Module 1: Monopoly Markets and Efficiency

Firm Level Econ: Markets and Allocations
Professor Larry DeBrock
Module 1: Monopoly Markets and Efficiency
Table of Contents
Module 1: Monopoly Markets and Efficiency ......................................................................... 1
Lesson 2-1: Building a Measure of Efficiency ...................................................................................2
Lesson 2-1.1: Consumer Surplus - Part 1 ..............................................................................................................2
Lesson 2-1.2: Consumer Surplus - Part 2 ..............................................................................................................7
Lesson 2-1.3: Producer Surplus ...........................................................................................................................13
Lesson 2-1.4. The Benevolent Dictator - Part 1 ..................................................................................................17
Lesson 2-1.5. The Benevolent Dictator - Part 2 ..................................................................................................21
Lesson 2-2: Other Market Outcomes: Monopoly ........................................................................... 25

Lesson 2-2.1: Monopoly Equilibrium - Part 1 ......................................................................................................25
Lesson 2-2.2: Monopoly Equilibrium - Part 2 ......................................................................................................30
Lesson 2-2.3 Marginal Revenue Curve in Monopoly ..........................................................................................33
Lesson 2-2.4: Social Costs of Monopoly ..............................................................................................................36
Lesson 2-2.5: Governments Intervene in Monopoly ..........................................................................................41
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Lesson 2-1: Building a Measure of Efficiency
Lesson 2-1.1: Consumer Surplus - Part 1
Greetings. In our previous video, we were able to establish the equilibrium in a perfectly
competitive market, very important, right? It's our first venture into any market structure.
Competitive markets are sort of a benchmark for us. As we said when we went through it, the
assumptions on the condition a market has to meet in order to be a perfectly competitive market
are pretty stringent. But on the other hand, all of microeconomics is essentially understanding
what it would be like if market exactly fit perfectly competitive markets. Then let's modify it, like
say maybe it's not really homogeneous products, maybe it's heterogeneous products, and we
mentioned the case of what would happen if all the other conditions hold, but say products are
differentiated, like ready to eat cereal. Well, it just explodes into all sorts of interesting and very
rich research results that you couldn't show about how that market will have all sorts of
interesting behaviors, and the equilibrium will be much different than say the market for a
prototypical competitive industry like say corn. So anyway, we've established that market, and
we're going to go forward and establish other markets as we go through future videos. But
before we go that far, we need to really think about this issue of understanding. So is it
equilibrium? How good is it? What we're going to do, is we're going to think about evaluating
market equilibrium. In other words, we know what the equilibrium looks like. Now what we need
to know is, is it good or bad? What are the characteristics of that? Remember, from the long,
long time ago in the videos, we started talking about resource allocation, and we said over the
vast history of recorded time, many resource allocation methods were basically just the king, or
the emperor would decide who gets what. We said that contemporary modern economies use
markets. So the question is, well, how good are markets? I mean, is that an outcome that we
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really like, or could there be something better? Could there be something else that will make it
stronger?
So we're going to evaluate market equilibrium, and our goal is going to be to build a metric to
measure efficiency. We want to build some rule. So you think of this as essentially a yardstick.
We want to build a yardstick that will allow us to measure how good or bad a certain outcome is.
This yardstick, which we're going to build, is going to be great for us because we can keep it
with us as we then go into other markets. Right now, you don't need to take a course in
economics to understand monopolies, or not very efficient for most people. I mean, monopoly is
great if you're the monopolist. You make an awful lot of money being a monopolist. But it's not
really good from society's point of view, and that's why we have rules against monopoly. We
have antitrust laws, Europe has very stringent antitrust laws, United States has also stringent
antitrust laws, and we spend a lot of money taking people to court, who we think might be
actually trying to either have established a monopoly, or trying to establish a monopoly, because
the monopoly is not going to measure up very well with the yardstick that we're going to build.
That's why there are laws put in place to that, but that's getting ahead of the game. We wanted
just to think now about building this yardstick to help us evaluate what's going on. Initially, we're
going to assume there is no government. That means that the implication is that there's two
parties.
The two parties are consumers and producers. What we want to do is figure out how this is
market allocation, whatever it is, and then obviously, we're going to build a yardstick, and then
we're going to hold it up against various allocations: monopoly, competition, oligopoly, all of
these things that we want to talk about in terms of markets. Remember that real number line I
drew that at one end had one, that's a monopolist, and the other end had n very large, that's
competitive, and the middle, we have this area called oligopoly, competition amongst just a few
big producers. The model that we've been talking about is mid-size automobiles and how Honda
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Accord and Toyota Camry are like the £900 gorillas in that market, and how they know a lot
about each other. They know a lot about how each other strategies are and how do they
compete in that century. So we're going to see results that will allow us to hold our yardstick up
to it, and say, "Well, that's pretty good, or that's not too good." Then we'll move forward with
that.
So we have two groups, and we're going to do something here which economists call welfare
analysis. So in economic, welfare analysis is basically the study of efficiency. When you hear
welfare on the media, they oftentimes talk about things that are government grants, food
stamps, or vouchers to help buy housing, or vouchers to go to schools, basically means income-
related issues, less than what economists call welfare. Economists call welfare, how good is this
outcome in the eyes of society? Has this outcome actually been efficient? So that's what we're
going to do going forward.
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We're going to start with consumers. The definition of consumer surplus is this excess of
consumer value, net of consumer expenditure. So think about this. Earlier, we talked about
when a consumer buys something, they're giving up one of this little green sheet of paper. This
green sheet of paper, of course, as I said before, they're really not worth much except for what
they can give you when you buy things. But when I decide to go out and buy something, like
let's say I want to buy a snickers bar, one of my favorite expenditures by the way, when I want
to buy a snickers bar, I lay a dollar down, and they give me a snickers bar. Now, the reason I
gave my dollar for the snickers bar is because I like that. In fact, I feel like that snickers bar, to
me, my consumer value for the snickers bar is in excess of this dollar. Otherwise, I wouldn't
have given it to you. I'd save the dollar for instead buying a cup of coffee, or a one dollar
McChicken sandwich at McDonald's, or something like that. There's all sorts of alternatives I
could use a dollar for, but without a gun pointed to my head, I am giving it to the producer and
say, "Give me that snickers bar." Now, I do that because I believe in my head that that snickers
bar is worth more than a dollar. So that's what we're trying to measure here. How much extra do
consumers value these product? That's what we call consumer surplus.
Suppose the value is $2.50. I shouldn't really reveal that to the to the salesperson, but it's really
$2.50. What that means is, I'd be willing to pay up to that, but no more than that. You'd say,
"Well, Larry, I've never pay $2.50 for a snickers bar." Yeah, I don't know about that. I was just
talking to some friends of mine.
I went to a cubs game the other night. I stayed in the hotel at night game. I went back to the
hotel, and laying on the credenza in my hotel room, there's a bottle of wine there, with little
opener, and then there was a snickers bar and a bag of M&M peanuts. Beside it was a little card
that told me what the price was. It said that that's snickers bar, one snickers bar. I won't even
tell you who owns this hotel, was six dollars. Now, guess what? I didn't eat that snickers bar.
The value to me of a snickers bar is pretty high, but not six dollars. But the point is, they put that
there because for somebody, it was worth six dollars. Then I just thought that they're not
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wasting time for the maid to have to clean it up in the morning, that somebody must be actually
paying six bucks for that. So there's all sorts of people out there, and what we're trying to figure
out is how much are people really willing to pay and when would they say, "No, I'm not going to
give you this because there's alternative things I can choose." Thanks.
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Lesson 2-1.2: Consumer Surplus - Part 2
Greetings, in a previous video we defined this concept called consumer surplus. And consumer
surplus for us was a measure of how much value the consumer gets above and beyond what
they are losing. The expenditures they have to give up something in order to get a product. The
example I used with stickers, you could think about stopping and having a some spaghetti and
meatballs for lunch or whatever. You're going to pay cash for it, and when you pay cash for that,
you're giving up alternative consumption. And the reason you're willing to do it without knowing
put a gun to your head and do it just because you believe that the value to you of that spaghetti
and meatball lunch is greater than what the price tag is says on the menu. Otherwise, you
wouldn't do it you say, I really don't get that much out of it, I'm going to go on move instead of
think I'll just go have a ham sandwich or something like that, okay. So we have to figure out how
to do this, and what we're going to do is we're going to think about as you know, we like graphs
here. So we're going to think about a graph to explain this, and so the graph we're going to talk
about we're going to put a vertical axis and a horizontal axis. And on the vertical axis, we're
going to put price which of course is measured in dollars and cents here. And on the horizontal
axis we're going to put cap Q and that's the output whatever the product is whether it's stickers
bars or spaghetti and meatballs or whatever. Jars of mayonnaise another one of our products
we'd like to talk about, and we have something called a demand curve.
Okay, and so I'm going to draw this demand curve and label it. And essentially the demand
curve is really, I'm going to write this out, in fact because I think it's important that you think this
through. The demand curve, Is a collection, Of consumers, Marginal, Willingness, To pay.
We talked about Larry's, Undeniable attraction to Snickers bars. I'd love to get Snickers bars for
free [LAUGH] that would be a great deal. But I don't really get that except when like the day
after Halloween on my kids at got some bags I can raid or something like that. But other than
that, I really have to go out and buy it now, I would love to get it for free, but I know I'm going to
actually have to pay green sheets of paper to get it. And in my head there's a maximum
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number, I'm not going to reveal it to you, okay. But we will actually reveal it because we will see
that anytime you quote a price, and I'm going to make a copy of this so I can start messing this
up. Anytime you quote a price, let's call this price P0, one of our favorite prices anytime you
quote a price. The demand curve tells you how many people will want to buy it, now by
definition that means there's an individual standing right here, Who doesn't get it. Why?
Because they voluntarily said look it's not worth it to me, I would pay up to, let's suppose this
price here is, let's put a number on this just so it means a little bit more. Let's say it's $3 for this
product. At $3 this individual says no, [LAUGH] my maximum value is actually, $2.90, now I
don't know what it really is, and I don't know who that person is.
But I do know that if you have collected enough points to accurately draw a demand curve, let's
put a little dream world here. We'll pull a bubble above the cartoon characters head, if you went
out and your boss said, you were a good statistician. Here's a bunch of data, I want you to
figure out what the demand curve looks like, remember those data that we talked about?
There's a bunch of consumers distributed normally for every possible price you might quote, any
price you might quote. Consumers are distributed like this and it turns out that the expected
value is this many people which we'll call Q0. Well, actually my this is the most likely event, it's
possible that at that price a ton of people want to buy it, but it's a low probability event. So in
expectation given all the data that you've got, the swipe card data from consumers at the
grocery store or at the drugstore or wherever they got these little swipe cards. This is the
expectation, that means when you do that that there's somebody, Down here all these people
here have value and they would buy it, but only of the prices low, these people don't exist when
the market is $3.
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On the other hand there is somebody who's standing right here, That might be Larry, I'm not
going to reveal my true value. But there's somebody who's standing right here, and this person's
value is $4.75.
Now you say Larry, how can you make a calculation like that? Well, I'm not saying how I see the
actual calculation in there all head spinning around I see their behavior. We have gathered data
about how consumers buy this product, and if you have gathered data and done a good
statistical analysis. You've got to demand curve and that tells you there is somebody, that
there's a lot of people, there's a lot of people who would be willing to pay that amount, we'll call
this Q1. At $4.75 there's still Q1 units being sold, there's a lot of people standing here he said
said. And so, these people who will pay more are giving us this idea of marginal willingness to
pay, they don't reveal it. They walk up and say, my good man, I would give you $7 from
Stickers, but I'm glad you'll give it to me for three. They just take it for three in this case this
individual who buys it would pay 4.75 is getting this much excess value, okay. In a previous
video, we have a definition for consumer surplus, which said it is the excess of consumer value
net of expenditure. This person gets the Snickers bar, this person standing right here buys that
Q1 unit and says boy, I would have paid 4.75 but lucky me, I only have to pay 3. There's
another individual standing right here, Who has a value in the middle here something like let's
say $4. This individual says I would have paid 4 but lucky me, I only have to pay 3, so this
individual gets this much net. And you can draw all these points because every point on this
curve if you've correctly constructed the demand curve from your data. Every point on the curve
represents, somebody's marginal willingness to pay this person right here, let's say is $5. This
person says I would pay $5 what that means is, that if the Stickers bar was actually $5.50,
which would be up here. This person says no, I'm not in that market, that point is not there right,
because it was $5.50 only this number of people would buy it. Because we see now at a price of
$3 I can add up, whoops. At a price of $3 I can add up the vertical distance between every point
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on the demand curve, because every point on the demand curve is somebody's marginal
willingness to pay. And I got to add all those up and so, the consumer surplus is this area.
So I'm going to draw a cleaner version of this picture, and I'll do that by inserting a clean page.
Draw this axis system, I got dollars and cents which is price up here. I got quantity here, and I've
got this demand curve which I'm going to draw as looking something like this. And if price is P0,
We know that these many people or these many units is going to be purchased. We shouldn't
just say these many people that many units because at various different prices Larry might have
two Stickers bars, okay. Larry might have three Stickers bar, so I could appear at many points
on here, okay. There could be Larry's drop-dead reservation price if the price gets all the way up
to eight bucks, I'll just buy one that's it. But if you're going to sell them to me for $0.10 yeah, I
might get a week's worth right now. This price tells us automatically that there are some people
over here who just don't even want the product. This is too high price for them, they're giving up
too many green sheets of paper. So they're not in this market, only Q0 units are purchased, but
by definition what that means, is that there's a bunch of people over here, Who say yes, I want
it, yes, I want it. And in fact, there's a whole continuum of these people, and we're going to add
up all of those vertical differences. Their value, Net of what they pay, that vertical bar is their
value net of what they've paid and if I add all those up. I get the area of this triangle, and so the
area of this triangle is called consumer surplus. It's the area below demand, And above, Price.
Whatever the price is going to be. This is the net value to consumers because of the existence
of this product, and the way the market has actually decided to allocate it. Because what we're
assuming here, is the market prices quoted P0 for whatever this product is, it's $57 for a barrel
of oil. Or it's $3.10 for a gallon of gasoline or whatever the product is, and there's some people
who have paid a lot more, they don't have to that net value to them is important. No, This is not
just some little, Academic exercise here that they try and throw more curves into your brain.
This is used every day in Washington, okay, every day in the United States and in many
countries.
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If you're going to promulgate a new regulation, if you're going to put a new regulation on,
Commerce, you have to do something called cost-benefit analysis. It's required by law, you
have to do a cost-benefit analysis. And what that is, is it says, tell us what the benefit of this
regulation is and tell us what the cost to society is. So for example, suppose we have a newer
rig that says, that you have to have side airbags on all new automobiles, you have to have side
airbags on all new automobiles. Well, there's going to be great benefit of that and you can do
this in scientists and engineers, health professionals and economist. Will actually calculate
what's the extra benefit from a side airbag, because there's reduced injuries, there's less
fatalities. All these things we can add up all these different benefits from that, but on the other
hand, it's costly, it's expensive to engineer a side airbag. The airbags themselves are expensive
also to build a device of the thing can explode out or the door will disintegrate and the airbag will
come out and help you, all these things are expensive. And what that means is the price of the
car is going to go up. Well, how do you measure that? Suppose the price of the car goes up by
10% because of that, well, you could look at something like this and say I know how that works
Larry. That means that in fact if you would think about this little graph, That shows us the
demand curve for automobiles.
If automobiles were used to be charged at P0, then consumer surplus to begin with was this
area, The entire triangle would be consumer surplus. We just decided that the consumer surplus
is the area below demand and above price, so it looks kind of like this. Now the government
puts this new regulation in place and as a result, we can figure out because we know a lot about
how much it's going to cost. The engineers can tell us exactly what extra labor is going to have
to go in what parts are going to have to go in all these things, and the price of the car is going to
go up to P1. Now as a result of P1, guess what happens? Well now at P1, we should have
labeled this to begin with kind of slow is that was Q0. Now we go back to Q1, but look what's
happened, consumer surplus in this world, Is now just this triangle, right. That's all consumer
surplus is now and so, the red triangle, Is consumer surplus after the price increase,
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Caused by the regulation of very nice things side airbags, but you don't get things for free. So
what's happened here is that the consumer surplus is now smaller than before and this
particular area, Is the loss in consumer surplus, Due to the increase in price. And that's
measured every day, there are armies of economists in Washington DC. And in fact in almost all
50 state houses in the country, because the state legislators also have cost benefit analysis. If
you're going to pass a new bill, they're required to produce what they often times call a white
paper. A white paper is basically a research paper where they looked through the effects to the
good side that's the benefits, and how much it cost to get those benefits. These laws almost all
have great benefits, but they also have great cost and so, what they're required to do is to try to
measure it and believe me. Any given day there are economists out there and measuring what's
going to be the impact on consumer surplus because of this new increase in the price of
vaccines. Or requirement that everybody has to have this particular vaccine now, so it's
basically going to raise the price of this vaccine. because there's going to be an increase in
demand because we all have to buy, buying vaccines and using good. Higher price, well, what
happens to consumer surplus because of that? Thanks.
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Lesson 2-1.3: Producer Surplus
Greetings. We're in this series of videos for trying to evaluate. We're trying to produce this
metric, a yardstick to measure the efficiency of the outcome. We started that by looking at a
story that said that we really want to build this metric and we're assuming no government
intervention. So we had two parties, we had consumers.
And we had producers, firms, buyers and sellers, wherever you want to think about this, okay.
And we already did consumer surplus. Consumer surplus was the surplus the consumers net of
their value of the product net of what they had to pay. By definition, every time they buy
something, they pass over this little sheet of green piece of a favor for it. They're giving up
something else, okay? So we have to say, they gave it to you without a gun to their head,
means that they're getting something back which they think is an excess of this. It would never
give you a dollar for something that's only have going to value them 95%, that doesn't make
sense, all right.
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Now we go at this side, we want to look at the producer side. So we're going to introduce a new
idea and it's going to be called producer surplus, and again, we will use it PS.
And this definition is a little bit more detailed. The definition says, it's the net revenue above
what is needed to have that unit of production on the market. And we're going to draw a graph
about it, of course, but I want to start by just talking about the intuition of this. We know back in
a day, we first constructed a supply curve and the definition of a supply curve said, how much
output will firms be willing to give to the market for different possible prices, okay? As you quote
different prices, firms will say, okay at that price, we're going to push q0 out. At a higher price,
we're going to push more out. It's like there was an upward sloping line, okay, but there was the
collection of points. If you've done a good job of actually building a statistical real model of what
the supply curve looks like, you know that is a collection of points that will tell how much firms
will actually put in the market for different possible prices.
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So let's think about this. We're now want to know what's the net above what needs to produce
those, and so we're going to do this by drawing our supply curve.
So we'll put an axis system and will have price on the vertical axis on the left quantity on the
horizontal axis. And we thought about supply curves that look like this, and we're going to use
linear when we win and if I get around to giving you some problems that you have to solve. I will
make sure to stick to a nice, smooth straight line, so you don't have to worry about the quadratic
function. But right now, I just sort of drew it up and its upward sloping, and that's what matters to
me. This is the supply curve and what the supply curve says is that, it tells us for different
possible prices, pick any price, this price. This price will give this exactly this amount of
production. No more, no less, okay.
If you quote this price, firms are going to produce this on our draw it and just put this on here,
pick an arbitrary price, P0. At that price, firms will offer Q0 units. Now, they're not offering Q1
because if you wanted to go out here to Q1, you got to give a higher price, okay? Let's just all
be learned when we did think the theory of costs. We looked at the marginal cost was the
response function of the firms that different puzzle prices. And the sum of those marginal costs
which of course, I should write that in here as we know that the supply curve is nothing other
than the sum from i equals 1 to n of the marginal cost of those of these firms.
Quote a price, the firm takes that price is given and says well, I thought that price my profit-
maximizing output is where I set marginal revenue is price equal to marginal cost, this upward
sloping line and I get an output. And I take all of the firms in the industry, add them up, and I
now know what market output is for that quoted price. And for a lower price, At that price, I can
only afford to give you this amount, okay? At this price, I would give you all the way out to here.
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So, let's understand that if suppose this happens to be the market price, and actually, I'm just
going to redraw it. I'm going to give you a cleaner picture and we'll talk it through again, because
I think it makes more sense. And as I am oftentimes prone to say, I have the pen.
So we put price here and we put quantity here, and we just drew a supply curve and look
something like this. And now, suppose the market price is actually P0. Well, at P0, the market
price, firms are going to provide Q0. But what we know is that in fact this unit, let's call this unit
Q sub alpha. This unit would have been supplied if you would just offered P alpha, by definition
of your properly constructed supply curve. If the price had actually been Ps of alpha, firms would
have sold Qs of alpha out there. Otherwise, you've done a bad job of drawing your supply
curve. By showing us that the supply curve is there, you're saying, gee, at a lower price, market
output would have been less, Q Alpha is less than Q0. So the fact of the matter is, that Q alpha
unit gives us an excess of this gap, the mark that the firms are actually getting P0. The firms are
actually getting P0 for their unit of production when they would have given it for just P alpha.
Good deal for the firm. That's a piece of producer surplus, its revenue in excess of what they
would have taken to provide that unit. Well, we can do that for every unit. You could say look,
for this unit, let's call this Q sub beta. Firms would have given us that unit at just piece of beta,
but lucky them, the market is actually saying here's what you get for it. There's one out up here,
let's call this Q sub 2, the market would have given you this unit for this price P sub 2. But in
fact, they get P0, and so they get this vertical gap, all the firms in this market get a revenue
driven by the market price. That's an excess would have taken, given what their costs are. So,
producer surplus is the area, Below price, The area below price above marginal cost, see, this is
the sum of marginal cost, i equals 1 to n for the i players in the industry. That's how we
constructed supply. So, the marginal cost curve is the marginal cost to society of resources
burned up. This kind of shows what they are, but these firms are getting net of that vertical gap,
you could do it for them. Thanks.
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Lesson 2-1.4. The Benevolent Dictator - Part 1
We have been constructing measures of efficiency and we've measured the consumers' rent.
Words that economists like to use is the rent that what consumers are getting above and
beyond what they need to. We've measured producers' rent, what they're getting above and
beyond what they need to. We call those consumer surplus; excessive value above what you
actually had to pay to get that product and producer surplus; excess of price or revenue in
excess of what you really would have needed given your cost structure to offer that unit. Now
we need to combine these two and so to make this happen, we're going to introduce a new
player to our lecture series. This person is called the benevolent dictator, okay? Now the
benevolent dictator is just exactly what it sounds like. A dictator can do anything he or she
wants, okay? The dictator can say "Here's the resource allocation I think which had happened
and here's how many units are producing and here is who gets what." That's what dictators can
do. But this dictator is a special one. This dictator is a benevolent dictator. So the benevolent
dictator he's down out to push people around, the benevolent dictator wants to see society get
the most efficient outcome. There's that word again, efficient. So let's think about this. We need
to come up with a goal then. I want you to see what is it that drives a benevolent dictator. So
we'll call this BD is just shorthand for the benevolent dictator and our benevolent dictator wants
to maximize social gain. You say well what's that Larry? That sounds okay. The benevolent
dictator wants to make society better. Well, I'm going to define social gain, which we'll call SG, is
defined as the sum of gains to all parties.
So right now we've only got two parties, consumers and producers, but we will pretty soon have
the government enter in because the government might decide they are going to for example
manipulate the market. So examples of the government decide that they're going to hold the
price of milk up. By holding the price of milk up, they're giving more revenues to milk producers,
but they're also using a lot of taxpayer's dollars to buy that milk and produce vast warehouses of
government cheese for distribution based on some rules that who gets what in terms of passing
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out free cheese. So we're going to have to put that in when we bring the government back into
the game, but right now we only have consumers and producers and so what we're going to say
then is that social gain is equal to the sum of consumer surplus plus producer surplus. So social
gain is the size of the pie. Now what do I mean by that?
Well I want you to think about this, the transactions in a market whether it's stickers or jars of
mayonnaise or whatever it is, consumers voluntarily hand our money to get something and they
do that because they get something that's a greater value than the green sheets of paper. The
green sheets of paper don't really have any value themselves, but they embody in your head,
you know what you're missing out because you no longer have that green sheet of paper to give
for something else. So consumers are handing over voluntarily green sheets of paper to get
products that they value in excess of those green sheets of paper. So that's good for society.
That net return to consumer surplus is good stuff for society and producers are doing the same
thing. They're voluntarily selling you products for money that turns out that they would have
more money than they actually have to have to do it because that supply curve shows us. When
we did the producer surplus for any given unit of output, if the market price is here there could
have been the marginal cost is down here, which is the supply curve is the sum of marginal
cost, firms would have sold that same unit for a much lower price. But the market prices don't
look this was what was on the market. We need a market clearing price and so producers and
consumers together get some excess happiness because of the existence of a market, and we
say that the pie that's generated. The size of the pie is this big. Now what's important for you to
understand is that when we talk about resource allocation, we mean to talk about the way the
market is clearing, however might not be a market, maybe it's a dictator, maybe it's the king.
The way the market allocator, let's say that, has passed this out we're going to be able to
measure how much benefit to consumers and how much benefit to firms, and if that pie is
bigger, by definition is more efficient. Now it's important that you remember one thing. The
benevolent dictator has no stake in the game. The benevolent dictator does not say "I value
consumers better than producers." No. The benevolent dictator can't tell who gets what. The
benevolent dictator only wants to make the size of the pie as large as possible. Now you might
say "No. I don't like that Larry." I think we ought to wait consumers at 80 percent and producers
at 20 percent. Okay, if we're going to divide it up that way. The benevolent dictator says "No.
That's not efficient. I want the whole size of the pie to be great" and you say "Well, sometimes
that means that a lot of the wrong people are getting it." Well that's a different issue. The
benevolent dictator will tell you if he or she was to sit down with you right now and talk about
this, the bigger the pie is, is unambiguously more efficient. If you don't like the distribution, you
as a society can come back later with a very sharp knife and cut up the pie and push things over
to different people, which is exactly what we do. Okay. We as a society want that pie to be as
big as possible and then later we'll put policies in place where we take money away from
wealthy people with a higher tax rate. We have what's known as a progressive income tax rate
in this country. People who make more money, pay greater taxes, and we use some of those
taxes to give vouchers to people with less income. We give him vouchers to send their kids to
the different schools. We give them vouchers to be able to compete in housing markets. We
give food stamps to people who don't have enough money because of the system for all
reasons to get to have food. That is a transfer from other taxpayers to different taxpayers or non
taxpayers depending on what their income level is. So the point from the benevolent dictator is
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get the pie as big as possible. That's unambiguously better and if you as society don't like the
distribution later, go back and cut it up. Redistribute anything you want, but it's always better to
have a pie of size 100 than a pie of size 99 because there's less to cut up and hand around. So
what we're going to do now is we're going to think about growing the size of that pie and so I
want you to think about this exercise. Again remember, the benevolent dictator doesn't care
who gets what. The benevolent dictator just wants. Just wants this to be maximized.
Well, let's draw a graph and see what that looks like. The first thing I'll do is to draw my axis
system. Put price on the vertical axis and quantity on the horizontal axis. I'm going to draw a
demand curve, it looks like this and a supply curve that looks like this. Bear with me while I
repeat this point again. Some of you will always say, "Why do you know where those are,
Larry?" I don't. I know the supply curve is upward sloping, and the demand curve is downward
sloping. I've drawn that. You and the company you work for, if you work in a statistics part of
that company, you can get the data to figure out what these look like. I'm just showing you the
general shape of these. Now, given these general shapes, I'm going to pick an output level and
let's just call this output level Alpha. Now at Alpha, it turns out, producers would have produced
this for two dollars and consumers would play, there is somebody up here whose marginal
willingness to pay is exactly here, let's say $10. So the consumers would pay, the marginal
willingness to pay.
I should put that one here because I like that phrase; marginal willingness to pay. There is a
person standing exactly at this spot who says, "I would pay up to $10 for that." Right now, we
don't know what the price is and we're not really interested in that. We're thinking about how the
benevolent dictator would look at this. So the benevolent dictator says, "Okay, I want you to
produce unit Alpha." So let's suppose that, let say well, at that unit of Alpha, the only way I could
figure out consumer surplus and the only way I could figure out producer surplus is what? Pick
back to our definition of consumer surplus. Our definition of consumer surplus was, consumer
value, net of what they have to spend, that's price. Producer surplus was, producer value, net of
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what they have to cause it. So their revenue is price. So the price is a very important strike point
for us. We need to know something about price. Suppose right now, bear with me, let's assume
that price is eight dollars. Let's suppose price is eight dollars. That means consumer surplus
would be, remember consumer surplus is difference between the demand curve and price. So if
it was eight, in this particular case, it would be like right here, and consumer surplus would be,
10 minus 1 is 8. Consumer surplus is 10, and they would have paid 10 but they only had to pay
eight. So the consumer surplus nets out to be two and producer surplus, they said, "Well, I
would have given that to you for two dollars. But now you're going to give me eight, that's great."
I get 8 minus 2 which is equal to 6. That makes social gain be equal to consumer surplus plus
producer surplus; 2 plus 6 is equal to 8. Now, that's not too hard but let's just for the moment, try
a different price.
I'll use blue here. Let's assume the price is actually five dollars, like a midpoint in there. The
prices is five dollars, what's happening here? Well, consumer surplus would be 10 minus 5,
which is 5. Producer surplus would be equal to the $5 they get minus the $2 that they would
have done it for, which is 3, and that makes social gain be equal to 5 consumer surplus, plus 3
producer surplus which is 8. Notice something here, as I hope you can see. No matter what
price I choose as the strike price, I chose an example of eight dollars, I chose an example of five
dollars; any price I want to choose, pick any price here, what's going to happen is the difference
between the consumer value and that price, plus the producers value in that price minus the
cross is always going to be that vertical gap. The strike price just decide who gets what share.
But remember, in the eyes of the benevolent dictator, the benevolent dictator doesn't care who
gets what. The benevolent dictator just knows that the size of the pie is going to grow by eight
because of the existence of that unit. Value to society, to consumers is 10. Cost of resources
burned up is just two. Who gets what share of it? Benevolent dictator doesn't care. But the
benevolent dictator knows for sure that that total gap would be the sum of consumer surplus
and producers surplus for that particular output level Alpha. Now, in our next step is to try and
figure out what the whole size looks like. Thanks.
20
Lesson 2-1.5. The Benevolent Dictator - Part 2
Greetings last time we introduced new character to our to our series of videos, and that
character is called the benevolent dictator. The benevolent dictator is just here to help us think
about how to measure efficiency because the benevolent dictator's goal is to maximize
efficiency, okay? To maximize the size of the pie, what are the net benefits to all the parties in
the market? And right now, we still don't have government involved with all the parties are just
consumers and producers.
Let's see if we can figure out how to model, how we can draw a graph to explain this. I'll show
you a supply curve and I'll show you a demand curve. And the supply curve, Of course, is the
sum of the marginal cost of production for all of the N firms. That's this N, all of the N firms in the
industry. And the demand curve is essentially our marginal, Willingness, To pay.
And last time, in the previous video, we understood that for any given output point, which we
introduced something called Alpha. For any given output point, The social gain, I'll write this
back up here. Social gain is the sum of the gains to consumers, that's consumer surplus, plus
the gains to producers, producers surplus. Those are the only two players in the game at this
point in our in our video construction. This particular unit alpha the net of consumer value above
price plus producer value price minus cost is the total vertical gap here, okay? The total vertical
gap would be that amount. Now, the benevolent dictator says, okay, I know output alpha that's
exactly the social game, but I don't like output alpha as the outcomes that we strive. Because if I
could just force you guys to do beta instead, we'd also get this. And in fact if I can get you all the
way out to here.
We'll call this Gamma. At the point gamma I know I don't want to stop short of gamma because
if I were to somehow stop anything short of gamma as a benevolent dictator, I would know that
there's a there is some value for that. But also by just going a little bit more to that just by going
a little bit more in that direction, I'm going to get more gain, more gain, more gain, more gain.
Every time let's step this through, okay? Let's save this? I'm going to go back because I'm going
21
to really mess this picture up now. I'm going to say that every time we add another unit I get
gain in excess of social cost of that amount. So keep going to the right each time I'm getting
gaining excess, each time we can gain an excess, each time, I'm getting gain and excess. I
don't want to stop short of gamma, because if I stopped going to short of gamma like say this
value.
That's good, but I still have some gain in here. You see this little spot? There's this little spot
here where there's still some gain and we can get. So if the benevolent dictator wants to do is to
push all the way out to that particular value.
Ask yourself the question was a benevolent dictator want to go pass gamma? And the answer is
now by going past gamma cost to society are greater than value, marginal willingness to pay of
consumers the cost of resources burned up. That's this one, is greater than what the value is to
society. So what's happening to the size of the pie if we go past gamma? Well, the size of the
pie is getting smaller because every units that we go past gamma is costing society more than
what society values it, that's a net negative amount, the pie is shrinking. The benevolent dictator
said no, no, no, grow the pie. So for every, just to keep pounding on this, it's good I did save an
extra picture. For every unit that we keep producing more we're getting extra gains and the pie
is growing, growing, growing, growing as we keep stepping to the right output, output, output,
output. We're getting you another slice, another slice, another slice, all these things are making
the pie larger until you get the gamma. Once you get to gamma you've maximized the size of
the pie. So for us this gamma is basically what we'll call the socially, I don't write it all out,
socially optimal output. The benevolent dictator would not have output less than that because if
the benevolent dictator picked some output less than that, let's think about this by drawing one
of my little balloons.
My little thump balloon would say look, If I were to have a situation like this, And this was my,
This is my demand curve and this is my supply curve, that if I were to stop here at this output
point, the size of the pie would not be as large as it could be. The benevolent dictator is a wait,
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wait, wait, don't do that, that allocation is wrong. Given what I know because I'm the benevolent
dictator, what I know about people's willingness to pay and that's this. And I know about
people's cost of operation, the marginal cost, which of course, is all contained in this supply
curve, the selling the marginal cost for the end players. I know that stopping at this point would
be wrong. What you need to know is go all the way out here, and that will make the pie as large
as possible. That's what the benevolent dictator wants, stopping a smaller pie is not efficient. It
is an allegation, the benevolent dictator, good, he or she would be wrong. But it could say let's
just do Q sub wrong and that's enough call it a day and go home. [LAUGH] That's not good
enough for the benevolent dictator. The benevolent dictator wants to make sure the pie for
society is as large as possible, and that happens by going out to this point, which we'll call Q
socially optimal, okay? Well, now, let's go back and think about what we know about a market.
If this was back in our videos about perfect competition. What would they be the perfectly
competitive output? Well, you say, well, it's easy. And this would be the price and this would be
the output. Now, at that output in price, what do consumers get? I know that Larry, give me the
pen and I'll show it for you. At that output price I know consumer surplus would be the area
below demand but above price, it's the net of what consumers would be willing to pay less what
they actually had to pay,. And there's a whole bunch of consumers there and they had it all up,
and this area would be consumer surplus. And what would producer surplus look like? Well,
producer surplus is the area below price but above what the true marginal cost is.
That's because for all of these units, Firms would have produced this unit. Let's call this Alpha.
Firms would have had produced this unit, but they get this price instead, that firms would have
purchased this unit for this price, that's what the supply curve says. But instead the market
actually gives them this amount. So all of these little distances add up to this triangle, which we
call Producer Surplus. We knew that, we looked at that, we understood that's the market
outcome. But now we see the total value to consumers is that blue triangle. The total net value
of consumers is that blue triangle consumer surplus and the net value to producers is that green
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triangle producer surplus. And that's the outcome of the competitive market. But wait, what
about our benevolent dictator? Our benevolent dictator looks at that and goes amazing. The
competitive outcome is exactly the same. As what I want to do produce.
The socially optimal output turns out to be Q0, we proved that earlier when we had this
understanding that the benevolent dictator wants to go all the way out to that point. That point is
socially optimal, no more, don't go over this direction, bad, all right? Don't stop short of that,
that's also bad, go right to that point. Well, it turns out, That yardstick that we have, the
benevolent dictator's yardstick, which says maximize the size of the pie. Guess who does it?
The competitive outcome. This is a very important result in economics, okay? There's a set of
fundamental theorems and economics and if you go onto yourself a PhD, you can in economics
you can bet that you're going to spend at least a week and a half on the proof of this particular
result, which says that a perfectly competitive outcome, the perfectly competitive industry. A
bunch of greedy profit-maximizing firms and a bunch of scheming consumers who want to pay
as little price as possible. That set of decentralized characters will actually end up finding the
exact point, the exact output point that maximizes the size of the pie. I remember, as we talked
about it, there's not a lot of markets that is fit. All of those conditions, those four conditions we
had for perfect competition, lots and lots of relatively small buyers and sellers, homogeneous
product, free entry and exit and perfect information. But if they do fit that and we do see a
competitive outcome, it turns out that competitive outcome is the best outcome we could ever
hope for, okay? Regardless of who is to make the decision, whether it's the dictator, whether it's
the king, whether you're throwing darts at the wall, the best outcome is the competitive
outcome. And what we're going to do in all of our remaining videos is look at what happens
when we no longer meet all those conditions of the competitive outcome. Something is different
either there's not a lot of firms like say a monopoly or there's bad information, we have
information failures. All of these things is going to cause the outcome to be at a smaller sized
pie than what a pure competitive outcome is all about. Thanks.
24
Lesson 2-2: Other Market Outcomes: Monopoly
Lesson 2-2.1: Monopoly Equilibrium - Part 1
Greetings. Today, we want to move into our second form of market. We're going to find this this
form as a monopoly and the definition of monopoly is pretty straightforward. A monopoly is a
sole supplier with no threat of entry. So we're talking about an industry where there's only one
firm, the industry, whatever the product is, it's only sold by one firm. That firm has a monopoly
and it's important that we put this little disclaimer on it.
Because there are situations where we sometimes see firms who have what appears to be a
monopoly position. They may be the only supplier of this product, but there could be a lot of
other firms out there who could supply this product if the price was just a little bit higher. Of
course, think about for example, firm has a technology that only they have that allows them to
produce the product a little bit cheaper than anybody else. Then they could sell at a price right
close to that and nobody else would have the wherewithal to enter because their cost curves will
all be higher. Now that would look like a monopolist but it's not realistic monopolist because that
monopolist would really have control of its own price. You would have to think about all these
other guys who could in fact enter the industry if they tried to raise the price too much. That
happens sometimes, but the type of monopoly we're talking about here is a pure monopolist. I'm
going to pose to has basically the only game in town. All right, and that monopolist then gets to
set its own price. So we're going to throw out this little exercise, we're going to realize it. The
monopolist doesn't look for a market price, the monopolist gets to set its own price. Competitive
firms were price takers, the monopolist is a price maker. The monopolist says, here's the price
folks, take it or leave it.
The first thing we want to do is to make sure we recognize where we are in the grand scheme of
things. And so we're going to reintroduce our number line. Remember we showed this earlier
25
and what we are right now is we're thinking about Marcus that have one firm. We did earlier
when we did the competitive, we did a situation wherein firms and N was very large.
Competitive industry has lots and lots and lots of buyers and sellers. Monopoly down here, Has
only one firm, and we want to figure out what does that firm do? Before we get there, we want to
first think about where does the monopoly come from? How do they get monopoly power in the
first place? And so there are several causes, I want to talk about three of them.
There's maybe as many stories about the monopolist is there are monopolist out there, but I'm
going to tell you three major causes. The one's called a natural monopoly, and a natural
monopoly. The definition I want you to think about is, it's a situation where economies of scale
are such that a single firm can supply the market at lower cost than two or more firms. That's
what the economists call a natural monopoly. It's a situation where the cost of supplying this
product is actually cheaper to just let one firm do it than to have multiple firms in the industry,
two or more. So, think about something like water, okay.
Provision of water in a city is much cheaper to have one firm than two because if you have two
firms doing it, you have two sets of water pipes under every street. Okay, that's patently
inefficient. If you're going to have the tear up the streets to put water mains through and then
connect to each house with these connect the lines, you don't want to have two different
companies going down the street. Some people's houses connect to Company A, some
people's house connect to Company B. You've got duplicate of costs all over the place, it's
wildly inefficient. So what happens in situations like that is that, we'll talk about this in more
detail later in this in these videos about monopoly. But what happens in situations like that is
essentially the government comes in and says, we're going to have one firm give you the water
supply and we, as the government will actually regulate their prices. So for example in the case
of water here, that's the way it is in all 50 states in the United States. And each one of those
states has a statewide regulatory authority that twice a year meets to set prices for these
regulated utilities. They say, we'll give you a monopoly. So there's only one company that owns
26
all the water rights that they could sell water to anybody in Champaign-Urbana. That one
company has a monopoly but the price they get the charge is set by the legislators in Springfield
in terms of not exceed by the legislature. The price that they get is set by an agency in
Springfield and that the state capital and that agency meets twice a year and decides what the
prices will be.
So that's one possible cause of monopoly. I got two more, okay. That's why I put numbers two
and three there. One of them, the government give away. The government can create a
monopoly, we'll call this government grants. Sometimes government grants are when the
government decides to pick some firms to say, I want you to create a new product for us. Okay,
and those products are let's say, spaceships. Well, I want you to create a new industry for me
and build something. So in the 60s, then President Kennedy made a declaration that said that in
the 1960s, the United States have put a man on the moon and that was very funny at the time
because wouldn't even have an idea of how to get a man up out of the atmosphere at that time.
Let alone put a man on the moon but an industry was created where they built these bigger and
better and stronger Saturn rocket boosters. And actually 50 years ago in 1969, somebody did
actually walk on the moon. Sometimes the government just has these open proposals and say,
we're going to fund the creation of an industry, who wants to be a part of this, and then they'll
pick somebody and said, okay. I'm going to give this money to McDonnell Douglas to build this
rocket booster or whatever.
Another type is what we call patents. Patents are essentially a grant that says if you get this
patent, you're the only game in town and you have control of that particular product or that
particular innovation for the next X years. And it varies, it used to just be 17 years and then they
raised it to 18 years. And then for some industries like for example, pharmaceuticals, they get
an extra two or three years on top because it turns out that once they invent a new drug, the
Food and Drug Administration mix them. Go through these efficacy trials where they give trials
and have lots of scientific tests of both control groups and stuff to see if this drug actually is A,
27
safe and B, does what they say it's does. And so, it takes a long time for those two happens,
sometimes two or three years to go through this before the Food and Drug Administration says,
okay good, you can sell it on the market. Well, the firm's got upset and say wait a minute, we
lost three of the 18 years that you give us for this monopoly. So for some industries like
pharmaceuticals actually get a little bit longer time, but regardless, a patent gives a firm an X
period of time where they're the only game in town.
And the reason for this is because research and development is really expensive, really
expensive. Let me just give you a little story to think about this. In the mid 20th century, there
was a gentleman named Chester Carlson who had a dream of creating something that would be
able to basically make a photocopy. In other words, he was thinking about what we now know
as a copy machine, a photocopy machine or sometimes referred to as a xerox machine named
after the first company that ever made one of these. And that guy, Chester Carlson spent a
good deal of his life many, many, many years with an idea that you ought to be able to take a
document and just have it be photocopied. He spent a large sums of his own money and he got
any one into debt and he had this idea that he was going to make this and eventually, he did.
He eventually produced a copy, he got a patent for some process called electrophotography,
but they later changed that to xerography. They being the company that he locked up with,
named Haloid Corporation. The Haloid Corporation was in Rochester, New York. And they
didn't like the name photography in there because another big company in Rochester, New York
located in Rochester, New York was Kodak. So they say, have it sound a little different, so they
changed the process to the name of xerography and they had this patent. Nobody else can
make one of these machines and so they started making these machines and they change their
name to xerox because that's what the idea was, and started to make lots of money. Now, the
reason to think about this is they spent tons of money in the development of this, and years and
years and years. But engineers estimate that if you put a team of engineers in a closed room
with a xerox machine, it would take them probably about five days to reverse-engineer. They
could take that apart and say, now I see how you do it. This is what's happening here, they're
going to shine some bright light on this chemical and things are going to copy onto the sheet of
paper. So if that was the case, if there wasn't for the patent protection, they could have put their
machine out and within two weeks, you're beat 19 different companies making the same
machine. So the idea of the patent is to shield somebody from competition for period of time that
will allow that company to reap the rewards of their great invention. Now, some countries don't
use patents that we use monetary awards for new ideas, okay.
Economist kind of like patents because patents sort of tell you how good the invention is. I mean
if you invent something like a xerox machine, it makes a pretty big difference, everybody can
instead of having to have thousands of typists typing up all the minutes for the board of directors
and everything else. You can just bake one copy, type it once and run it through a copy
machine and have enough for all the board members to read it and all those sorts of things. But
suppose you had a completely silly invention like left-handed coat hanger or something like that,
you're not going to get anything out of it. That's pretty much that patent, you're going to get
about what it's worth, nothing. So great ideas that will generate great economic activity will
really reward you and that's why people put so much money into their R&D shops to come up
with these new inventions, and then have that period of time, we call it patent where they are a
monopolist. We already know we haven't quite plated out yet, but Ruffles don't do a lot of great
28
things, except for the monopolists. [LAUGH] Monopolists can make a lot of money and
sometimes, this is what gives the structure for incentives for R&D. And the third major cause like
I said, there's probably lots of other little cause, is basically control of a natural resource.
You somehow have a control of some input that's required to make that particular product. You
have control of that input, nobody else can make it. Okay, you've got control of it. So, there's not
many cases where this happens, but they typically happen when you see new industry starting
up a new type of product. So, a story, you might think about the story of company called Alcoa,
Aluminum Company of America, A-L-C-O-A, which we know as the name Alcoa. Alcoa was
brought up on monopoly charges. We're going to find out later that monopoly is against the law
in most cases in the United States. And the US government filed a monopoly suit against Alcoa
because they said they had a monopoly because they had acquired through some foresight,
some interesting purchases. They had acquired most of the mineral rights to most of the bauxite
on the planet, different countries. They had bought the mineral rights for bauxite and bauxite
was a required natural resource to make aluminum. And in the mid 1930s, the government filed
this antitrust suit. It turns out that the antitrust suit dragged on too long and we got into the
middle of World War II. And in World War II, we needed a lot of aluminum. And as a result, lots
of expertise went into figuring out ways to make aluminum more efficiently not necessarily
requiring all the same inputs and the government built a lot of its own aluminum plants. In fact, a
lot more capacity than what alcohol itself had, because they've had to build things like planes
and all sorts of stuff.
After the war, the government sold those plants to two different companies, one is called Kaiser
Aluminum and one's called Reynolds Aluminum. And so Kaiser and Reynolds had together.
They were bigger than Alcoa. And so the government dropped its lawsuit about a monopoly in
that particular case. But prior to that, no one could enter that industry because Alcoa had control
of all of those natural resources.
29
Lesson 2-2.2: Monopoly Equilibrium - Part 2
Greetings, in a previous video we introduced this idea of what a monopolist is. A monopolist is a
firm that is the sole supplier to an industry. No threat of entry, that monopolist just go out and set
its profit maximizing price. Okay, it's going to choose price and output. You can say, well, it
chooses output or does it choose price, well, as you're going to see, that doesn't really matter.
So let's talk about monopoly profit maximization. Monopoly, Profit maximization.
And so monopolists have to face a similar creature, as all firms do, and that is demand curve.
And the demand curve, As all firms do, and that is a demand curve. And so the demand curve
will put the axis system price on the vertical axis and quantity on the horizontal axis. And notice
I'm using cap Q, but you can do cap Q or lowercase q because, by definition in this course,
we've been using a lowercase q to be output of the individual firm and cap Q to be output of the
market. But in a monopoly case, it's same thing, the firm is the market, there's only one supplier.
So whatever that supplier wants to produce, its own output being lowercase q, is identically
equal to the market output because they're the ones who are putting it on the market. And just
think about putting a demand curve on here, And we'll call this D0, and we have a marginal cost
curve. Monopolist is not above the law of diminishing marginal product. [LAUGH] Remember the
law of diminishing marginal product? When we did that tedious bunch of exercises of developing
cost curves, we said the cost curves have their particular characteristic shape, Like the marginal
cost curve or the average cost curve. Because of what happens in when you're looking at
production functions, the law of diminishing marginal product says that hiring extra inputs, these
extra inputs will give you more output, but not as much extra output as the previous inputs did.
It's not that they're just shoddy workers, it's that we're putting too many workers inside of our
fixed brick and mortar. And they're just marginally less efficient than the previous ones because
we're over utilizing that resource, sticking too many workers in the shop. Well, profit
maximization as we know from when we prove profit maximization, you want to profit maximize
by setting marginal revenue equal to marginal cost.
30
And we know what marginal cost is, but now we need to think about marginal revenue. What is
marginal revenue? Well, you say, Larry, that's easy, marginal revenue is the extra revenue you
get from producing one extra unit. Well, let me draw that on a on another picture. I'm going to
start a blank page here and I'm going to put on it a set of axes, I'm going to put dollars, which is
basically price and quantity. And I want to draw a demand curve that looks like this. And let's
suppose for a moment that price and this product is 100 and at a price of 100, we're selling 50
units. Where'd I get those numbers? I got the pen, I just made it up, okay? It's just possible, I
know the demand curve is downward sloping and I'm going to label this point as price of 100
and output of 50. Now, suppose this belongs to a monopolist, so we're thinking about marginal
revenue of a monopolist.
Monopolist says, you know, I think I want to sell an extra unit, I'd like to sell 51 units. So I'm
going to sell this 51st unit. Bow bear with me because this is kind of like an integer problem, it
really is a continuous function, but we'll do this. This is the 51st unit. Now, to sell the 51st unit,
what's this monopolist going to have to do? Well, the monopolist can no longer get $100
because at $100 50 people were willing to buy and that's it. If the monopolist wants to sell to
one more person, what does the monopolist have to do? Well, they definitionally have to lower
price. The only way they're going to get this person out there, given that we have accurately
constructed the demand curve, is we have to lower the price, let's say, to 99. By lowering the
price $1, they'll get an extra person on the market. And now you ask yourself the question, what
is the marginal revenue? I'm going to put this up here. Hm, what is the marginal revenue of the
51st unit? Question mark, question mark. And you might say, well, Larry, I think I see this
[COUGH] there's a person standing right here. And in order to get this person to buy the
product, yep, in order to get this person to buy the product, I have to lower the price to $99. And
this person, definitionally, gives me the $99. So I think the 51st unit has revenue, marginal
revenue, the extra revenue for the 51st unit is $99. [LAUGH] [SOUND] Not right, okay, it's not
right why? Because in order to lower the price to 99, in order to get this person, you had a lower
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price than 99. But what that means is you lost $1 on all of these previous customers because if
you really going to sell 51 units, you have to lower the price to 99, not just to that person, but
you have to lower the price to everybody, okay? And so to get that person out, price has to go
down, right? And so the marginal revenue would be equal to the $99 from this consumer minus
the $50 that you are foregoing by not just keeping price at $100 and selling to only 50 people.
You now lower the price and you're going to have to sacrifice, you only get $99 on each of those
first 50, okay? Then you get 99 on number 51, but you could have had 100 on each of those
first 50. So the marginal revenue is equal to 49 in this particular example. And the way to put
this here, and I'm going to put it in a big box, is that, Marginal revenue is less than price for a
monopolist. Marginal revenue is less than price for a monopolist. So, what we have to do is we
have to think about what does this marginal revenue really look like? And that's our next video,
is to think about drawing this marginal revenue curve, thanks.
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Lesson 2-2.3 Marginal Revenue Curve in Monopoly
Greetings. In the previous video, we determined that for a simple monopolist which we call a
one price monopolist, that monopolist will have marginal revenue less than price. We drew a
very simple little diagram that said, "Look, suppose I had this situation where this is price and
this is quantity and this was my demand curve, and I said at a $100 for price 50 people bought
the product. But if I want to attract the 51st buyer into the market I'll have to drop it to 99, and
that would in fact allow us to sell to 51 people." I'll draw an arrow to that spot. The reason that I
found marginal revenue is less than price is because while I can get a price of $99 out of that
person's pocket, I don't get to keep the full 99 as net revenue because by getting that price I had
to lower the price to everybody else, I can only charge one price. Economists call this a simple
monopoly otherwise known as a one price monopolist, and as a result of that marginal revenue
is less than price. How much? Well, in this particular case marginal revenue was really only $49
because you got the 51st unit, your marginal revenue was equal to the $99 out of that
consumer's pocket minus the $50 that you gave up by not staying at 50 units and therefore
getting a $100. I instead lowered the price to 99 to sell those extra units, and so marginal
revenue was in fact 49. What we want to do is make a simple rule about how this works, so I'm
going to draw another graph.
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I'm going to start by saying let's consider formal construction of marginal revenue with a linear
demand, so we're going to start by thinking this is a linear demand. So linear demand means
that essentially price is equal to a minus bQ, that will be our linear form. The linear form says
that essentially I'll do something like this and I know that my demand curve then, this is demand,
it has a vertical intercept of a that comes from this.
The vertical intercept is that first term, and the slope is equal to minus b, that comes from here,
this is the minus b which is the slope, it's a simple straight line. Now I want to think about what
the marginal revenue is, so to do this I'm going to do a little bit of calculus. Again, I'm not going
to ever ask you to derive this calculus but I'm going to show you using calculus a neat graphical
trick that you would have to use calculus to solve this but it will work perfectly, as long as you
stay in the world of linear demand curves. The definition of marginal revenue is that marginal
revenue is equal to the derivative of total revenue with respect to output. We know that, we
know total revenue is just equal to price times quantity, fortunately for us we have an algebraic
formula that tells us what price is, a minus bQ. So what we're going to do is we're going to take
this a minus bQ and substitute this in and we'll write therefore the total revenue is equal to price
times quantity, but we can rewrite that by understanding that price is just a minus bQ, so we'll
put a minus bQ times Q. All I've done is take this straightforward algebraic form and substitute in
for P, because we know from up here that P is just a minus bQ, but let's factor that through.
That means the total revenue would be equal to aQ minus bQ squared, that's good, now we
know marginal revenue from this formula. Marginal revenue would be equal to the derivative of
total revenue which is the derivative of aQ minus bQ squared with respect to output. Again,
those of you who know calculus, that's very straightforward, it would be equal to a minus 2bQ.
Those of you who don't know calculus believe me, I didn't pull a rabbit out of my hat, talk to your
friends in your group who do know calculus and say, "Is that really what happens there?" They'll
say, "Yes, that's a simple derivative." The derivative which is the slope of the revenue function, if
you have a linear demand curve the slope of the revenue function would be a minus 2bQ. Well,
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look at this, this is very interesting, it means that our marginal revenue curve has the same
vertical intercept as the demand curve. Marginal revenue has the same vertical intercept as
demand curve and that's good, we could think about drawing this curve by saying, "Well look, I
know that marginal revenue curve has the same vertical intercept as demand, but what's the
slope?" Well, its slope is twice the slope of the demand curve. The slope of the demand curve is
minus 1b, the slope of the marginal revenue curve is minus 2b, which means that the marginal
revenue curve goes down at twice the slope of the demand curve.
The marginal revenue curve has a slope of MR equals minus 2b, so it goes down twice as fast
as the demand curve. What that means is that this point, since it will go down twice as fast, if we
want to call this point alpha, that makes this point to be 2-alpha because it's the midpoint. It's
the midpoint because that line goes down twice as fast which means that essentially the
marginal revenue curve starts going negative once you get past the midpoint of the demand
curve, marginal revenue curve starts to go negative if you pass that point. Now, the important
thing for you here is to think about what this mean to you. What it means to you as long as we
use linear demand curves which I will, which is perfectly reasonable, as long as we have linear
demand curves, the monopolist marginal revenue curve, you don't need to do the calculus. So
monopolist marginal revenue curve will have the same vertical intercept as the demand curve,
and it will go down at twice the slope. So if I ever give you for example just for the heck of it, let's
draw another picture. Suppose I told you that the monopolist demand curve was 100 minus 6Q,
that you would know the marginal revenue curve would be also 100 for the vertical intercept
minus 12Q, and so it'd go down at twice the slope. All right, good. Thanks.
35
Lesson 2-2.4: Social Costs of Monopoly
Greetings. In the previous video, we looked at the profit maximizing decision of a monopolist.
Let's repeat what we found there. So I'm going to draw the monopoly equilibrium. We have a
vertical axis which measures price in dollars and cents, and we have a horizontal axis which
measures output. Again, this is the output of the market, as well as the firm because in our
monopoly case, the monopolist is the market. So we have a demand curve, it's downward
sloping like that, we'll call that D. It's just a downward-sloping line. You might ask, why did you
not drop the line? I didn't, I just know it's linear and it's downward-sloping, and this looks like a
fully general case for me. Then we have a marginal cost curve, and that marginal cost comes
from technology, the cost curve which can allow time when video is thinking about cost curves
and that generates a marginal cost curve looks like that. Then we have to think about profit
maximization. Profit max regardless of the industry you're in requires that you set marginal
revenue equal to marginal cost. So we need a marginal revenue curve. In our previous video,
we established that the demand curve is linear. A monopolist marginal revenue curve will also
be linear, it will have the same vertical intercept, this point up here, Alpha, and it will go down
twice the slope of the demand curve. So the marginal revenue for a monopolist will look like
that. You don't have to know in calculus, I did that for you last time, and those of you who know
calculus saw that there was a pretty straightforward calculus problem, but those of you who
don't, It's okay, all I need you to understand is that the marginal revenue for a monopolist, when
a monopolist has a linear demand curve, the marginal revenue for a monopolist will also be
linear, it will have the same vertical intercept as the demand curve, and I'll go down twice the
slope. That means the monopolist will want to set profit-maximizing output where marginal
revenue equals marginal cost, and we'll call this output Q star_M for the monopolist, and the
monopolist of course at that output point would price at this level.
So that's the price, the monopolist charges, and that's the output produces, and now we have to
think a bit about the welfare of this situation.. Before I get that, I want to actually talk about short
36
run and long run equilibrium because we spent a lot of time thinking about short run equilibrium
versus long run equilibrium in the competitive case. Well, in order to do that, let's put an
average cost curve on this picture. Where is the average cost curve? Well, I don't know for sure,
but I do know that the average total cost curve will be U-shaped, and it will have its minimum
somewhere along the marginal cost line. So this looks like a representative one that works for
me. Given that case, you know because we did this many times before that profit is equal to
total revenue minus total cost, but that's the same thing as writing price times quantity minus
average total cost times quantity, which means I just factor out the quantity and multiply it by
price minus average total cost. Same thing we've always done for this, basically property just
says, "What is my per unit markup times the number of units produced?" Well, the per unit
markup is this distance, price minus average total cost. So I'm going to pencil that in and say
here's the per unit markup, that vertical distance would be price minus average total cost, and
this is the number of units produced.
So we know if we took this times this or this times this, it would be the area of this shaded
rectangle. That would be the positive profits earned by the monopolist in the short run. So what
about the long run? Well, we know positive profits in the competitive case attracted entry. But by
definition in our monopoly, the definition of a monopoly market is there's no threat of entry. So
this monopolist could just keep earning these returns period after period. For example in the
case of the patent and we're just talking about Xerox, Xerox had protection in those days, patent
protection was 17 years. So Xerox had 17 years of earning positive profits because they were
the only game in town, the only people who made a photocopy machine was Xerox. Then after
the patents expired, all of a sudden everybody, every electronics company made their own
version of a photocopy machine. Here that can't be case.
I'm going to write at the top welfare economics, and remember what we said earlier, welfare
economics is essentially what economists call the part of economics where we think about the
efficiency properties of the outcome. What is our measure of social welfare? Well, we built that
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measure called social gain, some consumer surplus plus producer surplus, and we could think
about that. Let's just assume that we have a perfectly competitive industry. No monopoly right
now. Let's start with a perfectly competitive industry.
So to give you an idea what I'm doing here, I know we're in videos about monopoly, but I want
to start with a base case. What I'm going to do is I'm going to suppose this industry was actually
structured like a perfectly competitive industry, we would know what the outcome, looks like we
already understand how the benevolent dictator would measure that outcome. Then I want to
say, suppose somebody comes along and monopolizes the industry, what would the change in
social welfare be? What would the change in social gain be? So that's the game we're going to
play. So I'm going to draw a new graph, and it's going to be. I'll put the axis system in place. I'll
put price on the vertical axis, quantity on the horizontal axis, and I'm going to put a demand
curve that looks like this, and I'm going to put a supply curve that looks like this, and these will
just be the original situations. Now, given that situation, actually I'm going to make a copy of
this, there'll be page 7, go back here, and page 6. Given that situation, we would know the
competitive outcome. The competitive outcome would have price. We'll call this P_c for
competition, and this would be Q_c for competition, and the competitive outcome would have an
initial situation of this much consumer surplus. You remember the definition of consumer
surplus? Is the area below our demand but above price. The demand curve is our measure of
willingness to pay. There's an individual standing right here who would be happy to pay this
level. They'll still consume it at a price that's high. At a price this high, this consumer would still
want to buy. But fortunately for the consumer, market pressure pushes the price all the way
down here. So this consumer who would have paid $10, only has to pay four dollars. So there's
a net consumer gain, and we add all those up, and that's where we get that blue shaded
triangle, and we'll put a name on that just to remember this is consumer surplus. On the other
hand, we had a major for producers too, and we said, producers would have given you this unit
for this price. If you offered them this price, they would have given you this unit. But in fact they
38
actually get this price. So they're going to net that gain, and every one of these prices that the
earning is higher than what they would actually needed to bring that fourth given the way we
shape of our supply curve. So we know that producer surplus is the area below price but above
the marginal cost of production. The supply curve is nothing other than the sum for i equals 1 to
N, for N firms in the industry of their marginal cost of each of those i firms. We add up all their
marginal cost, some of those is actually the market supply curve, we've already established that.
This area down here would be producer surplus, and it turns out of course. Fortunately for us,
the benevolent dictator is remarkably happy with that outcome. The benevolent dictator doesn't
care who gets what, he or she doesn't care about the distribution of this. The size of consumer
surplus versus the size of producers, all the benevolent dictator wants to do is to maximize the
size of the pie, and this output Q_c maximizes the total gains to society. When you add up the
gains to consumers and add up the gains of producers, that makes that size of an outcome.
Now, that's good enough. Now suppose I tell you that someone comes along overnight and
monopolizes this industry. Now you might say, "Larry, that sounds like an interesting idea, but
that could never happen." Well, that's not quite true. Back around the early 1900s, 1905, this
relatively wealthy financier named J. P. Morgan pulled off a merger, where he merged a
substantial amount of all of our steel capacity in the country. There were hundreds of steel firms
in the country, and he was to merge these into one company which he called United States
Steel. The formation of US Steel was an attempt to get everybody in the steel industry to merge
into one company and they would have one company and have control of the price. Now, it
turns out they were not quite successful, but they did get as much as 80 percent of all the steel
production in that merger, but there were still some outliers who didn't join. But for the sake of
my little lecture, bear with me and say, supposed that J. P. Morgan had actually pulled it off and
got 100 percent of the steel firms to come together and just be one firm. Let's think about what
that firm would do. You can see that firm, I'm going to draw this picture, that firm would say,
well, you know what?
39
So I'm going to write up here so you know where we are. After the merger to monopoly, the
monopolist would do what? A monopolist want to set marginal revenue equals marginal cost. I
know what my marginal revenue curve looks like. It looks like the vertical. It's a linear curve
which has the same vertical intercept as demand and it goes down at twice the slope, and I also
know what my marginal cost is. Because I know that all of these firms that I purchased
overnight, they each had their own little marginal cost curve, and now those summed firms are
as my marginal cost. They used to be, let's say 80 steel firms out there, and I brought them all
in. They each had a different marginal cost, but now that combined marginal cost is my marginal
cost for my company because I own them all. Well, that means I can set marginal cost equal to
marginal revenue right here, and we would call this Q_m, and I would set the price right there,
and we would call that P_m. In this situation, we can see that in fact the New World Order, the
consumer surplus will be the area below demand but above price. There's still some people
standing out here who value that. But the price has gotten so high that the consumer surplus is
actually falling. So we'll measure the consumer surplus like this. The consumer surplus the area
below demand and above price. So we'll call this consumer surplus under the monopoly world,
and the producer surplus has now grown to this area. The producer surplus, the area below
price but above marginal cost is that area, and we'll call this producer surplus under monopoly.
This shaded area is what economists call deadweight loss. It is part of the pie that's gone. The
pie itself has shrunk. So you'd look at this previous picture that we had competitive there. You
can see the pie that is the total gain to society was the combination of producer surplus plus
consumer surplus. That's that entire large triangle was the gain to society. But now we're
missing this. This triangle is not there anymore, and economists call that deadweight loss,
because it's a loss of that offset. See some of the loss to consumers is actually offset because
producers are making higher rent. So the producer surplus actually grows, I can't show it to you
here but I can prove it to you if you want. The amount of producer surplus actually grows. So the
monopolist makes itself better off raising it's producer surplus, some of that is just taken away
from consumers pocket. But look, there's a lot of here that just nobody gets to the end, it's left
on the table so to speak, and that's what we call the social cost of monopoly. In this case, we're
going to call this the social cost of monopoly.
It's the deadweight loss because the monopolist had just essentially artificially restricted output.
This was the competitive output. The monopolist has just taken a lot of it off the market so that
he or she can push up the price and line the monopolist profits. Monopolist do well for
themselves, they can [inaudible]. So if there was a chance that they could do the old consumer
perfectly competitive, but they don't want to do that. They want to do this because this of course
maximizes their profit.
40
Lesson 2-2.5: Governments Intervene in Monopoly
Previously, we looked at monopoly profit maximization. So in a monopolist, the monopolist will

set marginal revenue equal to marginal cost, just like everybody does. We know what the
marginal cost looks like, and we also understand that for a monopolist, since it's a linear of
anchor, the marginal revenue for a monopolist would be also linear. It would have the same
vertical intercept, which I thought is that blue dot, and it will go down at twice the slope, twice as
fast. So the monopolist would set marginal revenue equals marginal cost and it would produce
at this output. We call that Q star_m and really jack up the price.
So in this case, the monopolist would have some producer surplus and there will be some
consumer surplus. But of course, if the benevolent dictator were to come to look at this, a
benevolent dictator would say, ''Wait. You should be producing out here.'' This is the socially
optimal output.
Because I know that if I could somehow force you being the dictator, if I could somehow force
you to produce an extra unit past Q star_m, that extra unit would generate returns to people in
excess of the cost of resources burned up. So there would be a clear gain to the size of the pie.
This distance would be the sum of consumer surplus and producer surplus generated by
producing one more unit. But of course if you put another one, another one, and another one,
another one and another one all the way out here, we would then have maximized the pie. That
benevolent dictator would never want to go to the right of this because by increasing output
more, the extra cost of that extra unit exceeds the value, and so the pie will start shrinking.
Returns to somebody, the benevolent dictator doesn't care who gets them, whether the
consumers or firms, but the total returns will be going down if we were to somehow mistakenly
move out in this direction. Okay. So this meant that we had this area here of essentially losses
to society.
We're missing this, okay? This was the social cost of monopoly. So because of the social costs
of monopoly, what we have to think about now is, well, what does the government do to respond
41
to that, and we know what the government does. We understand that it is in fact against the law
to have a monopoly. We're all going to think about these laws right now. The anti-trust laws,
essentially, there are many anti-trust laws, but the original one is called the Sherman Act.
Sherman Act had lots of parts to it, okay? Different sections that talk about different things, but
the two key sections are section 1 and section 2. Section 1 said, it's illegal for price-fixing. We'll
talk about that when we get further in a different video when we start thinking about how firms
might behave when there's a small number of firms and they might talk with each other and
some cost arrangement that makes section 1. Sherman Act Section 1 prohibits firms from
entering into any contract in restraint of trade. Typically, that is a contract where they decide to
fix the price. I'm tired of competing each other and broadening our brains out. Why don't we just
all agree, charges, pricing and go forward. We'll talk more about that later. Sherman Act Section
2 makes a monopolization illegal. Okay. So Section 1 is against fixing prices or fixing any type
of trade. It's just as illegal to fix advertising budgets as it is to fix prices. Firms might get together
and say, why do we keep spending all of our money advertising on TV? Let's just agree to not
new anymore television advertisements. Well, that's a violation of Sherman Act. A bunch of
firms can't get together and say, let's behave this way. Monopolization, so we're going to think
about monopolization right now because monopoly is the Sherman Act is in a sense a response
to what we have developed which was this idea there's a social cost to monopoly. There it was,
the social cost of monopoly.
So because of the social costs of monopoly, what we have to think about now is, well, what
does the government do to respond to that, and we know what the government does. We
understand that it is in fact against the law to have a monopoly. We're all going to think about
these laws right now. The anti-trust laws, essentially, there are many anti-trust laws, but the
original one is called the Sherman Act. Sherman Act had lots of parts to it, okay? Different
sections that talk about different things, but the two key sections are section 1 and section 2.
Section 1 said, it's illegal for price-fixing. We'll talk about that when we get further in a different
42
video when we start thinking about how firms might behave when there's a small number of
firms and they might talk with each other and some cost arrangement that makes section 1.
Sherman Act Section 1 prohibits firms from entering into any contract in restraint of trade.
Typically, that is a contract where they decide to fix the price. I'm tired of competing each other
and broadening our brains out. Why don't we just all agree, charges, pricing and go forward.
We'll talk more about that later. Sherman Act Section 2 makes a monopolization illegal. Okay.
So Section 1 is against fixing prices or fixing any type of trade. It's just as illegal to fix advertising
budgets as it is to fix prices. Firms might get together and say, why do we keep spending all of
our money advertising on TV? Let's just agree to not new anymore television advertisements.
Well, that's a violation of Sherman Act. A bunch of firms can't get together and say, let's behave
this way. Monopolization, so we're going to think about monopolization right now because
monopoly is the Sherman Act is in a sense a response to what we have developed which was
this idea there's a social cost to monopoly. There it was, the social cost of monopoly. So I have
to toe that there's a couple requirements for working with this monopolization. The first thing is
that you have to establish the existence of a monopoly. We'll talk about that here in a minute.
The second is that you have to worry about something called the Rule of Reason. So if you're
going to run a monopoly case, you have to first prove that the firm has monopoly power over an
industry. Secondly, you have to prove that, essentially, it's a bad monopoly.
So in other words, sometimes firms become monopolies because maybe a community's only big
enough to have one. There may be some small towns around here that only have one grocery
store and there may be some small towns that only have one bar. Now, you might say, well,
that's a monopoly and in fact, it would be. In that particular market there is only one seller, but
that's not because they were somehow pernicious and trying to dodge the law. It's just a town
isn't big enough to support two. So sometimes those things happen. On the other hand,
sometimes firms get the monopolies by engaging in all sorts of, let's say, unfriendly and anti-
competitive behavior against rivals. So we'll talk a bit about those things as we move forward.
I'm going to start by thinking about establishing the existence of monopoly. When you have a
monopoly case, if the government's going to run a monopoly case, the government first has to
show that the firm has sufficient size to be market power.
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Now, throughout these videos, I just been drawing an axis system that looks like this.
Start transcript at 7 minutes 23 seconds7:23
I put up here a price and I put down here a quantity for the market. Now, what is the industry?
Well, I don't know. Sometimes they don't even say, I just say price and quantity consider a
market, and then that's competitive and then I go forward. Sometimes we talked a bit back when
we were doing earlier videos about well, let's think about the market for oil. Let's think about the
market for gasoline and talk about how excise taxes impact that. But again, those were generic
markets. In the real-world sometimes firms don't have generic markets. So for example, the
government can go after a certain company which it did, that makes glass jars. They can say,
you know what? This company who makes glass jars actually makes 90 percent of all the glass
jars in the United States. We consider that a monopoly. Now, it's true.
44
Here I can draw another picture. It's true if the market were glass jars, we'll call this glass. This
company had 90 percent of all the glass jar production in the United States. I'll give you that. But
what the company argued when it went to courts, no, the market is not glass jars, the market is
containers. It's true glass jars are one form of containers, but they don't have to use glass.
People can put it in tin cans. People can put it in waxed paper cartons. People can wrap it up in
aluminum. There's all sorts of things that people could use for a container. They don't have to
use glass. The economist for this group was able to show that in fact when firms like the glass
firms raised their prices, it caused sales to the container group to grow. In other words, they
really were substitutes. When the glass firm raised its prices, it lost lots of sales because people
switched to tin cans or plastic jugs or other types of containers. In that case, the court decided
that this first step which was establish the existence of monopoly, said you haven't established
the existence of a monopoly here because in fact this firm while it might have 90 percent of the
glass jars, it has less than 30 percent of the container market. So it's not a monopoly and the
case was just dismissed right there. We didn't have to go any farther in that case. The other
thing that I talked about that's important is suppose you do establish the existence of the
monopoly, the second thing you have to do and this is very important, is you have to think about
the rule of reason.
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The rule of reason simply says, this was a Supreme Court interpretation. The rule of reason was
basically an interpretation by the Supreme Court. The Sherman Act was passed in 1890, and 21
years later in 1911, the US government filed monopolization charges against Standard Oil.
Standard Oil was a huge company owned by the Rockefellers that the government claimed was
a monopoly.
The Supreme Court, by the way, did the punchline, agreed with the government. Supreme Court
said, yeah this is a monopoly. But in the ruling, the Supreme Court laid out this doctrine of rule
of reason and said just because they have 90 percent of the market doesn't mean they're a bad
monopoly. The Supreme Court came up with this idea that it is still goes by this name, skill,
foresight, and industry. Skill, foresight, and industry it simply said, you could be a good
monopolist. The Supreme Court said through skill or foresight or industrial behavior, you could
be a monopolist just because you're so good at it. So think about the example, they said
actually wrote this, the Supreme Court it's very interesting because there's tons a footnote in
these Supreme Court rulings. There's one went on about, in our competitive system, we tell
people if you build a better mousetrap people will be the bath to your door. So make your
product as good as possible and you'll be a success. Then the Supreme Court said but the
logical conclusion might be that your product is so good that people only want to buy your
product. That might you might end up just because you have the best product out there, we
can't come back and beat you up and send you to jail and rot and say that you're breaking the
law because we asked you to make great products and then you'll be successful. So the skill,
foresight, and industry argument says sometimes monopolist could be good. Now, this has been
used in other cases. Back in the '70s, the government had a monopoly case against Kodak.
Back then you don't remember this because you have to be old like me to remember that. We
used to have these cameras called Instamatic cameras, and you bought a little plastic film
cartridge, opened the back of the camera, slapped it in and closed it, and you could take 26
pictures, and then you drive through parking lots and they'll have little photo booths there, and
46
you'll give it to them and you'll have your pictures developed in about a day. Well, it turned out
Kodak had 90 percent of the market for these little Instamatic film. There were other producers
out there, but they had 90 percent, and the government said this market is the market. There's
two different types of film. There's film for serious photographers that's called 35-millimeter film,
and then there's market for people who are just picking up a camera when they're taking a trip
to the beach for the weekend or something like that to take some pictures. Kodak lost the case.
But Kodak on appeal convinced the Appellate Court that through skill, foresight, and industry,
the reason they had a market dominance was because they made the best product. They
argued this first birthday argument, that if you're stopping by the drug store to pick up some film
to take some shots of your child's first birthday party, you've got a choice of picking up Kodak, or
you can save a buck by picking up Larry's Fly by Night film. You go home and pictures don't
work out and you use Larry's Fly by Night film and you can't really recreate that first birthday
party. So Kodak argued, we have the ability to charge higher prices than our rivals because we
have a much better product. The court agreed. The rule of reason would say, through your own
skill, foresight, and industry have built a superior product and you deserve that market share. So
that's what this art is all about. In the case of Standard Oil, the reason that the Supreme Court
wrote that is that they were going to find them guilty because they said one of John D.
Rockefeller's favorite strategic choices was dynamite.
There was evidence that he would dynamite some competitor's refineries, he would dynamite
some railroad tracks that his competitors oil was going on, that's at least was entered his
evidence. He was never convicted of any of that stuff. But the court felt that there was enough
shady action going here that this was not a monopoly just because they had a better product.
That's a generic product and they just had used different techniques to get where they are.
Finally, one thing to know was the case of antitrust cases against monopoly, the relief that the
government asked for is what we call structural relief.
In other words, what happens if you get found guilty? Well, structural relief is the idea that what
we really want is for this industry to be more competitive. So what we're going to do is we're
going to break you up. That's what they did. They broke Standard Oil up into many companies
that we now know. Standard, Mobil, Exxon, all these different types of companies that we now
know today. In fact, the companies they've broken up in real right now account for maybe 15
different oil firms that we know. It recognizes different independent entities because well, the
court just said, you've got too much market share here, we're going to break out these to
different firms and then you act more competitively against each other. Thanks.
47

Module 1: Monopoly Markets and Efficiency

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Firm Level Econ: Markets and Allocations

Professor Larry DeBrock

Module 1: Monopoly Markets and Efficiency

Lesson 2-2: Other Market Outcomes: Monopoly ........................................................................... 25

Lesson 2-1: Building a Measure of Efficiency

Lesson 2-1.1: Consumer Surplus - Part 1

Lesson 2-2: Other Market Outcomes: Monopoly

Lesson 2-2.1: Monopoly Equilibrium - Part 1

Previously, we looked at monopoly profit maximization. So in a monopolist, the monopolist will

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