Hi, I’m Saul Levmore and I teach law or really economics and law at the University of Chicago. It’s my good luck to be her to introduce you to the subject of economics. Well, what is economics?
Let’s play a game of free association. I say “economics,” you say whatever comes to mind. Economics—money. Economics—Wall Street, housing bubble, prices, incentives. Ohh, if you said incentives, that’s pretty sophisticated.
I think it’s easy to see why economics is relevant. Economics is everywhere. Economics is why buildings go up; economics is why cookies cost $3.00. Economics is about getting the seat you want on the plane. Economics is, yeah, it’s about making money, but it’s about human behavior in general. Economics is to the real world around you as meteorology is to the weather, it’s interpreting all the phenomena and figuring out if there’s anything we can do about that. How could that not be relevant to every one of us?
That’s a lot of what we’re going to talk about today. Economics is, formally at least, the study of the allocation of scarce resources. You don’t have enough of something, a lot of people want it, who gets it, how do they get it, what do they give for it, how do you get people to make more of the thing. All of that is economics. I’ll say it again; economics is about the allocation of scarce resources.
Economics is also about puzzles. Economics likes to assume, just to make its job easier, that people are rational. You know, what is a rational person? The rational man is the guy who sees that the price of wheat rises; he gets up earlier in the morning and grows more wheat on his farm. Economics is the guy who buys more of something when the price drops. That’s the rational man.
The rational man loves to download stuff from iTunes when iTunes price goes down, but the rational man also creates more music in his garage and sells it when he gets paid more by people who download it from iTunes. One guy wants the price low; one guy wants the price high. They’re using incentives to communicate with one another.
So economics is about exchanges, economics is about prices, therefore it’s about money and it’s about incentives. Once you have those four things down, you’re beginning to put the package together.
I said that economics was about puzzles. Economics is also about puzzles.
And these puzzles are even deep mysteries, have a lot to do with how economics got started in the first place. Kings would be really confused about some things. They would issue new coins, the coins would go out into the realm and the coins would disappear. Where were these coins going?
Peter the Great, I just read the other day, beheaded some 1,000 people for hoarding coins. And he could never figure out why when he issued silver coins, people would hide them or bury them in the fields. Why didn’t they want to use these coins? What was so great about holding them? Well, that’s the mystery that economics was out to solve. Peter the Great hired advisors and he wanted to figure these things out.
How come countries traded some things and not others? England and Portugal were sending wine and cheese back and forth, but some things never seemed to travel. Why was that? Well out of these puzzles came the study of economics. And the people who advised these Kings can be thought of as the first economists. And economists have continued to like puzzles ever since. Think about sovereigns in our own time. Think about something the government does and wonder why the government does it.
So a fire breaks out. You can imagine one world where ten competing fire departments, you’d look them up on the internet and you’d say, “Oh, how much to put out my fire?” And people would race around for prices to put out fires. That’s not the way it works. Instead, the government is in charge of firefighting. Economists are very interested in that, you know, why is the government in charge of firefighting and not growing wheat? Why doesn’t competition make firefighting work better or do governments somehow compete to see who’s better at putting out fires? Of course, there is a little bit of competition there because if the government does a bad job putting out fires or plowing the streets in the wintertime, then voters will throw them out of office and bring in new politicians. Still, that’s not exactly using prices, that’s using votes rather than prices. And our job today is to understand the use of prices.
Two of the things we are going to focus on today are prices and the form of competition. And let me say a little bit about them before we get there.
Prices and competition or its opposite, monopolies, are two central tools in the study of economics.
Prices are these things that tell people how much something costs, how much they have to sacrifice to buy it, how important it is to make more of the thing. We’re going to see a lot of prices today. By form of competition, I mean, the people who make these things, are they competing with other firms to make it or are they the only one out there making it.
A perfect competitor, economists like to say, is somebody who is out there trying to sell you something or make something, and though lots and lots of other people are trying to make the same thing, competing to make it better or at a lower price or whatever it is.
When they’re the only one out there, we call them a monopolist.
So the monopoly is a form of producing goods. A perfect competitor, economists like to say, is somebody who is out there trying to sell you something or make something, and though lots and lots of other people are trying to make the same thing, competing to make it better or at a lower price or whatever it is. The monopolist is somebody who for some reason or another has the market to itself.
And we’re going to spend a good deal of our time today understanding what’s so interesting about monopolies. Why governments care about them. Why governments even sometimes like monopolies. And why you and I might not like them so much.
So the monopoly is a form of producing goods. A perfect competitor, economists like to say, is somebody who is out there trying to sell you something or make something, and though lots and lots of other people are trying to make the same thing, competing to make it better or at a lower price or whatever it is. The monopolist is somebody who for some reason or another has the market to itself.
But probably 10 or 20 such tools, but we’re going to have time for two of them today and many applications of those tools.
Now you can even think of the government as a kind of monopoly. It’s sometimes that we say that the government has a monopoly on power, you know, they’re the only one who gets to have an army in most countries. But as we’ve already seen with the firefighting example, really the government allocates to itself the right to be a monopoly about many things. The government has a monopoly on making laws; it has a monopoly on fighting fires, on being the police. It’s a form of monopoly, but one that’s more influenced by votes than by prices. But there are many, many, many other monopolies out there that the government allows.
Think about the streets in your city. Well, if you had competition for producing and sending people water or electricity, you’d have 10, 15 companies digging up the street all the time laying pipes, putting in water, sending the electricity and the water to your house. Nobody wants to tolerate that. So instead, most governments say, let’s make that a monopoly. Either we will own it or we will some way or another hire a firm to do that. We’ll give only one firm the license to dig up the streets and put in the pipes. And then either other firms can compete to sell you water at your house or probably that one monopolist will sell water at your house. So the government doesn’t want many people digging up the street. On the other hand, it might recognize that there’s a problem with having only one supplier of water to you. We’re going to focus on that one supplier in a few minutes and in any event, we already know to call that a traditional monopolist.
While we’re talking about the government as a monopoly, notice that the government doesn’t charge you for firefighting. It’s a curious thing that economists are interested in. The government charges you for water, but when it puts out a fire in your house, it doesn’t charge you. It might even have rules requiring you to have fire extinguishers or in big buildings, sprinkler systems. Still, if the Trump Tower burns down and the government comes and saves it before it’s burned to a crisp, the government doesn’t say to Donald Trump, “Oh now you owe us a certain amount of money for saving your building.” We might begin to wonder why that is.
This is the sort of thing that economists are interested in.
Here’s another monopoly for you and another example of where we use markets sometimes but not other times.
Think about the college you go to. The first time you met that college, it was an intense competitor. Many colleges were probably competing for you to be a student there or certainly for your application fee. And you in turn were competing with many other applicants for seats in the college. It was a very, very active market.
Suddenly, it changed. You’re admitted to a college, you matriculate there, you show up, you need a dorm room, very, very, very few colleges say, “Oh, the third floor dorm rooms are better than the second floor dorm rooms. Let’s raise the price a little bit on the third floor.” No, no… suddenly, it’s as if there was no market at all. Colleges tend to hate prices. Colleges act as if there is no market at all. A course is overcrowded? They might tell you, you can take another time, they might add a section to the course. They might hire another teacher, they might stuff the room full of chairs, but the last thing they do is say, “Okay, everybody who wants to pay $189, please come in and sit in the first row.” Why is that?
That’s another good example of where sometimes we love markets and sometimes the players in the market, like the college in my example, **** the market and says, “No, no, no. There’s a reason why we should be some sort of community without a market.” Probably they gain something by this and they lose something by this. And again, that’s the sort of thing that economists are very interested in understanding. And I hope you will be too.
In economics, the best way to understand big puzzles is to break them down into little puzzles. Little puzzles are not so easy, but big puzzles, as we’ll see, are really beautiful. They’re beautiful to solve by putting together these tools, we can learn from the smaller puzzles. The key way we’re going to solve these puzzles today and in economics more generally, is by always thinking about these markets. Where does a market exist? What are prices doing? What’s competition doing? Do we have a monopolist or do we have a lot of competitors running around? These are the tools that we’re going to looking to use to solve problems. We want to understand the recent financial crisis that hit the world. We want to understand housing bubbles. We’re going to start with prices. We’re going to start with competition and then we’re going to understand the role of the government.
So, let’s start with prices.
When I say prices are special, I mean prices do everything. Prices tell oil companies when to dig deeper for oil. Prices tell me when to fly. Prices tell me when to fill my car with gas. Prices tell me whether to go to a restaurant early or go to the restaurant late. And in fact, when the restaurant doesn’t offer price differentials, I’m a little disappointed. Sometimes on a rainy day I think, “Boy, I bet there’s nobody going out to the restaurant now. I wish the restaurant would drop the price and then I’d be more eager to go to the restaurant. So sometimes we have prices and sometimes we don’t, but when we have them, they’re a little bit like magic.
Now, this magic can be a little puzzling. And indeed, prices have puzzled economists for hundreds, if not thousands of years. You know, why do things cost what they do? You know, say I eat a chocolate chip cookie. Why does that cookie cost a dollar or eighty cents or three dollars, or whatever the range it might be? Why does it cost that amount?
Well, first let’s see the puzzle associated with it. You might be inclined to say, well, a really good cookie costs more. People really like it. You’re forgetting that I said scarcity was important before, but that’s okay. Well, you might say, the more important the thing is, the more it costs. If I say, a house costs $300,000 and a cookie costs $1.00, why does the house cost more than the cookie?
You’re initial response might be, well, people need houses more. The cookie’s a luxury. Therefore, the house costs more. But that’s not really a successful way to think about it.
Think of the following classic example, air. Air is basically free. Take a nice big gulp of it as one advertisement used to say. The air is free. And then things like a diamond are classically super expensive. Economists used to say, “Why is a diamond more expensive than a breath of air?” Well, you already know the answer. The answer, you should say, is scarcity.
There are very, very few diamonds. You have to dig deep in the ground to get the diamond. Transport it thousands of mile, polish it, cut it, do this, do that. It’s a lot of work, it’s very hard to get them, there aren’t many of them. Diamonds are even more valuable than aisle seats on airplanes. Diamonds are expensive. They’re scarce.
Air, it’s available. You just breathe it in. Even where it’s not available, it’s available. If you go scuba diving, you just up at the surface, you capture some air in a tank, tanks are relatively cheap, you go underwater, you can breathe. It costs you just a few dollars. We know the answer to that now. A thousand years ago, that might have been a puzzle, but if I say, why is a diamond more expensive than air… more expensive than a gulp of air? It’s obvious that scarcity is the thing that’s really doing the job.
Now, let’s go back to cookies and houses now. That’s a little bit more complicated. Let’s do cookies first.
I love a good cookie. Imagine that I would pay $10 for a really fantastic, juicy, chocolate chip cookie. My kids always say, there’s no such thing as a juicy pastry. But that’s wrong. A really good cookie is juicy and worth $10.
Now, I’ve never paid $10 for a cookie, even though I would. So I go to the bakery, even my favorite bakery and I walk in and I say, “Oh, how much are those fantastic cookies?” The baker knows that I would pay $10 for the cookie. He can see it all over my face. But he says, “Well, that cookie is $3.00.” Well why doesn’t he charge me $10? I mean, he might check out my face when I walk in and charge $10, but of course, if he did that, I would revert to Todd’s strategy. I would just go out to the sidewalk, I would wait there. I would wait for somebody else to go into the bakery and buy the cookie for $3.00 and they’d come out and I’d give them $3.05 or something for the cookie.
So, sometimes we say, the baker is unable to price discriminate among people. The baker has to sell the cookies at one price because otherwise people will go in and arbitrage the cookies, there will be a market made as Todd tried to make a market for aisle and middle seats.
Well, that doesn’t answer the question of why the cookie costs $3.00. So imagine the cookie sells for $5.00. The baker sees there’s some people who really want the cookie. The baker starts raising his price and charging $5.00. What’s the next thing that will happen? Well other people will see, you could make a lot of money running a bakery. Just gather together chocolate chips, rent an oven, get some flour, get the other ingredients necessary for making chocolate chip cookies and you’ll start making cookies and the price will start dropping as more and more people offer cookies. They’ll undercut one another $4.50, $4.00, $3.99. Until the price goes down to, well… to the amount that it will cost that marginal bakery to produce that chocolate chip cookie.
So prices are inputs are signaling the baker how to make the cookies, the price of the cookie is signaling me about buying the cookie. And my desire for the cookie is bringing new competitors into the industry. In the long run, the price of that cookie will be the cost of combining the inputs. It’ll be based on the cost of supply in the cookie.
In the short run, if there’s a lot of demand for the cookie the price might rise. If suddenly a hundred people, like me, rush into the store and say we all want the cookie, maybe the baker can raise the price a little bit in order to allocate the cookies that are there. But if that keeps happening, new bakers will enter the industry; bakeries will be popping up all up and down the street and cookies will drop to $3.00, which is the cost of producing them.
Let’s compare it to that house. Say you have a house selling for $300,000. What does that mean? It means that builders trying to put together windows and bricks and doors and roofs and subzero refrigerators or whatever goes into the house, they put all those things together and maybe there’s great demand for housing, maybe incomes have risen, maybe a war has come to an end. Maybe somebody can sell that house for $500,000. If so, new building contractors will come in, just like bakers came into that previous market. They’ll start selling more houses, they’ll build houses; they’ll work overtime. And they’ll build houses and build houses and the price for housing will drop, again, until an equilibrium, we say, that marginal builder can produce a house just like that for $300,000. The price won’t drop any further because, by assumption, no builder can show up and put together those inputs for less than $300,000.
One builder might be better at building them than another builder. In that case, maybe that builder can really build a house for $280,000 and make a $20,000 profit. But once we run out of such builders, we’re left with the typical builder who can put the house together for $300,000.
So in the long run, the answer to the question of, gee, why is that house more expensive than that cookie? The answer to that is a little boring, but it’s not scarcity. The answer to that is that, in the long run, that’s the cost of the inputs of putting those things together . It just costs more for the earth, in a sense, to produce the house than to produce the cookie, based somewhat on the scarcity of those inputs, but in the long run because new competitors can come in; the key variable is the sum of the cost of all those inputs.
Once again, prices are messengers. Prices are little messengers that run back and forth. When the price of the house went up to $500,000, it was as if messengers went out and said to builders, “quick, work overtime; build more houses.” They said to the brick kilns, produce more bricks. When the price started dropping, imagine a lot of empty houses all over the place, messengers will run around and say, “Houses are not selling for $300,000 or less because there’s a glut of houses.” Builders won’t get up in the morning to build houses. No need to pound that hammer if you’re not going to get paid for it. The same thing for the baker, the prices run back and forth telling the bakeries when to produce more cookies, when to produce fewer cookies, when to open new stores and so forth.
Prices are messengers. That’s a good thing to know.
CHAPTER HEADING: Demand
Economists like to use the word, “demand,” to refer to the consumer side of the transaction. How much do people want the cookie? How much do people want the new houses?
Prices are probably the best way of measuring the intensity with which people prefer something.
And again, prices are a way of calibrating demand.
The more people would pay, the more the good was in demand. What we saw though was, in the long run, for competing objects like cookies in a bakery, houses on the housing market, in the long run, it was the cost of supplying them that mattered the most.
But there are exceptions to this. You know, imagine, you know, a trendy fashionable handbag. The cost of a designer putting together this handbag might really be $40. But the handbag might sell for 10 times that. Now that’s kind of an exceptional market and it’s worth thinking about what’s going on there. There are knock offs, of course, and the very same designer can produce more handbags. But in the short run, the designer seems to figure out that selling this handbag for $400, way above the cost of the inputs, that is, the cost of the assembly of the handbag, somehow triggers the market.
The higher price, in this sense, seems to attract people to the good for a while because it’s a fashion trend or a signal to them that this is a hot item to buy.
There are people who want to carry this handbag because it’s unique or there are people who are maybe who are even signaling, “Look, I can afford a $400 handbag.” Well, that’s not going to last long, right? We don’t see a fashion trend like that lasting very long because in the long run, people will produce competing bags or that designer will produce more of the bag or there will be knock offs that will be so good that nobody can tell them apart.
Same thing with sneakers. You know, I have boring running shoes and even more boring shoes. And I pay, you know, maybe $80 for them. All around me, I see colorful, trendy footwear that’s actually cheaper to assemble, canvas and a rope practically, but they cost much more money than that? Again, why is that? Well, that’s the demand side. That there’s a short-term fashion trend, in a way, where people really want the thing, thousands of it are made, they need to be allocated, they’re allocated by the price mechanism. The higher price, in this sense, seems to attract people to the good for a while because it’s a fashion trend or a signal to them that this is a hot item to buy.
Again, that doesn’t last long. We’ll learn more about this later on in the lecture when we turn to housing bubbles. There could be a bubble for something like sneakers. The price could go way, way, way up before more sneakers flood the market or the fashion goes out. I don’t think you will ever find a bubble for chocolate chip cookies. Now that is basically based on the cost of assembling the cookie, and many, many other people can enter the industry and produce the cookie and drive the price down. It’s hard to imagine a sustainable bubble for cookies. Handbags, some kinds of housing, certainly sneakers, they can be sold for a period of time at above the cost of putting them together. And it’s something that we need to keep track of.
A long time ago, before you were born, there was no internet. I know that’s hard to believe, but trust me, I was there and it’s true. And in the world before the internet, prices weren’t just little messengers; I think it’s fair to say that prices were everything. There were classified ads in the newspapers and they were all about price. You know, wanted, 2006 Audi, $4,000. Everything was associated with a price. Billboards were about prices. McDonalds’ ads were about prices. Prices are, after all, key information. They are those messengers that I keep talking about.
But there’s an interesting development in the internet world, which is that as we have more and more information about goods, my observation is that more of the information is about non-price attributes of goods. So for example, if you go on Amazon and you want to buy a book, I mean, the price is there. It’ll give you the retail price and they’ll tell you what a good price you can get from Amazon. But probably 95 percent of the information is reviews from readers or the condition of the book, if it’s a used book. There’s a great deal of information that’s being provided that’s not about prices. I think that’s a function of the internet. It’s much cheaper to convey information now than it was 100 years ago. And as a result, we have not just prices, but a great amount of non-price information.
And this might also be a result of affluence. You know, once upon a time, I might have said, “Ohh, I want to go on vacation and stay in a hotel. How much is a hotel on the English seaside?” And then I would get an answer. Now, oh now, well do you want air conditioning? Do you want a big room, a little room, how many square feet do you want? I mean, there’s a lot of information that goes into this. And this is probably a function of an affluent society where people don’t just want a hotel room in England, they want a particular location, they want a kind of room, the right ambiance, and a lobby and all of that information is being provided with 360 degree accuracy on the internet. So it may be that we are moving to a period where although prices are messengers, there are many, many more messengers out there and it’s these non-price attributes, as economists would call them.
CHAPTER HEADING: Arbitrage - Creating a market
A couple of Thanksgivings ago, I was sitting on a packed airplane. I was lucky enough to have an aisle seat. Sitting next to me was a really nice, tall, very tall student named Todd, and we chatted a little bit. And he asked me what I did for a living and I told him. And as soon as I told him that, he said, probably correctly, “Oh, well I guess you’re comfortable talking about money. “Listen, how about trading seats with me for $50.” I was a little bit startled. And Todd said, “You know, I’m a really big guy, I’m six-foot-eight, these middle seats cramp me. I really, really want an aisle seat. So every time I get on a plane I’m in a middle seat, I try to bargain with the person next to me to get the aisle seat so I can stretch out my legs. Fifty bucks?” I said, “Sure.” I don’t really mind the middle seat that much, and besides, maybe the guy in the window seat was interesting like Todd.
Let me ask Todd to tell me more about his bargaining for these seats. And he said, “Actually, now that you mention it, I’ve probably asked people 12 or 15 times to sell their seat to me for $50, and you’re the first person that’s ever did it.” Well, actually one time, he said, about two years ago, he was really frustrated but nobody had ever accepted his offer and he said to the person. “Okay, I’ll give you $300 for that aisle seat right now.” And as if commanded to do so, the person on the aisle said, “$300? Sure.”
Now think about Todd a little bit and the study of economics. We saw that economics was about the allocation of scarce resources. It’s the study of how we allocate scarce resources. Well, the scarce resource is the aisle seats. There are fewer aisle seats than people who want them. It’s scarce, at least on that airplane. Now also, there’s no market. Todd wishes there had been a big market out there where you got on the plane or you got on your computer and saw which seats were available and which seat you want and you could bid for your seat. Todd apparently was willing to pay $50 to get an aisle seat, but at least so far, no airline is saying, “oh, you can move to the aisle seat if you give me $47.80. So Todd was trying to create the market on his own. Of course, it’s a complicated market, in a sense; he had to create two markets. He had to sell his middle seat, and buy an aisle seat.
Now people do that on Wall Street and they make hundreds of millions of dollars. On Wall Street, we call it arbitrage.
They look for things that they think are mispriced where you can make money by selling one thing and buying another thing and maybe doing them backwards and forwards many, many times in a day. That’s in a way what Todd was trying to do, except he didn’t have a well-developed market. Todd wished there had been these markets, but he said he had to make them. He was trying to arbitrage middle seats and aisle seats.
Todd’s not the only one who really wants an aisle seat. And it makes you wonder how airlines allocate these seats. Some airlines do it by first come, first served. When I buy a seat to travel, I get on and I click and it offers me to change seats and it shows me the available seats, but there’s no way for me to trade with people who acquired seats before I did. Some airlines do it with a queue.
Southwest Airlines, for example. If you get up early in the morning or you have an automatic program, app, and you check in and you’re on of the first ones to check in, you get a good number, you’re at the front of the row, front of the line and then you can get whatever seat you want.
Some airline sell you seats in the sense that I guess Todd could buy a Business Class seat or a First Class Seat by paying much, much more money. So there are many ways that we allocate things, prices are only one of them. But prices are special.
Economists would say that prices are a means of showing your intensity of preference. If you really want an aisle seat, you pay $50 for it. If you really want an aisle seat, you might pay $120 for it. Similarly, if you don’t care, you might sell, you might sell to the low price or the high price.
Prices can be thought of… now pay attention to this. Prices can be thought of as little messengers that run back and forth between people who want things and people who can supply them. When I click on the website and I say, “Oh, I want this seat.” The seller, that is the airline now knows, “Oh there’s somebody out there that really wants that seat and might pay more for it.” And similarly when the airline lowers the seat on the plane or raises the seat on the plane, it’s signaling me how many of those seats it has and it’s trying to figure out whether I want that seat.
When I flew on Thanksgiving, I paid a lot of money for the seat. When I fly on a Sunday morning in the middle of February, the prices of the seat are much lower. Right? The airline’s programs sees when there’s more and more demand for seats on the airplane. When there’s more demand, prices start rising because it wants to allocate the scarcer source and I don’t just mean the aisle seats, I mean all the seats. It wants to allocate that scarcer resource so that people who will pay the most for it, ‘cause that’s how the airline will make more money. And similarly, when the program sees that the airline is about to fly half empty, it drops the price precipitously in order to attract people who are only willing to fly at a lower price.
So we’ve been talking about cookies and about houses and they are sold in competitive markets. Again, by competitive markets, I don’t mean anything complicated. Just that there are many buyers and sellers running around trying to service one another, get the business, buy the thing at a lower price and all of that. Those markets are the foundation of economics; economists spend a lot of time on competitive markets.
But not everything is sold on a competitive market and maybe less so than ever.
For example, non-profits occupy the healthcare field. Non-profits are important in education. Non-profits are important for supplying goods to poor people and so forth.
Governments are not competitive firms. They’re either monopolists or something else. Governments supply a lot. They supply a national defense and firefighting and national parks and schools and this and that. And then they are also monopolists. Monopolists again are single sellers, traditionally. They have a market all to themselves. Think about all the monopolists that we know. IPads are sold on monopoly markets because Apple has patents on critical aspects of the iPad.
Now you might say, well, an iPad has competitors of other tablets or PCs more generally. But there are a lot of people who really want what the iPad can offer them. So to some degree, Apple has a monopoly on selling iPads. To some degree it’s a competitor selling in the PC market or selling in the tablet market.
Many goods are like that. Say a new animated film comes out. I want to go see the movie. The maker of the movie has a copyright on that movie and can decide in what movie theaters that will be sold, which is to say, viewed. And in a sense has some control over the price the movie is shown. They can offer the movies as direct download; they can offer the movie in hardcore form or whatever you like. Well, again, is that a perfect market? Is that a monopolist? It’s somewhere in between. I don’t have to go to the movie. I might be just as happy to go to another movie or go to a concert or a baseball game. But to a degree, people who want to see that movie are stuck getting it from that supplier of the movie, which has a monopoly over the copyright.
Professional football games have that kind of monopoly. Again, no one has that monopoly on a chocolate chip cookie. The chocolate chip cookie is a commodity practically. Nobody has that commodity on an ingot of steel. You can produce that, it’s a commodity; it’s all over the place. It’s like water and air.
So there are many things, healthcare, government services, firefighting, iPads, a bridge over the Mississippi River connecting Iowa to Illinois. That’s a pretty effective monopoly because no one’s going to get permission to build eight bridges right next to each other and compete. So again, what we might think of as a situational monopoly over there.
We’re going to spend some time now moving to monopolies as probably the best example of these non-competition forms of selling things. And we’re going to see many lessons out of that, but we’re going to keep track of prices as we do it.
So again, to review where we are; prices come largely from costs, they also come from supply and demand. As we’re about to see, that’s remarkably so for monopolists where the demand is going to play an important feature in the price the monopolist charges.
Let’s examine those prices and messenger systems a little bit more carefully by thinking at the same time of an example where the airline is now not a competitor, where many, many airlines are flying, but let’s now begin to introduce the idea of the monopolist. That is the seller who does not face competition, but is the only one selling these seats.
CHAPTER SUBHEADING: Big Air; airline as monopolist
Let’s try an example together. Imagine that Todd was flying on a plane and to make the example as simple as possible, imagine the plane was owned by an airline called Big Air, for lack of a better name, and that Big Air was the only carrier flying between the two cities Todd and I were traveling. Say it was Boston to LaGuardia Airport in New York. So I have a chart here, of course I made it up, but it’s a pretty realistic chart in a way. And it shows that as Big Air charges more and more for a seat on the airline; any seat now, I’m done with aisle seats for a while. As Big Air chargers more for a seat on the airline, fewer people will want to travel on Big Air. Either they won’t travel to New York or they’ll drive, take the train, walk, donkey, what have you. But let’s have a look at it.
If they charge $50 a seat, 10,000 people will want to fly to New York that day. Wow! If they charge $5,000 a seat, basically, no one wants to go. Ten spoiled snobs will fly. And there you go on the bottom, $5,000, 10 seats. Big Air will collect $50,000 for those of you who are math challenged, that’s $5,000 times 10, just count the zeroes, see four zeroes. Put the four zeroes on the right.
And then in the more realistic range, at a price of $300, we see that 2,000 people will demand seats, that is, want to accept the offer to travel from Boston to New York on Big Air at that price on that day. And so, if it sells 2,000 tickets at $300 each, Big Air will collect $600,000 in revenue. I haven’t said anything about their costs yet.
If it raises the price more to $500, well it gets a lot of people, 1,000 of those 2,000 people will still want to pay for the seat and they’ll pay $500, but of course, 1,000 people then will not fly. So I’ve constructed the example so that Big Air takes in the most money when it charges $300. And again, you might be thinking, well what about $270, or $320. I’ve excluded all of that to make the example as easy as possible.
It’s not free for Big Air to fly to New York. It has costs. And as we known, these costs are very, very important in figuring out when to fly, how to fly, and what to charge. So here, I’ve reviewed the information that you have already in the first two columns and then I’ve put in some information about costs in the third and the fourth column.
Now, think of Big Air just charging $50, that sort of crazy low price, 10,000 people wanting to travel. We know that Big Air would have taken in $500,000 in revenue. That was in our previous slide. Well what does it cost Big Air to fly 10,000 people? And I’ve put in some huge number. You know, imagine that it costs and average of $300 a person, which would be $3 million to fly so many people. Why does it cost more, rather than less per seat when it wants to fly more and more people? Well, to a degree, when you start increasing the number of seats, that is, when you increase production or output, as we call it. To a degree, costs drop. You know, think about the pilot flying the plane. If you only have one passenger on the plane and you’ve got to pay the pilot, say $1,000 a day to fly the plane, then that $1,000 is bourn entirely by the customer sitting in seat 1A.
You put 10 customers on the plane, same pilot; the pilot’s salary can now be spread among 10 customers. So that’s relatively fixed cost of the pilot, that fixed cost drops or becomes a less important price as we have more and more customers. That would explain why, when we have a price of $5,000 with only 10 people flying, the average cost of flying is, say, $3,000 in the last line of the example. And that’s because there’s a pilot, there’s an airplane, there’s a ticket counter, there’s buying landing rights at LaGuardia, there are many fixed costs that now are divided among 10 people; 10 rich people. And then for the average cost of flying each of those persons is very, very high.
As you can see, working your way up from the bottom of the chart. When Big Air increases the number of passengers from 10 to 1,000, by dropping the price from $5,000 to $500, it gets what we sometimes call, economy to scale, it’s able to spread the pilot cost and the airplane costs and the landing costs and all those things I mentioned among more and more people, and so the average cost of sending someone to New York drops, in this case from $3,000 too $200.
Notice it stays there for a while and then it rises once they go to 10,000 seats. And why might that be? Well, they’ve probably run out of landing rights at LaGuardia. I mean, where would you land 10,000 people a day more than the system now holds. I can’t even imagine. They might buy away landing rights from other airlines at LaGuardia. They might fancifully suggest to the mayor of New York that Central Park needs **** and we put landing strips in Central Park and unload people there all day. It’s very hard to imagine how you could fly so many people so quickly every day from one city to another. And so I’ve imagined that the prices would rise a great deal. This is realistic for most things we make. That is, in the beginning, the price drops as you increase output and then eventually the price rises. Sometimes we say that the marginal costs rises over time.
Well now if we put these two trucks together, we can see how Big Air would make the most amount of money. That’s usually its job. We say that firms are trying to maximize profits. Again, we imagine the firm's a rational player that has a goal, and in this case its goal is to make as much money as possible.
Well, look at the example. When it charges $50 and those 10,000 people fly and land in Central Park, Big Air loses money. It spends $3 Million, but we saw that it takes in revenue of only $50 a seat times 10,000 is $500,000. It loses $2.5 million. Big Air never wants to do that. What about $300 a seat. Well that’s pretty good for Big Air. If prices of seats are $300, 2,000 people show up to the airport, that’s $600,000 in revenue and then by our assumption from the previous side, it costs Big Air $200 per seat to fly these people there for a total of $400,000 in costs. And as you can see, it yields a $200,000 profit.
Big Air can even do better if it charges $500 a seat, even though it only costs Big Air $200 to fly the person, by raising the price to $500, it loses half it’s customers, loses 1,000 people. Flies just 1,000 people, collects $500,000, $500 a seat times 1,000 seats. And its costs are $200,000. And so we can see that here is where it maximizes its profits hauling in $300,000 in net profit.
So we’re thinking a little bit about exactly how that happened and what might be good or bad about it. And so I really want to focus your attention on it. Think about Big Air’s price structure there. It was able to supply the seat for $200. And yet it figured out that it should charge $500. Let’s look at it first from Big Air’s point of view, and then from the 1,001st customer’s point of view.
From Big Air’s point of view, when it dropped the price… if it tries to drop the price from $500 to $300, in a way, you might think, well how can that be a bad thing? They’re going to take in 1,000 more customers who are willing to pay $300 a seat for the privilege of flying, when it only costs Big Air $200 a seat to supply the airplane and seats. So of course, you’d think Big Air would make more money by lower the price to $300. Indeed, any price that can charge above $200, it can make money. Costs me $200 to make the seat, I charge you $212; I chalk up another $12 in profit.
But Big Air in this example is a monopolist. Big Air is the only one flying, and so Big Air sees and says to itself, well wait a minute. If we drop the price from $500 to $300 in order to capture those extra people, we’re giving up charging $500 to the first 1,000 people we flew. After all, we have to charge everybody the same price in this example, like my cookie guy at the beginning of the lecture. So is it worth it to Big Air? No. Because when it drops the price from $500 to $300, it loses $200 a seat from the first 1,000 people. And it’s not worth losing $200,000 from those more intense, desired inframarginal customers, if you will, in order to make $100,000 from the new 1,000 people who will pay $300 a seat when it costs $200 to fly them.
So Big Air instead chooses, no. We will restrict output, we say, and fly at $500 a seat selling then… selling just 1,000 seats rather than 2,000 seats.
From a social point of view, think about it from the outside or even from the government’s point of view or the citizenry point of view. This is really a shame. After all, the cost of the resources of flying somebody to New York is apparent $200. And there are people out there willing to spend more than $200. Think of it as a resource, ecology thing. The costs of the resources on earth are such that for $200 you could fly another person from point A to point B. And that somebody out there willing to spend $300 for it, that person has a intense preference compared to the actual cost of doing it, but we deny them the flights. We say, “No, no. Because I am a monopolist and I can make more money at $500, I don’t want t sell it to you at $300.
Economists call this a deadweight loss. They say, boy, that’s a shame. There should be somebody, there is somebody willing to supply the seat at a tad over $200, even $300 in our example and that if somebody wants to pay $300 for it and yet we’re not matching them up. Now you’ve already seen that if this was a competition, if there were 10 airlines out there flying, of course another airline like my cookie maker would jump right in there and say, “Oh, come here, come here. We’ll fly you to New York. Give us $300… we can fly you for $200. It’s a great deal.” But again, because Big Air is a monopolist, it’s the only one flying this route and the demand structure; the prices are, as we’ve seen, Big Air will choose to restrict output to sell only 1,000 at $500 a seat.
We’re not quite telling you the truth in this example. Think, as I said, about that 1,001st customer. There is a customer there who sees that she’s willing to pay $300. Sees the price at $500. It’s as if she wants to whisper to the President of Big Air and say, “Okay, okay look. I understand that you don’t want to lower the price because then you’ve got to lower it to everybody else and you’ll make less money, but how about if I don’t tell anybody. Just sell me a seat for $300, I really want it badly; give me a seat for $300. It only costs you $200 to supply it, and then instead of making $300,000, you’ll make $300,000 plus the $200 profit… the $100 profit on selling me the seat.” Well, I guess if Big Air could trust her not to tell anybody about this and not to resell the seat to somebody else, Big Air would do it. But the important part **** is that we see that this deadweight loss leaves customers unhappy, if you will. Unsatisfied. There are, again, 1,000 people willing to pay at least what it costs to supply that seat and they’re not getting their seat.
Now, in the real world. Big Air does a little bit of each. Anybody that has flown an airline knows that sometimes the person next to you has paid much more or much less the seat for you. Anyone in the real world knows that Big Air, in fact, can do a little bit of this. They can have it both ways. If you're flying on an airline and you talk to the person next to you, you might find that they paid much more than you paid for your seat or much less than you paid for your seat. Big Air does not quite have to charge everybody the same for its chocolate chip cookie, if you will. There is an ability for it to control arbitrage. Now in this case, it does it by saying, “ Your ticket is non-refundable and non-transferable.” You can’t sell it back to us and just buy another ticket when the prices drop. And similarly, you can’t just go to the airport and trade it with other people.
They may do this maybe hiding behind a false claim about security or identification or something. I mean, it’s not entirely obvious why we let them do that. But for the time being they can do that and this allows them to discriminate in a way. That’s not meant as a terribly bad word here, it’s a word economists use to differentiate among customers. They are able to take the people who want to pay a lot of money and charge them a little bit more and take the people who want to pay closer to $200 and charge them less.
So in real life, Big Air discriminates among customers. And we will return to that in a minute. But in our example, we are assuming no ability to discriminate. It’s like the chocolate chip cookie of the house; you need to charge everybody the same amount perhaps because people could exchange tickets or something. And again, in that example we’ve now seen something pretty important. That the thing economists and governments don’t like about monopolies is this problem, and I’m going to call it a problem, that even though there are people who would pay more for the seat then it costs to supply it, they don’t get a seat. It’s Big Air’s restricting of the seats from 2,000 to 1,000 in order to make more money, in order to make $300,000 rather than $200,000 that is the source of this problem. And that problem is called by economists, deadweight loss.