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ECON20110 Fall 2013 - Lecture 10: Regulation — Transcript

by Glen Weyl · 7,953 words · 1,202 segments · language en · Watch on YouTube

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0:01uh we'll start by talking about
0:03Solutions when Monopoly is natural and
0:06those Solutions will be in the form of
0:08basically regulations and subsidies so
0:11we'll start by talking about when
0:13Monopoly is natural versus unnatural
0:15we'll talk about the ideal solutions to
0:17the natural monopoly problem and why
0:19these ideal Solutions fail we'll then
0:22talk about second best Solutions in
0:24particular average cost pricing and
0:27other reasons other than regulation why
0:28natural average cost pricing to the rise
0:31we'll talk about the distortions that
0:32are caused by average cost
0:35pricing uh and the dynamic
0:38distortions uh as well as the static
0:41distortions we'll then talk about how
0:43selection relates to the distortions of
0:46average cost pricing uh selection we
0:49talked about in the cost
0:51lecture that different customers can
0:54have different values or costs to the
0:56firm and then we'll talk about the
0:59empirical applications of that to
1:01Insurance markets as well as a little
1:03bit of policy stuff related to Obamacare
1:06and recent debates about policy for
1:08insurance F okay so today we're going to
1:12focus on natural
1:13monopoly but Monopoly can also be caused
1:16by forces other than quote unquote
1:19natural forces and myy what are some of
1:21the non-natural causes of
1:26Monopoly like would intellectual
1:28property be
1:31that's one can you think of others
1:35uh like government
1:37run yeah so those are two good examples
1:40so intellectual property either by
1:43patents copyrights Trade Secrets or
1:47government protection and that will be
1:48the focus of maybe not the next lecture
1:51May to lecture after that uh lobbying uh
1:54for protection from the
1:57government um
2:00another form is private or illegal
2:03violence um that's very important for
2:06the mafia for drug gangs
2:10Etc uh and they often control sin
2:13Industries uh or gambling that way as
2:16well as illegal Industries um and the
2:19right solution to that sort of Monopoly
2:21problem is basically law enforcement
2:23right and um there are also temporary
2:28advantages that people can get by being
2:30the first to the market and this tends
2:33to resolve itself over time um and
2:36transparency or lower bureaucracy for
2:38entry other things that Aid entry can
2:40help resolve that yeah REI
2:44exor yeah very temporary yeah uh yeah
2:48Evan would collusion be considered in
2:50this category or is it something
2:52else um that's a good question uh where
2:57would I put collusion is collusion
2:59classified is Monopoly or well it can be
3:01if it's perfect collusion it's usually
3:03not perfect collusion so it's usually
3:05not exactly the same
3:08but yeah I mean you could think of that
3:11as in some sense private or illegal
3:12violence like it's like they have some
3:14contract that they're enforcing to close
3:16the market yeah philli
3:20uh I guess I was thinking about
3:23collusion um created by one company like
3:28buying all the other although I suppose
3:30that uh if there was still free entry it
3:33couldn't G well I mean that that that's
3:36related but again I I think that the
3:38reason I would classify that in with
3:39private illegal violence is that law
3:41enforcement is really the way to get you
3:43know deal with that and law enforcement
3:45against mergers law enforcement against
3:46collusion Etc so okay but things are a
3:50little bit trickier when Monopoly is
3:52natural or inevitable and Christian what
3:55does it mean for a monopoly to be
3:56natural um it means that your long R
3:59average cost is decreasing so basically
4:01there's um economies of scale so it's
4:04most efficient for just one firm to
4:05produce all yeah so that's sufficient
4:09condition but actually you can get um
4:12econom you can get natural monopoly even
4:14without that so in particular if there
4:18are
4:21um if you have what's called
4:23subadditivity even if you don't have
4:25economies of scale throughout the whole
4:27range uh you can get natural monopoly so
4:29the average cost curve is like that so
4:32there's economies of scale over here but
4:34not over here and demand Cuts there then
4:38it's cheaper to have one firm producing
4:42than to have two firms producing where
4:44they'd have to produce at a higher uh
4:47cost even though there's not economies
4:49of scale through the full range does
4:51that make
4:53sense um okay the key question is
4:56whether there's economies of scale over
4:58the relevant range
5:00uh and up to the relevant point where
5:02demand Cuts so that can mean that even
5:05at the point of demand there's a little
5:06bit of diseconomies of scale as long as
5:08there's enough economies of scale over
5:10to the left to compensate okay so uh
5:14Ming what are some examples of a natural
5:16monopoly um Electric utilities and
5:20stuff y
5:22telephones those are good examples uh
5:25social networks are another natural
5:27monopoly because everyone wants to
5:29interact with each other on one network
5:32uh monitoring of income is another thing
5:35that I think is basically a natural
5:37monopoly because once I'm monitoring one
5:39person's income it's much easier to
5:40monitor another person's income than to
5:42do that separately because I can sort of
5:45if I'm moderating everybody's income
5:47together I can uh check that all the
5:51numbers line up with one another because
5:53the income has to be going from
5:54somewhere to somewhere else and so I
5:56think that's an important reason why
5:57government like Central izes the
6:00collection of taxes rather than farming
6:02it out to a lot of private companies um
6:06public transportation in many settings
6:08is a natural monopoly as well because
6:10you don't want to Overlay the public
6:12transit Network you just want to have
6:14one set of things operating there okay
6:17so here is a picture like I drew here
6:21where even though there's dis economies
6:23of
6:24scale it would still be more expensive
6:26to have two firms producing right
6:31okay um so the simplest solution to the
6:36Monopoly uh natural monopoly problem is
6:38just to mandate that prices are at
6:40average cost marginal cost sorry but
6:44usually if we have economies of scale
6:46through the full range marginal cost
6:47will be below average cost at the point
6:51uh that you want to mandate this follows
6:54directly from there being economies of
6:55scale and thus marginal cost pricing
6:57would require a subsidy and that would
6:59require that the government pours some
7:01money in not just that it forces prices
7:03down but that it also raises tax revenue
7:06and gives that as a subsidy um and that
7:09tax would have to come from some or all
7:11consumers via say an income tax a sales
7:13tax Etc which we'll talk about those
7:16types of taxes more in the electron
7:19redistribution um so some examples that
7:22are like that is that much public
7:24transportation actually makes a loss the
7:27Postal Service makes a loss most
7:29government services make losses in order
7:31to provide things at marginal cost or
7:34sometimes even below marginal cost
7:35prices yeah Christian so like the thing
7:37we Dre there with the slight dis
7:39economies of scale would marginal cost
7:41pricing still be better because marginal
7:43cost is actually yeah so there's
7:45actually going to be two we'll talk
7:46about this in a minute but if you think
7:48the marginal cost curve is going to
7:51come
7:56um so you know marginal cost might be
7:59like
8:00that so actually there's going to be too
8:02much production if you had average cost
8:03pricing here marginal cost pricing would
8:06actually lead to a higher price in a
8:07lower quantity and we'll talk about that
8:10in a minute
8:12actually
8:17um okay so all of these Solutions
8:19however require a lot of information so
8:21if we want to
8:22do uh marginal cost regulation then
8:25we're going to need to know the whole
8:27cost curve right because we need to Reg
8:29things down to cost and not just to
8:32average cost which we could check by
8:34like auditing the firm's accounts but we
8:36need to know what is their cost if they
8:37expand by one more unit right um and
8:41then we have to determine the subsidy so
8:42we need to know average cost as well
8:44right and this uh information problem is
8:49pretty severe because if the price
8:53that's charged is determined by marginal
8:56cost then the firm has a huge incentive
9:01to just raise its inframarginal costs in
9:03order to obtain more subsidy right
9:06because that it isn't even required to
9:09raise its price in order to do that
9:12right if it just says oh we had all
9:14these infam marginal costs they can just
9:16load up the government with a huge bill
9:19uh and that has no impact on how much
9:21they're even selling in the market or
9:23you know whether they're able to operate
9:25so that can be a major problem another
9:28approach that we could take was we could
9:29give pigouvian subsidies right but this
9:32would require knowing a fair bit about
9:33demand we wouldn't know need to know the
9:35whole demand curve but we would need to
9:37know it slope because the subsidy that
9:39you need to give remember is equal to
9:41the marginal consumer surplus which is
9:42equal to the slope of the uh price curve
9:45multiplied by the quantity so we need to
9:48know that or another solution which
9:51we'll talk about in the next lecture is
9:53allowing the firm to perfectly price
9:54discriminate but that would require
9:56knowing all of the consumer's
9:58willingness to pay the firm knowing all
10:00the consumer's willingness to pay and if
10:02we didn't want the firm just to make all
10:04those pro profits we need to have some
10:06way to extract that total willingness to
10:08pay from The Firm via some sort of
10:10competitive bidding which would require
10:12that there be a bunch of people who know
10:15what it's worth to have that Monopoly so
10:18that's again another reason uh why
10:20marginal cost pricing or any other
10:22perfect solution to Monopoly is
10:24difficult finally um the there's a major
10:28question under margin marginal cost
10:30pricing as to whether the service is
10:32worth creating at all if you charge
10:34marginal cost prices and there's
10:37positive demand but the firm is making a
10:40loss you have to give a subsidy and it's
10:42not clear whether the consumers would
10:44have been willing to pay for the
10:46service uh at all right so imagine that
10:49there was
10:50a
10:53situation where you
10:55know average costs were like this
10:58marginal cost
11:00were like that and
11:03demand was like this well then clearly
11:06it's not worth creating the service but
11:08at marginal cost pricing you couldn't
11:09know that because you wouldn't know that
11:11the demand curve was like sitting all
11:12the way below the average cost curve
11:15yeah uh can that happen even when there
11:17was previously an equilibrium uh in the
11:20in the markets
11:22like was pricing above cost okay no so
11:25but you'd have to like have some
11:27mechanism where the monopolist like okay
11:31so here's how it could happen Julian so
11:34the monopolist if he anticipates that
11:36you're now going to afterwards bring him
11:37to marginal cost pricing he might be
11:39willing to like charge some price and
11:42pretend like there was a
11:43market right and say that he was making
11:48like profits but actually he was making
11:50losses so that you would then bring him
11:53to the situation where he gets subsidies
11:55so it you know you'd have to do that for
11:58quite a long time and you'd have to be
12:01forced to take losses for quite a long
12:03time in order to screen that out but
12:04that would also require having Monopoly
12:06pricing for a while see so
12:09yeah okay so
12:13um another problem is what's called
12:16regulatory
12:18capture so that's the idea that
12:20regulation can easily become a means of
12:22corruption if you're giving all these
12:24subsidies because The Regulators can
12:27become sort of cozy with
12:29uh the regulated firms uh and because
12:32consumers are diffuse it's hard to
12:35monitor that The Regulators are actually
12:37doing their jobs and there's quite a lot
12:39of evidence that this happens um in
12:42practice though organized consumer
12:44groups can help combat this and this
12:47tends to happen most when things are
12:49very opaque when it's hard to for
12:51consumers or outside individuals other
12:53than the regulator and the firm to know
12:55what the firm's costs are
12:58right um um and Austin uh in what sense
13:03is this just another version of the
13:05information problem how is it similar to
13:07the information problem well I guess
13:09it's similar in the sense that this
13:11whole like asymmetric information
13:13between the regulators and the regulator
13:16makes it easier for them to kind of get
13:18away with it and also yeah between the
13:21regulators and the people that they are
13:23supposedly accountable to yeah I think
13:25that's the most important thing is that
13:27really um there's an ometric information
13:29problem between the regulators and the
13:31regulated but if they're cozy with each
13:34other well then the real isometric
13:36information is between both of them and
13:39whoever is monitoring them the consumers
13:41so in some sense the regulatory capture
13:43problem is really just another version
13:45of the asymmetric information problem
13:48and therefore the way to combat it is to
13:50try to have transparency as much as
13:52possible or some ideological group
13:56that's in charge of monitoring those
13:57Regulators that have interests closer to
14:00the consumers so for example I think one
14:02reason that environmental regulation
14:04Works quite well is that there's all
14:05these environmental lobbying groups that
14:08like sort of monitor to make sure
14:09whether the EPA and other groups are
14:11doing a good job and not only are there
14:13those groups but there's people to even
14:14monitors those groups which is that like
14:17there's a whole environmental movement
14:18and people know about like what's good
14:19and bad for the environment and you
14:21learn about that in schools and so forth
14:23all that information that people have is
14:25what keeps environmental regulation
14:27working well and what makes fin iial
14:29regulation for example works so poorly
14:31is everyone thinks finances just
14:32complicated they don't know exact they
14:34don't like you know Bankers but they
14:36don't know exactly what they don't like
14:37about them you know people don't really
14:39have any coherent thing and I think
14:40that's the reason why Financial
14:42regulations work so poorly and will
14:43continue to until we build that sort of
14:45a movement Yeah Austin so I know after
14:47the deep water Horizon disaster that
14:49talking about this whole regulatory
14:50capture problem would you say then that
14:52like the core reason for that would just
14:54be because the whole like Ultra de water
14:56Z is so complicated nobody understands
14:58it see even though everybody you know
15:00likes I think that the more complicated
15:03something is and like and in fact people
15:05create complexity precisely in order to
15:08try
15:09to yes sty the reg you know so I think
15:13there's a case for like keeping the way
15:15that something works relatively simple
15:17precisely for the purpose of allowing
15:20transparency all the way back to the
15:23public um okay so
15:27um to address some of these concerns in
15:31practice it's more common to use average
15:33cost than marginal cost pricing this is
15:35also called rate of return or Cost Plus
15:38regulation because usually the firm is
15:41allowed to earn some quote unquote
15:43profit but that's not really Pro
15:44economic profit it's just the return on
15:46the capital Investments that they made
15:48in the past um and these profits are
15:51cover cap some low rate to cover uh the
15:55Investments that were
15:57made um and a simp static model of this
16:00is just average cost pricing now um
16:04let's talk about what some of the
16:06benefits of average cost pricing are
16:08over marginal cost pricing we'll soon
16:10talk about some of its costs uh Joan uh
16:13what are some of the benefits that you
16:15think average cost pricing could have
16:17over marginal cost pricing um it would
16:19probably be easier to capure the average
16:21cost
16:23you yeah that's right it's easier to
16:26audit also it doesn't require subsid
16:29from the outside because the firms don't
16:31take losses and that makes it easier
16:32politically uh and it helps with other
16:35issues it it makes it less uh easy to
16:38corrupt for
16:39example
16:42um one only really needs to know the
16:44average cost at a single point you don't
16:47need to know what the whole curve looks
16:48like and if consumers are willing to buy
16:51at the average cost price then the
16:52product must have been worth creating
16:55right so average cross pricing lessens
16:58the information problem along a number
17:00of
17:02Dimensions um so to implement average
17:05cost pricing uh we usually use in the
17:10west uh in in oecd countries rate of
17:14return regulations on private companies
17:16but sometimes uh you could also use
17:18State
17:19ownership um a example of a private
17:23regulated firm is Comm Ed Edison which
17:27uh does the electricity here in
17:29Chicago and comad is a firm that owns a
17:34bunch of different Utilities in
17:35different parts of the countries and
17:37there's regulatory boards either State
17:39local or federal that oversee these
17:42things and they're usually made up of
17:44experts so for example the Illinois
17:46Commerce Commission is the one that
17:47regulates ComEd and sometimes there's an
17:51initial auction of the rights to run the
17:54um these sorts of concessions so the
17:56Federal Communications Commission does
17:58this with with the rights to the
18:00Spectrum uh and then there's an
18:03extensive team of Auditors that monitor
18:05prices look into the uh costs of the
18:08firm uh and they usually have a lot of
18:11economists as well um now these
18:15institutions usually have some
18:16combination of both economic and
18:19political goals political goals include
18:23Environmental Protection uh Equity so
18:25like you know making sure the poor don't
18:27have to pay as much
18:29uh as well as the protection of some
18:31politically important uh groups yeah
18:33Evan did you have a question yes how do
18:35they avoid collusion in these
18:37auctions oh well we'll talk about
18:39collusion and auctions later in the
18:41course but uh there's lots of theory
18:44about dealing with collusion and auction
18:47I mean that's not to say they always
18:48Implement an auction that's robust to
18:50collusion sometimes they do one that's
18:51very collusion proof partly because of
18:54reg I mean prone to collusion partly
18:56because of regulatory capture but there
18:58are certainly strategies for trying to
19:00avoid collusion in
19:01auctions
19:04um okay so um average cost pricing is
19:08actually quite common in a bunch of
19:09areas of the economy Mike fosco could
19:11you give some other examples of where
19:13average cost pricing is
19:15is um I assume monopolies that we have
19:19for the government that they it's not
19:21worth the marginal cost utilities maybe
19:24or yeah so uh what would you what was
19:28the second example
19:30pipelines pipelines are usually
19:32privately owned
19:34actually
19:36um well then the uh electricity yeah so
19:40we just talked about
19:41electricity um can you think of any
19:44others
19:47uh I mean intellectual penss maybe but
19:51those aren't
19:52regulated so those are people can charge
19:54whatever price they want for those
20:00so I mean there's other utilities right
20:03like water heating
20:06Etc uh there's also public transit
20:08infrastructure so some of that is
20:10charged at marginal cost prices but some
20:12of it's actually required to make back
20:14the costs of building it and so they're
20:16allowed to charge higher prices to make
20:18it back
20:20telecommunications uh has been in the
20:22hist history regulated according to
20:25average cost so in the United States
20:27AT&T used to be an average cost
20:29regulated uh Monopoly in the United
20:32States and then it was broken up in the
20:331980s to create competition but now
20:35they've all merged back together and
20:37we're getting back to maybe an
20:39unregulated
20:40Monopoly and more broadly sometimes you
20:43can bring lawsuits especially in some
20:45developing countries against firms for
20:48excessive pricing or earning too much
20:50profit and effectively that acts as an
20:52informal form of average cost uh
20:56regulation okay so average cost pricing
20:59can also result from free entry right if
21:01anyone can enter into the industry and
21:03there are a large number of equal aable
21:05managers it's not rocket science to
21:07figure out how to run the firm and
21:09there's no barriers to entry then
21:11anytime a firm is making profit we
21:12should expect that to bring an
21:14entren uh and some firms might even try
21:18to price lower close to average cost so
21:20that they don't have a lot of profits
21:22that would tempt in an entrant to come
21:24and enter against them so some have
21:27argued that equilibrium must therefore
21:29involve zero profits and average cost
21:32pricing um and uh this is a very common
21:36assumption in many economic models as we
21:39talked about earlier in the uh course
21:42I'm not sure it's that realistic because
21:43of firm heterogenity that might make it
21:46hard to imitate the best firms but it's
21:48often a reasonable Benchmark way of
21:51looking at things um so sometimes we get
21:54average cost pricing not from uh
21:56regulation but just from the competitive
21:58process
21:59and the key uh problem with that is that
22:02average cost pricing is not the same as
22:05marginal cost pricing and therefore
22:07average cost pricing will not be
22:08efficient so when marginal cost pricing
22:10leads to losses because marginal cost is
22:13below average cost then average cost
22:15will be above marginal cost by
22:16definition and therefore average cost
22:18pricing will lead to uh lower quantities
22:21and higher prices than uh marginal cost
22:24pricing will do and that will lead to a
22:26distortion a downward Distortion in the
22:27quantities and that's not dissimilar to
22:29the Monopoly Distortion but it's usually
22:31not as extreme the wedge rather than
22:34being between price and marginal revenue
22:36is between average cost and marginal
22:37cost which actually looks quite a bit
22:40like the wedge between price and
22:41marginal revenue it's equal to the
22:43negative of the slope of the average
22:45cost curve times the quantity the same
22:47way that it was the negative of the
22:48slope of the price curve uh times the
22:50quantity for um for the Monopoly
22:54Distortion now this in turn depends on
22:57the size of the market and the slope of
22:59the average cost curve but remember that
23:02it's also possible to have marginal cost
23:04that's above average cost and we'll talk
23:05about that in a minute but let me first
23:07just show you a picture of this yeah
23:08philli uh I didn't see any reference to
23:12the slope of the marginal cost curve in
23:14that equation that be relevant
23:17potentially not necessarily so it's
23:19actually no no one ever draws pictures
23:21this way but it is possible to have for
23:24example in in this picture a marginal
23:27cost curve that's in increasing and yet
23:29still is below the average cost curve
23:33and that uh can lead to um that can
23:36still lead to exactly the same
23:39issues uh yeah bar right um so in the
23:43example of like ComEd yeah uh there's
23:46also
23:47like I guess externalities of them
23:50producing like you might want them to
23:51produce less or to be be optimal U
23:54because of carbon yeah uh so in that
23:58case so that like favor maral cost
24:00pricing as opposed to average cost
24:01pricing well that would lead to you to
24:03favor average cost over marginal cost
24:05because average cost is higher than
24:07marginal cost
24:09typically oh right so in either case
24:12there's still like a distortion in like
24:14the optimal quantity rate yeah I mean
24:16usually we try to address these things
24:17separately by like having a pigouvian
24:19tax plus you know cost pricing but but
24:23yes in principle those two things can
24:25cancel out to some
24:27extent um
24:29uh yeah RI in the last slide you have
24:32something about the harger triangle yeah
24:34harburger triangle is what's here okay
24:36uh so here's the where the demand curve
24:39meets marginal cost that's the socially
24:40optimal Point demand curve me meets
24:42average cost is the uh equilibrium point
24:45and there's this Distortion between them
24:47which is this hard worker triangle yeah
24:50philli I think what I wanted to say is
24:53if marginal cost instead was just a
24:56flatline through e then the Distortion
24:59would be different in this case it would
25:01be bigger so intuitively it seems like
25:03the Distortion should depend on the
25:06marginal the slope of the marginal cost
25:09too if it was flat through
25:13E Yeah but if it was flat through e then
25:15the average cost wouldn't look like it
25:17looks like oh I see the average cost
25:19will half this okay
25:22that um okay
25:25so most classical
25:29distortions sorry uh this is the most
25:31classical Distortion and the one that's
25:33talked about most but um and maybe it's
25:36most important but um there are other
25:40distortions that can come from average
25:42cost pricing so one thing is that the
25:44market could fail to exist at all and
25:46Ming how could that happen sorry the
25:49market could fail to exist at all
25:51because of average cost pricing even
25:52though it would be socially efficient
25:53for it to exist how could that
25:56happen uh
25:59sorry I'm backing right now um does
26:02anyone else want to try to discuss that
26:04uh yeah Phillip uh in an insurance
26:07Market if heterogeneity well let's not
26:09talk about insurance markets I'm just
26:11talking about average cost pricing now
26:12like in a context of a
26:16monopoly uh yeah Wesley well I mean on
26:19that graph the second graph on the board
26:21you had a demand curve that didn't
26:22intersect average cost so then but but
26:25that was a case where it wouldn't have
26:27been valuable to create the market at
26:28all at all right right right so the
26:29firms wouldn't see a reason to enter the
26:31market yeah but but that's not bad it's
26:34not a distortion right because so that
26:37thing is what we would call a white
26:38elephant a white elephant is something
26:40where like you know it's not even worth
26:42creating at all but you know if you
26:44didn't have it's worth creating but they
26:47won't do it yeah so how could that work
26:49yeah Adam well it like maybe above the
26:52cuz that like goes below the marginal
26:54cost maybe it's like above that but then
26:57below the average cost curve then or
27:00would be a social benefit yeah that's
27:02absolutely right so um with average cost
27:06pricing there's no entry if demand is
27:08below average cost but that doesn't
27:09necessarily mean that there's no social
27:11value because demand could be below the
27:14AC but above the MC so in particular
27:17what you need to construct is something
27:19called the average utility curve which
27:21Bears the same relationship to the
27:22demand curve that the demand curve Bears
27:24to the marginal revenue
27:26curve um in particular it's the integral
27:30it's the gross consumer surplus divided
27:32by the
27:33quantity um and comparing this to
27:36average cost determines whether the
27:37market should exist at all or not so
27:42um basically the average utility curve
27:45would be up here and then even if there
27:47were some fixed cost which caused the
27:50average cost curve to like look like
27:52that you could figure out whether the
27:53market should Exist by whether the
27:55there's a point where the average
27:56utility curve lies of the average cost
28:00curve um so if the average cost curve is
28:05uh above the demand curve what you get
28:07is called death spiral so imagine that
28:10the quantity in the market were this
28:12well then in order to break even the
28:14firm would have to charge this price
28:16right but then that would mean that the
28:18quantity would be this but then it would
28:19have to charge this price and so forth
28:22and it collapses down to zero Yeah
28:25Austin there any real examples of death
28:27spirals
28:28oh yeah we'll talk about a bunch of
28:30those soon but I mean there's certainly
28:32like Goods that could be created where
28:35like there's no way you could make
28:36profit off of like enough profit to like
28:39compensate it but it would still be
28:40worth creating like I think a lot of
28:41drugs are like that because the thing is
28:43like any price you charge you don't make
28:46back your Revenue but uh the total value
28:50that you bring to Consumers is
28:52greater yeah because the thing is
28:53there's all this infr marginal consumer
28:55surplus that you're not capturing so
28:58unless you can perfectly price
28:59discriminate that can definitely happen
29:00so is that like the reason for like
29:02orphan drug pricing yeah I think well I
29:05mean but the thing is you need to give
29:06subsidies to the firms to research them
29:08you know what I mean so but that's one
29:09reason why I think we give subsidies to
29:11R&D is exactly that yeah tan you say an
29:14infer marginal what exactly does that
29:16mean infer marginal means like uh like
29:21people value the thing more than they're
29:22paying for it so they're like not a
29:25marginal consumer they're not someone
29:26who's just indifferent they're someone
29:27who values it more yeah Phil um are
29:31there situations where where average
29:34cost pricing causes a de Barrow it's
29:37possible to have a stable Monopoly price
29:40that result results in the market
29:43existing uh no so the re we'll talk
29:47about that in a second actually I think
29:48we're going to talk about that in a
29:49second let me just
29:55see no okay so no it's it's not and the
29:58reason is that if the the monopolist
30:01will never charge a price where he makes
30:03a loss if he were to charge a price
30:05below the average cost price then he
30:07would have to take a loss
30:09right and no monopolis would ever want
30:11to take a loss so monopolies will always
30:13charge prices that are weekly above the
30:15average cost price and therefore anytime
30:18average cost pricing leads to Market
30:19collapse Monopoly also leads to Market
30:22collapse so the Monopoly is always going
30:25to be at least as bad as aders elction I
30:28mean as as as uh average cost
30:33pricing okay so um now if marginal cost
30:38is greater than average cost there will
30:40also be a distortion and what what's the
30:41nature of that Distortion Austin so that
30:43would be basically excessive Supply yeah
30:46that's right so why is that well
30:49marginal cost above average
30:54cost would be great social yeah EX
30:58exactly um so this leads to excessive
31:02overs Supply so here's an example of
31:04this so if the average cost is
31:06increasing and the marginal cost is
31:07above the average cost then um there
31:11will be entry sorry uh average cost
31:13pricing will lead to too much uh Supply
31:15in the
31:17market okay so
31:21um at least as important is the effect
31:26uh that at least as important as is
31:28these static distortions is the effect
31:30that regulation has on longer term
31:32incentives so companies can often easily
31:36affect their costs by making efforts to
31:39cut cost or to cut workers that are not
31:41necessary by innovating to create more
31:44efficient production processes by
31:46choosing cheaper over more expensive
31:49inputs uh and two years ago the problem
31:52said how do you guys look at this but
31:54unless all of these things are
31:55controlled or monitored by a regulator
31:57the firm is going to have no incentive
31:59to reduce costs if they're getting
32:01average cost pricing right in fact the
32:04if the regulator tries to learn about
32:06what your cost is in order to regulate
32:07you you might have actually have an
32:09incentive to increase your costs so an
32:11example of that is that my father once
32:13worked for a defense contractor and this
32:16defense
32:17contractor um was like pitching a weapon
32:20system to the government and he found
32:22out a way to like bring the weapon
32:23system about 50% under budget and he
32:26pitched it to the general was in charge
32:28of the project the general said I would
32:30be der electing my duty to my country if
32:32I didn't spend every penny that was
32:35budgeted for this project and the reason
32:38was that uh he knew that Congress would
32:42reduce their budget if it realized that
32:45you could do it more cheaply right um so
32:50uh the now other uh causes of average
32:56cost pricing can have similarly perverse
32:58effects so if a comp like if average
33:01cost pricing just results from free
33:02entry and competition no company's going
33:04to want to innovate to reduce its cost
33:06because it knows that other companies
33:07will just um enter and uh eliminate the
33:11profits that it makes off of that right
33:13and we'll talk about ways to deal with
33:14that in lecture
33:1613 now one important cost uh source of
33:19nonlinear costs is selection and this is
33:22something we talked about in the lecture
33:25on costs right in markets where
33:29different consumers have different
33:30values to the
33:31firm
33:33um uh that the cost curve for the
33:37industry as a whole will be uh not flat
33:41so consider the cost to the government
33:43of covering everyone in society for
33:46insurance and let's let Q be the
33:49fraction of people that are covered and
33:52let's let P be the prevailing price
33:54right we can then create a demand curve
33:56which corresponds to if the price is
33:59this what fraction of the population
34:01will get coverage right and the cost
34:03curve is not going to be linear because
34:05the first people that want insurance
34:07that are willing to pay a lot for
34:08insurance may be more costly or less
34:11costly than the people who want
34:13insurance at lower prices so in
34:16particular there will be adverse
34:18selection if the riskiest people are the
34:21we say that there's adverse selection if
34:23the riskiest people the most costly
34:24people are the first ones into the
34:26market in that that case what would be
34:28the slope of the curves
34:30Austin the SL of the cost curves yeah
34:33actually
34:34Downes yep why because as you basically
34:39exhaust the more risky people you move
34:41towards less and less risky exactly
34:43exactly this is like the new healthcare
34:44legislation in predicting young healthy
34:48people are not looking Insurance yeah
34:50absolutely
34:55um uh if there's add advantageous
34:59selection uh we said there's
35:00advantageous selection if the people who
35:02are first into the market are the um
35:05most healthy uh and uh Austin could you
35:09give me a story of why that uh might be
35:11the case um so I could think in the case
35:15of like crop insurance for instance you
35:17have only the most educated you yeah uh
35:20most educated most like well-versed
35:22farmers are the ones getting crop
35:23insurance because they understand the
35:25whole like cyclic nature of of crops and
35:28so they're going to be the cheapest to
35:29Ure as you go further and further out
35:30you get to like family comies that just
35:32don't understand the LA nature what why
35:34would those people be more costly oh
35:36because they're just worse Farmers
35:37basically yeah worst Farmers firstly the
35:39good people understand yeah another
35:41thing you could think that's similar to
35:42that is like if people if like it's the
35:44hypochondriacs that most want uh health
35:48insurance because they're afraid they're
35:49going to get sick they probably also
35:50take the best care of their health right
35:53um and of course you get a mixture of
35:56these things over different ra ranges of
35:58course this is the cost curve for the
36:00industry as a whole rather than for an
36:02individual
36:03firm but um because insurance is sort of
36:06a social concern we can think of things
36:09in these terms so then selection is
36:12really the slope of the cost curve um
36:16and the slope of the average cost curve
36:19is enough because that'll give us the
36:21wedge right because remember that the
36:23difference between average and marginal
36:24cost is the slope of the average cost
36:26curve times the quantity and this is
36:28exactly what that inov 2010 paper that
36:30we talked about measured so again just
36:32to remind you of what we talked about
36:35when we did that there's a large
36:36aluminum manufacturer that offered two
36:39different plans like a low insurance
36:42plan that only covered minimal things
36:44and a high insurance plan um the first
36:47plan uh yeah and individual division
36:51managers within the firm were allowed to
36:53choose the price gap between these two
36:56plans and they claimed that this was
36:58sort of random that the managers just
37:00did it for whatever reason I think
37:02that's a questionable uh
37:04interpretation uh I'm not sure that it
37:06was really that random but if this is
37:08right well then those random prices will
37:10generate different fractions of people
37:12choosing the two plans and you can look
37:15at both the fraction of people who
37:16choose the plans but also at the claims
37:19of people to figure out whether that
37:22leads to higher or lower costs and this
37:24allows them to draw out the average cost
37:26curve and therefore the marginal cost
37:27cost curve and to figure out the
37:29Distortion okay so just again let's look
37:33at what they did so
37:36um they looked at divisions that charge
37:38different prices they looked at the
37:40quantities the fraction of people who
37:42choose the two plans based on that then
37:45they looked at the claims data and
37:46looked at the average cost corresponding
37:48to each one of those things and they
37:50drew a demand curve they drew a linear
37:52demand curve I probably would have
37:53driven some drawn something a little bit
37:54more concave but anyway they drew a
37:56linear demand curve curve through these
37:58points and a linear uh average cost
38:01curve that allows them to generate a
38:03marginal cost curve and to trace out the
38:06Distortion associated with adverse
38:09selection so if you just look at that
38:12picture that seems to indicate that
38:15adverse selection is pretty small I mean
38:16there is some but it's not a huge
38:19Distortion right quantity goes down to
38:22about 65% of people being covered from
38:24about 75% so it's not a it's not like
38:27the market collapses or anything like
38:29that um and that was a little bit of a
38:32let down when people found that because
38:34people had been expecting people have
38:35been talking for years about these
38:36adverse selection problems how they
38:38could destroy markets doesn't seem so
38:40bad here um but the question is uh you
38:44know what uh where is all the adverse
38:47selection that people had been expecting
38:49so Florence why do you think they might
38:51have found so little adverse selection
38:53in that study um
38:58not entirely sure but it might have been
39:02just
39:06uh sorry I kind
39:08of not
39:12exactly well so remember that that was a
39:16market where there was insurance
39:20right and what would you expect to
39:22happen if there's really really extreme
39:23adverse selection uh if it's if there's
39:26already been a lot of adverse selection
39:29and you would expect people not to offer
39:31insurance at those
39:34plac exactly so in some sense under
39:38extreme adverse selection the market
39:40would collapse but if the market
39:41collapsed we couldn't draw this picture
39:44right all the quantities would be down
39:46to zero right so the very fact that we
39:48can even draw this picture says there
39:50can't have been that severe adverse
39:52selection right and that's what Nathan
39:55hendin realized
39:57um so he uh did something very clever to
40:02investigate this um in particular he
40:07looked at markets where you can't
40:09purchase insurance at any price where if
40:12you have certain conditions they just
40:14say no we reject you we won't give you
40:16an insurance at any price that was
40:17actually one of the issues that
40:18Obamacare was trying to deal with
40:21um and so he wanted to ask whether
40:24selection was the cause of of that
40:28problem and so he looked at a survey of
40:31individuals who had these conditions
40:34asking them to reject How likely they
40:37thought it was that they were going to
40:38end up being hospitalized or getting
40:40sick or whatever and then he looked at
40:42whether they actually got sick and he
40:43correlated those things to figure out
40:45how much people knew about whether they
40:46were going to get sick or not and he
40:48used that as a proxy for whether adverse
40:50selection was very strong or not right
40:54um and in fact you can do this with
40:56these average and marginal cost thing so
40:57what he did is he basically said let's
40:59order everybody in terms of the chance
41:01of them getting sick and let's say if we
41:04were to charge this much for insurance
41:07what would be the average cost of people
41:09who would be willing to buy insurance at
41:10that rate and he used that to figure out
41:14basically how large of a like tax
41:19premium you'd have to pay in order to
41:21get insurance depending on what these
41:23distributions of private information
41:25were right
41:28um and in particular you do that on the
41:30first unit of insurance because if you
41:32have such severe adverse selection on
41:34the first unit of insurance you wouldn't
41:35expect people to have any insurance at
41:37all right and so here's what he found he
41:40found that um if you look at things
41:43where there wasn't rejections where you
41:45could buy insurance if you paid enough
41:48the private information looked like this
41:49it was pretty tightly clustered so you
41:51know if these people were buying
41:53Insurance well the average would only be
41:55around here right average cost and if
41:58these people were buying Insurance well
41:59the average cost would be around here on
42:02the other hand if for the areas where
42:04people are getting rejected if you if
42:07these people were buying Insurance well
42:08the average cost would be up here right
42:10and that would be really really high and
42:12so he showed that basically the
42:15effective tax you have to pay on
42:16insurance is about 75% in the markets
42:19where people got rejected and it was all
42:22around 10 or 15% in the markets where
42:24people didn't get rejected and that
42:26roughly corresponds to these pictures
42:29over here where the wedge was quite
42:31small right yeah go ahead so I'm a
42:34little confused about how you were like
42:35Computing cost there like yeah um what
42:37does the xais represent so this is like
42:39basically how much how sick you expect
42:42to
42:43get uh and so like you know imagine the
42:46people above this point are the ones who
42:48are buying Insurance well then the
42:50average is not going to be that much
42:51above the marginal but here it's going
42:53to be massively above the marginal right
42:55yeah Evan so wait this is what estimate
42:57their probability is like of getting
42:59some some bad condition yeah yeah Phil
43:03what are you talking about exactly when
43:05you say tax tax is this wedge it's like
43:08this difference between average and
43:09marginal cost because the thing is your
43:11cost is only the marginal cost but
43:13you're forced to pay the cost of the
43:14average person so it's effectively like
43:16a tax on
43:17insurance is the difference between the
43:19dotted line and the uh solid line the
43:23wedge no the difference between the the
43:27wedge is at this point what would be the
43:30average cost of people who who are have
43:33a higher cost than you that's the wedge
43:36because you're forced to pay for them
43:38rather than for
43:41yourself okay so the same types of
43:45approaches that we took to solving
43:47Market power
43:49problems um sorry to solving the
43:52Monopoly problem can solve the average
43:55cost uh Distortion here so if we wanted
43:57to have something more like marginal
43:59cost pricing we'd have to do things
44:01similarly here so for example we could
44:03give subsidies for buying
44:05Insurance um and uh Ming why would that
44:10create some of the similar problems uh
44:14that we discussed marginal cost pricing
44:16creating uh previously um so previously
44:20we discussed that subsidies for marginal
44:22cost pricing would problem because of
44:25the lack of information we have about
44:27the cost functions so the so I guess a
44:30similar thing that we would not have
44:31very good information about what exact
44:33cost with dealing with when want to
44:35subsidize people yeah so I mean people
44:37often Advocate giving subsidies for
44:39insurance but this requires you to know
44:41what like the marginal cost curves of
44:43are currently which we we have really no
44:46idea so when they set up Obamacare they
44:48set these subsidies but who knows what
44:49the right subsidies were they just sort
44:51of made them up right um another thing
44:55you can do is have a man date for
44:58Universal coverage and Mike fosco what
45:00what are some of the problems that you
45:02think that might create well depending
45:04the price theing the average costs then
45:08you're not really you'd have to price
45:09discriminate for everyone and then they
45:11have to accept all but what if you just
45:13forced everyone to buy insurance what
45:15could be bad about that people in there
45:17but then the people are healthier would
45:18have to pay a higher price than they
45:20would have to yeah but that's not
45:21socially inefficient necessarily so the
45:23question is what would the social
45:24inefficiency be that there's an
45:26oversupply
45:28yeah so the B big thing might be that it
45:31might not be optimal for everyone to get
45:33insurance but some people might have a
45:34lot of moral hazard like Insurance might
45:37make them like way over consume
45:40Healthcare right and that might be a
45:42real problem right and uh so it might be
45:46inefficient for them to get insurance
45:48like they might not have very many risks
45:49but but if they get insurance they might
45:51like take advantage of the medical
45:52system in all sorts of ways and they
45:53would know that it's not efficient for
45:55them to get healthare but they would now
45:57be forced to and then they would waste a
45:58lot of money so that's a major problem
46:03um cost based discrimination is another
46:06thing we could do we could charge
46:07different costs to everyone uh different
46:10prices to everyone based on their like
46:12expected cost and that could reduce the
46:14possibility of adverse selection but
46:16Philip what problems do you think that
46:18might create well it's as shown in that
46:22diagram with the residual private
46:24information even when the firm tries to
46:26get get as much information as possible
46:28they still don't manage to extract
46:30everything cuz the consumer mates yeah
46:32so that's one good thing is that like
46:34consumers might know more than the firms
46:37know um but another problem with it has
46:40to do with distribution right so if we
46:43charge everyone the costs of um of
46:48insuring them that can defeat a lot of
46:50the point of having Insurance in the
46:52first place so imagine you don't have
46:54long-term insurance that lasts your
46:55whole life but it's every year and every
46:57year based on whatever conditions you
46:59have you have to pay a different premium
47:03that would be a mess right because then
47:04if you got cancer on December 15th you
47:07would suddenly have to pay for the full
47:08cost of your cancer treatment right you
47:10wouldn't get any of the benefit of
47:12having insurance so like it sort of
47:14defeats a lot of the purpose of
47:15insurance to have that sort of
47:19pricing anyways we're done really early
47:22today so anyway I'll I'll make it up at
47:25the 900 p.m. on Monday when I'll answer
47:28your questions about the midterm if you
47:29have any questions about the midterm you
47:31can ask them now as well and otherwise
47:34good luck studying

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