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PROFESSOR: OK, so what we're
going to do today is continue

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00:00:29,310 --> 00:00:33,280
our discussion of oligopoly
which we started last time.

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00:00:33,280 --> 00:00:35,460
I want to return to the example
we were using last

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00:00:35,460 --> 00:00:41,760
time to discuss the example
of Cournot competition.

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00:00:41,760 --> 00:00:44,070
We started last time by talking
about general game

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00:00:44,070 --> 00:00:46,550
theory and the prisoner's
dilemma and the concept of

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00:00:46,550 --> 00:00:48,000
Nash equilibrium.

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00:00:48,000 --> 00:00:50,640
Then we turned to a specific
example of a Cournot

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00:00:50,640 --> 00:00:54,150
competition, the way we can
specifically model two firms

16
00:00:54,150 --> 00:00:56,420
competing in a market.

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00:00:56,420 --> 00:01:00,830
And so if you recall the example
from last time, we had

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00:01:00,830 --> 00:01:09,680
demand curve of the form p
equals 339 minus q where this

19
00:01:09,680 --> 00:01:13,220
is thousands of passengers
per month.

20
00:01:13,220 --> 00:01:17,430
And we had a marginal
cost of $147.

21
00:01:17,430 --> 00:01:19,610
And we have flat marginal cost,
so average cost equals

22
00:01:19,610 --> 00:01:25,130
marginal cost equals 147, equals
average cost. So flat

23
00:01:25,130 --> 00:01:28,070
marginal cost.

24
00:01:28,070 --> 00:01:32,185
And what we said, so therefore
if the firm was a monopolist,

25
00:01:32,185 --> 00:01:36,430
if American Airlines say was a
monopolist, they would set

26
00:01:36,430 --> 00:01:39,700
marginal revenue equal to
marginal cost which would be

27
00:01:39,700 --> 00:01:45,630
339 minus 2q equals 147.

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00:01:45,630 --> 00:01:49,770
And so the monopolist was going
to set a quantity of 96.

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00:01:49,770 --> 00:01:53,720
That was the monopolist quantity
with the price.

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00:01:53,720 --> 00:01:56,520
So the quantity of monopolist
is 96 and the price of

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00:01:56,520 --> 00:02:00,500
monopolist is $243.

32
00:02:00,500 --> 00:02:04,140
So that was the monopoly case.

33
00:02:04,140 --> 00:02:07,620
Something you should be very
facile with for tomorrow night

34
00:02:07,620 --> 00:02:12,410
is solving those kinds of
monopoly problems. And then we

35
00:02:12,410 --> 00:02:14,910
said, OK, but what if, in fact,
it recognizes that it's

36
00:02:14,910 --> 00:02:16,060
not a monopoly.

37
00:02:16,060 --> 00:02:17,160
There's another firm
in the market.

38
00:02:17,160 --> 00:02:19,450
United is in the
market as well.

39
00:02:19,450 --> 00:02:23,110
Well in that case it has to
consider its residual demand.

40
00:02:23,110 --> 00:02:27,930
So in that case we said the qa,
its residual demand, for

41
00:02:27,930 --> 00:02:31,570
American was equal to the
total market q minus the

42
00:02:31,570 --> 00:02:35,270
quantity absorbed
by United, qu.

43
00:02:35,270 --> 00:02:38,820
And we showed last time what
this leads to graphically.

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00:02:38,820 --> 00:02:42,870
And so we re-handed out figure
16-3 just to review.

45
00:02:42,870 --> 00:02:45,730
The notion was that each
firm develops a

46
00:02:45,730 --> 00:02:47,880
best response curve.

47
00:02:47,880 --> 00:02:52,060
Each firm says, based on what
the other firm's going to do,

48
00:02:52,060 --> 00:02:54,000
here is my best level
of production.

49
00:02:54,000 --> 00:02:56,950
Here's my profit maximizing
level of production.

50
00:02:56,950 --> 00:03:00,000
And each firm having developed
a curve, there's an

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00:03:00,000 --> 00:03:03,130
equilibrium where those curves
intersect because at that

52
00:03:03,130 --> 00:03:04,530
point both firms are happy.

53
00:03:04,530 --> 00:03:07,250
You've achieved your Nash
equilibrium because at that

54
00:03:07,250 --> 00:03:10,810
point both firms are satisfied
with the strategy they're

55
00:03:10,810 --> 00:03:13,350
playing given what the
other firm's playing.

56
00:03:13,350 --> 00:03:16,610
So that point of intersection,
both firms' best response are

57
00:03:16,610 --> 00:03:19,770
consistent with each other.

58
00:03:19,770 --> 00:03:22,410
And that's we developed
last time graphically.

59
00:03:22,410 --> 00:03:25,690
Intuitively, I think it follows
from the same logic,

60
00:03:25,690 --> 00:03:28,160
the idea is we're playing this
game and the game will only

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00:03:28,160 --> 00:03:29,560
have a stable outcome
if we're both

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00:03:29,560 --> 00:03:30,560
satisfied with the outcome.

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00:03:30,560 --> 00:03:32,200
If we're not both satisfied
we'll continue to change our

64
00:03:32,200 --> 00:03:34,670
behavior and it won't
be stable.

65
00:03:34,670 --> 00:03:36,850
And so what I want to do now is
talk about how we solve for

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00:03:36,850 --> 00:03:38,920
this mathematically.

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00:03:38,920 --> 00:03:41,520
So let's just think about the
mathematics of solving for

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00:03:41,520 --> 00:03:44,530
Cournot equilibrium.

69
00:03:44,530 --> 00:03:48,550
So what's the mathematics now?

70
00:03:48,550 --> 00:03:52,130
What's American Airlines's
residual demand function?

71
00:03:52,130 --> 00:03:59,050
Well their price, p sub a, is
equal to the total demand,

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00:03:59,050 --> 00:04:04,140
339, minus what they supply
minus what United supplies.

73
00:04:04,140 --> 00:04:09,450
So the price in the market,
they don't have separate

74
00:04:09,450 --> 00:04:14,350
prices, the price in the market
is going to be 339

75
00:04:14,350 --> 00:04:17,730
minus what each of
them supplies.

76
00:04:17,730 --> 00:04:22,510
So now American can't control q
sub u, American has to take

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00:04:22,510 --> 00:04:25,080
that as an outside
given factor.

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00:04:25,080 --> 00:04:26,950
That's what they're
responding to.

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00:04:26,950 --> 00:04:29,900
So American says, I need to
optimize this with respect to

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00:04:29,900 --> 00:04:32,160
what I can control
which is q sub a.

81
00:04:32,160 --> 00:04:32,900
So how does it do it?

82
00:04:32,900 --> 00:04:35,580
Well, it computes marginal
revenue.

83
00:04:35,580 --> 00:04:38,390
Well marginal revenue
is p times q sub a.

84
00:04:38,390 --> 00:04:46,590
So that's 339qa minus qa
squared minus quqa.

85
00:04:46,590 --> 00:04:47,840
Just multiplying through.

86
00:04:52,340 --> 00:04:54,660
That's their revenue function.

87
00:04:54,660 --> 00:04:58,610
So marginal revenue,
differentiating with respect

88
00:04:58,610 --> 00:05:03,290
to qa which is all they can
control, is going to be 339

89
00:05:03,290 --> 00:05:07,920
minus 2qa minus qu.

90
00:05:07,920 --> 00:05:09,360
That's going to be
their residual

91
00:05:09,360 --> 00:05:10,610
marginal revenue function.

92
00:05:13,250 --> 00:05:17,320
And they're going to set this
equal to marginal cost. So I'm

93
00:05:17,320 --> 00:05:22,550
going to set marginal revenue
equal to marginal cost. So

94
00:05:22,550 --> 00:05:26,710
they're going to set this equal
to 147 which is marginal

95
00:05:26,710 --> 00:05:29,140
cost. And solving.

96
00:05:29,140 --> 00:05:40,380
you get that qa equals
96 minus 1/2qu.

97
00:05:40,380 --> 00:05:42,290
qa equals 96 minus 1/2qu.

98
00:05:42,290 --> 00:05:45,440
Once again reviewing, what we're
doing is we're saying we

99
00:05:45,440 --> 00:05:48,290
set up their residual
demand function.

100
00:05:48,290 --> 00:05:50,980
We compute what that implies
in terms of revenues.

101
00:05:50,980 --> 00:05:53,366
We differentiate with respect
to their control variable, q

102
00:05:53,366 --> 00:05:56,110
sub a, to get a marginal
revenue function.

103
00:05:56,110 --> 00:06:02,990
You set that equal to marginal
cost. And you solve for their

104
00:06:02,990 --> 00:06:04,450
best response curve.

105
00:06:04,450 --> 00:06:06,910
Essentially you just solve
mathematically for the curve

106
00:06:06,910 --> 00:06:08,160
you see here graphically.

107
00:06:08,160 --> 00:06:11,080
You go to the graph and you
look at American's best

108
00:06:11,080 --> 00:06:13,070
response curve.

109
00:06:13,070 --> 00:06:14,360
That is exactly this line.

110
00:06:14,360 --> 00:06:17,970
When qu is 0, it intersects
at 196.

111
00:06:17,970 --> 00:06:21,570
When qu is 192, qa is 0.

112
00:06:21,570 --> 00:06:23,610
So you can see we've just
mathematically developed where

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00:06:23,610 --> 00:06:27,010
this best response
curve comes from.

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00:06:27,010 --> 00:06:29,355
We've just solved for that
mathematically through the

115
00:06:29,355 --> 00:06:33,970
similar mathematics of monopoly
profit maximization.

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00:06:33,970 --> 00:06:36,390
In this case we're essentially
saying, imagine you're a

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00:06:36,390 --> 00:06:39,300
monopoly except for the stuff
produced by the other guy.

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00:06:39,300 --> 00:06:40,140
That's the way to
think about it.

119
00:06:40,140 --> 00:06:41,810
Imagine you're a monopoly except
for what the other guy

120
00:06:41,810 --> 00:06:44,780
does and you get this best
response function.

121
00:06:44,780 --> 00:06:47,600
Now, since we set this problem
up to be symmetric--

122
00:06:47,600 --> 00:06:51,520
that is we said the marginal
cost identical for both firms,

123
00:06:51,520 --> 00:06:54,880
and the market demand applies
to both firms--

124
00:06:54,880 --> 00:06:58,240
since we set this up to be
symmetrical, then we know that

125
00:06:58,240 --> 00:07:00,840
we can also write a symmetrical
best response

126
00:07:00,840 --> 00:07:07,310
function for United, which
is q sub u equals 96

127
00:07:07,310 --> 00:07:09,390
minus 1/2 q sub a.

128
00:07:09,390 --> 00:07:12,690
We can solve for this but
there is a shortcut.

129
00:07:12,690 --> 00:07:14,820
If it's symmetrical problem
they'll have symmetrical best

130
00:07:14,820 --> 00:07:16,910
response functions.

131
00:07:16,910 --> 00:07:17,980
So we can just write
the symmetrical

132
00:07:17,980 --> 00:07:20,900
best response function.

133
00:07:20,900 --> 00:07:22,580
And then we can find
the equilibrium.

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00:07:22,580 --> 00:07:24,390
Remember the steps I went
through last time.

135
00:07:24,390 --> 00:07:26,200
Now we have n equations
and n unknowns.

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00:07:26,200 --> 00:07:28,820
We have two equations
and two unknowns.

137
00:07:28,820 --> 00:07:32,880
We can just solve by plugging
one into the other.

138
00:07:32,880 --> 00:07:41,900
And we get that qa star equals
qu star equals 64.

139
00:07:41,900 --> 00:07:45,000
Which is in fact where these
curves intersect.

140
00:07:45,000 --> 00:07:46,950
So that's how I found the
intersection of these curves

141
00:07:46,950 --> 00:07:49,760
was solving mathematically
for the optimal level of

142
00:07:49,760 --> 00:07:53,020
production given what the
other guy's doing.

143
00:07:53,020 --> 00:07:55,780
And the price, what's
the price?

144
00:07:55,780 --> 00:08:01,820
Well the price is 339 minus
q sub a minus q sub u.

145
00:08:01,820 --> 00:08:07,890
So it's 339 minus 128 or 211.

146
00:08:07,890 --> 00:08:14,980
So you end up with each
firm producing 64,000

147
00:08:14,980 --> 00:08:17,930
units a price of $211.

148
00:08:17,930 --> 00:08:20,260
And this is the Cournot
equilibrium.

149
00:08:20,260 --> 00:08:22,580
Because it's on both firms'
best response function.

150
00:08:22,580 --> 00:08:25,780
Both firms are maximizing
profits.

151
00:08:25,780 --> 00:08:28,160
And in maximizing profits they
both have chosen the same

152
00:08:28,160 --> 00:08:29,470
point to produce and
so you're done.

153
00:08:29,470 --> 00:08:30,110
They're happy.

154
00:08:30,110 --> 00:08:31,750
That's the Nash equilibrium.

155
00:08:31,750 --> 00:08:32,000
Yeah.

156
00:08:32,000 --> 00:08:33,333
AUDIENCE: So in the
last lecture was

157
00:08:33,333 --> 00:08:34,720
that game theory box.

158
00:08:34,720 --> 00:08:38,833
And this would be the lower
right hand box, correct?

159
00:08:42,617 --> 00:08:45,400
PROFESSOR: That's a very
good point, yes.

160
00:08:45,400 --> 00:08:49,300
This is sort of like game
theory but with a whole

161
00:08:49,300 --> 00:08:50,470
distribution.

162
00:08:50,470 --> 00:08:52,610
But in some sense it's like
at each point you've

163
00:08:52,610 --> 00:08:53,580
reached that point.

164
00:08:53,580 --> 00:08:56,540
But I really wouldn't draw
that parallel actually.

165
00:08:56,540 --> 00:08:57,790
The parallel that's important
from that is

166
00:08:57,790 --> 00:08:59,900
the equilibrium concept.

167
00:08:59,900 --> 00:09:01,905
The reason we choose the
prisoner's dilemma instead of

168
00:09:01,905 --> 00:09:03,460
choosing the equilibrium
concept--

169
00:09:03,460 --> 00:09:05,990
and the equilibrium concept is,
you're in equilibrium when

170
00:09:05,990 --> 00:09:10,970
each firm's dominant strategy
yields an equilibrium outcome.

171
00:09:10,970 --> 00:09:13,630
Here we've just taken that
intuition and solved

172
00:09:13,630 --> 00:09:15,980
mathematically for each firm's
dominant strategy.

173
00:09:15,980 --> 00:09:18,092
And that yields an equilibrium
outcome.

174
00:09:18,092 --> 00:09:21,870
AUDIENCE: That top left
box, there's no way--

175
00:09:21,870 --> 00:09:22,850
we shouldn't think about
that at all?

176
00:09:22,850 --> 00:09:24,900
PROFESSOR: No, actually it's a
great segue to what I'll talk

177
00:09:24,900 --> 00:09:27,930
about next which is a
cooperative equilibrium.

178
00:09:27,930 --> 00:09:30,930
So what we've solved for is we
solved for a non-cooperative

179
00:09:30,930 --> 00:09:32,400
equilibrium.

180
00:09:32,400 --> 00:09:33,470
Where they're not cooperating.

181
00:09:33,470 --> 00:09:35,280
So it's like the prisoner's
dilemma in the sense they end

182
00:09:35,280 --> 00:09:38,750
up in that lower corner.

183
00:09:38,750 --> 00:09:41,050
But in some sense I think that
parallel, I'm not sure how

184
00:09:41,050 --> 00:09:43,350
much that helps other than
thinking about the strategies

185
00:09:43,350 --> 00:09:46,560
and about thinking that that's
non-cooperative.

186
00:09:46,560 --> 00:09:50,560
We want to turn to next what
happens if they can cooperate.

187
00:09:50,560 --> 00:09:52,510
But before I do so,
two things.

188
00:09:52,510 --> 00:09:56,910
First of all, these problems do
not have to be symmetric.

189
00:09:56,910 --> 00:09:58,920
I've just solved symmetric
problem often, and you'll see

190
00:09:58,920 --> 00:10:00,620
symmetric problems, that
makes the math easier.

191
00:10:00,620 --> 00:10:01,740
But they don't have to be.

192
00:10:01,740 --> 00:10:04,090
American and United can be
different and you could solve

193
00:10:04,090 --> 00:10:04,600
the same math.

194
00:10:04,600 --> 00:10:08,480
And in fact Perloff goes through
an example like that.

195
00:10:08,480 --> 00:10:10,450
Symmetry is not guaranteed in
these problems, it's just a

196
00:10:10,450 --> 00:10:12,480
feature of the way
I set this up.

197
00:10:12,480 --> 00:10:15,460
So this question is a great
segue to the next topic, which

198
00:10:15,460 --> 00:10:17,790
is what about cooperative
equililbria.

199
00:10:17,790 --> 00:10:22,050
Can't American and United get
together and form a cartel?

200
00:10:24,700 --> 00:10:27,320
Remember we talked in the
prisoner's dilemma about how

201
00:10:27,320 --> 00:10:29,390
that would be the best outcome
if the two persons could just

202
00:10:29,390 --> 00:10:30,560
trust each other.

203
00:10:30,560 --> 00:10:33,490
Well here can't American and
United just trust each other

204
00:10:33,490 --> 00:10:35,680
and form a cartel?

205
00:10:35,680 --> 00:10:39,080
And what they do here
mathematically is pretty easy.

206
00:10:39,080 --> 00:10:42,580
They would just say, look, let's
get together and pretend

207
00:10:42,580 --> 00:10:45,060
we're one firm.

208
00:10:45,060 --> 00:10:49,320
Then let's act as that one firm
monopoly would and split

209
00:10:49,320 --> 00:10:51,710
the profits.

210
00:10:51,710 --> 00:10:52,750
It's the way a cartel
could work.

211
00:10:52,750 --> 00:10:55,190
They could say let's get
together, we'll produce as if

212
00:10:55,190 --> 00:10:57,800
we're a monopoly and let's
split the profits.

213
00:10:57,800 --> 00:10:59,670
Well what would happen
if they did that?

214
00:10:59,670 --> 00:11:03,910
Well we know that the total
monopoly production if they

215
00:11:03,910 --> 00:11:08,780
had been a monopoly is 96.

216
00:11:08,780 --> 00:11:12,210
So that's a big Q. The quantity
for the market is 96

217
00:11:12,210 --> 00:11:19,030
and the price if they're
a monopoly is $243.

218
00:11:19,030 --> 00:11:21,300
So what they did is they said,
look, we'll each do 48

219
00:11:21,300 --> 00:11:28,370
flights, for a total of 96 and
we'll charge $243 and we'll

220
00:11:28,370 --> 00:11:30,030
agree to do that.

221
00:11:30,030 --> 00:11:31,020
But what would happen?

222
00:11:31,020 --> 00:11:38,340
Well their profits to each firm
would be their 48 flights

223
00:11:38,340 --> 00:11:44,510
they do times the price they get
minus the marginal cost.

224
00:11:44,510 --> 00:11:47,190
Marginal cost is average
cost here.

225
00:11:47,190 --> 00:11:55,040
The price they get minus the
marginal cost. That would mean

226
00:11:55,040 --> 00:12:01,490
per firm the profits
would be $4,608.

227
00:12:01,490 --> 00:12:04,195
So each firm would make
$4,608 in profits.

228
00:12:04,195 --> 00:12:05,070
Actually that's four million.

229
00:12:05,070 --> 00:12:06,060
This is in thousands, right.

230
00:12:06,060 --> 00:12:09,400
So $4,608,000.

231
00:12:09,400 --> 00:12:12,300
Let's compare that to the
profits they made as Cournot

232
00:12:12,300 --> 00:12:13,690
competitors.

233
00:12:13,690 --> 00:12:15,936
Once again comparing the upper
box to the lower box, going

234
00:12:15,936 --> 00:12:16,770
back to the prisoner's
dilemma.

235
00:12:16,770 --> 00:12:19,830
I think that is actually
useful to think about.

236
00:12:19,830 --> 00:12:21,320
Let's compare that to what
happened when they were

237
00:12:21,320 --> 00:12:22,460
Cournot competitors.

238
00:12:22,460 --> 00:12:26,650
When they were Cournot they
each took 64 flights.

239
00:12:26,650 --> 00:12:31,260
They each did more flights when
they were competing, but

240
00:12:31,260 --> 00:12:36,890
they only got to charge $211
with that same marginal cost.

241
00:12:36,890 --> 00:12:39,840
So their profits as Cournot
competitors

242
00:12:39,840 --> 00:12:48,640
were $4,096,000 each.

243
00:12:48,640 --> 00:12:51,810
So by monopolizing and splitting
the market they

244
00:12:51,810 --> 00:12:55,360
raised their profits by
12.5%, by an eighth.

245
00:12:55,360 --> 00:12:59,200
Their profits went up by an
eighth, by 12.5%, which is a

246
00:12:59,200 --> 00:13:02,920
major jump in profits by getting
together and forming

247
00:13:02,920 --> 00:13:03,940
this cartel.

248
00:13:03,940 --> 00:13:06,790
Just as the two prisoners were
better off not ratting each

249
00:13:06,790 --> 00:13:08,680
other out, they were
both better off not

250
00:13:08,680 --> 00:13:09,780
ratting each other out.

251
00:13:09,780 --> 00:13:13,070
These guys are both better off
getting together and forming a

252
00:13:13,070 --> 00:13:19,380
cartel and splitting the
profits, same logic.

253
00:13:19,380 --> 00:13:22,710
So why don't we see these
cartels everywhere?

254
00:13:22,710 --> 00:13:24,376
Why do we have American
and United, why don't

255
00:13:24,376 --> 00:13:25,600
they just do this?

256
00:13:25,600 --> 00:13:27,790
Well that's for two reasons.

257
00:13:27,790 --> 00:13:31,530
Two reasons why we don't see
these cartels everywhere.

258
00:13:31,530 --> 00:13:34,745
The first reason, so
why not cartels?

259
00:13:40,380 --> 00:13:43,860
The first reason why we don't
see cartels is there's a

260
00:13:43,860 --> 00:13:45,110
fundamental instability.

261
00:13:49,220 --> 00:13:52,680
Cooperative equilibria are
fundamentally unstable because

262
00:13:52,680 --> 00:13:57,200
any one party has an
incentive to cheat.

263
00:13:57,200 --> 00:14:01,190
Any one party in a cartel can
make money by cheating because

264
00:14:01,190 --> 00:14:03,310
they stick the other firms
in the cartel.

265
00:14:03,310 --> 00:14:05,850
So let's just talk about
this for a second.

266
00:14:05,850 --> 00:14:08,800
Imagine what would happen if
American decided to cheat.

267
00:14:08,800 --> 00:14:10,560
Imagine they had this cartel,
it's running along, they're

268
00:14:10,560 --> 00:14:14,060
each making their $4,608,000
per month profit.

269
00:14:14,060 --> 00:14:16,020
They're all very happy.

270
00:14:16,020 --> 00:14:19,210
Now imagine American says, wait
a second, what if on the

271
00:14:19,210 --> 00:14:23,530
sly I increase my number
flights from 48 to 50?

272
00:14:23,530 --> 00:14:25,760
What if I just did that and did
it in a way which wasn't

273
00:14:25,760 --> 00:14:27,720
immediately transparent
to United?

274
00:14:27,720 --> 00:14:32,110
So American takes its q sub a
which was cranking along as 48

275
00:14:32,110 --> 00:14:35,200
and it raised it to 50.

276
00:14:35,200 --> 00:14:37,010
Well what happens?

277
00:14:37,010 --> 00:14:41,480
Well if they do that the total
quantity in the market instead

278
00:14:41,480 --> 00:14:45,320
of being 96 rises to 98.

279
00:14:45,320 --> 00:14:47,270
And if it rises to 98 that means
the price is going to

280
00:14:47,270 --> 00:14:48,150
fall, right?

281
00:14:48,150 --> 00:14:49,650
This is not a price
discriminating monopolist,

282
00:14:49,650 --> 00:14:51,740
this is a one price monopolist.
So if they want to

283
00:14:51,740 --> 00:14:54,850
sell 98 flights, the price
is going to have to fall.

284
00:14:54,850 --> 00:14:59,060
So the price is going to
fall to $241 from the

285
00:14:59,060 --> 00:15:02,270
current level of $243.

286
00:15:02,270 --> 00:15:03,790
Well you might say, gee
American just shot

287
00:15:03,790 --> 00:15:04,480
itself in the foot.

288
00:15:04,480 --> 00:15:07,500
Its just lowered the price
by selling more flights.

289
00:15:07,500 --> 00:15:10,510
But look what happens to
American's profits.

290
00:15:10,510 --> 00:15:19,020
American's profits are now 50
times 241 minus 147 which

291
00:15:19,020 --> 00:15:24,830
equals $4,700,000 which
is higher than it

292
00:15:24,830 --> 00:15:27,390
was making ib a cartel.

293
00:15:27,390 --> 00:15:32,750
American just increased its
profits to more than they were

294
00:15:32,750 --> 00:15:37,970
making when they cartelized
splitting the profits.

295
00:15:37,970 --> 00:15:40,280
And what's happened to United?

296
00:15:40,280 --> 00:15:42,070
So this is profits
for American.

297
00:15:45,840 --> 00:15:49,250
United's still doing 48 flights
but the price has now

298
00:15:49,250 --> 00:15:53,910
fallen to $241.

299
00:15:53,910 --> 00:16:04,930
So United's profits
fall to $4512.

300
00:16:04,930 --> 00:16:06,760
United's profits fall.

301
00:16:06,760 --> 00:16:09,520
American's profits go up.

302
00:16:09,520 --> 00:16:11,086
So basically American
has stuck it

303
00:16:11,086 --> 00:16:12,336
to United by cheating.

304
00:16:15,470 --> 00:16:17,470
It's raised its profits at
the expense of United.

305
00:16:17,470 --> 00:16:18,300
And why is that?

306
00:16:18,300 --> 00:16:19,360
What's the intuition?

307
00:16:19,360 --> 00:16:21,155
Well it goes back to our
monopoly intuition.

308
00:16:24,010 --> 00:16:28,570
Because when one firm cheats
in a cartel it gets all the

309
00:16:28,570 --> 00:16:32,250
benefit of the extra quantity,
but only feels part of the

310
00:16:32,250 --> 00:16:34,250
poisoning effect.

311
00:16:34,250 --> 00:16:36,090
Remember when a monopolist
increases its quantity.

312
00:16:36,090 --> 00:16:36,910
It's got these two effects.

313
00:16:36,910 --> 00:16:39,390
It sells more but poisons
its previous sales.

314
00:16:39,390 --> 00:16:42,060
Well here when American sells
two more flights, it sells

315
00:16:42,060 --> 00:16:44,840
more, it's got all that effect
like a monopolist would, but

316
00:16:44,840 --> 00:16:48,270
the poisoning effect is
shared with United.

317
00:16:48,270 --> 00:16:51,210
They don't feel as much pain
from that price going down

318
00:16:51,210 --> 00:16:52,860
because they're sharing
that pain with United.

319
00:16:52,860 --> 00:16:54,840
They get all of the benefit
from quantity going up and

320
00:16:54,840 --> 00:16:57,220
only part of the pain for
price coming down.

321
00:16:57,220 --> 00:16:59,516
And that's why it makes
sense to cheat.

322
00:16:59,516 --> 00:17:01,340
A monopolist would never
cheat itself.

323
00:17:01,340 --> 00:17:03,410
It'd make no sense for the
monopolist suddenly to go from

324
00:17:03,410 --> 00:17:06,480
96 to 98 and say, ha I've
cheated myself because it

325
00:17:06,480 --> 00:17:09,900
would feel the entire pain
of the poisoning effect.

326
00:17:09,900 --> 00:17:10,910
But American doesn't.

327
00:17:10,910 --> 00:17:13,119
That's shared with United.

328
00:17:13,119 --> 00:17:15,520
So it actually makes sense to
cheat because they get all the

329
00:17:15,520 --> 00:17:17,228
benefit of the more quantity and
only part of the cost of

330
00:17:17,228 --> 00:17:18,780
the lower price.

331
00:17:18,780 --> 00:17:24,540
And that's intuitively
what's going on.

332
00:17:24,540 --> 00:17:27,599
Questions about that?

333
00:17:27,599 --> 00:17:32,850
Well knowing this, clearly
United says, wait a second, if

334
00:17:32,850 --> 00:17:35,180
we form a cartel American
will cheat.

335
00:17:35,180 --> 00:17:37,330
So I'm going to cheat
first and the

336
00:17:37,330 --> 00:17:38,120
whole thing falls apart.

337
00:17:38,120 --> 00:17:40,020
And we get back to the repeated
game intuition we

338
00:17:40,020 --> 00:17:41,480
talked about in our game
theory lecture.

339
00:17:41,480 --> 00:17:44,350
Where if they can commit to
never cheat, if they can

340
00:17:44,350 --> 00:17:45,900
commit to punish each other if
they cheat, you might be able

341
00:17:45,900 --> 00:17:48,020
to make this work in a repeated
game, but only if the

342
00:17:48,020 --> 00:17:50,740
repeated game never ends.

343
00:17:50,740 --> 00:17:53,040
So if there's either not a
repeated game, or it's a

344
00:17:53,040 --> 00:17:54,980
repeated game with an end,
then there's going to be

345
00:17:54,980 --> 00:17:56,140
incentive for someone
to cheat.

346
00:17:56,140 --> 00:17:57,710
Once there's an incentive for
someone to cheat, the whole

347
00:17:57,710 --> 00:17:59,660
thing falls apart.

348
00:17:59,660 --> 00:18:03,780
And that's why cartels are
fundamentally unstable.

349
00:18:03,780 --> 00:18:09,070
Now there's a second reason why
we don't see cartels which

350
00:18:09,070 --> 00:18:10,830
economists would always
put second.

351
00:18:10,830 --> 00:18:13,270
We always put the economic
stuff first and the legal

352
00:18:13,270 --> 00:18:14,090
stuff second.

353
00:18:14,090 --> 00:18:17,250
The second is they're illegal,
but we think that's less

354
00:18:17,250 --> 00:18:22,480
important as economists because
we think folks are

355
00:18:22,480 --> 00:18:25,380
often smart enough to figure
their way around laws.

356
00:18:25,380 --> 00:18:26,150
Technically these are illegal.

357
00:18:26,150 --> 00:18:28,330
In fact, in the late 1800s
cartels were very

358
00:18:28,330 --> 00:18:29,170
common in the US.

359
00:18:29,170 --> 00:18:30,830
They were called the trusts.

360
00:18:30,830 --> 00:18:33,610
There were trusts in sugar,
railroads, other areas.

361
00:18:33,610 --> 00:18:35,940
This is how these robber barons
made all their money--

362
00:18:35,940 --> 00:18:38,120
the Rockefellers and the
Vanderbilts and stuff-- was by

363
00:18:38,120 --> 00:18:41,200
building monopolies.

364
00:18:41,200 --> 00:18:42,000
That's what made their money.

365
00:18:42,000 --> 00:18:45,420
And then in the early 20th
century Congress passed what

366
00:18:45,420 --> 00:18:50,040
was called anti-trust laws which
explicitly forbid the

367
00:18:50,040 --> 00:18:55,160
creation of cartels or
these kind of trusts.

368
00:18:55,160 --> 00:18:57,160
So technically they're
illegal.

369
00:18:57,160 --> 00:19:00,380
In fact, there are lots of ways,
and Perloff talks about

370
00:19:00,380 --> 00:19:02,840
this in his book, there are lots
of ways that firms can

371
00:19:02,840 --> 00:19:05,130
implicitly cartelize.

372
00:19:05,130 --> 00:19:10,880
There are ways that firms can
say, look we'll get together

373
00:19:10,880 --> 00:19:14,790
not under the government's
auspices and we'll agree that

374
00:19:14,790 --> 00:19:16,730
you raise your price and I'll do
it two weeks later and look

375
00:19:16,730 --> 00:19:17,610
like we're not a cartel.

376
00:19:17,610 --> 00:19:20,820
I'm just following you, but in
fact we've agreed to do it.

377
00:19:20,820 --> 00:19:28,480
So there is some implicit
cartelization and basically

378
00:19:28,480 --> 00:19:30,830
that's why there's an anti-trust
division exists

379
00:19:30,830 --> 00:19:31,160
that's quite large.

380
00:19:31,160 --> 00:19:34,290
The Department of Justice is
basically to prosecute exactly

381
00:19:34,290 --> 00:19:35,750
those cases when firms
try to do that.

382
00:19:38,480 --> 00:19:41,730
Now in fact, however, the
government has a bit of blood

383
00:19:41,730 --> 00:19:44,210
on its hands in this respect,
because sometimes the

384
00:19:44,210 --> 00:19:46,390
government actually promotes
cartels even though it might

385
00:19:46,390 --> 00:19:47,970
not mean to do so.

386
00:19:47,970 --> 00:19:52,480
And the best example was the
1981 voluntary export

387
00:19:52,480 --> 00:19:56,500
restraint policy, the Reagan
administration.

388
00:19:56,500 --> 00:20:00,070
1981 was the worst recession
before this one.

389
00:20:00,070 --> 00:20:02,085
Actually unemployment was
higher than this one.

390
00:20:02,085 --> 00:20:04,060
This is a very bad recession,
but actually unemployment was

391
00:20:04,060 --> 00:20:05,660
higher in 1981.

392
00:20:05,660 --> 00:20:08,430
It was well over 10%.

393
00:20:08,430 --> 00:20:11,940
And a big place where
unemployment was high was in

394
00:20:11,940 --> 00:20:13,670
the manufacturing sector,
particularly auto

395
00:20:13,670 --> 00:20:14,610
manufacturing.

396
00:20:14,610 --> 00:20:16,440
We were getting killed
by Japan.

397
00:20:16,440 --> 00:20:18,660
Basically this was the first
wave of Japan really producing

398
00:20:18,660 --> 00:20:20,490
much better cars than the US.

399
00:20:20,490 --> 00:20:22,180
And US car manufacturers
were suffering

400
00:20:22,180 --> 00:20:24,060
enormously as a result.

401
00:20:24,060 --> 00:20:27,700
So basically the Reagan
administration was trying to

402
00:20:27,700 --> 00:20:30,240
figure out what to
do about this.

403
00:20:30,240 --> 00:20:32,070
One thing you could do, and
we'll talk about in

404
00:20:32,070 --> 00:20:34,150
international trade in a few
lectures, you could impose a

405
00:20:34,150 --> 00:20:37,200
quota and you could actually say
to Japanese producers, you

406
00:20:37,200 --> 00:20:38,460
can't sell in America.

407
00:20:38,460 --> 00:20:39,965
But Reagan was a Republican.

408
00:20:39,965 --> 00:20:41,480
And Republicans are
for free trade.

409
00:20:41,480 --> 00:20:43,730
And he really couldn't
do that politically.

410
00:20:43,730 --> 00:20:45,740
Plus economists have often
said that's a bad idea.

411
00:20:45,740 --> 00:20:47,960
And we'll talk about why
that's a bad idea.

412
00:20:47,960 --> 00:20:51,410
What Reagan did instead was
said to the Japanese auto

413
00:20:51,410 --> 00:20:53,640
manufacturers, look, I'm
a charismatic guy.

414
00:20:53,640 --> 00:20:54,500
I'm Ronald Reagan.

415
00:20:54,500 --> 00:20:56,570
Why don't we get together in a
room and I'll convince you to

416
00:20:56,570 --> 00:20:58,810
just export less to America.

417
00:20:58,810 --> 00:21:01,220
Let's have a voluntary export
restraint agreement.

418
00:21:01,220 --> 00:21:02,990
Where I'm not going to put on a
quota, because that would be

419
00:21:02,990 --> 00:21:04,980
bad, I'm going to actually
suggest to you, I'm going to

420
00:21:04,980 --> 00:21:08,940
make you an offer you can't
refuse that you just export

421
00:21:08,940 --> 00:21:11,530
less to the US.

422
00:21:11,530 --> 00:21:14,230
It was basically a back door
way of imposing a quota

423
00:21:14,230 --> 00:21:17,880
without looking as politically
bad as actually imposing one.

424
00:21:17,880 --> 00:21:21,390
And in fact, Japanese automakers
agreed to this and

425
00:21:21,390 --> 00:21:24,630
reduced their sales
of cars in the US.

426
00:21:24,630 --> 00:21:27,550
Now why would they
agree to this?

427
00:21:27,550 --> 00:21:29,680
Now there's two explanations.

428
00:21:29,680 --> 00:21:31,850
One is they could have thought
if they didn't then a quota

429
00:21:31,850 --> 00:21:32,580
was coming.

430
00:21:32,580 --> 00:21:35,320
They could have said, look,
this is kind of an olive

431
00:21:35,320 --> 00:21:38,050
branch before they
lower the hammer.

432
00:21:38,050 --> 00:21:39,460
That's a really bad
set of metaphors,

433
00:21:39,460 --> 00:21:40,740
but you get the idea.

434
00:21:40,740 --> 00:21:43,020
That basically look, if we don't
do this, then he's going

435
00:21:43,020 --> 00:21:44,840
to impose a quota.

436
00:21:44,840 --> 00:21:46,890
The other is they could have
said, thank you Ronald Reagan,

437
00:21:46,890 --> 00:21:49,160
you've just formed
a cartel for us.

438
00:21:49,160 --> 00:21:51,690
We can't stop from competing
against each other.

439
00:21:51,690 --> 00:21:53,900
We can't stop cheating.

440
00:21:53,900 --> 00:21:55,510
We'd like to form a cartel
but we can't.

441
00:21:55,510 --> 00:21:57,610
But you've told us we have to
cartelize because you've

442
00:21:57,610 --> 00:21:59,680
limited how much we can sell.

443
00:21:59,680 --> 00:22:03,130
You've essentially said, look
you can't sell more than this.

444
00:22:03,130 --> 00:22:04,410
You have to agree to sell
more than that.

445
00:22:04,410 --> 00:22:06,470
You've essentially allowed us
a framework where we can get

446
00:22:06,470 --> 00:22:09,200
together and implicitly
cartelize in a way where it's

447
00:22:09,200 --> 00:22:10,820
hard to cheat because then
we'd be violating the

448
00:22:10,820 --> 00:22:12,990
agreement with America.

449
00:22:12,990 --> 00:22:16,410
So basically what Reagan gave
the Japanese was a cartel

450
00:22:16,410 --> 00:22:18,130
enforcing device.

451
00:22:18,130 --> 00:22:21,600
What American and United need is
some way where American and

452
00:22:21,600 --> 00:22:24,540
United can monitor each other to
make sure they don't cheat.

453
00:22:24,540 --> 00:22:25,820
That's what Reagan gave
the Japanese.

454
00:22:25,820 --> 00:22:27,530
Said, I'm going to report on how
many cars are selling in

455
00:22:27,530 --> 00:22:29,910
the US and you're going to agree
to limit it to this.

456
00:22:29,910 --> 00:22:32,260
And they're like, great, that
gives us the tool we need to

457
00:22:32,260 --> 00:22:34,330
enforce the cartel we wanted
in the first place.

458
00:22:34,330 --> 00:22:35,480
Thank you very much.

459
00:22:35,480 --> 00:22:36,580
They made a ton of money.

460
00:22:36,580 --> 00:22:38,930
American consumers lost out.

461
00:22:38,930 --> 00:22:40,720
And I'll talk more about
international trade on why

462
00:22:40,720 --> 00:22:41,500
that happens.

463
00:22:41,500 --> 00:22:43,170
But the bottom line
is, this end up

464
00:22:43,170 --> 00:22:46,070
being just like a quota.

465
00:22:46,070 --> 00:22:48,335
The bad thing about quotas and
things like this is that

466
00:22:48,335 --> 00:22:53,750
essentially they raise prices
and hurt American consumers.

467
00:22:53,750 --> 00:22:55,420
And in this case they were bad
for American consumers and

468
00:22:55,420 --> 00:22:57,340
very good for Japanese
producers.

469
00:22:57,340 --> 00:23:00,710
We essentially increased profits
for Japanese producers

470
00:23:00,710 --> 00:23:02,530
which they used to develop
better cars and then came in

471
00:23:02,530 --> 00:23:04,810
later and killed us in the
car market anyway.

472
00:23:04,810 --> 00:23:08,680
So it was dynamically a pretty
terrible policy.

473
00:23:08,680 --> 00:23:14,100
So that's the legal issues
around cartels.

474
00:23:14,100 --> 00:23:16,900
Now what I want to do now is
step back for a second and

475
00:23:16,900 --> 00:23:22,940
say, we've now talked about
three different kinds of

476
00:23:22,940 --> 00:23:27,300
market forms. We've talked about
perfect competition.

477
00:23:27,300 --> 00:23:28,810
We've talked about monopoly.

478
00:23:28,810 --> 00:23:30,070
And we've talked about
oligopoly.

479
00:23:30,070 --> 00:23:32,070
In particular, non-cooperative
oligopoly which is a more

480
00:23:32,070 --> 00:23:33,790
interesting case since within
cartels it's going to be hard

481
00:23:33,790 --> 00:23:34,950
to sustain.

482
00:23:34,950 --> 00:23:36,230
Non cooperative oligopoly.

483
00:23:36,230 --> 00:23:37,190
We've talked about three.

484
00:23:37,190 --> 00:23:38,750
How do these compare?

485
00:23:38,750 --> 00:23:41,730
So let's just do ourselves
a little chart.

486
00:23:41,730 --> 00:23:42,990
Let's consider the
three cases.

487
00:23:42,990 --> 00:23:51,010
We've got monopoly, oligopoly,
and perfect

488
00:23:51,010 --> 00:23:54,120
competition, three cases.

489
00:23:54,120 --> 00:23:56,970
Let's ask how they compare
on quantity and

490
00:23:56,970 --> 00:23:59,500
on profits per firm.

491
00:23:59,500 --> 00:24:03,750
Quantity produced in the market
and profits per firm.

492
00:24:03,750 --> 00:24:06,840
And let's do it for this
American, United example.

493
00:24:06,840 --> 00:24:09,940
Well we know the monopoly case,
we told you that in the

494
00:24:09,940 --> 00:24:13,210
monopoly case 96 units get
produced in the market.

495
00:24:13,210 --> 00:24:20,500
And the profits per firm
are $4,608,000.

496
00:24:20,500 --> 00:24:24,430
In the oligopoly case that's
the Cournot case, in the

497
00:24:24,430 --> 00:24:27,920
Cournot oligopoly case we said
the total amount in the market

498
00:24:27,920 --> 00:24:32,180
was 64 per firm or 128,000.

499
00:24:32,180 --> 00:24:34,010
And the profits per
firm were lower.

500
00:24:34,010 --> 00:24:40,510
They were $4,096,000 per firm.

501
00:24:40,510 --> 00:24:43,910
Now what about in perfect
competition?

502
00:24:43,910 --> 00:24:46,120
What's the quantity that's going
to be sold, what's the

503
00:24:46,120 --> 00:24:49,710
price going to be in perfect
competition?

504
00:24:49,710 --> 00:24:50,670
We haven't done perfect
competition.

505
00:24:50,670 --> 00:24:51,160
You can tell me.

506
00:24:51,160 --> 00:24:51,920
You can just do that
intuitively.

507
00:24:51,920 --> 00:24:54,310
What's going to happen in this
market if there's perfect

508
00:24:54,310 --> 00:24:55,090
competition what's this
price going to be?

509
00:24:55,090 --> 00:24:57,090
Somebody raise their
hand and tell me.

510
00:24:57,090 --> 00:24:57,870
Yeah in the back.

511
00:24:57,870 --> 00:24:59,271
AUDIENCE: [INAUDIBLE]

512
00:24:59,271 --> 00:25:01,920
PROFESSOR: 147, because price
equals marginal cost in

513
00:25:01,920 --> 00:25:03,130
perfect competition.

514
00:25:03,130 --> 00:25:08,890
So quantity would be 339
minus 147 or 192.

515
00:25:08,890 --> 00:25:10,450
There will be 192 units sold.

516
00:25:10,450 --> 00:25:11,970
And what will profits be?

517
00:25:11,970 --> 00:25:14,130
Zero.

518
00:25:14,130 --> 00:25:15,420
Zero profits in perfect
competition.

519
00:25:15,420 --> 00:25:17,640
With a flat marginal cost there
will be zero profits

520
00:25:17,640 --> 00:25:20,250
with perfect competition.

521
00:25:20,250 --> 00:25:33,970
So we can now compare this and
we could say, an oligopoly

522
00:25:33,970 --> 00:25:38,140
case leads to less output and
more profits than does perfect

523
00:25:38,140 --> 00:25:39,630
competition.

524
00:25:39,630 --> 00:25:42,150
And a monopoly case leads to
even less output and even more

525
00:25:42,150 --> 00:25:43,615
profits than does oligopoly.

526
00:25:46,530 --> 00:25:51,360
And basically how do we think
about welfare in this case.

527
00:25:51,360 --> 00:25:53,230
Well to think about welfare
you'd have to actually draw

528
00:25:53,230 --> 00:25:58,490
the diagrams to compute producer
and consumer surplus.

529
00:25:58,490 --> 00:26:03,435
What I could draw and show you
is basically social welfare is

530
00:26:03,435 --> 00:26:06,336
highest in the perfect
competition case, lowest in

531
00:26:06,336 --> 00:26:08,933
the monopoly case, and we talked
a couple times about

532
00:26:08,933 --> 00:26:09,965
the deadweight loss
of monopoly.

533
00:26:09,965 --> 00:26:10,970
This is not a price

534
00:26:10,970 --> 00:26:12,610
discriminating monopolist remember.

535
00:26:12,610 --> 00:26:15,500
This is a one price monopolist
so there's deadweight loss.

536
00:26:15,500 --> 00:26:18,190
And it turns out if you write
down the graph that it's in

537
00:26:18,190 --> 00:26:20,370
between the oligopoly case.

538
00:26:20,370 --> 00:26:24,050
Oligopolies cause some
deadweight loss, it's worse

539
00:26:24,050 --> 00:26:26,420
than perfect competition but
better then monopoly in terms

540
00:26:26,420 --> 00:26:28,440
of total welfare.

541
00:26:28,440 --> 00:26:31,670
And in fact, the bottom line
is, we can actually pretty

542
00:26:31,670 --> 00:26:33,060
much tell what happens
to welfare.

543
00:26:33,060 --> 00:26:34,920
A shortcut for thinking
about welfare

544
00:26:34,920 --> 00:26:37,890
is to look at quantity.

545
00:26:37,890 --> 00:26:42,000
Because remember what social
welfare is about, what causes

546
00:26:42,000 --> 00:26:44,730
deadweight loss, is trades
that aren't made.

547
00:26:48,330 --> 00:26:51,380
Under perfect competition
every trade that has a

548
00:26:51,380 --> 00:26:54,620
positive social surpluses
is made.

549
00:26:54,620 --> 00:26:57,420
So the closer the quantity
produced comes to the perfect

550
00:26:57,420 --> 00:27:00,310
competition level, the smaller
will be the deadweight loss,

551
00:27:00,310 --> 00:27:01,910
roughly speaking.

552
00:27:01,910 --> 00:27:04,480
So it isn't always true, and
you can find bizarre

553
00:27:04,480 --> 00:27:08,850
deviations, but a good rule of
thumb is that welfare, the

554
00:27:08,850 --> 00:27:10,450
distortion of perfect
competition will be

555
00:27:10,450 --> 00:27:13,090
proportional to how much
quantity falls relative to

556
00:27:13,090 --> 00:27:15,490
perfect competition.

557
00:27:15,490 --> 00:27:17,020
If quantity falls a lot
relative to perfect

558
00:27:17,020 --> 00:27:19,200
competition, that's going to
be a big loss in welfare.

559
00:27:19,200 --> 00:27:20,950
If quantity is falling just a
little, it's going to be a

560
00:27:20,950 --> 00:27:21,740
small loss in welfare.

561
00:27:21,740 --> 00:27:23,500
And that goes back to that
deadweight loss triangle.

562
00:27:23,500 --> 00:27:25,080
About the fact that it's
smallest right around the

563
00:27:25,080 --> 00:27:27,076
perfect combination equilibrium
and gets bigger as

564
00:27:27,076 --> 00:27:28,326
you move further away.

565
00:27:30,420 --> 00:27:34,600
So basically perfect combination
is the best,

566
00:27:34,600 --> 00:27:35,900
monopoly is the worst, oligopoly
would be somewhere

567
00:27:35,900 --> 00:27:37,150
in between.

568
00:27:43,380 --> 00:27:44,690
This leads to the question.

569
00:27:44,690 --> 00:27:46,180
I think you might look at this
chart and ask yourself is

570
00:27:46,180 --> 00:27:49,850
well, gee, does this sort of say
that the number of firms

571
00:27:49,850 --> 00:27:52,090
determines welfare?

572
00:27:52,090 --> 00:27:55,696
You've got one firm, two firms,
infinite firms so can

573
00:27:55,696 --> 00:27:58,190
we make a more general statement
about the role the

574
00:27:58,190 --> 00:27:58,930
number of firms.

575
00:27:58,930 --> 00:28:02,610
And it turns out the Cournot
model we can.

576
00:28:02,610 --> 00:28:06,260
Basically in the Cournot model,
the more firms there

577
00:28:06,260 --> 00:28:10,240
are, the closer you get to
perfect competition.

578
00:28:10,240 --> 00:28:13,550
In the Cournot model as n
increases you approach perfect

579
00:28:13,550 --> 00:28:16,040
competition.

580
00:28:16,040 --> 00:28:17,910
And in particular, and the book
does the math in this,

581
00:28:17,910 --> 00:28:20,940
you don't need to know the math,
it's more the intuition.

582
00:28:20,940 --> 00:28:24,440
But the book shows that the
markup in a market, price

583
00:28:24,440 --> 00:28:28,020
minus marginal cost over price,
in a Cournot market is

584
00:28:28,020 --> 00:28:31,410
equal to 1 over n times the
elasticity of demand.

585
00:28:36,250 --> 00:28:41,740
That is that we've said before
that markup was inversely

586
00:28:41,740 --> 00:28:44,370
proportional to elasticity
of demand.

587
00:28:44,370 --> 00:28:46,260
I might have used a different
letter, I might have used nu

588
00:28:46,260 --> 00:28:47,050
for that elasticity.

589
00:28:47,050 --> 00:28:48,150
But this is elasticity
of demand.

590
00:28:48,150 --> 00:28:49,380
I forget what letter
I used last time.

591
00:28:49,380 --> 00:28:51,600
Same elasticity I've
been using.

592
00:28:51,600 --> 00:28:55,200
So basically, we said before we
had this equation, right?

593
00:28:55,200 --> 00:28:56,915
We said markup was inversely
proportional

594
00:28:56,915 --> 00:28:58,290
to elasticity demand.

595
00:28:58,290 --> 00:29:00,540
The more inelastic was the good,
the higher market power

596
00:29:00,540 --> 00:29:02,080
the monopolist had.

597
00:29:02,080 --> 00:29:06,140
Well here we now divide by n.

598
00:29:06,140 --> 00:29:08,680
So the point is, that for a
given elasticity of demand the

599
00:29:08,680 --> 00:29:11,260
more firms that are competing in
the oligopolistic setting,

600
00:29:11,260 --> 00:29:19,050
the closer and closer you're
going to get to a zero mark-up

601
00:29:19,050 --> 00:29:21,750
with a Cournot equilibrium.

602
00:29:21,750 --> 00:29:24,500
So it's just this intuition
you see from this table.

603
00:29:24,500 --> 00:29:26,110
This is one firm.

604
00:29:26,110 --> 00:29:27,770
Then oligopoly can imagine
a number of branches.

605
00:29:27,770 --> 00:29:29,490
This is oligopoly with two
firms. You should be able to

606
00:29:29,490 --> 00:29:30,000
show yourself.

607
00:29:30,000 --> 00:29:32,410
If there were three firms, which
you can solve, that's

608
00:29:32,410 --> 00:29:33,600
three equations and
three unknowns.

609
00:29:33,600 --> 00:29:36,700
It's the same math
we just did.

610
00:29:36,700 --> 00:29:37,520
It's high school math.

611
00:29:37,520 --> 00:29:40,120
You can do this if you just put
in three firms, do three

612
00:29:40,120 --> 00:29:42,040
equations and three unknowns,
you get an even higher

613
00:29:42,040 --> 00:29:43,600
quantity and so on.

614
00:29:43,600 --> 00:29:45,360
So as the number of firms goes
up you're going to move that

615
00:29:45,360 --> 00:29:47,590
quantity up towards the perfect
competition level and

616
00:29:47,590 --> 00:29:50,260
profits will fall towards the
zero that we get from perfect

617
00:29:50,260 --> 00:29:52,780
competition.

618
00:29:52,780 --> 00:29:55,650
And this is consistent with
our rough notion.

619
00:29:55,650 --> 00:29:57,450
We talked about extremes, about
perfect competition

620
00:29:57,450 --> 00:29:59,990
being lots of firms, the
monopoly being one firm.

621
00:29:59,990 --> 00:30:02,870
But this confirms the rough
intuition of the more firms,

622
00:30:02,870 --> 00:30:04,690
the more competition.

623
00:30:04,690 --> 00:30:06,480
That's a good solid intuition.

624
00:30:08,980 --> 00:30:17,720
Now this raises the interesting
question about

625
00:30:17,720 --> 00:30:21,170
should we ever allow
the number of firms

626
00:30:21,170 --> 00:30:23,430
in a market to shrink.

627
00:30:23,430 --> 00:30:24,780
Should we ever allow the
number of firms in

628
00:30:24,780 --> 00:30:27,360
the market to shrink?

629
00:30:27,360 --> 00:30:31,810
What we call that is we
call that a merger.

630
00:30:31,810 --> 00:30:33,030
You've all heard of mergers.

631
00:30:33,030 --> 00:30:34,990
When two companies merge
to form one company.

632
00:30:34,990 --> 00:30:39,020
Well by the logic I just told
you that's going to be bad.

633
00:30:39,020 --> 00:30:41,320
I just said that the
more firms you

634
00:30:41,320 --> 00:30:42,440
have, the higher welfare.

635
00:30:42,440 --> 00:30:43,695
The more you get towards
perfect competition.

636
00:30:46,400 --> 00:30:47,840
And yet mergers happen
all the time.

637
00:30:47,840 --> 00:30:49,870
The government does
not stop them.

638
00:30:49,870 --> 00:30:52,070
The government typically
investigates them if they're

639
00:30:52,070 --> 00:30:54,810
big mergers, the government
would

640
00:30:54,810 --> 00:30:56,100
typically investigate them.

641
00:30:56,100 --> 00:31:00,290
But by and large they often
let them go through.

642
00:31:00,290 --> 00:31:02,370
Why is that?

643
00:31:02,370 --> 00:31:05,940
Why should the government
not stop all mergers?

644
00:31:05,940 --> 00:31:08,370
And in particular, if anyone for
extra credit, can anyone

645
00:31:08,370 --> 00:31:11,410
tell me what concept we covered
which would explain

646
00:31:11,410 --> 00:31:13,190
why it might make sense to
allow firms to merge.

647
00:31:13,190 --> 00:31:13,650
Yeah.

648
00:31:13,650 --> 00:31:14,940
AUDIENCE: The economy
of scale.

649
00:31:14,940 --> 00:31:17,410
PROFESSOR: Economies
of scale, exactly.

650
00:31:17,410 --> 00:31:18,980
That's the term I
was looking for.

651
00:31:18,980 --> 00:31:22,520
It could be that you have two
firms that are producing

652
00:31:22,520 --> 00:31:25,560
inefficiently relative to having
combined production.

653
00:31:25,560 --> 00:31:28,100
So you've got one plant that
produces the left shoes and

654
00:31:28,100 --> 00:31:31,850
one plant that produces
the right shoes.

655
00:31:31,850 --> 00:31:32,920
And that's not a good example
because they wouldn't really

656
00:31:32,920 --> 00:31:33,770
compete with each other.

657
00:31:33,770 --> 00:31:34,600
But you know the point.

658
00:31:34,600 --> 00:31:39,858
The point let's say you've got
two firms competing with each

659
00:31:39,858 --> 00:31:42,170
other and they're both running
a plant at half capacity.

660
00:31:42,170 --> 00:31:43,880
There's two separate plants
running half capacity, much

661
00:31:43,880 --> 00:31:46,090
more efficient to have them
merge and have one plant run

662
00:31:46,090 --> 00:31:47,920
at full capacity.

663
00:31:47,920 --> 00:31:51,020
And yes, if they merged they
would then be a monopolist,

664
00:31:51,020 --> 00:31:54,440
but it's possible the cost
efficiencies could be so high

665
00:31:54,440 --> 00:31:56,960
a monopolist with lower marginal
cost might be better

666
00:31:56,960 --> 00:31:59,560
than oligopolist with higher
marginal cost. This is kind of

667
00:31:59,560 --> 00:32:02,053
like the patent example
I did last lecture

668
00:32:02,053 --> 00:32:03,140
or the lecture before.

669
00:32:03,140 --> 00:32:05,120
Where I talked about how a
patent could be a good thing

670
00:32:05,120 --> 00:32:06,210
or a bad thing.

671
00:32:06,210 --> 00:32:09,370
It depends on how much demand
increases due to the patent.

672
00:32:09,370 --> 00:32:10,940
It's the same notion here.

673
00:32:10,940 --> 00:32:13,920
The tradeoff is on the one hand
you get marginal cost

674
00:32:13,920 --> 00:32:21,890
down by allowing a merger, on
the other hand you reduce the

675
00:32:21,890 --> 00:32:24,020
number of firms in the market
by allowing a merger.

676
00:32:24,020 --> 00:32:25,540
And there's that tradeoff.

677
00:32:25,540 --> 00:32:29,850
You're going to raise each
firm's mark-up ability but by

678
00:32:29,850 --> 00:32:32,270
lowering marginal cost you might
actually in essence,

679
00:32:32,270 --> 00:32:34,090
might in the end lower
the price.

680
00:32:34,090 --> 00:32:35,490
And that's exactly what
the Department of

681
00:32:35,490 --> 00:32:38,250
Justice does every day.

682
00:32:38,250 --> 00:32:39,950
And this is what is the hundreds
of economists that

683
00:32:39,950 --> 00:32:41,380
work for the Department of
Justice do, they have quite an

684
00:32:41,380 --> 00:32:42,410
interesting job.

685
00:32:42,410 --> 00:32:44,410
They have to go ahead and
evaluate these mergers.

686
00:32:44,410 --> 00:32:46,715
People want to merge and they
have to say, well which effect

687
00:32:46,715 --> 00:32:48,720
is going to be larger.

688
00:32:48,720 --> 00:32:51,490
How do we decide whether the
savings from economies of

689
00:32:51,490 --> 00:32:54,900
scale exceed the cost and
increase market power?

690
00:32:54,900 --> 00:32:58,790
And that's just an incredibly
hard thing to do.

691
00:32:58,790 --> 00:33:02,060
That turns out to be an
incredibly hard thing to do.

692
00:33:02,060 --> 00:33:04,540
And part of the reason it's hard
is exactly comes back to

693
00:33:04,540 --> 00:33:06,000
what I talked about when I
talked about regulating

694
00:33:06,000 --> 00:33:06,950
monopolies.

695
00:33:06,950 --> 00:33:10,090
Because the data is controlled
by the market participants.

696
00:33:10,090 --> 00:33:12,560
And so you can have necessarily
good data on what

697
00:33:12,560 --> 00:33:13,440
it's going to do.

698
00:33:13,440 --> 00:33:17,060
So a great example
is hospitals.

699
00:33:17,060 --> 00:33:19,560
Over the last 20 years there's
been enormous mergers in the

700
00:33:19,560 --> 00:33:21,040
hospital sector.

701
00:33:21,040 --> 00:33:23,300
Even here in Boston we've seen
huge mergers of things like

702
00:33:23,300 --> 00:33:25,766
the Beth Israel and Deaconess
hospitals merge.

703
00:33:25,766 --> 00:33:28,280
Other hospitals merged.

704
00:33:28,280 --> 00:33:30,770
These mergers were big and had
to go before regulators.

705
00:33:30,770 --> 00:33:32,760
And the hospitals rightly argue,
look, there's huge

706
00:33:32,760 --> 00:33:36,120
economies of scale in
hospital production.

707
00:33:36,120 --> 00:33:39,050
Partly because hospitals
are rarely full.

708
00:33:39,050 --> 00:33:40,880
They have to have excess
capacity in case somebody

709
00:33:40,880 --> 00:33:41,480
comes in injured.

710
00:33:41,480 --> 00:33:42,890
They have to have an
extra bed around.

711
00:33:42,890 --> 00:33:45,440
They don't want people sleeping
in the halls.

712
00:33:45,440 --> 00:33:48,040
As a result, in a situation
where you're rarely full,

713
00:33:48,040 --> 00:33:50,370
where you're constantly under
capacity, there could be huge

714
00:33:50,370 --> 00:33:53,950
economies of scale from
combining and using your

715
00:33:53,950 --> 00:33:56,070
combined space more
effectively.

716
00:33:56,070 --> 00:33:57,710
So pretty compelling argument.

717
00:33:57,710 --> 00:34:02,220
And for that reason,
pretty plausible.

718
00:34:02,220 --> 00:34:03,490
Most hospital mergers were
allowed through.

719
00:34:03,490 --> 00:34:06,300
Very few hospital mergers
were rejected.

720
00:34:06,300 --> 00:34:07,670
Well what happened?

721
00:34:07,670 --> 00:34:10,310
It turns out the hospitals
just lied.

722
00:34:10,310 --> 00:34:12,630
They kept exactly the same
production process they had

723
00:34:12,630 --> 00:34:15,929
before the merger and
just raised prices.

724
00:34:15,929 --> 00:34:19,159
So in fact, Beth Israel and
Deaconess each kept their

725
00:34:19,159 --> 00:34:21,520
building just like they
had before the merger.

726
00:34:21,520 --> 00:34:22,980
They just charged more.

727
00:34:22,980 --> 00:34:26,050
Essentially they just
cartelized.

728
00:34:26,050 --> 00:34:28,199
But the government let
it go through.

729
00:34:28,199 --> 00:34:30,920
And what we've done,
essentially, is we're fooled

730
00:34:30,920 --> 00:34:34,639
by the theory of these economies
of scale, when in

731
00:34:34,639 --> 00:34:38,030
fact there was nothing to
force the companies to

732
00:34:38,030 --> 00:34:40,719
necessarily do much
to realize them.

733
00:34:40,719 --> 00:34:43,520
We just allowed them to
have market power.

734
00:34:43,520 --> 00:34:46,310
So basically this is an
incredibly tricky and

735
00:34:46,310 --> 00:34:49,050
difficult issue in deciding
whether to allow mergers or

736
00:34:49,050 --> 00:34:52,856
not is basically evaluating
whether in practice you'll see

737
00:34:52,856 --> 00:34:54,880
the economies of scale
that justify the

738
00:34:54,880 --> 00:34:56,310
increased market power.

739
00:34:56,310 --> 00:35:00,590
And that's why the Department
of Justice has a hard job.

740
00:35:00,590 --> 00:35:01,840
Questions about that?

741
00:35:04,230 --> 00:35:08,560
One other point I want to make
here is about the size the

742
00:35:08,560 --> 00:35:14,990
market is, I've talked about how
mathematically the size of

743
00:35:14,990 --> 00:35:17,930
the market will lead to
more competition.

744
00:35:17,930 --> 00:35:20,360
There's also another reason,
which is the bigger the

745
00:35:20,360 --> 00:35:23,900
market, the harder to
enforce a cartel.

746
00:35:23,900 --> 00:35:29,365
If there's two players in the
market and one cheats, the

747
00:35:29,365 --> 00:35:32,790
other one has the first one
whacked or something.

748
00:35:32,790 --> 00:35:35,630
You know what's going on, you
can keep an eye on each other,

749
00:35:35,630 --> 00:35:37,580
you know who's to blame.

750
00:35:37,580 --> 00:35:39,920
When there's lots of players
in the market it becomes--

751
00:35:39,920 --> 00:35:43,070
so let's say there was 10
airlines flying, it becomes

752
00:35:43,070 --> 00:35:45,390
hard to figure out
who's cheating.

753
00:35:45,390 --> 00:35:48,430
Or more still, imagine the most
important cartel in the

754
00:35:48,430 --> 00:35:50,100
world which is OPEC.

755
00:35:50,100 --> 00:35:53,210
The Organization of Petroleum
Exporting Countries.

756
00:35:53,210 --> 00:35:56,270
This is an organization of 20
plus countries who control the

757
00:35:56,270 --> 00:35:58,100
world's oil supply.

758
00:35:58,100 --> 00:36:00,590
But there's no good way
of tracking who's

759
00:36:00,590 --> 00:36:01,370
selling what oil.

760
00:36:01,370 --> 00:36:04,160
We just know the total amount
of oil sold out there.

761
00:36:04,160 --> 00:36:07,600
So if a country like Venezuela
run by some nutty guy decides

762
00:36:07,600 --> 00:36:10,930
to cheat and throw a bunch of
oil on the market, it's hard

763
00:36:10,930 --> 00:36:14,930
for the other members of OPEC
to actually view that.

764
00:36:14,930 --> 00:36:17,280
OPEC's efficiency has
varied over time.

765
00:36:17,280 --> 00:36:19,485
At times OPEC has not done such
a good job of controlling

766
00:36:19,485 --> 00:36:22,730
the supply of oil in the world,
at other times it has.

767
00:36:22,730 --> 00:36:24,460
But basically the more players,

768
00:36:24,460 --> 00:36:26,400
the harder it becomes.

769
00:36:26,400 --> 00:36:29,400
And as a good example, which
is the cartel to produce

770
00:36:29,400 --> 00:36:32,140
mercury was an existing
cartel.

771
00:36:32,140 --> 00:36:35,150
Italy and Spain essentially had
controlled the market to

772
00:36:35,150 --> 00:36:38,010
sell mercury.

773
00:36:38,010 --> 00:36:39,780
They had a very well
functioning cartel.

774
00:36:39,780 --> 00:36:43,640
Other countries entered and
the cartel broke down.

775
00:36:43,640 --> 00:36:44,790
So we can see this.

776
00:36:44,790 --> 00:36:48,980
And this becomes a big issue in
thinking about the benefits

777
00:36:48,980 --> 00:36:51,220
of enforcing competition.

778
00:36:51,220 --> 00:36:53,230
And becomes a big issue
in government policy.

779
00:36:53,230 --> 00:36:54,750
Here's another government policy
issue which you may

780
00:36:54,750 --> 00:36:58,210
followed lately which is
the rare earths issue.

781
00:36:58,210 --> 00:37:00,170
You guys all know as scientists
better than I, the

782
00:37:00,170 --> 00:37:01,680
importance of rare earths, but
these are materials which are

783
00:37:01,680 --> 00:37:03,910
very important for putting
in cell phone

784
00:37:03,910 --> 00:37:04,930
batteries and other things.

785
00:37:04,930 --> 00:37:07,210
These are important
new materials

786
00:37:07,210 --> 00:37:08,890
for the modern economy.

787
00:37:08,890 --> 00:37:11,710
The US used to be the dominant
producer of rare earths and

788
00:37:11,710 --> 00:37:13,870
then China turned out were able
to produce it much more

789
00:37:13,870 --> 00:37:16,410
efficiently, so we just
let China take it.

790
00:37:16,410 --> 00:37:20,560
So now 97% of the world's rare
earths are produced in China.

791
00:37:20,560 --> 00:37:23,226
China's now started saying
things like, Japan we're mad

792
00:37:23,226 --> 00:37:25,980
at you, we're not selling you
rare earths, which is a huge,

793
00:37:25,980 --> 00:37:27,310
huge problem.

794
00:37:27,310 --> 00:37:29,200
And basically we've allowed
China to essentially

795
00:37:29,200 --> 00:37:31,160
monopolize this market.

796
00:37:31,160 --> 00:37:35,590
Now we tend to think in
economics it's a bad idea for

797
00:37:35,590 --> 00:37:38,330
the government to subsidize
businesses.

798
00:37:38,330 --> 00:37:39,920
The government should just let
the economy work and decide

799
00:37:39,920 --> 00:37:40,650
what works.

800
00:37:40,650 --> 00:37:42,000
But this may be a case where the
government wants to say,

801
00:37:42,000 --> 00:37:44,220
no, we are going to actually
subsidize rare earths

802
00:37:44,220 --> 00:37:46,350
production in America, to make
sure on national security

803
00:37:46,350 --> 00:37:49,650
grounds we have enough in case
China decides to shut us off.

804
00:37:49,650 --> 00:37:51,490
And that's exactly the kind of
issue the government has to

805
00:37:51,490 --> 00:37:56,230
face in terms of trying to
decide whether or not to try

806
00:37:56,230 --> 00:37:58,320
to actively get in there and
promote competition versus

807
00:37:58,320 --> 00:38:01,280
just letting the market work.

808
00:38:01,280 --> 00:38:02,530
Questions about that?

809
00:38:04,840 --> 00:38:08,660
Now I want to talk about one
last thing before we stop,

810
00:38:08,660 --> 00:38:13,110
which is the fact that Cournot
competition is not the only

811
00:38:13,110 --> 00:38:15,930
model of competition
out there.

812
00:38:15,930 --> 00:38:17,410
In fact it might not even
be the first one

813
00:38:17,410 --> 00:38:18,990
that comes to mind.

814
00:38:18,990 --> 00:38:22,120
In fact, if I said to you,
imagine two firms competing to

815
00:38:22,120 --> 00:38:26,200
sell something, the first thing
to come to your mind

816
00:38:26,200 --> 00:38:30,470
would probably not be best
response functions.

817
00:38:30,470 --> 00:38:33,060
If you say, well they just
compete over the price.

818
00:38:33,060 --> 00:38:34,670
And if there was really tough
competition the price would

819
00:38:34,670 --> 00:38:35,980
just come down.

820
00:38:35,980 --> 00:38:39,640
And the limit, if they're
incredibly good competitors,

821
00:38:39,640 --> 00:38:43,680
the price would have to come
down close to marginal cost.

822
00:38:43,680 --> 00:38:49,250
Well that is a different model
of competition that we call

823
00:38:49,250 --> 00:38:53,575
Bertrand or price competition.

824
00:39:01,260 --> 00:39:03,670
Cournot competition is
competition over quantities.

825
00:39:03,670 --> 00:39:06,350
You get together and decide how
much quantity to produce

826
00:39:06,350 --> 00:39:08,210
given what the other guy is
producing and then the market

827
00:39:08,210 --> 00:39:09,860
gives you the price.

828
00:39:09,860 --> 00:39:14,450
Bertrand competition is the flip
of that, which is firms

829
00:39:14,450 --> 00:39:17,540
set their price and they produce
whatever the market

830
00:39:17,540 --> 00:39:20,250
demands at that price.

831
00:39:20,250 --> 00:39:22,440
Once again, Cournot competition
is firms set their

832
00:39:22,440 --> 00:39:26,340
quantity and then they set
the price reading it

833
00:39:26,340 --> 00:39:27,940
off a demand curve.

834
00:39:27,940 --> 00:39:29,100
Bertrand competition is
totally different.

835
00:39:29,100 --> 00:39:31,110
They say, we're just going to
compete over price and we'll

836
00:39:31,110 --> 00:39:32,860
just produce whatever quantity
you want at that price.

837
00:39:32,860 --> 00:39:36,240
We don't really even care
what demand is.

838
00:39:36,240 --> 00:39:38,570
We're just going to compete
over price.

839
00:39:38,570 --> 00:39:44,090
And the idea is that you have
some marginal cost that firms

840
00:39:44,090 --> 00:39:46,360
will never go below
in the long run.

841
00:39:46,360 --> 00:39:48,390
And the question is how much
will they compete down to that

842
00:39:48,390 --> 00:39:51,640
marginal cost. In practice,
what's crazy about Bertrand

843
00:39:51,640 --> 00:39:55,240
competition is it's possible
with two firms you can get to

844
00:39:55,240 --> 00:39:59,070
the perfectly competitive
outcome, with only two firms.

845
00:39:59,070 --> 00:40:01,010
Because those two firms are
competitive enough in setting

846
00:40:01,010 --> 00:40:03,020
the price, they can fight it
all the way down to the

847
00:40:03,020 --> 00:40:03,720
marginal cost.

848
00:40:03,720 --> 00:40:06,870
That is if I ever try set it
to marginal cost plus $1,

849
00:40:06,870 --> 00:40:09,200
you'll come in and set it to
marginal cost plus $0.99,

850
00:40:09,200 --> 00:40:10,970
because you can still
make money.

851
00:40:10,970 --> 00:40:13,630
Now I'll come and set it to
marginal cost plus $0.98,

852
00:40:13,630 --> 00:40:14,840
because I can still
make money.

853
00:40:14,840 --> 00:40:17,680
And we'll compete it all the
way down until we both are

854
00:40:17,680 --> 00:40:19,810
charging marginal cost
plus a penny.

855
00:40:19,810 --> 00:40:21,990
And if anyone tries to sell a
higher price they can't sell

856
00:40:21,990 --> 00:40:23,140
the product because people
will only buy the

857
00:40:23,140 --> 00:40:24,390
lower priced good.

858
00:40:26,480 --> 00:40:30,930
So you could have a world with
Bertrand competition where

859
00:40:30,930 --> 00:40:32,560
essentially firms compete
over price.

860
00:40:32,560 --> 00:40:35,930
And where unlike this case, oh
I just covered it up, unlike

861
00:40:35,930 --> 00:40:38,350
our comparison where with two
firms there's still lots of

862
00:40:38,350 --> 00:40:39,730
profits to be made.

863
00:40:39,730 --> 00:40:41,920
In Bertrand competition it's
possible that two firms are

864
00:40:41,920 --> 00:40:45,340
enough, just two firms are
enough to get us to perfect

865
00:40:45,340 --> 00:40:46,500
competition.

866
00:40:46,500 --> 00:40:49,800
You don't need n firms.
Two firms are enough.

867
00:40:53,690 --> 00:40:54,990
And in some sense, if we thought
about it, that's

868
00:40:54,990 --> 00:40:56,760
probably the first model we
have in mind if we thought

869
00:40:56,760 --> 00:40:58,130
about firms competing
is they compete over

870
00:40:58,130 --> 00:40:59,370
where to set the price.

871
00:40:59,370 --> 00:41:01,820
And that's essentially what
the Bertrand model is.

872
00:41:01,820 --> 00:41:04,200
So two questions about that.

873
00:41:04,200 --> 00:41:08,150
The first is, well jeez,
which model do we use?

874
00:41:08,150 --> 00:41:10,035
How do we know whether it's
Bertrand competition or

875
00:41:10,035 --> 00:41:10,670
Cournot competition?

876
00:41:10,670 --> 00:41:12,440
How do we know which
model to use?

877
00:41:12,440 --> 00:41:14,760
We've got a market with two
firms in it, you tell us the

878
00:41:14,760 --> 00:41:17,310
models are going to give very
different answers, how do we

879
00:41:17,310 --> 00:41:18,890
know which one to use?

880
00:41:18,890 --> 00:41:21,450
And the answer is, basically
we don't know which

881
00:41:21,450 --> 00:41:22,640
one to use for sure.

882
00:41:22,640 --> 00:41:24,680
We can talk about the conditions
under which

883
00:41:24,680 --> 00:41:27,020
quantity competition is more
likely and under which price

884
00:41:27,020 --> 00:41:29,630
competition is more likely.

885
00:41:29,630 --> 00:41:32,540
Basically quantity competition
is going to be more likely

886
00:41:32,540 --> 00:41:36,000
when there's lags in the
production process.

887
00:41:36,000 --> 00:41:38,380
So that you can't flexibly say,
here's my price, I'll

888
00:41:38,380 --> 00:41:40,340
produce as much as I want.

889
00:41:40,340 --> 00:41:42,995
If an airline said, I'm charging
this, I'll fly as

890
00:41:42,995 --> 00:41:44,460
many guys as I want,
you can't do that.

891
00:41:44,460 --> 00:41:46,600
You only have so many planes.

892
00:41:46,600 --> 00:41:48,530
Airlines can't just set a price
and then meet whatever

893
00:41:48,530 --> 00:41:49,590
demand comes out.

894
00:41:49,590 --> 00:41:51,220
Airlines have to actually
sent a quantity.

895
00:41:51,220 --> 00:41:55,040
They have to say there's this
many flights we can do.

896
00:41:55,040 --> 00:41:58,350
So when there's lags in the
production process it's going

897
00:41:58,350 --> 00:42:00,250
to be hard to do pure
price competition.

898
00:42:00,250 --> 00:42:03,320
It's going to be more like
quantity competition.

899
00:42:03,320 --> 00:42:07,920
That's going to be like
airlines or cars.

900
00:42:07,920 --> 00:42:10,850
On the other hand, take
selling cereal at a

901
00:42:10,850 --> 00:42:13,390
supermarket.

902
00:42:13,390 --> 00:42:16,260
The supermarket if it runs out
of cereal the next day it can

903
00:42:16,260 --> 00:42:18,850
get a whole bunch more.

904
00:42:18,850 --> 00:42:21,060
The supermarket can almost
instantaneously replenish any

905
00:42:21,060 --> 00:42:22,640
supply it's out of.

906
00:42:22,640 --> 00:42:25,210
So there, you're more likely to
see same price competition

907
00:42:25,210 --> 00:42:27,680
between say cereals in
the supermarket.

908
00:42:27,680 --> 00:42:30,810
People can just compare
very easily.

909
00:42:30,810 --> 00:42:33,320
And if one's cheaper they'll
just buy it up and if it runs

910
00:42:33,320 --> 00:42:34,640
out the supermarket will
just reload the next

911
00:42:34,640 --> 00:42:36,190
day with that cereal.

912
00:42:36,190 --> 00:42:40,360
Essentially it's pretty
easy to meet quantity.

913
00:42:40,360 --> 00:42:43,080
So this is not a very
clean distinction.

914
00:42:43,080 --> 00:42:45,144
But the bottom line is quantity
competition is going

915
00:42:45,144 --> 00:42:46,960
to be more likely when
it's a hard good

916
00:42:46,960 --> 00:42:49,820
to produce on demand.

917
00:42:49,820 --> 00:42:51,885
And price competition more
likely when it's an easy good

918
00:42:51,885 --> 00:42:53,510
to do that.

919
00:42:53,510 --> 00:42:55,600
That's how you're going to
think about which kind of

920
00:42:55,600 --> 00:42:58,990
competition makes the most
sense in which context.

921
00:42:58,990 --> 00:43:02,140
That's point one.

922
00:43:02,140 --> 00:43:04,220
Point two, and the last
point I want to make.

923
00:43:04,220 --> 00:43:08,120
What can firms do to avoid
Bertrand competition.

924
00:43:08,120 --> 00:43:11,140
Let's say, for example, you're
a cereal producer.

925
00:43:11,140 --> 00:43:12,410
You're in a Bertrand market.

926
00:43:12,410 --> 00:43:14,340
Well this is a shitty
market to be in.

927
00:43:14,340 --> 00:43:17,930
I just said two firms can drive
your profits to zero.

928
00:43:17,930 --> 00:43:19,540
What do you do?

929
00:43:19,540 --> 00:43:22,161
What do cereal producers do?

930
00:43:22,161 --> 00:43:22,628
Yeah.

931
00:43:22,628 --> 00:43:23,562
AUDIENCE: Differentiate.

932
00:43:23,562 --> 00:43:26,240
PROFESSOR: They product
differentiate.

933
00:43:26,240 --> 00:43:29,570
So the way to beat Bertrand
competition is through product

934
00:43:29,570 --> 00:43:30,820
differentiation.

935
00:43:42,300 --> 00:43:44,610
Once your products are
different, then you can price

936
00:43:44,610 --> 00:43:46,340
above marginal cost. Then
they're not perfect

937
00:43:46,340 --> 00:43:48,860
substitutes anymore and you can
price above marginal cost.

938
00:43:48,860 --> 00:43:51,070
Have you ever asked yourself why
the hell there's so many

939
00:43:51,070 --> 00:43:51,770
kinds of cereal.

940
00:43:51,770 --> 00:43:54,130
I mean have you been
to the supermarket?

941
00:43:54,130 --> 00:43:55,470
It's crazy.

942
00:43:55,470 --> 00:43:57,410
Why are there so many kinds
of toothpaste and shampoo.

943
00:43:57,410 --> 00:43:59,580
It's all the same crap.

944
00:43:59,580 --> 00:44:00,140
Why?

945
00:44:00,140 --> 00:44:01,960
Because it's product
differentiation.

946
00:44:01,960 --> 00:44:05,130
It's to avoid Bertrand
competition.

947
00:44:05,130 --> 00:44:07,280
Because once you can
differentiate,

948
00:44:07,280 --> 00:44:08,590
you get market power.

949
00:44:08,590 --> 00:44:11,160
Differentiation provides
market power.

950
00:44:11,160 --> 00:44:13,225
In the book, this is too
detailed for the course, but

951
00:44:13,225 --> 00:44:15,290
in the book Perloff talks about
this as monopolistic

952
00:44:15,290 --> 00:44:16,520
competition.

953
00:44:16,520 --> 00:44:18,290
Which is sort of an odd
oxymoron, right?

954
00:44:18,290 --> 00:44:19,720
Monopolistic competition.

955
00:44:19,720 --> 00:44:25,840
But these are models of
differentiated products where

956
00:44:25,840 --> 00:44:28,700
essentially you can say, look
I'm different enough that

957
00:44:28,700 --> 00:44:31,510
essentially I can charge
a higher price than my

958
00:44:31,510 --> 00:44:33,420
competitor.

959
00:44:33,420 --> 00:44:35,250
This comes back the concept
of contestable

960
00:44:35,250 --> 00:44:37,150
markets we talked about.

961
00:44:37,150 --> 00:44:41,786
The idea is that, look, if
you're different you can

962
00:44:41,786 --> 00:44:42,650
charge a little bit
higher price.

963
00:44:42,650 --> 00:44:44,520
Once it's too high people are
going to switch back to the

964
00:44:44,520 --> 00:44:45,520
other food.

965
00:44:45,520 --> 00:44:47,150
But if you make it
different enough,

966
00:44:47,150 --> 00:44:49,070
people will pay something.

967
00:44:49,070 --> 00:44:53,010
The most famous example is
Apple Cinnamon Cheerios.

968
00:44:53,010 --> 00:44:55,180
Cheerios have been
around forever.

969
00:44:55,180 --> 00:44:57,280
And what happened was
people bought

970
00:44:57,280 --> 00:44:57,840
Cheerios, it was very popular.

971
00:44:57,840 --> 00:45:00,860
But then supermarkets started
producing generic Cheerios.

972
00:45:00,860 --> 00:45:03,760
And Cheerios are like pretty
freaking easy to produce.

973
00:45:03,760 --> 00:45:05,480
And it turned out they
were identical.

974
00:45:05,480 --> 00:45:08,020
And supermarkets charged
like half as much

975
00:45:08,020 --> 00:45:09,820
for the generic Cheerios.

976
00:45:09,820 --> 00:45:12,130
And Kellogg's, no Kellogg's?

977
00:45:12,130 --> 00:45:13,610
Not Kellogg's, the other one.

978
00:45:13,610 --> 00:45:14,470
General Mills.

979
00:45:14,470 --> 00:45:16,755
General Mills was
all like, any of

980
00:45:16,755 --> 00:45:18,590
you guys from Minnesota?

981
00:45:18,590 --> 00:45:20,560
Mall of America has this cool
General Mills thing in

982
00:45:20,560 --> 00:45:22,310
Minnesota, I remember it.

983
00:45:22,310 --> 00:45:25,620
So General Mills said,
well gee, we're

984
00:45:25,620 --> 00:45:26,330
getting killed here.

985
00:45:26,330 --> 00:45:28,560
These generic Cheerios are going
to wipe out our profits.

986
00:45:28,560 --> 00:45:31,680
So they invented the Apple
Cinnamon Cheerios.

987
00:45:31,680 --> 00:45:34,370
And this was a product
differentiation where

988
00:45:34,370 --> 00:45:36,390
basically they could still
charge a high price for Apple

989
00:45:36,390 --> 00:45:38,050
Cinnamon Cheerios because it was
different enough from the

990
00:45:38,050 --> 00:45:42,120
generic cheerios the supermarket
was making.

991
00:45:42,120 --> 00:45:43,500
And they could patent them.

992
00:45:43,500 --> 00:45:45,030
They could say, hey, we've got
a different thing we can

993
00:45:45,030 --> 00:45:48,370
patent our secret Apple
Cinnamon formula.

994
00:45:48,370 --> 00:45:50,910
So supermarkets now just
can't copy us.

995
00:45:50,910 --> 00:45:53,890
So for a while we get price
greater than the marginal

996
00:45:53,890 --> 00:45:56,200
cost. Or even if supermarkets
can copy them, they at least

997
00:45:56,200 --> 00:45:58,150
get for a while price above
marginal cost until

998
00:45:58,150 --> 00:46:01,220
supermarkets catch on and
make the product.

999
00:46:01,220 --> 00:46:04,630
So product differentiation is
the way that firms fight

1000
00:46:04,630 --> 00:46:06,350
Bertrand price competition.

1001
00:46:06,350 --> 00:46:07,900
So is this bad?

1002
00:46:07,900 --> 00:46:09,350
Once again we don't know.

1003
00:46:09,350 --> 00:46:12,190
It depends how much you like
Apple Cinnamon Cheerios.

1004
00:46:12,190 --> 00:46:15,970
Just like patents, it depends
on whether the new good they

1005
00:46:15,970 --> 00:46:19,960
invented delivers sufficient
extra consumer surplus that

1006
00:46:19,960 --> 00:46:22,670
it's worth the fact that they
can market prices on it.

1007
00:46:22,670 --> 00:46:25,380
In fact, one of the most famous
studies in this field

1008
00:46:25,380 --> 00:46:28,680
was done by my colleague Jerry
Hausman, who actually measured

1009
00:46:28,680 --> 00:46:31,860
the demand curve for Apple
Cinnamon Cheerios and the cost

1010
00:46:31,860 --> 00:46:35,040
of producing Apple Cinnamon
Cheerios and found that the

1011
00:46:35,040 --> 00:46:38,070
introduction of Apple Cinnamon
Cheerios raised consumer

1012
00:46:38,070 --> 00:46:40,710
welfare by $67 million a year.

1013
00:46:40,710 --> 00:46:42,980
That even though the prices were
high because of product

1014
00:46:42,980 --> 00:46:45,210
differentiation, people were so
happy with this wonderful

1015
00:46:45,210 --> 00:46:49,550
new taste, it shifted demand
out so much that actually

1016
00:46:49,550 --> 00:46:51,280
consumer welfare went up.

1017
00:46:51,280 --> 00:46:54,320
Even though this was a tool
introduced by the companies to

1018
00:46:54,320 --> 00:46:55,990
avoid price competition,
which should make

1019
00:46:55,990 --> 00:46:58,260
consumers better off.

1020
00:46:58,260 --> 00:47:04,170
So it's all about these
trade-offs between how much

1021
00:47:04,170 --> 00:47:06,430
does it make consumers better
off versus how much more

1022
00:47:06,430 --> 00:47:08,170
market power does it
give the producers.

1023
00:47:08,170 --> 00:47:11,910
And product differentiation is
another example of that.

1024
00:47:11,910 --> 00:47:15,260
Why don't we stop there
and we'll come back.

1025
00:47:15,260 --> 00:47:18,750
Good luck tomorrow night and
we'll come back on Wednesday

1026
00:47:18,750 --> 00:47:20,780
and move on to factor markets.