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JONATHAN GRUBER: OK, I
want to talk today about--
continue our discussion
of oligopoly.
Last time, we talked about
non-cooperative equilbria,
but in the start, we
said, gee, life would just
be better off if everyone
would just cooperate.
And someone even asked
me, "Well, why don't they
just cooperate?"
So let's talk about that.
Let's talk about cartels.
What happens when firms
try to cooperate--
achieve the cooperative
equilibrium in oligopolies?
Now, clearly, this is going
to be the best outcome.
So the fixed examples--
let's go back to our example
of last time, American United.
Recall, last time, we said
that demand was in the form
339 minus Q. Price
is 339 minus Q.
And that the marginal
cost was 147, OK?
Now, we talked about the
fact that if American
was a monopoly in this
market, they would simply
solve the monopolist's problem.
They would set marginal
revenue, which is 339 minus 2Q,
equal to marginal
cost, which is 147,
and they would get that
the optimal Q would be 96.
And then reading back
off the demand curve,
that would imply an optimal
quantity of $243, OK?
So that was what
we got last time.
Now, imagine that American
is not a monopoly,
but American United cooperate.
What if they got together
and said, "You know what?
Let's behave as if we're one
monopolist, flying 96 flights
and just splitting them equally.
We'll do 48, you do 48.
So let's cartelize.
Let's achieve the
monopoly outcome,
and we'll also share 50-50
the fruits of that outcome."
So in that case, each
firm would fly 48 flights
at a price of $243, OK?
And total profits
in the market--
each firm would then make
profits of 48 times--
price minus average cost, which
is marginal cost, because it's
flat--
times 243 minus 147--
or since I'm not like you guys,
I can't do that in my head--
4,608 per firm, OK?
So each firm would
achieve profits of--
take the 96 flights,
split them in 1/2,
and then each achieve
profits of 4,608.
Now, what we can see
is that these profits
are much higher
than what they got
in the non-cooperative
equilibrium.
Remember, the
non-cooperative equilibrium,
they were each doing 64
flights at a price of--
they were each doing 64
flights at a price of 211.
We saw that last time.
So what were their
non-cooperative profits?
Their non-cooperative
profits for each firm
was 64 times the 211 they
were charging, minus the 147
in marginal costs, or their
former profits were 4,096.
So their profits
used to be 4,096
when they weren't cooperating.
They've gone up by 12.5%
to 4,608 by cooperating.
So simply by getting together,
saying, "Don't be an asshole.
Let's cooperate.
Let's figure how to
make the most money."
Getting together, they solve
the prisoner's dilemma,
get to the best outcome, and
make a lot more money, OK?
So the question is, why
don't they always do
this in oligopolistic markets?
And fundamentally,
there's two reasons.
Now, normal people-- you'll see
when I'm done-- normal people
will teach them in a
different order than I will.
But let me start with the two
reasons the other economists
would teach them.
The first reason why
cartels don't form
is that they're
fundamentally unstable.
Cartels are fundamentally
unstable as long
as firms are self-interested.
Each individual firm in a cartel
has an incentive to cheat,
and that's because
they essentially
can solve the monopoly problem
of poisoning by cheating.
Let me explain how that works.
It's best to see
this through numbers.
Let's imagine that we start in
this cooperative equilibrium,
48 flights each and
profits of 4,608.
And now let's imagine,
that quietly, American
increased its number of
flights from 48 to 50.
American says, "Well, I know
I agreed 48, but on the sly,
I'm going to fly
two more flights
and hope they don't catch me."
OK?
Well, what's American's profits?
Well, their quantity is 50.
Q sub A is now 50.
What's the price?
If they're going to do 50
flights, what's the price?
Yeah?
I'm sorry?
It's 280-- the price is-- let's
see if you got that right.
I've got to check my notes.
No, if the price was 243
when they're a monopoly,
now they do two more flights.
Remember, they're adding
two flights to the total.
There used to be 96 flights.
Now it goes to 98 flights.
So the price falls to 241, OK?
So you were thinking about
them as alone, but remember,
there's still United
doing the flights too.
They're still doing 48 flights.
So there were 96 flights total.
Now it goes to 98.
So the price falls to 241, OK?
So what's their profits?
Their profits are now 50
times 241 minus 147, or 4,700.
Their profits have gone up.
OK, let me back up and do it
again because I went fast, OK?
They say they're going
to do two more flights.
We have to respect
the demand curve.
So there's going to
be two more flights.
The price has to fall.
If the price falls, then the
price has to fall to 241.
They now make
profits of 4,700, OK?
Well, if United is caught
with their pants down
and continues to do 48
flights, what does United make?
Well, United's still
doing 48 flights,
so the profits of United are 48
times 241 minus 147, or 4,512.
So American's profits are
up and United's profits
are down through
American cheating.
What happened?
How by cheating did they drop?
What's the intuition of why them
cheating drove their profits up
and United's down?
And in fact, if
you add these up,
lowered total profits
in the market.
What's going on?
Yeah.
AUDIENCE: It's in the quantity.
You're lowering the price that
you can sell each unit for,
but for American,
because they're
increasing the number of
units they're selling,
they still make
a greater profit,
whereas as United has stayed
the same, because each unit is
sold for less, then they're
making less of that.
JONATHAN GRUBER:
That's almost right.
You got most of it, but
there's one key wrinkle
that's important, which
is, a monopolist would
have the same argument.
The key thing is, what stops
the monopolist from raising
the price from where he is?
Yeah?
The poisoning effect, but think
about the poisoning effect.
Who does the poisoning
effect affect?
Everyone in the market.
Everyone sees a lower
price, but only American
gets more flights.
So they essentially
get the benefit.
It's like you said, they get the
benefit of the extra flights,
but only 1/2 the penalty
of the poisoning effect.
So for them, it is optimal to
lower the price and sell more,
because they share the negative
effect, the negative part
with United, but they get
all the positive part.
Once again, a
monopolist, when you
try to sell more
and lower the price,
there's a positive
part, which is
sell more units, but
a negative part, which
is the poisoning effect.
Well, here, American gets all
the positive part and only 1/2
the negative part.
So they make money
by cheating, OK?
Well, of course,
United knows this.
They saw the price go down.
They know American's cheating.
So United wants to cheat, and
the whole thing breaks apart.
So cartels are unstable,
because by cheating, you
get all the benefit but
only part of the cost.
And so cheating is
incentivized in a cartel,
and therefore, cartels
will break down.
They're not stable, OK?
So that's the primary
reason economists
say we don't see cartels.
The other reason people like to
bring up is this little thing,
they're illegal.
But you know, we don't
let stuff like that
bother the economists.
But they are illegal.
That's another reason
why we don't see cartels.
In the late 1800, cartels
were quite common.
In the late 1800s,
big industries
like oil and railroad
industries came
to be dominated by
a few large firms,
and they tried to
become cartels,
but it kept breaking down.
So in the late 1800s, with
oil companies, Standard Oil,
and the big railroad
companies, they
kept trying to have cartels
and it kept breaking down.
So they come up with this idea.
They basically said, "Look,
we can't trust each other.
So we're going to--
every firm is going to
turn over all its decisions
to a common trust.
And there'll be a trust
that's got representatives
from every firm on the board.
But we will publicly
commit to what
we're going to
produce at what price,
and therefore, we can make
sure there's no cheating."
So essentially, every
firm's still involved.
They're all on this trust board.
But they're making that
decision in a way that's
at least public to them,
not public to the public,
but public to them, so they can
make sure they're not cheating.
So they formed these trusts,
and essentially cartelized,
and made huge profits.
And it worked.
It solved the stability
problem because cheating
could be observed more readily.
Now, would it solve this for
very long, we don't know,
because the government--
the public got pissed,
and the government
came in and passed
what's called antitrust laws.
And antitrust laws
are laws which
do not permit the cartelization
of oligopolistic industries
in this way.
So let's talk about antitrust
laws and how they work
or how they don't work.
I want to do a couple examples.
One example is the
movie industry.
Now, the movie
industry, you know,
is a classic
oligopolistic industry.
There's a few players.
There's new players.
A24 is huge now, what
didn't exist 15 years ago.
But by and large, there's
sort of a few players
you've heard of which
dominate the industry, OK?
And the way the industry works
is movie companies make--
they produce the movies
and then sell them
to movie theaters
that show the movies.
They show a variety of
movies at any one time.
But what happened was
in the '30s and '40s,
the production companies started
buying up the movie theaters.
And what they do when they
bought the movie theaters,
they said to the movie
theater, "We now own you
and you will only
show our movies."
So they say to
the movie theater,
"We now own you, movie theater
on the corner of Lincoln
and Kennedy streets,
and we're MGM,
and you'll only
show MGM movies."
And essentially, what that
meant was essentially,
they were taking
over, monopolizing,
a given distribution network.
And they essentially
carved it up.
They agreed, OK, you
get these theaters.
We'll take these theaters.
And essentially, that was the
way they formed their cartel,
was through distribution.
And the federal
government jumped in
and said that that was
an antitrust violation.
The federal government
sued and won.
And so that industry,
that was broken up.
But did that mean--
that didn't mean folks
stopped trying to cartelize.
It just meant they stopping
being so obvious about it.
So later moves to
cartelize were more hidden.
So for example, in
the early 2000s,
airline industries
were in big trouble,
because oil prices were
going way up due to the Iraq
war and other factors.
Oil prices were going way
up, and the airline industry
was in trouble.
So in 2004, British
Airlines and Virgin Atlantic
had secret talks
about essentially
cartelizing the cross Atlantic
market from the East Coast
to London.
And what they did is they said,
"Look, if we sort of obviously
set our prices together,
people are going to notice.
So to do this
instead, we're going
to add fuel surcharges
to the bill.
We're going to say, 'Oh, oil
is getting more expensive.
Your price haven't changed, but
there's now a fuel surcharge
on your bill.'
And that fuel surcharge is
going to be something people
won't pay attention to
because they won't notice
that we're rising it together."
And these fuel surcharges
rose quickly from $10 to $120
per flight, and essentially
rose in lockstep.
They essentially
coordinated, but tried
to hide it by making
the coordination not
over the sticker price,
but over this thing that's
sort of at the bottom
of your ticket, which
is the fuel surcharge.
So this worked for awhile,
but then what happened?
Well, what happened was
the prisoner's dilemma.
Was it lawyers for--
lawyers for Virgin
Airlines started worrying
they were to get busted.
And they said, "Well, if we
go to the feds first and bust
British airlines, maybe
we'll get a better deal."
So they were essentially
the prisoner that ratted.
So Virgin Atlantic was
the prisoner that ratted,
and the whole thing broke down.
There were penalties,
more on British Airlines,
because Virgin Atlantic
ratted on them.
But just like the prisoner's
dilemma breaks down,
it broke down in reality.
And so that was something not
where the law really worked,
but where the
cartel was unstable.
And the end result
was Virgin Atlantic
paid no fees, paid no
penalty, and British Airlines
paid more than $500 million.
So British Airlines
clearly did not
study the prisoner's
dilemma, and did not
realize that they
should have gone first
in ratting out Virgin Atlantic.
Now, that said,
sometimes cartels
operate openly in the public
and get away with it, OK?
Let's talk about probably
the biggest open cartel
perhaps in America today, the
National Football League, OK?
The National Football League--
football is the
most popular sport
in America, the most
profitable sport in America.
There are 32 teams,
and they're essentially
32 businesses whose job it is
to produce football wins, OK?
Now, these businesses
have a huge incentive
to collude with their
fellow business,
however, because they can--
because of television rights.
So if the New York Giants
and the New York Jets
competed over the television
rights for their area,
they would compete
away the profits
that could be made by
getting a big contract.
If they collude and
say, "No, you can only--
we will only agree to
a contract together,"
they could get a higher
price for that contract,
because it's either you
give them the contract
or you're out.
If they competed,
TV companies would
compete against each other
and fight the price down, OK?
And in general, actually,
this goes more than this.
The League sells the rights to
televise games as a package.
So in fact, the National
Football League literally
sells, explicitly says, "We
have a cartel of 32 teams.
We are selling the monopoly
right to televise these games."
Somebody's got Sunday.
Somebody's got Thursday.
Somebody's got Monday
night, et cetera.
But it's a monopoly
product they're selling.
Now, how did they
get away with that?
Well, basically, actually
1957, they were busted.
That's a long time ago, I
think even before I was born,
that long ago.
OK, they were
busted and the court
ruled that the NFL was
violating antitrust laws, OK?
Now, that was 1957.
That was 60 years ago.
The NFL still makes
about $40 billion
on its television contract.
What happened?
Congress just exempted them.
Congress said, "Well,
you know what?"
We know they violate
antitrust, but we're
going to pass a law which
exempts them from antitrust law
and let them do it.
So it proves basically that
Americans like football more
than free markets,
and basically, we now
have a cartelized
football industry that--
because Congress basically
exempted them from the laws,
OK?
So those are some examples.
Yeah?
AUDIENCE: Is this also true
for other sports teams?
JONATHAN GRUBER: Other
sports teams, it is not as--
they are-- it's largely true
for other sports leagues.
It's largely true.
Some of it aren't as
explicit as football,
but it's largely true for the
other sports leagues as well.
AUDIENCE: What about on
the international level,
with things like
soccer, that are--
JONATHAN GRUBER: I
don't know, actually.
I presume it's--
I mean, I don't know they have
international antitrust laws.
I'm not sure how that works
with international leagues.
It's a good question.
OK, now, another
form of cartels--
we talked about cartels
and how companies have
incentive to put them together.
Actually, sometimes, the
government can make a cartel.
Yeah?
AUDIENCE: How well
[INAUDIBLE] working?
JONATHAN GRUBER: How's what?
AUDIENCE: How well
is OPEC working?
JONATHAN GRUBER: OPEC?
So OPEC is, as I mentioned
in the first lecture,
a series of countries that
get together to produce oil.
It's not working as well
as it was when I was a kid.
It worked really well.
Because more countries-- A,
more countries are cheating,
and more countries--
there's more oil
being found outside OPEC.
But it still works.
It's sort of a partially
functioning cartel,
is I think the way
to think about it.
OK, so let me actually--
let me go on and
talk about-- let's
do one more example
about a time when
a government made a cartel.
Here's one more
interesting example.
So in the early 1980s,
before the early 1980s,
the US dominated the
car production business.
Starting in the late '70s, Japan
started making huge inroads
into car production,
and by the early 1980s,
we're in recession
and car manufacturers
in the US were really
pissed that Japan was
taking so much of our market.
And we'll talk in a
couple of lectures
about international trade
and all those sort of issues,
but put those issues aside.
Right now, you just
have this issue
that car manufacturers
wanted to limit
the amount of Japanese
cars to come into America.
Now, you guys have been
reading in the paper
about international trade
and why economists typically
don't like limiting
international trade.
And Reagan was a
standard Republican,
the party of free trade.
So Reagan said,
"Well, we're not going
to limit the cars that
Japan wants to send in,
but we're going to tell
Japan, if you guys were
willing to agree to a
voluntary export restraint,
we wouldn't mind."
So we said to
Japan, they imposed
what they called a voluntary
export constraint, which
basically said, we won't
negotiate a deal with you.
You will voluntarily agree
to reduce the number of cars
you send to America, OK?
It's not a government policy.
This isn't big government.
This is negotiations
of a private company,
voluntary agreement.
OK.
Japan happily
agreed to this, why?
Yeah.
AUDIENCE: [INAUDIBLE]
JONATHAN GRUBER: No.
AUDIENCE: Sold cars
at higher price.
JONATHAN GRUBER: Because?
Because you made a cartel.
The Japanese companies used to
have to compete with each other
to sell the cars in America.
Now it's like, OK,
you guys get together
and limit how many
cars you send.
They're like, great,
you've given us an ability
to form a cartel, by
essentially telling us,
get together and figure out
how you're going to sell
this many cars to America.
So essentially, this voluntary
export constraint essentially
cartelized, and no
company could cheat.
So if you had a cartel, and
a company tried to cheat,
they couldn't sell
the cars to US.
US wouldn't let them
come into the US.
So essentially, the
US provided them a way
of enforcing their cartel.
What happened?
Well, the average price of
a Japanese car in America
went up by $1,200, OK?
US auto profits did go
up, but US consumers
lost out by way more
than producers gained.
And on net, the estimates
are that US consumers
were about three billion--
overall, US was about $3 billion
worse because of this policy.
Just examples of how
different government policies
can interact with the
cartelization of industries.
Yeah.
AUDIENCE: Company price
matches, isn't that sort
of like making a cartel?
Because the other
company would see it.
They're going to price match.
They wouldn't want to set a
price lower than what the--
JONATHAN GRUBER: Well,
it's a great question,
and you're pointing out
this is not a solid line.
And in some sense, the
question is, if it's true
that-- so for many
years, tobacco industry
worked this way.
There was one large
player, Philip Morris.
Philip Morris would
sort of raise the price
that everyone would match.
Now, as long as
there's no evidence
that they agreed to do
that, that is not illegal.
If there is evidence they
agreed to do that, it's illegal.
But as long as
it's just like, no,
this is the way it's going to
work, then that's not illegal.
So basically, that's sort
of an implicit cartel.
Now, once again, what's
holding it together?
Nothing.
A company could cheat
and try to charge less.
But basically, that
essentially-- they
figured they were working
better as a cartel,
and essentially,
it was hard to--
there was no way to bust it.
Yeah.
AUDIENCE: I mean, if a company
says to consumers like,
"If you can bring
in a lower price,
we'll sell it for that price."
JONATHAN GRUBER: That's
sort of a different--
I mean, you could imagine
you would need every company
to do that.
That would be a
cartel enforcing way
if every company had
that deal in a market.
But if one company
had that deal,
it doesn't enforce the cartel.
Every company needs
to have that deal.
And so the question is, if
every company on their own, OK,
we've decided
we're going to have
that deal, that
would essentially
be a way of trying to bring--
enforce a cartel, but
I think that would
be hard to say it was
an antitrust violation.
Good questions.
Other questions?
OK, so now, let's ask why
do we care about all this.
We care about all this because
it matters for ultimately
what matters to us
in this class, which
is economic welfare, OK?
So now, let's go to a second
thing I want to cover,
which is comparing
the equilbria.
We've now covered three
types of market structures,
perfect competition,
monopoly, and oligopoly.
Now, let's compare
them, and I want
to compare them in two
ways, quantity sold
and profits per firm,
profits earned per firm.
And we're going to stick with
the United, American market,
OK?
We know, if this is a monopoly,
if this is a monopoly,
if they can perfectly
cartelize, then
there'll be 96 flights total.
Each will fly 48 flights, and
profits per firm will be 4,608.
OK, we solved that already.
That's the cartel outcome.
The non-cooperative
outcome, which
we call the oligopoly outcome,
is they each sell 64 flights.
We solved that last time.
And as we solved here, they
each make profits of 4,096.
What's the competitive
outcome in this market?
What's the competitive
outcome in this market?
First of all, what's the price?
Somebody raise their
hand and tell me.
If this is a perfectly
competitive market,
what would the price be?
And then what would
the quantity be?
Yeah.
AUDIENCE: 147.
JONATHAN GRUBER:
Price would be 147,
because in a perfectly
competitive market,
price would be marginal cost.
So profits would be?
AUDIENCE: Zero.
JONATHAN GRUBER: Zero.
And quantity would be 339
minus 147, or 192, OK?
So here we have,
for a given market,
a nice table which
lets us compare
the three different
possible outcomes.
And what you see is
essentially, the more you
can monopolize, the higher
your profits but the smaller
the market, OK?
So basically,
three lessons here.
First of all,
generally speaking,
the oligopoly
outcome is somewhere
between the monopoly and
perfectly competitive outcome.
Where in between, take 14, 12.
If 14, 12 was bad,
it's how you figure out
where in between this outcome
comes between these two.
It's all about game theory, OK?
So that's what's exciting
about game theory is,
this is a wide range,
and game theory
is a set of
sophisticated tools that
let us pin down
where in this range
companies will end up
in a realistic case.
0.2 is, the more
you can monopolize,
the higher your profits will be.
But let us come to welfare.
Now, I haven't computed
social surplus here.
But here's the cheat,
I don't really need to.
I don't need to because
essentially, roughly speaking,
social welfare is proportional
to the quantity sold.
In other words, we know that in
a perfectly competitive market,
this is-- the welfare-maximizing
quantity is 192.
We know that there's 192
flights that maximize welfare,
because that's the
competitive outcome.
What we're saying is the more--
Oh, this shouldn't be 64.
It should be 128.
That's my bad.
128.
It's each doing 64.
We know that as we
monopolize the market,
there are fewer
and fewer flights.
Therefore, we're creating
a deadweight loss.
Essentially, deadweight
loss is proportional--
actually, it's sort of
exponentially proportional--
to the gap between
the quantity sold
and the competitive quantity.
Welfare is maximized
here by definition.
We proved that.
So any reduction for that means
it increased deadweight loss.
So the more you reduce quantity,
the more you lower welfare.
So essentially, as we
go down the column,
we lower profits but
raise social welfare.
Yeah.
AUDIENCE: When we're--
I'm not really sure.
Are we talking
about an oligopoly
that acts like a monopoly?
JONATHAN GRUBER:
Yeah, cartel/monopoly.
AUDIENCE: So there's
[INAUDIBLE]----
JONATHAN GRUBER: Yes.
But otherwise, you do 96, your
profits would be twice that.
But the bottom line is
that essentially, you've
got essentially more
profits in this market.
OK?
Other questions about that?
So the bottom line is, the
more competitive the market,
the higher the welfare, but
the lower the profits, OK?
So that's kind of
our bottom line
of how we think about this.
Questions about that?
OK, next I want to cover--
we've only covered
the case of two firms.
What if there are many firms?
After all, most oligopoly
markets are not just two firms.
We've talked about cars and
movie producing studios.
There are many firms, OK?
Well, the Cournot model is super
hard to do when there's more
firms, but there's
no reason you can't.
It literally just becomes three
equations and three unknowns
or four equations
and four unknowns.
Literally, as you can
see, you could simply see,
if you take that model
and add more firms,
it just expands the state space.
It becomes impossible the
graph, but you could solve it.
Eventually, you've got n
equations and n unknowns.
The key bottom line result
is that as the Cournot--
as the number of
firms gets large,
the Cournot
equilibrium approaches
the competitive equilibrium.
That is mathematically,
if you solve
this-- you don't
have to solve this--
but the bottom line condition
is, the markup that firms earn
is equal to minus 1 over
n times the elasticity.
In sort of a market--
this is sort of in a symmetric
Cournot market of the kind
we've been working with.
The markup is 1 over
the number of firms
times the elasticity of demand.
So think about
this for a second.
Imagine there is one firm.
Then this equation says the
market is equal to minus 1
over the elasticity of demand.
Where have we seen that before?
That's the monopoly condition.
That's the monopoly
market condition.
So when n equals 1, this is
an equation we've seen before,
the monopoly market condition.
When n equals 2, the firms
are making 1/2 as much.
When n equals 3, a third--
it goes a fact-- factor
third, et cetera.
What this says is n
approaches infinity,
we approach a
competitive outcome.
We'll never get there,
but we're asymptoting
towards a competitive outcome,
which basically says--
you know, it's sort of like my
point about contested markets.
You get a market that's
sort of competitive enough,
you're going to shrink the
markup as more and more firms
enter, OK?
So that's sort of a general
condition that we could derive,
that shows that as
more firms are in,
then you get a lower markup.
Now, I want to make--
there's actually--
But this actually
understates the case,
for an important
strategic reason,
which is, more firms
lowers the markup in a--
more firm lowers the markup in
a Cournot non-cooperative model.
But more firms also makes
a cooperative model harder.
So this is for the
non-cooperative model.
The non-cooperative
model, your profits
fall as there more firms.
But it also gets
harder to cooperate
as there are more
firms, because there
are more people
you have to trust,
more people you have
to keep hold of.
So a great example of this,
actually, for a long time,
mercury, the stuff we use
in thermometers and such,
only was found in
Italy and Spain,
in the mines in Italy and Spain.
And they had a cartel
between the two countries
to sell mercury.
What happened, other
countries discovered mercury,
and they couldn't keep
the cartel together,
and the price of
mercury fell a lot.
With the question about
OPEC, similar thing--
OPEC was much more successful
in the 1970s, when essentially,
the only source of oil were
basically these Arab nations
that form OPEC.
What happened over time
is we discovered more oil
around the world, in particular,
in Russia and in the US, which
has sort of broken the power of
this cartel to a large extent.
So the reason why a
bigger market moves us
towards a competitive
equilibrium
is that it makes it harder
to maintain a cartel, OK?
Now, let's actually-- the other
issue I want to cover here
is, I want to talk about
what does all this teach us
about a key policy issue,
which is the issue of mergers?
What does everything
we've learned here
tell us about thinking
about mergers?
OK, we know about mergers.
It happens all the time.
Two companies merge.
Well, it turns out
when companies merge
and they're large enough,
the federal government
regulates that.
The federal government
gets a vote on
whether that merger
is going to be allowed
to go forward, either
the Department of Justice
or the Federal Trade
Commission, depending
on what industry it is.
So the federal
government has to decide
how to evaluate whether two
firms merging is a good idea
or not, and essentially,
what it comes down to
is a simple trade-off, economies
of scale versus market power.
The benefit of two firms
merging is economies of scale.
If two firms have sort of
redundant production processes
and they merge, they
can be more efficient.
There can be positive economies
of scale for merging firms.
So it's cost
efficiencies, basically.
Economies of scale
deliver cost efficiencies.
On the other hand,
the more firms merge,
the more this n goes down,
and the more markets go up,
and the worse it
is for consumers.
So the trade-off is,
do you want to reduce--
is reducing n worth it in terms
of the economies of scale?
Or in other words, does
the producer efficiency
go up enough to make up
for the potential loss
to consumers of this less
competitive market, OK?
People understand that?
Now an interesting
case of this, which
has got very big implications
for all of us in America,
is hospital mergers.
During the decade
of the 2000s, there
was a rash of hospital mergers,
where hospitals said, look,
here's a classic case
for economies of scale,
because hospitals have what's
called a peak load problem.
They have to have empty beds.
Hospitals can't be
full all the time,
because there might be a car
accident, and people need beds.
So by definition, it's
inefficient for hospitals
to be 100% capacity.
Hospitals want to
have excess capacity.
The problem with that,
there's two hospitals
next to each other, each
with excess capacity,
that's inefficient.
It'd be more efficient
to have one hospital, one
merged hospital, then they
just manage the proper amount
of excess capacity.
And hospitals made
this argument,
and we basically approved
any hospital merger
that they wanted in the 2000s.
Well, what happened?
What happened is
the hospitals lied.
They kept both hospitals
open, kept all the empty beds,
and just raised prices.
So essentially, the
hospital mergers
did not deliver any of
the economies of scale
they promised, but did deliver
a lot of the market power
we feared.
So a huge cause of the
increase in medical spending
in the 2000s was these
hospital mergers,
which essentially took a lot
of the competitive pressure out
of the medical market
and didn't really deliver
economies of scale.
And this is the hard part
of being a regulator.
Most of what public policy
economists do in the world
is regulate.
All over the world,
there are thousands
of economists employed all
over the world, hundreds of--
tens of thousands,
whose job it is
to make regulatory
decisions of this nature,
and they're really hard.
Because we've drawn nice,
clean theoretical models here,
but we have to know
what's epsilon.
You know, how much--
what's epsilon, to figure
out the effect to consumers.
What are the economies of scale?
Will they exploit those
economies of scale, et cetera?
So these are really hard
and interesting decisions.
Now, let's go on to the last
topic I want to cover today,
which is price competition.
Price competition.
Now, the models we've
been discussing so far
have been what we call quantity
competition, that United
and American compete on
how many flights to send,
and then the demand curve tells
them what they can charge.
But in fact, in many markets,
that's not how firms compete.
In fact, we even mentioned it.
Someone mentioned about best
price offers, et cetera.
They don't compete on quantity,
they compete on price,
and that's a
different model, named
after another French economist.
A model of Bertrand
competition is
a model of price
competition, is a model
we call Bertrand competition.
This model says that basically,
two firms compete over
what price to set,
and then the quantity
is determined by the price that
results from that competition.
So they don't compete
over quantity.
They compete over price,
and the demand curve then
tells you the quantity, OK?
Now, in this case, what's
really striking about Bertrand
competition is that
unlike the Cournot model,
under Bertrand
competition, two firms
can be enough to get us to
the competitive equilibrium.
Why?
Why do we only
potentially need two firms
to get to the
competitive equilibrium?
Yeah.
AUDIENCE: I'll do you lower.
JONATHAN GRUBER: Why don't you
explain a little bit more what
you mean?
AUDIENCE: One firm [INAUDIBLE]
the other one what price are
lower, and like--
JONATHAN GRUBER: Exactly.
As long as there's
profits to be made,
it's like our entry/exit
decision, right?
As long as there's
profits to be made,
I'm going to come in at a
price one penny below you,
make one penny less profits,
and steal all the business
from you.
So if there's perfect
competition between firms
in a Bertrand
sense, then you only
need two firms to get to
the competitive equilibrium
in theory, OK?
So it's a very different idea.
Cournot competition, we
need many, many firms
to get close to this
competitive outcome.
With price competition,
because firms are always
kind of competing on one
penny below each other,
in a market that's
otherwise competitive,
you can actually drive the price
to competitive price through--
essentially, you can
actually drive the price down
to marginal cost.
It's sort of like I talked
about contestable markets
and as long as there's profit
to be made, someone would enter.
Here, as long as there's
profit to be made,
someone will lower
their price, and that'll
keep happening until price
equals marginal cost.
So in Bertrand
competition, you actually
can get close to or at--
to the competitive outcome
with a small number firms.
Now, two points to
make about this.
Your first point
is, well, holy shit,
how do I say which
one of these to use?
You've just taught me--
you've just spent a lecture
and 1/2 on this fancy model,
spent 37 seconds on this model.
How do I know which one to use?
You didn't write down any math,
so I don't know what to do.
I'm freaking out.
OK, how do I know
which one to use?
Well, the bottom
line is, we're not
going to ask you to do much
math about Bertrand competition,
other than sort of the intuition
about competing over price.
The more relevant
question is, how do you
think about the situations
where Cournot competition is
more likely and Bertrand
competition is more likely?
So what do you think?
In what types of
markets do you think
Cournot competition
would be more likely,
and what kinds of markets do
you think Bertrand competition
would be more likely?
Yeah.
AUDIENCE: Wouldn't
the Bertrand be really
efficient in an elastic market?
JONATHAN GRUBER: Well, no.
Elasticity is the same.
So basically,
elasticity is going
to have a similar
effect in both.
It's going to basically drive
the price down in both, OK?
Because the elasticity is
higher, it drove the markup.
Bertrand, it's going
to drive down in both.
So it's not actually
about elasticity.
It's something about
production processes.
What type of
production processes
are going to lend themselves
to price competition
versus quantity competition?
Think about it this
way, if I offer a price,
what do I have to do?
AUDIENCE: I think the better
the production is dominated
by the capital costs, or is it
[INAUDIBLE] the variable costs?
JONATHAN GRUBER: That's
roughly speaking right.
Basically, if there's
long lags in production,
I can't do price competition.
So if I say I'm going to
compete, people would say,
"Great, I want
all your product."
I'm like, great, you
can have it in a year.
That doesn't work.
So things like
auto companies are
going to have a hard time
with pure price competition,
because if Toyota says, "OK,
I'm $1 less," someone says,
"OK, great.
We want a million Toyotas
tomorrow," they can't do it.
So things which are
capital-intensive lagged
production processes it's
going to be hard to have pure--
real life, of course, there
could be some mix of these.
But it will tend more
towards quantity competition,
because you're really going to
know what you're going to sell,
because that's sort of-- you
can't just infinitely supply
it.
With other things
like cereal sales,
where you can sort
of immediately
crank up a million
more boxes of cereal
in like a day out of your
production processes,
there would be more likely
to be price competition.
Things with small
production lags,
then you'd be more likely
to have price competition,
because if you lower the
price, all of the sudden,
you dominate the market.
You can meet that demand, OK?
So essentially, we can think
about price competition
as being more likely the
smaller the production lag,
or maybe the less capital--
it's not really about capital
intensity, because you
can have a capital--
you can create things quickly.
It's more about production lags.
Now, we're never going to ask
you to tell us which is right,
and of course, in reality,
it lies somewhere in between.
But this just gives
you a sense of kind
of when one type of competition
is more likely than the other.
Yeah?
AUDIENCE: Does it
have anything to do
[INAUDIBLE] to protect the
cereal in the grocery store?
JONATHAN GRUBER: Great segue.
You've jumped ahead to the
last point I want to make,
which is, imagine you're in
a Bertrand competition world,
like with cereal.
That's a pretty awful world
if you're a producer, OK?
Basically, that's where
your markup's tiny,
because any time you
try to raise the price,
you get undercut.
What can you do?
Well, we've already
gotten the answer.
What you can do
is you can engage
in product differentiation.
You can engage in
product differentiation.
OK, so basically, the reason why
you're in Bertrand competition
is because you're
selling the same thing.
Once I'm selling
something different,
I take on the features
of a monopolist again.
So if I can get consumers
to not think of my good
as identical to my
competitors, then I
can price above marginal cost,
and people would still buy it.
The reason Bertrand competition
drives price to marginal cost
is because people view
the goods as identical.
But if they don't view
the goods as identical,
then I can keep price
above marginal cost, OK?
And the example--
breakfast cereals
is the perfect way
to illustrate this.
So back around
World War II, there
were essentially basically
like three types of cereal, OK?
There was Cheerios, there was
cornflakes, and Quaker oats.
OK, that's basically what
cereal was, not very exciting.
Now, but by 1970, there were
more than 150 breakfast cereals
to choose from,
including some which
are variations of Cheerios
and variation of cornflakes.
In fact, you could
all say in some sense,
all cereal is
variations of Cheerios,
and cornflakes, and oats.
And then-- and moreover now,
if you go to a store today,
you can actually buy generic
versions of brand name cereal.
You can buy Oatios
or Marshmallow
Mateys, which are Lucky Charms,
or what's the other one?
I love buying these big bags.
You guys ever buy
these generic Lucky
Charms, Marshmallow Mateys.
Generic Captain Crunch
is like, you know,
Ahoy Matey or something.
I don't know.
They've got these generic
things which you can buy,
which are really just the same.
So essentially, what
you do-- what companies
want to always do, which
are in Bertrand competition,
is always try to
product differentiate,
always try to figure out a
way they can create a market
where they can price
above marginal cost, OK?
So for example, let's take
General Mills, a company that
makes Cheerios, OK?
They're making
Cheerios, and then
all of a sudden, Oatios and
stuff started coming along
and they weren't making money.
What do they do?
They created different
kinds of Cheerios,
like Apple Cinnamon Cheerios.
General Mills did not create
Apple Cinnamon Cheerios out
of the goodness of their heart.
General Mills created
Apple Cinnamon Cheerios
because they were getting
killed in the Cheerio market,
and so they tried
to differentiate
by having a new
product on which they
could charge a higher price,
which is Apple Cinnamon
Cheerios.
Now, how do we feel about this?
Well, it's not clear.
On the one hand, by introducing
Apple Cinnamon Cheerios,
General Mills was able
to push its price greater
than marginal cost.
And as price pushed
above marginal cost,
quantity sold in
the market falls.
It created deadweight loss.
Quantity fell, and
that's bad, OK?
On the other hand,
Apple Cinnamon Cheerios
are quite good, OK?
So it actually ends up
being much like our patent
discussion, which
is, essentially,
by differentiating,
they've had two effects.
They've lowered consumer
surplus and welfare
by pricing above marginal
cost, but raised it
by shifting up the demand
curve, by creating a new good
that people want.
Yeah.
AUDIENCE: Isn't like-- doesn't
like consumer [INAUDIBLE] not
necessarily have to happen,
because then different people
have different demand
curves, and the demand
curve for like Apple
Cinnamon Cheerios is not--
hasn't been this good.
JONATHAN GRUBER:
No, the point is--
OK, it's another way
of stating my point.
Even if the demand curve--
let's say there's a new demand
curve for Apple Cinnamon
Cheerios.
It's way out, OK?
That's great, OK?
But still, the fact that they're
pricing above marginal cost
means they'll sell
fewer than they
would in a competitive market.
If they had invented
Apple Cinnamon Cheerios
and sold it at marginal cost,
they'd still be way better off.
So the trade-off
is, essentially,
how far out do we shift demand
by creating this new product,
versus how much do
we restrict sales
by pricing it above
marginal cost?
So essentially--
now, and now what
we have is a market with about
five firms that dominate it,
and about 5,000
brands of cereal, OK?
So it's constant
product differentiation.
And essentially,
this is the trade-off
with product
differentiation, which
is we get reduced sale--
we get deadweight loss,
because they're not pricing
it at marginal cost,
but we get new products
that people might like.
Yeah.
AUDIENCE: So if there's
a product with like--
JONATHAN GRUBER:
Differentiation.
AUDIENCE: Yeah, differentiation.
Is brand loyalty between
things like Adidas and Nike,
or like, Apple and Android,
where there are various
[INAUDIBLE] where you
feel strongly towards one,
is that good for both
of the two things
That you're choosing between?
JONATHAN GRUBER: Well, actually,
that's really interesting.
It depends on whether that
brand loyalty is based
on innovation or blind faith.
So this is, once
again, this gets
into the deep,
interesting issues
of industrial organization.
You talk about
game theory, which
is, if I can create brand
loyalty in a way that makes you
slightly better off, but
keeps you in my brand forever,
then that might be worse.
By creating it in a way that
makes you much better off,
that might be better.
So essentially, that's
why, for example, you
may have noticed you may be
getting one or two credit card
mailers.
Are you guys getting inundated
with credit card offers?
OK, it's not because
they love you guys.
It's because if
they hook you now,
then you might stick with
that credit card later.
So trying to exploit--
trying to get you, they're
trying to give you a good deal
now to get you
hooked later, so they
can charge up closer to
monopoly price later on.
So essentially,
there's a trade-off,
which is, if that loyalty
is based on real differences
in quality, that might be good.
If it's not, it might
not be, but the welfare
gets very murky.
It's a good question.
Other questions?
OK, so these are exciting
real world topics.
It's more reasons to go on
and study more economics.
But let's stop now.
We will come back and
we'll start talking
about factor markets on Monday.
