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JON GRUBER: All right, so today
we are going to continue
with our discussion of
producer theory.
And today we're going to move
beyond the unrealistic case of
perfect competition to the
somewhat more realistic case
of monopoly.
Now, we've been discussing
perfect competition thus far
as a form of market
organization, and that makes
sense in some context like fast
food and other things.
But in most contexts, we think
perfect composition is not the
way the world works.
There's some limits
on competition.
And we think that markets--
many markets, many of the goods
we consume have only a
few firms. Operating systems or
cars or a lot of things we
consume, typically have only
a few firms in them.
So the most realistic model of
markets would be one which
accounts for the fact that
there's less than an infinite
number of firms, there's
only a few firms.
That turns out also to
be the hardest model.
So what we do is we sort
of iterate there.
We started with one extreme,
which is a competitive market
where there's an infinite number
of firms, that allows
us to draw some interesting
conclusions.
Now we're going to reverse field
and talk about the other
extreme, monopoly, which
is only one firm.
We'll talk about monopoly
markets with only one firm.
Then we'll talk about oligopoly,
that middle case,
which is multiple firms.
So let's talk about monopoly,
a market where
there's only one firm.
The key thing to remember for
monopolies is they're no
longer price takers, they're
now price makers.
Competitive firms are
price takers.
They were given a price
by the market and
they reacted to that.
And as we saw in the long run,
that price settled at the
minimum of average cost. So
basically, they were given the
price which dictated production
efficiency.
They reacted to that in how
much they produced.
You got a flat long
run supply curve.
However, in a monopoly market,
we don't meet the conditions
for perfect competition.
In particular, one condition was
that consumers had perfect
substitutes between your
good and other
goods they could buy.
That's not true in a
monopoly market.
So if we think about that era,
sort of maybe, I don't know, I
don't have my computer history
isn't as good.
Maybe 10 years ago when Macs
were sort of at the nadir of
their popularity.
And really you had to be a
pretty high tech guy to be
using Linux and things
like that.
That Windows had virtually a
monopoly on operating systems.
Not really, but virtually.
Certainly unless you were a
high tech guy who could do
Linux and things like that,
pretty much if you wanted an
operating system,
you got Windows.
Windows pretty much
had a monopoly.
And that's may be as close as
we've come in the modern
economy to thinking about
an example of monopoly.
In that case, Bill Gates
had to decide--
wasn't given a price, he had to
decide how much to charge
for Windows.
And that decision determined
in turn how
much he would produce.
And that's exactly what we'll
talk about today, is how does
a monopolist decide both what
to charge and how much to
produce of their good?
So to do that, we're going
to turn to a new concept.
Well, not a new concept, but a
different way of looking at
something we've talked
about before,
which is marginal revenue.
If you remember, the profit
maximizing condition that we
derived when we started our
competition lectures was that
marginal revenue equals marginal
cost. That was our
profit maximizing condition,
was that marginal revenue
equals marginal cost.
Now we're going go to--
in perfect competition.
And the way we thought about
this marginal revenue equals
marginal cost, remember the
logic was this notion of
climbing this profit hill.
You want to produce any unit.
Think of yourself as climbing
this profit hill.
You're deciding, do I produce
the next unit?
And I produce the next unit as
long as the money I make off
that unit exceeds what it cost
to produce that unit.
So I climb that profit hill.
If marginal revenue is greater
than marginal cost,
I keep going up.
At the peak, marginal revenue
will equal marginal cost. Once
I go beyond that peak, marginal
revenue will fall
down below marginal cost and
I'll stop producing.
So the notion is I climb this
hill, which in the peak is
dictated by marginal revenue
equals marginal cost.
Now for a competitive firm,
we said marginal
revenue was just price.
So in perfect competition, the
rule was set price equal to
marginal cost. But that
was a particular
case of marginal revenue.
So for example, to see that,
let's look at Figure 14-1.
This is another way.
Probably next year when I teach
this, I'll put this in
the lecture on competition.
Just a way to think about how
marginal revenue is priced.
Remember, a perfectly
competitive firm faces a
perfectly elastic
demand curve.
They face a perfectly elastic
demand curve.
So they have to think about what
the implications are of
the marginal unit they sell.
Well if they sell little q
units, their revenue's a.
If they sell one more unit,
their revenue is b.
And the marginal revenue is the
height of that rectangle B
times the base.
The base is 1 because it
goes from q plus 1.
The height is p.
So the marginal revenue
is price.
This is a pretty
basic diagram.
So marginal revenue
is price for the
perfectly competitive firm.
Now let's look at the
monopoly case.
The difference with a
monopolist, as you see in
Figure 14-2, is they no longer
face a perfectly elastic
demand curve.
They now face a downward-sloping
demand curve.
Why is that?
Well remember, this is the
graph for little q.
The reason the graph for little
q was perfectly elastic
with a perfectly competitive
case was not that we said the
demand for the entire good
was perfectly elastic.
It's just that the residual
demand facing anyway one firm
was perfectly elastic.
Well now, a monopolist is the
only firm in the market.
So their residual demand
equals total demand.
Their residual demand
equals total demand.
So as long as total demand is
downward-sloping, as we
typically think it is,
then they'll face a
downward-sloping demand curve.
So unlike a perfectly
competitive firm, which faces
a perfectly elastic residual
demand curve, a monopoly firm
will face a downward-sloping
market demand curve.
They face the entire market
demand curve.
So this is demand curve.
Now we're talking about big Q's
not little q's anymore.
Or we could say little
q equals big Q.
There's only one firm.
So little q's and the big
Q's are the same.
So now the firm reacts not to
its residual firm demand
curve, which is flat, but
the downward-sloping
market demand curve.
Now, we're going to make
one assumption
here that's very important.
We'll come back to this at
the end of the lecture.
We're going to assume that the
monopolist can only charge one
price for their good
to all consumers.
So most of this lecture we're
going to assume a non-price
discriminating monopolist. We're
going to say that Bill
Gates can't look at you and say,
look, you look like you
really want Windows.
I'm going to charge
you more than her.
He can't do that.
He has one price.
He sells it to the stores
at one price.
So it's a non-price
discriminating monopolist
we're going to work with for the
first 2/3 of this lecture.
That monopolist has
to set one price.
Now, for that monopolist, for
Bill Gates with Windows circa
10 years ago, let's think about
his decision to produce
another unit.
He's originally producing at
Q, big Q at a price p1.
He's originally producing
a big Q at a price p1.
If he wants to sell one more
unit, he's going to have to
lower the price.
Because he now faces a
downward-sloping demand curve.
So if he wants to sell one more
unit, he's going to have
to lower the price to P2.
I have a big cockatoo at home.
This is his feather.
So he's going to have to
lower the price to P2.
What's that going to do?
Well, on the one hand, what
that's going to do is that's
going to mean on that next unit
he's going to make p2.
So he's going to get the
rectangle B. On the other
hand, on all the units he was
selling at p1, he now gets a
lower price p2.
So he loses the rectangle C.
So the marginal revenue for
this monopolist, the marginal
revenue is equal to the
rectangle B minus the rectangle
C. The marginal
revenue is rectangle B
minus rectangle C.
Or alternatively, you could say
that if we just write that
out, write out what that
is, that's p2 minus p1
minus p2 times Q1.
Or rewriting, we could rewrite
this then as marginal revenue
equals p plus delta p delta q,
how much the price changes
when you change the quantity,
times the
original quantity Q1.
Or one more time, for those of
you who prefer calculus.
If revenue equals p times q, and
q is a function of p, then
marginal revenue,
differentiating that, is p
plus dp dq times Q. So marginal
revenue is the price
plus the change in price from
selling another unit times the
initial quantity.
Once again, the graphics
are in this graph.
The math is here.
We just differentiate the
revenue equation.
This term is positive.
Price is always greater
than 0.
But this term is negative
because demand
curves slope down.
So there's now two effects.
There's a positive effect, which
is if I sell another
unit, I make money on
that other unit.
There's a negative effect, which
is to sell that other
unit, I have to lower the
price because I face
downward-sloping demand.
So there's two effects a
monopolist as he thinks about
wanting to sell another unit.
There's the money from that
unit, but the lower
willingness to pay for
all previous units.
And that's what makes a
monopolist a little more
interesting.
We basically think of the
monopolist as basically having
to work down the demand curve.
With a perfectly competitive
firm, they don't have to work
down the demand curve.
The demand's flat to them.
They can sell as much as they
want at that price because
they don't affect the price.
They want to sell 10 of that
price or a million at that
price, it doesn't matter.
Their demand curve's flat.
Not true for the monopolist.
If the monopolist wants to sell
more, he has to face the
wrath of the market.
And the wrath of the market is
such that if he wants to sell
more, he's going to have to
lower the price to do so.
Remember, once again assuming
he has to charge the same
price to everyone.
Assuming he's going to charge
the same price to everyone, if
he wants to sell more, he's
going to have to lower the
price to do so.
There's different ways
of [UNINTELLIGIBLE]
intuition on this.
I like to call this the
poisoning effect.
That's how I like to
think about it.
That basically, if I want to
sell another unit, I'm going
to poison the money I made
on all previous units.
Because if I want to sell
another unit, I have
to lower the price.
That's going to take away from
the money I was making on my
previous units.
So it's sort of a poisoning
effect is how I like
to think about it.
But you can have your own
intuition for it.
And basicallly, this poisoning
effect did not exist for the
perfectly competitive firm
because they couldn't affect
the price with their action.
They could sell however many
units they wanted at that flat
price and their actions did
not affect that price.
The poisoning effect only
exists with monopolists
because to sell that next
unit, they have
to lower the price.
Now, basically what that means
is to find equilibrium for a
monopolist, it's going to be
a little bit trickier.
And so let's go to Figure
14-3 and slowly walk
through Figure 14-3.
And we'll start walking
through.
What the monopolist is going
to want to do is draw a
marginal revenue curve.
With the perfectly competitive
firm, marginal revenue curve
was just a price, it
was given to them.
There was no marginal
revenue curve.
For a monopolist, there is
a marginal revenue curve.
So here I have a demand curve.
The demand curve I've drawn
here in this example.
The demand curve I've drawn here
is q equals 24 minus p.
That's a typical demand curve,
downward-sloping.
As the price goes up, people
want less of it.
And now we're in
market demands.
Because remember, little
q equals pq.
There's only one firm
in the market.
Now, here's the trick with
monopoly: mathematics.
The first thing you're going to
want to do is you're going
to want to invert this.
You're going to want say, OK,
that takes q, but what takes
the price a monopolist
is going to charge?
The price a monopolist is going
to charge is therefore
going to be 24 minus q.
That's going to be the
price that the
monopolist is going to charge.
Therefore, revenues, pq,
is 24q minus q squared.
So we inverted the
demand equation.
We do this because we want to
write down a revenue equation.
So that's the trick.
This is the mathematical trick
here is to invert this, so
then you can write down
a revenue equation.
We then differentiate this
revenue equation to get that
marginal revenues equals
24 minus 2q.
That's marginal revenues.
The next unit you sell, you
make 24 minus 2 times the
amount you're now selling.
And that's the marginal revenue
curve graphed here.
Now, basically what you see is
in this case the marginal
revenue curve starts at the same
point as the demand curve
on the y-axis and
lies everywhere
below the demand curve.
Now that first fact, that it
starts at the same intercept,
is not always true.
That is true because in this
case we assumed a linear
demand curve.
With a nonlinear demand curve,
marginal revenue curves can
start at different points
on the y-axis.
The second point about the
marginal revenue curve always
being below the demand curve is
always true regardless of
the function.
The marginal revenue is
always below demand.
Marginal revenue is always
below demand.
So that marginal revenue curve
will always be below the
demand curve because of
this poisoning effect.
Now, what I want to highlight
here is this means there's a
very important relationship
between marginal revenue and
the elasticity of demand.
So let's take our marginal
revenue equation and put it
back in change terms. p plus
delta p over delta q times Q.
And let's multiply
and divide by p.
So marginal revenue you can
rewrite as p plus p times
delta p over delta
q times Q over p.
So I just took this second term,
multiplied and divided
by p, the second term.
I just multiplied and
divided by p.
The reason I did that is because
that means you can
rewrite this.
This now starts to look like
an elasticity expression.
Remember the expression
for elasticity.
This looks like the inverse of
an elasticity expression.
Remember what elasticity of
demand was, delta q delta p
times p over Q. So that's
the inverse to
the elasticity demand.
So we can rewrite this as
marginal revenue equals p
times 1 plus 1 over the
elasticity of demand.
Marginal revenue equals p
times 1 plus 1 over the
elasticity of demand.
Think about what this
means for a second.
What is the marginal
revenue in a
perfectly competitive firm?
Well, as a perfectly competitive
firm, what's the
elasticity of demand facing a
perfectly competitive firm?
Infinity.
Perfectly elastic.
So marginal revenue by
L'Hopital's rule equals p.
So for a perfectly competitive
firm where elasticity is
infinity, marginal
revenue equals p.
Now instead, if we took a firm
where the elasticity of demand
was minus 1, the electricity
demand was minus 1, the
marginal revenue would be 0.
Why is that?
What that says is, if you're
a monopolist facing an
elasticity of demand of minus
1, then you make no money by
selling the next unit.
Because these two effects
exactly cancel.
It turns out with elasticity of
demand of negative 1, these
two effects exactly cancel.
Exactly what you make by selling
one more unit is
offset by how much you have to
lower the price on all your
previous units.
So an elasticity of demand
of minus 1, marginal
revenue equals 0.
And as you can see as the
elasticity of demand gets
below minus 1, as it approaches
0 from below.
As the elasticity of demand
approaches 0 from below--
OK, I should have said perfect
competition, I'm sorry, was
negative infinity,
not infinity.
Negative infinity.
As the elasticity of demand
approaches 0 from below, then
you're going to see that
the marginal revenue--
as you approach 0 from below,
marginal revenue is going to
become negative.
So for example, if the
elasticity of demand equals
minus 0.5, then the marginal
revenue equals minus p.
So if this is minus 0.5, then
this becomes minus 2.
So marginal revenue
equals minus p.
You lose money.
So as that elasticity of demand
approaches 0, you're
going to have a negative
marginal revenue from selling
the next unit.
And why is that?
With a very inelastic good,
you have to push the price
down so much to sell the next
unit that you lose money.
Think about a very elastic
versus very inelastic good.
With a very elastically demanded
good, to sell another
unit you don't have to change
the price much.
Because the demand curve's
very flat.
So there's not much of
a poisoning effect.
dp dq is small, or
dq dp is big.
OK, this is the inverse.
So dq dp is big with elasticity,
so dp dq is small.
With a very inelastically
demanded good, to sell one
more unit you're going to lower
the price a ton, which
is going to poison the revenues
you get from selling
that extra unit.
So that's why marginal revenue
will be higher, or will be a
larger fraction of p
as this elasticity
becomes more negative.
Yeah.
AUDIENCE:
[UNINTELLIGIBLE PHRASE]
elastic that means
[UNINTELLIGIBLE PHRASE]
irrespective of the price.
So couldn't you just charge a
higher price and get marginal
revenue [UNINTELLIGIBLE].
JON GRUBER: No, because
here's the thing.
You should have already been
charging that high price.
The point this is the margin.
So you go into a market
for insulin.
You say, look, these guys are
going to die without it.
I'm going to charge
$500,000 a shot.
But now the question we're
asking about marginal revenue.
And at $500,000, you sell to
everyone who can afford it and
everyone else dies.
Now you want to ask, what's the
marginal revenue as you're
trying to sell that 500,000
and first unit?
Well to sell that, since it's
inelastically demanded, if
that person could afford
anything like $500,000, they
would have bought it already.
They can't.
They can only afford $400,000.
We have to lower the
price to $400,000.
You're going to sell one more
unit at $400,000 but lose
$500,000 on all those other
units you were going to sell
at $500,000.
The point is it's about the
margin not the level.
Yes, monopolists make a huge
profit when it's inelastic.
I'll talk about that
in a minute.
But that next unit they're
going to lose money on.
So that's actually a good point
to segue to now, let's
talk about with this in place,
let's talk about how
monopolists maximize profits.
Let's talk about monopoly
profit maximization.
Let's go to Figure 14-4.
Profit Maximization
for a Monopolist.
Now, this is a lot more
confusing than perfectly
competitive firms, so let's
follow along here.
This is a case the cost
function here
is 12 plus q squared.
So I'm doing the cost
function, which
is 12 plus q squared.
That's the cost function.
And the demand function,
as before, is Q
equals 24 minus p.
So that's what's graphed here.
Now, recall the rule that profit
is maximized where
marginal revenue equals marginal
cost. Well, we know
marginal revenue.
We know marginal revenue--
we derived that above--
is 24 minus 2Q.
What's marginal cost with
this expression?
Well, marginal cost,
differentiation of the cost
equation, which is 2Q.
So the optimization term for a
monopolist is going to where
marginal revenue, which is 24
minus 2Q, equals marginal
cost, which is 2Q.
Or Q equals 6.
That's going to be the optimal
production level for the
monopolist.
So we can see that graphically
that's where the marginal cost
curve hits the marginal
revenue curve.
If you go downward from that
point, you get that the sales
are 6 units.
So marginal revenue equals
marginal cost at 6.
You should be able to see that
graphically, it's just where
the curves intersect.
Mathematically I just
did it here.
It's actually pretty
straightforward.
Here's the hard part.
What's the price?
We might say, well, gee,
marginal cost and marginal
revenue intersect at 6.
I'm going to draw the
dashed line over.
That means the price
is going to be 12.
Why can that not be the price?
Why is that wrong?
What would that violate
if the price was 12?
If you tried to sell
6 at a price of 12?
Yeah.
AUDIENCE: [INAUDIBLE].
JON GRUBER: It's not on
the the demand curve.
The monopolist still has to
respect the demand curve.
So monopolists in setting
their quantity, gets the
intersection of marginal revenue
and marginal cost. But
then in setting the price, they
still have to read off
the demand curve.
They can't change
consumer tastes.
So they charge a price of 18.
That's where you sell
a quantity of 6.
So monopolists it's a little
bit trickier in a perfectly
competitive firm.
You set marginal revenue equal
marginal cost to derive Q. But
then to get p, you've got to go
back and plug that into the
demand curve.
So with a Q of 6, I
have my Q of 6.
Well, what's the p?
Well, to get that p, I've
got to go back and
plug this in here.
At Q equals 6, p is
24 minus q, or 18.
So I've got to respect
the demand curve.
The monopolist has to respect
the demand curve.
The monopolist picks both price
and quantity, but he has
to pick them such that you get
a point on the demand curve.
And the way we solve it, is
the monopolist chooses a
quantity to set marginal revenue
equal to marginal
cost, and then chooses the price
that's consistent with
demand for that quantity.
Questions about that?
Now one last thing.
In the short run, we still have
another condition for
profit maximization, which
is the shutdown rule.
Remember the shutdown rule
we talked about perfectly
competitive firms in the short
run, which is even if profits
are negative, you might
not shut down.
You only shut down if price is
less than average variable
cost. So there's still
the shutdown rule.
So you only shutd own if price
is less than average variable
cost.
Now in this case, what's
the monopolist profits?
Well, the monopolist made
a profit of 60.
How do we see that?
Well that's graphically the box,
the rectangle, that's the
difference between the average
cost curve and
the price they get.
So they're charging 18.
Now once again, marginal
revenue is gone.
Think about marginal revenue
like an imaginary concept.
Marginal revenue isn't something
that actually exists
in the market.
Marginal revenue is just
something the monopolist draws
to pick what they're
going to do.
But then it disappears.
What the monopolist cares
about then is price.
They're charging 18.
Their average cost for
that unit is only 8.
So they're making a profit of
10 per unit on 6 units.
So they're making
a profit of 60.
And what you can see, what you
should be able to demonstrate
to yourself is, if a monopolist
sold 5 units.
I'm sorry, selling 6 units.
If the monopoly sold that
seventh unit, what you'll be
able to see is they would lose
money on the seventh unit.
Because yes, if they sold that
seventh unit, what happened if
they sold the seventh unit?
Well then their price would have
to be what if they wanted
to sell a seventh unit?
The price would have to be 17.
The price would have to be 17.
So to sell a seventh unit,
they'd have to
have a price of 17.
So basically at a price of
17, the price was 17.
Then what would happen?
Well, they'd sell one
more unit at 17.
That'd be good.
But they'd lose $1
on the previous 6
units, which is bad.
So how much revenues
would they make?
What would be their
marginal revenue?
Well, the marginal revenue would
be they make 17 minus
the 6 poisoning effect.
So marginal revenue equals 11.
What's their marginal cost?
Their marginal cost is 2Q.
Marginal cost is 14.
So they lose money.
So you should be able
to walk through
this exercise yourself.
You might say, gee, the marginal
cost of that next
unit is only 14.
They sell it for 17.
Gosh, they should do it.
What you're missing is by
selling it for 17, they've
lost the dollar extra
they make on each of
the previous 6 units.
And that poisoning
effect makes it
unprofitable to do this.
And that's why the monopolists
stop short of what would be
the perfectly competitive
outcome.
What would the perfectly
competitive firm do?
The perfectly competitive
firm would set marginal
cost equal to demand.
And they would end up producing
where marginal cost
equals demand.
So demand here is 24 minus p.
Marginal cost is 2Q.
So they would end up producing
where marginal cost equals
demand at a much higher
level charging a
slightly lower price.
So what you see is the
monopolist ends up selling
fewer units at a higher price.
Questions about that?
Yeah.
AUDIENCE: How does this work
for Microsoft where their
marginal costs are very
low or nonexistent?
JON GRUBER: Well, then what
would happen, if their
marginal costs were very
low or nonexistent.
Think of that marginal
cost curve then as
being much, much flatter.
It would intersect demand at
a much higher quantity.
Or it'd intersect marginal
revenue at a
somewhat higher quantity.
Not that much higher.
So if marginal cost is very
low, they produce more but
they make even more profits.
So it's a good question
actually, a good comparative
statics exercise.
You bring that marginal
cost curve down,
what's going to happen?
Quantity is going to go up, but
not as quickly as profits
are going to go up.
That's why Bill Gates is the
richest man in the world.
That's what happens.
You get really rich.
So basically, when you're a
monopoly, low marginal cost
you get really rich.
But that's a great thought
exercise to understand how
this monopoly example works.
Other questions about that?
So this is a good opportunity
to introduce an important
concept with monopolists, the
concept of market power.
What monopolists have, what Bill
Gates has that my local
McDonald's does not
is market power.
Or what he had, has less of
now, is market power.
Market power is the ability to
charge price above marginal
cost. The summary statistic of
how much power a monopolist
has is how much they can drive
their price above marginal
cost.
When Bill Gates marginal cost
dwindles to 0, his market
power gets bigger.
Price above marginal cost.
Now to think about this,
remember the condition for
profit maximization.
It was that marginal revenue,
which we wrote as p times 1
plus 1 over epsilon equals
marginal cost. So we can
rewrite this as marginal cost
over price equals 1 plus 1
over epsilon.
Now let's define the markup.
Let's define the markup as price
minus marginal cost, how
much money you make
on the next unit.
You sell for p, you get marginal
cost. It's money you
make the next unit.
If you define the markup, p
minus MC over p, that's the
percentage markup.
It's how much you make
on the next unit,
the percentage markup.
Then you can see that
that markup equals
minus 1 over epsilon.
So the markup for a monopoly
firm equals
minus 1 over epsilon.
This comes to the question
before about the insulin
example's sort of confusing.
Here we see your intuition
on insulin.
The lower its elasticity, the
more the monopolists can mark
up their price.
So your intuition
is shown here.
Yes, the monopolist
will charge an
incredible price for insulin.
They'll still lose a lot of
money if they try to raise
that price, if they try
to sell one more unit.
But the first initial price
they'll set will
be incredibly high.
Basically, what is the
constraint on Bill Gates?
What is the constraint
on Bill Gates?
It's Steve Jobs.
It's substitutes.
The only constraint on a
monopolist is the extent to
which people can sub--
actually, let me go back, that's
not a good example.
Let's [UNINTELLIGIBLE]
Bill Gates circa 10 years ago.
The constraint on Bill Gates
circa 10 years ago was a
mainframe or some other form
of doing a set of--
or 20 years ago it
was a typewriter.
It was basically the fact that
there was some other way to do
what Bill Gates was
letting you do.
If there was no other way to do
what Bill Gates was letting
you do, he would charge
an infinite price.
Clearly if there's
some other way--
and also, elasticity of course,
comes from substitutes
or one substitute is just
not to compute.
So if Bill Gates tried to charge
infinity for Windows,
people just wouldn't
own computers.
So the reason Bill Gates can't
charge infinity, and the
reason he can't charge infinity
for insulin is that
there's some elasticity
of demand.
People at some point will
just stop buying.
Either because they'll choose to
use a typewriter instead or
they just won't compute.
They'll write by hand
or something.
So basically at some point,
there is some elasticity
because there's a market
demand curve.
And basically what's going to
determine how much market
power the monopolist has is
going to be how elastic it is.
Basically, how close the
substitutes are for that good.
If there's close substitutes,
the monopolist won't be able
to charge a very high markup.
If there's not close substitutes
as of Window circa
10 years ago, the monopolist can
charge a very high markup
and become very, very rich.
Yeah.
AUDIENCE: But if there are
substitutes for the market,
then it's not a monopoly
anymore.
JON GRUBER: No, no, this
is the key thing.
Substitutes for that producer.
So basically, that's why
I said Steve Jobs
is not a good example.
Because then it's not
a monopoly anymore.
But the typewriter is
a good example.
That's a different good, that's
a different market,
different good that
substitutes.
So my point is any given good,
insulin being an exception,
but any good there's always
something you can do instead.
Insulin there is something
you can do
instead, you can be sick.
There's always something
you can do instead.
We don't have only one
thing in life.
So the elasticity of demand is
never perfectly inelastic.
It seems silly 10 years ago, but
20 years ago it actually
was a legitimate decision
whether to have a PC or not.
A lot of people just didn't
have computers.
You could always just
not have one.
That gives you inelasticity
of demand.
So basically, it's important
to recognize when we talk
about substitutes, I'm talking
about here not substitutes
within the market, but
substitutable activities,
other things you could
do with your money.
And the more other things are
you could do with your money,
the less markup that Bill Gates
can make on his Windows
operating system.
Questions about that?
OK, now we can ask, OK, gee,
John, this is all good and
interesting, but why did you
just waste the last lecture
and a half teaching us about
welfare if you're just going
to go back to producer theory?
Well, the reason is because
now we come to what the
welfare effects of monopoly.
And ask, what effects do
monopoly have on society?
And in fact, we can show you
that there's a deadweight loss
on society imposed
by monopoly.
To see that, let's go
to Figure 14-5.
And here we can show the
deadweight loss of monopoly.
And here's the same example
we were using.
Demand is Q equals 24 minus p.
Marginal cost is 2Q.
The cost function is
12 plus Q squared.
So marginal cost is 2Q.
As we saw before, the monopolist
chose to sell 6
units at a price of 18.
6 units at a price of 18.
The perfectly competitive firm
sets demand, which is 24 minus
Q, sets price, I'm sorry, equal
to marginal cost. Well,
price comes to demand
curve as 24 minus Q.
Marginal cost is 2Q.
So the perfectly competitive
firm sets Q equal to 8.
The perfectly competitive
firm sets q equal to 8.
They choose to sell 8 units
at a price of 16.
So you get the competitive
quantity Q sub c is eight and
the competitive price
piece p sub c is 16.
That's where graphically demand
equals marginal cost.
Or price equals marginal cost.
The monopoly firm sells 6
units at a price of 18.
So what is the welfare
effects of monopoly?
What we see is we know
that the competitive
firm maximizes welfare.
We learned that last time.
We know that the best you can
do is to sell 8 units at a
price of 16.
What happens when you sell
6 units at a price of 18?
What happens is consumer surplus
falls from A plus B
plus C. So with perfect
competition, consumer surplus
is A plus B plus C. With a
monopoly, consumer surplus
falls to the area A. So you lose
B plus C with monopoly.
Producer surplus under perfect
competition was the area D
plus E. Now under a monopolist,
the producer
surplus is equal to D plus E
plus B. The monopolist , in
this case, gained the rectangle
B, but gave up the
rectangle E. The consumer lost
the rectangle B, that was a
transfer to the monopolist. So
there was a transfer of the
rectangle B from the consumer to
the monopolist. But C plus
E have disappeared.
They're a deadweight loss.
They're deadweight loss because
in the perfectly
competitive equilibrium these
are trades that would have
made both parties better off.
That is, these are trades which
socially should happen.
They are trades where the value
to the consumer exceeds
the cost of producing
that unit.
Those seventh and eighth
units are units--
so take the seventh unit.
What's that worth to someone?
Well, it's worth 17.
We can read that off
the demand curve.
That's a willingness
to pay curve.
People are willing to pay 17
for that seventh unit.
What's it cost to produce?
It cost 14.
So you have a unit which people
want more than it costs
to produce, yet it's
not getting sold.
That's deadweight loss.
So monopolists induce deadweight
loss because units
that people value above
their marginal
cost doesn't get sold.
Units people value above their
marginal cost don't get sold.
And that's because this
poisoning effect.
Because while it's socially
optimal to sell those units,
while society is better off,
it's privately sub-optimal.
From the monopolist's
perspective, it's bad to sell
that unit because of this
poisoning effect.
So basically, the monopolist
is underselling,
underproducing.
In general, monopolists will
underproduce goods.
They'll sell too few goods
because to sell the right
amount would not be
profit maximizing.
Because remember, what's the
profits for the perfectly
competitive firm?
Profits for the perfectly
competitive firm?
Well, we know the profits of
perfectly competitive firm.
We know cost if they
sell 8 units.
We know the cost function
is, the cost here
is 12 plus Q squared.
So if they sell 8 units, their
costs are 12 plus 64,
which equals 76.
Their revenues if they sell 8
units are 8 units times the
price of 16.
8 units time the price
of 16, which is 128.
So what are their profits?
Their profits are 52.
So their profits are 52.
The monopolist's
profits are 60.
So the monopolist is
better off than the
competitive firm would be.
The competitive firm would
only make profits of 52.
Obviously the short run.
The long run they
make no profits.
But in the short run they
make profits of 52.
The monopolist makes
profits of 60.
So the monopolist is better off
than the competitive firm.
The difference of course, is to
do so they cause a social
deadweight loss.
Questions about that?
Yeah.
AUDIENCE: Is that what the
OPEC is doing right now?
JON GRUBER: I'm going to
come to that actually.
Time out on that.
Because OPEC is more
of an oligopoly.
And we'll come to that when
we talk about that
in a couple of lectures.
But I want to talk about one
more thing before we stop,
which is I want to talk about
the key assumption we made
here, which was the monopolist
could only charge
one price to everyone.
In fact, we know that's
not true.
In fact, we know in the world,
there's a large amount of what
we call price discrimination.
There's a large amount of
price discrimination.
We know that for many goods,
different prices get charged
to different consumers.
If you ever tried to book an
airline ticket the last
minute, you know exactly
what I mean.
Basically, different prices
in many, many contexts get
charged different consumers.
Everything from discounts for
senior citizens, to higher
price last-minute flights, to
specials, two for one specials.
People who buy two get
a special price on
the third, et cetera.
There's all sorts of price
discrimination just out there
in the world.
And in fact, there's very
few goods that are
sold at just one price.
McDonald's hamburger
is typically
sold at just one price.
They don't say like, fat people
got to pay more for
McDonald's hamburgers
or something.
But many, many goods we buy in
the real world are sold at
many prices.
And that's an example of a
price-discriminating firm.
And here's the crazy part.
Here's the crazy part.
It turns out that a
price-discriminating
monopolist maximizes
social welfare.
A price-discriminating
monopolist is as good as a
competitive outcome.
How can that be?
Let's go to Figure 14-6.
Here's the price-discriminating
monopolist. Now, the
price-discriminating
monopolist, what does he do?
This is a perfectly
price-discriminating
monopolist, someone who can
charge a different price to
every single consumer.
Well, if you were a
price-discriminating
monopolist, perfectly
price-discriminating
monopolist and you could charge
a different price to
every consumer, what do you
charge the first consumer?
24.
What do you charge the
second consumer?
23.
Third consumer, 22.
You literally charge them their
willingness to pay.
If you're perfectly
price-discriminating, then
what you do is literally charge
every consumer exactly
their willingness to pay.
You say look, I know your
willingness to pay function.
Your willingness pay function
is p is 24 minus Q. That's
your willingness to
pay function.
So I'm going to literally
charge you that.
I know that about you, it's
stamped on your head.
So I'm going to say, ah, you're
willing to pay 24 for
the first unit, 23 for the
second, et cetera.
In that case, what will the
perfectly price-discriminating
monopolist do?
Will they stop at 6 units?
No, they won't.
Because for that guy, there's
no poisoning effect.
There's no reason to
stop at 6 units.
That seventh unit, as we just
did the math, there's money to
be made on that seventh unit.
Because that seventh unit is
worth 17, but it only costs 14
to produce.
So the perfectly discriminating
monopolist will
sell it at 17.
Likewise the eighth unit, people
willing to pay 16 and
it cost 16 to produce.
So they'll sell it or not.
They're basically indifferent.
So we typically say
they'll sell it.
The point is, the perfectly
price-discriminating
monopolist will work all the way
down the demand curve to
the competitive outcome.
They will move to the
competitive market outcome
because there's no
poisoning effect.
There's no reason not to.
No reason not to sell
as many units.
No reason not to climb the same
hill the competitive firm
climbs and sell any unit where
the price exceeds the marginal
cost.
Well, what's interesting is
let's ask what's happened to
social welfare with this
perfectly price-discriminating
monopolist. Well, consumer
surplus is what?
What's consumer surplus
with the perfectly
price-discriminating
monopolist?
Somebody raised their hand.
Yeah.
AUDIENCE: Zero.
JON GRUBER: Zero.
Why is it zero?
AUDIENCE: Because they're
charged exactly
how the value is.
JON GRUBER: Exactly.
Consumer surplus is defined
as willingness
to pay minus price.
But your price is set equal to
your willingness to pay.
So by definition, consumer
surplus is 0.
With a perfectly
price-discriminating
monopolist, there's no
consumer surplus.
But what's producer surplus?
Same person, what's
producer surplus?
AUDIENCE: Everything else.
JON GRUBER: Everything else.
A plus B plus C plus D plus E.
There's no deadweight loss.
You get exactly the same social
welfare as you got with
perfect competition.
It's just divided differently.
With perfect competition,
consumers got A plus B plus C.
Producers got D plus E.
With a perfectly
price-discriminating
monopolist, the monopolist
gets everything.
But the total shaded
area is the same.
So really fascinating because
here we have the ultimate
screw on consumers.
We think about competition
as being the
best thing for consumers.
Lots of firms selling goods at a
competitive market where you
can shop and do what's
best for you.
It's not surprising intuitively
that that's the
best thing for society.
What's very surprising
intuitively is having a
producer who can screw every
single consumer out of every
penny they value something is
equally good for society.
And why is that?
That's because we've made a
particular assumption, which
is social welfare is the sum
of producer surplus and
consumer surplus.
The linear sum.
Since it's is sum, we don't care
in that function who gets
the dollars.
We just care about the total
amount of dollars, the total
size of the pie.
We don't care who gets what
slice of the pie, we just care
about the total size
of the pie.
And the total size of the pie
is the same with a perfectly
price-discriminating
monopolist and
a competitive firm.
What this highlights is that
that's a pretty stupid way to
think about social welfare.
Clearly, we don't feel the same
way about a market where
people get everything
they want and a
market where people--
all they're willing to pay is
sucked out of them by a greedy
monopolist. Clearly we don't.
And that's why we're going to
need to think more richly
about equity and think more
richly about the division of
resources in society.
Because it turns out that you
can have equally good outcomes
from an efficiency perspective
that are very, very different
from an equity perspective.
And this is the first example
we'll see of that.
What we'll do when we get
towards the end of the course
lectures, like 23, 24, lectures
like that, we're
going to start talking
about equity.
And what are different rules we
can think of for dividing
this pie that might give
us a different answer?
OK, questions about that?
All right.
OK, so anyway, we'll
stop here then.
Let's remember that perfectly
price-discriminating
monopolist is obviously also
a silly concept just like a
perfectly competitive firm's
a silly concept.
What we're going to do next
time is come back and talk
about price discrimination in
reality and what firms do to
try to approximate this
golden outcome.
