Hi, I’m Saul Levmore and I teach law or really economics and law at the University of Chicago. It’s my good luck to be her to introduce you to the subject of economics. Well, what is economics?
Let’s play a game of free association. I say “economics,” you say whatever comes to mind. Economics—money. Economics—Wall Street, housing bubble, prices, incentives. Ohh, if you said incentives, that’s pretty sophisticated.
I think it’s easy to see why economics is relevant. Economics is everywhere. Economics is why buildings go up; economics is why cookies cost $3.00. Economics is about getting the seat you want on the plane. Economics is, yeah, it’s about making money, but it’s about human behavior in general. Economics is to the real world around you as meteorology is to the weather, it’s interpreting all the phenomena and figuring out if there’s anything we can do about that. How could that not be relevant to every one of us?
That’s a lot of what we’re going to talk about today. Economics is, formally at least, 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 do they get it, what do they give for it, how do you get people to make more of the thing. All of 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 guy who sees that the price of wheat rises; he gets up earlier in the morning and grows more wheat on his farm. Economics is the guy who buys more of something when the price drops. That’s the rational man.
The rational man loves to download stuff from iTunes when iTunes price goes down, but the rational man also creates more music in his garage and sells it when he gets paid more by people who download it from iTunes. One guy wants the price low; one guy wants the price high. They’re using incentives to communicate with one another.
So economics is about exchanges, economics is about prices, therefore it’s about money and it’s about incentives. Once you have those four things down, you’re beginning to put the package together.
I said that economics was about puzzles. Economics is also about puzzles.
And these puzzles are even deep mysteries, have a lot to do with how economics got started in the first place. Kings would be really confused about some things. They would issue new coins, the coins would go out into the realm and the coins would disappear. Where were these coins going?
Peter the Great, I just read the other day, beheaded some 1,000 people for hoarding coins. And he could never figure out why when he issued silver coins, people would hide them or bury them in the fields. Why didn’t they want to use these coins? What was so great about holding them? Well, that’s the mystery that economics was out to solve. Peter the Great hired advisors and he wanted to figure these things out.
How come countries traded some things and not others? England and Portugal were sending wine and cheese back and forth, but some things never seemed to travel. Why was that? Well out of these puzzles came the study of economics. And the people who advised these Kings can be thought of as the first economists. And economists have continued to like puzzles ever since. Think about sovereigns in our own time. Think about something the government does and wonder why the government does it.
So a fire breaks out. You can imagine one world where ten competing fire departments, you’d look them up on the internet and you’d say, “Oh, how much to put out my fire?” And people would race around for prices to put out fires. That’s not the way it works. Instead, the government is in charge of firefighting. Economists are very interested in that, you know, why is the government in charge of firefighting and not growing wheat? Why doesn’t competition make firefighting work better or do governments somehow compete to see who’s better at putting out fires? Of course, there is a little bit of competition there because if the government does a bad job putting out fires or plowing the streets in the wintertime, then voters will throw them out of office and bring in new politicians. Still, that’s not exactly using prices, that’s using votes rather than prices. And our job today is to understand the use of prices.
Two of the things we are going to focus on today are prices and the form of competition. And let me say a little bit about them before we get there.
Prices and competition or its opposite, monopolies, are two central tools in the study of economics.
Prices are these 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 the thing. We’re going to see a lot of prices today. By form of competition, I mean, the people who make these things, are they competing with other firms to make it or are they the only one out there making it.
A perfect competitor, economists like to say, is somebody who is out there trying to sell you something or make something, and though lots and lots of other people are trying to make the same thing, competing to make it better or at a lower price or whatever it is.
When they’re the only one out there, we call them a monopolist.
So the monopoly is a form of producing goods. A perfect competitor, economists like to say, is somebody who is out there trying to sell you something or make something, and though lots and lots of other people are trying to make the same thing, competing to make it better or at a lower price or whatever it is. The monopolist is somebody who for some reason or another has the market to itself.
And we’re going to spend a good deal of our time today understanding what’s so interesting about monopolies. Why governments care about them. Why governments even sometimes like monopolies. And why you and I might not like them so much.
So the monopoly is a form of producing goods. A perfect competitor, economists like to say, is somebody who is out there trying to sell you something or make something, and though lots and lots of other people are trying to make the same thing, competing to make it better or at a lower price or whatever it is. The monopolist is somebody who for some reason or another has the market to itself.
But probably 10 or 20 such tools, but we’re going to have time for two of them today and many applications of those tools.
Now you can even think of the government as a kind of monopoly. It’s sometimes that we say that the government has a monopoly on power, you know, they’re the only one who gets to have an army in most countries. But as we’ve already seen with the firefighting example, really the government allocates to itself the right to be a monopoly about many things. The government has a monopoly on making laws; it has a monopoly on fighting fires, on being the police. It’s a form of monopoly, but one that’s more influenced by votes than by prices. But there are many, many, many other monopolies out there that the government allows.
Think about the streets in your city. Well, if you had competition for producing and sending people water or electricity, you’d have 10, 15 companies digging up the street all the time laying pipes, putting in water, sending the electricity and the water to your house. Nobody wants to tolerate that. So instead, most governments say, let’s make that a monopoly. Either we will own it or we will some way or another hire a firm to do that. We’ll give only one firm the license to dig up the streets and put in the pipes. And then either other firms can compete to sell you water at your house or probably that one monopolist will sell water at your house. So the government doesn’t want many people digging up the street. On the other hand, it might recognize that there’s a problem with having only one supplier of water to you. We’re going to focus on that one supplier in a few minutes and in any event, we already know to call that a traditional monopolist.
While we’re talking about the government as a monopoly, notice that the government doesn’t charge you for firefighting. It’s a curious thing that economists are interested in. The government charges you for water, but when it puts out a fire in your house, it doesn’t charge you. It might even have rules requiring you to have fire extinguishers or in big buildings, sprinkler systems. Still, if the Trump Tower burns down and the government comes and saves it before it’s burned to a crisp, 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 that is.
This is the sort of thing that economists are interested in.
Here’s another monopoly for you and another example of where we use markets sometimes but not other times.
Think about the college you go to. The first time you met that college, it was an intense competitor. Many colleges were probably competing for you to be a student there or certainly for your application fee. And you in turn were competing with many other applicants for seats in the college. It was a very, very active market.
Suddenly, it changed. You’re admitted to a college, you matriculate there, you show up, you need a dorm room, very, very, very few colleges say, “Oh, the third floor dorm rooms are better than the second floor dorm rooms. Let’s raise the price a little bit on the third floor.” No, no… suddenly, it’s as if there was no market at all. Colleges tend to hate prices. Colleges act as if there is no market at all. A course is overcrowded? They might tell you, you can take another time, they might add a section to the course. They might hire another teacher, they might stuff the room full of chairs, but the last thing they do is say, “Okay, everybody who wants to pay $189, please come in and sit in the first row.” Why is that?
That’s another good example of where sometimes we love markets and sometimes the players in the market, like the college in my example, **** the market and says, “No, no, no. There’s a reason why we should be some sort of community without a market.” Probably they gain something by this and they lose something by this. And again, that’s the sort of thing that economists are very interested in understanding. And I hope you will be too.
In economics, the best way to understand big puzzles is to break them down into little puzzles. Little puzzles are not so easy, but big puzzles, as we’ll see, are really beautiful. They’re beautiful to solve by putting together these tools, we can learn from the smaller puzzles. The key way we’re going to solve these puzzles today and in economics more generally, is by always thinking about these markets. Where does a market exist? What are prices doing? What’s competition doing? Do we have a monopolist or do we have a lot of competitors running around? These are the tools that we’re going to looking to use to solve problems. We want to understand the recent financial crisis that hit the world. We want to understand housing bubbles. We’re going to start with prices. We’re going to start with competition and then we’re going to understand the role of the government.
So, let’s start with prices.
When I say prices are special, I mean 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 gas. Prices tell me whether to go to a restaurant early or go to the restaurant late. And in fact, when the restaurant doesn’t offer price differentials, I’m a little disappointed. Sometimes on a rainy day I think, “Boy, I bet there’s nobody going out to the restaurant now. I wish the restaurant would drop the price and then I’d be more eager to go to the restaurant. So sometimes we have prices and sometimes we don’t, but when we have them, they’re a little bit like magic.
Now, this magic can be a little puzzling. And indeed, prices have puzzled economists for hundreds, if not thousands of years. You know, why do things cost what they do? You know, say I eat a chocolate chip cookie. Why does that cookie cost a dollar or eighty cents or three dollars, or whatever the range it might be? Why does it cost that amount?
Well, first let’s see the puzzle 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 before, but that’s okay. Well, you might say, the more important the thing 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?
You’re initial response might be, well, people need houses more. The cookie’s a luxury. Therefore, the house costs more. But that’s not really a successful way to think about it.
Think of the following classic example, air. Air is basically free. Take a nice big gulp of it as one advertisement 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, you should say, is scarcity.
There are very, very few diamonds. You have to dig deep in the ground to get the diamond. Transport it thousands of mile, polish it, cut it, do this, do that. It’s a lot of work, it’s very hard to get them, there aren’t many of them. Diamonds are even more valuable than aisle seats on airplanes. Diamonds are expensive. They’re scarce.
Air, it’s available. You just breathe it in. Even where it’s not available, it’s available. If you go scuba diving, you just up at the surface, you capture some air in a tank, tanks are relatively cheap, you go underwater, you can breathe. It costs you just a few dollars. We know the answer to that now. A thousand years ago, that might have been a puzzle, but if I say, why is a diamond more expensive than air… more expensive than a gulp of air? It’s obvious that scarcity is the thing that’s really doing the job.
Now, let’s go back to cookies and houses now. That’s a little bit more complicated. Let’s do cookies first.
I love a good cookie. Imagine that I would pay $10 for a really fantastic, juicy, chocolate chip cookie. My kids always say, there’s no such thing as a juicy pastry. But that’s wrong. A really good cookie is juicy and worth $10.
Now, I’ve never paid $10 for a cookie, even though I would. So I go to the bakery, even my favorite bakery and I walk in and I say, “Oh, how much are those fantastic cookies?” The baker knows that I would pay $10 for the cookie. He can see it all over my face. But he says, “Well, that cookie is $3.00.” Well why doesn’t he charge me $10? I mean, he might check out my face when I walk in and charge $10, but of course, if he did that, I would revert to Todd’s strategy. I would just go out to the sidewalk, I would wait there. I would wait for somebody else to go into the bakery and buy the cookie for $3.00 and they’d come out and I’d give them $3.05 or something for the cookie.
So, sometimes we say, the baker is unable to price discriminate among people. The baker has to sell the cookies at one price because otherwise people will go in and arbitrage the cookies, there will be a market made as Todd tried to make a market for aisle and middle seats.
Well, that doesn’t answer the question of why the cookie costs $3.00. So imagine the cookie sells for $5.00. The baker sees there’s some people who really want the cookie. The baker starts raising his price and charging $5.00. What’s the next thing that will happen? Well other people will see, you could make a lot of money running a bakery. Just gather together chocolate chips, rent an oven, get some flour, get the other ingredients necessary for making chocolate chip cookies and you’ll start making cookies and the price will start dropping as more and more people offer cookies. They’ll undercut one another $4.50, $4.00, $3.99. Until the price goes down to, well… to the amount that it will cost that marginal bakery to produce that chocolate chip cookie.
So prices are inputs are signaling the baker how to make the cookies, the price of the cookie is signaling me about buying the cookie. And my desire for the cookie is bringing new competitors into the industry. In the long run, the price of that cookie will be the cost of combining the inputs. It’ll be based on the cost of supply in the cookie.
In the short run, if there’s a lot of demand for the cookie the price might rise. If suddenly a hundred people, like me, rush into the store and say we all want the cookie, maybe the baker can raise the price a little bit in order to allocate the cookies that are there. But if that keeps happening, new bakers will enter the industry; bakeries will be popping up all up and down the street and cookies will drop to $3.00, which is the cost of producing them.
Let’s compare it to that house. Say you have a house selling for $300,000. What does that mean? It means that builders trying to put together windows and bricks and doors and roofs and subzero refrigerators or whatever goes into the house, they put all those things together and maybe there’s great demand for housing, maybe incomes have risen, maybe a war has come to an end. Maybe somebody can sell that house for $500,000. If so, new building contractors will come in, just like bakers came into that previous market. They’ll start selling more houses, they’ll build houses; they’ll work overtime. And they’ll build houses and build houses and the price for housing will drop, again, until an equilibrium, we say, that marginal builder can produce a house just like that for $300,000. The price won’t drop any further because, by assumption, no builder can show up and put together those inputs for less than $300,000.
One builder might be better at building them than another builder. In that case, maybe that builder can really build a house for $280,000 and make a $20,000 profit. But once we run out of such builders, we’re left with the typical builder who can put the house together for $300,000.
So in the long run, the answer to the question of, gee, why is that house more expensive than that cookie? The answer to that is a little boring, but it’s not scarcity. The answer to that is that, in the long run, that’s the cost of the inputs of putting those things together . It just costs more for the earth, in a sense, to produce the house than to produce the cookie, based somewhat on the scarcity of those inputs, but in the long run because new competitors can come in; the key variable is the sum of the cost of all those inputs.
Once again, prices are messengers. Prices are little messengers that run back and forth. When the price of the house went up to $500,000, it was as if messengers went out and said to builders, “quick, work overtime; build more houses.” They said to the brick kilns, produce more bricks. When the price started dropping, imagine a lot of empty houses all over the place, messengers will run around and say, “Houses are not selling for $300,000 or less because there’s a glut of houses.” Builders won’t get up in the morning to build houses. No need to pound that hammer if you’re not going to get paid for it. The same thing for the baker, the prices run back and forth telling the bakeries when to produce more cookies, when to produce fewer cookies, when to open new stores and so forth.
Prices are messengers. That’s a good thing to know.
CHAPTER HEADING: 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 the new houses?
Prices are probably the best way of measuring the intensity with which people prefer something.
And again, prices are a way of calibrating demand.
The more people would pay, the more the good was in demand. What we saw though was, in the long run, for competing objects like cookies in a bakery, houses on the housing market, in the long run, it was the cost of supplying them that mattered the most.
But there are exceptions to this. You know, imagine, you know, a trendy fashionable handbag. The cost of a designer putting together this handbag might really be $40. But the handbag might sell for 10 times that. Now that’s kind of an exceptional market and it’s worth thinking about what’s going on there. There are knock offs, of course, and the very same designer can produce more handbags. But in the short run, the designer seems to figure out that selling this handbag for $400, way above the cost of the inputs, that is, the cost of the assembly of the handbag, somehow triggers the market.
The higher price, in this sense, seems to attract people to the good for a while because it’s a fashion trend or a signal to them that this is a hot item to buy.
There are people who want to carry this handbag because it’s unique or there are people who are maybe who are even signaling, “Look, I can afford a $400 handbag.” Well, that’s not going to last long, right? 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 of the bag or there will be knock offs that will be so good that nobody can tell them apart.
Same thing with sneakers. You know, I have boring running shoes and even more boring shoes. And I pay, you know, maybe $80 for them. All around me, I see colorful, trendy footwear that’s actually cheaper to assemble, canvas and a rope practically, but they cost much more money than that? Again, why is that? Well, that’s the demand side. That there’s a short-term fashion trend, in a way, where people really want the thing, thousands of it are made, they need to be allocated, they’re allocated by the price mechanism. The higher price, in this sense, seems to attract people to the good for a while because it’s a fashion trend or a signal to them that this is a hot item to buy.
Again, that doesn’t last long. We’ll learn more about this later on in the lecture when we turn to housing bubbles. There could be a bubble for something like sneakers. The price could go way, way, way up before more sneakers flood the market or the fashion goes out. I don’t think you will ever find a bubble for chocolate chip cookies. Now that is basically based on the cost of assembling the cookie, and many, many other people can enter the industry and produce the cookie and drive the price down. It’s hard to imagine a sustainable bubble for cookies. Handbags, some kinds of housing, certainly sneakers, they can be sold for a period of time at above the cost of putting them together. And it’s something that we need to keep track of.
A long time ago, before you were born, there was no internet. I know that’s hard to believe, but trust me, I was there and it’s true. And in the world before the internet, prices weren’t just little messengers; I think it’s fair to say that prices were everything. There were classified ads in the newspapers and they were all about price. You know, wanted, 2006 Audi, $4,000. Everything was associated with a price. Billboards were about prices. McDonalds’ ads were about prices. Prices are, after all, key information. They are those messengers that I keep talking about.
But there’s an interesting development in the internet world, which is that as we have more and more information about goods, my observation is that more of the information is about non-price attributes of goods. So for example, if you go on Amazon and you want to buy a book, I mean, the price is there. It’ll give you the retail price and they’ll tell you what a good price you can get from Amazon. But probably 95 percent of the information is reviews from readers or the condition of the book, if it’s a used book. There’s a great deal of information that’s being provided that’s not about prices. I think that’s a function of the internet. It’s much cheaper to convey information now than it was 100 years ago. And as a result, we have not just prices, but a great amount of non-price information.
And this might also be a result of affluence. You know, once upon a time, I might have said, “Ohh, I want to go on vacation and stay in a hotel. How much is a hotel on the English seaside?” And then I would get an answer. Now, oh now, well do you want air conditioning? Do you want a big room, a little room, how many square feet do you want? I mean, there’s a lot of information that goes into 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 kind of room, the right ambiance, and a lobby and all of that information is being provided with 360 degree accuracy on the internet. So it may be that we are moving to a period where although prices are messengers, there are many, many more messengers out there and it’s these non-price attributes, as economists would call them.
CHAPTER HEADING: Arbitrage - Creating a market
A couple of Thanksgivings ago, I was sitting on a packed airplane. I was lucky enough to have an aisle seat. Sitting next to me was a really nice, tall, very tall student named Todd, and we chatted a little bit. And he asked me what I did for a living 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 trading seats with me for $50.” I was a little bit startled. And Todd said, “You know, I’m a really big guy, I’m six-foot-eight, these middle seats cramp me. I really, really want an aisle seat. So every time I get on a plane I’m in a middle seat, I try to bargain with the person next to me to get the aisle seat so I can stretch out my legs. Fifty bucks?” I said, “Sure.” I don’t really mind the middle seat that much, and besides, maybe the guy in the window seat was interesting like Todd.
Let me ask Todd to tell me more about his bargaining for these seats. And he said, “Actually, now that you mention it, I’ve probably asked people 12 or 15 times to sell their seat to me for $50, and you’re the first person that’s ever did it.” Well, actually one time, he said, about two years ago, he was really frustrated but nobody had ever accepted his offer and he said to the person. “Okay, I’ll give you $300 for that aisle seat right now.” And as if commanded to do so, the person on the aisle said, “$300? Sure.”
Now think about Todd a little bit 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 the aisle seats. There are fewer aisle seats than people who want them. It’s scarce, at least on that airplane. Now also, there’s no market. Todd wishes there had been a big market out there where you got on the plane or you got on your computer and saw which seats were available and which seat you want and you could bid for your seat. Todd apparently was willing to pay $50 to get an aisle seat, but at least so far, no airline is saying, “oh, you can move 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 they make hundreds of millions of dollars. On Wall Street, we call it arbitrage.
They look for things that they think are mispriced where you can make money by selling one thing and buying another thing and maybe doing them backwards and forwards many, many times in a day. That’s in a way what Todd was trying to do, except he didn’t have a well-developed market. Todd wished there had been these markets, but he said he had to make them. He was trying to arbitrage middle seats and aisle seats.
Todd’s not the only one who really wants an aisle seat. And it makes you wonder how airlines allocate these seats. Some airlines do it by first come, first served. When I buy a seat to travel, I get on and I click and it offers me to change seats and it shows me the available seats, but there’s no way for me to trade with people who acquired seats before I did. Some airlines do it with a queue.
Southwest Airlines, for example. If you get up early in the morning or you have an automatic program, app, and you check in and you’re on of the first ones to check in, you get a good number, you’re at the front of the row, front of the line and then you can get whatever seat you want.
Some airline sell you seats in the sense that I guess Todd could buy a Business Class seat or a First Class Seat by paying much, much more money. So there are many ways that we allocate things, prices are only one of them. But prices are special.
Economists would say that prices are a means of showing your intensity of preference. If you really want an aisle seat, you pay $50 for it. If you really want an aisle seat, you might pay $120 for it. Similarly, if you don’t care, you might sell, you might sell to the low price or the high price.
Prices can be thought of… now pay attention to this. Prices can be thought of as little messengers that run back and forth between people who want things and people who can supply them. When I click on the website and I say, “Oh, I want this seat.” The seller, that is the airline now knows, “Oh there’s somebody out there that really wants that seat and might pay more for it.” And similarly when the airline lowers the seat on the plane or raises the seat on the plane, it’s signaling me how many of those seats it has and it’s trying to figure out whether I want that seat.
When I flew on Thanksgiving, I paid a lot of money for the seat. When I fly on a Sunday morning in the middle of February, the prices of the seat are much lower. Right? The airline’s programs sees when there’s more and more demand for seats on the airplane. When there’s more demand, prices start rising because it wants to allocate the scarcer source and I don’t just mean the aisle seats, I mean all the seats. It wants to allocate that scarcer resource so that people who will pay the most for it, ‘cause 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 in order to attract people who are only willing to fly at a lower price.
So we’ve been talking about cookies and about houses and they are sold in competitive markets. Again, by competitive markets, I don’t mean anything complicated. Just that there are many buyers and sellers running around trying to service one another, get the business, buy the thing at a lower price and all of that. Those markets are the foundation of economics; economists spend a lot of time on competitive markets.
But not everything is sold on a competitive market and maybe less so than ever.
For example, non-profits occupy the healthcare field. Non-profits are important in education. Non-profits are important for supplying goods to poor people and so forth.
Governments are not competitive firms. They’re either monopolists or something else. Governments supply a lot. They supply a national defense and firefighting and national parks and schools and this and that. And then they are also monopolists. Monopolists again are single sellers, traditionally. They have a market all to themselves. Think about all the monopolists that we know. IPads are sold on monopoly markets because Apple has patents on critical aspects of the iPad.
Now you might say, well, an iPad has competitors of other tablets or PCs more generally. But there are a lot of people who really want what the iPad can offer them. So to some degree, Apple has a monopoly on selling iPads. To some degree it’s a competitor selling in the PC market or selling in the tablet market.
Many goods are like that. Say a new animated film comes out. I want to go see the movie. The maker of the movie has a copyright on that movie and can decide in what movie theaters that will be sold, which is to say, viewed. And in a sense has some control over the price the movie is shown. They can offer the movies as direct download; they can offer the movie in hardcore form or whatever you like. Well, again, is that a perfect market? Is that a monopolist? It’s somewhere in between. I don’t have to go to the movie. I might be just as happy to go to another movie or go to a concert or a baseball game. But to a degree, people who want to see that movie are stuck getting it from that supplier of the movie, which has a monopoly over the copyright.
Professional football games have that kind of monopoly. Again, no one has that monopoly on a chocolate chip cookie. The chocolate chip cookie is a commodity practically. Nobody has that commodity on an ingot of steel. You can produce that, it’s a commodity; it’s all over the place. It’s like water and air.
So there are many things, healthcare, government services, firefighting, iPads, a bridge over the Mississippi River connecting Iowa to Illinois. That’s a pretty effective monopoly because no one’s going to get permission to build eight bridges right next to each other and compete. So again, what we might think of as a situational monopoly over there.
We’re going to spend some time now moving to monopolies as probably the best example of these non-competition forms of selling things. And we’re going to see many lessons out of that, but we’re going to keep track of prices as we do it.
So again, to review where we are; prices come largely from costs, they also come from supply and demand. As we’re about to see, that’s remarkably so for monopolists where the demand is going to play an important feature in the price the monopolist charges.
Let’s examine those prices and messenger systems a little bit more carefully by thinking at the same time of an example where the airline is now not a competitor, where many, many airlines are flying, but let’s now begin to introduce the idea of the monopolist. That is the seller who does not face competition, but is the only one selling these seats.
CHAPTER SUBHEADING: Big Air; airline as monopolist
Let’s try an example together. Imagine that Todd was flying on a plane and to make the example as simple as possible, imagine the plane was owned by an airline called Big Air, for lack of a better name, and that Big Air was the only carrier flying between the two cities Todd and I were traveling. Say it was Boston to LaGuardia Airport in New York. So I have a chart here, of course I made it up, but it’s a pretty realistic chart in a way. And it shows that as Big Air charges more and more for a seat on the airline; any seat now, I’m done with aisle seats for a while. As Big Air chargers more for a seat on the airline, fewer people will want to travel on Big Air. Either they won’t travel to New York or they’ll drive, take the train, walk, donkey, what have you. But let’s have a look at it.
If they charge $50 a 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 go on the bottom, $5,000, 10 seats. Big Air will collect $50,000 for those of you who are math challenged, that’s $5,000 times 10, just count the zeroes, see four zeroes. Put the four zeroes on the right.
And then in the more realistic range, at a price of $300, we see that 2,000 people will demand seats, that is, want to accept the offer to travel from Boston to New York on Big Air at that price on that day. And so, if it sells 2,000 tickets at $300 each, Big Air will collect $600,000 in revenue. I haven’t said anything about their costs yet.
If it raises the price more to $500, well it gets a lot of people, 1,000 of those 2,000 people will still want to pay for the seat and they’ll pay $500, but of course, 1,000 people then will not fly. So I’ve constructed the example so that Big Air takes in the most money when it charges $300. And again, you might be thinking, well what about $270, or $320. I’ve excluded all of that to make the example as easy as possible.
It’s not free for Big Air to fly to New York. It has costs. And as we known, these costs are very, very important in figuring out when to fly, how to fly, and what to charge. So here, I’ve reviewed the information that you have already in the first two columns and then I’ve put in some information about costs in the third and the fourth column.
Now, think of Big Air just charging $50, that sort of crazy low price, 10,000 people wanting to travel. We know that Big Air would have taken in $500,000 in revenue. That was in our previous slide. Well what does it cost Big Air to fly 10,000 people? And I’ve put in some huge number. You know, imagine that it costs and average of $300 a person, which would be $3 million to fly so many people. Why does it cost more, rather than less per seat when it wants to fly more and more people? Well, to a degree, when you start increasing the number of seats, that is, when you increase production or output, as we call it. To a degree, costs drop. You know, think about the pilot flying the plane. If you only have one passenger on the plane and you’ve got to pay the pilot, say $1,000 a day to fly the plane, then that $1,000 is bourn entirely by the customer sitting in seat 1A.
You put 10 customers on the plane, same pilot; the pilot’s salary can now be spread among 10 customers. So that’s relatively fixed cost of the pilot, that fixed cost drops 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’s a pilot, there’s an airplane, there’s a ticket counter, there’s buying landing rights at LaGuardia, there are many fixed costs that now are divided among 10 people; 10 rich people. And then for the average cost of flying each of those persons is very, very high.
As you can see, working your way up from the bottom of the chart. When Big Air increases the number of passengers from 10 to 1,000, by dropping the price from $5,000 to $500, it gets what we sometimes call, economy to scale, it’s able to spread the pilot cost and the airplane costs and the landing costs and all those things I mentioned among more and more people, and so the average cost of sending someone to New York drops, in this case from $3,000 too $200.
Notice it stays there for a while and then it rises once they go to 10,000 seats. And why might that be? Well, they’ve probably run out of landing rights at LaGuardia. I mean, where would you land 10,000 people a day more than the system now holds. I can’t even imagine. They might buy away landing rights from other airlines at LaGuardia. They might fancifully suggest to the mayor of New York that Central Park needs **** and we put landing strips in Central Park and unload people there all day. It’s very hard to imagine how you could fly so many people so quickly every day from one city to another. And so I’ve imagined that the prices would rise a great deal. This is realistic for most things we make. That is, in the beginning, the price drops as you increase output and then eventually the price rises. Sometimes we say that the marginal costs rises over time.
Well now if we put these two trucks together, we can see how Big Air would make the most amount of money. That’s usually its job. We say that firms are trying to maximize profits. Again, we imagine the firm's a rational player that has a goal, and in this case its goal is to make as much money as possible.
Well, look at the example. When it charges $50 and those 10,000 people fly and land in Central Park, Big Air loses money. It spends $3 Million, but we saw that it takes in revenue of only $50 a seat times 10,000 is $500,000. It loses $2.5 million. Big Air never wants to do that. What about $300 a seat. Well that’s pretty good for Big Air. If prices of seats are $300, 2,000 people show up to the airport, that’s $600,000 in revenue and then by our assumption from the previous side, it costs Big Air $200 per seat to fly these people there for a total of $400,000 in costs. And as you can see, it yields a $200,000 profit.
Big Air can even do better if it charges $500 a seat, even though it only costs Big Air $200 to fly the person, by raising the price to $500, it loses half it’s customers, loses 1,000 people. Flies just 1,000 people, collects $500,000, $500 a seat times 1,000 seats. And its costs are $200,000. And so we can see that here is where it maximizes its profits hauling in $300,000 in net profit.
So we’re thinking a little bit about exactly how 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 price structure there. It was able to supply the seat for $200. And yet it figured out that it should charge $500. Let’s look at it first from Big Air’s point of view, and then from the 1,001st customer’s point of view.
From Big Air’s point of view, when it dropped the price… if it tries to drop the price from $500 to $300, in a way, you might think, well how can that be a bad thing? They’re going to take in 1,000 more customers who are willing to pay $300 a seat for the privilege of flying, when it only costs Big Air $200 a seat to supply the airplane and seats. So of course, you’d think Big Air would make more money by lower the price to $300. Indeed, any price that can charge above $200, it can make money. Costs me $200 to make the seat, I charge you $212; I chalk up another $12 in profit.
But Big Air in this example is a monopolist. Big Air is the only one flying, and so Big Air sees and says to itself, well wait a minute. If we drop the price from $500 to $300 in order to capture those extra people, we’re giving up charging $500 to the first 1,000 people we flew. After all, we have to charge everybody the same price in this example, like my cookie guy at the beginning of the lecture. So is it worth it to Big Air? No. Because when it drops the price from $500 to $300, it loses $200 a seat from the first 1,000 people. And it’s not worth losing $200,000 from those more intense, desired inframarginal customers, if you will, in order to make $100,000 from the new 1,000 people who will pay $300 a seat when it costs $200 to fly them.
So Big Air instead chooses, no. We will restrict output, we say, and fly at $500 a seat selling then… selling just 1,000 seats rather than 2,000 seats.
From a social point of view, think about it from the outside or even from the government’s point of view or the citizenry point of view. This is really a shame. After all, the cost of the resources of flying somebody to New York is apparent $200. And there are people out there willing to spend more than $200. Think of it as a resource, ecology thing. The costs of the resources on earth are such that for $200 you could fly another person from point A to point B. And that somebody out there willing to spend $300 for it, that person has a intense preference compared to the actual cost of doing it, but we deny them the flights. We say, “No, no. Because I am a monopolist and I can make more money at $500, I don’t want t sell it to you at $300.
Economists call this a deadweight loss. They say, boy, that’s a shame. There should be somebody, there is somebody willing to supply the seat at a tad over $200, even $300 in our example and that if somebody wants to pay $300 for it and yet we’re not matching them up. Now you’ve already seen that if this was a competition, if there were 10 airlines out there flying, of course another airline like my cookie maker would jump right in there and say, “Oh, come here, come here. We’ll fly you to New York. Give us $300… we can fly you for $200. It’s a great deal.” But again, because Big Air is a monopolist, it’s the only one flying this route and the demand structure; the prices are, as we’ve seen, Big Air will choose to restrict output to sell only 1,000 at $500 a seat.
We’re not quite telling you the truth in this example. Think, as I said, about that 1,001st customer. There is a customer there who sees that she’s willing to pay $300. Sees the price at $500. It’s as if she wants to whisper to the President of Big Air and say, “Okay, okay look. I understand that you don’t want to lower the price because then you’ve got to lower it to everybody else and you’ll make less money, but how about if I don’t tell anybody. 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’ll make $300,000 plus the $200 profit… the $100 profit on selling me the seat.” Well, I guess if Big Air could trust her not to tell anybody about this and not to resell the seat to somebody else, Big Air would do it. But the important part **** is that we see that this deadweight loss leaves customers unhappy, if you will. Unsatisfied. There are, again, 1,000 people willing to pay at least what it costs to supply that seat and they’re not getting their seat.
Now, in the real world. Big Air does a little bit of each. Anybody that has flown an airline knows that sometimes the person next to you has paid much more or much less the seat for you. Anyone in the real world knows that Big Air, in fact, can do a little bit of this. They can have it both ways. If you're flying on an airline and you talk to the person next to you, you might find that they paid much more than you paid for your seat or much less than you paid for your seat. Big Air does not quite have to charge everybody the same for its chocolate chip cookie, if you will. There is an ability for it to control arbitrage. Now in this case, it does it by saying, “ Your ticket is non-refundable and non-transferable.” You can’t sell it back to us and just buy another ticket when the prices drop. And similarly, you can’t just go to the airport and trade it with other people.
They may do this maybe 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 for the time being they can do that and this allows them to discriminate in a way. That’s not meant as a terribly bad word here, it’s a word economists use to differentiate among customers. They are able to take the people who want to pay a lot of money and charge them a little bit more and take the people who want to pay closer to $200 and charge them less.
So in real life, Big Air discriminates among customers. And we will return to that in a minute. But in our example, we are assuming no ability to discriminate. It’s like the chocolate chip cookie of the house; you need to charge everybody the same amount perhaps because people could exchange tickets or something. And again, in that example we’ve now seen something pretty important. That the thing economists and governments don’t like about monopolies is this problem, and I’m going to call it a problem, that even though there are people who would pay more for the seat then it costs to supply it, they don’t get a seat. It’s Big Air’s restricting of the seats from 2,000 to 1,000 in order to make more money, in order to make $300,000 rather than $200,000 that is the source of this problem. And that problem is called by economists, 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 is not offering me the seat.
If you were a couple of steps ahead of me, you may be wondering if I’ve overestimated the deadweight loss. After all, what happens to those people who wanted to pay more money than it costs to produce the seat, but were denied by Big Air? Well, I might drive to New York, I might fly through Milwaukee to New York, I might go do something else that day, but whatever else it does with my $300, I am after all spending that money somewhere else.
Now think about the average transaction when you spend $300. Someone might offer, you know, a Notebook computer to you for $300 and you might think, oh great, I actually would have paid $375 for it, but the market, amazing as it is, is offering this for $300 and you buy it. Well that extra $75 you would have paid $375, the market it offering it to you for $300, that extra bit is the opposite of deadweight loss. Like, just as Big Air denied you something even though you would have paid more than it cost to make it, here’s an example of where they don’t extract for you the real cost of this Notebook computer. You have $75 of consumer surplus, economists call it.
You could just think of it as benefit from living in a civilization or benefit from living in a market where you are not always the person who pays just the edgy price that the market is selling the thing at.
Almost every day when you buy something, you would have paid a little or a lot more for it than the person charged you and that’s a lot of surpluses that you are gaining and it’s the advantage of living in a civilization. It’s the advantages of living in a market. And it is exactly the flip of a coin of the deadweight loss.
So my first choice of how to spend the $300 might have been to fly to New York on Big Air and I was willing to pay $300, say, and they could have supplied it for $200 and they didn’t give me the seat, I lost $100 in surplus. But I probably took that $300 and went somewhere else and got maybe $70 of surplus or $20 of surplus. Not more than $100 of surplus or that would have been my first choice of the thing to do rather than to fly to New York on Big Air.
But for everyone who is denied a market here because of monopolists, that person does have that money to spend somewhere else and they get some surplus somewhere else. And so this example does overstate the deadweight loss and that’s probably something we should keep in mind. But again, the key idea is, is that the monopolist looks at the market, figures out the demand, maximizes its price always by remembering that if it lowers the price, it has to lower it to all the customers in the examples we’ve seen.
I’ve already said that in real life, Big Air does not charge the same amount for each seat. But it’s a little bit more clever and it does differentiate among customers on a plane. So for example, I might pay $300 for the seat; the person next to me might have wanted to get that seat very early and might have paid $400 for it. And then it might be somebody who really didn’t care when she traveled, she waited till the last minute, there were empty seats, Big Air, Expedia, Travelocity or somebody offered that seat at a much lower price. So Big Air has discriminated among or differentiated among consumers.
You’ve probably also figured out by now that that decreases rather than increases the deadweight loss. After all, it make it more likely that Big Air is selling seats that it can make for $200 to people who are willing to pay more than $200 for them because it’s already sold seats to the $500 people and then it’s able to lower the price without people conducting arbitrage and trading the seats.
So price discrimination by a monopolist allows it to make more money, also decreases the deadweight loss though it might get us a little nervous for other reasons. After all, the monopolist is already going to make much, much more money and there might be people who don’t like that or they might worry that the monopolist is setting markets up on purpose in order to price discriminate. The important thing though is to see that it’s decreasing the deadweight loss.
Notice that the monopolist doesn’t necessarily get to keep all this money; the more clever the monopolist, the more clever the government. Imagine a very clever monopolist in the computer world. The monopolist sees that more people want to travel on Thanksgiving; it raises the price of seats. Nobody wants to travel on Sunday afternoon; it lowers the price of seats. It can get much more sophisticated. It might see from my frequent flyer number that I’m somebody who really likes to travel at certain times of day and when I log on to get a seat, it might charge me more for a seat at that time. Programs do this already. As the plane fills up, as it sees who I am, it knows more about me. The more information it has about me, the more it can see inside my brain, the more it knows to charge me more in certain situations.
The monopolist can get good at differentiating among us, perhaps almost perfectly, so that as we show up, it knows exactly our reservation price, which is to say, the amount we would pay and any higher price, we won’t travel.
I guess a good government could take this money away if it wanted to. A government might say, “Well, to the extent that we are giving you the monopoly, after all, we’re the one that’s deciding how many planes can land in 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 forth. So if the government gives or allows Big Air this monopoly, the government might say, well we want to tax away a good deal of that money, or price it away in order to use the money for a public works or to build La Guardia, to expand the runway or what have you. Well, it’s easy to see how the government does that.
The government might auction off landing rights. The government might say, well, we’re willing to sell the rights to fly 10 planes a day to LaGuardia, let’s see how much you all will pay for it. And they would have a competition among the airlines and the airlines know how much they can price discriminate and therefore they know whether they’ll make that $600,000 or $300,000 or much more than than if they can discriminate. And if they can make a million dollars by charging everybody their reservation price, then they might bid $800,000 for the right to land at LaGuardia.
So when you see a monopoly price discriminate, don’t immediately think that the monopoly is making all that money, there might be somebody, and especially the government that’s able to extract a good deal of that profit through an auction or a taxing scheme.
The reason why I put the example that way is I wanted to introduce the idea that for a monopoly to thrive, it needs to have a way of preventing competitors from entering the market. Sometimes we say that monopolies thrive where there are barriers to entry. There has to be something that keeps the competitors out. In the cookie case, nothing kept out new bakeries. And so as soon as the price of cookies started rising, more people entered the market and started producing those wonderful chocolate chip cookies. In the case of Big Air, it’s the landing rights at LaGuardia that are the barrier to entry. If the government doesn’t have any more to offer or whoever the port authority who owns LaGuardia only sells off a certain amount, that’s a barrier to entry that prevents other firms from entering.
IPad has patents. Movies have copyrights. The bridge over the Mississippi has the situation of a monopoly by licensing. Lawyers have some licenses, doctors have some licenses. Everywhere we look where there’s 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 big role in either creating or sustaining these barriers to entry.
Indeed, we might say that while it’s true that monopolies thrive because of barriers to entry, that’s what keeps the competitors out. The barriers to entry themselves either require government complicity or come about because of government complicity.
We don’t need to review too much, but let’s just remember where we are. We’ve seen that a price discriminating monopolist can charge people different prices on the airplane or anywhere else; $500 to this one $400 for that one, $300 for that one. It can make even more money that way, though it might have to give some of the money back if the original monopoly is auctioned off to it.
But let’s not lose site of the basic idea that the run of the mill monopolist, which can only charge everybody the same price or they’ll exchange cookies on the sidewalk, if you will. That monopolist does need, when it raises price to sell to fewer people. That’s what’s creating the deadweight loss of people who want to pay more than it costs to produce the thing, but the thing is not being sold to them.
So, the next time you’re hanging around with friends, you’re eating pizza, you’re doing whatever, and somebody says, “What’s wrong with a monopolist?” I hope you know the answer. You take a deep breath and you say, “Well, there’s this thing called deadweight loss and…” and then you’re off and running and you’ve got the picture down. We can do better than that, but that’s a great first answer.
Another thing we saw is that most monopolies come into being or is sustained with the help of government. The government gives the right to build across the Mississippi. The government gives a patent. The Constitution tells the government to give patents. I’m not complaining about the government giving patents. It might be a good way to get innovation out of people. But nevertheless, 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 might be the right to be the only one to be able to sell off a space at a given location or near a given train stop. The government is intimately involved with monopolies. And I don’t just mean patents and copyrights in our Constitution. Think about the post office, for example. Well once upon a time, there was a Constitution and it gave our government the right to create currency, to set up a post office, but almost every other country has the same government-sponsored monopoly. Why? Well it might be a little bit like digging up the streets putting in cables and pipes. We don’t really need 10 different couriers carrying things around door to door. We don’t want everybody to have the right to put a little slot in your doorway to get things in there. So the government had a monopoly on delivering the mails. Maybe it was a good idea; maybe it was a bad idea.
What became of it? Well, as we know, that monopoly has become less and less valuable. Indeed, the monopoly on the postal service is a guaranteed way to lose billions of dollars a year. No one’s using the postal service. A part of it is that monopolies are also associated with a little kind 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 probably stop caring about the snacks you’re serving on board. I mean, after all, what else are they going to do? They’re going to need you to fly to LaGuardia. It’s a long time before somebody’s able to break down your monopoly and build a high speed bullet train or find another way to get people quickly from point A to point B.
Same thing with the post office, the world changed. Fax machines were invented. Fed Ex came about. These can all be seen as responses to a monopoly, in this case a government owned monopoly, but it could have been any monopoly, but got a little slow. And so we often associate monopolies with the failure to innovate and we associate the breaking down of monopoly with the extra profit that spurs innovation.
Would I rather compete with a monopolist or a chocolate chip cookie maker? Well, if I can think of a way to break over that barrier to entry, the monopolist is charging a very high price; it’s much easier to get into that market and make a lot of money in the shadow of the monopoly and to knock down that Goliath. The government does not own federal Express, and Federal Express in a way, is very profitable, in part because it’s in the shadow of the government’s monopoly. Nobody else is allowed to deliver mail to your front door. Nobody else can send what we call First Class mail that way.
Federal Express itself is a little bit of a mystery, I mean, think about the development of the fax machine and then email. You know, once email was invented, why in the world would anybody send a fax? I have to say, I find that mystifying and I think economics offers no great answer to that, that as we get technology after technology from birds to mail to stage coach to cars to one and on and on, Fed Ex, fax machines, email, texting and so forth, and a little bit of the previous technology stays in effect, the monopolies are a little bit broken, but the government does try to get involved with each monopoly as it goes on. It’ll be interesting to see what happens to the fax machine and email eventually in this context.
It’ll be interesting to see where the fax machine is 10 years from now. Now it’s not just monopolies that suffer from this problem of innovation. So I don’t mean to blame everything on them. If you think of the great American industrial enterprises of the 18th and the 19th century, they’re all gone. The great railroads are no longer here, the great water companies and power companies, the great mining companies, they’re just a shadow of their former selves, and now we’re accustomed to thinking about Google or Microsoft and Facebook as the up and coming very large company. A chip maker is likely to be the biggest company now, whereas 50 years ago it might have been a coal company.
And it’s not because they were monopolies necessarily, just that large firms might have trouble adjusting to new technologies, to innovation and so forth. Monopolies, however, seem to have the biggest problem of all. On the other hand, there are some firms that survive over a long period of time. You know, think about the university you are in now. Universities that were great 100 years ago are by and large, the universities that are great today. So there’s an industry that seems to have kept up with the times or have been protected by other means.
So I don’t mean to say that every great enterprise is bound to doom, but it is interesting that the ones that remain alive are intense competition. These universities are competing for you, competing for government grants, competing for donors; they are really in a very competitive industry. And I think it tells us something, that they’re still around whereas the great industrial firms of the 18th century are gone.
In our modern world, Big Air has a funny business. It knows that it needs the government to sustain its monopoly; it 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 airline snacks, it might not be training pilots, it might not be learning about metal fatigue. It might actually be about learning how to get along with government. After all, an important part of its business is retaining its monopoly, getting those landing rights at the best available prices, and maintain them against competition. Big Air is in the business of seeking help from the government. It’s not something we like to say in a capitalist society, but it is something that’s true.
At the same time, the government, which is to say our politicians, finds itself in the business of wanting to do business with Big Air. Think about the typical government official. The government official needs to get reelected. They need campaign financing, they need money. Big Air is a natural for contributing to campaigns. Big Air wants its monopoly, the government politicians want money to run campaigns, this is a match made in heaven, or at least in the skies.
And so Big Air… we need to think about that part of the monopoly’s business that involved getting favors or rights out of the government. Sometimes in economics, we call this “rent seeking.” The idea refers to the fact that businesses need to spend resources in order to get in the position where they have the monopoly power. There is this rent they want, the monopoly profit, they want that extra money that can only come by being a monopolist, but they have to spend money to get there.
And as we are about to see, the extreme case, they might spend so much money to get that monopolist, that they’re really not much of a monopolist at all. And let’s see how that might happen.
Now in middle school, they taught you; they taught me too, that governments are perfect. That the government knows that it needs to do what’s good for the citizenry, if the government does a bad job, the voters will kick the government out of office and get themselves some new politicians. Well, in that world, the government will decide where it wants monopolies. It might decide, oh, having only one firm land at LaGuardia is a good idea or we need to encourage inventors, let’s have patents. Post office is a good thing. In other areas it might decide a monopoly is a bad thing. The government might do what is in the best interest of the economy, which is to say, the citizens at large.
But you know we’re not in middle 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 look for jobs for themselves and their relatives after they are out of office. In this kind of world, the government cannot necessarily be relied on to do what’s good for its citizens. And so it’s a good idea for us to keep track of what’s in it for Big Air, what’s in it for the government and see how the two work together.
Think about this.
Someone sitting in the White House, runs for reelection, might spend these days, a billion dollars getting reelected; a billion dollars.
President Obama will probably spend about one billion dollars on his reelection. And his opponents will probably spend about the same amount competing for the right to run against him and then running against him. That’s two billion dollars in resources spent on the voters. It’s very unlikely that a big part of that two billion dollars is getting us information that we cannot otherwise get from newspapers and other sources. So that’s a kind of waste. That is, people competing for our votes or competing for attention might compete with one another in a kind of arms race where they spend and spend and spend in order to outdo one another and actually there’s a lot of waste involved.
The same thing is true on the other side. When Big Air and its competitors compete to get these landing rights at LaGuardia or somebody competes for the right to build a bridge across the Mississippi river. They too might compete with each other and they might compete so much as to throw the baby out with the bathwater. And that’s what we want to turn to next, to see how rent seeking can be destructive.
This rent seeking idea is not entirely something new to us.
Think about a typical election.
Partly because they want to get reelected and partly because they’re in power, and so there are many donors who want to send them money in order to get in the good graces of the government. At the same time, their opponents compete in a primary in order to figure out who will run against the incumbent, and then they too have to run a campaign in November. That too can add up to about a billion dollars these days.
So we have two billion dollars spent every Presidential election cycle on just one job. Now an optimist might say that that two billion dollars goes to 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 telling them where the White House is and what our foreign policy is and so forth. But most of us think that’s ridiculous. Most of it is spent on advertisements meant to appeal to our emotions. They’re not providing us with information that we cannot get from other sources. So we’re 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 or monopolists or would be monopolists are wasting money rent seeking or competing in order to get this monopoly. Five contractors might bid against one another with lunches, jobs for politician’s relatives and other thing… and worse maybe, all in order to get a government contract. And that’s a topic I want to turn to now and see how it’s possible that rent seeking can be so destructive.
CHAPTER SUBHEADING: The pay all auction
Politicians spending on a campaign, would-be monopolists spending for the right to get the monopoly and countries going to war can all be thought of in one economic model. Economists sometimes call this a pay all auction.
And think of the following metaphor. Imagine an auction in which I bid $10, you bid $12, she bids $14, going, going, gone, she gets it. We call that a standard auction or if you want to be fancy, an English auction. It goes to the highest bidder, the highest bidder pays the amount bid and the highest bidder then gets that amount.
There are many other kinds of auctions. In a pay all 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, it’s pay all. Everybody needs to pay the amount of his or her highest bid. Now you can see right away why this is a popular way to think 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 off their young, and as they invest more and more in the war, it’s not as if you get these resources back when the war is over and you lose or win. So everybody has to spend the amount that they’ve spent and they can’t get that money back. And as the war drags on, it becomes attractable having spent a trillion dollars on a war whereas, oh a little bit more you can outlast the opponent maybe and beat them and get something for your whole trillion dollars.
That’s why economists like this idea of a pay all auction model. Same thing 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.
So I use the expression, “pay all auction” to refer to this idea that in some auctions, you pay and I pay, one of us wins, but nobody gets their money back. 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 bid more for a house than I did, you pay to get the house, but I at least get my money back. A campaign, a war, these seem more like the pay all auction.
Imagine that big Air values those landing rights at LaGuardia at $300. Big Air would pay up to $300 to get those landing rights, it needs to spend month on taking politicians to lunch, on giving money to campaigns, who knows what else, in order to secure that right. Big Air starts out by maybe spending $100 hoping to be the highest bidder. Perhaps American Airlines comes in and bids $200. And maybe United Airlines comes and bids $250. Well think about Big Air’s position now. It values the rights at $300, it’s already spent $100, isn’t getting that back. The highest bid is $350. It might as well add another $260 to its bid because that way it will outbid the highest bidder and it might get the rights even though it might not want to spend all that money in the first place if it can start all over again.
Well if you add all that amount of money, you get a number much bigger than $300. So a great amount of money can be spent on wining and dining politicians and other uses of resources, maybe even more than the amount of money than it’s worth to any single competitor. And again, that’s what we mean by saying that rent seeking can be very, very wasteful. So now, if you’re sitting around eating pizza and somebody says to you, “What’s wrong with monopoly?” You’ll have a very sophisticated answer. You’re first move is, again, to say, “Well, let me first explain deadweight loss to you.” But then you can say, “It’s not just deadweight loss; the deadweight loss problem is exacerbated by rent seeking.” Because the deadweight loss, once Big Air has the monopoly and sells the seats, it sells too few seats at to high a price, but then there’s also the loss of Big Air spending money on wining and dining politicians in order to get the landing rights at LaGuardia. The deadweight loss from the rent seeking might even be bigger than the deadweight 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 in order to get its monopoly in the first place. We already know that Big Air can make a lot of money if it’s the only one flying from Boston to LaGuardia, but it has to acquire those landing rights. And imagine that the government is auctioning off those landing rights. So one airline can fly the route. Big Air is willing to pay up to $300 for it, let’s imagine. But maybe American Airlines is willing to pay $300 as well. And maybe United is also willing to pay $300. They can all see they could make a lot of money being the monopolist here.
Now the government puts it out to bid. Of course, it might not do that explicitly; it might be, let’s see who can curry favor with the politicians. In that case, the money will really be wasted. Big Air might jump into the fray and spend $100 wining and dining and trying to pay off politicians, but United is not far behind and it bids $200. And then perhaps American Airlines goes for broke and bids $250, it’ll only make $50 if it gets the contract… if it gets the landing rights because it’s going to make $300 and has now spent $250. But from the point of view of Big Air, which has already invested, you might say, $100, it pays to invest another $250. That is, even though it would have spent $350 altogether and lose money on the deal, right now it’s going to lose $100 and have nothing to show for it. So it might be willing to throw in another $250 to make the $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 in order to make $300 and American Airlines would have wasted money and United Airlines will have wasted money and the over all rent seeking can be quite large.
So now, when you’re sitting around having pizza and somebody says to you, “Ah, what’s wrong with a monopoly anyway?” You’re really ready to go. You start off again with deadweight loss and you show how people who might be willing to pay $300 for an airline seat or $500 for an airline seat might be denied that seat even though the airline can produce it for $200 because the airline has raised price and cut back on output in order to maximize its profits. There’s the first piece of deadweight loss.
But now that deadweight loss might be doubled or something by the other part of the transaction in that Big Air and it is competitors seeking to be this monopolist in the first place might waste a lot of money wining and dining politicians or doing other things in order to get the monopoly in the first place.
I guess the problem could be even worse, it could be trouble. Politicians might 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 this wining and dining and campaign contributions, the government might inefficiently set up LaGuardia only to handle one airline in order to get rent seeking from the airlines. So you see how monopolies and the structure of government begin to fit together.
The monopolist gets to make more money once it’s a monopoly, but in order to be a monopoly, it often needs the government’s help. And in turn, the government might sometimes need the monopoly in order to fuel the politicians and their preferences. This is the very unhappy side of monopoly.
Moreover, in our world, the most important items are no longer heavy items that are hard to transport, but they’re services where healthcare and legal services and accounting and computer services and the like. And these seem to be offered in the worldwide market. So we think about the monopoly problems associated with them, but we’re more likely to think that there are network effects, meaning a good solution in one place can spread out and expand to other places. CHAPTER HEADING: Putting it all together; The seamless web that is economics
I hope you’re beginning to see what a seamless web is, this thing we call Economics. We started out with prices and the prices were the little messengers that ran back and forth 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 thing and he could sell the item at a higher price by cutting back on the output. Albeit by creating deadweight loss so that there were people who’s demand was unsatisfied even though they wanted to pay a price that the earth could supply the good for.
That was the bad side of monopoly. We also saw that there might be a good side to monopoly. The government might want monopolies to create incentives for innovators. The government might want a monopoly to spread the letters around through the postal service. The government in the beginning was seen as the good player that tried to figure out where monopolies were good and where monopolies were bad.
Then we introduced complexity and saw, well, the government might not be such a good player. The government might like some monopolies and have in interest in this rent seeking, in this play by the monopolists to get in position where they could charge these high prices and keep up 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 sort of a complex mix where everything you see in government, in monopoly, in competition and prices begins to interact with one another.
I told you a little bit of time ago. I said earlier that in economics, the big questions could be decomposed into little questions. And maybe now it’s time to work our way back up to some big questions. Let’s think about the recent housing bubble we experienced.
I think we all have the same picture which is housing prices were going up and up. People were borrowing more and more money on these houses. Bank perhaps were too free to lend money giving people mortgages on houses that might have not been so valuable. And eventually the housing market collapsed. People were left holding houses that really weren’t worth the amount of money they had borrowed. People were walking away from the mortgages. Banks were in trouble, there was colossal financial failure. Big Wall Street firms were in trouble. The government thought it had to step in and so forth.
How could such a housing bubble occur ? If economics is so good, if these prices are these clever little messengers I’ve described, why didn’t these messengers do their job? Why didn’t they run back and forth and say, “Whoa! The price is just too high, don’t buy housing. Don’t construct more.” Instead, we had people all over the country building houses even though houses are now decaying empty in Nevada and California and Florida and elsewhere. Something went wrong, and maybe economists are to blame.
First let me defend economists. You might say, how can economists not see the housing bubble? I’m afraid the answer to that is like saying, how can meteorologists not predict the weather next July 4th or how could physicists not know where I’ll be standing in two weeks? It’s true that every motion I make between now and two weeks from now is easily described by the laws of physics. There’s gravity and motion and mass times velocity and each step is very, very easy. But how they all come together and how in two weeks I’ll be standing wherever I am seems like a problem way beyond any of today’s physicists or psychologists, and the same with meteorology. We might be very good at predicting weather eight hours from now, 24 hours from now, but predicting the weather three days from now turns out to be a massively difficult task.
But, economists are no better at predicting future fads than meteorologists are at predicting the weather next year or physicists are at predicting where I will be in two weeks.
That’s the way it is in some parts of economics. Economists are very, very good at knowing if the price of wheat goes up now, here’s what will happen tomorrow. And they’re very good at some long-term forecasting too. But knowing what will happen in the long run in the housing market turns out to be very complicated. One reason it’s complicated is that people are not just buying houses to live in them; they’re buying houses as an investment. They’re buying houses because they’re afraid that if they don’t buy the house the house will go up on value and they won’t be able to afford the same house later on. They are, in a sense, speculating in housing even as they’re also living in it.
It’s very tricky to figure out people’s speculation because it’s about the psychology of everyone thinking prices are going up, I better buy, buy, buy now. And that’s what we mean by a bubble. We mean that people are afraid to stay out of the market because they’re afraid prices will rise. So they buy the item in question or they see everyone else making money and they think, I’ll make money too. But then the price ends up having little to do with their actual demand for the product that is their actual preference for it. And certainly has very little to do with the actual cost of the assembly and the inputs.
I’ve already promised that we’ll never see a bubble in chocolate chip cookies. I think you can see why. It’s unlikely that anybody will need to speculate in it. Why would you ever speculate in a chocolate chip cookie? If you really like cookies and you’re afraid the prices will go up and up and up, well, buying the cookie now won’t do any good. It’s just going to get stale and you’ll just count on more bakers entering into the market, baking new cookies later on. You’ll know that you can always buy them based on the price of the inputs.
I doubt there will very be a bubble in rental prices for housing even. Again, it’s a short-term market. People are not speculating in it. They can live in a place and then wait and then a year later rent somewhere else. So bubbles occur more in things that are being held for their speculative value. You might invest in art. Art could have a bubble. And housing can have a bubble as well.
The bubbles are most like to arise where people are speculating on the future and where there are fads. People just don’t know whether a given artist will be popular in the future. They might buy, buy, buy thinking it will go up. They might buy housing thinking people will like this kind of housing or that housing will be too expensive for them to afford in the future. It’s very unlikely to happen in short-term markets, in markets of things that go stale. It’s much more likely to happen in things that involved fads or fashions and it could happen even in commodities. People might buy silver or coal fearful that the price will go up and not sure that new miners can bring 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 housing case, the government did not see the bubble coming any more than the private market saw the bubble coming. So there’s a lot of disagreement among economists about whether the government is part of the problem or part of the solution in bubbles. Again though, that’s something you need to study in the future because we can’t afford too many bubbles in your lifetime.
Well you know, only because people think why didn’t economists tell us that housing was overpriced? And then we would have cut back on mortgages or something.
Whenever we have a bubble that bursts or a recession or a Great Depression, it’s natural for people to blame economists. It’s like, if you have bad weather, blame the weather forecaster for not telling you about it in advance. So maybe economists should have seen the housing bubble. Maybe if prices were these great little messengers running around, as I insist.
Maybe economists should have seen those prices doing their job and they should have said, “Oh, oh, housing is too expensive,” and encourage the government not to let banks lend so much money or not to support mortgages as much and maybe we could have softened the recent great recession.
Do you remember Todd, on the airplane? I suggested to Todd that he really needs to think more about prices and how monopolies are put together. He really faced 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 that aisle seat holder, in a sense, was a monopolist knowing that he was the only one that Todd could bargain with to sell the seat. And sure enough, the monopolist cut back on out put and raised price, only two out of 13 sold their seats to Todd and on apparently at $300.
Well I think you now know what to advise Todd. You should do what I told him. I told Todd, when you get on an airplane the next time and you see you’re in the middle seat, immediately talk to four or five people who have aisle seats in the vicinity near where you are about to go and say to the four of them. “Okay, I’m a tall guy. I really want an aisle seat. I have been known to pay $20 or even up to $40 for an aisle seat. Anyone of you want to do it?” That will create some competition among those four people and rather than being one monopolist who can sell the seat, there will be four people who do that.
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 does a great deal of travel, probably gets to fly first class, but when he flies coach, eh 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 I should say, my strategy for Todd is going to work very long, and maybe you see why. Over time airlines will gather more and more information about us and they’ll realize that somebody is selling a seat to Todd for $40 when that $40 could have been the airline’s money. So the airline should be selling Todd the aisle seat for $40 or maybe even working out exchanges among seats. Think how good the airline could be about this. It knows who’s in every seat, it knows a lot about their seating preferences and it can gather information from past sales and past flights about how much people will pay for aisle seats on given flights. I suspect that within a year or two, the airline will be offering trades that it will be itself a market maker arbitrager of seats on planes.
That should remind you in a way of other companies that capitalize on information they have in the internet age and use them to create markets. So for example, when you go to supermarket check out, that barcode inform is being recorded by the supermarket. Now it’s, you know, a little bit pathetic. They say, “Oh, 30 percent off on bananas for you because I see you like bananas.” But think about all the information they have and all the things they can do with it. They might be able to raise prices for you on some things; they might know that more people buy things on rainy days and sunny days. They might make specific recommendations for you. In the long run it’s probably great. There is nothing I would like more than a seller to know everything about me and know all my preferences. I could walk in the store and rather than going up and down the isles, the seller could just roll up a basket of goods and say, here’s what you want and here’s our price. That would be fantastic. That’s probably the direction we’re heading in, all jokes aside is that is that the more information the airline has about me the more information the supermarket has about me, the less it will be about price and the more it will be about assembling things that meet my preferences with price just one attribute to work out at the end.
Sixty years ago most people thought monopolies were just down right bad. They had figured out deadweight loss, and they didn’t like the fact that monopolies restricted output in order to raise prices and deny people things they otherwise would have bought.
About 20 years ago, people thought monopolies were doubly bad because added to the deadweight loss was the rent seeking insight we’ve seen. And they thought… people thought, not only are monopolies bad because of deadweight loss, but there’s extra loss created by the monopolies competing to be monopolies in the first place by wasting money on politicians or on advertising or on other things that might give them this monopoly position.
In the internet age, things have turned around a little bit. We begin to appreciate the good sides of a monopoly as well. First of all, we live in a global world. It’s harder to be a monopolist of most good because goods can be transported from other countries. You don’t just need a monopoly in Washington or in your state capitol; you need a worldwide monopoly unless the good is very, very heavy to transport. And so there’s more competition from abroad. If we see window seven having a great 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 they would have thought, oh this is a really bad monopoly because it will be very expensive to bring in Italian typewriters.
So in a global world, we’re less concerned about traditional monopolies, perhaps a little bit more interested in intellectual property and those kinds of monopolies, and we’re looking to see where the new competition might come from.
By now you know that I’m going to go back to my central theme of prices. Think about prices in the global economy. How do we know where to get things from? Why is iPad outsourced to China? Again, it’s prices that are traveling the globe. Apple wants a component, it tries to figure out who can make that most cheaply, the component can be made most cheaply in one location, people will pay more for the iPad at another location, the prices race back and forth faster than the iPad. And eventually the iPad finds its way from the maker to the end user.
The prices are therefore a way to think about countries and their role in the world economy. Think in this case about your future where India and China are the growing economic powers of the day. And think how different those economies are and how they rely on monopoly rent seeking and prices. It’s a good example for us of things that we’ve learned.
Now, take the case of China first. China is not outwardly a capitalist economy, though it has a lot of capitalism in it. It brilliantly uses local governments in competition with one another. So local government officials want to be promoted, they want to make it to the Central Committee; they want to get more payments. They do this by showing that in their region of the country, standards of living are rising; people are safer, there aren’t a lot of deaths from earthquakes or industrial accidents and so forth. Competition among local governments seems to be the key of what makes China work. Prices help China interact with the rest of the world, but within China, power relationships and competition seems to be what makes it work. It’s a top down economy in a way where people at the grassroots are operating in order to advance in power and wealth.
India is a very, very different kind of economy. In the Indian economy the government famously has trouble producing infrastructure. There are many cities in India where upper middle class people and certainly wealthy people are paying for health, education, even water in the private market. There’s nominally a government supplied system, but then there’s a very now, well-developed grassroots system where entrepreneurs step in where government fails and entrepreneurs offer this. In that kind of system, prices play a key role. If I want water and I want clean water, I go see who provides the water best. In China if I want water and the water’s bad, I hold the strike and I complain and then the media pick up on it and the local government official is embarrassed and says, “Oh, people here have unrest.” Unrest is a terrible thing and before the local official can be slapped out of position by the Central Party, the local official has an incentive to supply water better and improve the infrastructure.
India, prices and markets. China, power, rent seeking, monopoly, competition among these monopolies, the government comparing them one to another. We don’t know which works better.
China takes your breath away if you’re an economist. If you’re an economist in my generation, you were brought up thinking that central planning fails, only markets can do the job, and only prices as messengers running around, that’s the only way to make the world go faster. And now suddenly we find that our major economic competitor is really only using prices modestly instead are using non-priced things including power structures and promotions to fuel the economy. And they’re not bad at it. There are roads in China and factories and railroads and gas supplies, it’s fantastic. And bridges go up and buildings go up quickly. And they’re not going up quickly because the little prices are going around as messengers. They’re going up quickly because a very clever government that has thought about rent seeking and thought about how to eliminate corruption and wining and dining has tried to figure out how to get people to compete that the buildings there will go up faster, better and safer than the building over there. It’s a very, very impressive feat and it’s a big challenge for economics in your generation.
Look at the distance we’ve traveled together today. We started with airplane seats and chocolate chip cookies and houses and we found our way to landing rights at LaGuardia and to tulips in the Netherlands and to skyscrapers going up and to India and China and back again to airlines and all over the place. That’s what the great thing about economics is. Economics is a set of tools that helps you understand, interpret and improve the world around you. It’s unbelievably exciting. In **** Law, economics helped me make law from a dry subject where one memorized a bunch of rules, found in a dusty treatous[ph] into a live thing where you could use law to change people’s behavior.
Economics is everywhere around us, it’s easy to access and it comes with a set of tools that you get better and better at using. It’s unbelievably exciting.
Economics is now a tool for you. Economics is now a way that you’re going to improve the world around you. Economics is the way that you’re going to understand your cell phone carrier and why taxis cost what they do and why drinking straws are free, why they supply them with some drinks and not others. You’re going to understand travel better and the world better and foreign affairs better.
Use prices, think about monopolies, use theories about how people compete and how they act to change human behavior.
It’s a bunch of tools to put in your hand to understand the world around you. Go learn more about it. Go understand the world about you and go make it a better place. Thank you very much and good luck.