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ECON20110 Fall 2013 - Lecture 5: Industry Supply and Rents — Transcript

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0:01okay while he's doing this I'm going to
0:03get
0:04started so today we're going to consider
0:06the um aggregation of individual firm
0:10Supply functions to um to an industry
0:15Supply we'll uh start by doing that by
0:19adding up uh the supplies horizontally
0:23and deriving um and using the concept of
0:28entry points points uh
0:30of on the price in which the firm enters
0:32into the industry to do that um and
0:36because some firms will enter at um uh
0:41this will create uh Kinks and possibly
0:45even
0:45discontinuities in uh the in aggregate
0:49supply but uncertainty about those entry
0:51points will tend to smooth this out and
0:53and I'll show you how that works then
0:55we'll talk about free entry barriers to
0:57entry and the long run
1:00and talk about how the rents that firms
1:03derive the profits that they earn come
1:05from them being more efficient than
1:06other firms and we'll compare the
1:09textbook analysis in which which you
1:12read about in Varian in which in the
1:14long run entry eliminates
1:16profits um except when there are
1:19barriers to entry to uh an analysis that
1:23all push a little bit under which um in
1:26reality I think a lot there are scarce
1:29Talent that allow people to be in an
1:31industry and that stop people from
1:33entering the industry to drive out uh
1:36profits and so then we'll talk about the
1:38distribution of talent and in particular
1:40Zip's
1:41law
1:44um uh as a
1:47regularity that
1:54um what is this thing
2:02um we'll talk about uh Zip's law as an
2:05empirical regularity on the nature of
2:07the distribution of talent uh in a
2:11society okay uh and then this will set
2:14the stage for many of the things we're
2:16going to be studying throughout the rest
2:17of the
2:18course so deriving industry Supply from
2:21uh individual firm Supply is pretty
2:23simple basically what you do is you just
2:25add up the supply curves horizontally
2:28that is at any given price you sum
2:30together the amount being supplied by
2:32all the individual firms now this is
2:35particularly simple when all firms enter
2:37the industry at uh at Zer at zero
2:41because all that um the supply curve is
2:45in that case is the inverse of
2:47individual firms marginal cost curves so
2:49the aggregate supply is the sum of the
2:52inverse of all the marginal cost curves
2:54at a given
2:56price so um if you then invert aggregate
3:00um Supply itself that will give you the
3:04marginal cost of the industry as a
3:08whole so let's consider a simple example
3:12uh let's imagine that there's an input I
3:14which costs $1 and that we have uh the
3:17production functions uh given here I to
3:22you know times something to some power
3:24etc etc
3:26etc um can uh Christian can you come up
3:30to the board or uh if you want to do it
3:33with paper and pencil you can do it that
3:34way uh derve the total cost associated
3:37with these production functions um I can
3:40do it on the board do we have an eraser
3:42good
3:44question yeah there's one there's one
3:46right there yeah
4:09so Q
4:12=
4:149 I to
4:17the
4:19yeah um then we just want to get I in
4:22terms of Q because we know that each
4:25unit of iot cost $1 so that's the same
4:27as the cost yeah so then we want but so
4:30we just invert it so I
4:33=
4:385 you want me do that for all of them
4:41yeah okay uh then for the next
4:43one uh
4:45I
4:47equals
4:495
4:53q uh for the next one I
4:57equals um 5
5:01there's
5:03q^2 uh and then for the last
5:06one uh I
5:12equal 5 q to be 7 very nicely
5:18done um okay so that's uh exactly what
5:23he just did so now um Austin can you
5:27derive the marginal costs from those
5:30AR request for these yeah
5:54[Music]
5:59I'm not sure okay so those are the total
6:02costs how do you derive marginal cost
6:04from total
6:06cost planking
6:10um marginal cost is the cost of the
6:13marginal
6:15unit the next one right and that is the
6:21rate at which the total changes when you
6:23increase the quantity right so how do
6:26you derive it so it's yes exactly
6:45there's a
6:47trick what do I missing no no no you you
6:50you've got it but there's a trick see
6:52you bring that down and it cancels with
6:53the f n I've set it up that way to make
6:56it easy for you
7:10oh that one's not quite right yeah
7:12that's 10/3 because there I tricked you
7:14by having the trick and then not having
7:18it and then the last one you get seven
7:21there right okay
7:24so uh Ming is Ming here yeah Ming um can
7:30you derive the supply functions from
7:32those marginal
7:38costs sorry no I think it's
7:41okay just
7:57use it's just an inv
8:00yeah so you see we got from production
8:02functions to a total cost by inverting
8:06then we took a derivative then we
8:07inverted again you see it's just the
8:09same steps over and over
8:19again no it's not one over it it's the
8:22inverse
8:25function is it 5 it's Q to 4 is equal to
8:29p and so you have to then find Q as a
8:32function of
8:34P right the marginal cost is set equal
8:37to the price so P equal Q to 4 yes and
8:41then you solve for Q in terms of
8:55P exactly that's the supply function for
8:58the first firm
9:00so then what about the second
9:20FR yeah what's this is this 50 over no
9:24that's 10 over 3 * Q the five shouldn't
9:28be there all
9:37[Music]
9:40right
9:42right and then for this last one he
9:44didn't do it but it's 7even * uh Q 2
9:49fths wait this is the this the
9:52production function yeah but the
9:53marginal cost is 7 * 2 7
10:10exactly you guys see how that works yeah
10:12da can you explain the intuition behind
10:15uh that MTH just really quickly okay so
10:20firms um the production function turns
10:23into the cost function just because
10:26that's how much input you need in order
10:28to produce that output
10:30derivative of total cost is marginal
10:32cost and then marginal C they produce up
10:36to the point where marginal cost equals
10:37to
10:38price right and so you invert the
10:42marginal cost in order to obtain the
10:44supply
10:46function oh in order to yeah
10:50okay
10:52okay so yeah that's exactly what Ming
10:56just
10:57did um
11:00and then the industry Supply function is
11:02just the sum of all of these things
11:04together so to graph um I'm going to
11:08switch the axes so these are the
11:11individual firm
11:13um uh Supply functions that we just
11:16derived and then we add them up
11:18horizontally to obtain this industry
11:20Supply
11:21function okay so this was nice and
11:24simple because all the firms were
11:27entered the industry uh price of zero
11:30that is they were all willing to produce
11:31as soon as the price was anything
11:33positive at all right but many firms if
11:36they have fixed cost would not be
11:37willing to end enter an industry if the
11:40price were very very small they might
11:42require a price that was higher
11:44significantly above zero before they
11:46would be willing to enter the industry
11:47in the first place um so let's go
11:52through uh some examples of that um uh
11:57Victor Victor
12:01Victor you
12:04here um anyone else want to derive the
12:07marginal cost from these total cost
12:09functions uh
12:11reishi uh yeah why don't you come up and
12:14do it or you can just read it off if you
12:17just know what it is but so be q and
12:21then
12:22yeah 13 q 4 + 5 q uh this thing you said
12:28was 1/3 Q
12:29oh sorry uh 1 plus
12:3313 4 + 5 q 7 + 115 Cub yeah exactly you
12:41see how he did that because all the
12:42things were just quadratic right and so
12:44you just brought down the two and that
12:46uh and that give it to you right
12:52um okay so
12:55um those are the uh marginal cost
12:59arrived so um Mitch
13:04Mitch is Mitch here
13:08no
13:10okay uh anyone else want to derive the
13:12supply functions from
13:15those um Wesley
13:18right so
13:23um
13:24just the invert right uhhuh but
13:29uh do these firms want to enter the
13:31industry when the price is equal to zero
13:34would imagine if the price were 1 cent
13:35would all these firms want to be
13:37producing at
13:39all no only when it's profit yeah so
13:42what at what price does each of these
13:44firms enter the industry and then what
13:45is their supply once they've entered the
13:54industry um the price that's the minimum
13:57on their average cost per or where the
13:59average
14:00cost well what is the lowest cost that
14:03any of these firms faces for each one of
14:05them so this firm if it produces zero
14:08its marginal cost is zero what's this
14:11firm's marginal cost if it produces zero
14:14so what price would it be willing to
14:15enter the
14:18industry just one yeah okay right
14:21because if the price is less than one
14:23then they're making losses on even the
14:25first unit right okay so then that would
14:28inter for
14:30yeah okay and then what are their uh
14:33Supply functions conditional on the
14:36mentoring okay well so the first one
14:40Supply function just
14:42be P yeah right and but that would and
14:46that would start out the pressent zero
14:48yeah the second one would be 3 * qu pus
14:53one exactly and that would start at one
14:56exactly okay so it's discontinuous yeah
14:59uh the third one would start at it would
15:03be five * quty pus 4 I mean
15:071 starting at four and then the last one
15:11would be 15 *
15:157
15:17yeah yeah uh remind me of your name
15:20again myy right okay good um if like
15:23assuming these firms were like running
15:27or like already in the market they would
15:29continue to produce until the price was
15:32like the coefficient in front of the Q
15:35right uh yeah exactly so they would exit
15:37if the price was below this was below
15:39the if they were already in the industry
15:41yeah okay so why would they only want to
15:44enter once their fixed costs have been
15:46met it's there's no fixed costs here
15:49everything's marginal costs here we'll
15:51talk about fixed cost in a second I mean
15:53the uh like the the number before the
15:56que like in the second one the one
15:58because otherwise I mean that's like the
16:01lowest cost that they face everything I
16:03mean like imagine that you know on your
16:05first unit all you need to do is buy the
16:09fuel but if the fuel already costs quite
16:13a bit then you're never going to run a
16:15flight unless someone at least gives you
16:18enough to meet your fuel needs right and
16:20that's the point here if like the
16:22marginal cost starts somewhere and then
16:24goes up from there they're not going to
16:25be willing to produce anything until the
16:27price at least gets above that minimum
16:28minimum
16:31level remind me of your name Su sorry so
16:36those are those are cost cost functions
16:38right so those are marginal cost
16:39functions oh right yeah I thought they
16:41were cost
16:42function okay so um if we add all these
16:47things up what we're going to get is a
16:50supply function with Kinks so I'll show
16:52that to
16:53you so the reason is that the individual
16:56Supply functions one starts here and
16:58goes go up like that one starts here
17:00goes up like that etc etc so when you
17:02add them up you get Kinks at the point
17:04at which each firm enters the
17:08industry okay however if they enter at a
17:12positive quantity which will typically
17:14happen when there's fixed costs um there
17:17are actual
17:18discontinuities not just uh not just um
17:23entry uh that causes Kinks so imagine
17:27that you had firms with fixed cost of
17:29respectively 0 256 54s 40
17:3530ths uh and their variable costs were
17:38given by these well then you could form
17:40their average costs as well as their
17:43marginal costs and you have to they're
17:46only going to produce at the point where
17:47the marginal cost is above the average
17:50cost
17:52um but so now they're going to and
17:55they're going to have actually exactly
17:56the same Supply functions as they had up
17:59there because the marginal cost
18:00functions are the same but they're they
18:02going to enter producing in the first
18:05case Zero because he had zero fixed cost
18:07but in the second case when he first
18:09enters he'll the minimum amount he'll be
18:11willing to produce is five and the third
18:13guy minimum amount he'll be willing to
18:15produce is one and the fourth guy the
18:17minimum amount he'll be willing to
18:18produce is 20 because once he enters
18:21he's able to defay his fixed costs and
18:24he'll entered a positive quantity he
18:25needs to sell enough to defay his fixed
18:27costs
18:30um okay so the way you do that is you
18:32look at the marginal cost and that's
18:35going to intersect with the average cost
18:36somewhere this is like one example of
18:37those curves and the entry point is here
18:40he enters at this price but at this
18:43quantity which is greater than zero
18:45right and so that leads under those
18:47curves to these discontinuous Supply
18:50functions for each firm not only are
18:52there Kinks they're actually jumps and
18:54when you add those up you get an
18:55industry supply curve that's jumpy like
18:58that
19:00okay so uh I'm sure you can imagine that
19:03mathematically this is kind of annoying
19:06because it makes it difficult to use
19:08calculus um and it creates some
19:11paradoxes like what if you had the
19:13demand curve and it cut through this Gap
19:15here what would happen exactly right um
19:21yeah Julian right yeah which so what
19:24line is the industry Supply there well
19:28it's this
19:29this thing over here but it's you see
19:31it's all broken up so is it is the
19:33orange line one of the lines that's in
19:35the industry Supply or is it not yes yes
19:38this thing is the industry
19:44Supply I had to graph it as a piecewise
19:46function so it came out a bunch of
19:47different colors but yeah um so if any
19:52firm has a fixed cost then would it be
19:55uh dis like U discontinuous or at least
19:57have some Kinks
20:00pretty much any firm that has a fixed
20:01cost will enter at a it will enter at a
20:04positive price and it will uh have yes
20:08it will have unless it has zero marginal
20:10cost if it has if it is zero marginal
20:13cost then it will enter a price of zero
20:15but it will enter at a positive quantity
20:18uh yeah Austin how kinky are real
20:20industry Supply CS okay uh well this is
20:23what I was going to talk about now um
20:26okay so um
20:30so one question is you know what happens
20:31if demand falls into one of those gaps
20:33is there no Supply there what do we even
20:35make of that now in practice this is not
20:38as big of a problem as it appears for
20:40the reasons that Austin uh was starting
20:42to get at so firms may have entry points
20:46but usually we don't know exactly what
20:47that entry point is for certain right uh
20:50because you know it depends on the
20:53setting and you know uh it's sort of
20:55unpredictable and that uncertainty will
20:57smooth out the supply curve um so if you
21:01think about average or expected Supply
21:03it will be smooth the second thing is
21:06that if the discontinuities are small
21:10then they don't matter very much and if
21:12any given firm's output is a small part
21:14of the industry's output then all the
21:17discontinuities have to be small because
21:19if a firm's total output is small then
21:21its entry point has to be small as well
21:24so in the real world uh individual firms
21:28make a big difference right it might not
21:30be the case that there are like a huge
21:32number of firms in an industry but if
21:34that's true then we shouldn't really be
21:35using a perfectly competitive model
21:37anyway what would really happen if the
21:40demand curve went through one of these
21:41points is that this firm would realize
21:44oh the market is like really relying on
21:46me to supply this extra quantity I'm
21:48going to raise the price up you see what
21:50I
21:51mean
21:54um and uh so just the fact that we use
21:58the price taking assumption sort of
22:00rules out a lot of these kinky things
22:02it's not that things can't be kinky it's
22:04that if they are kinky then or you know
22:07uh have jumps in them especially then
22:09that means that one firm is very
22:11important to the operation of the
22:12industry as a whole and that a oligopoly
22:14model is a better way to think about
22:16things than an a perfectly competitive
22:18model so almost anytime you use perfect
22:20competition it makes sense to assume a
22:22more smooth Supply function because if
22:24that weren't the case then you perfect
22:27competition wouldn't be the right way to
22:28model the problem okay so to get a basic
22:32idea of how uncertainty can um smooth
22:36things
22:38out uh let's take a a simple example
22:43imagine that there are five firms and
22:46each one is only ever going to produce
22:48one unit it'll either produce one unit
22:50or no units right um and so the only
22:53relevant question for the firms is at
22:56what price they'll start producing but
22:57imagine we're on certain about this and
23:00that it follows and don't be too worried
23:02if you don't know this sort of notation
23:04but it has a probability
23:06distribution um that has an exponential
23:09distribution let's say for different
23:11parameters so then the question is what
23:14is the expected industry Supply uh if
23:20this is the probability that any given
23:25firm I running one through five has an
23:29entry price the price at which they're
23:30willing to sell that one unit below that
23:33value um Kim do you know what the
23:36industry Supply would be
23:40then okay so this is the probability
23:44what would be the expected amount that
23:45the industry supplies if the price was
23:47equal to Price p if this is the
23:50probability that the firm will be
23:51willing to sell its one unit uh at a
23:55price less than uh
24:06ke well the amount supplied by Any Given
24:08firm on average right is just the
24:10probability that their entry point is
24:12below the price in the market right so
24:15if we if we ask what's the amount
24:17supplied by all the
24:20firms what what would that
24:23be imagine that it's independent across
24:26firms
24:31sure you have to some yeah you just add
24:34up all those functions right so it would
24:37be 5 - e to the -1 P minus E to -2 P
24:44minus E -3 P
24:50Etc so um this is perfectly smooth even
24:55though each individual firm in fact has
24:58has a jump in its Supply and the reason
25:01is because we're uncertain about the
25:02point at which that jump occurs so the
25:04average production is smooth right so
25:08this is what the individual firm
25:10expected supplies look like and they sum
25:12up to this nice smooth industry expected
25:16Supply um Barett right yeah uh sorry uh
25:21why is there can you explain like the
25:24uncertainty um and like whether or not
25:27they Supply
25:29so the point is that um imagine that we
25:32like we just don't know as an external
25:35Observer and Economist exactly what
25:37point at which the firm is going to
25:38enter the industry right then from our
25:41perspective all we can know is what the
25:42average Supply is going to
25:44be right and that average Supply will be
25:47smooth even though the actual Supply is
25:50going to have these jumps in it you see
25:52what I mean because of our uncertainty
25:54it smooth things
25:56out uh su su su okay you just said that
26:00did you just explain the previous pictor
26:02again like how why like each of the
26:03firms um like how you were able to graph
26:06each of the firms if you didn't really
26:07know what their supply would be well
26:09because this is their expected Supply so
26:12that's if the price is equal to a
26:16certain amount what is the probability
26:18that they're going to be supplying their
26:19one unit right if they Supply their unit
26:21with 50% chance and the expected Supply
26:23is 0.5 if they Supply their unit with
26:26100% chance then the expected Supply is
26:28one how are these probabilities like
26:30determined well by this function that I
26:32gave
26:35you uh yeah D so if you have them
26:38producing different units you just have
26:39the like say a firm produces five units
26:42another one produces seven you just have
26:44that times the probability of that firm
26:46producing that number of units and yeah
26:48so you have you have like you know a
26:51distribution of units produced by one
26:53firm a distribution of units produced by
26:56the other firm conditional on price and
26:58you add those all up horizontally which
27:00is can be a little bit messy probability
27:02wise but this is something we'll use a
27:04lot well like rather than necessarily
27:06having um you know a supply function
27:10we'll have someone who maybe is only
27:11supplying one unit but we're uncertain
27:13about whether they'll Supply it or not
27:15so on average the amount that they'll do
27:17so like for example in auctions in
27:19auctions for example when someone's
27:22buying right you know you think auction
27:25they either buy it or they don't that's
27:26not the right way to think about an
27:27auction right way to think about an
27:28auction is what is the average amount
27:30that they buy where amount that they buy
27:32is the probability of them buying it as
27:35a function of the price that you set
27:37right and so that's how you like form a
27:38smooth demand curve out of an auction
27:40but you don't know what the chance what
27:42they're willing to pay Tanner what's on
27:44the what's the y- AIS me uh this is
27:48price okay price is the y- AIS uh total
27:53units in expectation is on the
27:56x-axis uh yeah Adam um I'm just like so
28:00in the in the real world when you're
28:02trying to figure out a supply curve how
28:04would you know what firms would enter at
28:07certain prices well you don't know
28:09that's exactly the point and so you have
28:11to have some way to summarize the
28:12uncertainty you have about that and you
28:14use probability distributions to do that
28:17so you say well look I don't know but
28:18it's probably approximately this and it
28:20probably has a spread of this you know
28:23and you use a probability distribution
28:24to do that and we'll talk about one
28:25particular probability distribution
28:27that's useful the pred distribution
28:29because it's a good approximation to the
28:30distribution of talent um so all yeah
28:34yeah so in this graph is like the blue
28:36firm or you're like the least likely to
28:38enter early exactly yeah exactly so like
28:44you know at this price well we're
28:46getting on average like half the firms
28:48entering because on average we're like
28:50halfway up their curve and at this price
28:52like you know most of the firms are
28:54likely entering and so we get the you
28:56know higher the chance that all of them
28:58are entering is getting higher and
29:00higher
29:02okay so in these pictures firms were
29:06earning uh positive profits right
29:09because um on average say imagine that
29:12the price were this on average this firm
29:15is going to be producing for a price
29:18that's way uh is going to be willing to
29:21produce at a price that's way less than
29:22that and so on average they're going to
29:23earn a profit that's equal to the area
29:25in between right
29:28um so uh what determines the size of
29:32these uh
29:34Kim what determines the size of the
29:36profits that the firm
29:41earns how much do they produce yeah so
29:45the more they produce the more profits
29:47they're going to earn right what else
29:49what else plays a role in determining
29:53that yeah so but but but can you give a
29:57little bit more of a sense like in the
29:58graph or intuitively what that relates
30:03to so like let's look back at this
30:05picture which of these firms is earning
30:07the most profits at any given
30:13price the blue
30:16one well the blue one is the one that's
30:18least likely to produce so he's not
30:20going to be earning it these guys who
30:22produce more are more likely to be
30:24earning it but also it's not really the
30:27fact that at this price they're
30:28producing that much more because they're
30:29really not producing that much more it's
30:31really that they would have been willing
30:32to produce at lower prices right the
30:35fact that their curve stays flat until
30:38you get towards the price right that's
30:40what uh makes them make a lot of profit
30:43right or wouldn't that um wouldn't that
30:46be produ of surplus as opposed to profit
30:49yeah let's call it prod you can call it
30:51whatever you want they they're basically
30:52I view them as the same thing so
30:56um so so this is um but remember that
31:02the prices in a market are determined by
31:03how much everybody else produces by an
31:06intersection between supply and demand
31:08right and so what's really important
31:11given that that um you know imagine that
31:14we had a demand curve that was down like
31:16this right it would be mostly everybody
31:18else's production that would determine
31:21what the equilibrium price was right and
31:25so what really matters is how much more
31:27efficient you are than everybody else in
31:29the market how much profit you're going
31:31to earn right so I view it as there
31:35being two basic sources of rents under
31:38perfect
31:39competition one is that you're able to
31:41produce more because you're able to keep
31:43your marginal costs down for a longer
31:47range of
31:48quantities but the second and maybe more
31:50interesting thing is that at the
31:54marginal cost price at the pr the market
31:58uh price if your average costs are
32:01really low relative to the marginal
32:05costs of everyone else in the market
32:07then you're going to be making a lot of
32:09profits so what does that mean you
32:12always produce up to the point where the
32:13price is equal to your marginal cost
32:16right but you're going to make more
32:18profits the higher those marginal costs
32:21are relative to your average cost now
32:23what would you call some I would call
32:25something where the uh marginal cost is
32:28much higher than the average cost very
32:30stressed or stressed out why would I say
32:33that because it means that on the margin
32:35they're producing a lot less than
32:37they're producing on average that is
32:39like their productivity for the next
32:41unit is much lower than their average
32:43productivity overall if you think you
32:45know if you when you get stressed out
32:47right it's because you're being asked to
32:48do so much that you know on the margin
32:52you're not able to achieve very much uh
32:54because you have so much in but uh on
32:58average you're much more productive than
32:59that your sort of capacity has been worn
33:01down to the point where you're much less
33:03productive and what this says is that in
33:05a competitive
33:07equilibrium you actually want to be
33:09stressed out the more stressed out you
33:11are the more rents you're making because
33:14if you're someone who's extremely
33:15valuable right people are going to want
33:18you to do a lot up to the point where
33:20you're no longer uh that valuable on the
33:23margin right uh so when you see people
33:26who are stressed out like you know the
33:28best doctors the best restaurants that
33:30are overflowing with people uh you know
33:33talented people are constantly having to
33:34turn down off that's the logic of the
33:36market right uh at work yeah Tanner can
33:39you explain the first part the stretches
33:42of bar well that just means that you can
33:44keep that marginal cost low over a wide
33:47range of quantities so like you can keep
33:49producing at low marginal cost so that
33:52allows you to produce more than the
33:54other person so so the uh earning R the
33:57stress margin means you keep it low for
33:59a long time so there are two different
34:00things the first one is you want to be
34:02producing a lot which requires you to
34:04keep your marginal cost low over a wide
34:06range but then given how much you're
34:07producing you want your average cost to
34:09be low relative to your marginal cost at
34:11that point so you want your marginal
34:13cost to be low relative to everyone else
34:15but your Mar cost be high relative to
34:16your average cost exactly okay yeah hey
34:19Mike is that why in the previous graph
34:22uh the best firms are the ones making
34:24most profits have very like flat curves
34:28exactly
34:32exactly
34:36um okay so um a natural question is
34:43shouldn't these profits that firms are
34:45earning attract other firms to enter the
34:48industry and this is a very classic idea
34:51that in the long run if there's free
34:52entry firms will earn no
34:55profits um
34:58another way of putting this is that it's
34:59only short-term advantages that allow
35:02firms to earn profits so for example you
35:04know in California there was a gold rush
35:06and all the people who were on the spot
35:08when the gold rush started made a lot of
35:09money but then everyone rushed in and
35:11all the profits went away and people
35:12lived pretty miserably right um and you
35:16know anytime someone has profits someone
35:18else will try to imitate them so for
35:20example Groupon came into the market but
35:23they didn't really have anything all
35:24that distinctive and very quickly
35:25everyone copied what they were doing and
35:28they uh you know are not doing so well
35:30now
35:32um similarly if one firm has a better
35:34technology than another firm you should
35:36expect other firms to switch to that
35:38technology so they can more effectively
35:40compete so for example Apple was like
35:42you know one of the first companies to
35:43really come out with one of these
35:45Touchscreen cell phones but very quickly
35:48after that because they didn't have
35:49anything to protect them on that other
35:51firms entered to imitate them right and
35:54on the other hand any firm that uh is
35:57making losses uh will want to exit the
36:00market and there's a very famous onion
36:02story about this that I that I love uh
36:06that I'm going to read to you
36:09uh on
36:12AR yeah well so this is BAS this is sort
36:15of illustrating the idea by its uh fa
36:19failure so
36:25uh you guys can just read it yourself
36:27house
36:57okay so so that's the principle that not
37:00only free entry but also that any firm
37:03that doesn't produce anything that's
37:04worth any money uh should should have to
37:07exit the market right
37:09um and as a result the long run supply
37:13curve should be flat at the minimum of
37:16the average cost curve where the average
37:18cost curve is defined over all possible
37:20Technologies firms could use and every
37:22firm is just being is viewed in this
37:25Vision as just being using one short run
37:28technology now that's not quite true it
37:30doesn't quite have to be flat even in
37:31this view if there's a small number of
37:34firms and entry occurs at a non-trivial
37:37fraction of total quantity because then
37:39demand needs to grow by enough to make
37:42it worth another firm entering right so
37:45if the price you know if you get price
37:48going up to here right then another firm
37:52will enter down at this price because
37:54they wouldn't be willing to enter until
37:56you got to this price right so you
37:58because of that lumpiness you might have
38:02uh it being a little Jagged like this
38:05but again as the number of firms gets
38:07large right those problems uh as we
38:11mentioned go away so what you um see is
38:16you know there would be a little bit of
38:18steepness here but as more and more
38:19firms entered uh all those firms would
38:23be adjusting right and so the amount of
38:26steepness would get lower and lower and
38:27lower uh yeah Christian and usually
38:29those jumps like if we're approximate
38:31with a flat curve the jumps would happen
38:32at trivial quantities yeah at very small
38:35quantities when there's a small number
38:36of firms in the industry right but again
38:38perfect competition wouldn't be a very
38:40good assumption in that case right okay
38:43so this um process of competition can of
38:47course be inhibited by government policy
38:49or by private violence um and these
38:54impediments are called barriers to entry
38:57uh is Andrew here yeah yeah uh Andrew
39:00could you give some examples of barriers
39:02to entry um I guess like liqu license
39:05laws uhhuh if you Lim the number of
39:08people that can actually sell
39:10liqu that's a very good example yeah um
39:14so
39:16doctors uh taxi drivers who have
39:18medallions the similar idea um
39:21regulatory barriers like forcing people
39:24in order to get into an industry to
39:26comply with sarban foxly right that's
39:28like very very costly and that could
39:30keep firms out of the industry because
39:33they now have to comply with all sorts
39:34of regulations Violence by Il legal drug
39:37cartels in Mexico is another important
39:40barrier to entry into the drug industry
39:42in Mexico also just Petty harassment or
39:46bigotry uh is a big impediment to entry
39:49so a lot of minority owned businesses
39:52where the person is a minority uh racial
39:54minority within whatever neighborhood
39:56are harassed to the point where it's
39:57very hard for them to enter and compete
40:00um contractual Arrangements can also do
40:03this uh by exploiting market dominance
40:06in other areas so um in Peru uh when
40:10they opened up to free trade with the
40:11United States because they thought it
40:12would bring them competition they got a
40:14nasty surprise and found out that it
40:16could also bring large US companies that
40:18could buy up all the competing companies
40:20within Brazil because they have no
40:21antitrust laws and turn it into a giant
40:24cartel so uh sa Miller came into to Peru
40:27and rather than competing with the
40:28Peruvian Brands they bought up all the
40:30brands and they raised the prices on
40:31beer now they had to avoid anyone trying
40:34to come into the country to compete with
40:35them so what they did is they went to
40:37all of the posts uh along the beach in
40:40Brazil which is where about 40% of beer
40:43in Brazil is consumed because people
40:44like to go to the beach and drink beer
40:46there and so they went to all the posts
40:48on the beach and they said either you
40:49have to carry our beer uh or uh sorry
40:53either you can't carry our beer or you
40:56have to only carry beer right you have
40:58to have an exclusive arrangement with us
41:00and that they couldn't afford to be cut
41:02off from all the Peruvian beer brands
41:04right and so they did exclusive deals
41:07with uh the Prov with sa Miller and that
41:11made it very very hard for foreigners to
41:13come in and compete with
41:15them um now these uh types of barriers
41:19to entry are usually created by lobbying
41:22violence or exploitation of Market power
41:25and economists usually call these
41:27activities rent seeking and we view them
41:30as bad for three uh principal reasons
41:32what are those reasons Adam um
41:37well one main thing would be um it
41:41would Supply and uh on that basis you
41:45know artificially affect price that's
41:48right so it'll it'll inefficiently
41:51allocate Goods what are the other um
41:54potentially harmful effects um
41:58also there'd be like a a focus on like
42:01the lobbying or or whatever um whatever
42:05like means to achieve that instead of
42:08actually focusing yeah so they're
42:09spending a lot of resources on trying to
42:11do that right um and finally it usually
42:15benefits a favored group right so like
42:19this company why should they make the
42:21money why shouldn't the consumers have
42:22that we don't necessarily think that's a
42:24good distribution of those resources now
42:26I think the most important of these
42:28reasons is the waste um that's uh spent
42:33on trying to acquire these Privileges
42:35and the reason I think that is that we
42:38often do give barriers to entry and we
42:39think it's a good beneficial thing for
42:42policy to do in the context of
42:44intellectual property like patents
42:46trademarks copyrights that prevent
42:48people from competing with existing
42:50firms because we know that potentially
42:53without those free entry will drive
42:55profits to zero but then of course how
42:58would firms recoup the costs of
43:00investing in creating those creative
43:02products right um now we're going to
43:05discuss this extensively in lecture 13
43:07but the key point I want to make here is
43:09that this is an a Bui entry we generally
43:11think is good because the things that
43:13are incentivized by the profits are not
43:17lobbying or violence right they're
43:20creating valuable uh new ideas for
43:24society right um so what really makes uh
43:29profits like this or barriers to entry
43:31like this good or bad I think is where
43:34the rents that they create go so when
43:37rents go to drug mafias this is really
43:39really bad because this encourages them
43:41to be extremely violent to compete for
43:43dominance of the drug market and to kill
43:45all sorts of people in the process on
43:47the other hand and this is very
43:49self-serving uh the rents that I get
43:52from you know you guys wanting to listen
43:54to me teach you because I have you know
43:57published papers and journals and so
43:59forth are a way of encouraging me to
44:02create those ideas right um similarly a
44:07lot of people are willing to pay a huge
44:09amount of money to have a authentic work
44:11of art even if they could never in any
44:14way tell that from a fake why well I
44:17think it's socially beneficial because
44:19it gives the artti the original artist
44:20an incentive to create the work you know
44:23why should we care whether it's a fake
44:25or a real well it's just a social taboo
44:28but it's a useful social taboo because
44:30it encourages the artists to create um
44:35art so uh one question I've always had
44:39about this is whether all the rents that
44:43um people uh get for producing drugs
44:47that prolong people's lives at the very
44:49end of their lives are really good or
44:51bad uh and the reason is of course they
44:54benefit people by extending their lives
44:56but we we as a society spent a huge
44:58amount on the last two weeks of lives uh
45:01really to only extend them by a very
45:04very small amount and I think the reason
45:06that that happens is that a lot of the
45:09old people who are dying would rather
45:11just die in peace rather than live in
45:13pain for longer and their children would
45:16probably rather save the money but the
45:18problem is that the parents think the
45:22children think that the parents think
45:24that if they don't force them to stay
45:26alive that they don't love them and want
45:27to save the money right and so uh you
45:31get stuck in this
45:32cycle of um of both being forcing each
45:37other to uh do this very wasteful thing
45:41and as a result one thing I've advocated
45:44was that you could have you know a a
45:47populous policy where you say look it's
45:49fine if you want to charge you know a
45:51young person something for preventative
45:53care whatever but when it's at the end
45:55of life with Grandma you have no right
45:57to earn a profit off of that you should
46:00be absolutely required to sell that at
46:02cost so that everyone has access to that
46:04and that would sound very populist and
46:06you know uh left wi but what it would
46:08actually have the effect of doing is
46:10discouraging all innovation in that area
46:12and therefore stopping uh uh innovations
46:16that would uh increase the cost right uh
46:19so I thought that that's like a
46:20politically palatable way to stop
46:22healthc care costs from rising yeah yeah
46:25uh yeah chrisan
46:27what's so for the rinse for this stuff
46:31is that just like in place because of
46:33the social tabos like the authentic art
46:35like it's only in place because people
46:37think they no it's because of the
46:38intellectual property that these guys
46:39get on it but I think you know what we
46:41should say is we should have a populist
46:42campaign that like you know intellectual
46:44property is fine on stuff you know
46:46that's not at the end of life because
46:48this is like the most taboo area right
46:50we can say but you know when it's
46:51Grandma dying on her deathbed you have
46:53no right to make a profit off of that uh
46:55yes you will what if like innovation in
46:57that area like or end of life Innovation
46:59actually like reduces the costs of like
47:02prolonging the end of life like wouldn't
47:04that be a positive if it reduces the
47:06cost I'm all for it if it if it allows
47:08at very very high cost especially
47:11because of the patent uh someone to
47:13extend their life in misery for an extra
47:15few days I think that's very bad yeah
47:17Austin I remember reading that a
47:19discontinuity in the inheritance tax
47:21created a big discount your death rates
47:23yeah I have heard about that I think
47:25it's pretty small actually I mean it's I
47:28I think it's like you know a few
47:29thousand people like died a few months
47:31earlier than they should have died but I
47:34don't think there were that many like
47:35deaths that would not have otherwise
47:37occurred uh in other words like it went
47:40up and then it went back down you know
47:42there was like a it it was like you know
47:44when everybody when the capital gains
47:46tax went down they sold their stocks a
47:49year earlier but it's not like they
47:50actually sold more stocks than the
47:51otherwise would have sold all these
47:53people were going to die they just
47:54decided to die a little bit earlier
47:56there was like 25 % more deaths on
47:57December 31st than on January 1st yeah
48:00exactly but that's but but that could be
48:02because a 12.5 increase on one day and a
48:0412.5 decrease on the other you know what
48:06I mean so yeah Evan how many of these
48:09drugs are made to just give people a few
48:11extra weeks and how many of them are
48:12made to try and fit and give people
48:15years and they just need to recoup the
48:17cost because it didn't
48:19work um that's an interesting question I
48:22mean what Pago's principle would tell us
48:25is that if you reduce the
48:27for the state of the world where you end
48:30up you know uh not extending it by years
48:35then you'll selectively discourage
48:38things that are targeted that way we
48:40might not know what the original
48:41intentions are but if we pay people for
48:43their final product uh we're more likely
48:47to get that type of stuff being created
48:49you know what I
48:51mean um but that's a good
48:55question um okay
48:58so regardless of whether barriers to
49:01entry are good or bad um these barriers
49:04are external to the market and the usual
49:07idea is that the market left to itself
49:09would essentially eliminate
49:10profits and this is one of the deepest
49:13and oldest and most cited ideas in
49:15economics and it's quite useful in write
49:17in some context like intellectual
49:19property but actually I think it's much
49:21less broadly applicable than you might
49:23have learned or might think and the rest
49:25of the lecture covers the natural limits
49:27that exist to the principle of free
49:28entry so the basic problem is that many
49:31activities require Talent if a
49:34technology is such that any idiot can
49:37implement the optimal technology then
49:39sure free entry will eliminate uh
49:41profits but this is only possible in
49:43limited circumstances you know someone
49:46might say to you oh Steve Jobs is making
49:48a lot of profits why don't you just
49:50enter into being Steve Jobs that might
49:52not be that easy or like LeBron James is
49:54making a lot of money why don't you just
49:56be LeBron James well I'm not sure
49:59everyone can do that costlessly right um
50:02so uh because Talent is
50:05scarce uh it will command a rent and
50:09this is a barrier to entry but there's
50:11nothing like artificial or government
50:14imposed about it right um what free
50:17entry really requires is the absence of
50:20a need for
50:22talent um yeah Julian well can't I mean
50:26obviously you can't if you want you
50:28can't be Steve Jobs but a firm could
50:30hire Steve Jobs and then it would just
50:33cost them a lot of money to hire steeve
50:35jobs if if he's the whole reason why
50:37apple is making all those profits right
50:39yeah but like you know question is what
50:42is a firm then is is this I mean any
50:45comp any company that hires Steve Jobs
50:48sort of is Apple in some sense you know
50:50what I mean like I'm not sure Apple was
50:53all that much more than Steve Jobs and
50:54what he created you know found out after
50:57they fired him and they went down the
50:59tubes right uh uh yeah Barett um so
51:02would that imply that if like the human
51:05capital of like um less productive
51:08people was raised that would like Drive
51:10profits towards
51:11zero yeah I mean if it's raised up to
51:14the level of of the people that they're
51:15competing with absolutely because then
51:17they don't have the lead out in front of
51:18the other guys yeah Austin how do like
51:22rapidly prototyped kind of like internet
51:24starts like Twitter coming into this
51:25stuff cuz they don't arguably have
51:28brilliant ideas and at least today it's
51:30not terribly difficult to create the
51:32services at the beginning and yet
51:34they're able to re massive massive
51:35massive profits well I think it depends
51:38a lot on like the degree of economies of
51:41scale like Twitter has a huge economies
51:43of scale effect because of the network
51:46effects that exist um in that industry
51:49and that me that uh only one firm can
51:52really exist whereas Groupon didn't have
51:54very many economies of scale and there
51:56therefore they it was very easy for
51:58someone to enter and compete with them
52:00whereas you know Twitter and Facebook
52:02even if they're only slightly better
52:03than the next best person there's only
52:05going to be one firm anyway and they can
52:07milk that slight Advantage multiplied by
52:10a large number of people for a big
52:12profit yeah Mike um doesn't this also
52:14vary based on like the industry in which
52:16it takes place like yeah I'll talk a
52:19bunch about that in a second actually
52:20yeah Evan Twitter is not making profits
52:22actually they're making huge losses well
52:25yeah they're making paper profit profits
52:27on their IPO most likely but not yet
52:29yeah D so does this mean when you have
52:32technology that can kind of substitute
52:35for a person's Talent like for example
52:37if you have a new graphic design program
52:39makes it much easier that just makes it
52:41so that this well we'll talk a little
52:44bit about that in one second it's a
52:45little bit more complicated uh but but
52:48but yeah um is it is it possible that
52:51like if the poor became more productive
52:54that would actually like uh cause like a
52:57loss in economic growth because then
52:59there would be like less of an incentive
53:01no it wouldn't uh but oh less of an
53:05incentive to become rich well like if
53:08profits are driven towards zero well no
53:10because the market always allocates
53:12things optimally so like if the poor
53:14became more productive it would be less
53:15socially necessary to have productive
53:17people and therefore it wouldn't be
53:19important to have an incentive to have
53:21people like that right in other words
53:23like the whole logic of the market right
53:25this is the Invisible Hand it creates
53:27rewards in the places where there's
53:28social value to create those rewards
53:30right so like if there were more poor
53:32people there would be no social value in
53:34having people who are super productive
53:36because there would be lots of good
53:37substitutes for those people the reason
53:39why Lebron James commands a lot of money
53:41is so that people have an incentive to
53:42try to become like LeBron James even if
53:44they can uh Philip yeah so the logic of
53:50competition would be revised to say that
53:53the marginal entrance earns Z profits
53:57but if someone has sufficiently powerful
54:00specialized Talent so that they're they
54:03earn are far more efficient at one
54:05industry than another they can still
54:07earn yeah and that's basically just the
54:09you know the probabilistic thing that we
54:10were doing right that was exactly what
54:12it was showing they look like Smooth
54:14Supply curves but really those were like
54:16uncertainty about the person's entry
54:18points right and the rent that someone
54:20earns is really how much they're better
54:24than the other people in terms of where
54:26they're willing to enter so
54:29absolutely okay so in the long
54:32run uh you know it might be the case
54:36that profits on um
54:39touchscreen uh cell phones went to zero
54:41right apple is probably not making that
54:44much money off the iPhone uh anymore
54:46because it's been it's got so much
54:48competition Samsung and so forth but
54:51then Apple introduced the App Store and
54:53that gave them a bit of an advantage for
54:55a while now other phones now are
54:56starting to have as good app stores so
54:58maybe they're losing their computer
55:00advantage on that as well right um so
55:03well it's true that narrowly defined
55:05Industries and this is getting back to
55:07Mike's Point uh will tend to have a lot
55:11of ability to freely enter and drive
55:14profits out um for example Nokia didn't
55:18last long as a cell phone uh Behemoth
55:21because it was really easy to produce
55:23the cheap cell phones that they made and
55:25American car companies it was pretty
55:27easy to imitate at Japanese showed uh
55:30the processes and maybe even improve on
55:33the processes with which they made their
55:35cars or to imitate the large the Legacy
55:37Airlines which weren't doing anything
55:38special U and the lowcost airlines came
55:41in but um often broader Industries are
55:45defined not by narrow easily imitated
55:49individual products but precisely by the
55:52process of constantly bringing out new
55:54products so um Mike what what might be
55:57some examples of Industries like that um
56:01that are product yeah
56:04uh like I don't think ta really existed
56:08before the iPad came
56:10out yeah that's right but it's not the
56:12tablet industry there's like a broader
56:14industry of consumer electronics in
56:16which it sits because the tablet
56:18industry is not really defined by
56:19Innovation but the broader electronics
56:21Industry is so if you look narrowly at
56:23one segment it's true but the whole
56:25Electronics industry is not about one
56:27segment it's about constantly creating
56:30new segments right
56:33um uh yeah so is that basically saying
56:36like if you're apple and you already
56:37have an advantage in Innovation you're
56:39just going to keep pushing the advantage
56:41so you'll keep your R well unless you
56:44have free entry into becoming an
56:46Innovation Hub like apple does which
56:48maybe in the very long run is true but
56:50then people innovate innovate a totally
56:52different type of firm which isn't an
56:53Innovation Hub but is a data Hub you see
56:55what I mean so the more broadly you look
56:58people may have abilities that are very
57:00hard to in any reasonable time uh enter
57:03into
57:05imitating
57:07um Google has a constantly expanding
57:11Empire right like they if they just sat
57:14on only doing search they probably would
57:16have gotten superseded but they've now
57:17moved into uh operating systems and
57:21Google Now and maps and and by
57:23constantly adding these new Services
57:25that's how they stay ahead of the
57:26competition Microsoft uh on the other
57:29hand thought that it could just rest on
57:31its patents and its operating system and
57:33its Network effects and then they got
57:36completely screwed because they realized
57:38that you know actually the next place
57:41was everything on the internet and that
57:42the operating system on the on the
57:45actual computer didn't matter in in the
57:47next round right and good Innovation
57:50machines are hard to imitate you need to
57:53imitate a process of generating ideas
57:55not copying a particular technical
57:57process right and an engine like that
58:00often requires scarce Talent like Steve
58:03Jobs now
58:06um even in a narrow industry where
58:11prices will come down over time
58:13especially in response to a demand shock
58:16this doesn't always happen by new
58:18entrance coming in it can actually
58:20happen with lower price and maybe a
58:22little bit lower
58:24quality um instead it can happen by the
58:28people at the top finding a way to reach
58:31everybody and this is I think what
58:33Barett was getting at uh or somebody was
58:35getting at before uh Austin yeah um and
58:39that can mean that the people at the top
58:41get a huge amount of rent and the people
58:43at the bottom get driven out of the
58:45industry rather than the people at the
58:47bottom driving out the profits for the
58:49people at the top so um Rishi do you
58:53have some can you think of some examples
58:54of that um
58:57as it like for the just rents of the
59:01we're we're like the way that prices
59:03come down over time or the industry
59:05reacted to a demand shock was not by a
59:08lot more crappy firms entering and
59:10driving down the prices for the few
59:12original firms but rather the few
59:14original firms found a way to reach the
59:16best firms I mean did reach everybody
59:20um like like you were talking about
59:23LeBron before profal Sports in general
59:27yeah you have the the very top players
59:30make a lot of money and have a lot of
59:32demand and the very bottom players are
59:34either driven out or the firms aren't
59:36really going to Target them as much as
59:37the yeah so I mean if you think about
59:39some demand shocks that you might think
59:41in the long run would be greeted by
59:43entry like the increase during the baby
59:47boom in demand for popular music that
59:49was not greeted by entry into the music
59:51industry actually people the number of
59:53musicians went way down but what
59:55happened happened was that you developed
59:56this whole popular culture radio
59:59television Etc that allowed the top
1:00:01people to reach many many more people
1:00:03and drive out the people down below
1:00:06professional sports during the 20th
1:00:07century grew up as the demand for sports
1:00:10increased but rather than that making
1:00:12there be more sports team it actually
1:00:13made there be less because the top
1:00:15sports teams found ways to reach uh
1:00:18everybody the fast food Revolution was
1:00:20like this again during the baby boom
1:00:22there was demand for lots of
1:00:24standardized relatively
1:00:26decent quality uh food but rather than
1:00:29that leading to many more restaurants it
1:00:31led to consolidation and the few
1:00:33restaurants that were able to replicate
1:00:34the standards of quality most broadly uh
1:00:38took over the industry this also happens
1:00:41with gourmet food with celebrity chefs
1:00:43where in the short term uh increase in
1:00:46demand for Gourmet Foods might make lots
1:00:47of local restaurants but maybe in the
1:00:49longer term there will be a few
1:00:50celebrity chefs who just like Rick bis
1:00:52spread the tentacles of their empire all
1:00:55over the country
1:00:57um or uh mass production of design
1:01:00during the 1950s when people were
1:01:02getting to be more middle class and
1:01:05wanting you know uh nicer designed uh
1:01:08products it's POS uh what what happened
1:01:11was not there was many more people going
1:01:13into handycrafts but rather a few
1:01:16designers got big jobs designing Mass
1:01:19market products that were then uh given
1:01:21to everyone and I think this could well
1:01:23be an important part of the future of
1:01:25Education in medicine I think I say to
1:01:27all my colleagues that they they should
1:01:29ask themselves the question what is the
1:01:31most broadly defined class with the
1:01:33property that you are the single best
1:01:35person in the entire world to be
1:01:36teaching that class because that's how
1:01:38you're going to be making your money
1:01:39because with these mukes uh you know if
1:01:42someone is not the absolute best why why
1:01:45even waste your time listening to them
1:01:47why not listen to whoever is the best at
1:01:49teaching that class right um and
1:01:52similarly with medicine why like go to
1:01:54your local Doctor Who's Maybe seen like
1:01:56a thousand patients in their whole life
1:01:59rather than have like statistical
1:02:00algorithms that take in all the
1:02:02information from all patients in the
1:02:04world and prescribe you the best
1:02:05treatment based on what we observe of
1:02:07you uh and have doctors running those
1:02:10algorithms that will make the doctor
1:02:12sure the best at analyzing the data uh
1:02:15you know extremely uh wealthy but uh it
1:02:19will put out of business all the other
1:02:21lower quality uh doctors right so this
1:02:24is called the Superstar effect
1:02:26and it means that if one individual can
1:02:28reach a very large part of the market
1:02:30then the market adjusts by F focusing
1:02:33more and more on those absolute top
1:02:35people rather than by having more people
1:02:37enter and so while that does bring down
1:02:40prices and cost dramatically it's not by
1:02:43more people entering but actually by
1:02:45more technological focus on getting the
1:02:47top people to reach
1:02:49everybody and in that type of an
1:02:51industry the distribution of talent is
1:02:54absolutely crucial because it determines
1:02:56rents and the nature of the long-term
1:02:59response if you have more concentration
1:03:00of talent at the top there's going to be
1:03:03a desire to try to get those top people
1:03:05to reach everybody rather than to have
1:03:08the people who are
1:03:11um who are just have more people enter
1:03:14into the industry right but note that
1:03:17it's not the entire distribution of
1:03:18talent that matters only the people
1:03:21towards the top right suppose that there
1:03:23were some people that were very um good
1:03:25but there was a large number of them and
1:03:27then everybody else was really bad well
1:03:29that would still sort of be like free
1:03:30entry because there would be a large
1:03:32pool of people who would all be equally
1:03:34good to compete what really matters is
1:03:36how differentiated things are at the
1:03:37very top of the distribution and this
1:03:40top part of the distribution is called
1:03:41its
1:03:42tail and if there are many people who
1:03:45are way out like no matter how far you
1:03:47get there's like still people who are
1:03:49further and further out um that's called
1:03:51a fat tail
1:03:52distribution um and this is we the
1:03:56Geniuses are really much better than
1:03:58even the very good people and there's a
1:04:00highly unequal distribution of talent
1:04:02another name that's used for this is
1:04:04called black swans when you have the one
1:04:06very rare event being very very
1:04:08important now often it's assumed that
1:04:11distributions are thin tailed many
1:04:14distributions are like this so anytime
1:04:16you have a distribution that has finite
1:04:17upper and lower bounds it's thin tailed
1:04:20and usually the most important thing
1:04:21about finite bounded distributions
1:04:23that's being assumed is not that they're
1:04:25bound but rather that they're thin
1:04:26tailed that's really what's being baked
1:04:28in it's that you know you don't have
1:04:30these extreme events playing much of a
1:04:32role normal distributions are that way
1:04:34too um but we know that this is not
1:04:37consistent with a lot of the evidence
1:04:39that we have about the distribution of
1:04:41talent in fact most evidence we have
1:04:43shows that Talent distribution is
1:04:45extremely fat-tailed follows what's
1:04:47called a power law or a par distribution
1:04:50yeah philli what is a metric that's used
1:04:52to measure Talent uh I'll go through
1:04:55some of in just a second
1:04:57um okay but that
1:05:01distribution has uh the following form
1:05:04the number of people who are above a
1:05:06given level is equal to that level
1:05:08divided by some constant to some power
1:05:12to some negative power so it dies off
1:05:15with a power of the level that you're at
1:05:18some ways of thinking about this
1:05:19distribution is the fraction of people
1:05:22who have um Talent above level two times
1:05:25X is 1/ 2 to the alpha of that above the
1:05:29level
1:05:30X uh so let's say that if Alpha is equal
1:05:35to 1.2 then about 20% of people have 80%
1:05:39of the
1:05:41talent um if another way of putting it
1:05:44is that the fifth most talented person
1:05:46is 1 over 5 to the 1 over Alpha as
1:05:49talented is the most talented
1:05:51person and uh these are a little bit
1:05:56uh tricky when Alpha is not equal to one
1:05:59but the lower Alpha is the more unequal
1:06:01it's going to be because that means the
1:06:03more spaced out things are at the top
1:06:05relative to further down the
1:06:08distribution income which is one measure
1:06:10of talent is um a power law with
1:06:14alphabit somewhere between 1.5 and 3
1:06:17wealth is somewhere between 1 and two
1:06:20coo compensation has an alpha of about
1:06:24three uh but the most prominent one is
1:06:26Alpha equal to one which is called Zip's
1:06:28law which says that the fifth most
1:06:30talented person is one fifth as talented
1:06:32as the top uh first most talented person
1:06:35the second most talented person is one
1:06:36half as talented as the top person so
1:06:38you see there's really big gaps at the
1:06:40top and smaller and smaller gaps as you
1:06:42go
1:06:44down
1:06:46um so um I'm going to show two examples
1:06:50of something following Zip's law uh but
1:06:53it also applies to comparative advantage
1:06:55of countries and things to many areas of
1:06:58Economics where almost anywhere you look
1:07:00you find power law distributions like
1:07:02this yeah Austin how do you when you're
1:07:04calculating like CEO compensation the
1:07:06alpha value for that how do you
1:07:08differentiate Talent from nonlinear
1:07:10returns to Talent you just I'm just
1:07:13saying you put in CEO pay and you get
1:07:17this distribution that's all I mean yeah
1:07:20Mike um can I ask about something on the
1:07:22last slide you said that th tail
1:07:24distributions are implied by
1:07:26uh like boundedness yeah any bounded
1:07:28distribution is thin tailed wouldn't it
1:07:30be but like if you're taking a
1:07:31distribution of like sports Talent or
1:07:34something there's got to be like a most
1:07:36talented person right like aren't those
1:07:37still yeah so a lot of people think that
1:07:39way and that's what led a lot of people
1:07:40to assume bounded distributions but the
1:07:43thing is well that is true at literally
1:07:45the absolute top like it's a lot of our
1:07:50models are like based on looking at
1:07:54limiting
1:07:56things right and when you look at
1:07:59limiting things uh it's bad to assume
1:08:03something that where you're only looking
1:08:06at the behavior at the absolute absolute
1:08:08top you see what I mean like it's like
1:08:10ly tall's rule right it's true that like
1:08:14you know the top may be going to zero
1:08:15but if the bottom is also going to zero
1:08:18right then you need to think about what
1:08:19does the behavior look like as you get
1:08:21towards the top and the income
1:08:23distribution really really looks like
1:08:25Paro now literally there is a richest
1:08:27person so it is bounded but that's sort
1:08:30of not M beside the point the point is
1:08:32it looks like Paro until the very very
1:08:34end yeah D how what exactly does it mean
1:08:37for someone to be x times talented than
1:08:40someone else is this determined by their
1:08:42well this is what Philip said I I was
1:08:44giving some examples of what I mean by
1:08:45that so one example is income but you
1:08:48know well I'll give you some other
1:08:49examples in a second yeah Tanner like
1:08:51even if it might look like it's found
1:08:53now like you know you might say LeBron
1:08:55is the best basketball
1:08:56player in all time yeah exactly someone
1:09:00else yeah exactly so yeah if you use a
1:09:04physical metric of talent such as
1:09:06movement speed for runners you might
1:09:09argue that it's thin tail it'll be thin
1:09:10tailed there or certainly there's
1:09:13there's got to be some sort of found on
1:09:15how fast you so that that's absolutely
1:09:17right so one interesting thing about
1:09:19this is usually these thin tailed things
1:09:22have to do with cases where you're like
1:09:26measuring it in some objective unit like
1:09:28height like imagine height is one to one
1:09:30with basketball skill which it isn't but
1:09:32but imagine that then like clearly like
1:09:34there's there's a pretty thin tail
1:09:36distribution of height just not going to
1:09:38get above a certain amount but because
1:09:40of the Superstar effect those very top
1:09:43people even the small distances get
1:09:45magnified into these huge income
1:09:47differences right so um yeah uh yeah
1:09:52Austin is it treated as an economic
1:09:54question the kind of reasoning behind
1:09:56those CU I was just thinking like yeah
1:09:57no that's that's that's interesting so
1:10:00there are some papers behind them but I
1:10:01don't find them ultimately convincing
1:10:03precisely on this point that I just said
1:10:05like all the models that justify this
1:10:08are based on everything growing
1:10:10proportionately at a random rate and
1:10:13that leads to this behavior on the upper
1:10:15tail but I don't think that's what's
1:10:17going on I don't think it has to do with
1:10:18the underlying physical properties of
1:10:20the growth I think it has to do with the
1:10:21technology through which that thing
1:10:23reaches large numbers of people and I
1:10:25think any good model of this has to
1:10:27somehow take that into account and I
1:10:28don't think anyone's done that as far as
1:10:29I know so I'm just thinking like math
1:10:31talent for instance is much more fat
1:10:33tail for Eon Talent there's many more
1:10:35math prodes than there are Eon prodes
1:10:38yeah I mean and I think again it has to
1:10:40do with like the selective process I
1:10:42mean so like one example of this is
1:10:44physical Beauty so like I think that in
1:10:47your at least in my lived experience
1:10:49just going around physical beauty is
1:10:51clearly thin tailed like you know you
1:10:54meet someone who's beautiful versus
1:10:56someone who's very beautiful and there's
1:10:57a difference but like it sort of wears
1:11:00off pretty quickly as you get down that
1:11:02distribution uh but um but for super
1:11:06models that's not true at all right like
1:11:08you could have slight differences and it
1:11:10would make an enormous difference in
1:11:12their income because they're reaching
1:11:14such a huge number of people one way of
1:11:17thinking about the difference between um
1:11:19thin tails and fat tails that I quite
1:11:21like is like a thin tail distribution is
1:11:25some where where as you're getting
1:11:26better and better at the thing you feel
1:11:28more and more like I'm mastering this
1:11:30I'm on top of this I'm better than most
1:11:31people whatever right um like driving is
1:11:34like that typing is like that you sort
1:11:36of like get comfortable with your level
1:11:39but you know economics or math or
1:11:41intellectual Pursuits or money all these
1:11:43sorts of things are fat tailed because
1:11:45the better you get the more you realize
1:11:47that the really top people are still way
1:11:49ahead of you right so that actually
1:11:52there's a mathematical formulation in
1:11:54which that's exactly what thin uh tailed
1:11:56versus fat tailed means it means as you
1:11:58get higher up is it are you falling sort
1:12:01of behind the top or are you getting
1:12:03closer to the
1:12:05top um okay so here's some other things
1:12:08that um follow Zip's law so firm size as
1:12:13a um measured in the number of employees
1:12:17if you graph the
1:12:19frequency against the size in log terms
1:12:22you get a slope of negative 1 that
1:12:24indicates zip law similarly for City
1:12:27size within a country or in the world
1:12:30there's almost a perfect fit if you have
1:12:32the log of the rank of the city against
1:12:34the log of the population you get almost
1:12:36a perfect negative one fit and you'll
1:12:38see if you just look at like cities in
1:12:40any country the second city is usually
1:12:42pretty close to half the size of the
1:12:44first the third city is about third the
1:12:47size of the first Etc uh yeah Christian
1:12:50wait why is the negative one so
1:12:52correspond a SL well you basically take
1:12:56these things and you take the log of
1:12:58both sides of them and you'll see you
1:12:59got a negative one in front of this guy
1:13:02right so
1:13:05yeah okay um it also applies to words in
1:13:09any language including English so uh
1:13:12yeah philli I'm just curious is that
1:13:15generally true for only natural
1:13:17languages or also formal languages I
1:13:19don't know I don't know probably for
1:13:22formal languages but I'm not sure okay
1:13:24so this extreme heterogeneity at the top
1:13:28of the distribution I think raises some
1:13:30important questions one is that you know
1:13:32rents might be quite important even in
1:13:34the long run because the uh free entry
1:13:38logic is not really going to be right
1:13:39the people at the very top are going to
1:13:41appropriate a lot of those rents and
1:13:42them reaching other people is going to
1:13:44be an important part um in some sense we
1:13:48might think free entry is actually more
1:13:49of an anomaly rather than the rule and
1:13:52what IP tries to do is to redress this
1:13:55failing of the market to follow its
1:13:57natural nature rather than thinking a
1:13:59free entry is the default we might think
1:14:01that actually this Talent stuff is the
1:14:03default and IP is a way to restore the
1:14:05natural nature of the market allowing
1:14:07people to appropriate those uh those
1:14:10rents
1:14:12um uh if some firms are much bigger than
1:14:16other firms it's unlikely that they're
1:14:18going to be price takers right because
1:14:20if we have some people who are really
1:14:22really big at the top as we said that's
1:14:24going to basically make a very
1:14:25concentrated industry and make those top
1:14:28people unlikely to be price takers right
1:14:31and that will create Market power and
1:14:33motivate our study of Market power later
1:14:35in the course um also it'll mean that
1:14:39the income distribution is very unequal
1:14:40at the top which will make
1:14:42redistribution attractive and also mean
1:14:45that you can raise a lot of Revenue by
1:14:46taxing the rich because there will be at
1:14:49any level that you tax people a lot more
1:14:51people who are richer than that and who
1:14:52will pay the tax but who won't actually
1:14:54want to reduce the amount that they work
1:14:57so much of the rest of the course is
1:14:58going to be driven by these things that
1:15:00come out of the fact that we have these
1:15:02fat tail distributions of talent and
1:15:06income great

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