[SQUEAKING]
[RUSTLING] [CLICKING]
JONATHAN GRUBER: OK,
so let's continue.
So this is actually,
in some sense,
a key breaking
point in the course.
Which is, in some sense
what we've done so far
is give you a set of
tools to understand
how to think about how consumers
and producers make decisions,
and then to understand how you
compare positive and normative
implications of economics.
What we're going to do
for the rest of the class,
for the rest of the
semester, is we're
going to start to talk about how
you apply those tools to more
realistic situations.
Let me answer your very first
question, what you learn today
is not on the midterm, OK?
So that's the question that's
all on your mind because it is.
So the midterm tomorrow
night will cover everything
through what we covered
through last week,
but what we learn today
will not be in the midterm.
But don't leave because
it will be on the final
and it is interesting.
So what we're going
to do today is
talk about taking the tools we
developed so far in this class
and applying to more
realistic situations.
And the more realist situation
we're going to start with
is the case of monopoly.
And we don't talk about
monopoly profit maximization.
Now so far on the
producer side we've
been discussing one extreme
of how the market's organized,
which is perfect competition.
And perfect competition
is a wonderful sort
of theoretical
benchmark but never
actually exists in reality.
No market is
perfectly competitive.
The other extreme is not widely
applicable but still does
exist in reality,
which is monopoly, OK?
Monopoly is a situation where a
market only has one firm in it.
So a market with one firm
is a monopoly market, OK?
So that's basically a case
where you have only one
firm providing the good, OK?
Now in reality,
most markets fall
between perfect competition,
which never truly exists,
and monopoly, which
rarely exists.
Most markets are in between,
we call them oligopolies.
That's markets
with several firms
but not perfectly competing.
And we'll get to that.
But that's actually one of
the harder things we'll cover,
so we're going to start with
this other extreme of monopoly
which gives us a lot
of the insights we
need for oligopoly but
in a much simpler case.
Now, the key thing with
monopoly, the key difference
from what we've done so
far is that now firms
are going to be price
makers, not price takers.
That's going to be the key
change from the perfectly
competitive situation.
The perfectly
competitive situation,
from any given
firm's perspective
the price is something given
them by the great market.
OK, we talked with
our two diagrams side
by side about how the
market gives the price.
But we sort of-- from any
given firm's perspective
they were price taker.
They couldn't affect the price.
Monopolists however,
when you're the only firm
you get to set the price.
So monopolists are going to be
price makers, not price takers.
And that's going to change the
dynamics of everything we do,
and that'll be our
focus today, OK?
So that's going to
be the big change,
we'll go from competitive
markets to monopoly markets.
Now, for the first 2/3
or 3/4 of the lecture
we're going to make
one other assumption.
We are going to assume there is
one price in this market, that
is no price discrimination.
This monopolist sets
the price, but he
sets one price for everybody.
So if a monopolist
is selling a good,
they sell that at one price
to everybody buys the good.
Now once again, this
is not super realistic,
monopolists often have
different prices for goods.
But it's a very important,
helpful extreme.
And you've got to remember that
we're imposing this constraint
because it's going to
drive the intuition I'm
going to come to next, OK?
So you're a firm selling
a good at one price.
You offer it up, anybody can
buy it at that price, OK?
Now, what we're going to do--
if you remember, a mon-- the
fundamental part of producer
that holds is the
goal of monopolists
is to maximize his profits, OK,
which is revenues minus costs.
And as we showed
before, profits are
maximized when marginal
revenue equals marginal cost.
That's the profit
maximization point.
Now, nothing on the cost
side is going to change.
So monopolish monopolist,
the way we get cost curves
doesn't change.
That's all about--
remember, because that just
comes the technology
production and that
comes from input prices.
So nothing on the cost
side is going to change.
All that hard and
somewhat boring
work we did deriving
cost functions and stuff,
that all is-- that's done.
The only place monopoly gets
exciting is on the margin
revenue side, because before we
said marginal revenue was just
price for a price taker.
But that's no longer true.
Marginal revenue is
no longer just price.
Now marginal revenue's going
to be more interesting.
So the monopoly
difference, if you will,
or the imperfect
competition difference,
doesn't come at all
from the cost side.
That side is done, doesn't
matter what kind of market
you're looking at, OK?
All the interesting
action here is
on the revenue side as we think
about monopoly and oligopoly
markets, OK?
So to think about that,
let's go to figure 11-1.
Think about-- let's start by
think about a competitive firm.
This is a diagram I
could have shown earlier.
It just sort of is a way to
think about a competitive firm.
Think about a competitive
firm's profits.
So imagine that this firm--
to make life easy
let's imagine that we
have a firm with
marginal cost of 0, OK?
So you've got demand curve, and
so therefore any money you make
is profit.
And we're in the short run, OK?
So there's profit
in the short run,
even for this perfectly
competitive firm.
But a perfectly competitive
firm faces a horizontal demand
curve.
So if they sell
q units, OK, they
make profits of area
a, which is simply
q times P1, little q times P1.
If they sell q
plus 1 units, they
make an extra profit
rectangle of B.
So literally, the marginal--
the extra profit they make
is just the amount
P. It's 1 times P1.
The horizontal distance
from q to q plus 1 is 1,
the vertical distance is P1.
So the marginal profit
is just the price, OK?
Marginal revenue, I'm
sorry, it's just the price.
Yeah?
AUDIENCE: [INAUDIBLE]
competitive [INAUDIBLE]..
JONATHAN GRUBER: Once it's in
the short run there can be,
right?
In the short run there can be
profit in a competitive market.
In the long run
there's no profit, OK?
So basically, their
marginal revenue,
what they make-- that next unit
they make is the price, OK?
Now let's think about
a monopoly firm.
A monopoly firm does not face a
perfectly elastic demand curve
because a monopoly firm's demand
curve is the whole market.
Notice little q has become
big Q on the x-axis.
The monopolist no longer faces
only their perfectly elastic
firm demand.
They face a market demand, which
can be any degree of elasticity
but typically is
somewhat elastic.
It's downward sloping.
Now let's say
you're a monopolist
and you're selling big
Q units at a price P1.
Your profits are C plus A. Once
again, same marginal cost of 0
to make this easy, or C plus A.
Now let's say you want
to sell one more unit.
Well, what's different?
What's different is
now you're facing
a downward sloping demand curve.
So if you want to
sell one more unit
you have to lower the price.
That's the difference.
If you want to
sell another unit,
you can only do so by
lowering the price.
And you're a price maker, so
you have the right to do that.
So if you want to
sell another unit,
two things are going to happen.
A, you are going to
sell a second unit
and make money on that unit.
That's the area B.
But b-- I should
say one and two.
One, you sell the second unit.
That's the area B.
Two, you will lose money
all the other units
you sold because now you
have to lower the price.
Because remember, there's
only one price, OK?
So basically, you
used to make A plus C.
Now you make A plus B. You've
added B, but you've lost C.
So what is the marginal revenue?
The marginal revenue
for a monopolist
is now the area B minus the
area C. Or P2, which is area B--
1 times P2 minus
P2 minus P1 minus
P2 times Q0, the
original quantity.
OK?
This is the area C,
but this is the area
B. The original quantity
times the change in price.
So your marginal revenue is
not this simple just priced
more and more.
Now it's this more
complicated term, OK?
More generally, marginal
revenue can be defined
as-- the marginal
revenue is defined as--
marginal revenue is defined as
P plus delta P delta Q times Q.
That's marginal revenue.
The first term is
positive, that's
the money you make
on the next unit.
The second term is negative
because, by definition,
the demand curve's
downward sloping.
There's no given goods
anymore in this class.
Demand may be on a test
but not in reality.
The demand curve's
downward sloping, OK?
So this term is negative.
Now once again,
I'm writing delta
but really it's derivative.
So this is all increment--
this is all-- this
is sort of epsilon changes.
This is Q0, OK?
This is sort of epsilon changes.
But the bottom line is, for
an epsilon change in price
you get--
for an epsilon
change in quantity
you get the price
on the unit you
sell minus the money you lost.
And then you too can
no longer sell, OK?
This is the key intuition
of monopoly math.
The k-- yeah?
AUDIENCE: What's that
equation equal to?
That [INAUDIBLE]
JONATHAN GRUBER: This is
your marginal revenue.
I just did it graphically.
That's your marginal revenue.
You just see that
from the graph, OK,
and I just rewrote it here, OK?
So basica-- or for those of
you into calculus, if you just
differentiate, just-- if those
of you who have your calculus,
you could just write, you
know, dR dQ, d revenue dQ, OK,
what do you get?
You get P plus dP dQ
times Q. That's just
the derivative of revenue
with respect to quantity, OK?
So let's think
intuitively about what's
going on here because this
is very, very important.
What's going on here
is to sell another unit
you have to lower your price.
You're working your way
down your demand curve.
And therefore, it
offsets the benefit
you get from selling
another unit, OK?
I like to call this
the poisoning effect.
I mean, it's not
original to me but it's
a term that I've heard use that
I like, the poisoning effect.
The idea is that to
sell another unit,
I have to poison
myself a little bit
by lowering the price on all
the previous units I sold.
If I want to go out in the
market and force consumers
to buy one more unit, I've
got to lower the price
on all the units which
offsets money I used to make.
So that's why we call it a
sort of poisoning effect.
Now, why doesn't a competitive
firm face this issue?
Why are we just
bringing this up now?
Why does a monopoly firm
face a poisoning effect
and a competitive firm doesn't?
Or alternatively, another
way to ask the question
is, in what situation
would a monopoly firm
not face a poisoning effect?
Yeah?
AUDIENCE: Actually,
in a [INAUDIBLE]
in a competitive
firm [INAUDIBLE]
JONATHAN GRUBER: Right.
They're not-- that's
[INAUDIBLE] right.
The competitive firm's
the price taker.
But in particular, even
though the price taker,
why when they sell more quantity
is there no poisoning effect?
Yeah?
AUDIENCE: Demand is
perfectly inelastic?
JONATHAN GRUBER: Demand
it's is perfectly elastic.
The firm faced a
perfectly elast--
so likewise, a monopolist facing
a perfectly elastic demand
would also have no
poisoning effect.
Think of it this
way, what is dP dQ
with perfectly elastic demand?
Zero.
The price doesn't
change, you sell more.
So the reason the
perfectly competitive firm
face no poisoning effect
is because it's facing a--
it doesn't, the
price doesn't have
to change to sell
more units, OK?
But a monopolist faces
a poisoning effect
because it's got a downward
sloping demand curve.
OK?
So we can actually see this--
so what we want to
do in figure 11-3
is we graph the monopolist's
marginal revenue curve.
So let's actually work
out the math here.
Let's imagine there's
a demand curve.
Let's imagine that I've
got a demand curve--
and I'm just making this
up-- demands of the form A
equals 24 minus p, OK?
Let's just say that's
the demand curve, OK?
Now the first step is to
flip the way we express this
and write this-- write price
as a function of quantity
because now the monopolist
is choosing his price.
So we can write that p
equals 24 minus Q, OK?
Just inverting it, writing
price as a function of quantity.
So in this case revenues,
which are equal to p times Q,
are equal to 24Q
minus Q squared.
I just multiply through by Q.
So marginal revenues
differentiating
are just 24 minus 2Q, OK?
So once again, this is a new
sort of mathematical trick
you'll have to get used to.
Flip the demand curve,
so you express price
as a function of quantity.
Multiply through by Q
and then differentiate,
and you get that marginal
revenue is 24 minus 2Q.
So you can see that
in figure 11-3,
the marginal revenue curve is
the demand curve shifted in,
OK?
Now in fact, this
nice relationship
will not always hold.
This sort of picture
of a marginal revenue
curve being the demand
curve shift [INAUDIBLE]
will not always hold.
It only holds for
certain functional forms.
Mostly we'll use functional
forms for where it holds.
The main lesson is the
marginal revenue curve
has to be at or below
the demand curve.
That's the proof, OK?
Whether it has this nice sort
of shifted in relationship,
that depends very much
on functional form.
But what is absolutely true
is the marginal revenue curve
is always everywhere at
or below the demand curve.
Why?
Because the demand curve--
because by selling
a next unit you're
going to make less through
this poisoning effect.
So the marginal
revenue curve is always
below the demand
curve, all right?
Questions about that?
OK, so now let's go on and
let's talk about the critical
relationship which I just
developed-- intuitive,
let's do it mathematically--
between marginal revenue and
the elasticity of demand.
OK, so take this--
we've got our marginal
revenue expression,
marginal revenue equals p plus
delta p delta Q times Q, OK?
Now take that expression and
multiply and divide by p.
So I'm just going to
take this expression,
I'm going to multiply
and divide by p, OK?
Then I'm going to
get p plus delta
p over p delta Q over
Q times Q over p--
oh, p plus p.
I'm sorry, no, I did this wrong.
My bad, don't write that down.
I've got to look
more at my notes.
I'm going to write it as--
I'm going to multiply
and divide by p.
p plus p times, yeah, delta
p delta Q times Q over p.
I skipped a step.
So I just multiplied
and divided by p,
multiplied and divided by p.
p plus p times delta Q, delta
p over delta Q times Q over p,
OK?
Now if you look at this
expression, delta p over delta
Q times Q over p,
that is the inverse
of the elasticity of demand.
So you can rewrite this
as p plus p times 1
over the elasticity of demand.
Or rewriting one more
time, that marginal revenue
equals p times 1 plus 1 over
the elasticity of demand.
Marginal revenue
equals p times 1 plus 1
over the elasticity of demand.
So think about
this for a second.
This gets the intuition
we just talked about.
If e is-- if the elasticity
is negative infinite--
is negative infinity--
OK I had it wrong with 0.
It's the elasticity of demand
is negative infinity then you've
a competitive market.
Perfectly competitive market
is elasticity of demand
negative infinity so you get
a competitive market, OK?
As the elasticity of demand--
but if the elasticity of demand
is 0, if the elasticity of--
if the elasticity of demand goes
like-- the elasticity of demand
is negative 1.
Let's do that case.
So negative infinity is
perfectly competitive, OK?
What about negative 1?
What's special about
the elasticity of demand
of negative 1 in this case?
What's the marginal revenue?
0.
That's the case going
back to figure 11-2 where
B and C exactly cancel out.
So you probably
thought about this
when you looked at this graph.
You probably quickly
asked yourself, well,
should the monopolist
try to sell more or not?
Well the answer is, the
elasticity of demand
is minus 1, they're indifferent.
So this is sort of
the important insight.
With an elastic
demand of minus 1,
me monopolist is indifferent
about selling another unit
because what they gain
from selling the unit they
lose on the previous units.
If the elasticity of demand
is greater than minus 1
absolute value, then
they're going to lose money
by selling additional units.
If the elasticity of
demand is less than 1,
then they're going to make money
by selling additional units.
But let's-- I'm skipping ahead.
Let's go on and talk about
profit maximization, OK?
So let's go on and take the
next step which is the monopoly
profit maximization.
Imagine a monopolist's
cost function curve is
of the form 12 plus q squared.
Let's take the same
monopolist and write down
cost function of 12
plus q squared, OK?
So with this cost function,
marginal cost equals 2q.
That's marginal cost with
this cost function, OK?
So what's the profit
maximization rule?
It's that marginal revenue
equals marginal cost.
Well marginal revenue, we wrote
down here, is 24 minus 2Q,
so it's where 24 minus
2Q equals marginal--
I should-- equals marginal cost.
Now with monopolists
here's the trick,
little q and big Q are the same.
So I wrote a little
q here, but if you're
the only firm in the
market little q and big Q
are the same, right?
There's only one
firm in the market.
So 24 minus 2Q equals--
it's a big Q now-- equals 2Q.
So the optimization point
is where 24 equals 4Q or Q
star equals six.
That's the optimal-- that's
the profit maximizing
sale on quantity for
the monopolist is
where 24 minus 2Q, where
marginal revenue equals
marginal cost.
We derive marginal revenue, OK?
Marginal cost we know how to
derive from our cost function.
We set them equal and we get
the optimizing quantity, OK?
And you can see
this in figure 11-4.
Figure 11-4 shows
what's going on here.
So I've driven all the va--
I've drawn all the various cost
curves for this cost function,
OK?
I've driven all
the various costs
first for this cost function.
You can see the
marginal cost curve
and then you can see it
intersects the marginal revenue
curve at a quantity of 6.
Intersects the marginal revenue
curve at a quantity of 6, OK?
What is the price?
Someone raise their hand
and tell me, tell me why.
The quantity 6, what's--
what price has the
monopolist set?
Yeah?
AUDIENCE: 18.
JONATHAN GRUBER: 18.
Why-- you're supposed
to get that wrong.
You didn't-- you didn't, you
didn't follow my instructions,
you didn't get it wrong.
You got it right,
I'm just joking.
How did you know it
was 18 and not 12?
Usually people guess 12
because that's the point where
the curves intersect.
Why is it 18?
AUDIENCE: You can go
up to the demand curve
because that's what
people are willin--
JONATHAN GRUBER: Because
even the monopolist,
as powerful as he is,
has to respect demand.
So the monopolist if they're
going to sell 6 units,
they have to choose a
price such that people
want to buy 6 units.
So your intuition,
which is my fault--
I've always said, look
where the curves intersect,
do a quantity and a price--
your quick intuition,
which was to look and say
the price was 12, which was the
wrong answer I usually get, OK,
is wrong because you
need to actually respect
the demand curve.
So a monopolist solves
for the optimal quantity,
but then to get
the optimal price
he has to plug this back
into the demand curve.
Well, what's demand?
Demand is 24 minus p.
So-- I'm sorry, it's p equals
24 minus Q, that's our demand.
So if Q star is 6, then
price is 24 minus 6, or 18.
P star is 18, and that is
what you will get wrong
when you do this.
If you're going to get anything
wrong in monopoly problems
this is what you're going
to get wrong, OK, which
is remembering you can't just--
at the end you have to
do an extra step here.
To get the price you have
to solve for quantity,
but then respect the demand
curve to get the price.
There's a question somewhere.
OK, yeah, question?
AUDIENCE: [INAUDIBLE] of the
intersection of the [INAUDIBLE]
JONATHAN GRUBER:
It's pretty much--
yeah, it's pretty
much meaningless.
So that intersection used to
pin down the quantity, but price
has to come from
the demand curve
because you have to respect--
you can't sell
something consumers
don't want to buy, OK?
So you've got to respect
that demand curve.
And in fact, you
can show yourself--
so basically-- OK,
so basically that's
the profit maximization except
this stupid goddamn shutdown
rule still holds.
In the short run we still have
to respect to shut down rule,
so you still have
to check, is price
less than average variable cost?
Now once again, in this
function OK, in this f--
you have to check
with the price.
So even if profits
are negative you're
still going to have to
check if price is greater
than average variable costs.
Now here at 6 units, the
average variable cost is 6.
You see-- we could see--
you see the dashed line.
If we sell 6 units, the
average variable cost is 6.
So clearly price is greater
than the average variable cost.
You wouldn't shut down, you're
making positive profits,
in fact.
You're making profits of 60,
OK, so you wouldn't shut down.
But you always do have to
check the shut down rule, OK?
So that's how you do a
monopoly problem, OK?
Just to go back, how you
do a monopoly problem,
you'll be given
a cost function--
you know what to do
those in your sleep--
and a demand function.
The demand function gets
turned into a marginal revenue
function simply through
these couple of steps.
So the demand function gives
you a marginal revenue function.
If you have marginal revenue
and you have marginal cost,
then you know how to solve
for optimal quantity.
If you have optimal quantity and
you respect the demand curve,
you know how to solve for price.
Once you have a price, OK,
and an average cost curve
you can both check the shutdown
rule and compute profits.
Profits are simply the price
you get minus average costs.
So we can compute the profit
and check the shutdown rule, OK?
So the only thing we
did here that's new
is this sort of interesting
quirk that we have,
this new marginal
revenue function.
Otherwise, it's the same sort
of analysis we did before.
So this should be doable
with some practice.
Now, the key-- a key concept
here that we need to think
about, that comes to question,
you might have asked yourself
at some point--
you might have said,
well, if monopolists
are the only firm in the
market, why don't they
just charge whatever they want?
Why do they have to--
why are they sort of constrained
by the sort of mathematics
we've done before?
And to answer this, let's turn
to the concept of market power.
The market power
of monopolists we
will define as their ability
to charge price greater
than marginal cost.
Your ability to charge price
greater than margin cost
is your market power.
In other words, competitive
firms have no market power.
They have to charge
a price that's
the same as their marginal cost.
And that's why
they make no money.
Monopolists have
market power, OK?
So now let's return
to the condition
for profit maximization.
We said that
marginal revenue can
be rewritten as
price times 1 plus 1
over the elasticity
of demand, right?
That equals marginal cost.
So we can rewrite this as
marginal cost over price
equals 1 plus 1 over the
elasticity of demand.
And this is the monopolist's
market power condition.
So if we define the market--
so we can define something
we call a markup.
Casually we can call it
profits, but technically it's
the markup, OK, as
the percentage markup
a monopolist can
make as p minus MC
over p, how much of the price
is actually a markup over cost?
It's sort of an
intuitive concept.
So basically, how
much of the money
you get for the unit is a markup
as a share of the money you
get?
Then that is simply--
that is equal to minus 1
over the elasticity of demand.
So the monopolist markup is
equal to 1 over-- minus 1
over the elasticity of demand.
So if the elasticity of
demand is negative infinity,
that is a perfectly
competitive market.
Then the markup is what?
0, just like a competitive firm.
Competitive firms have
to charge marginal cost.
But as demand gets
more inelastic
the monopolist gains
power to mark up the price
and make money.
And this answers our
question of why monopolists
aren't infinitely powerful.
What is the limiting
factor of monopolists?
It's not other firms
producing their good.
What's the limiting
factor on monopolists?
Yeah?
AUDIENCE: How much more will
they compete with [INAUDIBLE]
JONATHAN GRUBER: Yeah,
it's other products.
So think about a
monopolist in insulin.
They can charge
whatever the hell
they want, right, because
basically there's nothing else
to buy.
Well, maybe multiple
insulin products,
but imagine one
insulin product, OK?
So nothing constrains
the monopolist.
He should charge an
infinite price up to,
like, what Congress
will put up with, OK?
But if you think about
a monopolist in a good
where there's a substitute-- so
if I'm the monopolist in gum,
if I'm a gum-opolist,
OK, then I'm
constrained by how
much people want
to-- eventually people just
substitute the candy, OK?
Anything-- so I'm
constrained not
by competitors in my
market, but by the fact
that consumers can
substitute to other goods.
So what's the limit
on monopolists?
Consumers, we're the
limit on monopolists.
Our willingness to put up
with that good relative
to other goods, i.e.
Our elasticity of
demand, is the only thing
limiting monopolists, OK?
So basically, there is market
discipline to monopolists.
Even though they're the
only provider of a good
they're still subject
to market discipline.
It's just the discipline
doesn't come from other firms,
it comes from consumers, OK?
So a great example of
this is let's look,
if you go on-- at least as of
last year, if you go on Amazon
and look at the
prices of two goods
that you've probably
had to consume
in high school, Huckleberry
Finn and Great Gatsby, two books
that many of you had to
consume in high school.
You had to read
Huckleberry Finn,
you had to read Great Gatsby.
They're both
comparable lengths--
Great Gatsby is a
little shorter I think,
but they're both
comparable lengths.
The production cost--
the marginal cost
to produce them is probably
pretty comparable, OK?
But if you go on
Amazon, Huck Finn
costs $4 and the Great
Gatsby costs $16.
Now why is this?
Why is this, anyone know?
Why does Great Gatsby
cost four times as much?
AUDIENCE: [INAUDIBLE] it
was banned [INAUDIBLE]
JONATHAN GRUBER:
That's interesting.
That's not enough to explain.
It's not banned
in enough places,
fortunately, to explain that.
What else is going
on, anyone know?
Yeah, in the red shirt, yeah?
AUDIENCE: [INAUDIBLE]
competitive-- it has, like,
has no copyright infringement.
JONATHAN GRUBER: Exactly.
The Great Gatsby still
has copyright protection.
That is, only people who get
permission from the great--
from William Scott
Fitzgerald's descendants--
F. Scott Fitzgerald, I'm sorry,
descendents get to produce it.
They have a monopoly on the
good that is The Great Gatsby.
Huck Finn, it turns out that 75
years after an author's death
copyright protection expires.
F. Scott Fitzgerald hasn't
been dead for 75 years,
Mark Twain has.
So Huck Finn can now
be produced by anyone.
You can go out tomorrow and
produce a copy of Huck Finn
and sell it.
So we think probably Huck
Finn should be produced
in a pretty competitive market.
That is, basically
the $4 you pay
for Huck Finn should be roughly
the cost of producing a book.
OK, now no market's
perfectly competitive,
a little markup but not much.
Whereas The Great Gatsby, it's
not limited by competition.
But it is limited by
the fact that if they
try to charge $500
for Great Gatsby
teachers would assign
something else, OK?
There's still a limit.
It's only $16, that's
not a whole lot for one
of the great works
of literature, OK?
It's still only $16.
So why is it only $16?
Because it's limited
by the fact there
are other great works of
literature people can turn to.
So Huck Finn is limited
by the competition
within the market for the--
across producers producing
some homogeneous good.
It's probably a pretty close to
the competitive market, right?
It's pretty easy to just set up
a shop and produce Huck Finn,
whereas The Great Gatsby
has this extra effect which
is copyright
protected, so its only
limited by the
elasticity of demand.
Yeah?
AUDIENCE: [INAUDIBLE] be
like, [INAUDIBLE] like,
the effect of, like, when you
increase price again, and even
more with piracy, in a sense?
Like, if, like, when you have,
like, a really, like, expensive
good it leaves, like,
more incentive to steal?
JONATHAN GRUBER:
That's a great point.
So the elasticity
of demand, I should
say the elasticity of
demand for that good,
where one of the substitutes
could be an illegal substitute.
That's a good point.
OK, so let's go on and
talk about the next topic
I want to cover today, which
is how do we-- because now we
have a new set of tools
we've developed that's
really cool which lets
us ask the question,
not just what do monopolies do,
but how do we feel about it?
That is, we can now turn to
talking about the welfare
effects of monopoly.
What are the welfare
effects of monopoly?
How do we feel about monopoly?
Well, let's start with
the standard case,
that is the case we've
covered so far as opposed
to a case I'll cover
in a minute, OK?
And let's look at
figure 11-5, which
is the example we just solved
for, the example where demand
equals 24 minus Q and
cost is 12 plus Q squared.
So here we sh--
once again what do we do?
We set marginal cost
equal to marginal revenue.
So they sell 6 units.
We then say, what price
permits them to sell 6 units?
The price of 18.
So the equilibrium
is at a price of--
is that e little m,
little m for monopoly, OK?
They sell 6 units
at a price of 18.
Well at that equilibrium,
what's consumer surplus?
It's A, the area under the
demand curve, above the price.
So consumer surplus is area
A. What's producer surplus?
It's B plus D, the area below
the price above the supply
curve, but only for the
units that are sold.
So the consumer gets A, the
producer gets B plus D, OK?
But C plus E is
not our units that
are not sold for which
the marginal-- for which
the willingness to pay is above
the willingness to supply.
And what do we call those units?
Units that are not sold--
someone raise their hand
and tell me--
units that are not sold for
which the willingness to pay
is above the
willingness to supply?
Yeah?
AUDIENCE: [INAUDIBLE]
JONATHAN GRUBER: Loss.
Those are units,
that's an inefficiency.
Those units that are not sold
that efficiently should be.
That is, we've broken--
this our first example ever.
This is a super exciting
moment of breaking
the first fundamental
theorem of welfare economics.
The first fundamental
theory of welfare economics
was that the equilibrium,
the competitive equilibrium
maximizes welfare.
Well, that's no longer true.
Here we have an equilibrium
that comes out of competition.
It's what the market
delivers, but it
doesn't maximize welfare.
There's a dead weight
loss, and that's
because the market's
imperfectly competitive.
This is our first
ever example of what
we call a market failure.
And that's what,
from my perspective,
makes economics fun.
If there were no
market failures,
if all markets functioned the
way we said they function, then
basically we could have been
largely done with the course
by now.
What makes this
all interesting is
markets don't function
the way we said they
function in that extreme case.
And therefore, a
market failure is
defined as a case where the
market equilibrium does not
maximize social welfare.
So whenever the
market equilibrium
does not maximize
social welfare,
you've got a market failure.
In the perfectly
competitive case
we didn't have a failure
because the market equilibrium
maximized welfare.
That's not true here.
Now the market equilibrium
does not maximize welfare.
Therefore, it's
a market failure.
Hint, what's exciting
about that to me
is that means there might be a
potential role for policy, OK?
So far in this course,
the government's
just been a bad guy.
Its done nothing but set
mean minimum wages and things
like that, and terrible
price ceilings.
But in fact, as
we'll see next time,
this starts to introduce
the role for the government
as a good guy, OK?
Now, what makes-- to
drive this situation home,
make this more interesting,
let's contrast that to the more
realistic case of
price discrimination,
or potentially more realistic
case of price discrimination.
Now what happens if we
don't force the monopolist
to only charge one price?
What if we allow the monopolist
to charge different prices
to different consumers?
Here's a cool
conclusion actually,
kind of crazy conclusion.
If monopolists can perfectly
price discriminate,
that is that they can
sell a separate price
for every consumer, then
monopoly is welfare maximizing.
If monopolists can set a perfect
price for every consumer,
then monopoly does
maximize social welfare.
To see that, simply
look at figure 11-6.
Now let's take a perfectly
price discriminating monopolist.
Let's think about what--
this prices they've set.
Well, essentially what they're
going to do is set price where?
A price discriminating
monopolist
is going to set the price
for each unit to what?
Yeah?
AUDIENCE: The demand.
JONATHAN GRUBER: The demand,
the willingness to pay.
If you're perfectly
price discriminating,
you will screw
consumers to the max.
And how do you do that?
By delivering them no surplus.
By taking all the
surplus for yourself.
So for the first
unit, you charge 5.
For the second
unit, you charge 4.
And for the sixth
unit you charge 18.
Now, the [INAUDIBLE]---- now the
previous monopolist stopped
at 6.
Why do he stop at 6?
Because the sale of the seventh
unit would have lost him money.
He would've had to lower the
price on all previous units.
But the price
[INAUDIBLE] monopolist
has no poisoning
effect because he
doesn't have to lower the
price on the previous units.
He can say for
that seventh unit,
I'm going to sell
that one at 17.
I'm going to make
17, and I'm not
going to lose any
money because I can
keep the other prices the same.
So with a perfectly price
discriminating monopolist,
you get rid of the
poisoning effect.
They can just march their
way down the demand curve,
charging every consumer exactly
their willingness to pay.
Therefore, they will
continue to produce
until the competitive
equilibrium.
They will continue to produce
until willingness to pay
equals willingness to supply.
But they will capture
all the surplus.
So the new equilibrium
will be EC,
the competitive equilibrium,
but the entire surplus
goes to the monopolist.
So the fascinating
case, there's--
we maximize social welfare,
but only because we
define social welfare
in this particular way,
which is the simple sum of
consumer producer surplus.
Here, producers get
all the surplus,
therefore welfare is maximized.
So a perfectly price
discriminating monopolist,
OK, gets maximized
social welfare, OK?
Now, there's two interesting
points to come out of this.
Point one is this is a
cool way to understand
why there's a dead
weight loss for monopoly.
It's cool to understand
because you can see-
you can focus on that point
E sub M and think about why
the perfectly price [INAUDIBLE]
monopolist gets to sell another
unit and the regular
monopolist doesn't.
Because the regular monopolist
has the poising effect
and the perfectly price
discriminating monopolist
does not.
So it's a good way
to sort of think
about that intuition of
the poisoning effect.
That's lesson one.
Lesson two is, gee, we may
want to talk about definition
of welfare that's not just
the sum of consumer producer
surplus.
A model of welfare that delivers
the fact that a producer that
can screw every single consumer
out of any of their surplus
is the best possible
outcome might not
be a model we're
so happy with, OK?
But that we can come back to.
But for now it's a nice extreme.
And in fact, in reality
no firm is perfectly
price discriminating, OK?
Amazon tried to be.
There was a controversy
a number of years
ago where Amazon would set
your price according to your--
what's the little, the string
of numbers address, IP address.
They literally would set
prices by IP address.
They'd literally
say, well you know,
you're coming from an IP address
that's, for example, you're
in a high-high income area.
I'm going to charge you more.
You're in a
university, therefore
you need this book for a course.
Therefore, I'm going to
charge you more, et cetera.
That, they got busted and
that was found illegal.
But just because you can't
perfectly price discriminate
doesn't mean we don't have lots
of examples of partial price
discrimination.
So what are examples in the real
world of price discrimination?
What do firms do?
And what's the general-- let
me ask, tell me what firms do.
And also I wonder, what's
the general principle?
What's the basic
idea that firms--
if you want to
price discriminate,
what do you want to figure out?
What is your goal to figure out?
Yeah.
AUDIENCE: Isn't
[INAUDIBLE] make airplanes?
JONATHAN GRUBER:
[INAUDIBLE] the what?
AUDIENCE: Airplanes.
JONATHAN GRUBER: Airplanes.
So explain.
AUDIENCE: Because
if know somebody
is buying a ticket, like,
two days before a flight,
it's probably for
a business trip
so they can pay
a lot more money.
JONATHAN GRUBER: And why are
they willing to pay more money?
AUDIENCE: Um, because
the elasticity is--
JONATHAN GRUBER: The
elasticity is low because?
AUDIENCE: Because
they have to do it.
JONATHAN GRUBER:
They have to go.
If you're going to buy two
days before, you got to go.
If you're buying six
months before, you know,
you might have to
go that day, you
might not have to go that day.
You might have to-- but if
you're buying last minute,
you've got to go so
your elasticity's lower.
So price discriminating
monopolists
look for signals of elasticity.
That's their search.
They can't literally know
your willingness to pay.
Amazon tried, but even
Amazon couldn't perfectly
know your willingness to pay.
So they're looking for
signals that are correlated
with your willingness to pay.
One signal is whether you want
to fly at the last minute.
That means you have
a low elasticity.
You're screwed,
you've got to go.
What's another
thing airlines do?
What's another signal of
elasticity the airlines use?
How else-- yeah.
AUDIENCE: How long have
you been on the website?
JONATHAN GRUBER: They don't--
I don't know if they actually
use that, how long you
been on the website.
They could, that would
be kind of interesting.
AUDIENCE: [INAUDIBLE]
JONATHAN GRUBER:
Yeah, I don't know.
But that, that's pretty subtle.
What's a more blunt one they
used even before websites?
Yeah?
AUDIENCE: Search history?
JONATHAN GRUBER: No,
even before search--
I know you guys grew
up with internet
but there was life
before the internet.
And even before the internet,
airlines price discriminated.
What did they--
what did they do?
In the back, yeah.
AUDIENCE: You have, like
business class and--
JONATHAN GRUBER: Yeah, different
levels of flight, right?
Why is a first class ticket
more than a coach ticket?
Because rich guys are less
elastic than poor guys.
So basically, another way
of price discriminating
within the same flight is
by having different quality.
So what they do
is they say, we're
going to give you a
higher quality product,
but look, first class business--
so I flew business class
for the first time in my life.
I was very exciting.
I went to India, I
flew business class.
It was awesome.
But it raised the price of the
ticket from $1,000 to $2,500.
Now, it was better but
it wasn't $1,500 better.
Or [INAUDIBLE] put this,
let me rephrase that.
It cost more, but it's certainly
didn't cost $1,500 more.
I got a bigger
seat, and like, you
know, people slaved over me.
But like, it certainly
did not cost them $1,500
to provide that service.
They clearly made more of a
markup on the business class
seat than they did
in the coach seat
because I was less elastic.
Why?
Because someone else was
paying for my flight,
OK, so as less elastic.
And that's-- if you talk to
people in business class,
none of them are paying
for their own flights.
They're either super rich or
their company's paying, OK?
So the bottom line, that's
another way airlines
[INAUDIBLE].
Let's get away from airlines.
What are other examples
of price discrimination?
Yeah.
AUDIENCE: Isn't that a
common thing, like, Google,
like, [INAUDIBLE] actually
use your search history
and cookies to, like, figure
out how much money you make
and how much you're willing
to spend on certain items?
JONATHAN GRUBER: I think--
I have to look this up.
I think they're not
allowed to do that.
They're allowed to do that
in targeting advertising,
but I don't know if they're
allowed to setting the price.
I don't know if a
company's allowed
to that setting the price.
Yeah?
AUDIENCE: Sometimes chains will
be more expensive in cities
and less expensive
in rural areas.
Like, the same meal
at McDonald's can
cost a different
amount depending on--
JONATHAN GRUBER: Exactly, or--
that's exactly right.
Restaurants or supermarkets.
Now here's what's interesting,
if you look at a McDonald's,
OK, its prices--
no, it's true for both.
Basically, if you look
like, like if I buy--
when I buy McDonald's on the
highway out in the suburbs
it's more expensive than I
would buy here in Cambridge.
Why is that?
Why is-- why is a big so-- yeah?
AUDIENCE: Not a lot
of other options.
JONATHAN GRUBER: Yeah.
I'm like, I'm driving.
Where am I going to go?
I can't say, oh, it's too
expensive, I'm going next door.
So that's an example.
Inner city price-- supermarkets
charge much higher prices
in the city than
out of the city.
Now you might think that's
sort of strange, OK?
But that's because
in the city people
have to walk to get there.
They don't have
a lot of options.
There's not a lot of shopping.
Outside, they can drive from
supermarket to supermarket, OK?
So there's all these complicated
things that go into it.
One of my-- let me
sort of tell you
a couple of my
favorite examples.
One of my favorite examples
is early bird specials.
Now you guys might
not know about this,
but you might've hung out
with your grandparents
and known that, like, if
you go to a restaurant
sometimes before 5 o'clock
or 5:30, it's cheaper.
Or if you go to a matinee
movie, a movie during the day
is cheaper than
a movie at night.
Same movie, why?
Why is a movie during the day
cheaper than a movie at night?
Yeah.
AUDIENCE: Because
in the night time
you probably want
to go to the movies
more because you're off work
and you have things to do.
And so there's like--
like, if you went
early you're purposely
looking for a cheaper option.
So you [INAUDIBLE].
JONATHAN GRUBER: You're
more elastic during the day
because basically you're
an old retired person's
who's got nothing but
time in their hands.
It's like, you can shop
around movie theaters,
you decide to go to movie
or take a nap, et cetera.
Same thing with early
dinner specials.
People who have more time
to shop are more elastic.
At night you're going
out to see the movie.
These are people, you know--
in some sense it's
sort of interesting.
You think midnight movies--
I don't know if this is
true, midnight movies
should charge and most of all.
Because that's a bunch of
insane fans, right, who
have to see the movie first.
It seems like the midnight
showing should charge the most.
I don't know if that's true.
That would be
interesting to look at.
OK, that's one example.
Another example I
love is Disneyland.
Disneyland and Disney
World charge less
if you live within 20
or so miles of the park.
Why?
Because you can go whenever.
So when I took my kids to Disney
World, if I went up and said,
I'm sorry kids, it was
$10 more than I thought,
we're not going, I would
have had a riot on my hands.
Once you're there,
you're inelastic.
You're going to Disney World.
There's nothing else
to do in Orlando.
I mean, but there's
other parks, I guess.
But like, but if you
live locally you can
decide whether to go or not.
And then probably the most
interesting recent example
is Tesla.
So during-- I feel like, did
I tell you guys the Tesla
hurricane story yet?
I don't think so, right?
OK, so during the
hurricane in Florida--
Irma, I guess it was?
In Florida, Tesla-- so Tesla
so two cars, two models,
the cheaper model and
the more expensive model.
And the more expensive
model had some nice doodads,
but most importantly the
battery lasted longer.
The cheaper model
was like 300 miles,
the more expensive model
was like 500 miles.
During hurricane Irma, Tesla
as a gesture of goodwill said,
hey guys who drive
the cheap car,
you can now drive 500 miles.
And they're like, what the
hell, it's the same battery?
Tesla said, well it turns
out, it's the same battery.
The only difference
is a piece of software
that we can turn off or on.
So why did Tesla do that?
Why did Tesla have a piece of
software they turn off or on
and turn it off for some
people to make them drive less?
Why did they do that?
There's someone else involved.
Can anyone tell me
about what Tesla
thought, meaning besides
the, oh, must be an asshole.
What else?
What's the other--
what's the kind of--
what's Tesla's thought process?
Actually, it was
perfect economics.
Yeah?
AUDIENCE: Price discrimination.
JONATHAN GRUBER: Right,
it's price discrimination.
But how?
How are you price discriminating
by making some people--
yeah?
AUDIENCE: You can make a
500 mile car more expensive.
JONATHAN GRUBER: Exactly.
It's like first class.
You're basically saying,
I want to charge more
for a better product.
I can't charge more
for the same product,
so if I give everyone 500
miles I can't charge more.
But by making one product
better I can separate demand.
I can sell the expensive product
to the low elasticity of demand
consumers and the less
expensive to the high
elasticity of demand.
But it's actually the same damn
product, I just did it as a way
to price discriminate.
So Tesla, in an
effort to be nice,
screwed themselves by revealing
that they had been actually
falsely screw-- you
know screwing consumers.
It's not [INAUDIBLE]----
it's good economics.
It makes total sense.
OK, this actually
follows one last example.
When the first laser
printers came out,
OK, it turned out
that you could buy one
for home that was like half
the price one for office.
And someone took them apart
and found the one for home
was the one for the office
plus an extra piece that
made it go slower.
And they did that
simply because they
knew the office guys were less
price elastic than the home
guys.
So they wanted an expensive
one-- so they said,
the office one's faster.
Isn't this cool?
It was faster because they
didn't add an extra piece that
made to go slower, OK?
And that's the same thing.
So let's stop there,
and we'll come back
and talk more monopoly.
Good luck tomorrow night
and we'll talk more
about monopoly on Wednesday.
