Market failure

(Managerial Economics)

Manish K. Singh

Department of Management Studies

Indian Institute of Technology Delhi

Readings:
- Tabarrok and Cowen: Chapters 13-16

September 7, 2019
Background

I On June 5, 1981, the Centers for Disease Control and

Prevention reported that a strange outbreak of pneumonia
was killing young, healthy homosexual men in Los Angeles.
I Similar reports streamed in from San Francisco, New York,
and Boston.
I What had at first looked like a disease peculiar to homosexual
men turned out to be a worldwide killer caused by HIV (the
human immunodeficiency virus).
I Since 1981, AIDS (acquired immune deficiency syndrome) has
killed more than 28 million people.
Market development

I There is no known cure for AIDS

I However, in the United States, deaths from AIDS dropped by
approximately 50% between 1995 and 1997.
I The major cause of the falling death rate was the
development of new drugs called combination antiretrovirals,
such as Combivir.
I A single pill of Combivir costs about $12.50 - at two per day,
every day, that’s nearly $10,000 per year.
I The cost of Combivir production is 50 cents. However, the
market price is 25 times the cost.
Market failure
Competitive markets drive the price of a good down to marginal cost

I There are three reasons why HIV drugs are priced well above
cost.
1. Market power: is the power to raise price above marginal
cost without fear that other firms will enter the market. A
monopoly is a firm with market power.
2. The ‘you can’t take it with you’ effect: If you are dying of
disease, what better use of your money do you have than
spending it on medicine that might prolong your life? If you
can’t take it with you, then you may as well spend your money
trying to stick around a bit longer. Consumers with serious
diseases, therefore, are relatively insensitive to the price of
life-saving pharmaceuticals.
3. The ‘other people’s money’ effect: If the cost of medicine is
paid by public or private health insurers, it makes consumers
insensitive to the price of medicines.
Market power
I Patents: A patent is a government grant that gives the
owner the exclusive rights to make, use, or sell the patented
product.
1. GlaxoSmithKline owns the Combivir patent. Even though the
formula to manufacture it is well known and easily duplicated,
competitors who try to make Combivir or its equivalent will be
jailed, at least in the United States and other countries where
the patent is enforced.
I Government regulations (law preventing entering of
competitors)
1. Indonesian clove monopoly, Algerian wheat, matchboxes
2. Indian postal services, automobile manufacturing, airline
ownership, Coal India
I Exclusive access to an important input
I Economies of scale: Subways, electricity and water
transmission, major highways, cable TV
Market power
How to use market power to maximize profit

I Price above cost but how much above cost?

1. You have the price setting power
2. However, even with no competitors, if you raise price, you will
sell fewer units: Downward sloping demand curve
3. If you want to increase the production too much, you will have
to lower down the prices
4. Profitable if Marginal Revenue (MR) > Marginal Cost (MC)
but Marginal Revenue is not equal to the Price (P) (MR 6= P)
Market power
How to use market power to maximize profit
Market power
How to use market power to maximize profit
Market power
The case of Combivir
What’s wrong with monopoly?
1. Deadweight loss: Monopolies reduce total surplus
What’s wrong with monopoly?
2. Corruption and inefficiency

1. Corruption
I Indonesian President Suharto (in office from 1967 to 1998),
gave the lucrative clove monopoly to his playboy son, Tommy
Suharto. Cloves are a key ingredient in Indonesian cigarette,
and the monopoly funnelled hundreds of millions of dollars to
Tommy. A lot of rich playboy buy Lamborghinis - Tommy
bought the entire company.
I In Algeria, a dozen or so army generals each control a key
good. Indeed, the public ironically refers to each general by
the major commodity that they monopolize - General Steel,
General Wheat, General Tire, and so forth.
2. Inefficiency
I The case of Coal India: Inefficiency of Coal India increases the
price of electricity in India, which increases the cost for all
downstream industries making some of them incompetent.
What’s wrong with monopoly?
3. Tying and bundling

1. Tying: Tying occurs when to use one good, the consumer

must use a second good that is sold (only) by the same firm.
A firm can price discriminate by tying two goods and carefully
setting their prices.
I Hewlett-Packard (HP) photo printer/scanner/copier sells for
just $69. A full set of color ink cartridges, however, will set
you back $44.
I Xbox game consoles are priced below cost, and Xbox games
are priced above cost.
2. Bundling: Bundling is requiring that products be bought
together in a bundle or package.
I Microsoft sell Word Excel, Outlook, Access, and PowerPoint in
a bundle called Microsoft Office.
I Cable TV packages
Benefits of monopoly?
Incentive for research and development

I It costs a billion dollar to bring a new drug to market in US. If

pharmaceutical patents are not enforced, the number of new
drugs will decrease.
I Profit fuels the fire of invention.
I Monopoly-when it increases innovation-may increase economic
growth.
How to incentivise research and development?

I Eyes on the Prize

1. SpaceShipOne, won the $10 million Ansari X Prize for being
the first privately developed manned rocket capable of reaching
space and returning in a short time.
2. Netflix, the DVD distribution firm, offered and paid a $1
million prize for improvements to its movie recommendation
system.
3. The Department of Defense in US has sponsored prizes for
driverless vehicles.
I Patent buyout: Government buys the rights to the patent and
rip it up! Competitors would enter the field, drive the price
down to the average cost of production, and eliminate the
deadweight loss. In other words, Combivir would fall from
$12.50 a pill to 50 cents a pill, and more of the world’s poor
could afford to be treated for AIDS.
How to incentivise research and development?
Allow price discrimination
How to incentivise research and development?
Price discrimination is common

1. Airline ticket price: Cheap for vacationers, high for business

men
2. University admission: 80-20 rule. 80% student will subsidize
the 20% poor but smart kids
3. Hardback vs paperback book
How to incentivise research and development?
Price discrimination: What the monopoly wants to achieve?
How to incentivise research and development?
Is price discrimination bad?

I Perfect price discrimination implies transfer of consumer

surplus from consumers to produces
I Price-discriminating monopolist produces more output than a
single-price monopolist, so price discrimination can’t always
be bad.
I Price discrimination is bad if the total output with price
discrimination falls or stays the same, but if output increases
under price discrimination, then total surplus will usually
increase.
I Price discrimination provides incentive to do research where
market size is limited: It costs about the same to develop a
drug for a rare or a common disease but the revenues are
much greater for a drug that treats a common disease.
Natural Monopoly
Economies of scale and the regulation of monopolies

I Monopolies can arise naturally when economies of scale

create circumstances where one large firm (or a handful of
large firms) can produce at lower cost than many small firms.
I Every home can produce its own electric power with a small
generator or solar panel, but the cost of producing electricity
in this way would be higher than buying electricity produced
from a dam even if the dam was a natural monopoly.
I Why this is of concern?
I Even though natural monopolies produce less than the optimal
quantity, competitive firms would also produce less than the
optimal quantity because they could not take advantage of
economies of scale.
I A monopoly with large economies of scale can have a lower
price than competitive firms.
Natural Monopoly
Regulating natural monopolies
A Price Control on a Monopoly Can Increase Output
Experience regulating monopolies

I International experience
1. Regulation of retail subscription rates for cable TV
2. California’s deregulated wholesale electricity prices in 1998
3. Antitrust against AT&T
4. British Telecom
I The Indian experience
1. Indian Railways
2. Telecom: BSNL/MTNL experience
3. Power sector in India
4. NHAI (National Highways Authority of India)
5. Reliance Mumbai metro
Some other sources of market power

Source Example

1. Patents GSK’s patent on Combivir

2. Laws preventing entry of com-
petitors
3. Economies of scale
4. Hard to duplicate inputs
5. Innovation
Indonesian clove monopoly, Algerian wheat
monopoly, U.S. Postal Service
Subways, cable TV, electricity transmission,
major highways
Oil, diamonds, Rolex watches
Apple’s iPod, Wolfram’s Mathematica soft-
ware, eBay
Cartels and Oligopoly

I Cartel: A cartel is a group of suppliers that tries to act as if

they were a monopoly.
I Oligopoly: An oligopoly is a market that is dominated by a
small number of firms.
Cartels and Oligopoly
How it works?
Cartels and Oligopoly
Why they fail?

Cartels tend to collapse and lose their power for three reasons:
1. Cheating by the cartel members
2. New entrants and demand response
I The high prices of a cartel will attract new entrants; and those
entrants do not feel bound by previous agreements.
3. Government prosecution and regulation
I The antitrust laws give the government the power to regulate
or prohibit business practices that may be anticompetitive.
Cartels and Oligopoly
The incentive to cheat
Thank You!

Questions