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PROFESSOR: OK, so what we're
going to do today is continue
our discussion of oligopoly
which we started last time.
I want to return to the example
we were using last
time to discuss the example
of Cournot competition.
We started last time by talking
about general game
theory and the prisoner's
dilemma and the concept of
Nash equilibrium.
Then we turned to a specific
example of a Cournot
competition, the way we can
specifically model two firms
competing in a market.
And so if you recall the example
from last time, we had
demand curve of the form p
equals 339 minus q where this
is thousands of passengers
per month.
And we had a marginal
cost of $147.
And we have flat marginal cost,
so average cost equals
marginal cost equals 147, equals
average cost. So flat
marginal cost.
And what we said, so therefore
if the firm was a monopolist,
if American Airlines say was a
monopolist, they would set
marginal revenue equal to
marginal cost which would be
339 minus 2q equals 147.
And so the monopolist was going
to set a quantity of 96.
That was the monopolist quantity
with the price.
So the quantity of monopolist
is 96 and the price of
monopolist is $243.
So that was the monopoly case.
Something you should be very
facile with for tomorrow night
is solving those kinds of
monopoly problems. And then we
said, OK, but what if, in fact,
it recognizes that it's
not a monopoly.
There's another firm
in the market.
United is in the
market as well.
Well in that case it has to
consider its residual demand.
So in that case we said the qa,
its residual demand, for
American was equal to the
total market q minus the
quantity absorbed
by United, qu.
And we showed last time what
this leads to graphically.
And so we re-handed out figure
16-3 just to review.
The notion was that each
firm develops a
best response curve.
Each firm says, based on what
the other firm's going to do,
here is my best level
of production.
Here's my profit maximizing
level of production.
And each firm having developed
a curve, there's an
equilibrium where those curves
intersect because at that
point both firms are happy.
You've achieved your Nash
equilibrium because at that
point both firms are satisfied
with the strategy they're
playing given what the
other firm's playing.
So that point of intersection,
both firms' best response are
consistent with each other.
And that's we developed
last time graphically.
Intuitively, I think it follows
from the same logic,
the idea is we're playing this
game and the game will only
have a stable outcome
if we're both
satisfied with the outcome.
If we're not both satisfied
we'll continue to change our
behavior and it won't
be stable.
And so what I want to do now is
talk about how we solve for
this mathematically.
So let's just think about the
mathematics of solving for
Cournot equilibrium.
So what's the mathematics now?
What's American Airlines's
residual demand function?
Well their price, p sub a, is
equal to the total demand,
339, minus what they supply
minus what United supplies.
So the price in the market,
they don't have separate
prices, the price in the market
is going to be 339
minus what each of
them supplies.
So now American can't control q
sub u, American has to take
that as an outside
given factor.
That's what they're
responding to.
So American says, I need to
optimize this with respect to
what I can control
which is q sub a.
So how does it do it?
Well, it computes marginal
revenue.
Well marginal revenue
is p times q sub a.
So that's 339qa minus qa
squared minus quqa.
Just multiplying through.
That's their revenue function.
So marginal revenue,
differentiating with respect
to qa which is all they can
control, is going to be 339
minus 2qa minus qu.
That's going to be
their residual
marginal revenue function.
And they're going to set this
equal to marginal cost. So I'm
going to set marginal revenue
equal to marginal cost. So
they're going to set this equal
to 147 which is marginal
cost. And solving.
you get that qa equals
96 minus 1/2qu.
qa equals 96 minus 1/2qu.
Once again reviewing, what we're
doing is we're saying we
set up their residual
demand function.
We compute what that implies
in terms of revenues.
We differentiate with respect
to their control variable, q
sub a, to get a marginal
revenue function.
You set that equal to marginal
cost. And you solve for their
best response curve.
Essentially you just solve
mathematically for the curve
you see here graphically.
You go to the graph and you
look at American's best
response curve.
That is exactly this line.
When qu is 0, it intersects
at 196.
When qu is 192, qa is 0.
So you can see we've just
mathematically developed where
this best response
curve comes from.
We've just solved for that
mathematically through the
similar mathematics of monopoly
profit maximization.
In this case we're essentially
saying, imagine you're a
monopoly except for the stuff
produced by the other guy.
That's the way to
think about it.
Imagine you're a monopoly except
for what the other guy
does and you get this best
response function.
Now, since we set this problem
up to be symmetric--
that is we said the marginal
cost identical for both firms,
and the market demand applies
to both firms--
since we set this up to be
symmetrical, then we know that
we can also write a symmetrical
best response
function for United, which
is q sub u equals 96
minus 1/2 q sub a.
We can solve for this but
there is a shortcut.
If it's symmetrical problem
they'll have symmetrical best
response functions.
So we can just write
the symmetrical
best response function.
And then we can find
the equilibrium.
Remember the steps I went
through last time.
Now we have n equations
and n unknowns.
We have two equations
and two unknowns.
We can just solve by plugging
one into the other.
And we get that qa star equals
qu star equals 64.
Which is in fact where these
curves intersect.
So that's how I found the
intersection of these curves
was solving mathematically
for the optimal level of
production given what the
other guy's doing.
And the price, what's
the price?
Well the price is 339 minus
q sub a minus q sub u.
So it's 339 minus 128 or 211.
So you end up with each
firm producing 64,000
units a price of $211.
And this is the Cournot
equilibrium.
Because it's on both firms'
best response function.
Both firms are maximizing
profits.
And in maximizing profits they
both have chosen the same
point to produce and
so you're done.
They're happy.
That's the Nash equilibrium.
Yeah.
AUDIENCE: So in the
last lecture was
that game theory box.
And this would be the lower
right hand box, correct?
PROFESSOR: That's a very
good point, yes.
This is sort of like game
theory but with a whole
distribution.
But in some sense it's like
at each point you've
reached that point.
But I really wouldn't draw
that parallel actually.
The parallel that's important
from that is
the equilibrium concept.
The reason we choose the
prisoner's dilemma instead of
choosing the equilibrium
concept--
and the equilibrium concept is,
you're in equilibrium when
each firm's dominant strategy
yields an equilibrium outcome.
Here we've just taken that
intuition and solved
mathematically for each firm's
dominant strategy.
And that yields an equilibrium
outcome.
AUDIENCE: That top left
box, there's no way--
we shouldn't think about
that at all?
PROFESSOR: No, actually it's a
great segue to what I'll talk
about next which is a
cooperative equilibrium.
So what we've solved for is we
solved for a non-cooperative
equilibrium.
Where they're not cooperating.
So it's like the prisoner's
dilemma in the sense they end
up in that lower corner.
But in some sense I think that
parallel, I'm not sure how
much that helps other than
thinking about the strategies
and about thinking that that's
non-cooperative.
We want to turn to next what
happens if they can cooperate.
But before I do so,
two things.
First of all, these problems do
not have to be symmetric.
I've just solved symmetric
problem often, and you'll see
symmetric problems, that
makes the math easier.
But they don't have to be.
American and United can be
different and you could solve
the same math.
And in fact Perloff goes through
an example like that.
Symmetry is not guaranteed in
these problems, it's just a
feature of the way
I set this up.
So this question is a great
segue to the next topic, which
is what about cooperative
equililbria.
Can't American and United get
together and form a cartel?
Remember we talked in the
prisoner's dilemma about how
that would be the best outcome
if the two persons could just
trust each other.
Well here can't American and
United just trust each other
and form a cartel?
And what they do here
mathematically is pretty easy.
They would just say, look, let's
get together and pretend
we're one firm.
Then let's act as that one firm
monopoly would and split
the profits.
It's the way a cartel
could work.
They could say let's get
together, we'll produce as if
we're a monopoly and let's
split the profits.
Well what would happen
if they did that?
Well we know that the total
monopoly production if they
had been a monopoly is 96.
So that's a big Q. The quantity
for the market is 96
and the price if they're
a monopoly is $243.
So what they did is they said,
look, we'll each do 48
flights, for a total of 96 and
we'll charge $243 and we'll
agree to do that.
But what would happen?
Well their profits to each firm
would be their 48 flights
they do times the price they get
minus the marginal cost.
Marginal cost is average
cost here.
The price they get minus the
marginal cost. That would mean
per firm the profits
would be $4,608.
So each firm would make
$4,608 in profits.
Actually that's four million.
This is in thousands, right.
So $4,608,000.
Let's compare that to the
profits they made as Cournot
competitors.
Once again comparing the upper
box to the lower box, going
back to the prisoner's
dilemma.
I think that is actually
useful to think about.
Let's compare that to what
happened when they were
Cournot competitors.
When they were Cournot they
each took 64 flights.
They each did more flights when
they were competing, but
they only got to charge $211
with that same marginal cost.
So their profits as Cournot
competitors
were $4,096,000 each.
So by monopolizing and splitting
the market they
raised their profits by
12.5%, by an eighth.
Their profits went up by an
eighth, by 12.5%, which is a
major jump in profits by getting
together and forming
this cartel.
Just as the two prisoners were
better off not ratting each
other out, they were
both better off not
ratting each other out.
These guys are both better off
getting together and forming a
cartel and splitting the
profits, same logic.
So why don't we see these
cartels everywhere?
Why do we have American
and United, why don't
they just do this?
Well that's for two reasons.
Two reasons why we don't see
these cartels everywhere.
The first reason, so
why not cartels?
The first reason why we don't
see cartels is there's a
fundamental instability.
Cooperative equilibria are
fundamentally unstable because
any one party has an
incentive to cheat.
Any one party in a cartel can
make money by cheating because
they stick the other firms
in the cartel.
So let's just talk about
this for a second.
Imagine what would happen if
American decided to cheat.
Imagine they had this cartel,
it's running along, they're
each making their $4,608,000
per month profit.
They're all very happy.
Now imagine American says, wait
a second, what if on the
sly I increase my number
flights from 48 to 50?
What if I just did that and did
it in a way which wasn't
immediately transparent
to United?
So American takes its q sub a
which was cranking along as 48
and it raised it to 50.
Well what happens?
Well if they do that the total
quantity in the market instead
of being 96 rises to 98.
And if it rises to 98 that means
the price is going to
fall, right?
This is not a price
discriminating monopolist,
this is a one price monopolist.
So if they want to
sell 98 flights, the price
is going to have to fall.
So the price is going to
fall to $241 from the
current level of $243.
Well you might say, gee
American just shot
itself in the foot.
Its just lowered the price
by selling more flights.
But look what happens to
American's profits.
American's profits are now 50
times 241 minus 147 which
equals $4,700,000 which
is higher than it
was making ib a cartel.
American just increased its
profits to more than they were
making when they cartelized
splitting the profits.
And what's happened to United?
So this is profits
for American.
United's still doing 48 flights
but the price has now
fallen to $241.
So United's profits
fall to $4512.
United's profits fall.
American's profits go up.
So basically American
has stuck it
to United by cheating.
It's raised its profits at
the expense of United.
And why is that?
What's the intuition?
Well it goes back to our
monopoly intuition.
Because when one firm cheats
in a cartel it gets all the
benefit of the extra quantity,
but only feels part of the
poisoning effect.
Remember when a monopolist
increases its quantity.
It's got these two effects.
It sells more but poisons
its previous sales.
Well here when American sells
two more flights, it sells
more, it's got all that effect
like a monopolist would, but
the poisoning effect is
shared with United.
They don't feel as much pain
from that price going down
because they're sharing
that pain with United.
They get all of the benefit
from quantity going up and
only part of the pain for
price coming down.
And that's why it makes
sense to cheat.
A monopolist would never
cheat itself.
It'd make no sense for the
monopolist suddenly to go from
96 to 98 and say, ha I've
cheated myself because it
would feel the entire pain
of the poisoning effect.
But American doesn't.
That's shared with United.
So it actually makes sense to
cheat because they get all the
benefit of the more quantity and
only part of the cost of
the lower price.
And that's intuitively
what's going on.
Questions about that?
Well knowing this, clearly
United says, wait a second, if
we form a cartel American
will cheat.
So I'm going to cheat
first and the
whole thing falls apart.
And we get back to the repeated
game intuition we
talked about in our game
theory lecture.
Where if they can commit to
never cheat, if they can
commit to punish each other if
they cheat, you might be able
to make this work in a repeated
game, but only if the
repeated game never ends.
So if there's either not a
repeated game, or it's a
repeated game with an end,
then there's going to be
incentive for someone
to cheat.
Once there's an incentive for
someone to cheat, the whole
thing falls apart.
And that's why cartels are
fundamentally unstable.
Now there's a second reason why
we don't see cartels which
economists would always
put second.
We always put the economic
stuff first and the legal
stuff second.
The second is they're illegal,
but we think that's less
important as economists because
we think folks are
often smart enough to figure
their way around laws.
Technically these are illegal.
In fact, in the late 1800s
cartels were very
common in the US.
They were called the trusts.
There were trusts in sugar,
railroads, other areas.
This is how these robber barons
made all their money--
the Rockefellers and the
Vanderbilts and stuff-- was by
building monopolies.
That's what made their money.
And then in the early 20th
century Congress passed what
was called anti-trust laws which
explicitly forbid the
creation of cartels or
these kind of trusts.
So technically they're
illegal.
In fact, there are lots of ways,
and Perloff talks about
this in his book, there are lots
of ways that firms can
implicitly cartelize.
There are ways that firms can
say, look we'll get together
not under the government's
auspices and we'll agree that
you raise your price and I'll do
it two weeks later and look
like we're not a cartel.
I'm just following you, but in
fact we've agreed to do it.
So there is some implicit
cartelization and basically
that's why there's an anti-trust
division exists
that's quite large.
The Department of Justice is
basically to prosecute exactly
those cases when firms
try to do that.
Now in fact, however, the
government has a bit of blood
on its hands in this respect,
because sometimes the
government actually promotes
cartels even though it might
not mean to do so.
And the best example was the
1981 voluntary export
restraint policy, the Reagan
administration.
1981 was the worst recession
before this one.
Actually unemployment was
higher than this one.
This is a very bad recession,
but actually unemployment was
higher in 1981.
It was well over 10%.
And a big place where
unemployment was high was in
the manufacturing sector,
particularly auto
manufacturing.
We were getting killed
by Japan.
Basically this was the first
wave of Japan really producing
much better cars than the US.
And US car manufacturers
were suffering
enormously as a result.
So basically the Reagan
administration was trying to
figure out what to
do about this.
One thing you could do, and
we'll talk about in
international trade in a few
lectures, you could impose a
quota and you could actually say
to Japanese producers, you
can't sell in America.
But Reagan was a Republican.
And Republicans are
for free trade.
And he really couldn't
do that politically.
Plus economists have often
said that's a bad idea.
And we'll talk about why
that's a bad idea.
What Reagan did instead was
said to the Japanese auto
manufacturers, look, I'm
a charismatic guy.
I'm Ronald Reagan.
Why don't we get together in a
room and I'll convince you to
just export less to America.
Let's have a voluntary export
restraint agreement.
Where I'm not going to put on a
quota, because that would be
bad, I'm going to actually
suggest to you, I'm going to
make you an offer you can't
refuse that you just export
less to the US.
It was basically a back door
way of imposing a quota
without looking as politically
bad as actually imposing one.
And in fact, Japanese automakers
agreed to this and
reduced their sales
of cars in the US.
Now why would they
agree to this?
Now there's two explanations.
One is they could have thought
if they didn't then a quota
was coming.
They could have said, look,
this is kind of an olive
branch before they
lower the hammer.
That's a really bad
set of metaphors,
but you get the idea.
That basically look, if we don't
do this, then he's going
to impose a quota.
The other is they could have
said, thank you Ronald Reagan,
you've just formed
a cartel for us.
We can't stop from competing
against each other.
We can't stop cheating.
We'd like to form a cartel
but we can't.
But you've told us we have to
cartelize because you've
limited how much we can sell.
You've essentially said, look
you can't sell more than this.
You have to agree to sell
more than that.
You've essentially allowed us
a framework where we can get
together and implicitly
cartelize in a way where it's
hard to cheat because then
we'd be violating the
agreement with America.
So basically what Reagan gave
the Japanese was a cartel
enforcing device.
What American and United need is
some way where American and
United can monitor each other to
make sure they don't cheat.
That's what Reagan gave
the Japanese.
Said, I'm going to report on how
many cars are selling in
the US and you're going to agree
to limit it to this.
And they're like, great, that
gives us the tool we need to
enforce the cartel we wanted
in the first place.
Thank you very much.
They made a ton of money.
American consumers lost out.
And I'll talk more about
international trade on why
that happens.
But the bottom line
is, this end up
being just like a quota.
The bad thing about quotas and
things like this is that
essentially they raise prices
and hurt American consumers.
And in this case they were bad
for American consumers and
very good for Japanese
producers.
We essentially increased profits
for Japanese producers
which they used to develop
better cars and then came in
later and killed us in the
car market anyway.
So it was dynamically a pretty
terrible policy.
So that's the legal issues
around cartels.
Now what I want to do now is
step back for a second and
say, we've now talked about
three different kinds of
market forms. We've talked about
perfect competition.
We've talked about monopoly.
And we've talked about
oligopoly.
In particular, non-cooperative
oligopoly which is a more
interesting case since within
cartels it's going to be hard
to sustain.
Non cooperative oligopoly.
We've talked about three.
How do these compare?
So let's just do ourselves
a little chart.
Let's consider the
three cases.
We've got monopoly, oligopoly,
and perfect
competition, three cases.
Let's ask how they compare
on quantity and
on profits per firm.
Quantity produced in the market
and profits per firm.
And let's do it for this
American, United example.
Well we know the monopoly case,
we told you that in the
monopoly case 96 units get
produced in the market.
And the profits per firm
are $4,608,000.
In the oligopoly case that's
the Cournot case, in the
Cournot oligopoly case we said
the total amount in the market
was 64 per firm or 128,000.
And the profits per
firm were lower.
They were $4,096,000 per firm.
Now what about in perfect
competition?
What's the quantity that's going
to be sold, what's the
price going to be in perfect
competition?
We haven't done perfect
competition.
You can tell me.
You can just do that
intuitively.
What's going to happen in this
market if there's perfect
competition what's this
price going to be?
Somebody raise their
hand and tell me.
Yeah in the back.
AUDIENCE: [INAUDIBLE]
PROFESSOR: 147, because price
equals marginal cost in
perfect competition.
So quantity would be 339
minus 147 or 192.
There will be 192 units sold.
And what will profits be?
Zero.
Zero profits in perfect
competition.
With a flat marginal cost there
will be zero profits
with perfect competition.
So we can now compare this and
we could say, an oligopoly
case leads to less output and
more profits than does perfect
competition.
And a monopoly case leads to
even less output and even more
profits than does oligopoly.
And basically how do we think
about welfare in this case.
Well to think about welfare
you'd have to actually draw
the diagrams to compute producer
and consumer surplus.
What I could draw and show you
is basically social welfare is
highest in the perfect
competition case, lowest in
the monopoly case, and we talked
a couple times about
the deadweight loss
of monopoly.
This is not a price
discriminating monopolist remember.
This is a one price monopolist
so there's deadweight loss.
And it turns out if you write
down the graph that it's in
between the oligopoly case.
Oligopolies cause some
deadweight loss, it's worse
than perfect competition but
better then monopoly in terms
of total welfare.
And in fact, the bottom line
is, we can actually pretty
much tell what happens
to welfare.
A shortcut for thinking
about welfare
is to look at quantity.
Because remember what social
welfare is about, what causes
deadweight loss, is trades
that aren't made.
Under perfect competition
every trade that has a
positive social surpluses
is made.
So the closer the quantity
produced comes to the perfect
competition level, the smaller
will be the deadweight loss,
roughly speaking.
So it isn't always true, and
you can find bizarre
deviations, but a good rule of
thumb is that welfare, the
distortion of perfect
competition will be
proportional to how much
quantity falls relative to
perfect competition.
If quantity falls a lot
relative to perfect
competition, that's going to
be a big loss in welfare.
If quantity is falling just a
little, it's going to be a
small loss in welfare.
And that goes back to that
deadweight loss triangle.
About the fact that it's
smallest right around the
perfect combination equilibrium
and gets bigger as
you move further away.
So basically perfect combination
is the best,
monopoly is the worst, oligopoly
would be somewhere
in between.
This leads to the question.
I think you might look at this
chart and ask yourself is
well, gee, does this sort of say
that the number of firms
determines welfare?
You've got one firm, two firms,
infinite firms so can
we make a more general statement
about the role the
number of firms.
And it turns out the Cournot
model we can.
Basically in the Cournot model,
the more firms there
are, the closer you get to
perfect competition.
In the Cournot model as n
increases you approach perfect
competition.
And in particular, and the book
does the math in this,
you don't need to know the math,
it's more the intuition.
But the book shows that the
markup in a market, price
minus marginal cost over price,
in a Cournot market is
equal to 1 over n times the
elasticity of demand.
That is that we've said before
that markup was inversely
proportional to elasticity
of demand.
I might have used a different
letter, I might have used nu
for that elasticity.
But this is elasticity
of demand.
I forget what letter
I used last time.
Same elasticity I've
been using.
So basically, we said before we
had this equation, right?
We said markup was inversely
proportional
to elasticity demand.
The more inelastic was the good,
the higher market power
the monopolist had.
Well here we now divide by n.
So the point is, that for a
given elasticity of demand the
more firms that are competing in
the oligopolistic setting,
the closer and closer you're
going to get to a zero mark-up
with a Cournot equilibrium.
So it's just this intuition
you see from this table.
This is one firm.
Then oligopoly can imagine
a number of branches.
This is oligopoly with two
firms. You should be able to
show yourself.
If there were three firms, which
you can solve, that's
three equations and
three unknowns.
It's the same math
we just did.
It's high school math.
You can do this if you just put
in three firms, do three
equations and three unknowns,
you get an even higher
quantity and so on.
So as the number of firms goes
up you're going to move that
quantity up towards the perfect
competition level and
profits will fall towards the
zero that we get from perfect
competition.
And this is consistent with
our rough notion.
We talked about extremes, about
perfect competition
being lots of firms, the
monopoly being one firm.
But this confirms the rough
intuition of the more firms,
the more competition.
That's a good solid intuition.
Now this raises the interesting
question about
should we ever allow
the number of firms
in a market to shrink.
Should we ever allow the
number of firms in
the market to shrink?
What we call that is we
call that a merger.
You've all heard of mergers.
When two companies merge
to form one company.
Well by the logic I just told
you that's going to be bad.
I just said that the
more firms you
have, the higher welfare.
The more you get towards
perfect competition.
And yet mergers happen
all the time.
The government does
not stop them.
The government typically
investigates them if they're
big mergers, the government
would
typically investigate them.
But by and large they often
let them go through.
Why is that?
Why should the government
not stop all mergers?
And in particular, if anyone for
extra credit, can anyone
tell me what concept we covered
which would explain
why it might make sense to
allow firms to merge.
Yeah.
AUDIENCE: The economy
of scale.
PROFESSOR: Economies
of scale, exactly.
That's the term I
was looking for.
It could be that you have two
firms that are producing
inefficiently relative to having
combined production.
So you've got one plant that
produces the left shoes and
one plant that produces
the right shoes.
And that's not a good example
because they wouldn't really
compete with each other.
But you know the point.
The point let's say you've got
two firms competing with each
other and they're both running
a plant at half capacity.
There's two separate plants
running half capacity, much
more efficient to have them
merge and have one plant run
at full capacity.
And yes, if they merged they
would then be a monopolist,
but it's possible the cost
efficiencies could be so high
a monopolist with lower marginal
cost might be better
than oligopolist with higher
marginal cost. This is kind of
like the patent example
I did last lecture
or the lecture before.
Where I talked about how a
patent could be a good thing
or a bad thing.
It depends on how much demand
increases due to the patent.
It's the same notion here.
The tradeoff is on the one hand
you get marginal cost
down by allowing a merger, on
the other hand you reduce the
number of firms in the market
by allowing a merger.
And there's that tradeoff.
You're going to raise each
firm's mark-up ability but by
lowering marginal cost you might
actually in essence,
might in the end lower
the price.
And that's exactly what
the Department of
Justice does every day.
And this is what is the hundreds
of economists that
work for the Department of
Justice do, they have quite an
interesting job.
They have to go ahead and
evaluate these mergers.
People want to merge and they
have to say, well which effect
is going to be larger.
How do we decide whether the
savings from economies of
scale exceed the cost and
increase market power?
And that's just an incredibly
hard thing to do.
That turns out to be an
incredibly hard thing to do.
And part of the reason it's hard
is exactly comes back to
what I talked about when I
talked about regulating
monopolies.
Because the data is controlled
by the market participants.
And so you can have necessarily
good data on what
it's going to do.
So a great example
is hospitals.
Over the last 20 years there's
been enormous mergers in the
hospital sector.
Even here in Boston we've seen
huge mergers of things like
the Beth Israel and Deaconess
hospitals merge.
Other hospitals merged.
These mergers were big and had
to go before regulators.
And the hospitals rightly argue,
look, there's huge
economies of scale in
hospital production.
Partly because hospitals
are rarely full.
They have to have excess
capacity in case somebody
comes in injured.
They have to have an
extra bed around.
They don't want people sleeping
in the halls.
As a result, in a situation
where you're rarely full,
where you're constantly under
capacity, there could be huge
economies of scale from
combining and using your
combined space more
effectively.
So pretty compelling argument.
And for that reason,
pretty plausible.
Most hospital mergers were
allowed through.
Very few hospital mergers
were rejected.
Well what happened?
It turns out the hospitals
just lied.
They kept exactly the same
production process they had
before the merger and
just raised prices.
So in fact, Beth Israel and
Deaconess each kept their
building just like they
had before the merger.
They just charged more.
Essentially they just
cartelized.
But the government let
it go through.
And what we've done,
essentially, is we're fooled
by the theory of these economies
of scale, when in
fact there was nothing to
force the companies to
necessarily do much
to realize them.
We just allowed them to
have market power.
So basically this is an
incredibly tricky and
difficult issue in deciding
whether to allow mergers or
not is basically evaluating
whether in practice you'll see
the economies of scale
that justify the
increased market power.
And that's why the Department
of Justice has a hard job.
Questions about that?
One other point I want to make
here is about the size the
market is, I've talked about how
mathematically the size of
the market will lead to
more competition.
There's also another reason,
which is the bigger the
market, the harder to
enforce a cartel.
If there's two players in the
market and one cheats, the
other one has the first one
whacked or something.
You know what's going on, you
can keep an eye on each other,
you know who's to blame.
When there's lots of players
in the market it becomes--
so let's say there was 10
airlines flying, it becomes
hard to figure out
who's cheating.
Or more still, imagine the most
important cartel in the
world which is OPEC.
The Organization of Petroleum
Exporting Countries.
This is an organization of 20
plus countries who control the
world's oil supply.
But there's no good way
of tracking who's
selling what oil.
We just know the total amount
of oil sold out there.
So if a country like Venezuela
run by some nutty guy decides
to cheat and throw a bunch of
oil on the market, it's hard
for the other members of OPEC
to actually view that.
OPEC's efficiency has
varied over time.
At times OPEC has not done such
a good job of controlling
the supply of oil in the world,
at other times it has.
But basically the more players,
the harder it becomes.
And as a good example, which
is the cartel to produce
mercury was an existing
cartel.
Italy and Spain essentially had
controlled the market to
sell mercury.
They had a very well
functioning cartel.
Other countries entered and
the cartel broke down.
So we can see this.
And this becomes a big issue in
thinking about the benefits
of enforcing competition.
And becomes a big issue
in government policy.
Here's another government policy
issue which you may
followed lately which is
the rare earths issue.
You guys all know as scientists
better than I, the
importance of rare earths, but
these are materials which are
very important for putting
in cell phone
batteries and other things.
These are important
new materials
for the modern economy.
The US used to be the dominant
producer of rare earths and
then China turned out were able
to produce it much more
efficiently, so we just
let China take it.
So now 97% of the world's rare
earths are produced in China.
China's now started saying
things like, Japan we're mad
at you, we're not selling you
rare earths, which is a huge,
huge problem.
And basically we've allowed
China to essentially
monopolize this market.
Now we tend to think in
economics it's a bad idea for
the government to subsidize
businesses.
The government should just let
the economy work and decide
what works.
But this may be a case where the
government wants to say,
no, we are going to actually
subsidize rare earths
production in America, to make
sure on national security
grounds we have enough in case
China decides to shut us off.
And that's exactly the kind of
issue the government has to
face in terms of trying to
decide whether or not to try
to actively get in there and
promote competition versus
just letting the market work.
Questions about that?
Now I want to talk about one
last thing before we stop,
which is the fact that Cournot
competition is not the only
model of competition
out there.
In fact it might not even
be the first one
that comes to mind.
In fact, if I said to you,
imagine two firms competing to
sell something, the first thing
to come to your mind
would probably not be best
response functions.
If you say, well they just
compete over the price.
And if there was really tough
competition the price would
just come down.
And the limit, if they're
incredibly good competitors,
the price would have to come
down close to marginal cost.
Well that is a different model
of competition that we call
Bertrand or price competition.
Cournot competition is
competition over quantities.
You get together and decide how
much quantity to produce
given what the other guy is
producing and then the market
gives you the price.
Bertrand competition is the flip
of that, which is firms
set their price and they produce
whatever the market
demands at that price.
Once again, Cournot competition
is firms set their
quantity and then they set
the price reading it
off a demand curve.
Bertrand competition is
totally different.
They say, we're just going to
compete over price and we'll
just produce whatever quantity
you want at that price.
We don't really even care
what demand is.
We're just going to compete
over price.
And the idea is that you have
some marginal cost that firms
will never go below
in the long run.
And the question is how much
will they compete down to that
marginal cost. In practice,
what's crazy about Bertrand
competition is it's possible
with two firms you can get to
the perfectly competitive
outcome, with only two firms.
Because those two firms are
competitive enough in setting
the price, they can fight it
all the way down to the
marginal cost.
That is if I ever try set it
to marginal cost plus $1,
you'll come in and set it to
marginal cost plus $0.99,
because you can still
make money.
Now I'll come and set it to
marginal cost plus $0.98,
because I can still
make money.
And we'll compete it all the
way down until we both are
charging marginal cost
plus a penny.
And if anyone tries to sell a
higher price they can't sell
the product because people
will only buy the
lower priced good.
So you could have a world with
Bertrand competition where
essentially firms compete
over price.
And where unlike this case, oh
I just covered it up, unlike
our comparison where with two
firms there's still lots of
profits to be made.
In Bertrand competition it's
possible that two firms are
enough, just two firms are
enough to get us to perfect
competition.
You don't need n firms.
Two firms are enough.
And in some sense, if we thought
about it, that's
probably the first model we
have in mind if we thought
about firms competing
is they compete over
where to set the price.
And that's essentially what
the Bertrand model is.
So two questions about that.
The first is, well jeez,
which model do we use?
How do we know whether it's
Bertrand competition or
Cournot competition?
How do we know which
model to use?
We've got a market with two
firms in it, you tell us the
models are going to give very
different answers, how do we
know which one to use?
And the answer is, basically
we don't know which
one to use for sure.
We can talk about the conditions
under which
quantity competition is more
likely and under which price
competition is more likely.
Basically quantity competition
is going to be more likely
when there's lags in the
production process.
So that you can't flexibly say,
here's my price, I'll
produce as much as I want.
If an airline said, I'm charging
this, I'll fly as
many guys as I want,
you can't do that.
You only have so many planes.
Airlines can't just set a price
and then meet whatever
demand comes out.
Airlines have to actually
sent a quantity.
They have to say there's this
many flights we can do.
So when there's lags in the
production process it's going
to be hard to do pure
price competition.
It's going to be more like
quantity competition.
That's going to be like
airlines or cars.
On the other hand, take
selling cereal at a
supermarket.
The supermarket if it runs out
of cereal the next day it can
get a whole bunch more.
The supermarket can almost
instantaneously replenish any
supply it's out of.
So there, you're more likely to
see same price competition
between say cereals in
the supermarket.
People can just compare
very easily.
And if one's cheaper they'll
just buy it up and if it runs
out the supermarket will
just reload the next
day with that cereal.
Essentially it's pretty
easy to meet quantity.
So this is not a very
clean distinction.
But the bottom line is quantity
competition is going
to be more likely when
it's a hard good
to produce on demand.
And price competition more
likely when it's an easy good
to do that.
That's how you're going to
think about which kind of
competition makes the most
sense in which context.
That's point one.
Point two, and the last
point I want to make.
What can firms do to avoid
Bertrand competition.
Let's say, for example, you're
a cereal producer.
You're in a Bertrand market.
Well this is a shitty
market to be in.
I just said two firms can drive
your profits to zero.
What do you do?
What do cereal producers do?
Yeah.
AUDIENCE: Differentiate.
PROFESSOR: They product
differentiate.
So the way to beat Bertrand
competition is through product
differentiation.
Once your products are
different, then you can price
above marginal cost. Then
they're not perfect
substitutes anymore and you can
price above marginal cost.
Have you ever asked yourself why
the hell there's so many
kinds of cereal.
I mean have you been
to the supermarket?
It's crazy.
Why are there so many kinds
of toothpaste and shampoo.
It's all the same crap.
Why?
Because it's product
differentiation.
It's to avoid Bertrand
competition.
Because once you can
differentiate,
you get market power.
Differentiation provides
market power.
In the book, this is too
detailed for the course, but
in the book Perloff talks about
this as monopolistic
competition.
Which is sort of an odd
oxymoron, right?
Monopolistic competition.
But these are models of
differentiated products where
essentially you can say, look
I'm different enough that
essentially I can charge
a higher price than my
competitor.
This comes back the concept
of contestable
markets we talked about.
The idea is that, look, if
you're different you can
charge a little bit
higher price.
Once it's too high people are
going to switch back to the
other food.
But if you make it
different enough,
people will pay something.
The most famous example is
Apple Cinnamon Cheerios.
Cheerios have been
around forever.
And what happened was
people bought
Cheerios, it was very popular.
But then supermarkets started
producing generic Cheerios.
And Cheerios are like pretty
freaking easy to produce.
And it turned out they
were identical.
And supermarkets charged
like half as much
for the generic Cheerios.
And Kellogg's, no Kellogg's?
Not Kellogg's, the other one.
General Mills.
General Mills was
all like, any of
you guys from Minnesota?
Mall of America has this cool
General Mills thing in
Minnesota, I remember it.
So General Mills said,
well gee, we're
getting killed here.
These generic Cheerios are going
to wipe out our profits.
So they invented the Apple
Cinnamon Cheerios.
And this was a product
differentiation where
basically they could still
charge a high price for Apple
Cinnamon Cheerios because it was
different enough from the
generic cheerios the supermarket
was making.
And they could patent them.
They could say, hey, we've got
a different thing we can
patent our secret Apple
Cinnamon formula.
So supermarkets now just
can't copy us.
So for a while we get price
greater than the marginal
cost. Or even if supermarkets
can copy them, they at least
get for a while price above
marginal cost until
supermarkets catch on and
make the product.
So product differentiation is
the way that firms fight
Bertrand price competition.
So is this bad?
Once again we don't know.
It depends how much you like
Apple Cinnamon Cheerios.
Just like patents, it depends
on whether the new good they
invented delivers sufficient
extra consumer surplus that
it's worth the fact that they
can market prices on it.
In fact, one of the most famous
studies in this field
was done by my colleague Jerry
Hausman, who actually measured
the demand curve for Apple
Cinnamon Cheerios and the cost
of producing Apple Cinnamon
Cheerios and found that the
introduction of Apple Cinnamon
Cheerios raised consumer
welfare by $67 million a year.
That even though the prices were
high because of product
differentiation, people were so
happy with this wonderful
new taste, it shifted demand
out so much that actually
consumer welfare went up.
Even though this was a tool
introduced by the companies to
avoid price competition,
which should make
consumers better off.
So it's all about these
trade-offs between how much
does it make consumers better
off versus how much more
market power does it
give the producers.
And product differentiation is
another example of that.
Why don't we stop there
and we'll come back.
Good luck tomorrow night and
we'll come back on Wednesday
and move on to factor markets.
