and try to
find out from people.
Gee, how much are you willing
to pay for another unit,
another unit, another unit?
So in principle, the government
could actually
measure demand curve by
doing market research.
Although in practice,
this is quite hard.
It turns out in practice--
The first rule of economics is
believe what people do, not
what they say.
Turns out, if you ask people
what they're willing to pay,
you get very silly answers,
relative to actually do it.
So for example, this comes up
a lot in when the government
needs to value environmental
damage.
So if we need to ask how much
should we charge BP for the
damage they did to the Gulf, we
need to value how sad are
people that the wetlands
are ruined.
Well, the only thing to
do is to ask people.
And it turns out when
you do that, you get
incredibly silly answers.
Things like, for example, if you
ask people how sorry are
you if 10 ducks died, they'll
say I'm this sad.
Say how sad are you if
a million ducks died?
They'll say, I'm the
same amount sad.
OK, that doesn't make sense.
You ask people what's it
worth to save a duck
versus saving a whale.
And you ask in that order,
they'll say saving a duck is
worth $100, saving a whale
is worth $100.
Or it's worth $150.
You ask the other order.
You say, how much is
it worth to save a
whale and then a duck.
Well then, saving a whale
is worth $300.
And a duck's only worth
$50, same question
just a different order.
People do not give sensible
answers when you ask them what
things are worth.
The best way to know is to
actually vary the price, is to
actually run experiments where
you actually say, OK, we have
to actually give people
different prices and see how
they behave, actually trace
out the demand curve.
That turns out to be very hard
to do, especially for things
like valuing damage
to wetlands.
But even for things like valuing
prescription drugs,
you've got to literally--
It's hard to run the experiment
where, literally, I
give you a different price
than you for a
prescription drug.
That's a little bit tricky.
So it's hard to get
the demand curve.
So that's the first problem
the government faces.
But in some sense, that's the
less difficult problem.
It is tracing out the
demand curve.
In principle, there
are ways to do it.
In principle, you could run
experiments where you vary the
price and you get that
demand curve.
In practice, the difficulty
is firm supply
curves are much harder.
And why is that?
Because let's say the government
comes to you and
says, look I'm doing great.
I've nailed down the
demand curve.
I just need to know your supply
curve, so I can set
your price.
What's your supply
curve again?
OK, what are you going to say?
AUDIENCE: [INAUDIBLE]
PROFESSOR: Aw, this stuff
costs a fortune to make.
You would not believe what it
costs this stuff to make.
My supply curve--
12 plus Q squared?
Ha!
That's a joke.
It's 30 plus 18Q squared.
Are you kidding?
My supply curve is crazy high.
And the problem is, the
government doesn't know.
Because with consumers, at least
I can run experiments to
get the demand.
With the firm, I can't get
inside their books.
I can't really know.
And if I get inside the books,
they can cook their books and
make it look like stuff
costs more.
How can I really know?
Just like it's difficult for
the board of directors to
figure out whether the CEO of a
company needs his own plane,
it's very difficult for
government regulators to
figure out what it actually
costs to produce these drugs.
And as a result, it's very
hard to get this right.
And the problem is if the
government gets it wrong, it
can make it worse than not
regulating at all.
So for example, if the
government came in, and let's
say, the government said look,
I can't believe this firm.
12 plus Q squared sounds way
too high for cost. I think
marginal costs are much
lower than that.
And I think the competitive
price should be 10 because I
know the firm is going
to lie to me.
I know they're going to tell
me numbers too big.
So I'm going to say that
equilibrium should be
competitive, should
be a price of 10.
And at a price of 10, the firm
is now operating off the
marginal revenue curve
at that low price
because it's below 16.
So at a price of 10, the firm
is going to set marginal
revenue equal to marginal cost.
Well, marginal revenue
at a price of 10 is the price.
That's all they can
charge is 10.
So they're going to set price
equal to marginal cost. The
marginal cost with a
production of 10--
The marginal cost is 2Q.
So set price equal to 2Q.
Or 10 equals 2Q.
Or Q equals five.
They'll produce five units.
They'll say look, if you're only
going to let me charge
10, I'm only going to
produce five units.
That's what I'll produce.
That's what's optimal for
me at a price of 10.
What you see is--
Now if you look at this graph
and you look at the firm
producing five units.
What you see is the firm
produces five units.
Now, the total surplus
has fallen.
It's just A plus B plus D. The
consumer surplus is very high.
We don't have the horizontal
line of 10 here.
But draw yourself that
horizontal line of 10, which
is where the dashed line of five
intersects the marginal
cost curve.
You could see there's a
big consumer surplus.
It's A plus B plus half of D and
a little producer surplus,
which is that triangle that's
the lower half of D. But look
what's happened to
social surplus.
Before the government got
involved, the deadweight loss
was just C plus E. Now the
government, by misregulating
the price, has created
deadweight losses of C plus E
plus F plus G plus H. The
government has just increased
the deadweight loss a lot,
by getting involved and
misregulating.
And in particular, that area
that increases it--
Here's the interesting thing.
Falling from eight to six caused
that little triangle.
Falling from six to five, just
one more unit, causes a
trapezoid, which is probably
bigger than that triangle.
Why?
Because we're moving
farther and farther
away from the optimum.
We're losing more and more
trades that were socially
beneficial.
Remember at the optimum,
deadweight loss is very small.
But as you move farther and
farther away, that deadweight
loss gets bigger and bigger.
So this government
misregulation, instead of
moving us to what's optimal,
by just moving us one below
where we were as a monopolist
has caused all this huge extra
deadweight loss and
made things worse.
Indeed, it could be worse.
Imagine the government chose a
price so low the firm just
said, forget it.
I'm going to shut down.
You could lose all surplus
in this market.
If the government came
in and said, no, we
don't believe you.
The price should be whatever.
It wouldn't be, in this case,
because in this case, price is
always greater than
marginal cost.
But let's say the government
came in another case and set a
price that was too low.
It could just cause the
firm to shut down.
Then all social surplus in the
market would disappear.
OK?
So basically, there's these
difficulties with the
regulation, which is it's hard
to know how to set the price.
Now in practice, of course, what
happens is governments
set the price too high.
In practice, the government
would much rather err on the
side of letting monopolists make
a little money than err
on the side of there being
too little of the good.
So government, facing
uncertainty about what the
right level to set is, will
typically end up erring on the
side of monopolists, partly
because of the way of the
nature of regulation.
So let's say you are
president whatever.
And you want to regulate
this new good.
OK, somebody made the new good
and you want to regulate it.
Well who are you going to hire
to be the regulator?
Well clearly, someone who knows
something about the market.
So there's a new good.
My favorite example
of an outdated
technology is the umbrella.
I really think we've
got to figure out a
better way to do umbrellas.
They suck.
In the wind, they blow up.
They're useless, right.
There's got to be a better
umbrella out there.
Let's say somebody finally
figures out a better umbrella.
But they've got a
patent on it.
And so you want to
regulate it.
It's got some natural monopoly
producing it.
It uses unobtanium.
And the only can find it
in one place, Pandora.
So they've got to--
They're the only guys--
Isn't that the stupidest name
ever for a material?
How could they have not come
up with a better name than
unobtanium?
Anyway, so it uses unobtanium.
And basically they have
this natural monopoly.
So you want to regulate it
Well, who are you going to
find to regulate it?
Well you know, once there was an
expert in making umbrellas
with unobtanium.
That person who you're
going to hire.
That's the right
person to hire.
Unfortunately, that probably
means they're probably
friendly with all the guys
that make umbrellas with
unobtanium.
And they're not going
to want to be too
tough on their buddies.
So the natural person who's
going to regulate, by their
nature, is going to tend to be
someone who's going to think
sort of on the industry's
side.
Moreover, what are they going to
do after they're done being
the regulator?
They're going to go back into
the business of making
umbrellas with unobtanium.
So they're not going to want to
be too mean to the business
because they're going to
be making money off
it five years hence.
So you've got this problem that
regulators are going to
have a natural tendency to be
sort of friendly towards
industry they're regulating.
And that's going to lead
to an upward bias.
The question is, how much is
that upward bias in the price
relative to what the monopolist
would actually do.
And much like a patent,
it depends.
You can draw examples where
the government regulation
would improve things and
examples where the government
regulation would make
things worse.
You can do examples
either way.
And what, at least, is
interesting here is this is
the first example we've seen
or one of the few examples
we've seen where the government,
at least, could
possibly make things better.
Even though it's not
clear they will.
At least, they could possibly
make things better.
And that's because--
Why is that?
This is a very important
insight.
Why is that?
That's because everything we've
dealt with so far, the
market does everything well.
We haven't needed
a government.
What natural monopolies do is
they say, wow, here's a case
of what we call a
market failure.
The market has failed to
maximize social surplus.
And that opens the door for
potential gains for government
intervention.
Basically, as long as markets
are functioning well in a
competitive manner, there's no
door open for the government
to make things better.
The government can just
make things worse.
It's only when there's market
failures, of which natural
monopoly is one example, can
the government come in and
potentially make
things better.
It won't necessarily do so.
But at least there's a door
open to doing so.
Questions about that--
OK, the last thing I want to
talk about, today, is an
example that's in between a
natural monopoly and no
natural monopoly, which
is what we call
a contestable market.
A contestable market--
A contestable market is one
which says that there is a
natural monopoly, but it's not
so big that someone couldn't
come in and compete if the
profits got too large.
Or another way of saying this
is, just because there's a
monopoly doesn't mean there's
a whole lot of market power.
Just because there's a monopoly
doesn't mean there's
a whole lot of market power.
So imagine a natural monopoly
market with a very modest
fixed cost, a fixed cost
that's, you know,
real but not enormous.
As long that monopolist who
gets in first keeps their
price near marginal cost,
no will ever enter.
As long as they get their price
near marginal cost, no
one will enter, even if they're
making a small profit.
No one will enter because no one
could ever make money then
and pay the fixed.
No one could ever come in,
pay the fixed cost,
and still make money.
So no one's ever
going to enter.
But if that price ever got too
far above marginal cost, then
someone would say, ah, there's
so much profit to be made.
That'll cover my fixed costs.
I'm coming in.
That's what we mean by
contestable market, a market
which can exist with a monopoly
and can exist with
someone making money.
And yet ultimately, there's
sufficiently easy entry that,
basically, the monopolist is
forced to behave almost like a
competitive firm.
So it's sort of like market
pressure on monopolists.
It's a weird outcome where you
get a monopoly market but
pricing close to competitive
levels because of
this threat of entry.
Now the most famous example
of this is in airlines and
airline deregulation.
Until the 1970s, the way
airlines worked in the US is
there were private airline
companies.
Many of them don't exist
anymore, Eastern, Pan Am.
Ones you don't know about,
don't exist anymore.
And they were regulated.
It was a regulated oligopoly.
We haven't really talked
about oligopolies yet.
It was a few firms competing.
But think of it as a monopoly.
It's basically regulated
monopoly.
In particular, they
had monopolies
on different routes.
So what happened is the
government would
say New York to Boston.
That is the route that Eastern
Airlines owns.
And they fly that without
competition.
But in order to make sure they
don't rip off the consumer,
we're going to regulate
their prices.
So Eastern Airlines, you fly
this without competition.
But we're going to
regulate what you
can charge the consumer.
And this was because the
government viewed airlines as
a natural monopoly.
It said, look, airplanes are
really big and expensive.
There's huge fixed cost to
becoming an airline.
So we think this is a
natural monopoly.
And we're going to
regulate it.
However, economists started
pointing out, and experts
started pointing out that no,
in fact, this was actually a
very contestable market.
That it turned out
it wasn't that
expensive to produce airplanes.
There were a lot of older
airplanes you could
refurbish, et cetera.
And that basically this is
a market where, if the
government opened it up to
competition, you could
actually get some--
That threat of entry
eventually could
drive prices down.
And so basically, after a lot of
debate, the government, in
the late 1970s, did deregulate
airlines.
One of the most important
changes in government policy
in the 1970s was they
deregulated airlines.
And what happened?
Well, three things happened.
First of all, prices
fell enormously.
Prices fell by about a third.
Flying from point A to point B
fell by a third, other places
more extreme.
When I was an undergraduate at
MIT, I could fly from Boston
to Newark for $19 each way.
There was this airline called
People's Express that was
introduced in the wave of
deregulation in the 1980s.
People's Express--
It was fascinating.
I don't know what their planes
were held together by.
And the thing was, you didn't
even buy a ticket.
You just went and
waited on line.
They let you on the plane.
And when the plane was
full, they took off.
And they made you pay
on the plane.
I still, to this day, don't
know what happened if you
didn't have the money, if they
like threw you off, get
parachutes or something.
I don't know what they did.
But literally, they'd come down
the middle of the aisle
with a little credit
card thing.
And they'd make you
pay on the plane.
I mean literally, it was cheaper
than taking a bus.
It was incredible,
$19 each way.
So prices came way, way down.
The second effect was
many more routes
were offered to consumers.
Suddenly, routes which the
government had said, no that's
not profitable.
You shouldn't fly that.
New entrants said, no, in
fact, it is profitable,
government.
You just had the cost
structure wrong.
And it is profitable to fly from
Pittsburgh to Akron, or
whatever, wherever
they now fly.
There are hundreds more places
you can fly now than you could
in the 1970s.
Hundreds and hundreds of routes
that just didn't exist
because the government
regulators assumed they
weren't profitable.
But in fact, they were.
Once there was competition in
these contestable markets,
they did turn out to
be profitable.
And the final thing that
happened was that quality of
airline travel deteriorated
massively.
When I was a kid, and
you flew on planes.
It was really nice.
I mean there was tons
of leg room.
You got tons of free food,
free movies, free drinks.
And I didn't do that
when I was a kid.
My parents did.
Basically, it was an
unbelievably nice experience.
It's not so nice now.
I think as any of you who have
flown will attest to.
Now they're charging
you for everything.
And you can barely fit your legs
in if you're over 5'2".
Now, why did this happen?
Somebody tell me.
Why did this happen?
Why did deregulation lead from
a world where flights were
unbelievably comfy to a world
where flights are uncomfy?
Yeah.
AUDIENCE: It's more profitable
to have more people taking it.
And--
PROFESSOR: Sure, but that
was always true.
It was always more profitable
to have
more people on a plane.
It was always more profitable
to not give them nice stuff.
That hasn't changed.
What has changed?
Yeah.
AUDIENCE: You have-- there's
competition.
So they need to reduce
their cost more.
PROFESSOR: What's that?
AUDIENCE: There's more
competition.
So they need to reduce
their cost.
PROFESSOR: There is
more competition.
But there was some competition
before.
But you're right.
Your about halfway there.
What else?
AUDIENCE: Consumers aren't
willing to pay for leg room
and all that stuff.
PROFESSOR: Basically before, if
there was a route with two
airlines on it--
A lot of them, I said there's
two airlines.
And you wanted to compete.
How did you compete?
You couldn't compete on price.
Right?
If Eastern and Pan Am were
flying New York to Boston,
they couldn't compete
on price.
The price was regulated.
So how did they compete, by
being as nice as possible on
everything else, even though
consumers didn't
really value it.
Well, once they competed on
price, they said, look,
consumers don't really care
so much about this
crappy airline food.
We're going to get rid of
it and charge 20% less.
And lo and behold, they did.
What's ironic, of course, is
everyone bitches about how bad
airlines are.
But they don't bitch about
how cheap they are.
It is so cheap to fly now,
compared to when I was a kid.
Based on what happened is they
went from competing on
non-price factors to
competing on price.
There's always competitive
pressure.
There's always competitive
pressure.
It's just before, the
competition had to be on
things which consumers
didn't like.
But they liked it enough
that you might as
well compete on it.
Because it was not that
consumers didn't like it all.
Obviously they liked
it some, or they
wouldn't have bothered.
Now they've moved to a more
efficient form of competition,
which is to compete on price
rather than on quantity.
Yeah.
AUDIENCE: When you said the
government regulated the
price, only wasn't that just
on the upper level
that you got that?
PROFESSOR: No.
The government just regulated
the price.
Now, so this is a big victory
for economists.
Yay for economists--
We did a great job.
But we whiffed on one thing.
We whiffed on one thing, which
we did not foresee, which has
led deregulation to be much
less beneficial than we
thought it was going to be.
What we whiffed on was the
hub and spoke system.
We whiffed on the fact that,
while building airplanes is
contestable, building slots
at airports is not.
That there's a limited number
of slots at airports.
And it's incredibly hard to
build a new airport because of
environmental regulations
and other things.
What that meant was there is
still a natural monopoly in
airport slots, even if
there's not much of a
natural monopoly in planes.
The result is that now what
airlines do is funnel everyone
through their hub and then
out to the spokes.
And as a result, because of that
they have developed new
quasi monopolies.
So to fly from point A to point
B, for many A's and B's,
only one airline flies it.
Because it's economical
for them because
point A is their hub.
But airline B can't
get into that hub.
They can't get a gate
at that hub.
So as a result, they can't
effectively fly from A to B.
So my wife is from
Minneapolis.
We had to go to Minneapolis.
Northwest had a monopoly on
going to Minneapolis.
So I could fly from Boston to
LA for half the price of
Boston to Minneapolis.
Why, because Northwest
controlled all the gate slots
in Minneapolis.
They had a natural monopoly
on that resource.
And that's what economists
missed.
So deregulation worked in some
markets with a lot of
competition.
Like the New York to LA market
is very competitive.
It did not work in other
markets, where there was this
natural hub.
And so one airline
could dominate.
Or a few airlines
could dominate.
And that's why you could
see some crazy pricing
differentials.
That's why, for example,
I could fly to
Baltimore for $127.
But to DC, it cost me $500, even
though they're less than
an hour apart by car.
This is because the constraint
on slots has limited the
amount of competition
that can go on.
And so that's sort of an example
of where competition
can work and where it can't to
try to deal with these natural
monopoly problems.
All right, let me stop there.
And we'll come back
on Wednesday
and talk about oligopoly.
Good luck tomorrow night
on the exam.
It's tomorrow night?
Yeah, tomorrow night.
Good luck.
Everyone looked confused
for a second.
Next week--
Oh--
OK, just joking, April fools,
Halloween fools.
Good luck next week
on the exam.
