[SQUEAKING]
[RUSTLING]
[CLICKING]
JONATHAN GRUBER: OK,
so let's continue
our discussion of monopolies.
Last time, we talked
about monopolies
and talked about how they're
another extreme of the market
structure spectrum.
We have perfectly
competitive firms,
where there's facing a
perfectly elastic demand curve,
and competing with essentially
infinite number of other firms
and taking prices, versus a
monopolist who owns the market
and sets the price,
but therefore,
faces this poisoning
effect, which
leads them to under-produce
and creates deadweight loss.
So today, we want to continue
our discussion of monopolies
with three sort of
separate topics.
OK, the first topic
I want to cover
is, where do
monopolies come from?
So the stork does
not bring monopolies.
They come from somewhere else.
So sort of, how do
monopolies arise?
And there's really two
sources of monopoly
that I want to focus on today.
The first is
monopolies that arise
from cost advantages,
the monopolies that
arise from cost advantages.
So some markets come with
a natural built-in cost
advantage for one participant.
So it could be there's an
essential input, like there's
one rock quarry in town.
And whoever controls
the rock quarry,
they supply the rocks
for the whole area.
In that case, we say
that this is an example
of a natural monopoly.
A natural monopoly
is a market where,
for all relevant quantities,
one firm can always
produce at a lower average
cost than another firm can.
So for all relevant
quantities, one firm
can always produce
at a lower average
cost than can other firms.
OK, this basically
is the same as saying
that it's a market where average
cost is everywhere declining,
at least in the relevant
production range.
You can imagine where, so
for some crazy quantities,
average cost increases.
But where average costs
is everywhere declining
is a market with a
natural monopoly.
So why would this be true?
Let's consider what I
think is the simplest case.
Let's think about
a water utility,
delivering water
to people's houses
through pipes underground.
Once those pipes are laid, it
is that the giant fixed costs
are paid, and the marginal
costs are trivial.
It's the cost of the water.
The fixed costs are so large
relative to the marginal costs
that average cost
always declines.
In our typical
production function,
remember, average cost first
declines, then goes back up.
It first declines, you
pay off the fixed costs,
then back up as the rising
marginal costs start
to dominate.
This is a market where
that second purchase never
gets big enough, say
where, essentially,
marginal productivity
is close to flat,
so the marginal cost curve
isn't rising that fast, and/or
the fixed costs are enormous.
So we could see
that in figure 12.1.
Imagine a water utility, which
has roughly flat marginal cost.
That is, the marginal cost
is the cost of procuring
another gallon of water.
Now once again, at
some point, if you
want to give every
person in America
one million gallons of
water, marginal costs
would start to rise.
But for the relevant
range, it's roughly flat.
And yet there's
enormous fixed costs.
You got to lay
those water pipes.
So in that world, average
cost is everywhere declining.
It's approaching marginal
cost, but it never
crosses marginal cost.
In such a world,
once one firm has
laid the pipes that's
providing water,
it never makes sense for
another firm to enter.
Entry never makes sense.
Why is that?
Because if another firm
thinks about entering,
they can say, oh, look this
water utility is making all
this money, this is a great
market to enter-- remember,
we talked about
unlimited entry and exit
and perfect competition
that drives profits away.
Well, let's say another firm
says, look at all this profits,
I want into this market.
The first firm
will say, I'm just
going to tell you right now,
if you enter this market,
I will price at marginal
cost until you leave.
For the first firm,
they've already
paid to lay down the
pipes, so as long
as they're pricing at marginal
cost, they're not losing money.
But for the second firm,
they will lose money
if the firm stays
at marginal cost.
So they'll just never enter.
Because they know the first
firm has a barrier to entry.
They have a natural monopoly,
having laid down those pipes.
Having already paid that
fixed cost, that sunk,
they will win any battle.
They'll just price at
or near marginal cost
and drive any competitors
out of the market.
So these kinds of essentially
natural monopolies
arise when enormous fixed
costs create a barrier to entry
when enormous fixed costs
create a barrier to entry.
You can see natural monopoly.
And that's one common way
monopolies arise in the world.
Think of utilities.
Delivering water is a
classic example of that.
That's one way we
get monopolies.
The second way we get monopolies
is through government action.
Governments also create
monopolies remember,
today I told you we talk about
governments as good guys.
But still governments
can do things which
can create deadweight loss.
And now sometimes,
governments do
this for a good reason, like
a natural monopoly reason,
like the postal
service for example.
Local postal delivery,
delivering letters locally,
has all the features
of a natural monopoly.
It's a huge fixed cost
of building all the post
offices and a small marginal
cost of transmitting letters
from place to place.
Now however, in other cases,
this is not necessarily true.
In the US, we have very few
government-created monopolies.
The rest of the world,
especially in the developing,
it's much more common.
Many countries have
the government control
the production of steel,
the airlines are controlled
by the government ,
banking is often controlled
by the government.
These are places where
probably evidence suggests
it would be more efficient to
not have the government control
this.
There is no real natural
monopoly in banking.
But it's more for political
reasons that they're created.
But that's not really
that relevant in the US.
Even the post office
isn't a monopoly anymore,
with FedEx and UPS and stuff.
So it's not really
relevant in the US.
The more relevant for the US,
way that the government creates
monopoly is by creating
barriers to entry.
The government could
create barriers
to entry, the most prominent
of which is patents.
The most prominent barrier
to entry is a patent.
This is the case where
the fixed cost here
isn't building a pipe.
It's coming up with an idea.
And that basically
the government
has a law which says that,
if you have a new idea
and you patent it, you
are granted a monopoly
to sell the
resulting good for 20
years from the date of patent.
So when you patent
a good, you're
granted the right to a monopoly
over that market for 20 years.
Essentially, the government
is creating a monopoly.
It's saying, once
you've patented that--
now remember, very
importantly-- especially
for drug development--
it's not the date at which
the good comes to market.
It's the data at which you file.
So if you file for a
patent and it takes you
19 years to develop the
product, then you only
get one year monopoly
in the market.
So it's the sum.
20 years is both the development
period and the sales period.
You get 20 years from
the date you file.
Now, patents are quite
interesting because the welfare
implications are kind of mixed.
On the one hand, a patent,
by creating monopoly,
creates deadweight loss.
For potentially up
to 20 years, you've
got deadweight loss
in that market,
because one firm has
the monopoly right
to sell the good.
On the other hand, why might
patents be a good idea.
Yeah.
AUDIENCE: [INAUDIBLE]
for developing drugs,
the company that can't
ever make any money off
of its research and
development costs
will never be incentivized
to develop it [INAUDIBLE]..
JONATHAN GRUBER: Right.
Because research and development
is a huge fixed cost.
And if you pay that
huge fixed cost,
and the minute you develop it
someone else can just copy you,
then you'd never invest
those fixed costs.
We'll talk later in the
course about externalities.
But you think of this as
sort of a positive spillover
from R&D. When firms do R&D,
when a firm invents something,
it benefits everybody who
might produce that good.
So if I invent something,
then everybody could copy me,
could benefit.
So I will not invest
in R&D unless I
can be sure I might get
some money out of it.
And that's what the patent does.
It reduces those
spillovers by saying, OK,
you get to own this for 20
years and make some money on it.
Therefore, go ahead and invest.
In other words,
what a patent does
is, essentially, the
government's saying,
you're going to get a reward
for being first to market.
And that reward is 20
years of privilege of being
a monopolist in a market.
Therefore, that's an incentive
for you to go and invent.
Yeah.
AUDIENCE: What's the process
like for extending your patent?
Because I know
Disney, for example,
has [INAUDIBLE]
which is giving them
more years than what they had?
JONATHAN GRUBER: That's
a very detailed concept
that I don't have
enough time to get into,
but there's a whole bunch of
legal battles around that.
But the bottom line is,
there's a patent tradeoff here.
The tradeoff is,
on the one hand,
it's what we call a static
versus dynamic tradeoff, sort
of today versus the future.
At any point in time, there's
a ton of deadweight loss
out there, because
monopolists who have patents
are under-producing.
At the same time,
over time, we're
getting cool new products
because of patents.
And that's the tradeoff.
How did 20 years get picked?
Ideally, you'd have
some optimal period
to resolve that tradeoff, the
ultimate result of a tradeoff
long enough to get creation,
but short enough so
that the gains on
that creation don't
exceed the deadweight
loss from monopoly.
And that's an example
how a monopoly can
arise from a government action.
And the point is that, for both
natural monopolies and patents,
there are legitimate reasons
for monopolies to arise.
So what I want to say is,
monopolies are not bad.
They're not necessarily an
inherent flaw in the system.
There are legitimate
reasons to have monopolies,
both because of natural
monopoly and because of patent.
But they do, at any point in
time, create deadweight loss.
Yeah.
AUDIENCE: Is there
a way to measure
how the impact of [INAUDIBLE]
something that receives patent,
like how [INAUDIBLE] that
relates to the deadweight loss
[INAUDIBLE]?
JONATHAN GRUBER: It's
a great question.
There are people who do
spend their lives doing that.
And basically, the
way you would do
it is you would essentially
measure the consumer
surplus created from the
new good, versus-- it
would be the triangle sizes.
It would be, how much
consumer surplus would
you get from the new good
versus deadweight loss
from that good sales
being restricted.
Now obviously, if
it's a good that
never would have existed
otherwise, by definition,
the patent's a good thing.
Because who cares
about deadweight loss
if you never would have
had it in the first place.
The question really is
about the substitutability.
If you're patenting
something which
is only incrementally better,
then maybe it's not worth it.
So that's sort of the tradeoff.
Other questions?
OK, so now let's talk about
addressing or regulating
monopolies.
Let's go back to think about
our natural monopoly case.
Let's think about our
natural monopoly case.
Actually, I'm going to call
this section not regulating.
I'm going to call this
addressing monopolies,
addressing monopolies.
There are different ways that
we can address monopolies.
And we'll go back to our natural
monopoly case to make it easy.
The first way we
can address monopoly
is through government
regulation.
So let's step back here.
The bottom line is, we have
a monopoly that should exist,
say a natural monopoly.
It exists naturally.
At the same time, that is
creating a deadweight loss.
It's creating inefficiency.
So the brilliance,
the insight of
the first fundamental
theorem of all for economics
was, the competition
through entry and exit
will bring us the
efficient production level
and reduce deadweight loss.
Here with a natural
monopoly, that doesn't work.
Competition can't
work, therefore,
we end up with a
deadweight loss,
because the firm that owns
the market is under-producing.
This is the first case, as I
mentioned last time, of what we
call a market failure.
The market outcome
is not delivering
the welfare-maximizing
result. And once there's
a market failure, there is
a potential beneficial role
for government.
I said last time, with
no market failures,
government's just the bad guy.
With no market failures,
all government can do,
it can help with
the redistribution.
But from an efficiency
perspective,
all the government can
do is muck up the market.
But once there's
a market failure,
there's a potential role for
the government addressing it.
So to see that, let's return
to our monopoly example
from last time in figure 12.2.
Figure 12.2 is our monopoly
example from last time.
Remember, we had
demand curve that
was Q equals 24 minus
P. We had a cost
curve that delivered the
marginal cost of MC equals 2Q.
And that's graphed here.
And we said last time
that the monopoly outcome
would be at E sub M. The
monopolist would sell
6 units at the price
of 18, creating
a deadweight loss of C plus E.
Now, what if the government
came along and simply mandated
that the monopolist was not
allowed to charge more than 16?
The government says, look, I
understand it's a monopoly.
I'm not going to try to
break up the monopoly.
It's a natural
monopoly, whatever.
Simple rule-- price
ceiling of 16.
Now, when I mentioned pricing
a couple of lectures ago,
you should have
learned to say, boo,
price ceilings, bad, increase
deadweight loss, terrible.
But now, suddenly
a price ceiling
can actually get rid
of deadweight loss.
How's that possible?
Let's take a look.
In this case, the monopolist
knew marginal revenue curve
is a bit different.
The new marginal revenue curve
is the old marginal revenue
curve, until you
get to the point
where the first dashed line
intersects marginal revenue.
It's the old marginal
revenue curve,
until you get where the marginal
cost crosses marginal revenue.
Then it jumps to
the flat line at 16.
Essentially, the new
marginal revenue curve
is downward sloping
till the point
where marginal cost
equals marginal revenue.
Then it jumps back
up to the flat part
that goes from 6 to 8.
Now the exact shape
doesn't matter.
It's the intuition that matters.
The point is the following.
Think about the
monopolist's decision.
He decides, based on the
logic of the last time,
to sell six units.
That's the point
where the poisoning
effect offsets the benefits
of selling another unit.
Now let's say the
government comes and says,
monopolists, you can't
charge more than 16.
Well, once a monopolist
is forced to charge 16,
now think about her decision
to sell the seventh unit.
Well, before she didn't want
to sell the seventh unit,
because selling the
seventh unit meant she
had to lower the price to 17.
Well now she has to lower
the price to 16 already,
so why not sell
the seventh unit?
Indeed, why not sell
the eighth unit?
We've essentially gotten
rid of the poisoning effect
by pre-poisoning them, by
already telling them, look,
you can't charge more than 16.
There's no way to
charge more than that,
so you might as well
sell eight units.
So by telling the
monopolist they
have to charge a
competitive price,
you will force them to sell
the competitive quantity
and you get rid of
deadweight loss.
That's our first example
of how the government has
improved things.
The government has gotten
rid of the deadweight loss
by setting a price ceiling.
Price ceiling, in a perfect
market, is only bad,
but a price ceiling here
can actually improve things.
So that actually
sounds pretty good.
So what's the problem?
Why not, in reality,
just say, hey, we
can solve all our
monopoly problems
by just having the
government regulate the price
at the competitive level?
What's the problem, in
reality, with that solution?
Yeah.
AUDIENCE: How would
the government
know the competitive level?
JONATHAN GRUBER: How the
hell does the government
the competitive level?
It's great with this chart.
But in reality, the
government doesn't
know where the competitive
level is because there's
two difficult points.
What does the government
need to collect?
First of all, the
government needs
to know what the
demand curve is.
Well, it turns
out demand curve's
aren't written on our foreheads
or out there on the dark web.
Demand curves are something
which you have to estimate.
You have to gather
information from people.
And it turns out that
it's pretty hard.
Because if you want
to gather information
on what people are
willing to pay for apples,
you can just go to stores and
look at the prices charged
for apples.
But if you want to gather
information on the willingness
to pay for getting water
delivered to your house,
there's no market to turn to.
It turns out to be
pretty hard to figure out
how you value a lot of goods,
which is natural monopolies.
Now, you might say,
well, why do you just ask
people what it's worth to them?
You just say to people, look,
tell me you demand for water.
It turns out that's really
hard because people aren't
very good at thinking
about how to assign prices
to things they don't shop for.
If I say to you,
what's an apple worth,
the first thing in
your head is, you
think about being in a
supermarket looking at apples
and what they cost.
You don't think about
the inherent value
to you of consuming an apple.
But when you think about
what water is worth,
you have to think about
sort of the inherent value.
And so you have to
rely on something
that we call contingent
valuation, which
is the economist's fancy
word for just asking
people what it's worth to them.
The problem is, people
aren't very good about that.
So for example, a
classic case was the rise
in environmental issues.
How much is it worth
to have clean air?
How much is it worth to
save the Grand Canyon?
So it turns out people
give sort of crazy answers
that violate all the rules we
set up in the first lecture
by utility functions.
Like for example,
if you asked folks
what it's worth
to save the Grand
Canyon as a single question,
and then you ask them
as the third question on the
list, it's worth 1/5 as much
to save the Grand Canyon was
the third question on the list,
which doesn't make any sense.
It doesn't matter what
the other questions are.
If you ask people,
how much they would
pay to save seals and
whales, in that order,
they'd say saving seals is
worth $142 and whales $195.
So whales and seals
are about the same.
But when you reverse
the order, whales
are worth about twice
what seals are worth, just
by reversing the order.
Well, more
relevantly, if you ask
people what it's worth to
save a bird or 10 birds
or 1,000 birds or
a million birds,
they give you pretty
much the same answer,
which doesn't make any sense.
So basically, the problem is
these contingent valuation
methods don't really
give sensible answers.
And it's very hard to
get sensible answers.
In my other course,
Public Economics,
we talk about lots of
interesting clever methods
for trying to get people
to reveal their preferences
for these public goods.
But it turns out to be hard.
So that's one problem, is it's
hard to measure the demand
curve.
The other problem is, it's hard
to measure the supply curve.
Because where does
supply curve come from?
It's sort of a firm's
marginal cost function.
You as the regulator do not
know what their marginal cost
function is.
So how do you find out?
You ask them.
You say, hey, business
I'm going to regulate,
I'd like to know what
your marginal cost is.
And by the way, the
lower you tell me
it is, the lower price I'm
going to let you charge.
So what's your marginal cost?
Oh, god, our marginal
cost is horribly high.
It terrible.
You wouldn't believe
it, can't complain
enough about how high
our marginal cost is.
And basically, unless the
regulator perfectly knows
the production function
and perfectly knows
the input prices, none of
which are perfectly known
by anybody but the
firm, they aren't
going to know what the
supply curve looks like
and what the marginal
cost looks like.
Question.
AUDIENCE: Couldn't they also,
say, in a public company,
basically inspect their factory
and manufacturing [INAUDIBLE]??
JONATHAN GRUBER: You
could absolutely do that
and you can try to collect data.
But ultimately, they could,
that day that you show up
with the inspector, have a
really expensive-looking setup
in their factory or whatever.
It's basically very, very hard.
So basically, the problem is
that regulation-- and this
will generally be
a feature when we
talk about the benefits of
government intervention.
We'll say, market
failure makes it possible
that government
intervention can make things
better, but not definite.
So the way to think
about the logic
is, in a perfectly competitive
market with no market failure,
government intervention only
makes things less efficient.
We're leaving
redistribution aside.
It only makes things
less efficient.
When you move to
markets with failure,
you open up the possibility
that government intervention
can make things better, but
not for sure that it will.
You open up the possibility.
It's a necessary but not
a sufficient condition
for saying the government
improves efficiency.
So for example, imagine
that the government came in
to this market
and said, we think
the competitive price is 10.
We think the
competitive price is 10.
Well, if the government
set the price equal to 10,
we know that firms
are going to produce
where marginal revenue--
which is now just
10, because it's
regulated-- equals marginal
cost, so where 10 equals 2q.
Little q and big Q are the
same because of the monopolist.
Where 10 equals 2q,
or where q equals 5.
So if the government
comes in and says,
we're fixing your
price at 10, we
know the firm
produced five units.
Well, with five units, the
deadweight loss is even bigger.
The key trick with deadweight
loss triangles, deadweight loss
is essentially
proportional to how far you
deviate from the optimal point.
So the more you
move to the left,
the bigger the deadweight
loss triangle is going to get.
So deadweight loss
with 5 units sold
is bigger than deadweight
loss with 6 units sold.
So the government's
actually made things worse.
By coming and setting
this price of 10,
the government's
made things worse.
Indeed, the government
could actually
set the price so
low you shut down.
The government could set the
price below the shutdown point
and wipe the whole
business off the map.
So here we have the tradeoff.
The government can
potentially make
the market more efficient
through price regulation,
but it won't necessarily.
It depends on its
level of information
and how well it does
setting the price
relative to the
competitive price.
So basically, this
is a very sort
of interesting and difficult
problem for the government.
So one way is
through regulation.
Questions about that?
The other way to try to
address monopoly is by saying,
is there some way to
introduce competition?
That is, even in what feels
like a natural monopoly market,
is there some way to
choose competition?
So for example, think
about broadband delivery.
Now we're still wired.
In the future,
it's all wireless.
This is different.
But it's still wired.
The way it works is,
broadband delivery
has features of a
natural monopoly, which
is, someone has to lay the wires
to your house to deliver it.
At the same time, once
those wires are laid,
it's a 0 marginal cost to allow
you to connect to the internet.
So what governments do in other
countries, but not the US--
in the US, we have competition.
Everybody lays their
own lines down.
In Europe, they recognize
that's inefficient.
It's a natural monopoly.
What they do is, they have one
set of publicly laid lines,
and you compete to deliver
content over those lines.
So there's competition where
the monopoly is not natural,
which is over the
speed and the quality.
It's the quality
of the connection.
But the lines themselves, since
that's a giant fixed cost,
they realize there can't
be competition over that.
So that's one way
you could try to deal
with a natural monopoly.
In other words, the
government could
control the pipes underground
delivering the water
and have firms compete over
delivering the water to you.
So that's one way
to deal with it.
Another example is to think
about the public sector
and think about education,
education delivery.
Now, for those of you
who grew up in the US,
you are evidence of the success
of the US educational system.
But you are the
exception, not the rule.
The US educational system,
by international standards,
performs very badly.
Probably out of the
top 30 countries,
we're like 15th in terms
of things like math scores
and other things like that.
Yet, we spend more
money per pupil
than any other
educational system
in the world by a large amount.
So if you look at figure
12-3, figure 12-3 shows,
in the blue, primary
school spending per pupil,
and in the red, eighth
grade math scores.
And you can see the US spends
way more than other people,
but our scores
aren't any better.
Indeed, it doesn't
look like there's
a very strong
relationship here at all
between how much countries spend
and what you get in return.
But at least it's
quite striking how low
the US is given how
high our spending is.
Now, why is that?
One reason is because we have
given local schools a monopoly.
We have said to
local schools, you
have a monopoly where you get to
deliver the education to anyone
who lives within a certain
radius of your school.
We've created that
natural monopoly.
And once we created
that natural monopoly,
we reduce pressures on firms
to produce efficiently.
We've essentially said to
firms, you have a monopoly.
There's no reason you have
to produce efficiently.
Because there's
no entry and exit,
which can put those
pressures on you.
So in some sense, that's a
government-created monopoly.
Your local public school is a
government-created monopoly.
So what can we do for that?
What can we do?
Well, we can actually
introduce competition.
So for example, we can
have public school choice,
which many cities now
have, where, in fact, you
don't have to go to the
school in your neighborhood.
You can try to go to any
school in the district.
You can essentially
enter a lottery
and try to move around to
other schools in the district.
And that introduces competition.
Because then the
schools that want
kids will have to
be better and have
to produce more efficiently.
And then a further
mode of that is,
you can have charter schools.
Charter schools are publicly
funded, but not city provided.
They're in between public
schools and private schools.
Charter schools are
separate schools,
which get funding
from the government.
But they aren't under the
local government's control.
Regulatory control, but
they aren't delivered
by the city as education.
And that provides more public
school choice for individuals.
And there's a lot of evidence,
much of it by my colleagues
here at MIT, which
shows that there's
been enormous benefits
to these movements,
that public school choice
and charter schools
have delivered-- now
I know some of you
might have seen the John Oliver
segment a couple of years
ago where he ragged
on charter schools.
I mean, I love him in general,
but he was wrong on that one.
There's a couple of bad actors.
But by and large,
charter schools
have been an enormous benefit
to the education system
by introducing competition
and allowing students
an option to improve their
educational outcomes.
Now, the furthest out
option, and something
you'll hear a lot of
discussion of, is vouchers.
The most radical option is
what we call public school
vouchers, or just vouchers.
Here's how this would work.
This is a very popular idea
on the conservative side
of the spectrum.
Here's how this would work.
So I live in Lexington.
What that means is, if I
send my kid to a Lexington
public school, it's free.
But the minute I pull
my kid out and send him
to a private school, it
costs me the entire amount.
So imagine a Lexington public
school education's worth
$10,000.
I'm essentially getting
$10,000, conditional on sending
my kids to a Lexington school.
The minute I choose to
send them elsewhere,
I literally give
up that $10,000.
A voucher system would
say, the way it would work
is, everyone in town
would get a check
or would get a
voucher for $10,000
to be used at any
school they want.
So if you want to go in
Lexington, you just hand it in.
Life's never changed.
But now if you want to
go to private school,
we're allowing you to
take your money elsewhere.
That puts competitive
pressure not just
on schools within the district
but on the whole district.
The whole district now
says, wait a second,
if we don't do a
good job, people
are going to leave and
take their money elsewhere.
So the idea is to actually
set up broader competition
to put pressure on districts
to improve their performance.
So this has been a
longtime attractive option
to many economists.
And I've spent a whole long time
talking about the pros and cons
of this in my other class.
But briefly speaking, the
pros are all the reasons
we like competition in markets.
It'll cause more
production efficiency
because schools would
have to compete.
The cons are numerous, though.
One con is, you then have to
have the public sector that
has a vested interest in
making sure private schools are
delivering a public
quality education.
So basically, you could set up
a private school that is just
a football training academy.
And suddenly, people could take
their voucher and go there,
and suddenly they
wouldn't get education.
That's one con.
Another con of these systems
is that they're expensive.
So take me.
I live in Lexington.
I'm a pretty rich guy.
I sent my kids to
private school.
I sent them and I paid.
Now, imagine Lexington
had a voucher system
and they give me a
check for $10,000.
Why should Lexington give a
relatively rich guy $10,000?
That's sort of silly.
I was already sending my
kids to private school.
So who would be the big winner
from a system like this?
Well, some winners
would be kids who
then get a better education.
But a lot of winners would be
rich people who already sent
their kids to private school.
We'd just be
handing them checks.
That's not a great outcome.
So there are
definitely tradeoffs
inherent in a system like this.
I know there's a few questions.
Let's do a couple of
questions, then we'll move on.
Yeah, in the back.
AUDIENCE: So say you
have these vouchers,
and instead of going
to the public school,
students are leaving to the
private school, and then
the fixed cost of having
the infrastructure
of a public school, that's then
spread out over less students.
So how do you account for, the
price of teaching one student
might go up if there are these
students that are leaving?
JONATHAN GRUBER: That
is an awesome question.
There's two elements to that.
Question one is, there is an
actual natural monopoly feature
to local public education.
So remember, competition
doesn't make sense when
it's a true natural monopoly.
There is some natural
monopoly element.
So as you shrink the
number, you suddenly
are raising the average cost.
And that is a potential problem.
There's an efficiency issue.
There's also an
equity issue, which
is, who uses the
vouchers and leaves?
The people with motivated
parents who are with it.
Who gets left behind?
People's parents who don't
give a shit about him.
There's an equity issue,
too, of, suddenly,
you're pulling all the smart
kids, all the motivated kids
out of the public schools
and leaving the kids
behind who aren't motivated or
whose parents aren't motivated.
There's an equity
issue there, too,
so that's another tradeoff.
Yeah.
AUDIENCE: You got
a good education.
JONATHAN GRUBER: How do you tell
if people get a good education?
Well, that's [INAUDIBLE].
AUDIENCE: Well, if you're
going to get a good education.
JONATHAN GRUBER: Well,
that's another problem.
Which is, competition, one of
our fundamental assumptions
of perfect competition
was perfect information.
That's fine when you're
looking at apples or maybe
even computers.
It's not so easy
looking at schools.
Now, schools
publish test scores.
You can look at the test scores
of kids who go to that school.
But once again, that's
not that reliable,
because if smart kids
are going to the school,
they'll have high test
scores, even if teachers suck.
For example, Harvard--
sorry, I couldn't resist.
[LAUGHTER]
So basically, you
can't really tell that.
In other words, there's
a number of failures
of the private
education market, that
are a problem with this
kind of voucher solution.
But it doesn't mean it's wrong.
It means it's interesting.
There's a tradeoff.
On the one hand, we'd
introduce competition,
which would maybe increase
efficiency in the market.
On the other hand, there's
a lot of market failures
which might get in the way
of this functioning properly.
Fascinating topic, and if
you want to learn more,
I urge you take 1441.
We spend a whole lecture
talking about it.
So that was the second
topic I want to talk about.
Once again, we've
started down the road
of questioning the wisdom of the
market, so the road of market
failures.
The first market
fail is monopoly.
We've talked about the
pros and cons of trying
to deal with monopoly.
But I want to talk
about one other topic
before we leave
monopolies, which
is this topic of what we call
contestable markets, which
is sort of an informal term.
But I really like
it as an intuition,
so I'd like to spend
some time on it.
Contestable markets are monopoly
markets without market power
or without much market power.
That is, we talked
about monopolists
as having lots of market power.
Remember, we said the markup
was essentially proportional.
We said that monopolists
had a markup, price
minus marginal cost over price,
which is equal to minus 1
over the elasticity of demand.
That was their markup.
And so you know some markets,
different monopoly markets
will have different
levels of market power.
You can be a monopolist, but
not have much market power
if consumers are very elastic.
But there's another reason
why monopolists face pressure
besides the
elasticity of demand,
which is, in some sense, the
size of the barrier to entry.
So one reason monopolists are
constrained in their pricing
is because demand's elastic.
Another reason is because
the barriers to entry
might not be that large.
So you could think
of it, roughly
speaking, for a given
elasticity of demand,
the larger the barrier to entry,
the more market power you have.
Because the larger
the barrier to entry,
the more you can be sure no
other firm's going to come in.
Or in other words,
the amount to which
you can charge above marginal
cost for a given elasticity
is proportional to how severe
the barriers to entry are.
If there's no way a second firm
can get in, then essentially,
you get to just
obey this formula.
But if a second firm
can get in easily,
then you might not even be
able to have this big a markup.
Because if you try,
someone's going
to come in and
steal your profits.
So in other words, there's
essentially an important issue,
which is that the
market monopolists can
get as a function both of
elastic demand and the size
of their barriers to entry.
This is an important
issue that came up
in the area of airline
deregulation, which
is what I want to talk
about for a few minutes.
It's an important application
of the kind of stuff
we've been talking about.
Now, how many of you
have seen Mad Men.
Jeez, really?
Wow, OK, it's a
pretty good show.
I mean, it's not outstanding.
How many have seen Breaking Bad?
OK, good.
That, you have to all see.
Mad Men's pretty good.
But basically, what's
nice about Mad Men,
it shows what flying was
like when I was a kid.
When I was a kid, when you
flew, it was like luxurious.
You went on, there was
plenty of leg room.
You had free meals, free
movies, free drinks.
And the reason was because--
I sort of skipped
ahead in the story.
When I was a kid,
airlines were regulated.
What that meant was
that, essentially,
the government viewed airlines
as a natural monopoly.
They said, look, planes
are very expensive.
There's a big fixed cost,
so it's a natural monopoly.
We don't think competition
will work well here,
so we're going to have
regulation of airlines.
What that meant
was, the government
set the price of every
flight and regulated
where planes could go.
So airlines every
year would submit
a set of routes they wanted
to fly and a set of prices.
And the government would
approve or turn them down.
It was a regulated market.
And it was generally viewed
that the government basically
sort of screwed this up
and set the rates too high.
That was sort of
the general view,
that, basically, government,
because, essentially, they
didn't really understand
the supply curve,
they were being
fooled by the airlines
to think costs were higher
than they were and were setting
prices too high.
But economists said, look,
this is not a natural monopoly.
Because in fact,
it's not actually
that cheap to get a used
plane and enter this business.
Because these companies turn
over their planes all the time.
And yes, buying a new
plane's expensive.
But getting a
well-functioning used plane
isn't that expensive.
And you could easily create
competitors in this business.
They said it was what we called
a contestable market, a market
with very low barriers
to entry, that, in fact,
if you allowed competition,
you would have a lot of entry
into this market.
And it would function fine, that
it wasn't a natural monopoly,
it was a contestable market.
And they argued, in fact, that
if you lacked competition,
price would fall very
close to marginal cost.
Price could fall very
close to marginal cost.
So in fact, economists
carried the day.
In the 1970s, we deregulated
the airline industry.
The government stopped setting
prices and regulating routes.
What happened?
OK, three things happened.
The first thing is,
price fell enormously.
The cost of flying
fell by about 1/3.
The best example was the airline
I took home from MIT in 1984
called People Express.
People Express
Airlines introduced--
this was sort of shortly
after deregulation.
I could fly from Boston
to Newark for $29.
Now, how did that work?
It was crazy.
You showed up at the airport.
There was no reservations.
You just waited on line.
They let people on until
the plane was full.
Then you waited
for the next one.
You paid on the plane
with a credit card.
I still to this
day don't know what
happened if you didn't pay.
Did they throw you
out the window?
I don't know.
But you paid on the plane.
And it was incredibly
competitive.
And this is what happened.
Flying got incredibly cheap.
The second thing that happened
is you had many more routes.
It turned out that
the government
thought that flying
from point A to point B
wasn't profitable
often when it was.
So the government wouldn't let
airlines flight from point A
to point B, when,
if fact, airlines
could make plenty of
money doing that flight.
So you had cheaper
flights and more routes.
The third thing
is, flying sucks.
When I was a kid,
flying was awesome--
meals, booze, big seats.
Now it's terrible-- no
meals, no booze, tiny seats.
Why?
Why did this happen?
Flights got cheaper and
there are more of them,
but why were they
suddenly crappier?
Yeah.
AUDIENCE: There was
more competition
so they were trying to bring
down the marginal cost so bring
prices lower.
JONATHAN GRUBER: Right,
that's one way to put it.
But the point is, what
this example points out
is that there's
always competition.
Yeah, what were
you going to say?
AUDIENCE: I was going to
say price discrimination.
They could discriminate based
on what people [INAUDIBLE]
JONATHAN GRUBER:
It actually wasn't.
They still price discriminate.
It wasn't quite that.
But yeah.
AUDIENCE: People were
willing to fly [INAUDIBLE]
JONATHAN GRUBER: They
were willing to fly.
But what were they doing before?
Yeah.
AUDIENCE: If you couldn't
compete on price,
you could compete
on luxuriousness.
JONATHAN GRUBER: Right.
So there were multiple
airlines before.
The government said we'll
only compete on price.
But they said, great, we'll
compete on other stuff.
Remember, economic actors
want to be economic actors.
They want to use economic tools.
So if the government
says to airlines,
we're not going to let
you charge a higher price,
they're like great,
we'll compete
by having better food,
better drinks, bigger seats.
Once the government
said, now you
have a new mode
of competing, they
realized people
weren't willing to pay
for better food and better
drinks and bigger seats.
They'd rather fly cheaper.
So they switched the
mode of competition
from quality competition
to price competition.
They used to use
quality competition.
Now they use price competition.
This means that all of us who
complain that flying sucks
should just shut up.
Because if we really
cared that much,
then there'd be a good airline
that charged more and gave you
better stuff.
But there's not.
I mean, JetBlue's
a little better.
But by and large,
there's not airlines
that charge more and
give you better stuff.
And that's because,
at the end of the day,
we would rather fly cheaper
than have this extra stuff.
It wasn't worth the money
that we were paying for it.
Which really says that
regulation was failing here.
Regulation was forcing
airlines to compete
in an inefficient way.
They're competing by giving us
nice meals when we would rather
have the money.
So it was an example
that regulation failed.
So that's all really good news.
But there's one piece of bad
news, which is that, economists
aren't all-knowing.
And the economists, there's
a fourth outcome we missed,
which was the rise of
the hub and spoke system.
Which is that what we
missed is that airplanes
aren't a natural monopoly,
but airports are.
And what airlines started
doing is essentially
taking over airport
slots, and then saying,
we are going to have
all the flights.
So for example, my wife
is from Minneapolis.
We used to go to Minneapolis,
the only option was Northwest.
Northwest owned all the slots
in the Minneapolis airport.
And they'd say, if you ever
fly anywhere on Northwest,
we're going to route you from
Minneapolis to wherever you go.
It was called the
hub and spoke system.
You always went to a
central point and went out.
So US Air had Pittsburgh.
Northwest had Minneapolis.
American had Dallas, et cetera.
They had these hubs
that you'd go through.
What that meant was,
they essentially
got a monopoly on the
route into the hubs,
because they had monopoly
on the slots in the airport.
Now you might say, well,
that's easy to fix.
Don't give monopoly
slots in the airport.
But that's harder to
fix than you think.
Because whenever the
airport in Minneapolis
would say to Northwest, we
want to allow other airlines,
they'd say, great, we're
moving our headquarters out
of Minneapolis.
See ya.
And they'd say, OK,
fine, we won't do that.
So essentially, there
became political equilibrium
where these local airlines
were such big employers,
they'd bully the
governments into letting
them dominate the airports.
And they essentially
recreated a monopoly.
But the monopoly
wasn't on planes.
It was on airport slots.
And actually, flying got
much more expensive again.
So the price of flights
really came down
until airlines figured out
this hub and spoke system,
and they've gone back up since.
Now, they're still cheaper than
they were under regulation.
But roughly speaking, the price
fell by more like more than 50%
initially, and then
sort of risen back up.
It's still lower than
it was under regulation.
But it's risen back
up because there's
this sort of new
natural monopoly problem
that we didn't see.
So that leads to crazy
things, like a price
of a nonstop to
San Francisco today
is something like half
as much from Boston
as a flight to Minnesota.
Now, I don't know how
your geography skills are,
but San Francisco's a
lot farther from Boston
than Minnesota is, so it's
clearly not a marginal cost
issue.
So that's an example.
It's sort of a nice
case study of kind of,
our motivation was right, by and
large economists got it right.
By and large, we're better
off in a deregulated world.
But not as well
off as we thought,
because we missed this other
element of natural monopoly.
Why don't I stop there.
We will continue next time
by talking about oligopoly.
