WEBVTT 00:00:00.040 --> 00:00:02.460 The following content is provided under a Creative 00:00:02.460 --> 00:00:03.870 Commons license. 00:00:03.870 --> 00:00:06.910 Your support will help MIT OpenCourseWare continue to 00:00:06.910 --> 00:00:10.560 offer high quality educational resources for free. 00:00:10.560 --> 00:00:13.460 To make a donation or view additional materials from 00:00:13.460 --> 00:00:17.865 hundreds of MIT courses, visit MIT OpenCourseWare at ocw. 00:00:17.865 --> 00:00:19.115 mit. edu. 00:00:25.168 --> 00:00:26.620 PROFESSOR: Once again to put this in the 00:00:26.620 --> 00:00:27.830 context of where we are. 00:00:27.830 --> 00:00:30.530 We're talking about producer theory. 00:00:30.530 --> 00:00:31.660 And we're talking about how firms 00:00:31.660 --> 00:00:33.230 decide how much to produce. 00:00:33.230 --> 00:00:36.810 We started with a perfect competition, and that nailed 00:00:36.810 --> 00:00:40.100 down the fact that with under perfect competition we got the 00:00:40.100 --> 00:00:44.920 zero profit long run perfectly elastic supply curve. 00:00:44.920 --> 00:00:47.940 We then, last time, talked about monopoly as another 00:00:47.940 --> 00:00:51.440 extreme and talked about how monopolists choose both their 00:00:51.440 --> 00:00:53.000 price and their quantity. 00:00:53.000 --> 00:00:55.750 They set margin around or equal to marginal cost. That 00:00:55.750 --> 00:00:56.790 gives them a quantity. 00:00:56.790 --> 00:00:59.620 And then they choose the price off the demand curve and how 00:00:59.620 --> 00:01:03.370 that leads to profits and how that leads to monopolists 00:01:03.370 --> 00:01:05.960 producing less than the competitive level. 00:01:05.960 --> 00:01:08.640 And we also ended by talking about a perfectly price 00:01:08.640 --> 00:01:12.520 discriminating monopolist, one that can actually charge each 00:01:12.520 --> 00:01:15.540 consumer their willingness to pay and therefore, absorb all 00:01:15.540 --> 00:01:17.430 the social surplus. 00:01:17.430 --> 00:01:20.480 Now, I want to come back and start, this morning, by 00:01:20.480 --> 00:01:23.620 talking again about price discrimination and realizing 00:01:23.620 --> 00:01:26.430 that, in some sense, we know that there's no such thing as 00:01:26.430 --> 00:01:27.680 perfect price discrimination. 00:01:27.680 --> 00:01:29.410 There's no monopolist out there charging us literally 00:01:29.410 --> 00:01:31.650 exactly what we're willing to pay. 00:01:31.650 --> 00:01:34.090 But there are lots of examples of price discrimination in the 00:01:34.090 --> 00:01:35.340 real world. 00:01:35.340 --> 00:01:38.150 And sometimes they're kind of obvious. 00:01:38.150 --> 00:01:39.670 Sometimes they're not. 00:01:39.670 --> 00:01:43.020 But what they all have in common is the notion of trying 00:01:43.020 --> 00:01:46.430 to find some signal of our willingness to pay and using 00:01:46.430 --> 00:01:48.200 that to set the price. 00:01:48.200 --> 00:01:50.070 So instead of being like our original monopolist, just 00:01:50.070 --> 00:01:51.130 setting one price. 00:01:51.130 --> 00:01:53.790 Monopolists are forever trying to find some signal, some 00:01:53.790 --> 00:01:56.870 underlying signal of our willingness to pay and using 00:01:56.870 --> 00:01:58.420 that to set the price. 00:01:58.420 --> 00:01:58.930 OK. 00:01:58.930 --> 00:02:02.970 So for example, a classic example we know is airlines. 00:02:02.970 --> 00:02:03.450 OK. 00:02:03.450 --> 00:02:05.000 What airlines do-- 00:02:05.000 --> 00:02:07.480 Airlines charge you more, for example, if you book your 00:02:07.480 --> 00:02:10.370 ticket the last minute. 00:02:10.370 --> 00:02:13.300 And the notion of course-- or towards the last minute. 00:02:13.300 --> 00:02:15.370 At the very last minute they may end up charging you less. 00:02:15.370 --> 00:02:17.740 But as you get close to the date when you want to leave, 00:02:17.740 --> 00:02:19.900 the price goes up. 00:02:19.900 --> 00:02:24.100 The notion, of course, is that who is going to buy tickets 00:02:24.100 --> 00:02:26.523 close to the date they want to leave. It's largely going to 00:02:26.523 --> 00:02:31.400 be business people, not the vacation traveler. 00:02:31.400 --> 00:02:33.050 The vacation traveler is going to plan ahead 00:02:33.050 --> 00:02:34.120 and buy far in advance. 00:02:34.120 --> 00:02:36.110 The one that's going to buy a week before is the business 00:02:36.110 --> 00:02:38.460 person who just got a meeting scheduled. 00:02:38.460 --> 00:02:41.830 Business people are going to be less price sensitive. 00:02:41.830 --> 00:02:43.100 They're going to have a higher willingness to pay. 00:02:43.100 --> 00:02:44.920 They've got to get to the meeting. 00:02:44.920 --> 00:02:45.750 They're not paying anyway. 00:02:45.750 --> 00:02:47.230 The company's paying. 00:02:47.230 --> 00:02:48.210 And they're just to do what they need 00:02:48.210 --> 00:02:50.080 to get to the meeting. 00:02:50.080 --> 00:02:52.250 So that's a less price sensitive population. 00:02:52.250 --> 00:02:53.620 So that's the population you want to hit 00:02:53.620 --> 00:02:56.165 with a higher price. 00:02:56.165 --> 00:02:59.630 So you want to price up tickets that you buy towards 00:02:59.630 --> 00:03:01.270 the end because those are more likely to be the people who 00:03:01.270 --> 00:03:04.440 are least price sensitive. 00:03:04.440 --> 00:03:07.360 So let's ask another question. 00:03:07.360 --> 00:03:10.220 Somebody tell me why do movie theaters charge less for 00:03:10.220 --> 00:03:13.220 matinees than for movies at night? 00:03:13.220 --> 00:03:14.540 Why do movie theaters charge less? 00:03:14.540 --> 00:03:16.280 If you go see the first movie of the day-- and you guys 00:03:16.280 --> 00:03:16.900 probably don't anymore. 00:03:16.900 --> 00:03:19.000 But when you were kids you did. 00:03:19.000 --> 00:03:21.170 And when I take my take my kids, I do. 00:03:21.170 --> 00:03:24.230 And that afternoon matinee movie costs less. 00:03:24.230 --> 00:03:25.480 Why is that? 00:03:27.730 --> 00:03:29.410 Yeah. 00:03:29.410 --> 00:03:30.590 Anyone want to take a chance at that? 00:03:30.590 --> 00:03:33.130 And related to it, you can also ask the question. 00:03:33.130 --> 00:03:35.570 Why do restaurants have early bird specials? 00:03:35.570 --> 00:03:37.400 Why, when you go to restaurant, often will they 00:03:37.400 --> 00:03:39.660 charge you less if you go there in the early hours as 00:03:39.660 --> 00:03:40.780 opposed to later? 00:03:40.780 --> 00:03:41.560 So what's going on with that? 00:03:41.560 --> 00:03:43.054 Someone tell me. 00:03:43.054 --> 00:03:43.511 Yeah. 00:03:43.511 --> 00:03:45.150 AUDIENCE: They're not using up all their 00:03:45.150 --> 00:03:46.560 seats in the afternoon. 00:03:46.560 --> 00:03:48.440 So they might as well lower the price. 00:03:48.440 --> 00:03:49.960 PROFESSOR: In the afternoon they're not. 00:03:49.960 --> 00:03:52.390 Although the truth is, a lot of the time they're-- 00:03:52.390 --> 00:03:55.370 If you look at a movie theater today, it's almost never full, 00:03:55.370 --> 00:03:58.640 except for like the opening night of a very popular movie. 00:03:58.640 --> 00:03:59.530 So that's part of it. 00:03:59.530 --> 00:04:00.800 But let's talk about the demand side. 00:04:00.800 --> 00:04:03.800 What else is special about the type of people? 00:04:03.800 --> 00:04:05.990 Why don't you go on what's special about the type of 00:04:05.990 --> 00:04:08.480 people who want to see movies or go to restaurants at those 00:04:08.480 --> 00:04:09.460 different times? 00:04:09.460 --> 00:04:10.741 They're not willing to pay as much. 00:04:10.741 --> 00:04:12.750 PROFESSOR: Yeah, they're basically people with a lot of 00:04:12.750 --> 00:04:14.400 free time on their hands. 00:04:14.400 --> 00:04:14.940 Right? 00:04:14.940 --> 00:04:18.149 The people who are going out to dinner early, the people 00:04:18.149 --> 00:04:19.690 who see movies in the afternoon, these are people 00:04:19.690 --> 00:04:22.089 who are unemployed or have little kids. 00:04:22.089 --> 00:04:23.990 And they're just looking to kill time. 00:04:23.990 --> 00:04:25.660 And so basically, these are people who 00:04:25.660 --> 00:04:27.590 are willing to shop. 00:04:27.590 --> 00:04:30.330 These are people who are going to say look, I've got to fill 00:04:30.330 --> 00:04:31.340 in some time. 00:04:31.340 --> 00:04:32.310 I don't have to go right now. 00:04:32.310 --> 00:04:33.480 I can go any time. 00:04:33.480 --> 00:04:36.070 So I'm going to be more price sensitive. 00:04:36.070 --> 00:04:37.715 The people who are going to dinner later, who are going 00:04:37.715 --> 00:04:39.410 out to the movie at night, they're working all day. 00:04:39.410 --> 00:04:40.230 They have no choice. 00:04:40.230 --> 00:04:42.180 They have to see the movie at night. 00:04:42.180 --> 00:04:43.050 Or they're in school all day. 00:04:43.050 --> 00:04:44.410 They have to see the movie at night. 00:04:44.410 --> 00:04:47.280 They're less price elastic. 00:04:47.280 --> 00:04:48.830 So that's why you want to set the movie 00:04:48.830 --> 00:04:50.740 price higher at night. 00:04:50.740 --> 00:04:54.470 Alternatively, another reason could be-- 00:04:54.470 --> 00:04:56.270 One signal of willingness to pay is price sensitivity. 00:04:56.270 --> 00:04:57.520 What's another signal? 00:04:57.520 --> 00:04:59.000 It's going to be income. 00:04:59.000 --> 00:05:00.830 Who's going to be seeing the movies during the day and 00:05:00.830 --> 00:05:03.520 going to the dinner early? 00:05:03.520 --> 00:05:06.520 It's elderly individuals and families with small kids who 00:05:06.520 --> 00:05:09.320 are the most resource strapped. 00:05:09.320 --> 00:05:10.840 People who have plenty of disposable income 00:05:10.840 --> 00:05:11.540 are going at night. 00:05:11.540 --> 00:05:11.980 They're working. 00:05:11.980 --> 00:05:12.500 They're young. 00:05:12.500 --> 00:05:13.920 They're singles and young couples. 00:05:13.920 --> 00:05:15.120 They work all day or are in school all day. 00:05:15.120 --> 00:05:15.920 They go at night. 00:05:15.920 --> 00:05:17.710 They have more disposable income. 00:05:17.710 --> 00:05:20.300 The people going during the day are the elders and the 00:05:20.300 --> 00:05:22.640 people with young kids who have less disposable income. 00:05:22.640 --> 00:05:24.750 And as a result they're going to be more price sensitive. 00:05:24.750 --> 00:05:26.690 So you want to charge them a lower price. 00:05:26.690 --> 00:05:29.240 So that's another example of price discrimination. 00:05:29.240 --> 00:05:33.390 OK, why does Disney World charge you less if you live in 00:05:33.390 --> 00:05:37.360 the area than if you do not. 00:05:37.360 --> 00:05:38.310 This is true fact. 00:05:38.310 --> 00:05:40.830 Disney World charges you less if you're from Orlando than if 00:05:40.830 --> 00:05:42.300 you're not from Orlando. 00:05:42.300 --> 00:05:43.550 Why is that? 00:05:45.520 --> 00:05:46.830 Someone tell me. 00:05:46.830 --> 00:05:47.060 Yeah. 00:05:47.060 --> 00:05:49.445 AUDIENCE: I think the Disney can go any time. 00:05:49.445 --> 00:05:53.976 So you might as well you might as well take 00:05:53.976 --> 00:05:56.600 them to other places. 00:05:56.600 --> 00:05:58.480 PROFESSOR: I mean, basically the idea is look, if I just 00:05:58.480 --> 00:06:01.210 spent a grand on a plane ticket to take my kids to 00:06:01.210 --> 00:06:05.150 Orlando to Disney World, I'm not going to kvetch over $10 00:06:05.150 --> 00:06:06.980 either way, getting in or not getting in. 00:06:06.980 --> 00:06:09.550 But if I live in the area, I may or may not go. 00:06:09.550 --> 00:06:10.620 I can go to a park, instead. 00:06:10.620 --> 00:06:11.820 I can go do something else, instead. 00:06:11.820 --> 00:06:14.110 It's just one of many choices for me. 00:06:14.110 --> 00:06:16.000 The point is, having paid the fixed cost of getting to 00:06:16.000 --> 00:06:19.820 Orlando, I'm going to be much less price sensitive about 00:06:19.820 --> 00:06:22.090 getting into the park than other people who live there, 00:06:22.090 --> 00:06:25.450 who have lots of other choices. 00:06:25.450 --> 00:06:27.390 Likewise, having paid the money to get there, I have 00:06:27.390 --> 00:06:29.270 shown I have more disposable income because I paid the 00:06:29.270 --> 00:06:29.980 money to get there. 00:06:29.980 --> 00:06:31.660 I've shown I have enough disposable income that I'm 00:06:31.660 --> 00:06:33.440 willing to drop money on a plane ticket to take my kids 00:06:33.440 --> 00:06:34.340 to Disney World. 00:06:34.340 --> 00:06:35.942 So I'm going to have more income that we 00:06:35.942 --> 00:06:37.330 are willing to pay. 00:06:37.330 --> 00:06:40.560 OK, so basically the point is companies are 00:06:40.560 --> 00:06:42.510 forever doing this. 00:06:42.510 --> 00:06:47.090 The ultimate example was, briefly, Amazon.com started 00:06:47.090 --> 00:06:49.470 pricing by IP address. 00:06:49.470 --> 00:06:51.820 For a while, it was a controversy over Amazon 00:06:51.820 --> 00:06:55.940 started literally charging, getting people's IP addresses 00:06:55.940 --> 00:06:58.337 and literally adjusting prices based on saying, oh, this 00:06:58.337 --> 00:06:59.660 person is from a university library. 00:06:59.660 --> 00:07:01.200 University libraries aren't price sensitive. 00:07:01.200 --> 00:07:03.440 We'll charge them more, et cetera. 00:07:03.440 --> 00:07:05.490 That got shut down. 00:07:05.490 --> 00:07:07.480 But that was the ultimate form of trying to be price 00:07:07.480 --> 00:07:08.980 discriminatory. 00:07:08.980 --> 00:07:10.725 That was as close as we'll come to perfect price 00:07:10.725 --> 00:07:11.120 discrimination. 00:07:11.120 --> 00:07:14.020 The point is, in general, people with market power, 00:07:14.020 --> 00:07:16.840 people that set the price above marginal cost will in 00:07:16.840 --> 00:07:20.900 general be looking for parties which are high income and low 00:07:20.900 --> 00:07:23.730 elasticity to which they can charge a higher price. 00:07:23.730 --> 00:07:24.010 Yeah. 00:07:24.010 --> 00:07:26.562 AUDIENCE: Another example, like MIT, they actually ask 00:07:26.562 --> 00:07:27.258 for your income statement. 00:07:27.258 --> 00:07:29.186 And then, based on that, they give you their price. 00:07:29.186 --> 00:07:31.420 PROFESSOR: Well, see that's very interesting. 00:07:31.420 --> 00:07:32.060 That's very interesting. 00:07:32.060 --> 00:07:33.480 MIT-- 00:07:33.480 --> 00:07:35.780 What's tricky about that is-- 00:07:35.780 --> 00:07:37.660 Is that about exploiting price sensitivity? 00:07:37.660 --> 00:07:39.990 Or is that about equity? 00:07:39.990 --> 00:07:42.810 That's a bit harder because MIT could claim-- 00:07:42.810 --> 00:07:44.770 And probably, actually, it's true. 00:07:44.770 --> 00:07:45.500 They're not doing it. 00:07:45.500 --> 00:07:46.840 Because the truth is, MIT could charge 00:07:46.840 --> 00:07:47.530 whatever they want. 00:07:47.530 --> 00:07:48.400 They'd still fill the class. 00:07:48.400 --> 00:07:49.020 Right? 00:07:49.020 --> 00:07:50.570 So it's not really about-- 00:07:50.570 --> 00:07:52.530 I think in MIT's case, it's not really about price 00:07:52.530 --> 00:07:53.450 sensitivity. 00:07:53.450 --> 00:07:55.990 It's about income redistribution and some notion 00:07:55.990 --> 00:07:57.540 of making sure low income people can come and 00:07:57.540 --> 00:07:58.540 afford to be here. 00:07:58.540 --> 00:07:59.700 But that is a good point. 00:07:59.700 --> 00:08:03.140 The difficulty with empirical economics is often, 00:08:03.140 --> 00:08:04.480 correlation versus causation. 00:08:04.480 --> 00:08:07.580 The same fact can have many different descriptions, many 00:08:07.580 --> 00:08:09.440 different explanations. 00:08:09.440 --> 00:08:10.420 OK? 00:08:10.420 --> 00:08:12.980 So just wanted to give you some brief examples to think 00:08:12.980 --> 00:08:15.460 about the fact that we see price discrimination in 00:08:15.460 --> 00:08:16.590 reality all the time. 00:08:16.590 --> 00:08:19.060 Nonetheless, we do our classic monopoly model. 00:08:19.060 --> 00:08:21.010 We assume there's one price. 00:08:21.010 --> 00:08:23.370 And the truth is the one price monopolist is probably closer 00:08:23.370 --> 00:08:25.180 to the truth than the perfectly price discriminating 00:08:25.180 --> 00:08:27.800 monopolist. But the truth, as often in this course, is going 00:08:27.800 --> 00:08:29.800 to be somewhere in between. 00:08:29.800 --> 00:08:32.580 OK, questions about that. 00:08:32.580 --> 00:08:35.230 What I want to focus on primarily, for this lecture, 00:08:35.230 --> 00:08:39.299 is where do monopolies come from. 00:08:39.299 --> 00:08:40.539 How do monopolies arrive? 00:08:40.539 --> 00:08:43.789 How do we end up in this situation, where instead of 00:08:43.789 --> 00:08:47.810 many firms competing to sell a good, we only have one? 00:08:47.810 --> 00:08:52.570 And there's basically two sources of monopolies, two 00:08:52.570 --> 00:08:53.600 sources that give birth to 00:08:53.600 --> 00:08:57.260 monopolies in modern societies. 00:08:57.260 --> 00:09:01.505 The first source is cost advantages. 00:09:08.140 --> 00:09:10.260 The first source is cost advantages. 00:09:10.260 --> 00:09:15.790 Some markets come with natural cost advantages, natural 00:09:15.790 --> 00:09:19.970 reasons why there's a benefit to being one 00:09:19.970 --> 00:09:21.950 player in the market. 00:09:21.950 --> 00:09:25.040 So for example, it could be that there's, essentially, 00:09:25.040 --> 00:09:28.260 only one usable input. 00:09:28.260 --> 00:09:30.940 So let's say there's a rock quarry in town. 00:09:30.940 --> 00:09:32.130 You've got to get rocks from. 00:09:32.130 --> 00:09:33.720 And there's just one rock quarry. 00:09:33.720 --> 00:09:36.360 And rocks are really expensive to transport. 00:09:36.360 --> 00:09:39.160 So basically, if you live in that town, the person who owns 00:09:39.160 --> 00:09:41.620 that rock quarry is going to be the monopolist. No one else 00:09:41.620 --> 00:09:43.390 is really going to compete because it would cost them so 00:09:43.390 --> 00:09:45.290 much to transport rocks from another 00:09:45.290 --> 00:09:47.210 quarry in another town. 00:09:47.210 --> 00:09:48.270 OK? 00:09:48.270 --> 00:09:50.080 Basically, the point is. 00:09:50.080 --> 00:09:53.340 Sometimes, there are these fixed costs. 00:09:53.340 --> 00:09:57.420 And whoever has paid the fixed cost has an enormous natural 00:09:57.420 --> 00:10:00.040 advantage over other players, over other 00:10:00.040 --> 00:10:01.740 entrants to the markets. 00:10:01.740 --> 00:10:04.315 And we call those natural monopolies. 00:10:11.010 --> 00:10:12.470 Natural monopolies-- 00:10:12.470 --> 00:10:18.300 Natural monopoly is a firm where for all the relevant 00:10:18.300 --> 00:10:23.580 quantities over any relevant range, the average cost for 00:10:23.580 --> 00:10:29.190 one firm is always below the average cost of a new entrant. 00:10:29.190 --> 00:10:32.230 The average cost for the one firm that's in the market is 00:10:32.230 --> 00:10:34.490 already always going to be below the average cost for any 00:10:34.490 --> 00:10:36.670 new entrant. 00:10:36.670 --> 00:10:40.580 And that is going to be true in markets with very large 00:10:40.580 --> 00:10:45.140 fixed costs and very small marginal costs. 00:10:45.140 --> 00:10:48.440 A natural monopoly will occur when there's very large fixed 00:10:48.440 --> 00:10:54.340 cost and very small marginal cost. In that case, what we'll 00:10:54.340 --> 00:10:59.650 see is average cost is always declining. 00:10:59.650 --> 00:11:02.160 Natural monopolies arise when average 00:11:02.160 --> 00:11:03.680 cost is always declining. 00:11:03.680 --> 00:11:05.990 If average cost is always declining, it's never going to 00:11:05.990 --> 00:11:10.330 make sense for another entrant to come in the market. 00:11:10.330 --> 00:11:13.400 And an example we could think of-- 00:11:13.400 --> 00:11:16.400 The best example I could think is like a water utility, the 00:11:16.400 --> 00:11:19.210 folks who deliver water to our houses. 00:11:19.210 --> 00:11:21.570 The fixed costs of delivering water are enormous. 00:11:21.570 --> 00:11:24.490 You've got to lay the pipe to deliver the water 00:11:24.490 --> 00:11:25.790 all through the town. 00:11:25.790 --> 00:11:27.890 Those are enormous fixed costs. 00:11:27.890 --> 00:11:28.965 The marginal costs are trivial. 00:11:28.965 --> 00:11:29.930 I mean, water is cheap. 00:11:29.930 --> 00:11:30.440 You get the water. 00:11:30.440 --> 00:11:32.380 You send it through the pipes. 00:11:32.380 --> 00:11:33.280 OK? 00:11:33.280 --> 00:11:36.360 It would never make sense to have two companies deliver 00:11:36.360 --> 00:11:37.896 water throughout the town. 00:11:37.896 --> 00:11:40.900 It wouldn't make sense to have another company come in, rip 00:11:40.900 --> 00:11:43.750 up the roads, lay a competing set of pipes all through the 00:11:43.750 --> 00:11:46.840 town to compete. 00:11:46.840 --> 00:11:49.040 It just wouldn't make sense because those fixed costs are 00:11:49.040 --> 00:11:50.990 so huge relative to the marginal costs. 00:11:50.990 --> 00:11:52.350 They could never make money. 00:11:52.350 --> 00:11:53.700 That first company-- 00:11:53.700 --> 00:11:56.390 If a second company came in and threatened to do that, the 00:11:56.390 --> 00:11:59.100 first company could always keep the price low enough that 00:11:59.100 --> 00:12:00.350 that second company could never 00:12:00.350 --> 00:12:02.510 recover their fixed costs. 00:12:02.510 --> 00:12:04.740 Because the first company has already paid the fixed cost, 00:12:04.740 --> 00:12:06.350 they're already in. 00:12:06.350 --> 00:12:07.980 A second company could never come in and 00:12:07.980 --> 00:12:09.280 cover those fixed costs. 00:12:09.280 --> 00:12:13.380 So if we see figure 15-1. 00:12:13.380 --> 00:12:18.380 Here's an example of a firm, of a water utility, low 00:12:18.380 --> 00:12:21.180 marginal cost. There was a high fixed cost. So the 00:12:21.180 --> 00:12:23.410 initial average costs are very high. 00:12:23.410 --> 00:12:25.930 But the average costs are declining constantly because 00:12:25.930 --> 00:12:29.020 the marginal costs are low, relative to fixed costs. 00:12:29.020 --> 00:12:30.950 OK? 00:12:30.950 --> 00:12:35.340 So if demand for the good goes up, over some relevant range-- 00:12:35.340 --> 00:12:37.840 If demand gets to be infinite, it may make sense to lay 00:12:37.840 --> 00:12:38.830 another set of pipes. 00:12:38.830 --> 00:12:41.350 You know, the first set of pipes may get overwhelmed. 00:12:41.350 --> 00:12:43.760 But as long as demand can be met by the set of pipes that's 00:12:43.760 --> 00:12:49.070 been laid, there's absolutely no reason for another firm to 00:12:49.070 --> 00:12:50.510 enter this market. 00:12:50.510 --> 00:12:53.000 If another firm ever threatened to do so, the first 00:12:53.000 --> 00:12:55.236 firm would just lower price and say, look, you're going to 00:12:55.236 --> 00:12:58.010 have to spend so much money putting that set of pipes in 00:12:58.010 --> 00:13:00.590 through town you'll never be able to make it up. 00:13:00.590 --> 00:13:02.500 Because having laid those set of pipes-- 00:13:02.500 --> 00:13:05.730 Remember what the shut down condition is. 00:13:05.730 --> 00:13:08.320 As long as that first firm can charge price greater than 00:13:08.320 --> 00:13:11.060 marginal, can charge price above average variable cost, 00:13:11.060 --> 00:13:13.460 which is marginal cost in this case. 00:13:13.460 --> 00:13:15.060 As long as that firm can charge price above marginal 00:13:15.060 --> 00:13:17.760 cost, it will always stay in business. 00:13:17.760 --> 00:13:20.560 And that second firm can't make any money at a price near 00:13:20.560 --> 00:13:23.100 the marginal cost because they can't cover their fixed cost. 00:13:23.100 --> 00:13:25.470 So they'll essentially chase them out. 00:13:25.470 --> 00:13:27.920 So essentially, the fact that they've had that set of pipes 00:13:27.920 --> 00:13:32.910 already laid down gives them a threat, a credible threat, 00:13:32.910 --> 00:13:37.270 that that second firm cannot enter. 00:13:37.270 --> 00:13:40.380 Thus, we call natural monopolies are places where 00:13:40.380 --> 00:13:43.920 other firms face barriers to entry. 00:13:43.920 --> 00:13:46.630 Natural monopolies are where there are barriers to entry, 00:13:46.630 --> 00:13:50.630 where other firms cannot enter because they'd have to pay 00:13:50.630 --> 00:13:51.930 those enormous fixed costs. 00:13:51.930 --> 00:13:56.180 And it would never make economic sense to do so. 00:13:56.180 --> 00:13:56.660 OK. 00:13:56.660 --> 00:14:00.050 And in that case, you're going to get a monopoly. 00:14:00.050 --> 00:14:02.840 And we call it a natural monopoly because, in some 00:14:02.840 --> 00:14:04.910 sense, the monopoly is the right thing to do. 00:14:04.910 --> 00:14:08.660 It is actually economically efficient for there to be only 00:14:08.660 --> 00:14:11.260 one provider of water in the town. 00:14:11.260 --> 00:14:12.380 That's the economically efficient outcome. 00:14:12.380 --> 00:14:16.020 It is economically inefficient to pay a second set of those 00:14:16.020 --> 00:14:17.930 enormous fixed costs. 00:14:17.930 --> 00:14:21.410 Now, then you say, well what about the fact that monopolist 00:14:21.410 --> 00:14:23.220 will under produce water, charge too much. 00:14:23.220 --> 00:14:25.360 We'll get to that in a minute. 00:14:25.360 --> 00:14:29.090 But when there's natural monopolies, the goods should 00:14:29.090 --> 00:14:30.080 be delivered by a monopoly. 00:14:30.080 --> 00:14:32.050 That's the right thing to do. 00:14:32.050 --> 00:14:36.330 But there's a second reason why monopolies arise, which is 00:14:36.330 --> 00:14:39.040 a little more pernicious, which is government actions. 00:14:44.830 --> 00:14:48.680 Sometimes monopolies are unnatural and created by the 00:14:48.680 --> 00:14:50.940 government. 00:14:50.940 --> 00:14:54.510 So a classic example is when governments actually decide 00:14:54.510 --> 00:14:56.350 that they're going to deliver a good and only they'll 00:14:56.350 --> 00:14:59.980 deliver the good, like the postal service. 00:14:59.980 --> 00:15:03.040 When a government decides look, we are just going to 00:15:03.040 --> 00:15:04.040 deliver this good. 00:15:04.040 --> 00:15:05.040 We're just going to have the postal service. 00:15:05.040 --> 00:15:09.450 And for many, many years, if you wanted to send a package 00:15:09.450 --> 00:15:11.000 from one place to another, you had to do it through the 00:15:11.000 --> 00:15:12.980 postal service. 00:15:12.980 --> 00:15:14.160 Well, it turned out of course, that 00:15:14.160 --> 00:15:15.870 wasn't a natural monopoly. 00:15:15.870 --> 00:15:19.220 As we know through the growth of FedEx and others, there was 00:15:19.220 --> 00:15:21.820 actually quite a good distance to compete in that market. 00:15:21.820 --> 00:15:24.290 And eventually, those other folks delivering packages came 00:15:24.290 --> 00:15:27.420 in and competed in that market. 00:15:27.420 --> 00:15:32.470 And in fact, in the US, it's very rare to have a government 00:15:32.470 --> 00:15:35.630 provided good, a purely government provided good. 00:15:35.630 --> 00:15:37.900 It's very rare. 00:15:37.900 --> 00:15:39.300 Historically, it wasn't. 00:15:39.300 --> 00:15:41.100 And in many other parts of the world, it's not. 00:15:41.100 --> 00:15:42.790 In many other parts of the world, governments run the 00:15:42.790 --> 00:15:46.860 banks, the airlines, all utilities. 00:15:46.860 --> 00:15:48.560 So in many other parts of the world, governments will 00:15:48.560 --> 00:15:50.830 actually set up these monopolies 00:15:50.830 --> 00:15:53.180 through government action. 00:15:53.180 --> 00:15:56.350 And basically, that is something which is not done 00:15:56.350 --> 00:15:59.080 much in the US but done elsewhere. 00:15:59.080 --> 00:16:02.520 Now however, one place we do set up monopolies in the US, 00:16:02.520 --> 00:16:04.210 which is pretty important, is through 00:16:04.210 --> 00:16:05.663 the issuing of patents. 00:16:09.570 --> 00:16:16.220 If you invent, say a new drug, and you patent it. 00:16:16.220 --> 00:16:18.760 You then have the exclusive right to sell that chemical 00:16:18.760 --> 00:16:22.110 compound for 17 years. 00:16:22.110 --> 00:16:24.860 So if you come up with some new chemical compound to treat 00:16:24.860 --> 00:16:29.380 whatever, you have the exclusive right to market that 00:16:29.380 --> 00:16:32.830 chemical compound for 17 years. 00:16:32.830 --> 00:16:35.430 That is a government sanctioned monopoly. 00:16:39.240 --> 00:16:43.480 Now, is that a good thing or a bad thing? 00:16:43.480 --> 00:16:44.610 Are patents-- 00:16:44.610 --> 00:16:46.820 The government has just created a monopoly. 00:16:46.820 --> 00:16:49.020 Could someone tell me why that might be actually a good thing 00:16:49.020 --> 00:16:50.400 for the government to do? 00:16:50.400 --> 00:16:50.600 Yeah. 00:16:50.600 --> 00:16:53.025 AUDIENCE: Schumpeter talks about how it's a way to cause 00:16:53.025 --> 00:16:53.246 innovation. 00:16:53.246 --> 00:16:54.916 Because no one would put that many dollars into drug 00:16:54.916 --> 00:16:56.392 research, if they weren't going to be 00:16:56.392 --> 00:16:57.130 able to make money. 00:16:57.130 --> 00:17:00.082 Because the marginal cost was so low that other people-- 00:17:00.082 --> 00:17:02.050 The cost of establishing a pharmaceutical company 00:17:02.050 --> 00:17:04.018 [UNINTELLIGIBLE] is really low. 00:17:04.018 --> 00:17:06.314 So other people would come and cut out all their 00:17:06.314 --> 00:17:06.970 profits that they had. 00:17:06.970 --> 00:17:09.829 PROFESSOR: Exactly, if you put all these resources into 00:17:09.829 --> 00:17:12.550 inventing a drug, it's not like laying pipes. 00:17:12.550 --> 00:17:14.670 Once you invented it, someone could just copy it the next 00:17:14.670 --> 00:17:17.069 day and produce it at the same cost you can. 00:17:17.069 --> 00:17:18.930 So why would you ever do that? 00:17:18.930 --> 00:17:21.660 Why would you, as someone who, even if you cared about the 00:17:21.660 --> 00:17:23.819 benefits to the world, still want to make some money. 00:17:23.819 --> 00:17:26.170 Why would you spend billions and millions of dollars 00:17:26.170 --> 00:17:27.230 inventing these new drugs? 00:17:27.230 --> 00:17:28.760 If the next day, someone else can just say, 00:17:28.760 --> 00:17:29.260 that's a great idea. 00:17:29.260 --> 00:17:32.190 I'll produce that for $0.47 a pill, just like you will. 00:17:32.190 --> 00:17:33.300 And you won't make any money off it. 00:17:33.300 --> 00:17:35.550 And you'll have lost all this money you invested. 00:17:35.550 --> 00:17:39.060 So the argument for patents is you want an incentive for 00:17:39.060 --> 00:17:42.040 innovation, which suggests there's a trade-off here. 00:17:42.040 --> 00:17:45.170 On the one hand, you want an incentive for innovation. 00:17:45.170 --> 00:17:48.210 On the other hand, once you create this monopoly, they can 00:17:48.210 --> 00:17:50.510 charge outrageous prices. 00:17:50.510 --> 00:17:51.480 There is a drug. 00:17:51.480 --> 00:17:52.270 There are drugs. 00:17:52.270 --> 00:17:55.290 Genzyme is very big company started here in Massachusetts. 00:17:55.290 --> 00:17:59.510 And the whole reason they exist is to create drugs for 00:17:59.510 --> 00:18:01.250 very, very rare diseases. 00:18:01.250 --> 00:18:02.950 Diseases that strike like 100,000 people a 00:18:02.950 --> 00:18:05.410 year but are deadly. 00:18:05.410 --> 00:18:08.100 Like Gaucher's disease is a famous example of this one. 00:18:08.100 --> 00:18:09.270 So they create these drugs. 00:18:09.270 --> 00:18:11.190 They put billions of dollars into research, 00:18:11.190 --> 00:18:12.960 create these drugs. 00:18:12.960 --> 00:18:15.100 And then, having created them and gotten a patent, charge 00:18:15.100 --> 00:18:18.350 like $100,000 a year to use the drugs. 00:18:18.350 --> 00:18:22.310 Drugs that cost, you know, $500 a year to produce. 00:18:22.310 --> 00:18:25.770 Now on the one hand, if these drugs didn't exist, 00:18:25.770 --> 00:18:26.930 people would die. 00:18:26.930 --> 00:18:29.060 These are literally lifesaving drugs. 00:18:29.060 --> 00:18:31.930 These are people who used to die, who now live because of 00:18:31.930 --> 00:18:34.060 these drugs. 00:18:34.060 --> 00:18:36.710 And these drugs never would have been invented if Genzyme 00:18:36.710 --> 00:18:38.660 couldn't have made some money off them. 00:18:38.660 --> 00:18:40.910 On the other hand, you've got a product which costs $500 a 00:18:40.910 --> 00:18:44.500 year to make, and they're charging $100,000 a year to 00:18:44.500 --> 00:18:46.200 people to use. 00:18:46.200 --> 00:18:48.100 And in particular, when it comes to drugs like for 00:18:48.100 --> 00:18:52.250 treating AIDS in the developed world where people cannot-- 00:18:52.250 --> 00:18:54.240 There's no way they can afford that kind of money. 00:18:54.240 --> 00:18:55.030 That's a problem. 00:18:55.030 --> 00:18:55.529 Yeah. 00:18:55.529 --> 00:18:58.148 AUDIENCE: But aren't you not only paying for them to 00:18:58.148 --> 00:18:59.521 produce the drug but paying for all the 00:18:59.521 --> 00:19:01.180 research that went into-- 00:19:01.180 --> 00:19:02.860 PROFESSOR: Exactly, that's right. 00:19:02.860 --> 00:19:03.690 You're paying for all the research. 00:19:03.690 --> 00:19:04.570 That's why they never would have 00:19:04.570 --> 00:19:05.760 invented it if they couldn't. 00:19:05.760 --> 00:19:07.350 So you're paying for the research. 00:19:07.350 --> 00:19:09.460 They also take home a nice, hefty profit at 00:19:09.460 --> 00:19:10.350 the end of the day. 00:19:10.350 --> 00:19:11.480 But that is true. 00:19:11.480 --> 00:19:13.390 You are also paying for the research that goes into that. 00:19:13.390 --> 00:19:15.120 And people wouldn't put that money up front. 00:19:15.120 --> 00:19:17.090 That research is funded by investors. 00:19:17.090 --> 00:19:19.303 And investors would not invest in Genzyme and give them money 00:19:19.303 --> 00:19:21.590 to do research if they weren't going to get a return. 00:19:21.590 --> 00:19:22.660 So if Genzyme-- 00:19:22.660 --> 00:19:26.920 Of that $99,500 Genzyme makes on that Gaucher's disease 00:19:26.920 --> 00:19:30.260 drug, most of it is going back to pay the people who funded 00:19:30.260 --> 00:19:31.040 the research. 00:19:31.040 --> 00:19:32.170 But a healthy chunk is not. 00:19:32.170 --> 00:19:35.750 A healthy chunk is market power monopoly profit. 00:19:35.750 --> 00:19:36.070 Yeah. 00:19:36.070 --> 00:19:39.320 AUDIENCE: Could the government then have subsidies for some 00:19:39.320 --> 00:19:42.570 types of licensing to ensure that the consumers are not 00:19:42.570 --> 00:19:44.902 affected because everyone cannot afford the 00:19:44.902 --> 00:19:45.570 drug without it. 00:19:45.570 --> 00:19:48.500 PROFESSOR: I'm going to come to that in a second. 00:19:48.500 --> 00:19:50.770 Now actually, let me just hold that thought for a second 00:19:50.770 --> 00:19:52.710 because I want to actually show you how we think about 00:19:52.710 --> 00:19:54.490 whether patent is a good idea or not. 00:19:54.490 --> 00:19:56.320 So let's go to figure 15-2. 00:19:56.320 --> 00:19:59.400 I just want to, sort of, show you how what you guys seem to 00:19:59.400 --> 00:20:01.980 understand intuitively, we can illustrate in the kind of 00:20:01.980 --> 00:20:03.850 graphs we've been using. 00:20:03.850 --> 00:20:05.580 Once again, we want to think about going back and forth 00:20:05.580 --> 00:20:08.230 between the intuition and the graphical and mathematical 00:20:08.230 --> 00:20:10.050 aspects of this stuff. 00:20:10.050 --> 00:20:15.120 So here we have a monopolist. Imagine that you have a good 00:20:15.120 --> 00:20:18.700 where the original demand curve is D1. 00:20:18.700 --> 00:20:21.470 A good where the original demand curve is D1 and the 00:20:21.470 --> 00:20:26.490 original consumer surplus is that dotted area C plus 1 plus 00:20:26.490 --> 00:20:27.990 that slashed triangle. 00:20:27.990 --> 00:20:31.960 So it's based on the area above the competitive price PC 00:20:31.960 --> 00:20:33.900 under the demand curve D1. 00:20:33.900 --> 00:20:35.050 So you have a good. 00:20:35.050 --> 00:20:37.480 It's some drug, which people like. 00:20:37.480 --> 00:20:38.910 And there's some demand for it. 00:20:38.910 --> 00:20:41.890 And it's produced competitively at a price PC 00:20:41.890 --> 00:20:44.340 with the consumer surplus of that triangle. 00:20:44.340 --> 00:20:47.730 Now, let's say a monopolist comes along and says, we can 00:20:47.730 --> 00:20:50.290 make this drug way better. 00:20:50.290 --> 00:20:52.070 We could make a much better drug, but we're going to need 00:20:52.070 --> 00:20:53.260 a patent for it. 00:20:53.260 --> 00:20:54.510 Well, two things happen. 00:20:54.510 --> 00:20:58.530 On the one hand, the demand curve shifts way out. 00:20:58.530 --> 00:21:01.360 Now you've got something which people value a lot more. 00:21:01.360 --> 00:21:04.430 They're much more willing to pay for this better drug. 00:21:04.430 --> 00:21:05.240 OK? 00:21:05.240 --> 00:21:06.540 And that's the benefit. 00:21:06.540 --> 00:21:10.100 That's the innovation effect on demand. 00:21:10.100 --> 00:21:12.370 On the other hand, the price goes up to the 00:21:12.370 --> 00:21:14.930 monopolist's price. 00:21:14.930 --> 00:21:17.386 Where marginal revenue equals marginal cost, they're going 00:21:17.386 --> 00:21:21.930 to produce at Q sub m and charge a higher price P sub m. 00:21:21.930 --> 00:21:23.770 Whereas, if this is a perfectly competitive firm, 00:21:23.770 --> 00:21:27.930 they produce much more, where D2 hits the marginal cost and 00:21:27.930 --> 00:21:31.260 consumer surplus would be much larger. 00:21:31.260 --> 00:21:35.830 So the trade off is, on the one hand, you end up here. 00:21:35.830 --> 00:21:38.750 In this case I've drawn, you end up with a larger consumer 00:21:38.750 --> 00:21:41.890 surplus, even with monopoly. 00:21:41.890 --> 00:21:45.300 But you could imagine drawing the same graph, in the case 00:21:45.300 --> 00:21:47.110 where consumer surplus falls. 00:21:47.110 --> 00:21:49.540 You can imagine demand doesn't go up that much. 00:21:49.540 --> 00:21:52.380 But the monopolist gets the monopoly price. 00:21:52.380 --> 00:21:54.390 And you could imagine drawing this triangle such that the 00:21:54.390 --> 00:21:56.330 new consumer surplus triangle is smaller than the old 00:21:56.330 --> 00:21:58.010 consumer surplus triangle. 00:21:58.010 --> 00:21:59.080 OK? 00:21:59.080 --> 00:22:00.790 So it's not obvious which way this goes. 00:22:00.790 --> 00:22:01.580 You have two effects. 00:22:01.580 --> 00:22:04.900 On the one hand, you have the effect that demand shifts out. 00:22:04.900 --> 00:22:08.110 That creates a potential for more social surplus. 00:22:08.110 --> 00:22:10.400 On the other hand, you have the case that the monopolist 00:22:10.400 --> 00:22:12.500 artificially prices too high. 00:22:12.500 --> 00:22:14.670 That causes a reduction in social surplus. 00:22:14.670 --> 00:22:17.120 In this case, the former dominated the latter. 00:22:17.120 --> 00:22:19.170 But I hope you can see you can draw this in cases where that 00:22:19.170 --> 00:22:20.750 wouldn't be true. 00:22:20.750 --> 00:22:23.520 And that's the tricky thing with patents. 00:22:23.520 --> 00:22:24.800 It's going to depend. 00:22:24.800 --> 00:22:27.230 If you're patenting something which is really demand 00:22:27.230 --> 00:22:28.480 increasing, that's great. 00:22:28.480 --> 00:22:30.070 But if you're patenting something which is just a 00:22:30.070 --> 00:22:33.090 copycat of something that exists and all you're doing is 00:22:33.090 --> 00:22:34.130 turning a competitive market-- 00:22:34.130 --> 00:22:36.430 In the limit, imagine I somehow snookered the 00:22:36.430 --> 00:22:39.570 government into giving me a patent for something which 00:22:39.570 --> 00:22:42.690 literally does no more than what's existed. 00:22:42.690 --> 00:22:44.830 But somehow I could fool-- 00:22:44.830 --> 00:22:46.840 In that case, have to do a little more or people wouldn't 00:22:46.840 --> 00:22:48.945 buy it, just a little more than what existed. 00:22:48.945 --> 00:22:50.350 It wouldn't increase demand much. 00:22:50.350 --> 00:22:57.830 But I would then have these monopoly rents. 00:22:57.830 --> 00:22:58.430 OK? 00:22:58.430 --> 00:23:02.250 So that's basically the trade off with patents. 00:23:02.250 --> 00:23:05.430 All right, question about that. 00:23:05.430 --> 00:23:07.830 Now, let me move on then and talk about-- 00:23:07.830 --> 00:23:09.030 The question was raised about-- 00:23:09.030 --> 00:23:12.090 Well, couldn't the government do something about this, in 00:23:12.090 --> 00:23:13.520 terms of trying to address this problem. 00:23:13.520 --> 00:23:16.100 And we just talked about the government as bad guy in 00:23:16.100 --> 00:23:16.960 creating this problem. 00:23:16.960 --> 00:23:18.170 Although, it's not necessarily a problem 00:23:18.170 --> 00:23:19.740 in the case of patents. 00:23:19.740 --> 00:23:21.890 But there's also the role of government as potential good 00:23:21.890 --> 00:23:25.990 guy, which is can the government help in this case 00:23:25.990 --> 00:23:27.480 of natural monopoly? 00:23:27.480 --> 00:23:30.780 So natural monopoly, we've got this awkward situation where 00:23:30.780 --> 00:23:32.150 clearly a monopoly makes sense. 00:23:32.150 --> 00:23:33.980 It doesn't make sense to have competitive people delivering 00:23:33.980 --> 00:23:35.330 water in town. 00:23:35.330 --> 00:23:37.990 But once you've got one person delivering water, they'll 00:23:37.990 --> 00:23:41.400 charge you a fortune for it, well above marginal cost. And 00:23:41.400 --> 00:23:42.090 that's inefficient. 00:23:42.090 --> 00:23:45.700 That lowers social surplus relative to the optimal level 00:23:45.700 --> 00:23:47.650 of provision. 00:23:47.650 --> 00:23:50.600 So can the government solve this problem? 00:23:50.600 --> 00:23:54.730 Could the government, for example, come in and say look, 00:23:54.730 --> 00:23:56.340 we recognize there's a natural monopoly. 00:23:56.340 --> 00:23:59.410 We recognize that you, Rubrico, are the only company 00:23:59.410 --> 00:24:00.690 that makes sense to deliver water. 00:24:00.690 --> 00:24:05.210 But we are going to regulate you in a way to maximize the 00:24:05.210 --> 00:24:07.890 social surplus, given that natural monopoly. 00:24:07.890 --> 00:24:09.450 So to see that, let's go to the highly 00:24:09.450 --> 00:24:11.510 complicated figure 15-3. 00:24:11.510 --> 00:24:12.870 OK, we'll have to walk through this slowly. 00:24:12.870 --> 00:24:15.040 It's a lot of stuff going on here at once. 00:24:15.040 --> 00:24:17.340 OK? 00:24:17.340 --> 00:24:17.800 15-3. 00:24:17.800 --> 00:24:20.750 We're back to the usual curves we were using last time. 00:24:20.750 --> 00:24:24.080 The demand curve is P equals 24 minus Q. 00:24:24.080 --> 00:24:27.510 The cost curve is 12 plus Q squared. 00:24:27.510 --> 00:24:30.160 So the marginal cost is just 2Q. 00:24:30.160 --> 00:24:33.980 The competitive outcome was to produce eight units 00:24:33.980 --> 00:24:37.170 at a price of 16. 00:24:37.170 --> 00:24:39.450 The monopoly outcome was to produce six units 00:24:39.450 --> 00:24:42.210 at a price of 18. 00:24:42.210 --> 00:24:43.210 OK? 00:24:43.210 --> 00:24:47.130 And you ended up with the monopolist causing a 00:24:47.130 --> 00:24:51.670 deadweight loss of C plus E. That was where we were last 00:24:51.670 --> 00:24:53.362 time in this example. 00:24:53.362 --> 00:24:55.980 And let's say this was a natural monopoly. 00:24:55.980 --> 00:24:58.610 So that's why there's a monopolist there. 00:24:58.610 --> 00:25:04.460 Now, what if the government came in and mandated that the 00:25:04.460 --> 00:25:09.540 monopolist can charge no more than the competitive price? 00:25:09.540 --> 00:25:10.550 Let's say the government knew what the 00:25:10.550 --> 00:25:11.300 competitive price was. 00:25:11.300 --> 00:25:13.490 The government says, look, I took 14.01. 00:25:13.490 --> 00:25:14.320 I see this graph. 00:25:14.320 --> 00:25:16.560 I know the competitive price is 16. 00:25:16.560 --> 00:25:18.000 So I'm going to say, monopolist-- 00:25:18.000 --> 00:25:19.390 You're the monopolist. You go ahead. 00:25:19.390 --> 00:25:21.180 And no one else can deliver water. 00:25:21.180 --> 00:25:22.350 It makes sense for you to do it. 00:25:22.350 --> 00:25:26.510 But I'm going to regulate that you cannot charge consumers a 00:25:26.510 --> 00:25:29.670 price above 16. 00:25:29.670 --> 00:25:33.730 What you can see in that case, is the government will turn 00:25:33.730 --> 00:25:38.580 the monopolist from a price maker to a price taker. 00:25:38.580 --> 00:25:41.620 And in doing so, the government will undo the 00:25:41.620 --> 00:25:44.810 poisoning effect we talked about last time and cause the 00:25:44.810 --> 00:25:48.720 monopolist to behave as if it was a competitive firm. 00:25:48.720 --> 00:25:52.860 So to see that, we have to ask, well what's the marginal 00:25:52.860 --> 00:25:57.310 revenue curve now for the monopolist, given this 00:25:57.310 --> 00:26:01.930 government mandate that it can charge no more than 16? 00:26:01.930 --> 00:26:06.650 Well, the marginal revenue curve, up to the point it 00:26:06.650 --> 00:26:09.790 sells six, is the old marginal revenue curve. 00:26:09.790 --> 00:26:11.570 So we're working down this marginal revenue curve. 00:26:11.570 --> 00:26:13.540 And up to that point, where marginal revenue intersects 00:26:13.540 --> 00:26:17.910 marginal cost, that's the marginal revenue curve. 00:26:17.910 --> 00:26:21.480 And that's where the monopolist would stop. 00:26:21.480 --> 00:26:23.980 But the problem is the monopolist isn't actually able 00:26:23.980 --> 00:26:26.290 to charge more than 16. 00:26:26.290 --> 00:26:29.570 So now, if it's charging 16, now it asks itself well, 00:26:29.570 --> 00:26:32.130 should I produce that seventh unit. 00:26:32.130 --> 00:26:34.210 Remember last time we did the math. 00:26:34.210 --> 00:26:36.770 The monopolist should not produce the seventh unit. 00:26:36.770 --> 00:26:38.590 Because last time we showed that, because of that 00:26:38.590 --> 00:26:41.785 poisoning effect, profits would fall if it produced that 00:26:41.785 --> 00:26:42.840 seventh unit. 00:26:42.840 --> 00:26:46.910 But now it's not true because now it's only charging 16. 00:26:46.910 --> 00:26:50.300 So if it's charging 16, and if it produces that seventh unit, 00:26:50.300 --> 00:26:52.380 it's still going to charge 16. 00:26:52.380 --> 00:26:55.270 The poisoning effect has gone away. 00:26:55.270 --> 00:26:56.620 There's no more poisoning effect. 00:26:56.620 --> 00:26:58.990 There's no loss to producing the seventh unit because the 00:26:58.990 --> 00:27:00.040 most it can get is 16. 00:27:00.040 --> 00:27:01.240 It would like to price it much higher. 00:27:01.240 --> 00:27:02.470 It can't. 00:27:02.470 --> 00:27:11.780 Since the most it can price at is 16 he says, well gee, then 00:27:11.780 --> 00:27:12.640 there's no poisoning effect. 00:27:12.640 --> 00:27:17.390 I might as well produce at the competitive level. 00:27:17.390 --> 00:27:19.900 And basically, what you can see is if you tell the 00:27:19.900 --> 00:27:22.130 monopolist they can't charge more than the competitive 00:27:22.130 --> 00:27:25.810 price, then they will produce at the competitive level. 00:27:25.810 --> 00:27:28.820 And you'll end up at that competitive outcome, even with 00:27:28.820 --> 00:27:31.240 a monopolist, because that will be the profit maximizing 00:27:31.240 --> 00:27:34.770 thing for the monopolist to do. 00:27:34.770 --> 00:27:38.130 So sounds like we've got a pretty good solution here. 00:27:38.130 --> 00:27:38.720 Right? 00:27:38.720 --> 00:27:42.020 If there's a natural monopoly, we just come in and say you 00:27:42.020 --> 00:27:45.470 can't charge more than the competitive price. 00:27:45.470 --> 00:27:47.520 So in theory, government can fix this. 00:27:47.520 --> 00:27:49.250 We've been talking about government as a bad guy. 00:27:49.250 --> 00:27:50.590 Here's government as a good guy. 00:27:50.590 --> 00:27:52.160 Government can come in and fix this. 00:27:52.160 --> 00:27:54.180 What's the problem with that? 00:27:54.180 --> 00:27:55.890 What's the problem, in practice, with carrying out 00:27:55.890 --> 00:27:58.588 what I just laid out here in theory? 00:27:58.588 --> 00:27:59.084 Yeah. 00:27:59.084 --> 00:28:00.696 AUDIENCE: How does the government know what the 00:28:00.696 --> 00:28:01.068 competitive price is? 00:28:01.068 --> 00:28:02.458 PROFESSOR: How does the government know what the 00:28:02.458 --> 00:28:03.170 competitive price is? 00:28:03.170 --> 00:28:06.590 How does the government know what these curves look like? 00:28:06.590 --> 00:28:08.590 Now, let's think about both curves. 00:28:08.590 --> 00:28:10.170 OK, first the government needs to know-- 00:28:10.170 --> 00:28:11.630 If it wants to know the competitive price, it's got to 00:28:11.630 --> 00:28:14.260 know the demand curve and the supply curve. 00:28:14.260 --> 00:28:16.910 Well the demand curve, in principle, the government 00:28:16.910 --> 00:28:17.370 could learn. 00:28:17.370 --> 00:28:20.010 The government could go out and survey people and get a 00:28:20.010 --> 00:28:22.820 sense of kind of, could collect some data, could run 00:28:22.820 --> 00:28:24.670 some experiments and try to find out from people. 00:28:24.670 --> 00:28:27.200 Gee, how much are you willing to pay for another unit, 00:28:27.200 --> 00:28:28.460 another unit, another unit? 00:28:28.460 --> 00:28:30.250 So in principle, the government could actually 00:28:30.250 --> 00:28:33.160 measure demand curve by doing market research. 00:28:33.160 --> 00:28:36.020 Although in practice, this is quite hard. 00:28:36.020 --> 00:28:38.100 It turns out in practice-- 00:28:38.100 --> 00:28:41.580 The first rule of economics is believe what people do, not 00:28:41.580 --> 00:28:42.670 what they say. 00:28:42.670 --> 00:28:44.760 Turns out, if you ask people what they're willing to pay, 00:28:44.760 --> 00:28:47.640 you get very silly answers, relative to actually do it. 00:28:47.640 --> 00:28:50.470 So for example, this comes up a lot in when the government 00:28:50.470 --> 00:28:52.930 needs to value environmental damage. 00:28:52.930 --> 00:28:57.590 So if we need to ask how much should we charge BP for the 00:28:57.590 --> 00:29:01.830 damage they did to the Gulf, we need to value how sad are 00:29:01.830 --> 00:29:04.820 people that the wetlands are ruined. 00:29:04.820 --> 00:29:07.100 Well, the only thing to do is to ask people. 00:29:07.100 --> 00:29:07.930 And it turns out when you do that, you get 00:29:07.930 --> 00:29:09.510 incredibly silly answers. 00:29:09.510 --> 00:29:11.815 Things like, for example, if you ask people how sorry are 00:29:11.815 --> 00:29:14.820 you if 10 ducks died, they'll say I'm this sad. 00:29:14.820 --> 00:29:16.560 Say how sad are you if a million ducks died? 00:29:16.560 --> 00:29:18.290 They'll say, I'm the same amount sad. 00:29:18.290 --> 00:29:19.820 OK, that doesn't make sense. 00:29:19.820 --> 00:29:23.240 You ask people what's it worth to save a duck 00:29:23.240 --> 00:29:25.790 versus saving a whale. 00:29:25.790 --> 00:29:27.660 And you ask in that order, they'll say saving a duck is 00:29:27.660 --> 00:29:30.460 worth $100, saving a whale is worth $100. 00:29:30.460 --> 00:29:31.830 Or it's worth $150. 00:29:31.830 --> 00:29:32.650 You ask the other order. 00:29:32.650 --> 00:29:33.870 You say, how much is it worth to save a 00:29:33.870 --> 00:29:34.940 whale and then a duck. 00:29:34.940 --> 00:29:36.310 Well then, saving a whale is worth $300. 00:29:36.310 --> 00:29:38.690 And a duck's only worth $50, same question 00:29:38.690 --> 00:29:40.640 just a different order. 00:29:40.640 --> 00:29:42.900 People do not give sensible answers when you ask them what 00:29:42.900 --> 00:29:43.760 things are worth. 00:29:43.760 --> 00:29:46.640 The best way to know is to actually vary the price, is to 00:29:46.640 --> 00:29:50.770 actually run experiments where you actually say, OK, we have 00:29:50.770 --> 00:29:52.580 to actually give people different prices and see how 00:29:52.580 --> 00:29:56.460 they behave, actually trace out the demand curve. 00:29:56.460 --> 00:29:59.210 That turns out to be very hard to do, especially for things 00:29:59.210 --> 00:30:00.960 like valuing damage to wetlands. 00:30:00.960 --> 00:30:03.380 But even for things like valuing prescription drugs, 00:30:03.380 --> 00:30:04.550 you've got to literally-- 00:30:04.550 --> 00:30:07.480 It's hard to run the experiment where, literally, I 00:30:07.480 --> 00:30:08.710 give you a different price than you for a 00:30:08.710 --> 00:30:09.890 prescription drug. 00:30:09.890 --> 00:30:10.900 That's a little bit tricky. 00:30:10.900 --> 00:30:12.080 So it's hard to get the demand curve. 00:30:12.080 --> 00:30:13.870 So that's the first problem the government faces. 00:30:13.870 --> 00:30:17.740 But in some sense, that's the less difficult problem. 00:30:17.740 --> 00:30:19.230 It is tracing out the demand curve. 00:30:19.230 --> 00:30:20.720 In principle, there are ways to do it. 00:30:20.720 --> 00:30:22.450 In principle, you could run experiments where you vary the 00:30:22.450 --> 00:30:25.620 price and you get that demand curve. 00:30:25.620 --> 00:30:29.860 In practice, the difficulty is firm supply 00:30:29.860 --> 00:30:31.060 curves are much harder. 00:30:31.060 --> 00:30:32.520 And why is that? 00:30:32.520 --> 00:30:34.195 Because let's say the government comes to you and 00:30:34.195 --> 00:30:35.300 says, look I'm doing great. 00:30:35.300 --> 00:30:36.570 I've nailed down the demand curve. 00:30:36.570 --> 00:30:38.340 I just need to know your supply curve, so I can set 00:30:38.340 --> 00:30:39.210 your price. 00:30:39.210 --> 00:30:41.290 What's your supply curve again? 00:30:41.290 --> 00:30:42.055 OK, what are you going to say? 00:30:42.055 --> 00:30:43.262 AUDIENCE: [INAUDIBLE] 00:30:43.262 --> 00:30:45.490 PROFESSOR: Aw, this stuff costs a fortune to make. 00:30:45.490 --> 00:30:48.550 You would not believe what it costs this stuff to make. 00:30:48.550 --> 00:30:49.450 My supply curve-- 00:30:49.450 --> 00:30:50.360 12 plus Q squared? 00:30:50.360 --> 00:30:50.850 Ha! 00:30:50.850 --> 00:30:51.280 That's a joke. 00:30:51.280 --> 00:30:53.480 It's 30 plus 18Q squared. 00:30:53.480 --> 00:30:54.050 Are you kidding? 00:30:54.050 --> 00:30:56.720 My supply curve is crazy high. 00:30:56.720 --> 00:31:00.340 And the problem is, the government doesn't know. 00:31:00.340 --> 00:31:02.950 Because with consumers, at least I can run experiments to 00:31:02.950 --> 00:31:03.480 get the demand. 00:31:03.480 --> 00:31:05.800 With the firm, I can't get inside their books. 00:31:05.800 --> 00:31:06.650 I can't really know. 00:31:06.650 --> 00:31:08.840 And if I get inside the books, they can cook their books and 00:31:08.840 --> 00:31:10.240 make it look like stuff costs more. 00:31:10.240 --> 00:31:11.010 How can I really know? 00:31:11.010 --> 00:31:13.340 Just like it's difficult for the board of directors to 00:31:13.340 --> 00:31:16.900 figure out whether the CEO of a company needs his own plane, 00:31:16.900 --> 00:31:18.640 it's very difficult for government regulators to 00:31:18.640 --> 00:31:21.845 figure out what it actually costs to produce these drugs. 00:31:21.845 --> 00:31:26.570 And as a result, it's very hard to get this right. 00:31:26.570 --> 00:31:31.700 And the problem is if the government gets it wrong, it 00:31:31.700 --> 00:31:35.200 can make it worse than not regulating at all. 00:31:35.200 --> 00:31:40.180 So for example, if the government came in, and let's 00:31:40.180 --> 00:31:42.750 say, the government said look, I can't believe this firm. 00:31:42.750 --> 00:31:45.370 12 plus Q squared sounds way too high for cost. I think 00:31:45.370 --> 00:31:46.930 marginal costs are much lower than that. 00:31:46.930 --> 00:31:50.060 And I think the competitive price should be 10 because I 00:31:50.060 --> 00:31:51.470 know the firm is going to lie to me. 00:31:51.470 --> 00:31:52.740 I know they're going to tell me numbers too big. 00:31:52.740 --> 00:31:54.795 So I'm going to say that equilibrium should be 00:31:54.795 --> 00:31:57.740 competitive, should be a price of 10. 00:31:57.740 --> 00:32:01.500 And at a price of 10, the firm is now operating off the 00:32:01.500 --> 00:32:04.130 marginal revenue curve at that low price 00:32:04.130 --> 00:32:05.940 because it's below 16. 00:32:05.940 --> 00:32:09.660 So at a price of 10, the firm is going to set marginal 00:32:09.660 --> 00:32:14.790 revenue equal to marginal cost. Well, marginal revenue 00:32:14.790 --> 00:32:17.560 at a price of 10 is the price. 00:32:17.560 --> 00:32:19.490 That's all they can charge is 10. 00:32:19.490 --> 00:32:22.450 So they're going to set price equal to marginal cost. The 00:32:22.450 --> 00:32:27.040 marginal cost with a production of 10-- 00:32:27.040 --> 00:32:29.010 The marginal cost is 2Q. 00:32:29.010 --> 00:32:31.090 So set price equal to 2Q. 00:32:31.090 --> 00:32:33.490 Or 10 equals 2Q. 00:32:33.490 --> 00:32:35.280 Or Q equals five. 00:32:35.280 --> 00:32:37.230 They'll produce five units. 00:32:37.230 --> 00:32:38.520 They'll say look, if you're only going to let me charge 00:32:38.520 --> 00:32:41.020 10, I'm only going to produce five units. 00:32:41.020 --> 00:32:41.750 That's what I'll produce. 00:32:41.750 --> 00:32:46.450 That's what's optimal for me at a price of 10. 00:32:46.450 --> 00:32:48.030 What you see is-- 00:32:48.030 --> 00:32:50.240 Now if you look at this graph and you look at the firm 00:32:50.240 --> 00:32:53.585 producing five units. 00:32:53.585 --> 00:32:56.540 What you see is the firm produces five units. 00:32:56.540 --> 00:32:59.540 Now, the total surplus has fallen. 00:32:59.540 --> 00:33:04.670 It's just A plus B plus D. The consumer surplus is very high. 00:33:04.670 --> 00:33:06.320 We don't have the horizontal line of 10 here. 00:33:06.320 --> 00:33:09.360 But draw yourself that horizontal line of 10, which 00:33:09.360 --> 00:33:12.120 is where the dashed line of five intersects the marginal 00:33:12.120 --> 00:33:13.870 cost curve. 00:33:13.870 --> 00:33:15.430 You could see there's a big consumer surplus. 00:33:15.430 --> 00:33:18.980 It's A plus B plus half of D and a little producer surplus, 00:33:18.980 --> 00:33:21.800 which is that triangle that's the lower half of D. But look 00:33:21.800 --> 00:33:23.550 what's happened to social surplus. 00:33:23.550 --> 00:33:26.550 Before the government got involved, the deadweight loss 00:33:26.550 --> 00:33:30.190 was just C plus E. Now the government, by misregulating 00:33:30.190 --> 00:33:33.210 the price, has created deadweight losses of C plus E 00:33:33.210 --> 00:33:36.840 plus F plus G plus H. The government has just increased 00:33:36.840 --> 00:33:41.240 the deadweight loss a lot, by getting involved and 00:33:41.240 --> 00:33:43.710 misregulating. 00:33:43.710 --> 00:33:47.150 And in particular, that area that increases it-- 00:33:47.150 --> 00:33:49.150 Here's the interesting thing. 00:33:49.150 --> 00:33:52.490 Falling from eight to six caused that little triangle. 00:33:52.490 --> 00:33:55.650 Falling from six to five, just one more unit, causes a 00:33:55.650 --> 00:33:59.280 trapezoid, which is probably bigger than that triangle. 00:33:59.280 --> 00:34:00.250 Why? 00:34:00.250 --> 00:34:01.770 Because we're moving farther and farther 00:34:01.770 --> 00:34:03.170 away from the optimum. 00:34:03.170 --> 00:34:05.890 We're losing more and more trades that were socially 00:34:05.890 --> 00:34:08.199 beneficial. 00:34:08.199 --> 00:34:10.929 Remember at the optimum, deadweight loss is very small. 00:34:10.929 --> 00:34:13.190 But as you move farther and farther away, that deadweight 00:34:13.190 --> 00:34:14.190 loss gets bigger and bigger. 00:34:14.190 --> 00:34:17.760 So this government misregulation, instead of 00:34:17.760 --> 00:34:23.280 moving us to what's optimal, by just moving us one below 00:34:23.280 --> 00:34:25.870 where we were as a monopolist has caused all this huge extra 00:34:25.870 --> 00:34:29.120 deadweight loss and made things worse. 00:34:29.120 --> 00:34:31.280 Indeed, it could be worse. 00:34:31.280 --> 00:34:33.630 Imagine the government chose a price so low the firm just 00:34:33.630 --> 00:34:34.100 said, forget it. 00:34:34.100 --> 00:34:36.000 I'm going to shut down. 00:34:36.000 --> 00:34:37.699 You could lose all surplus in this market. 00:34:37.699 --> 00:34:39.360 If the government came in and said, no, we 00:34:39.360 --> 00:34:39.880 don't believe you. 00:34:39.880 --> 00:34:41.130 The price should be whatever. 00:34:41.130 --> 00:34:43.300 It wouldn't be, in this case, because in this case, price is 00:34:43.300 --> 00:34:45.580 always greater than marginal cost. 00:34:45.580 --> 00:34:47.445 But let's say the government came in another case and set a 00:34:47.445 --> 00:34:48.239 price that was too low. 00:34:48.239 --> 00:34:49.650 It could just cause the firm to shut down. 00:34:49.650 --> 00:34:53.090 Then all social surplus in the market would disappear. 00:34:53.090 --> 00:34:54.190 OK? 00:34:54.190 --> 00:34:56.540 So basically, there's these difficulties with the 00:34:56.540 --> 00:34:59.720 regulation, which is it's hard to know how to set the price. 00:34:59.720 --> 00:35:02.620 Now in practice, of course, what happens is governments 00:35:02.620 --> 00:35:04.570 set the price too high. 00:35:04.570 --> 00:35:08.740 In practice, the government would much rather err on the 00:35:08.740 --> 00:35:11.160 side of letting monopolists make a little money than err 00:35:11.160 --> 00:35:13.720 on the side of there being too little of the good. 00:35:13.720 --> 00:35:15.170 So government, facing uncertainty about what the 00:35:15.170 --> 00:35:18.410 right level to set is, will typically end up erring on the 00:35:18.410 --> 00:35:20.460 side of monopolists, partly because of the way of the 00:35:20.460 --> 00:35:21.990 nature of regulation. 00:35:21.990 --> 00:35:26.700 So let's say you are president whatever. 00:35:26.700 --> 00:35:28.310 And you want to regulate this new good. 00:35:28.310 --> 00:35:30.660 OK, somebody made the new good and you want to regulate it. 00:35:30.660 --> 00:35:33.630 Well who are you going to hire to be the regulator? 00:35:33.630 --> 00:35:34.700 Well clearly, someone who knows 00:35:34.700 --> 00:35:36.740 something about the market. 00:35:36.740 --> 00:35:38.930 So there's a new good. 00:35:38.930 --> 00:35:41.020 My favorite example of an outdated 00:35:41.020 --> 00:35:42.420 technology is the umbrella. 00:35:42.420 --> 00:35:43.490 I really think we've got to figure out a 00:35:43.490 --> 00:35:44.360 better way to do umbrellas. 00:35:44.360 --> 00:35:45.030 They suck. 00:35:45.030 --> 00:35:46.410 In the wind, they blow up. 00:35:46.410 --> 00:35:47.110 They're useless, right. 00:35:47.110 --> 00:35:48.490 There's got to be a better umbrella out there. 00:35:48.490 --> 00:35:52.050 Let's say somebody finally figures out a better umbrella. 00:35:52.050 --> 00:35:54.150 But they've got a patent on it. 00:35:54.150 --> 00:35:54.720 And so you want to regulate it. 00:35:54.720 --> 00:35:56.480 It's got some natural monopoly producing it. 00:35:56.480 --> 00:35:57.950 It uses unobtanium. 00:35:57.950 --> 00:35:59.750 And the only can find it in one place, Pandora. 00:35:59.750 --> 00:36:01.090 So they've got to-- 00:36:01.090 --> 00:36:02.835 They're the only guys-- 00:36:02.835 --> 00:36:04.640 Isn't that the stupidest name ever for a material? 00:36:04.640 --> 00:36:06.300 How could they have not come up with a better name than 00:36:06.300 --> 00:36:07.250 unobtanium? 00:36:07.250 --> 00:36:09.570 Anyway, so it uses unobtanium. 00:36:09.570 --> 00:36:11.320 And basically they have this natural monopoly. 00:36:11.320 --> 00:36:12.950 So you want to regulate it 00:36:12.950 --> 00:36:14.770 Well, who are you going to find to regulate it? 00:36:14.770 --> 00:36:16.540 Well you know, once there was an expert in making umbrellas 00:36:16.540 --> 00:36:18.510 with unobtanium. 00:36:18.510 --> 00:36:20.220 That person who you're going to hire. 00:36:20.220 --> 00:36:21.370 That's the right person to hire. 00:36:21.370 --> 00:36:22.630 Unfortunately, that probably means they're probably 00:36:22.630 --> 00:36:24.270 friendly with all the guys that make umbrellas with 00:36:24.270 --> 00:36:25.900 unobtanium. 00:36:25.900 --> 00:36:26.790 And they're not going to want to be too 00:36:26.790 --> 00:36:29.100 tough on their buddies. 00:36:29.100 --> 00:36:31.110 So the natural person who's going to regulate, by their 00:36:31.110 --> 00:36:35.560 nature, is going to tend to be someone who's going to think 00:36:35.560 --> 00:36:37.070 sort of on the industry's side. 00:36:37.070 --> 00:36:38.970 Moreover, what are they going to do after they're done being 00:36:38.970 --> 00:36:40.050 the regulator? 00:36:40.050 --> 00:36:41.190 They're going to go back into the business of making 00:36:41.190 --> 00:36:42.440 umbrellas with unobtanium. 00:36:42.440 --> 00:36:43.910 So they're not going to want to be too mean to the business 00:36:43.910 --> 00:36:45.000 because they're going to be making money off 00:36:45.000 --> 00:36:46.550 it five years hence. 00:36:46.550 --> 00:36:49.340 So you've got this problem that regulators are going to 00:36:49.340 --> 00:36:51.390 have a natural tendency to be sort of friendly towards 00:36:51.390 --> 00:36:52.700 industry they're regulating. 00:36:52.700 --> 00:36:55.280 And that's going to lead to an upward bias. 00:36:55.280 --> 00:36:59.970 The question is, how much is that upward bias in the price 00:36:59.970 --> 00:37:02.160 relative to what the monopolist would actually do. 00:37:02.160 --> 00:37:03.860 And much like a patent, it depends. 00:37:03.860 --> 00:37:05.850 You can draw examples where the government regulation 00:37:05.850 --> 00:37:08.180 would improve things and examples where the government 00:37:08.180 --> 00:37:09.730 regulation would make things worse. 00:37:09.730 --> 00:37:11.490 You can do examples either way. 00:37:11.490 --> 00:37:14.170 And what, at least, is interesting here is this is 00:37:14.170 --> 00:37:15.623 the first example we've seen or one of the few examples 00:37:15.623 --> 00:37:16.670 we've seen where the government, at least, could 00:37:16.670 --> 00:37:18.270 possibly make things better. 00:37:18.270 --> 00:37:19.730 Even though it's not clear they will. 00:37:19.730 --> 00:37:21.600 At least, they could possibly make things better. 00:37:21.600 --> 00:37:22.710 And that's because-- 00:37:22.710 --> 00:37:23.365 Why is that? 00:37:23.365 --> 00:37:24.910 This is a very important insight. 00:37:24.910 --> 00:37:25.740 Why is that? 00:37:25.740 --> 00:37:27.530 That's because everything we've dealt with so far, the 00:37:27.530 --> 00:37:29.710 market does everything well. 00:37:29.710 --> 00:37:31.280 We haven't needed a government. 00:37:31.280 --> 00:37:34.290 What natural monopolies do is they say, wow, here's a case 00:37:34.290 --> 00:37:36.970 of what we call a market failure. 00:37:36.970 --> 00:37:40.480 The market has failed to maximize social surplus. 00:37:40.480 --> 00:37:44.860 And that opens the door for potential gains for government 00:37:44.860 --> 00:37:46.220 intervention. 00:37:46.220 --> 00:37:49.130 Basically, as long as markets are functioning well in a 00:37:49.130 --> 00:37:52.650 competitive manner, there's no door open for the government 00:37:52.650 --> 00:37:53.270 to make things better. 00:37:53.270 --> 00:37:55.590 The government can just make things worse. 00:37:55.590 --> 00:37:58.640 It's only when there's market failures, of which natural 00:37:58.640 --> 00:38:02.720 monopoly is one example, can the government come in and 00:38:02.720 --> 00:38:03.730 potentially make things better. 00:38:03.730 --> 00:38:06.170 It won't necessarily do so. 00:38:06.170 --> 00:38:09.210 But at least there's a door open to doing so. 00:38:09.210 --> 00:38:11.840 Questions about that-- 00:38:11.840 --> 00:38:14.990 OK, the last thing I want to talk about, today, is an 00:38:14.990 --> 00:38:20.160 example that's in between a natural monopoly and no 00:38:20.160 --> 00:38:22.200 natural monopoly, which is what we call 00:38:22.200 --> 00:38:23.460 a contestable market. 00:38:29.890 --> 00:38:31.610 A contestable market-- 00:38:31.610 --> 00:38:36.080 A contestable market is one which says that there is a 00:38:36.080 --> 00:38:41.180 natural monopoly, but it's not so big that someone couldn't 00:38:41.180 --> 00:38:44.860 come in and compete if the profits got too large. 00:38:44.860 --> 00:38:47.960 Or another way of saying this is, just because there's a 00:38:47.960 --> 00:38:52.020 monopoly doesn't mean there's a whole lot of market power. 00:38:52.020 --> 00:38:53.800 Just because there's a monopoly doesn't mean there's 00:38:53.800 --> 00:38:55.750 a whole lot of market power. 00:38:55.750 --> 00:38:58.740 So imagine a natural monopoly market with a very modest 00:38:58.740 --> 00:39:02.030 fixed cost, a fixed cost that's, you know, 00:39:02.030 --> 00:39:05.440 real but not enormous. 00:39:05.440 --> 00:39:08.700 As long that monopolist who gets in first keeps their 00:39:08.700 --> 00:39:12.940 price near marginal cost, no will ever enter. 00:39:12.940 --> 00:39:14.770 As long as they get their price near marginal cost, no 00:39:14.770 --> 00:39:16.700 one will enter, even if they're making a small profit. 00:39:16.700 --> 00:39:21.090 No one will enter because no one could ever make money then 00:39:21.090 --> 00:39:21.690 and pay the fixed. 00:39:21.690 --> 00:39:23.340 No one could ever come in, pay the fixed cost, 00:39:23.340 --> 00:39:24.940 and still make money. 00:39:24.940 --> 00:39:26.720 So no one's ever going to enter. 00:39:26.720 --> 00:39:30.370 But if that price ever got too far above marginal cost, then 00:39:30.370 --> 00:39:32.210 someone would say, ah, there's so much profit to be made. 00:39:32.210 --> 00:39:33.210 That'll cover my fixed costs. 00:39:33.210 --> 00:39:34.960 I'm coming in. 00:39:34.960 --> 00:39:37.260 That's what we mean by contestable market, a market 00:39:37.260 --> 00:39:41.010 which can exist with a monopoly and can exist with 00:39:41.010 --> 00:39:41.880 someone making money. 00:39:41.880 --> 00:39:47.630 And yet ultimately, there's sufficiently easy entry that, 00:39:47.630 --> 00:39:52.100 basically, the monopolist is forced to behave almost like a 00:39:52.100 --> 00:39:53.250 competitive firm. 00:39:53.250 --> 00:39:56.410 So it's sort of like market pressure on monopolists. 00:39:56.410 --> 00:39:59.080 It's a weird outcome where you get a monopoly market but 00:39:59.080 --> 00:40:01.670 pricing close to competitive levels because of 00:40:01.670 --> 00:40:04.290 this threat of entry. 00:40:04.290 --> 00:40:07.910 Now the most famous example of this is in airlines and 00:40:07.910 --> 00:40:10.620 airline deregulation. 00:40:10.620 --> 00:40:14.900 Until the 1970s, the way airlines worked in the US is 00:40:14.900 --> 00:40:16.400 there were private airline companies. 00:40:16.400 --> 00:40:18.750 Many of them don't exist anymore, Eastern, Pan Am. 00:40:18.750 --> 00:40:21.290 Ones you don't know about, don't exist anymore. 00:40:21.290 --> 00:40:24.010 And they were regulated. 00:40:24.010 --> 00:40:25.650 It was a regulated oligopoly. 00:40:25.650 --> 00:40:26.940 We haven't really talked about oligopolies yet. 00:40:26.940 --> 00:40:28.150 It was a few firms competing. 00:40:28.150 --> 00:40:29.490 But think of it as a monopoly. 00:40:29.490 --> 00:40:31.540 It's basically regulated monopoly. 00:40:31.540 --> 00:40:33.380 In particular, they had monopolies 00:40:33.380 --> 00:40:34.570 on different routes. 00:40:34.570 --> 00:40:35.630 So what happened is the government would 00:40:35.630 --> 00:40:38.120 say New York to Boston. 00:40:38.120 --> 00:40:41.740 That is the route that Eastern Airlines owns. 00:40:41.740 --> 00:40:44.930 And they fly that without competition. 00:40:44.930 --> 00:40:46.940 But in order to make sure they don't rip off the consumer, 00:40:46.940 --> 00:40:49.200 we're going to regulate their prices. 00:40:49.200 --> 00:40:50.950 So Eastern Airlines, you fly this without competition. 00:40:50.950 --> 00:40:52.260 But we're going to regulate what you 00:40:52.260 --> 00:40:54.750 can charge the consumer. 00:40:54.750 --> 00:40:57.350 And this was because the government viewed airlines as 00:40:57.350 --> 00:40:58.050 a natural monopoly. 00:40:58.050 --> 00:41:01.750 It said, look, airplanes are really big and expensive. 00:41:01.750 --> 00:41:04.720 There's huge fixed cost to becoming an airline. 00:41:04.720 --> 00:41:05.990 So we think this is a natural monopoly. 00:41:05.990 --> 00:41:08.650 And we're going to regulate it. 00:41:08.650 --> 00:41:10.750 However, economists started pointing out, and experts 00:41:10.750 --> 00:41:14.580 started pointing out that no, in fact, this was actually a 00:41:14.580 --> 00:41:16.150 very contestable market. 00:41:16.150 --> 00:41:17.400 That it turned out it wasn't that 00:41:17.400 --> 00:41:18.360 expensive to produce airplanes. 00:41:18.360 --> 00:41:20.610 There were a lot of older airplanes you could 00:41:20.610 --> 00:41:22.960 refurbish, et cetera. 00:41:22.960 --> 00:41:24.620 And that basically this is a market where, if the 00:41:24.620 --> 00:41:27.120 government opened it up to competition, you could 00:41:27.120 --> 00:41:28.680 actually get some-- 00:41:28.680 --> 00:41:29.720 That threat of entry eventually could 00:41:29.720 --> 00:41:32.620 drive prices down. 00:41:32.620 --> 00:41:34.535 And so basically, after a lot of debate, the government, in 00:41:34.535 --> 00:41:37.960 the late 1970s, did deregulate airlines. 00:41:37.960 --> 00:41:39.965 One of the most important changes in government policy 00:41:39.965 --> 00:41:42.880 in the 1970s was they deregulated airlines. 00:41:42.880 --> 00:41:44.390 And what happened? 00:41:44.390 --> 00:41:46.270 Well, three things happened. 00:41:46.270 --> 00:41:49.520 First of all, prices fell enormously. 00:41:49.520 --> 00:41:51.790 Prices fell by about a third. 00:41:51.790 --> 00:41:53.980 Flying from point A to point B fell by a third, other places 00:41:53.980 --> 00:41:55.050 more extreme. 00:41:55.050 --> 00:41:59.040 When I was an undergraduate at MIT, I could fly from Boston 00:41:59.040 --> 00:42:02.000 to Newark for $19 each way. 00:42:02.000 --> 00:42:04.490 There was this airline called People's Express that was 00:42:04.490 --> 00:42:06.880 introduced in the wave of deregulation in the 1980s. 00:42:06.880 --> 00:42:07.590 People's Express-- 00:42:07.590 --> 00:42:08.680 It was fascinating. 00:42:08.680 --> 00:42:11.440 I don't know what their planes were held together by. 00:42:11.440 --> 00:42:14.510 And the thing was, you didn't even buy a ticket. 00:42:14.510 --> 00:42:15.920 You just went and waited on line. 00:42:15.920 --> 00:42:16.830 They let you on the plane. 00:42:16.830 --> 00:42:18.240 And when the plane was full, they took off. 00:42:18.240 --> 00:42:20.350 And they made you pay on the plane. 00:42:20.350 --> 00:42:21.740 I still, to this day, don't know what happened if you 00:42:21.740 --> 00:42:23.350 didn't have the money, if they like threw you off, get 00:42:23.350 --> 00:42:24.070 parachutes or something. 00:42:24.070 --> 00:42:25.320 I don't know what they did. 00:42:25.320 --> 00:42:26.880 But literally, they'd come down the middle of the aisle 00:42:26.880 --> 00:42:28.720 with a little credit card thing. 00:42:28.720 --> 00:42:30.030 And they'd make you pay on the plane. 00:42:30.030 --> 00:42:33.065 I mean literally, it was cheaper than taking a bus. 00:42:33.065 --> 00:42:37.400 It was incredible, $19 each way. 00:42:37.400 --> 00:42:40.240 So prices came way, way down. 00:42:40.240 --> 00:42:42.640 The second effect was many more routes 00:42:42.640 --> 00:42:44.200 were offered to consumers. 00:42:44.200 --> 00:42:47.040 Suddenly, routes which the government had said, no that's 00:42:47.040 --> 00:42:47.740 not profitable. 00:42:47.740 --> 00:42:49.140 You shouldn't fly that. 00:42:49.140 --> 00:42:50.910 New entrants said, no, in fact, it is profitable, 00:42:50.910 --> 00:42:51.220 government. 00:42:51.220 --> 00:42:53.040 You just had the cost structure wrong. 00:42:53.040 --> 00:42:57.070 And it is profitable to fly from Pittsburgh to Akron, or 00:42:57.070 --> 00:43:00.670 whatever, wherever they now fly. 00:43:00.670 --> 00:43:03.140 There are hundreds more places you can fly now than you could 00:43:03.140 --> 00:43:04.520 in the 1970s. 00:43:04.520 --> 00:43:07.220 Hundreds and hundreds of routes that just didn't exist 00:43:07.220 --> 00:43:08.350 because the government regulators assumed they 00:43:08.350 --> 00:43:09.250 weren't profitable. 00:43:09.250 --> 00:43:10.210 But in fact, they were. 00:43:10.210 --> 00:43:13.180 Once there was competition in these contestable markets, 00:43:13.180 --> 00:43:14.430 they did turn out to be profitable. 00:43:16.660 --> 00:43:20.200 And the final thing that happened was that quality of 00:43:20.200 --> 00:43:23.870 airline travel deteriorated massively. 00:43:23.870 --> 00:43:25.920 When I was a kid, and you flew on planes. 00:43:25.920 --> 00:43:27.580 It was really nice. 00:43:27.580 --> 00:43:29.420 I mean there was tons of leg room. 00:43:29.420 --> 00:43:33.820 You got tons of free food, free movies, free drinks. 00:43:33.820 --> 00:43:34.690 And I didn't do that when I was a kid. 00:43:34.690 --> 00:43:35.640 My parents did. 00:43:35.640 --> 00:43:39.120 Basically, it was an unbelievably nice experience. 00:43:39.120 --> 00:43:40.490 It's not so nice now. 00:43:40.490 --> 00:43:42.680 I think as any of you who have flown will attest to. 00:43:42.680 --> 00:43:43.920 Now they're charging you for everything. 00:43:43.920 --> 00:43:47.650 And you can barely fit your legs in if you're over 5'2". 00:43:47.650 --> 00:43:51.490 Now, why did this happen? 00:43:51.490 --> 00:43:52.100 Somebody tell me. 00:43:52.100 --> 00:43:53.080 Why did this happen? 00:43:53.080 --> 00:43:56.260 Why did deregulation lead from a world where flights were 00:43:56.260 --> 00:44:00.890 unbelievably comfy to a world where flights are uncomfy? 00:44:00.890 --> 00:44:01.155 Yeah. 00:44:01.155 --> 00:44:04.408 AUDIENCE: It's more profitable to have more people taking it. 00:44:04.408 --> 00:44:04.906 And-- 00:44:04.906 --> 00:44:06.490 PROFESSOR: Sure, but that was always true. 00:44:06.490 --> 00:44:07.800 It was always more profitable to have 00:44:07.800 --> 00:44:08.650 more people on a plane. 00:44:08.650 --> 00:44:11.070 It was always more profitable to not give them nice stuff. 00:44:11.070 --> 00:44:12.080 That hasn't changed. 00:44:12.080 --> 00:44:13.000 What has changed? 00:44:13.000 --> 00:44:13.340 Yeah. 00:44:13.340 --> 00:44:14.663 AUDIENCE: You have-- there's competition. 00:44:14.663 --> 00:44:16.380 So they need to reduce their cost more. 00:44:16.380 --> 00:44:17.253 PROFESSOR: What's that? 00:44:17.253 --> 00:44:18.702 AUDIENCE: There's more competition. 00:44:18.702 --> 00:44:21.120 So they need to reduce their cost. 00:44:21.120 --> 00:44:22.300 PROFESSOR: There is more competition. 00:44:22.300 --> 00:44:24.620 But there was some competition before. 00:44:24.620 --> 00:44:25.470 But you're right. 00:44:25.470 --> 00:44:26.440 Your about halfway there. 00:44:26.440 --> 00:44:27.063 What else? 00:44:27.063 --> 00:44:29.485 AUDIENCE: Consumers aren't willing to pay for leg room 00:44:29.485 --> 00:44:29.970 and all that stuff. 00:44:29.970 --> 00:44:33.260 PROFESSOR: Basically before, if there was a route with two 00:44:33.260 --> 00:44:34.730 airlines on it-- 00:44:34.730 --> 00:44:35.970 A lot of them, I said there's two airlines. 00:44:35.970 --> 00:44:37.320 And you wanted to compete. 00:44:37.320 --> 00:44:38.490 How did you compete? 00:44:38.490 --> 00:44:40.210 You couldn't compete on price. 00:44:40.210 --> 00:44:41.285 Right? 00:44:41.285 --> 00:44:44.660 If Eastern and Pan Am were flying New York to Boston, 00:44:44.660 --> 00:44:45.900 they couldn't compete on price. 00:44:45.900 --> 00:44:46.720 The price was regulated. 00:44:46.720 --> 00:44:48.960 So how did they compete, by being as nice as possible on 00:44:48.960 --> 00:44:51.600 everything else, even though consumers didn't 00:44:51.600 --> 00:44:53.170 really value it. 00:44:53.170 --> 00:44:55.080 Well, once they competed on price, they said, look, 00:44:55.080 --> 00:44:56.650 consumers don't really care so much about this 00:44:56.650 --> 00:44:58.650 crappy airline food. 00:44:58.650 --> 00:45:01.380 We're going to get rid of it and charge 20% less. 00:45:01.380 --> 00:45:03.960 And lo and behold, they did. 00:45:03.960 --> 00:45:06.180 What's ironic, of course, is everyone bitches about how bad 00:45:06.180 --> 00:45:08.050 airlines are. 00:45:08.050 --> 00:45:10.800 But they don't bitch about how cheap they are. 00:45:10.800 --> 00:45:13.990 It is so cheap to fly now, compared to when I was a kid. 00:45:13.990 --> 00:45:16.080 Based on what happened is they went from competing on 00:45:16.080 --> 00:45:19.240 non-price factors to competing on price. 00:45:19.240 --> 00:45:21.570 There's always competitive pressure. 00:45:21.570 --> 00:45:22.760 There's always competitive pressure. 00:45:22.760 --> 00:45:24.610 It's just before, the competition had to be on 00:45:24.610 --> 00:45:26.160 things which consumers didn't like. 00:45:26.160 --> 00:45:28.030 But they liked it enough that you might as 00:45:28.030 --> 00:45:28.770 well compete on it. 00:45:28.770 --> 00:45:30.130 Because it was not that consumers didn't like it all. 00:45:30.130 --> 00:45:31.050 Obviously they liked it some, or they 00:45:31.050 --> 00:45:32.750 wouldn't have bothered. 00:45:32.750 --> 00:45:35.250 Now they've moved to a more efficient form of competition, 00:45:35.250 --> 00:45:38.770 which is to compete on price rather than on quantity. 00:45:38.770 --> 00:45:39.251 Yeah. 00:45:39.251 --> 00:45:41.014 AUDIENCE: When you said the government regulated the 00:45:41.014 --> 00:45:43.580 price, only wasn't that just on the upper level 00:45:43.580 --> 00:45:44.542 that you got that? 00:45:44.542 --> 00:45:45.790 PROFESSOR: No. 00:45:45.790 --> 00:45:48.560 The government just regulated the price. 00:45:48.560 --> 00:45:51.680 Now, so this is a big victory for economists. 00:45:51.680 --> 00:45:53.370 Yay for economists-- 00:45:53.370 --> 00:45:54.220 We did a great job. 00:45:54.220 --> 00:45:57.430 But we whiffed on one thing. 00:45:57.430 --> 00:46:01.130 We whiffed on one thing, which we did not foresee, which has 00:46:01.130 --> 00:46:03.620 led deregulation to be much less beneficial than we 00:46:03.620 --> 00:46:05.150 thought it was going to be. 00:46:05.150 --> 00:46:08.990 What we whiffed on was the hub and spoke system. 00:46:08.990 --> 00:46:12.780 We whiffed on the fact that, while building airplanes is 00:46:12.780 --> 00:46:18.200 contestable, building slots at airports is not. 00:46:18.200 --> 00:46:20.190 That there's a limited number of slots at airports. 00:46:20.190 --> 00:46:23.020 And it's incredibly hard to build a new airport because of 00:46:23.020 --> 00:46:25.320 environmental regulations and other things. 00:46:25.320 --> 00:46:28.770 What that meant was there is still a natural monopoly in 00:46:28.770 --> 00:46:30.780 airport slots, even if there's not much of a 00:46:30.780 --> 00:46:32.970 natural monopoly in planes. 00:46:32.970 --> 00:46:36.920 The result is that now what airlines do is funnel everyone 00:46:36.920 --> 00:46:41.570 through their hub and then out to the spokes. 00:46:41.570 --> 00:46:44.990 And as a result, because of that they have developed new 00:46:44.990 --> 00:46:46.440 quasi monopolies. 00:46:46.440 --> 00:46:48.820 So to fly from point A to point B, for many A's and B's, 00:46:48.820 --> 00:46:50.150 only one airline flies it. 00:46:50.150 --> 00:46:51.670 Because it's economical for them because 00:46:51.670 --> 00:46:53.210 point A is their hub. 00:46:53.210 --> 00:46:55.460 But airline B can't get into that hub. 00:46:55.460 --> 00:46:57.830 They can't get a gate at that hub. 00:46:57.830 --> 00:47:01.060 So as a result, they can't effectively fly from A to B. 00:47:01.060 --> 00:47:02.940 So my wife is from Minneapolis. 00:47:02.940 --> 00:47:03.960 We had to go to Minneapolis. 00:47:03.960 --> 00:47:06.420 Northwest had a monopoly on going to Minneapolis. 00:47:06.420 --> 00:47:09.890 So I could fly from Boston to LA for half the price of 00:47:09.890 --> 00:47:12.410 Boston to Minneapolis. 00:47:12.410 --> 00:47:15.680 Why, because Northwest controlled all the gate slots 00:47:15.680 --> 00:47:16.560 in Minneapolis. 00:47:16.560 --> 00:47:18.790 They had a natural monopoly on that resource. 00:47:18.790 --> 00:47:20.160 And that's what economists missed. 00:47:20.160 --> 00:47:23.170 So deregulation worked in some markets with a lot of 00:47:23.170 --> 00:47:23.550 competition. 00:47:23.550 --> 00:47:27.180 Like the New York to LA market is very competitive. 00:47:27.180 --> 00:47:29.740 It did not work in other markets, where there was this 00:47:29.740 --> 00:47:31.030 natural hub. 00:47:31.030 --> 00:47:35.590 And so one airline could dominate. 00:47:35.590 --> 00:47:37.040 Or a few airlines could dominate. 00:47:37.040 --> 00:47:38.660 And that's why you could see some crazy pricing 00:47:38.660 --> 00:47:40.180 differentials. 00:47:40.180 --> 00:47:41.490 That's why, for example, I could fly to 00:47:41.490 --> 00:47:43.510 Baltimore for $127. 00:47:43.510 --> 00:47:48.480 But to DC, it cost me $500, even though they're less than 00:47:48.480 --> 00:47:50.640 an hour apart by car. 00:47:50.640 --> 00:47:55.800 This is because the constraint on slots has limited the 00:47:55.800 --> 00:47:58.420 amount of competition that can go on. 00:47:58.420 --> 00:48:00.730 And so that's sort of an example of where competition 00:48:00.730 --> 00:48:03.040 can work and where it can't to try to deal with these natural 00:48:03.040 --> 00:48:04.460 monopoly problems. 00:48:04.460 --> 00:48:06.670 All right, let me stop there. 00:48:06.670 --> 00:48:08.690 And we'll come back on Wednesday 00:48:08.690 --> 00:48:09.930 and talk about oligopoly. 00:48:09.930 --> 00:48:12.550 Good luck tomorrow night on the exam. 00:48:12.550 --> 00:48:13.400 It's tomorrow night? 00:48:13.400 --> 00:48:14.430 Yeah, tomorrow night. 00:48:14.430 --> 00:48:15.150 Good luck. 00:48:15.150 --> 00:48:17.030 Everyone looked confused for a second. 00:48:17.030 --> 00:48:18.100 Next week-- 00:48:18.100 --> 00:48:20.750 Oh-- 00:48:20.750 --> 00:48:23.570 OK, just joking, April fools, Halloween fools. 00:48:23.570 --> 00:48:24.820 Good luck next week on the exam.