Saul Levmore: Monopolies as an Introduction to Economics | Big ThinkApr 09, 2022
Hi, I'm Saul Levmore and I teach law or really
economicsand law at the University of Chicago. I have the good fortune to be her to present to you the topic of
economics. Well, what is economics? Let's play a game of free association. I say “economics”, you say whatever comes to mind. Economy: money. Economy: Wall Street, real estate bubble, prices, incentives. Ohh, yes you said incentives, that's pretty sophisticated. I
thinkit's easy to see why economics is relevant. The economy is everywhere. Economics is the reason buildings are built; Economy is the reason cookies cost $3.00. Economics is about getting the seat you want on the plane.
Economics, yes, is about making money, but it is about human behavior in general. Economics is to the real world around us what meteorology is to weather: it interprets all the phenomena and finds out if there is anything we can do about it. How could that not be relevant to each of us? That's a lot of what we're going to talk about today. Economics is, at least formally, the study of the allocation of scarce resources. You don't have enough of something, a lot of people want it, who gets it, how they get it, what they give for it, how do you get people to do more of it.
All that is economics. I'll say it again; Economics is about the allocation of scarce resources. Economics is also about puzzles. Economics likes to assume, just to make its job easier, that people are rational. You know, what is a rational person? The rational man is the one who sees that the price of wheat rises; He gets up earlier in the morning and grows more wheat on his farm. The economical person is the one who buys more of something when the price drops. That is the rational man. The rational man loves to download things from iTunes when the price of iTunes goes down, but the rational man also creates more music in his garage and sells it when the people who download it from iTunes pay him more.
One guy wants the low price; a guy wants the price to be high. They are using incentives to communicate with each other. So economics is about exchanges, economics is about prices and therefore it is about money and incentives. Once you've mastered those four things, you'll start putting your package together. I said economics was about puzzles. Economics is also about puzzles. And these enigmas are even deep mysteries and have a lot to do with how the economy began in the first place. The kings would be really confused about some things. They would issue new coins, the coins would go out into the kingdom and disappear.
Where were these coins going? Peter the Great, I just read the other day, beheaded about 1,000 people for hoarding coins. And he could never understand why, when he issued silver coins, people hid them or buried them in the fields. Why didn't they want to use these coins? What was so good about holding them? Well, that's the mystery that economics was intended to solve. Peter the Great hired advisors and wanted to figure these things out. How is it possible that countries trade in some things and not others? England and Portugal shipped wine and cheese back and forth, but some things never seemed to travel.
What was that for? From these enigmas arose the study of economics. And the people who advised these Kings can be considered the first economists. And economists continue to like puzzles ever since. Let's
thinkabout the sovereigns of our time. Think about something the government does and ask yourself why it does it. Then a fire breaks out. You can imagine a world where ten fire departments compete, you would look them up on the Internet and say, "Oh, how much do I need to put out my fire?" And people would run for prices to put out the fires.
That's not how it works. Instead, the government is in charge of fighting fires. Economists are very interested in that, you know? Why is the government in charge of putting out fires and not growing wheat? Why doesn't competition make firefighting work better or do governments somehow compete to see who is better at putting out fires? Of course, there is a bit of competition because if the government does a bad job putting out fires or plowing the streets in winter, voters will remove them and bring in new politicians. Still, that's not exactly using prices, but votes instead of prices.
And our job today is to understand the use of prices. Two of the things we will focus on today are prices and the form of competition. And let me tell you a little about them before we get there. Prices and competition or their opposite,
monopolies, are two central tools in the study of economics. Prices are those things that tell people how much something costs, how much they have to sacrifice to buy it, how important it is to make more of it. Today we will see many prices. By form of competition, I mean that the people who make these things either compete with other companies to make them or are the only ones making them.
A perfect competitor, economists like to say, is someone who is out there trying to sell you something or make something, and even though tons of other people are trying to do the same thing, they are competing to do it better or at a lower price. or whatever. When they are the only ones that exist, we call them monopolists. So monopoly is a way of producing goods. A perfect competitor, economists like to say, is someone who is out there trying to sell you something or make something, and even though tons of other people are trying to do the same thing, they are competing to do it better or at a lower price. or whatever.
The monopolist is someone who for some reason or another has the market for himself. And today we are going to dedicate a lot of our time to understanding what is interesting about
monopolies. Why governments care about them. Why governments sometimes even like monopolies. And why you and I might not like them as much. So monopoly is a way of producing goods. A perfect competitor, economists like to say, is someone who is out there trying to sell you something or make something, and even though tons of other people are trying to do the same thing, they are competing to do it better or at a lower price. or whatever.
The monopolist is someone who for some reason or another has the market for himself. But probably 10 or 20 of those tools, but today we'll have time for two of them and many applications of those tools. Now you can even think of government as a kind of monopoly. Sometimes we say that the government has a monopoly on power, you know, it's the only one that can have an army in most countries. But as we have already seen with the firefighting example, in reality the government claims the right to be a monopoly on many things. The government has a monopoly on making laws;
He has a monopoly on fighting fires, on being a police officer. It is a form of monopoly, but one that is more influenced by votes than by prices. But there are many, many, many other monopolies that the government allows. Think about the streets of your city. Well, if you had competition to produce and send water or electricity to people, you would have 10 or 15 companies digging in the street all the time, laying pipes, laying water, sending the electricity and water to your house. Nobody wants to tolerate that. So instead, most governments say: let's make that a monopoly.
We will either own it or one way or another we will hire a company to do it. We will only give one company the license to dig the streets and install the pipes. And then other companies may compete to sell water to your house or that monopolist will probably sell water to your house. That is why the government does not want many people to be digging in the street. On the other hand, you might recognize that there is a problem with having only one water supplier. We will focus on that supplier in a few minutes and, in any case, we already know how to call it a traditional monopolist.
While we talk about the government as a monopoly, keep in mind that the government does not charge you to put out fires. It is something curious that interests economists. The government charges you for water, but when it puts out a fire in your house, it doesn't charge you. You might even have rules that require you to have fire extinguishers or, in large buildings, sprinkler systems. Still, if Trump Tower burns down and the government comes and saves it before it burns to the ground, the government doesn't say to Donald Trump, "Oh, now you owe us a certain amount of money for saving your building." We might begin to wonder why this is so.
This is the kind of thing that economists are interested in. Here is another monopoly and another example of how we use markets sometimes but not others. Think about the university you are going to. When you first encountered that university, it was an intense competitor. Many universities were probably competing to get you to be a student there or, certainly, to pay the application fee. And you, in turn, were competing with many other applicants for places at the university. It was a very, very active market. Suddenly, it changed. You get admitted to a college, you enroll there, you show up, you need a dorm, very, very, very few colleges say, “Oh, the dorms on the third floor are better than the dorms on the second floor.
Let’s raise the price a little on the third floor.” No, no... suddenly, it's as if there was no market at all. Universities tend to hate prices. Universities act as if there were no market. Is a course crowded? They may tell you that you can take another time and they may add a section to the course. They could hire another teacher, they could fill the room with chairs, but the last thing they would do is say, "Okay, everyone who wants to pay $189, please come in and sit in the front row." Why is that? That's another good example of how sometimes we love markets and sometimes market actors, like the university in my example, control the market and say, “No, no, no. “There’s a reason we should be kind of a non-market community.” They probably gain something from this and lose something from this.
And again, those are the kinds of things that economists are very interested in understanding. And I hope you are too. In economics, the best way to understand big puzzles is to break them down into small puzzles. Small puzzles are not so easy, but large puzzles, as we will see, are really beautiful. They are beautiful to solve by putting these tools together, we can learn from the smallest puzzles. The key way we are going to solve these puzzles today and in the economy in general is by always thinking about these markets. Where is there a market? What are prices doing?
What is the competition doing? Do we have one monopolist or do we have many competitors running around? These are the tools that we will seek to use to solve problems. We want to understand the recent financial crisis that hit the world. We want to understand real estate bubbles. We will start with the prices. We will start with competition and then understand the role of government. So, let's start with the prices. When I say the prices are special, I mean that the prices do everything. Prices tell oil companies when to dig deeper for oil. Prices tell me when to fly.
Prices tell me when to fill my car with gasoline. Prices tell me whether to go to a restaurant early or go to a restaurant late. And in fact, when the restaurant doesn't offer price differences, I get a little disappointed. Sometimes on a rainy day I think, “Wow, I bet no one goes to the restaurant now. I wish the restaurant would lower the price and then I would want to go to the restaurant more. So sometimes we have prices and sometimes we don't, but when we do, they're a little magical. Now, this magic can be a little disconcerting.
And, in fact, prices have baffled economists for hundreds, if not thousands, of years. You know, why do things cost what they cost? You know, let's say I eat a chocolate chip cookie. Why does that cookie cost a dollar, or eighty cents, or three dollars, or whatever range? Why does it cost that amount? Well, first let's look at the enigma associated with it. You might be inclined to say, well, a really good cookie costs more. People really like it. You're forgetting that I said scarcity was important earlier, but that's okay. Well, you could say that the more important something is, the more it costs.
If I say a house costs $300,000 and a cookie costs $1.00, why does the house cost more than the cookie? Your initial response might be, well, people need more houses. The cookie is a luxury. Therefore, the house costs more. But that's not really a successful way to think about it. Consider the next classic example, air. The air is basically free. Take a big drink, as one ad used to say. The air is free. And then things like a diamond are classically super expensive. Economists used to say, “Why is a diamond more expensive than a breath of air?” Well, you already know the answer.
The answer, we should say, is scarcity. There are very, very few diamonds. You have to dig deep into the ground to get the diamond. Transport it thousands of miles, polish it, cut it, do this, do that. It's a lot of work, it's very difficult to get them, there aren't many. Diamonds are even more valuable than airplane aisle seats. Thediamonds are expensive. They are scarce. Air is available. You just inhale it. Even where it is not available, it is available. If you're going to dive, you just come up to the surface, catch some air in a tank, tanks are relatively cheap, you go under and you can breathe.
It costs you only a few dollars. We know the answer to that now. A thousand years ago, that might have been an enigma, but if I say, why is a diamond more expensive than air...more expensive than a breath of air? It is obvious that scarcity is what really gets the job done. Now, back to the cookies and the houses. That's a little more complicated. First let's make cookies. I love a good cookie. Imagine paying $10 for a really fantastic, moist chocolate chip cookie. My children always say that there is no such thing as juicy cakes. But that's wrong.
A really good cookie is juicy and worth 10 dollars. Now, I have never paid $10 for a cookie, although I would. So I go to the bakery, even my favorite bakery, and I walk in and I'm like, "Oh, how much are those fantastic cookies?" The baker knows that he would pay $10 for the cookie. You can see it all over my face. But he says, "Well, that cookie costs $3.00." Well, why don't you charge me 10 dollars? I mean, he could look me in the face when I walk in and charge me $10, but of course, if he did that, he'd go back to Todd's strategy.
He would just go out to the sidewalk, wait there. He would wait for someone else to come into the bakery and buy the cookie for $3.00 and he would come out and give them $3.05 or something like that for the cookie. So sometimes we say, the baker cannot discriminate prices between people. The baker has to sell the cookies at a single price because otherwise people will come in and arbitrage the cookies, creating a market like Todd tried to create a market for aisle and middle seats. Well, that doesn't answer the question of why the cookie costs $3.00. Let's imagine that the cookie sells for $5.00.
The baker sees that there are some people who really want the cookie. The baker begins to increase his price and charge $5.00. What will happen next? Well, other people will see: you could make a lot of money running a bakery. Just gather chocolate chips, rent an oven, get some flour, get the other ingredients needed to make chocolate chip cookies and you will start making cookies and the price will start to drop as more and more people offer cookies. They will mark each other down by $4.50, $4.00, $3.99. Until the price drops to, well… the amount it will cost that marginal bakery to produce that chocolate chip cookie.
So, prices are inputs that tell the baker how to make the cookies, the price of the cookie tells me how to buy the cookie. And my wish for the cookie is to bring new competitors to the industry. In the long run, the price of that cookie will be the cost of combining the inputs. It will be based on the cost of supplying the cookie. In the short term, if there is a lot of demand for cookies, the price could rise. If suddenly a hundred people, like me, run into the store and say we all want the cookie, maybe the baker can raise the price a little so he can distribute the cookies there.
But if that keeps happening, new bakers will enter the industry; Bakeries will pop up all over the street and cookies will drop to $3.00, which is the cost of producing them. Let's compare it with that house. Let's say you have a house that sells for $300,000. What does that mean? It means that builders who are trying to put together windows and bricks and doors and roofs and subzero refrigerators or whatever goes into the house, put all those things together and maybe there's a huge demand for housing, maybe incomes have gone up, maybe a war has come. an end.
Maybe someone can sell that house for $500,000. If so, new construction contractors will enter, just as bakers entered the previous market. They will start selling more houses, they will build houses; They will work overtime. And they will build houses and build houses and the price of housing will fall, again, until it reaches an equilibrium, we say, in which the marginal builder can produce such a house for $300,000. The price will not drop any further because, presumably, no builder can show up and assemble those supplies for less than $300,000. One builder might be better than another builder at building them.
In that case, maybe that builder can actually build a house for $280,000 and make a $20,000 profit. But once we run out of those builders, we're left with the typical builder who can build the house for $300,000. So, in the long run, the answer to the question: why is that house more expensive than that cookie? The answer is a little boring, but it's not a shortage. The answer is that, in the long run, that is the cost of the supplies needed to put those things together. Simply, in a certain sense, it costs the Earth more to produce the house than to produce the cookie, based to some extent on the scarcity of those inputs, but in the long term because new competitors may appear;
The key variable is the sum of the cost of all those inputs. Once again, prices are messengers. Prices are little messengers that come and go. When the price of the house rose to $500,000, it was as if messengers came out and told the builders: “Quick, work overtime; build more houses.” They told the brick kilns to produce more bricks. When the price started to drop, imagine a bunch of empty houses everywhere, messengers would run around and say, "Houses aren't selling for $300,000 or less because there's a glut of houses." Builders will not get up in the morning to build houses.
There's no need to hit that hammer if you're not going to get paid for it. The same goes for the baker: prices come and go, telling bakeries when to produce more cookies, when to produce fewer cookies, when to open new stores, etc. Prices are messengers. Good to Know. CHAPTER TITLE: Demand Economists like to use the word “demand” to refer to the consumer side of the transaction. How much do people want the cookie? How much do people want new houses? Prices are probably the best way to measure how strongly people prefer something. And again, prices are a way to gauge demand.
The more people paid, the greater the demand for the good. However, what we saw was that, in the long run, for competing objects like cookies in a bakery or houses in the real estate market, what mattered most was the cost of supplying them. But there are exceptions to this. You know, imagine, you know, a fashion bag. The cost for a designer to put together this bag could actually be $40. But the bag could sell for 10 times as much. That's an exceptional market and it's worth thinking about what's happening there. Of course, there are imitations and the same designer can produce more bags.
But in the short term, the designer seems to realize that selling this bag for $400, well above the cost of inputs, that is, the cost of assembling the bag, somehow skyrockets the market. The higher price, in this sense, seems to attract people to the good for a while because it is a fashion trend or a signal to them that it is a fashion item to buy. There are people who want to carry this bag because it's unique or there are people who are maybe even pointing out, "Look, I can afford a $400 bag." Well, that's not going to last long, is it?
We don't see a fashion trend like that lasting very long because in the long run, people will produce competing bags or that designer will produce more bags or there will be knockoffs that are so good that no one will be able to tell them apart. . Same with sneakers. You know, I have boring running shoes and even more boring shoes. And I pay, you know, maybe 80 bucks for them. All around me I see colorful, modern footwear, which is actually cheaper to put together, practically a tarp and rope, but do they cost much more money than that? Again, why is that?
Well, that's the demand side. That there is a short-term fashion trend, in a way, where people really want the thing, thousands of them are made, they need to be allocated, they are allocated through the price mechanism. The higher price, in this sense, seems to attract people to the good for a while because it is a fashion trend or a signal to them that it is a fashion item to buy. Again, that doesn't last long. We'll learn more about this later in the conference when we move on to housing bubbles. There could be a bubble for something like sneakers.
The price could go up a lot before more sneakers flood the market or the trend fades. I don't think you'll ever find a bubble for chocolate chip cookies. That's basically based on the cost of assembling the cookie, and many, many other people can come into the industry and produce the cookie and drive the price down. It's hard to imagine a sustainable bubble for cookies. Handbags, some types of housing, and certainly sneakers, can be sold over a period of time at a price higher than the cost of assembling them. And it's something we need to be aware of.
A long time ago, before you were born, the Internet did not exist. I know it's hard to believe, but believe me, I've been there and it's true. And in the pre-Internet world, prices weren't just small messengers; I think it's fair to say that prices were everything. There were classified ads in the newspapers and they were all about prices. You know, looking for a 2006 Audi, $4,000. Everything was associated with a price. The billboards talked about prices. McDonalds ads were about prices. After all, prices are key information. It's those messengers I keep talking about. But there is an interesting development in the Internet world: as we have more and more information about goods, my observation is that more of the information refers to non-price attributes of the goods.
So, for example, if you go to Amazon and you want to buy a book, the price is there. They will give you the retail price and tell you what a good price you can get on Amazon. But probably 95 percent of the information is reader reviews or the condition of the book, if it's a used book. A lot of information is provided that is not about pricing. I think it's a function of the Internet. It is much cheaper to transmit information now than it was 100 years ago. And as a result, we have not only prices, but a large amount of non-price information.
And this could also be a result of wealth. You know, once I might have said, “Ohh, I want to go on vacation and stay in a hotel. How much does a hotel cost on the English coast? And then I would get a response. Now, oh well, do you want air conditioning? Do you want a big room, a small room, how many square feet do you want? I mean, there's a lot of information related to this. And this is probably a function of an affluent society where people don't just want a hotel room in England, they want a particular location, they want a type of room, the right environment and a lobby, and all that information is being distributed. provided with 360 degree accuracy on the Internet.
So it may be that we are moving towards a period where, although prices are messengers, there are many, many more messengers out there and they are these non-price attributes, as economists would call them. CHAPTER TITLE: Arbitrage: Creating a Market A couple of Thanksgiving days ago, I was sitting on a plane full of people. I was lucky enough to have an aisle seat. Sitting next to me was a very tall, very tall, very nice student named Todd, and we chatted a little. And he asked me what I did and I told him. And as soon as I told him that, he said, probably correctly, “Oh, well, I guess you're comfortable talking about money. "Listen, how about you trade seats with me for $50?" I was a little surprised.
And Todd said, “You know, I'm a big guy, I'm six foot eight, these middle seats are tight on me. I really want an aisle seat. So every time I get on a plane I'm in the middle seat, I try to negotiate with the person next to me to get me the aisle seat so I can stretch my legs. Fifty dollars? I said, "Sure." I don't really care that much about the middle seat and besides, maybe the guy in the window seat was as interesting as Todd. Let me ask Todd to tell me more about his negotiation for these seats.
And he said, “Actually, now that you mention it, I probably asked people 12 or 15 times to sell me his seat for $50, and you're the first person to do that.” Well, actually one time, he said, about two years ago, he was really frustrated but no one had accepted his offer and he told the person. “Okay, I’ll give you $300 for that aisle seat right now.” And as if on command, the person in the hallway said, “$300? Sure." Now think a little about Todd and the study of economics. We saw that economics was about the allocation of scarce resources. It's the study of how we allocate scarce resources.
Well, the scarce resource is aisle seats. There are fewer seats in the aisle than peoplewho love them. It's scarce, at least on that plane. Now there is no market either. Todd wishes there had been a big marketplace where you got on the plane or used your computer and saw what seats were available and what seat you wanted and you could bid on your seat. Todd was apparently willing to pay $50 to get an aisle seat, but at least so far, no airline says, "Oh, you can upgrade to the aisle seat if you give me $47.80." So Todd was trying to create the market on his own.
Of course, it's a complicated market, in a sense; he had to create two markets. He had to sell his middle seat and buy an aisle seat. Now people do that on Wall Street and make hundreds of millions of dollars. On Wall Street we call it arbitrage. They look for things that they think are priced incorrectly where money can be made by selling one thing and buying another and perhaps doing it backwards and forwards many, many times in a day. In a way, that's what Todd was trying to do, except he didn't have a well-developed market. Todd wished these markets had existed, but he said he had to create them.
He was trying to referee the middle seats and the aisle seats. Todd isn't the only one who really wants an aisle seat. And one wonders how airlines assign these seats. Some airlines do it on a first-come, first-served basis. When I buy a seat to travel I get on and click and it offers me to change seats and shows me the available seats, but there is no way I can exchange with people who purchased seats before me. Some airlines do it with a queue. For example, Southwest Airlines. If you get up early in the morning or have an automatic schedule, an app, you sign up and you're one of the first to check in, you get a good number, you're at the front of the line, at the front of the line and then you can get the seat you want.
Some airlines sell seats in the sense that I suppose Todd could buy a business class or first class seat for much, much more money. So there are many ways we allocate things, prices are just one of them. But the prices are special. Economists would say that prices are a means of showing the intensity of your preference. If you really want an aisle seat, you pay $50 for it. If you really want an aisle seat, you can pay $120 for it. Similarly, if you don't care, you could sell, you could sell at the low price or the high price.
You can think about the prices… now pay attention to this. Prices can be thought of as little messengers that go back and forth between the people who want things and the people who can provide them. When I click on the website and say, "Oh, I want this seat." The seller, that is, the airline, now knows, "Oh, there is someone who really wants that seat and could pay more for it." And similarly, when the airline lowers or raises a seat on the plane, it tells me how many of those seats it has and tries to determine if I want that seat.
When I flew on Thanksgiving Day, I paid a lot of money for the seat. When I fly on a Sunday morning in mid-February, the seat prices are much lower. Good? Airline programs see when there is increasing demand for seats on the plane. When there is more demand, prices start to rise because they want to allocate the scarcest source and I'm not just talking about the aisle seats, I'm talking about all the seats. You want to allocate that scarcer resource so that people will pay more for it, because that's how the airline will make more money. And similarly, when the program sees that the airline is about to fly half empty, it drops the price precipitously to attract people who are only willing to fly at a lower price.
CHAPTER TITLE: Non-competitive markets We have been talking about cookies and houses and they are sold in competitive markets. Once again, when I talk about competitive markets I don't mean anything complicated. It's just that there are a lot of buyers and sellers running around trying to serve each other, get the business, buy the item at a lower price and all that. These markets are the basis of the economy; Economists spend a lot of time on competitive markets. But not everything is sold in a competitive market and perhaps less than ever. For example, nonprofit organizations occupy the healthcare field.
Nonprofits are important in education. Non-profit organizations are important in providing goods to the poor, etc. Governments are not competitive companies. Either they are monopolists or something else. Governments supply a lot. They provide national defense, firefighting, national parks, schools and this and that. And they are also monopolists. Monopolists again are sole sellers, traditionally. They have a market to themselves. Think of all the monopolists we know. iPads are sold in monopolistic markets because Apple has patents on critical aspects of the iPad. Now you could say, well, an iPad has competitors from other tablets or PCs in general. But there are many people who really want what the iPad can offer them.
So to some extent, Apple has a monopoly on selling iPads. To some extent, it is a competitor that sells in the PC market or in the tablet market. Many products are like this. Let's say a new animated movie comes out. I want to go see the movie. The creator of the film has a copyright on that film and can decide in which theaters it will be sold, that is, seen. And in a sense he has some control over the exhibition price of the film. They can offer the movies as a direct download; They can offer the movie in hardcore format or however you want.
Well, again, is that a perfect market? Is that a monopolist? It's somewhere in between. I don't have to go to the movies. You might be just as happy to go see another movie, go to a concert, or go to a baseball game. But to some extent, people who want to see that movie are forced to get it from the movie provider, who has a monopoly on the copyright. Professional football games have that kind of monopoly. Again, no one has a monopoly on a chocolate chip cookie. The chocolate chip cookie is practically a staple. Nobody has that commodity in a steel ingot.
You can produce that, it's a commodity; It's everywhere. It's like water and air. So there are a lot of things: health care, government services, firefighting, iPads, a bridge over the Mississippi River connecting Iowa to Illinois. This is a pretty effective monopoly because no one will get permission to build eight bridges next to each other and compete. Again, what we might consider a situational monopoly there. We are going to spend some time analyzing monopolies as probably the best example of these ways of selling things without competition. And we're going to learn a lot of lessons from that, but we'll track pricing as we do.
So again, to review where we are; Prices largely come from costs, but also from supply and demand. As we will see, this is surprisingly true for monopolists, where demand will play a large role in the price the monopolist charges. Let's look at those pricing and messaging systems a little more closely, while thinking about an example where the airline is no longer a competitor, where many, many airlines fly, but let's now start introducing the idea of the monopolist. That is the seller who has no competition, but he is the only one selling these seats. CHAPTER SUBTITLE: Big Air;
The airline as a monopolist Let's try an example together. Imagine that Todd was flying on an airplane, and to make the example as simple as possible, imagine that the airplane was owned by an airline called Big Air, for lack of a better name, and that Big Air was the only airline flying among the two cities. Todd and I were traveling. Let's say you went from Boston to New York's LaGuardia Airport. So I have a graph here, of course I made it up, but in some ways it's a pretty realistic graph. And it shows that as Big Air charges more and more for a seat on the airline; any seats now, I'm done with aisle seats for a while.
As Big Air charges more for a seat on the airline, fewer people will want to fly on Big Air. Either they won't travel to New York or they will drive, take the train, walk, ride a donkey, whatever. But let's take a look. If they charge $50 per seat, 10,000 people will want to fly to New York that day. Wow! If they charge $5,000 a seat, basically no one wants to go. Ten spoiled snobs will fly. And there you have it below: $5,000, 10 seats. Big Air will raise $50,000 for those of you who struggle with math, that's $5,000 times 10, just count the zeros, see four zeros.
Put the four zeros to the right. And then, in the most realistic range, at a price of $300, we see that 2,000 people will demand seats, that is, they will want to accept the offer to travel from Boston to New York on Big Air at that price on that day. And so, if you sell 2,000 tickets at $300 each, Big Air will collect $600,000 in revenue. I haven't said anything about its costs yet. If you increase the price further to $500, well, it will attract a lot of people, 1,000 of those 2,000 people will still want to pay for the seat and will pay $500, but of course, 1,000 people then won't fly.
So I've constructed the example so that Big Air receives the most money when he charges $300. And again, you might be thinking, well, how about $270 or $320? I've excluded all of that to make the example as easy as possible. For Big Air, it's not free to fly to New York. It has costs. And as we know, these costs are very, very important in determining when to fly, how to fly, and how much to charge. So here I reviewed the information they already have in the first two columns and then put information about the costs in the third and fourth columns.
Now, think about Big Air just charging $50, that kind of incredibly low price, 10,000 people wanting to travel. We know that Big Air would have made $500,000 in revenue. That was on our previous slide. Well, how much does it cost Big Air to transport 10,000 people? And I have put in a huge amount. You know, imagine it costs an average of $300 per person, which would be $3 million to transport that many people. Why does it cost more, rather than less, per seat when you want to transport more and more people? Well, to a certain extent, when you start increasing the number of seats, that is, when you increase production or production, as we call it.
To some extent, costs go down. You know, think about the pilot who flies the plane. If you only have one passenger on the plane and you have to pay the pilot, say $1,000 a day to fly the plane, then that $1,000 is paid entirely by the customer sitting in seat 1A. You put 10 clients on the plane, same pilot; The pilot's salary can now be divided among 10 clients. So that's the relatively fixed cost of the pilot, that fixed cost falls or becomes a less important price as we have more and more customers. That would explain why, when we have a price of $5,000 with only 10 people flying, the average cost of flying is, say, $3,000 in the last line of the example.
And that's because there is a pilot, there is a plane, there is a ticket counter, there is buying landing rights at LaGuardia, there are many fixed costs that are now divided among 10 people; 10 rich people. And then the average cost of flying for each of those people is very, very high. As you can see, moving up from the bottom of the chart. When Big Air increases the number of passengers from 10 to 1000, by lowering the price from $5000 to $500, it gets what we sometimes call economy of scale, it is able to spread the cost of the pilot and the costs of the plane and the costs of landing and I mentioned all those things to more and more people, so the average cost of sending someone to New York drops, in this case from $3,000 to $200.
Notice that it stays there for a while and then increases once they hit 10,000 seats. And why might that be? Well, they're probably out of landing rights at LaGuardia. I mean, where would you take 10,000 more people a day than the system now supports? I can't even imagine it. They could buy landing rights from other airlines at LaGuardia. They could fancifully suggest to the mayor of New York that Central Park needs transportation and that we put landing strips in Central Park and unload people there all day. It is very difficult to imagine how it is possible to transport so many people by plane so quickly every day from one city to another.
And that's why I imagined that prices would go up a lot. This is realistic for most things we do. That is, at first, the price goes down as production increases and eventually the price goes up. We sometimes say that marginal costs increase over time. Well, now if we put these two trucks together, we can see how Big Air would make the most money. That's usually their job. We say that companies try to maximize their profits. Again we imagine that the company is a rational actor thatYou have a goal and in this case your goal is to make as much money as possible.
Well, look at the example. When you charge $50 and those 10,000 people fly and land in Central Park, Big Air loses money. He spends $3 million, but we saw that he makes an income of only $50 per seat multiplied by 10,000, which is $500,000. Loses 2.5 million dollars. Big Air never wants to do that. How about $300 per seat? Well, that's pretty good for Big Air. If seat prices are $300, 2,000 people show up at the airport, that's $600,000 in revenue, and then based on our assumption on the previous side, it costs Big Air $200 per seat to get these people there for a total of $400,000 in costs.
And as you can see, it produces a profit of $200,000. Big Air can even do better by charging $500 per seat, even though it only costs Big Air $200 to take the person, by raising the price to $500 they lose half their customers, they lose 1,000 people. Fly with just 1,000 people and raise $500,000, $500 per seat times 1,000 seats. And its costs are $200,000. And so we can see that this is where you maximize your profits, generating $300,000 in net profits. So we're thinking a little bit about how exactly that happened and what might be good or bad about it. And so I really want to focus your attention on it.
Think about Big Air's pricing structure there. He was able to supply the seat for $200. And yet, he discovered that he should charge $500. Let's look at it first from Big Air's point of view and then from the point of view of customer number 1,001. From Big Air's point of view, when they lowered the price... if they try to lower the price from $500 to $300, in a way, you would think, how can that be a bad thing? They are going to accept 1,000 more customers who are willing to pay $300 per seat for the privilege of flying, when it only costs Big Air $200 per seat to supply the plane and the seats.
So, of course, you'd think Big Air would make more money if they dropped the price to $300. In fact, any price that can exceed $200 can make money. It costs me $200 to make the seat, I charge you $212; I made another $12 profit. But Big Air in this example is a monopolist. Big Air is the only one flying, so Big Air sees him and says to himself, wait a minute. If we lower the price from $500 to $300 to capture those additional people, we will stop charging $500 for the first 1,000 people we fly. After all, in this example we have to charge everyone the same price, like he did to the cookie boy at the beginning of the conference.
So is it worth it for Big Air? No. Because when you drop the price from $500 to $300, you lose $200 per seat for the first 1,000 people. And it's not worth losing $200,000 from those most intense and desired inframarginal customers, so to speak, to gain $100,000 from the new 1,000 people who will pay $300 per seat when it costs $200 to fly with them. So Big Air chooses no. We will restrict production, we say, and fly at $500 a seat, then selling...selling only 1,000 seats instead of 2,000. From a social point of view, think about it from the outside or even from the point of view of the government or the point of view of the citizenry.
This is really a shame. After all, the cost of resources to take someone to New York is evidently $200. And there are people willing to spend more than 200 dollars. Think of it as a resource, a matter of ecology. Resource costs on Earth are such that for $200 you could get another person from point A to point B. And if someone is willing to spend $300 for it, that person has an intense preference compared to the actual cost of doing so. . , but we denied them flights. We say, “No, no. Since I am a monopolist and can make more money with $500, I don't want to sell it to you for $300.
Economists call this a deadweight loss. They say, boy, that's a shame. There should be someone, there is someone willing to offer the seat for a little over $200, even $300 in our example, and that's if someone wants to pay $300 for it and we still don't match it. Now you've seen that if this were a competition, if there were 10 airlines flying, of course another airline like my cookie maker would jump in and say, “Oh, come here, come here. We'll fly you to New York. Give us $300…we can fly you for $200. Its alot". But again, because Big Air is a monopolist, it is the only one flying this route and demand structure; prices are, as we have seen, Big Air will choose to restrict production to sell only $1,000 to $500 a seat.
We are not telling you the truth in this example. Think, like I said, about that customer number 1,001. There is a client who sees that she is willing to pay 300 dollars. She sees the price at $500. It's like she wants to whisper to the president of Big Air and say, “Okay, okay, she looks at her. I understand that you don't want to lower your price because then you'll have to lower it for everyone else and you'll make less money, but what if I don't tell anyone? Just sell me a seat for $300, I really want it badly; Give me a seat for $300.
It only costs you $200 to supply it, and then instead of making $300,000, you will make $300,000 plus the $200 profit… the $100 profit from selling me the seat.” Well, I guess if Big Air could trust her not to tell anyone about this and not resell the seat to someone else, Big Air would do it. But the important thing is that we see that this loss of efficiency leaves customers unhappy, so to speak. Dissatisfied. There are, again, 1,000 people willing to pay at least what it costs to provide that seat and they don't get it. Now, in the real world. Big Air does a little of each.
Anyone who has flown on an airline knows that sometimes the person next to you has paid much more or much less for the seat. Anyone in the real world knows that Big Air can, in fact, do a little of this. They can have it both ways. If you fly on an airline and talk to the person next to you, you may find out that they paid much more than you paid for your seat or much less than you paid for your seat. Big Air doesn't have to charge everyone the same for their chocolate chip cookie, so to speak.
He has the ability to control the refereeing. Now, in this case, you do it by saying: “Your ticket is non-refundable and non-transferable.” You can't resell it to us and just buy another ticket when prices drop. And likewise, you can't just go to the airport and exchange it with other people. They may do this by hiding behind a false claim about security or identification or something. I mean, it's not entirely obvious why we let them do that. But at the moment they can do that and this allows them to discriminate in some way. This doesn't mean it's a terribly bad word, it's a word economists use to differentiate between customers.
They can take the people who want to pay a lot of money and charge them a little more and take the people who want to pay closer to $200 and charge them less. So in real life, Big Air discriminates between customers. And we'll come back to that in a minute. But in our example, we assume that there is no ability to discriminate. It's like the house chocolate chip cookie; You have to charge everyone the same amount, maybe because people could exchange bills or something like that. And again, in that example we have seen something quite important. What economists and governments don't like about monopolies is this problem, and I'm going to call it a problem, that although there are people who would pay more for the seat than it costs to offer it to them, they don't.
I won't get a seat. The source of this problem is Big Air's restriction of seats from 2,000 to 1,000 to make more money, to make $300,000 instead of $200,000. And economists call that problem deadweight loss. Again, referring to the idea that I would pay more for the seat than it costs to plan it, produce it, and yet Big Air won't offer me the seat. If you were a couple steps ahead of me, you might wonder if I've overestimated deadlift loss. After all, what about those people who wanted to pay more money than it costs to produce the seat, but Big Air denied them?
Well, I could drive to New York, I could fly through Milwaukee to New York, I could go do something else that day, but whatever I do with my $300, after all, I'm spending that money somewhere else. Now think about the average transaction when you spend $300. Someone might offer you, you know, a laptop for $300 and you might think, oh great, I actually would have paid $375 for it, but the market, as amazing as it is, offers you this for $300 and you buy it. Well, you would have paid that additional $75 for $375, the market offers it to you for $300, that extra part is the opposite of the loss of efficiency.
For example, just like Big Air denied you something even though you would have paid more than it cost to make it, here's an example of how they don't extract the true cost of this laptop from you. You have $75 of consumer surplus, economists call it. You could think of it as a benefit of living in a civilization or a benefit of living in a market where you are not always the person paying the price at which the market sells the thing. Almost every day when you buy something, you would have paid a little or a lot more than what the person charged you and that is a lot of surpluses that you are getting and that is the advantage of living in a civilization.
These are the advantages of living in a market. And it's exactly the flip of a coin of lost efficiency. So my first choice on how to spend the $300 might have been to fly to New York on Big Air and I was willing to pay $300, let's say, and they could have provided it to me for $200 and they didn't give me the seat, you lost $100 in overage. But I probably took that $300 and went somewhere else and got maybe $70 or $20 surplus. No more than $100 overage or that would have been my first choice instead of flying to New York on Big Air.
But for everyone who is denied a market here because of the monopolists, that person does have that money to spend somewhere else and gets some surplus somewhere else. So this example overstates the efficiency loss and that's probably something we should keep in mind. But again, the key idea is that the monopolist looks at the market, calculates demand, maximizes his price always remembering that if he lowers the price, he has to lower it for all customers in the examples we have seen. I have already said that in real life Big Air does not charge the same for each seat.
But it's a little smarter and differentiates between customers on a plane. So, for example, you might pay $300 for the seat; The person next to me might have wanted to get that seat very early and would have paid $400 for it. And then it could be someone who didn't really care when they traveled, waited until the last minute, there were empty seats, Big Air, Expedia, Travelocity or someone offered them that seat at a much lower price. Thus, Big Air has discriminated or differentiated consumers. You've probably already noticed that this decreases, rather than increases, deadweight loss. After all, it makes it more likely that Big Air is selling seats it can make for $200 to people who are willing to pay more than $200 for them because it has already sold seats to people for $500 and can then lower the price without people. that carry out arbitrations and market the seats.
So price discrimination by a monopolist allows it to make more money and also reduces deadweight loss, although it might make us a little nervous for other reasons. After all, the monopolist is already going to make much, much more money, and there may be people who don't like that or who worry that the monopolist is purposely creating markets to discriminate prices. However, the important thing is to see that the loss of efficiency is decreasing. CHAPTER TITLE: Monopolies and government; Strange bedfellows or partners in profits? Note that the monopolist does not necessarily keep all this money; the smarter the monopolist, the smarter the government.
Imagine a very intelligent monopolist in the computer world. The monopolist sees that more people want to travel on Thanksgiving Day; increases the price of seats. Nobody wants to travel on Sunday afternoon; lowers the price of seats. It can get much more sophisticated. You could see from my frequent flyer number that I'm someone who really likes to travel at certain times of the day and when I log on to get a seat, I might be charged more for a seat at that time. Programs already do this. As the plane fills up, when he sees who I am, he knows more about me.
The more information he has about me, the more he can see inside my brain, the more he knows to charge me more in certain situations. The monopolist can differentiate himself from us, perhaps almost perfectly, so that when we show up, he knows exactly our reserve price, that is, the amount we would pay, and at any higher price, we will not travel. I suppose a good government could take this money from us if it wanted to. A government could say, “Well, as long as we give them themonopoly, after all, we are the ones who decide how many planes can land at LaGuardia.
Instead of selling all those landing rights to Big Air, the government could have set things up so that Big Air would have competed with American Airline, United Air Lines, and so on. So if the government gives or allows Big Air this monopoly, the government could say, well, we want to tax a good portion of that money, or price it to use it for public works or to build La Guardia. to widen the track or whatever. Well, it's easy to see how the government does it. The government could auction off landing rights. The government could say, well, we're willing to sell the rights to fly 10 planes a day to LaGuardia, let's see how much everyone will pay for it.
And you would have competition between the airlines and the airlines know how much they can price discriminate and therefore they know whether they will make $600,000 or $300,000 or much more than if they could discriminate. And if they can make a million dollars by charging everyone the reserve price, then they could offer $800,000 for the right to land at LaGuardia. So when you see a monopoly price discriminating, don't immediately think that the monopoly is making all that money; There might be someone, and especially the government, who is able to extract a good portion of that profit through an auction or tax scheme.
The reason I put the example that way is that I wanted to introduce the idea that for a monopoly to thrive, it must have a way to prevent competitors from entering the market. We sometimes say that monopolies thrive where there are barriers to entry. There has to be something to keep competitors away. In the case of cookies, nothing prevented the entry of new bakeries. And as soon as the price of cookies started to rise, more people entered the market and started producing those wonderful chocolate chip cookies. In the case of Big Air, it is the landing rights at LaGuardia that constitute the barrier to entry.
If the government has nothing else to offer or the port authority that owns LaGuardia only sells a certain amount, that is a barrier to entry that prevents other companies from entering. The iPad has patents. Movies are copyrighted. The bridge over the Mississippi has a monopoly status through license. Lawyers have some licenses, doctors have some licenses. Everywhere we look, wherever there is some monopoly power, there are some barriers to entry. And do you see what all these examples have in common? It's that the government, the law, plays a very, very important role in creating or maintaining these barriers to entry.
In fact, we could say that while it is true that monopolies thrive thanks to barriers to entry, that is what keeps competitors at bay. Barriers to entry themselves require government complicity or arise through government complicity. We don't need to review too much, but let's remember where we are. We have seen that a price-discriminating monopolist can charge different prices to people on the plane or elsewhere; $500 to this one, $400 to that one, $300 to that one. He can make even more money that way, although he might have to pay back some of the money if the original monopoly is auctioned off to him.
But let's not lose sight of the basic idea that the run-of-the-mill monopolist can only charge everyone the same price or they will exchange cookies on the sidewalk, so to speak. That monopolist does need, when the price rises, to sell to fewer people. That is what is creating the loss of efficiency of people who want to pay more than what it costs to produce the product, but do not sell it to them. So the next time you're out with friends, you're eating pizza, you're doing whatever, and someone asks you, "What's wrong with a monopolist?" I hope you know the answer.
You take a deep breath and say, "Well, there's this thing called deadlift loss and..." and then you get going and you have the picture down. We can do better than that, but that's a great first answer. Another thing we saw is that most monopolies are born or sustained with the help of the government. The government grants the right to build on the other side of the Mississippi. The government grants a patent. The Constitution tells the government to grant patents. I'm not complaining about the government granting patents. It could be a good way to get innovation out of people.
However, the patent is the right to be a monopolist. A copyright is a right to be a monopolist. A license is often the right to be a monopolist. A developer's right to build a skyscraper could be the right to be the only one who can sell space in a certain location or near a certain train stop. The government is intimately involved with monopolies. And I'm not just talking about patents and copyrights in our Constitution. Let's think, for example, of the post office. Well, once upon a time there was a Constitution that gave our government the right to create currency and establish a post office, but almost every other country has the same government-sponsored monopoly.
Because? Well, it could be a bit like digging up the streets by putting in cables and pipes. We don't really need 10 different couriers carrying things from door to door. We don't want everyone to have the right to put a little slot in the door for things to fit through. So the government had a monopoly on mail delivery. Maybe it was a good idea; maybe it was a bad idea. What happened to it? Well, as we know, that monopoly has become less and less valuable. In fact, a postal service monopoly is a guaranteed way to lose billions of dollars a year.
Nobody uses the postal service. In part, monopolies are also associated with a bit of laziness or lack of innovation. After all, if you're a monopoly, you might be able to make a lot of money sending people to LaGuardia, but after a while, you'll probably stop caring about the snacks you serve on board. I mean, after all, what else are they going to do? They'll need you to fly to LaGuardia. It takes a long time before anyone can break their monopoly and build a high-speed bullet train or find another way to get people quickly from point A to point B.
The same thing happened with the post office, the world changed. Fax machines were invented. Fed Ex emerged. All of these can be seen as responses to a monopoly, in this case a government-owned monopoly, but it could have been any monopoly, but it got a little slow. And that's why we often associate monopolies with a lack of innovation and associate monopoly breaking with the additional profit that stimulates innovation. Would you rather compete with a monopolist or a chocolate chip cookie maker? Well, if I can think of a way to overcome that barrier to entry, the monopolist is charging a very high price; it is much easier to enter that market and make a lot of money in the shadow of the monopoly and take down that Goliath.
The government does not own Federal Express, and Federal Express, in some ways, is very profitable, in part because it is in the shadow of the government monopoly. No one else can deliver mail to your doorstep. No one else can send what we call first class mail that way. Federal Express itself is a bit of a mystery, I mean, think about the development of the fax machine and then email. You know, once email was invented, why would anyone send a fax? I have to say that I find it puzzling and I think economics doesn't offer much of an answer to that, that as we acquire technology after technology, from birds to mail, errands, automobiles, etc., Fed Ex, fax machines, email, texting, etc., and a bit of the old technology remains in place, the monopolies are a bit broken, but the government tries to get involved with each monopoly as it goes.
It will be interesting to see what eventually happens with the fax machine and email in this context. It will be interesting to see where the fax machine will be in 10 years. Now, it is not only monopolies that suffer from this innovation problem. So I don't want to blame them for everything. If you think about the great American industrial companies of the 18th and 19th centuries, they are all gone. The big railroads are no longer here, the big water and energy companies, the big mining companies, they are just a shadow of their former selves, and now we are used to thinking of Google or Microsoft and Facebook as the best and a company is coming. very big.
A chip maker is likely to be the largest company now, whereas 50 years ago it might have been a coal company. And it is not because they were necessarily monopolies, but simply because large companies could have problems adapting to new technologies, innovation, etc. Monopolies, however, seem to have the biggest problem of all. On the other hand, there are some companies that survive for a long period of time. You know, think about the university you're in now. The universities that were excellent 100 years ago are, generally, the universities that are excellent today. So there is an industry that seems to have kept up or been protected by other means.
So I don't want to say that every great company is destined to fail, but it is interesting that the ones that remain alive are intensely competitive. These universities compete for you, compete for government grants, compete for donors; They really are in a very competitive industry. And I think that tells us something: that they still exist, while the great industrial companies of the 18th century no longer exist. In our modern world, Big Air has a funny business. He knows he needs the government to sustain his monopoly; needs those landing rights at LaGuardia not to be sold to other airlines.
And so Big Air's most important business might not be serving snacks to airlines, it might not be training pilots, it might not be learning about metal fatigue. Actually, it might be about learning to get along with the government. After all, an important part of your business is maintaining your monopoly, getting those landing rights at the best available prices, and keeping them from the competition. Big Air is dedicated to seeking help from the government. It's not something we like to say in a capitalist society, but it's true. At the same time, the government, meaning our politicians, is in the business of wanting to do business with Big Air.
Think about the typical government official. The government official needs to be re-elected. They need campaign financing, they need money. Big Air is a natural for contributing to campaigns. Big Air wants its monopoly, government politicians want campaign money, this is a match made in heaven, or at least in the skies. And then Big Air... we have to think about that part of the monopoly business that involved obtaining favors or rights from the government. Sometimes in economics we call it “rent seeking.” The idea refers to the fact that companies need to spend resources to get to the position where they have monopoly power.
What they want is that rent, the monopoly profit, they want that extra money that you can only get by being a monopolist, but they have to spend money to get there. And as we're about to see, in the extreme case, they could spend so much money to get that monopolist, that they're actually not much of a monopolist at all. And let's see how that could happen. Now in high school they taught you; They also taught me that governments are perfect. That the government knows it needs to do what is good for the citizens, if the government does a bad job, the voters will throw out the government and get new politicians.
Well, in that world, the government will decide where it wants monopolies. You could decide, oh, having just a solid ground at LaGuardia is a good idea or we should encourage inventors, let's have patents. The post office is a good thing. In other areas you might decide that a monopoly is a bad thing. The government could do what is best for the economy, that is, for citizens in general. But you know we're not in high school anymore. And now we know that government politicians have their own incentives. And part of their incentives is to get more money and campaign donations.
Part of their job is to find work for themselves and their families after leaving office. In this type of world, the government cannot necessarily be trusted to do what is good for its citizens. Therefore, it is a good idea for us to track the benefits that Big Air and the government bring and see how the two work together. Think about this. Someone sitting in the White House, running for re-election, could these days spend a billion dollars to get re-elected; billion dollars. President Obama will probably spend around $1 billion on his re-election. And his opponents will probably spend about the same amount competing for the right to compete against him and then compete against him.
That's two billion dollars in resources spent on voters. It is highly unlikely that much of that $2 billion will give us information we couldn't otherwise get from newspapers and other sources. SoThat's kind of a waste. That is, people competing for our votes or attention could compete with each other in a kind of arms race where they spend and spend and spend to outdo each other, and there's actually a lot of waste involved. The same thing happens on the other side. When Big Air and its competitors compete to get these landing rights at LaGuardia or someone competes for the right to build a bridge over the Mississippi River.
They could also compete with each other and could compete to the point of throwing out the baby with the bathwater. And that's what we want to address next, looking at how rent-seeking can be destructive. This idea of rent seeking is not entirely new to us. Think about a typical election. Partly because they want to be re-elected and partly because they are in power, so there are many donors who want to send them money to please the government. At the same time, their opponents compete in a primary to determine who will run against the incumbent, and then they too have to campaign in November.
That can also add up to around $1 billion today. So we spend two billion dollars every presidential election cycle on a single job. Now, an optimist might say that those two billion dollars go toward informing voters, reminding them when Election Day is, by the way, it's the first Tuesday after the first Monday in November, don't forget. And maybe tell them where the White House is and what our foreign policy is, etc. But most of us think that's ridiculous. Most of it is spent on ads aimed at appealing to our emotions. They do not provide us with information that we cannot obtain from other sources.
So we are wasting a good part of the two billion dollars in a kind of arms race between politicians. Similarly, on the other side of the transaction, donors, monopolists, or would-be monopolists are wasting money seeking rents or competing to obtain this monopoly. Five contractors could compete with each other with lunches, jobs for politicians' relatives and other things... and perhaps worse, all to get a government contract. And that's a topic I want to come back to now and see how it is possible that rent-seeking can be so destructive. CHAPTER SUBTITLE: The Pay-for-All Auction Politicians spending on a campaign, would-be monopolists spending for the right to obtain a monopoly, and countries going to war can all be considered in a single economic model.
Economists sometimes call this an all-pay auction. And think about the following metaphor. Imagine an auction where I bid $10, you bid $12, she bids $14, it goes, it goes, it goes, she gets it. We call this a standard auction or, if you want to be fancier, an English auction. It goes to the highest bidder, the highest bidder pays the bid amount and the highest bidder gets that amount. There are many other types of auctions. In an all-pay auction, I bid $10, you bid $12, she bids $14, maybe I bid $16, then I get it for $16, but she has to pay $14 and you have to pay the $12.
That is, everything is paid. Everyone must pay the amount of their highest bid. Now you can immediately see why this is a popular way of thinking about war. Because if two countries go to war, they spend a lot of money buying tanks and planes and they spend a lot of money killing their young people, and as they invest more and more in the war, it's not like they get those resources back. when the war ends and you lose or win. Then everyone has to spend the amount they have spent and they can't get that money back.
And as the war drags on, it becomes attractive to have spent a trillion dollars on a war while, oh, a little bit longer, maybe you can survive the opponent and defeat them and get something for your trillion dollars. That's why economists like this idea of a pay-for-all auction model. The same thing happens with a campaign: you spend a lot of money on your campaign, I run against you and I spend a lot of money running against you, one of us wins, none of us gets our money back. It's not like a standard auction where if you lose, at least you don't have to pay.
That's why I use the expression "pay for the entire auction" to refer to this idea that in some auctions, you pay and I pay, one of us wins, but no one gets the money back from him. It's like going to war. You use tanks, you kill people, I use tanks, I kill people. One of us wins, but we don't get our money back. In a standard auction, if you outbid me on a house, you pay to keep the house, but at least I get my money back. A campaign, a war, seem more like a full-payment auction.
Let's imagine that Big Air values those landing rights at LaGuardia at $300. Big Air would pay up to $300 to obtain those landing rights, it needs to spend a month lunching politicians, giving money to campaigns, who knows what else, to guarantee that right. Big Air starts by perhaps spending $100 in hopes of being the highest bidder. Maybe American Airlines will come in and offer $200. And maybe United Airlines will come and offer $250. Well, let's now think about Big Air's position. He values the rights at $300, he has already spent $100 and he won't get it back. The highest bid is $350. You could also add another $260 to your bid because that way you'll outbid the highest bidder and you could get the rights even if you don't want to spend all that money in the first place if you can start all over again.
Well, if you add up all that amount of money, you get a figure much higher than $300. Therefore, a lot of money can be spent on invitations to politicians and other uses of resources, perhaps even more than the amount of money it is worth to any individual competitor. And again, that's what we mean when we say rent-seeking can be hugely wasteful. So now, if you're sitting eating pizza and someone asks you, "What's wrong with monopoly?" You will have a very sophisticated answer. Your first step is, again, to say, "Well, first let me explain weight loss to you." But then you can say, “It's not just about weight loss; the problem of deadweight loss is exacerbated by rent-seeking.” Due to the loss of efficiency, once Big Air has a monopoly and sells the seats, it sells very few seats at too high a price, but there is also the loss that Big Air spends money on invitations to politicians to obtain the rights to landing. in La Guardia.
The efficiency loss from rent-seeking could be even greater than the efficiency loss from not selling seats to people who are willing to pay more than the cost of producing them. Let's imagine Big Air participating in an auction to obtain its monopoly. We already know that Big Air can make a lot of money if it is the only one flying from Boston to LaGuardia, but it has to acquire those landing rights. And let's imagine that the government is auctioning off those landing rights. Then an airline can fly the route. Big Air is willing to pay up to $300 for it, let's imagine.
But maybe American Airlines is also willing to pay $300. And maybe United is willing to pay $300, too. Everyone can see that they could make a lot of money by being the monopolist here. Now the government is putting it out to tender. Of course, you may not do this explicitly; May be, let's see who can win the favor of politicians. In that case, the money will really be wasted. Big Air might jump into the fray and spend $100 on dining and dining and try to bribe politicians, but United isn't far behind and offers $200. And then maybe American Airlines will go all out and offer $250, you'll only make $50 if you get the contract... if you get the landing rights because you'll make $300 and now you've spent $250.
But from the point of view of Big Air, which has already invested, you could say, 100 dollars, it is worth investing another 250 dollars. That is, even though you would have spent $350 total and lost money on the deal, right now you are going to lose $100 and have nothing to show for it. So you might be willing to put in another $250 to make $300. Well, following that logic, we can see that if Big Air does that and actually gets the landing rights, Big Air will have spent $350 to earn $300 and American Airlines will have wasted money and United Airlines will have wasted money and above all Rent seeking can be quite large.
So now, when you're sitting there eating pizza and someone says, "Oh, what's wrong with a monopoly?" You're really ready to go. You start over with a deadweight loss and show how people who might be willing to pay $300 for an airplane seat or $500 for an airplane seat can be denied that seat even though the airline can produce it. for $200 because they have increased the price and reduce their production to maximize their profits. There's the first deadweight loss. But now that deadweight loss could be doubled or something like that by the other side of the transaction in that Big Air and their competitors who are looking to be this monopolist in the first place could waste a lot of money wining and dining with politicians or doing other things to get the monopoly in the first place.
I guess the problem could be even worse, it could be a problem. Politicians could change things; maybe the government knows that really the best way to run LaGuardia is to have three competing airlines. But in its quest to get all these meals and campaign contributions, the government could inefficiently set up LaGuardia to handle only one airline in order to extract revenue from the airlines. Then you see how the monopolies and the government structure begin to fit together. The monopolist can make more money once he is a monopolist, but to be one, he often needs help from the government.
And in turn, the government may sometimes need monopoly to feed politicians and their preferences. This is the saddest side of monopoly. Furthermore, in our world, the most important items are no longer heavy items that are difficult to transport, but health services, legal services, accounting, IT and the like. And these seem to be offered on the world market. So we think about the monopoly problems associated with them, but we are more likely to think that there are network effects, meaning that a good solution in one place can spread and expand to other places. CHAPTER TITLE: Putting it all together;
The integrated network that is the economy I hope you are beginning to see what an integrated network is, what we call economy. We started with prices and prices were the little messengers that came and went coordinating supply and demand. We saw that competition is what happened in the market to create these exchanges. Then we introduced the idea of a monopolist. The monopolist had a market to himself. He was the only one selling the item and could sell it at a higher price by reducing production. Although creating a loss of dead weight, so that there were people whose demand was not satisfied even though they wanted to pay a price for which the land could supply the good.
That was the bad side of monopoly. We also saw that monopoly could have a good side. The government might want monopolies to create incentives for innovators. The government might want a monopoly to distribute letters through the postal service. At first, the government was seen as the good player trying to figure out where monopolies were good and where they were bad. Then we introduced complexity and saw that, well, the government might not be such a good actor. The government might like some monopolies and have an interest in this rent-seeking, this play by the monopolists to put themselves in a position where they could charge these high prices and maintain barriers to entry that would keep out lower-priced competitors.
In that case, the government is not the solution, but part of the problem. So we had a kind of complex mix where everything you see in government, in monopoly, in competition, and in pricing begins to interact with each other. I told you a little bit ago. I said before that in economics big questions can be broken down into small questions. And maybe now is the time to revisit some important questions. Let's think about the recent real estate bubble we experienced. I think we all have the same picture: house prices went up and up. People were borrowing more and more money for these houses.
Perhaps the banks were too free to lend money by giving people mortgages on houses that might not have been as valuable. And finally the real estate market collapsed. People were left with houses that weren't really worth the amount of money they had borrowed. People were moving away from mortgages. The banks were in trouble, there was a colossal financial failure. The big companies on Wall Street were in trouble. The government thought they had to intervene and so on. How could such a real estate bubble occur? If the economy is so good, if these prices are these smart little messengers that I have described, why are these messengersDidn't they do their job?
Why didn't they run around and say, “Wow! The price is too high, do not buy a home. Don’t build more.” Instead, we had people across the country building homes even though homes are now deteriorating and empty in Nevada, California, Florida and elsewhere. Something went wrong and maybe economists are to blame. First let me defend the economists. You could say: how is it possible that economists don't see the real estate bubble? I'm afraid the answer is like saying: How can meteorologists not predict the weather on the Fourth of July, or how can physicists not know where I will be in two weeks?
It's true that every move I make between now and two weeks from now is easily described by the laws of physics. There is gravity, motion and mass multiplied by speed and each step is very, very easy. But how they all come together and how in two weeks I will be wherever I am seems like a problem beyond any physicist or psychologist today, and the same goes for meteorology. We may be very good at predicting the weather eight hours from now or 24 hours from now, but predicting the weather three days from now turns out to be a tremendously difficult task.
But economists are no better at predicting future fashions than meteorologists are at predicting next year's weather or physicists at predicting where I will be in two weeks. That's how it is in some parts of the economy. Economists are very, very good at knowing if the price of wheat goes up now, this is what will happen tomorrow. And they are also very good at making long-term forecasts. But knowing what will happen in the long term in the real estate market is very complicated. One of the reasons it's complicated is that people don't just buy houses to live in;
They are buying houses as investments. They are buying houses because they fear that if they don't buy it, its value will increase and they won't be able to afford the same house later. In a sense, they are speculating on the home even though they also live in it. It is very difficult to discover people's speculation because it is about everyone's psychology thinking that prices are rising, I better buy, buy, buy now. And that's what we mean by bubble. We mean that people are afraid to stay out of the market because they fear prices will rise. Then they buy the item in question or see everyone else making money and think: I'll make money too.
But then the price ends up having little to do with your actual demand for the product, that is, your actual preference for it. And it certainly has very little to do with the actual cost of assembly and supplies. I already promised that we will never see a bubble in chocolate chip cookies. I think you can see why. It is unlikely that anyone needs to speculate on this. Why would you ever speculate about a chocolate chip cookie? If you really like cookies and you're afraid the prices will go up and up, well, buying the cookie now won't do any good.
It will simply become obsolete and will rely on more bakers entering the market and baking new cookies later. You will know that you can always buy them based on the price of the inputs. I highly doubt there is a bubble even in home rental prices. Again, it is a short-term market. People don't speculate about it. They can live in one place and then wait and then a year later rent somewhere else. So bubbles occur more in things that are held for their speculative value. You could invest in art. Art could have a bubble. And the real estate sector may also have a bubble.
Bubbles are more likely to arise where people speculate about the future and where there are fads. People just don't know if a certain artist will be popular in the future. They could buy, buy, buy thinking it will go up. They might buy homes thinking that people will like this type of home or that it will be too expensive for them to afford in the future. It is very unlikely to happen in short-term markets, in markets for things that become obsolete. It's much more likely to happen in things that involve fads and could even happen in commodities.
People may buy silver or coal afraid that the price will rise and not be sure that new miners will be able to get the coal out of the ground at a reasonable price. Some people have faith that governments can intervene and control these bubbles. You know, in the case of housing, the government didn't see the bubble coming, just like the private market didn't see the bubble coming. That's why there is a lot of disagreement among economists about whether the government is part of the problem or part of the solution in bubbles. However, again, that's something you should look into in the future because we can't afford too many bubbles in your lifetime.
Well, you know, just because people think, why didn't economists tell us that housing was overvalued? And then we would have cut mortgages or something. Whenever a bubble, recession, or Great Depression bursts, it's natural for people to blame economists. It's like, if you have bad weather, blaming the meteorologist for not warning you in advance. So maybe economists should have seen the housing bubble. Maybe if prices were those big little messengers running around, as I insist. Maybe the economists should have seen that those prices were doing their job and should have said, "Uh-oh, housing is too expensive," and encouraged the government to not let the banks lend as much money or not support mortgages as much and Perhaps we could have softened the recent great recession.
Do you remember Todd, on the plane? I suggested to Todd that he really needs to think more about pricing and how monopolies are created. He really was facing a monopoly. He wanted an aisle seat; He was a polite guy sitting in the middle. He turned to the person next to him and offered him $50 for the seat. But the holder of the aisle seat, in a sense, was a monopolist knowing that he was the only one with whom Todd could negotiate to sell the seat. And sure enough, the monopolist reduced production and increased price, only two out of 13 sold the seats from him to Todd and apparently for $300.
Well, I think now you know what to advise Todd. You should do what I told him. I told Todd, the next time you get on a plane and see that you're in the middle seat, immediately talk to four or five people who have seats in the aisle near where you're about to go and tell all four of them from them. “It's okay, I'm a tall guy. I really want an aisle seat. I have been known to pay $20 or even as much as $40 for an aisle seat. Do any of you want to do it? That will create some competition between those four people and instead of there being one monopolist who can sell the seat, there will be four people who will do it.
Well, once you see that idea, you can see that staying away from a monopoly is a way to get a lower price. And sure enough, that's what Todd does. I'm happy to report that Todd is now a consultant who travels a lot, probably flying first class, but when he travels coach, he says he often makes this offer to four or five people in the aisle and regularly pays $40 for his seat. So breaking the monopoly was a way for Todd to lower the price. I don't think Todd's strategy, or should I say my strategy for Todd, is going to work for long, and maybe you can understand why.
Over time, airlines will gather more and more information about us and realize that someone is selling Todd a seat for $40, when that $40 could have been the airline's money. So the airline should sell Todd the aisle seat for $40 or maybe even negotiate seat swaps. Think how good the airline could be at this. It knows who is in each seat, knows a lot about their seat preferences, and can gather information from past sales and flights about how much people will pay for aisle seats on certain flights. I suspect that within a year or two the airline will offer deals that will make it a market maker for airline seats.
This should remind you in some ways of other companies that capitalize on the information they have in the Internet age and use it to create markets. So, for example, when you go to the supermarket checkout, the supermarket records the barcode report. Now it's, you know, a little pathetic. They say, "Oh, 30 percent off bananas for you because I see you like bananas." But think about all the information they have and everything they can do with it. They may be able to increase the prices of some things; You may know that more people buy things on rainy and sunny days.
They may make specific recommendations for you. In the long run it will probably be great. There is nothing I would like more than for a salesperson to know everything about me and know all my preferences. You could walk into the store and instead of going up and down the aisles, the salesperson could simply roll up a basket of products and say, this is what you want and this is our price. That would be fantastic. That's probably the direction we're headed in, joking aside, is that the more information the airline has about me, the more information the supermarket has about me, the less it's about pricing and the more it's about putting things together. that meet my preferences with price, just one attribute to resolve in the end.
Sixty years ago most people thought that monopolies were simply bad. They had discovered the loss of efficiency and did not like the fact that monopolies restricted production to raise prices and deny people things they would otherwise have bought. About 20 years ago, people thought that monopolies were doubly bad because the loss of dead weight was compounded by the perception of rent-seeking that we have seen. And they thought... people thought, not only are monopolies bad because of deadweight loss, but there are additional losses created by monopolies competing to be monopolies in the first place by wasting money on politicians or on advertising or on other things that could give them this. monopoly position.
In the age of the Internet, things have changed a bit. We also began to appreciate the good sides of a monopoly. First of all, we live in a global world. It is more difficult to be a monopolist of most goods because goods can be transported from other countries. You don't just need a monopoly in Washington or your state capital; a global monopoly is needed unless the good is very, very heavy to transport. And that's why there is more competition from abroad. If we see that window seven has a large market share, we immediately think, "Um, I wonder if there will be competition from China?" Whereas, 50 years ago, people would have seen a typewriter come out and thought, "Oh, this is a really bad monopoly because it's going to be very expensive to bring in Italian typewriters." So in a global world, we're less concerned about traditional monopolies, maybe a little more interested in intellectual property and those kinds of monopolies, and we're looking at where the new competition might come from.
By now you know that I am going to return to my central topic of prices. Let's think about prices in the global economy. How do we know where to get things from? Why is the iPad outsourced to China? Once again, it is the prices that travel around the world. Apple wants a component, it tries to figure out who can make it cheaper, the component can be made cheaper in one place, people will pay more for the iPad somewhere else, prices come and go faster than the iPad. And finally, the iPad comes from the manufacturer to the end user.
Prices are therefore a way of thinking about countries and their role in the global economy. Think in this case about your future, where India and China are the growing economic powers of the moment. And think about how different those economies are and how they depend on rent-seeking and monopolistic pricing. It is a good example for us of the things we have learned. Now, let's first take the case of China. China is apparently not a capitalist economy, although it does have a lot of capitalism. It brilliantly uses local governments in competition with each other. So local government officials want to be promoted, they want to get to the Central Committee;
They want to receive more payments. They do this by demonstrating that in their region of the country living standards are increasing; People are safer, there are not many deaths from earthquakes or industrial accidents, etc. Competition between local governments seems to be the key to what makes China tick. Prices help China interact with the rest of the world, but within China, power relations and competition seem to be what makes it work. It is a top-down economy in which grassroots people operate to advance in power and wealth. India is a very, very different type of economy. In the Indian economy, the government is having trouble producing infrastructure.
There are many cities in India where upper middle class people and certainly rich people pay for healthcare, education and even water in the private market. Nominally there is a system provided by thegovernment, but there is also a very well-developed grassroots system where businesspeople step in when the government fails and businesspeople offer this. In that type of system, prices play a key role. If I want water and I want clean water, I'm going to see who provides it to me best. In China, if I want water and the water is bad, I go on strike and complain and then the media notices and the local government official gets embarrassed and says, "Oh, people here are rioting." Riots are a terrible thing and before the Central Party can remove the local official from office, the local official has an incentive to provide better water and improve infrastructure.
India, prices and markets. China, power, rent seeking, monopoly, competition between these monopolies, the government comparing them to each other. We don't know which one works best. China takes your breath away if you are an economist. If you are an economist of my generation, you were raised thinking that central planning fails, that only markets can do the job and that only prices are messengers that circulate around; That's the only way to make the world go faster. And now, suddenly, we find that our main economic competitor is actually only using prices modestly, instead using priceless things, including power structures and promotions, to drive the economy.
And they're not bad at it. There are roads in China, factories, railways and gas supplies, it's fantastic. And bridges and buildings are built quickly. And they are not rising quickly because small prices circulate like messengers. They are increasing rapidly because a very smart government that has thought about rent-seeking and how to eliminate corruption and wining and dining has tried to figure out how to get people to compete so that buildings are built faster, better and safer. than the building there. It is a very, very impressive feat and a great challenge for the economy of its generation.
Look at the distance we've traveled together today. We started with airplane seats and chocolate chip cookies and houses and found our way to landing rights at LaGuardia and tulips in the Netherlands and skyscrapers rising to India and China and back to airlines and all parts. That's the good thing about economics. Economics is a set of tools that help you understand, interpret and improve the world around you. It's incredibly exciting. At **** Law, economics helped me turn law from a dry subject where one memorized a bunch of rules, found in a dusty treatise, into something alive where the law could be used to change the behavior of people. people.
The economy is everywhere around us, it is easy to access and comes with a set of tools that you can use better and better. It's incredibly exciting. The economy is now a tool for you. Economics is now a way to improve the world around you. Economics is how you are going to understand your cell phone operator and why taxis cost what they cost and why drinking straws are free, why they supply some drinks and not others. You will better understand travel, the world, and foreign affairs. Use prices, think about monopolies, use theories about how people compete and how they act to change human behavior.
It's a lot of tools you can put in your hand to understand the world around you. Go learn more about this. Go understand the world around you and make it a better place. Thank you very much and good luck.
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