oligopoly

Krugman and rockets and feathers

pnrj critique of neoclassical economics, current events, macroeconomics, personal, public policy , , , , , ,

Jul 17 JDN 2459797

Well, this feels like a milestone: Paul Krugman just wrote a column about a topic I’ve published research on. He didn’t actually cite our paper—in fact the literature review he links to is from 2014—but the topic is very much what we were studying: Asymmetric price transmission, ‘rockets and feathers’. He’s even talking about it from the perspective of industrial organization and market power, which is right in line with our results (and a bit different from the mainstream consensus among economic policy pundits).

The phenomenon is a well-documented one: When the price of an input (say, crude oil) rises, the price of outputs made from that input (say, gasoline) rise immediately, and basically one to one, sometimes even more than one to one. But when the price of an input falls, the price of outputs only falls slowly and gradually, taking a long time to converge to the same level as the input prices. Prices go up like a rocket, but down like a feather.

Many different explanations have been proposed to explain this phenomenon, and they aren’t all mutually exclusive. They include various aspects of market structure, substitution of inputs, and use of inventories to smooth the effects of prices.

One that I find particularly unpersuasive is the notion of menu costs: That it requires costly effort to actually change your prices, and this somehow results in the asymmetry. Most gas stations have digital price boards; it requires almost zero effort for them to change prices whenever they want. Moreover, there’s no clear reason this would result in asymmetry between raising and lowering prices. Some models extend the notion of “menu cost” to include expected customer responses, which is a much better explanation; but I think that’s far beyond the original meaning of the concept. If you fear to change your price because of how customers may respond, finding a cheaper way to print price labels won’t do a thing to change that.

But our paper—and Krugman’s article—is about one factor in particular: market power. We don’t see prices behave this way in highly competitive markets. We see it the most in oligopolies: Markets where there are only a small number of sellers, who thus have some control over how they set their prices.

Krugman explains it as follows:

When oil prices shoot up, owners of gas stations feel empowered not just to pass on the cost but also to raise their markups, because consumers can’t easily tell whether they’re being gouged when prices are going up everywhere. And gas stations may hang on to these extra markups for a while even when oil prices fall.

That’s actually a somewhat different mechanism from the one we found in our experiment, which is that asymmetric price transmission can be driven by tacit collusion. Explicit collusion is illegal: You can’t just call up the other gas stations and say, “Let’s all set the price at $5 per gallon.” But you can tacitly collude by responding to how they set their prices, and not trying to undercut them even when you could get a short-run benefit from doing so. It’s actually very similar to an Iterated Prisoner’s Dilemma: Cooperation is better for everyone, but worse for you as an individual; to get everyone to cooperate, it’s vital to severely punish those who don’t.

In our experiment, the participants in our experiment were acting as businesses setting their prices. The customers were fully automated, so there was no opportunity to “fool” them in this way. We also excluded any kind of menu costs or product inventories. But we still saw prices go up like rockets and down like feathers. Moreover, prices were always substantially higher than costs, especially during that phase when they are falling down like feathers.

Our explanation goes something like this: Businesses are trying to use their market power to maintain higher prices and thereby make higher profits, but they have to worry about other businesses undercutting their prices and taking all the business. Moreover, they also have to worry about others thinking that they are trying to undercut prices—they want to be perceived as cooperating, not defecting, in order to preserve the collusion and avoid being punished.

Consider how this affects their decisions when input prices change. If the price of oil goes up, then there’s no reason not to raise the price of gasoline immediately, because that isn’t violating the collusion. If anything, it’s being nice to your fellow colluders; they want prices as high as possible. You’ll want to raise the prices as high and fast as you can get away with, and you know they’ll do the same. But if the price of oil goes down, now gas stations are faced with a dilemma: You could lower prices to get more customers and make more profits, but the other gas stations might consider that a violation of your tacit collusion and could punish you by cutting their prices even more. Your best option is to lower prices very slowly, so that you can take advantage of the change in the input market, but also maintain the collusion with other gas stations. By slowly cutting prices, you can ensure that you are doing it together, and not trying to undercut other businesses.

Krugman’s explanation and ours are not mutually exclusive; in fact I think both are probably happening. They have one important feature in common, which fits the empirical data: Markets with less competition show greater degrees of asymmetric price transmission. The more concentrated the oligopoly, the more we see rockets and feathers.

They also share an important policy implication: Market power can make inflation worse. Contrary to what a lot of economic policy pundits have been saying, it isn’t ridiculous to think that breaking up monopolies or putting pressure on oligopolies to lower their prices could help reduce inflation. It probably won’t be as reliably effective as the Fed’s buying and selling of bonds to adjust interest rates—but we’re also doing that, and the two are not mutually exclusive. Besides, breaking up monopolies is a generally good thing to do anyway.

It’s not that unusual that I find myself agreeing with Krugman. I think what makes this one feel weird is that I have more expertise on the subject than he does.

Are unions collusion?

pnrj critique of neoclassical economics, ethics, market failure, public policy , , , , , , , , , , ,

Oct 31 JDN 2459519

The standard argument from center-right economists against labor unions is that they are a form of collusion: Producers are coordinating and intentionally holding back from what would be in their individual self-interest in order to gain a collective advantage. And this is basically true: In the broadest sense of the term, labor unions are are form of collusion. Since collusion is generally regarded as bad, therefore (this argument goes), unions are bad.

What this argument misses out on is why collusion is generally regarded as bad. The typical case for collusion is between large corporations, each of which already controls a large share of the market—collusion then allows them to act as if they control an even larger share, potentially even acting as a monopoly.

Labor unions are not like this. Literally no individual laborer controls a large segment of the market. (Some very specialized laborers, like professional athletes, or, say, economists, might control a not completely trivial segment of their particular job market—but we’re still talking something like 1% at most. Even Tiger Woods or Paul Krugman is not literally irreplaceable.) Moreover, even the largest unions can rarely achieve anything like a monopoly over a particular labor market.

Thus whereas typical collusion involves going from a large market share to an even larger—often even dominant—market share, labor unions involve going from a tiny market share to a moderate—and usually not dominant—market share.

But that, by itself, wouldn’t be enough to justify unions. While small family businesses banding together in collusion is surely less harmful than large corporations doing the same, it would probably still be a bad thing, insofar as it would raise prices and reduce the quantity or quality of products sold. It would just be less bad.

Yet unions differ from even this milder collusion in another important respect: They do not exist to increase bargaining power versus consumers. They exist to increase bargaining power versus corporations.

And corporations, it turns out, already have a great deal of bargaining power. While a labor union acts as something like a monopoly (or at least oligopoly), corporations act like the opposite: oligopsony or even monopsony.

While monopoly or monopsony on its own is highly unfair and inefficient, the combination of the two—bilateral monopoly—is actually relatively fair and efficient. Bilateral monopoly is probably not as good as a truly competitive market, but it is definitely better than either a monopoly or monopsony alone. Whereas a monopoly has too much bargaining power for the seller (resulting in prices that are too high), and a monopsony has too much bargaining power for the buyer (resulting in prices that are too low), a bilateral monopoly has relatively balanced bargaining power, and thus gets an outcome that’s not too much different from fair competition in a free market.

Thus, unions really exist as a correction mechanism for the excessive bargaining power of corporations. Most unions are between workers in large industries who work for a relatively small number of employers, such as miners, truckers, and factory workers. (Teachers are also an interesting example, because they work for the government, which effectively has a monopsony on public education services.) In isolation they may seem inefficient; but in context they really exist to compensate for other, worse inefficiencies.


We could imagine a world where this was not so: Say there is a market with many independent buyers who are unwilling or unable to reliably collude, and they are served by a small number of powerful unions that use their bargaining power to raise prices and reduce output.


We have some markets that already look a bit like that: Consider the licensing systems for doctors and lawyers. These are basically guilds, which are collusive in the same way as labor unions.

Note that unlike, say, miners, truckers, or factory workers, doctors and lawyers are not a large segment of the population; they are bargaining against consumers just as much as corporations; and they are extremely well-paid and very likely undersupplied. (Doctors are definitely undersupplied; with lawyers it’s a bit more complicated, but given how often corporations get away with terrible things and don’t get sued for it, I think it’s fair to say that in the current system, lawyers are undersupplied.) So I think it is fair to be concerned that the guild systems for doctors and lawyers are too powerful. We want some system for certifying the quality of doctors and lawyers, but the existing standards are so demanding that they result in a shortage of much-needed labor.

One way to tell that unions aren’t inefficient is to look at how unionization relates to unemployment. If unions were acting as a harmful monopoly on labor, unemployment should be higher in places with greater unionization rates. The empirical data suggests that if there is any such effect, it’s a small one. There are far more important determinants of unemployment than unionization. (Wages, on the other hand, show a strong positive link with unionization.) Much like the standard prediction that raising minimum wage would reduce employment, the prediction that unions raise unemployment has largely not been borne out by the data. And for much the same reason: We had ignored the bargaining power of employers, which minimum wage and unions both reduce.

Thus, the justifiability of unions isn’t something that we could infer a priori without looking at the actual structure of the labor market. Unions aren’t always or inherently good—but they are usually good in the system as it stands. (Actually there’s one particular class of unions that do not seem to be good, and that’s police unions: But this is a topic for another time.)

My ultimate conclusion? Yes, unions are a form of collusion. But to infer from that they must be bad is to commit a Noncentral Fallacy. Unions are the good kind of collusion.

Is privacy dead?

pnrj futurism, market failure, public policy , , , , , , , , , , , , , ,

May 9 JDN 2459342

It is the year 2021, and while we don’t yet have flying cars or human-level artificial intelligence, our society is in many ways quite similar to what cyberpunk fiction predicted it would be. We are constantly connected to the Internet, even linking devices in our homes to the Web when that is largely pointless or actively dangerous. Oligopolies of fewer and fewer multinational corporations that are more and more powerful have taken over most of our markets, from mass media to computer operating systems, from finance to retail.

One of the many dire predictions of cyberpunk fiction is that constant Internet connectivity will effectively destroy privacy. There is reason to think that this is in fact happening: We have televisions that listen to our conversations, webcams that can be hacked, sometimes invisibly, and the operating system that runs the majority of personal and business computers is built around constantly tracking its users.

The concentration of oligopoly power and the decline of privacy are not unconnected. It’s the oligopoly power of corporations like Microsoft and Google and Facebook that allows them to present us with absurdly long and virtually unreadable license agreements as an ultimatum: “Sign away your rights, or else you can’t use our product. And remember, we’re the only ones who make this product and it’s increasingly necessary for your basic functioning in society!” This is of course exactly as cyberpunk fiction warned us it would be.

Giving up our private information to a handful of powerful corporations would be bad enough if that information were securely held only by them. But it isn’t. There have been dozens of major data breaches of major corporations, and there will surely be many more. In an average year, several billion data records are exposed through data breaches. Each person produces many data records, so it’s difficult to say exactly how many people have had their data stolen; but it isn’t implausible to say that if you are highly active on the Internet, at least some of your data has been stolen in one breach or another. Corporations have strong incentives to collect and use your data—data brokerage is a hundred-billion-dollar industry—but very weak incentives to protect it from prying eyes. The FTC does impose fines for negligence in the event of a major data breach, but as usual the scale of the fines simply doesn’t match the scale of the corporations responsible. $575 million sounds like a lot of money, but for a corporation with $28 billion in assets it’s a slap on the wrist. It would be equivalent to fining me about $500 (about what I’d get for driving without a passenger in the carpool lane). Yeah, I’d feel that; it would be unpleasant and inconvenient. But it’s certainly not going to change my life. And typically these fines only impact shareholders, and don’t even pass through to the people who made the decisions: The man who was CEO of Equifax when it suffered its catastrophic data breach retired with a $90 million pension.

While most people seem either blissfully unaware or fatalistically resigned to its inevitability, a few people have praised the trend of reduced privacy, usually by claiming that it will result in increased transparency. Yet, ironically, a world with less privacy can actually mean a world with less transparency as well: When you don’t know what information you reveal will be stolen and misused, you will constantly endeavor to protect all your information, even things that you would normally not hesitate to reveal. When even your face and name can be used to track you, you’ll be more hesitant to reveal them. Cyberpunk fiction predicted this too: Most characters in cyberpunk stories are known by their hacker handles, not their real given names.

There is some good news, however. People are finally beginning to notice that they have been pressured into giving away their privacy rights, and demanding to get them back. The United Nations has recently passed resolutions defending digital privacy, governments have taken action against the worst privacy violations with increasing frequency, courts are ruling in favor of stricter protections, think tanks are demanding stricter regulations, and even corporate policies are beginning to change. While the major corporations all want to take your data, there are now many smaller businesses and nonprofit organizations that will sell you tools to help protect it.

This does not mean we can be complacent: The war is far from won. But it does mean that there is some hope left; we don’t simply have to surrender and accept a world where anyone with enough money can know whatever they want about anyone else. We don’t need to accept what the CEO of Sun Microsystems infamously said: “You have zero privacy anyway. Get over it.”

I think the best answer to the decline of privacy is to address the underlying incentives that make it so lucrative. Why is data brokering such a profitable industry? Because ad targeting is such a profitable industry. So profitable, indeed, that huge corporations like Facebook and Google make almost all of their money that way, and the useful services they provide to users are offered for free simply as an enticement to get them to look at more targeted advertising.

Selling advertising is hardly new—we’ve been doing it for literally millennia, as Roman gladiators were often paid to hawk products. It has been the primary source of revenue for most forms of media, from newspapers to radio stations to TV networks, since those media have existed. What has changed is that ad targeting is now a lucrative business: In the 1850s, that newspaper being sold by barking boys on the street likely had ads in it, but they were the same ads for every single reader. Now when you log in to CNN.com or nytimes.com, the ads on that page are specific only to you, based on any information that these media giants have been able to glean from your past Internet activity. If you do try to protect your online privacy with various tools, a quick-and-dirty way to check if it’s working is to see if websites give you ads for things you know you’d never buy.

In fact, I consider it a very welcome recent development that video streaming is finally a way to watch TV shows by actually paying for them instead of having someone else pay for the right to shove ads in my face. I can’t remember the last time I heard a TV ad jingle, and I’m very happy about that fact. Having to spend 15 minutes of each hour of watching TV to watch commercials may not seem so bad—in fact, many people may feel that they’d rather do that than pay the money to avoid it. But think about it this way: If it weren’t worth at least that much to the corporations buying those ads, they wouldn’t do it. And if a corporation expects to get $X from you that you wouldn’t have otherwise paid, that means they’re getting you to spend that much that you otherwise wouldn’t have—meaning that they’re getting you to buy something you didn’t need. Perhaps it’s better after all to spend that $X on getting entertainment that doesn’t try to get you to buy things you don’t need.

Indeed, I think there is an opportunity to restructure the whole Internet this way. What we need is a software company—maybe a nonprofit organization, maybe a for-profit business—that is set up to let us make micropayments for online content in lieu of having our data collected or being force-fed advertising.

How big would these payments need to be? Well, Facebook has about 2.8 billion users and takes in revenue of about $80 billion per year, so the average user would have to pay about $29 a year for the use of Facebook, Instagram, and WhatsApp. That’s about $2.50 per month, or $0.08 per day.

The New York Times is already losing its ad-supported business model; less than $400 million of its $1.8 billion revenue last year was from ads, the rest being primarily from subscriptions. But smaller media outlets have a much harder time gaining subscribers; often people just want to read a single article and aren’t willing to pay for a whole month or year of the periodical. If we could somehow charge for individual articles, how much would we have to charge? Well, a typical webpage has an ad clickthrough rate of 1%, while a typical cost-per-click rate is about $0.60, so ads on the average webpage makes its owners a whopping $0.006. That’s not even a single cent. So if this new micropayment system allowed you to pay one cent to read an article without the annoyance of ads or the pressure to buy something you don’t need, would you pay it? I would. In fact, I’d pay five cents. They could quintuple their revenue!

The main problem is that we currently don’t have an efficient way to make payments that small. Processing a credit card transaction typically costs at least $0.05, so a five-cent transaction would yield literally zero revenue for the website. I’d have to pay ten cents to give the website five, and I admit I might not always want to do that—I’d also definitely be uncomfortable with half the money going to credit card companies.

So what’s needed is software to bundle the payments at each end: In a single credit card transaction, you add say $20 of tokens to an account. Each token might be worth $0.01, or even less if we want. These tokens can then be spent at participating websites to pay for access. The websites can then collect all the tokens they’ve received over say a month, bundle them together, and sell them back to the company that originally sold them to you, for slightly less than what you paid for them. These bundled transactions could actually be quite large in many cases—thousands or millions of dollars—and thus processing fees would be a very small fraction. For smaller sites there could be a minimum amount of tokens they must collect—perhaps also $20 or so—before they can sell them back. Note that if you’ve bought $20 in tokens and you are paying $0.05 per view, you can read 400 articles before you run out of tokens and have to buy more. And they don’t all have to be from the same source, as they would with a traditional subscription; you can read articles from any outlet that participates in the token system.

There are a number of technical issues to be resolved here: How to keep the tokens secure, how to guarantee that once a user purchases access to an article they will continue to have access to it, ideally even if they clear their cache, delete all cookies, or login from another computer. I can’t literally set up this website today, and even if I could, I don’t know how I’d attract a critical mass of both users and participating websites (it’s a major network externality problem). But it seems well within the purview of what the tech industry has done in the past—indeed, it’s quite comparable to the impressive (and unsettling) infrastructure that has been laid down to support ad-targeting and data brokerage.

How would such a system help protect privacy? If micropayments for content became the dominant model of funding online content, most people wouldn’t spend much time looking at online ads, and ad targeting would be much less profitable. Data brokerage, in turn, would become less lucrative, because there would be fewer ways to use that data to make profits. With the incentives to take our data thus reduced, it would be easier to enforce regulations protecting our privacy. Those fines might actually be enough to make it no longer worth the while to take sensitive data, and corporations might stop pressuring people to give it up.

No, privacy isn’t dead. But it’s dying. If we want to save it, we have a lot of work to do.

What if we taxed market share?

pnrj inequality, market failure, public policy , , , , , , ,

Apr 18 JDN 2459321

In one of his recent columns, Paul Krugman lays out the case for why corporate tax cuts have been so ineffective at reducing unemployment or increasing economic growth. The central insight is that only a small portion of corporate tax incidence actually seems to fall on real capital investment. First, most corporate tax avoidance is via accounting fictions, not real changes in production; second, most forms of investment and loan interest are tax-deductible; and the third is what I want to focus on today: Corporations today have enormous monopoly power, and taxing monopoly profits is Pigouvian; it doesn’t reduce efficiency, it actually increases it.

Of course, in our current system, we don’t directly tax monopoly profits. We tax profits in general, many—by some estimates, most—of which are monopoly (or oligopoly) profits. But some profits aren’t monopoly profits, while some monopolies are staggeringly powerful—and we’re taxing them all the same. (In fact, the really big monopolies seem to be especially good at avoiding taxes: I guarantee you pay a higher tax rate than Apple or Boeing.)

It’s difficult to precisely measure how much of a corporation’s profits are due to their monopoly power. But there is something that’s quite easy to measure that would be a good proxy for this: market share.

We could tax each corporation’s profits in direct proportion—or even literally equal to—its market share in a suitably defined market. It shouldn’t be too broad (“electronics” would miss Apple’s dominance in smartphones and laptops specifically) or too narrow (“restaurants on Broadway Ave.” would greatly overestimate the market share of many small businesses); this could pose some practical difficulties, but I think it can be done.


And what if a corporation produces in many industries? I offer a bold proposal: Use the maximum. If a corporation controls 10% of one market, 20% of another, and 60% of another, tax all of their profits at the rate of 60%.

If they want to avoid that outcome, well, I guess they’ll have to spin off their different products into different corporations that can account their profits separately. Behold: Self-enforcing antitrust.

Of course, we need to make sure that when corporations split, they actually split—it can’t just be the same CEO and board for 40 “different corporations” that all coordinate all their actions and produce subtle variations on the same product. At that point the correct response is for the FTC to sue them all for illegal collusion.

This would also disincentivize mergers and acquisitions—the growth of which is a major reason why we got into this mess of concentrated oligopolies in the first place.

This policy could be extremely popular, because it directly and explicitly targets big business. Small businesses—even those few that actually are C corporations—would see their taxes dramatically reduced, while trillion-dollar multinationals would suddenly find that they can no longer weasel out of the taxes every other company is paying.

Indeed, if we somehow managed to achieve a perfectly-competitive market where no firm had any significant market share, this corporate tax would effectively disappear. So any time some libertarian tries to argue that corporate taxes are interfering with perfect free market competition, we could point out that this is literally impossible—if we had perfect competition, this corporate tax wouldn’t do anything.

In fact, the total tax revenue would be proportional to the Herfindahl–Hirschman Index, a commonly-used measure of market concentration in oligopoly markets. A monopoly would pay 100% tax, so no one would ever want to be a monopoly; they’d immediately split into two firms so that they could pay a tax rate of 50%. And depending on other characteristics of the market, they might want to split even further than that.

I’ll spare you the algebra, but total profits in a Cournot equilibrium [PDF] with n firms are proportional to n/(n+1)^2, but with a tax rate of 1/n, this makes the after-tax profits proportional to (n-1)/(n+1)^2; this is actually maximized at n = 3. So in this (admittedly oversimplified) case, they’d actually prefer to split into 3 firms. And the difference between a monopoly and a trinopoly is quite significant.

Like any tax, this would create some incentive to produce less; but this could be less than the incentive against expanding monopoly power. A Cournot economy with 3 firms, even with this tax, would produce 50% more and sell at a lower price than a monopoly in the same market.

And once a market is highly competitive, the tax would essentially feel like a constant to each firm; if you are only 1% of the market, even doubling your production to make yourself 2% of the market would only increase your tax rate by 1 percentage point.

Indeed, if we really want to crack down on corporate tax avoidance, we could even charge this tax on sales rather than profits. You can’t avoid that by offshoring production; as long as you’re selling products in the US, you’ll be paying taxes in the US. Firms in a highly-competitive industry would still only pay a percentage point or two of tax, which is totally within a reasonable profit margin. The only firms that would find themselves suddenly unable to pay would be the huge multinationals that control double-digit percentages of the market. They wouldn’t just have an incentive to break up; they’d have no choice but to do so in order to survive.

How can we stop rewarding psychopathy?

pnrj ethics, market failure, public policy , , , , , , , , , , , , ,

Oct 1, JDN 24578028

A couple of weeks ago The New York Times ran an interesting article about how entrepreneurs were often juvenile delinquents, who then often turn into white-collar criminals. They didn’t quite connect the dots, though; they talked about the relevant trait driving this behavior as “rule-breaking”, when it is probably better defined as psychopathy. People like Martin Shkreli aren’t just “rule-breakers”; they are psychopaths. While only about 1% of humans in general are psychopaths, somewhere between 3% and 4% of business executives are psychopaths. I was unable to find any specific data assessing the prevalence of psychopathy among politicians, but if you just read the Hare checklist, it’s not hard to see that psychopathic traits are overrepresented among politicians as well.

This is obviously the result of selection bias; as a society, we are systematically appointing psychopaths to positions of wealth and power. Why are we doing this? How can we stop?

One very important factor here that may be especially difficult to deal with is desire. We generally think that in a free society, people should be allowed to seek out the sort of life they want to live. But one of the reasons that psychopaths are more likely to become rich and powerful is precisely that they want it more.

To most of us, being rich is probably something we want, but not the most important thing to us. We’d accept being poor if it meant we could be happy, surrounded by friends and family who love us, and made a great contribution to society. We would like to be rich, but it’s more important that we be good people. But to many psychopaths, being rich is the one single thing they care about. All those other considerations are irrelevant.

With power, matters are even more extreme: Most people actually seem convinced that they don’t want power at all. They associate power with corruption and cruelty (because, you know, so many of the people in power are psychopaths!), and they want no part of it.

So the saying goes: “Power tends to corrupt, and absolute power corrupts absolutely.” Does it, now? Did power corrupt George Washington and Abraham Lincoln? Did it corrupt Mahatma Gandhi and Nelson Mandela? I’m not saying that any of these men were without flaws, even serious ones—but was it power that made them so? Who would they have been, and more importantly, what would they have done, if they hadn’t had power? Would the world really have been better off if Abraham Lincoln and Nelson Mandela had stayed out of politics? I don’t think so.

Part of what we need, therefore, is to convince good people that wanting power is not inherently bad. Power just means the ability to do things; it’s what you do that matters. You should want power—the power to right wrongs, mend injustices, uplift humanity’s future. Thinking that the world would be better if you were in charge not only isn’t a bad thing—it is quite likely to be true. If you are not a psychopath, then the world would probably be better off if you were in charge of it.

Of course, that depends partly on what “in charge of the world” even means; it’s not like we have a global government, after all. But even suppose you were granted the power of an absolute dictatorship over all of humanity; what would you do with that power? My guess is that you’d probably do what I would do: Start by using that power to correct the greatest injustices, then gradually cede power to a permanent global democracy. That wouldn’t just be a good thing; it would be quite literally and without a doubt the best thing that ever happened. Of course, it would be all the better if we never built such a dictatorship in the first place; but mainly that’s because of the sort of people who tend to become dictators. A benevolent dictatorship really would be a wonderful thing; the problem is that dictators almost never remain benevolent. Dictatorship is simply too enticing to psychopaths.

And what if you don’t think you’re competent enough in policy to make such decisions? Simple: You don’t make them yourself, you delegate them to responsible and trustworthy people to make them for you. Recognizing your own limitations is one of the most important differences between a typical leader and a good leader.

Desire isn’t the only factor here, however. Even though psychopaths tend to seek wealth and power with more zeal than others, there are still a lot of good people trying to seek wealth and power. We need to look very carefully at the process of how we select our leaders.

Let’s start with the private sector. How are managers chosen? Mainly, by managers above them. What criteria do they use? Mostly, they use similarity. Managers choose other managers who are “like them”—middle-aged straight White men with psychopathic tendencies.

This is something that could be rectified with regulation; we could require businesses to choose a more diverse array of managers that is more representative of the population at large. While this would no doubt trigger many complaints of “government interference” and “inefficiency”, in fact it almost certainly would increase the long-term profitability of most corporations. Study after study after study shows that increased diversity, particularly including more equal representation of women, results in better business performance. A recent MIT study found that switching from an all-male or all-female management population to a 50-50 male/female split could increase profits by as much as forty percent. The reason boards of directors aren’t including more diversity is that they ultimately care more about protecting their old boys’ club (and increasing their own compensation, of course) than they do about maximizing profits for their shareholders.

I think it would actually be entirely reasonable to include regulations about psychopathy in particular; designate certain industries (such as lobbying and finance; I would not include medicine, as psychopaths actually seem to make pretty good neurosurgeons!) as “systematically vital” and require psychopathy screening tests as part of their licensing process. This is no small matter, and definitely does represent an incursion into civil liberties; but given the enormous potential benefits, I don’t think it can be dismissed out of hand. We do license professions; why shouldn’t at least a minimal capacity for empathy and ethical behavior be part of that licensing process?

Where the civil liberty argument becomes overwhelming is in politics. I don’t think we can justify any restrictions on who should be allowed to run for office. Frankly, I think even the age limits should be struck from the Constitution; you should be allowed to run for President at 18 if you want. Requiring psychological tests for political office borders on dystopian.

That means we need to somehow reform either the campaign system, the voting system, or the behavior of voters themselves.

Of course, we should reform all three. Let’s start with the voting system itself, as that is the simplest: We should be using range voting, and we should abolish the Electoral College. Districts should be replaced by proportional representation through reweighted range voting, eliminating gerrymandering once and for all without question.

The campaign system is trickier. We could start by eliminating or tightly capping private and corporate campaign donations, and replace them with a system similar to the “Democracy Vouchers” being tested in Seattle. The basic idea is simple and beautiful: Everyone gets an equal amount of vouchers to give to whatever candidates they like, and then all the vouchers can be redeemed for campaign financing from public funds. It’s like everyone giving a donation (or monetary voting), but everyone has the same amount of “money”.

This would not solve all the problems, however. There is still an oligopoly of news media distorting our political discourse. There is still astonishingly bad journalism even in our most respected outlets, like the way the New York Times was obsessed with Comey’s letter and CNN’s wall-to-wall coverage of totally unfounded speculation about a missing airliner.

Then again, CNN’s ratings skyrocketed during that period. This shows that the problems run much deeper than a handful of bad journalists or corrupt media companies. These companies are, to a surprisingly large degree, just trying to cater to what their audience has said it wants, just “giving the people what they want”.

Our fundamental challenge, therefore, is to change what the people want. We have to somehow convince the public at large—or at least a big enough segment of the public at large—that they don’t really want TV news that spends hours telling them nothing and they don’t really want to elect the candidate who is the tallest or has the nicest hair. And we have to get them to actually change the way they behave accordingly.

When it comes to that part, I have no idea what to do. A voting population that is capable of electing Donald Trump—Electoral College nonsense notwithstanding, he won sixty million votes—is one that I honestly have no idea how to interface with at all. But we must try.

Monopoly and Oligopoly

pnrj core principles, Top 10 things to know about economics , , , , , , , , , , , ,

JDN 2457180 EDT 08:49

Welcome to the second installment in my series, “Top 10 Things to Know About Economics.” The first was not all that well-received, because it turns it out it was just too dense with equations (it didn’t help that the equation formatting was a pain.) Fortunately I think I can explain monopoly and oligopoly with far fewer equations—which I will represent as PNG for your convenience.

You probably already know at least in basic terms how a monopoly works: When there is only one seller of a product, that seller can charge higher prices. But did you ever stop and think about why they can charge higher prices—or why they’d want to?

The latter question is not as trivial as it sounds; higher prices don’t necessarily mean higher profits. By the Law of Demand (which, like the Pirate Code, is really more like a guideline), raising the price of a product will result in fewer being sold. There are two countervailing effects: Raising the price raises the profits from selling each item, but reduces the number of items sold. The optimal price, therefore, is the one that balances these two effects, maximizing price times quantity.

A monopoly can actually set this optimal price (provided that they can figure out what it is, of course; but let’s assume they can). They therefore solve this maximization problem for price P(Q) a function of quantity sold, quantity Q, and cost C(Q) a function of quantity produced (which at the optimum is equal to quantity sold; no sense making them if you won’t sell them!):

monopoly_optimization

As you may remember if you’ve studied calculus, the maximum is achieved at the point where the derivative is zero. If you haven’t studied calculus, the basic intuition here is that you move along the curve seeing whether the profits go up or down with each small change, and when you reach the very top—the maximum—you’ll be at a point where you switch from going up to going down, and at that exact point a small change will move neither up nor down. The derivative is really just a fancy term for the slope of the curve at each point; at a maximum this slope changes from positive to negative, and at the exact point it is zero.

derivative_maximum

monopoly_general

This is a general solution, but it’s easier to understand if we use something more specific. As usual, let’s make things simpler by assuming everything is linear; we’ll assume that demand starts at a maximum price of P0 and then decreases at a rate 1/e. This is the demand curve.

linear_demand

Then, we’ll assume that the marginal cost of production C'(Q) is also linear, increasing at a rate 1/n. This is the supply curve.

linear_supply

Now we can graph the supply and demand curves from these equations. But the monopoly doesn’t simply set supply equal to demand; instead, they set supply equal to marginal revenue, which takes into account the fact that selling more items requires lowering the price on all of them. Marginal revenue is this term:

marginal_revenue

This is strictly less than the actual price, because increasing the quantity sold requires decreasing the price—which means that P'(Q) < 0. They set the quantity by setting marginal revenue equal to marginal cost. Then they set the price by substituting that quantity back into the demand equation.

Thus, the monopoly should set this quantity:

linear_monopoly_solution

They would then charge this price (substitute back into the demand equation):

linear_monopoly_price

On a graph, there are the supply and demand curves, and then below the demand curve, the marginal revenue curve; it’s the intersection of that curve with the supply curve that the monopoly uses to set its quantity, and then it substitutes that quantity into the demand curve to get the price:

elastic_supply_monopolistic_labeled

Now I’ll show that this is higher than the price in a perfectly competitive market. In a competitive market, competitive companies can’t do anything to change the price, so from their perspective P'(Q) = 0. They can only control the quantity they produce and sell; they keep producing more as long as they receive more money for each one than it cost to produce it. By the Law of Diminishing Returns (again more like a guideline) the cost will increase as they produce more, until finally the last one they sell cost just as much to make as they made from selling it. (Why bother selling that last one, you ask? You’re right; they’d actually sell one less than this, but if we assume that we’re talking about thousands of products sold, one shouldn’t make much difference.)

Price is simply equal to marginal cost:

perfect_competition_general

In our specific linear case that comes out to this quantity:

linear_competitive_solution

Therefore, they charge this price (you can substitute into either the supply or demand equations, because in a competitive market supply equals demand):

linear_competitive_price

Subtract the two, and you can see that monopoly price is higher than the competitive price by this amount:

linear_monopoly_premium

Notice that the monopoly price will always be larger than the competitive price, so long as e > 0 and n > 0, meaning that increasing the quantity sold requires decreasing the price, but increasing the cost of production. A monopoly has an incentive to raise the price higher than the competitive price, but not too much higher—they still want to make sure they sell enough products.

Monopolies introduce deadweight loss, because in order to hold the price up they don’t produce as many products as people actually want. More precisely, each new product produced would add overall value to the economy, but the monopoly stops producing them anyway because it wouldn’t add to their own profits.

One “solution” to this problem is to let the monopoly actually take those profits; they can do this if they price-discriminate, charging a higher price for some customers than others. In the best-case scenario (for them), they charge each customer a price that they are just barely willing to pay, and thus produce until no customer is willing to pay more than the product costs to make. That final product sold also has price equal to marginal cost, so the total quantity sold is the same under competition. It is, in that sense, “efficient”.

What many neoclassical economists seem to forget about price-discriminating monopolies is that they appropriate the entire surplus value of the product—the customers are only just barely willing to buy; they get no surplus value from doing so.

In reality, very few monopolies can price-discriminate that precisely; instead, they put customers into broad categories and then try to optimize the price for each of those categories. Credit ratings, student discounts, veteran discounts, even happy hours are all forms of this categorical price discrimination. If the company cares even a little bit about what sort of customer you are rather than how much money you’re paying, they are price-discriminating.

It’s so ubiquitous I’m actually having trouble finding a good example of a product that doesn’t have categorical price discrimination. I was thinking maybe computers? Nope, student discounts. Cars? No, employee discounts and credit ratings. Refrigerators, maybe? Well, unless there are coupons (coupons price discriminate against people who don’t want to bother clipping them). Certainly not cocktails (happy hour) or haircuts (discrimination by sex, the audacity!); and don’t even get me started on software.

I introduced price-discrimination in the context of monopoly, which is usually how it’s done; but one thing you’ll notice about all the markets I just indicated is that they aren’t monopolies, yet they still exhibit price discrimination. Cars, computers, refrigerators, and software are made under oligopoly, a system in which a handful of companies control the majority of the market. As you might imagine, an oligopoly tends to act somewhere in between a monopoly and a competitive market—but there are some very interesting wrinkles I’ll get to in a moment.

Cocktails and haircuts are sold in a different but still quite interesting system called monopolistic competition; indeed, I’m not convinced that there is any other form of competition in the real world. True perfectly-competitive markets just don’t seem to actually exist. Under monopolistic competition, there are many companies that don’t have much control over price in the overall market, but the products they sell aren’t quite the same—they’re close, but not equivalent. Some barbers are just better at cutting hair, and some bars are more fun than others. More importantly, they aren’t the same for everyone. They have different customer bases, which may overlap but still aren’t the same. You don’t just want a barber who is good, you want one who works close to where you live. You don’t just want a bar that’s fun; you want one that you can stop by after work. Even if you are quite discerning and sensitive to price, you’re not going to drive from Ann Arbor to Cleveland to get your hair cut—it would cost more for the gasoline than the difference. And someone is Cleveland isn’t going to drive all the way to Ann Arbor, either! Hence, barbers in Ann Arbor have something like a monopoly (or oligopoly) over Ann Arbor haircuts, and barbers in Cleveland have something like a monopoly over Cleveland haircuts. That’s monopolistic competition.

Supposedly monopolistic competition drives profits to zero in the long run, but I’ve yet to see this happen in any real market. Maybe the problem is that conceit “the long run”; as Keynes said, “in the long run we are all dead.” Sometimes the argument is made that it has driven real economic profits to zero, because you’ve got to take into account the cost of entry, the normal profit. But of course, that’s extremely difficult to measure, so how do we know whether profits have been driven to normal profit? Moreover, the cost of entry isn’t the same for everyone, so people with lower cost of entry are still going to make real economic profits. This means that the majority of companies are going to still make some real economic profit, and only the ones that had the hardest time entering will actually see their profits driven to zero.

Monopolistic competition is relatively simple. Oligopoly, on the other hand, is fiercely complicated. Why? Because under oligopoly, you actually have to treat human beings as human beings.

What I mean by that is that under perfect competition or even monopolistic competition, the economic incentives are so powerful that people basically have to behave according to the neoclassical rational agent model, or they’re going to go out of business. There is very little room for errors or even altruistic acts, because your profit margin is so tight. In perfect competition, there is literally zero room; in monopolistic competition, the only room for individual behavior is provided by the degree of monopoly, which in most industries is fairly small. One person’s actions are unable to shift the direction of the overall market, so the market as a system has ultimate power.

Under oligopoly, on the other hand, there are a handful of companies, and people know their names. You as a CEO have a reputation with customers—and perhaps more importantly, a reputation with other companies. Individual decision-makers matter, and one person’s decision depends on their prediction of other people’s decision. That means we need game theory.

The simplest case is that of duopoly, where there are only two major companies. Not many industries are like this, but I can think of three: soft drinks (Coke and Pepsi), commercial airliners (Boeing and Airbus), and home-user operating systems (Microsoft and Apple). In all three cases, there is also some monopolistic element, because the products they sell are not exactly the same; but for now let’s ignore that and suppose they are close enough that nobody cares.

Imagine yourself in the position of, say, Boeing: How much should you charge for an airplane?

If Airbus didn’t exist, it’s simple; you’d charge the monopoly price. But since they do exist, the price you charge must depend not only on the conditions of the market, but also what you think Airbus is likely to do—and what they are likely to do depends in turn on what they think you are likely to do.

If you think Airbus is going to charge the monopoly price, what should you do? You could charge the monopoly price as well, which is called collusion. It’s illegal to actually sign a contract with Airbus to charge that price (though this doesn’t seem to stop cable companies or banks—probably has something to do with the fact that we never punish them for doing it), and let’s suppose you as the CEO of Boeing are an honest and law-abiding citizen (I know, it’s pretty fanciful; I’m having trouble keeping a straight face myself) and aren’t going to violate the antitrust laws. You can still engage in tacit collusion, in which you both charge the monopoly price and take your half of the very high monopoly profits.

There’s a temptation not to collude, however, which the airlines who buy your planes are very much hoping you’ll succumb to. Suppose Airbus is selling their A350-100 for $341 million. You could sell the comparable 777-300ER for $330 million and basically collude, or you could cut the price and draw in more buyers. Say you cut it to $250 million; it probably only costs $150 million to make, so you’re still making a profit on each one; but where you sold say 150 planes a year and profited $180 million on each (a total profit of $27 billion), you could instead capture the whole market and sell 300 planes a year and profit $100 million on each (a total profit of $30 billion). That’s a 10% higher profit and $3 billion a year for your shareholders; why wouldn’t you do that?

Well, think about what will happen when Airbus releases next year’s price list. You cut the price to $250 million, so they retaliate by cutting their price to $200 million. Next thing you know, you’re cutting your own price to $150.1 million just to stay in the market, and they’re doing the same. When the dust settles, you still only control half the market, but now you profit a mere $100,000 per airplane, making your total profits a measly $15 million instead of $27 billion—that’s $27,000 million. (I looked it up, and as it turns out, Boeing’s actual gross profit is about $14 billion, so I underestimated the real cost of each airplane—but they’re clearly still colluding.) For a gain of 10% in one year you’ve paid a loss of 99.95% indefinitely. The airlines will be thrilled, and they’ll likely pass on much of those savings to their customers, who will fly more often, engage in more tourism, and improve the economy in tourism-dependent countries like France and Greece, so the world may well be better off. But you as CEO of Boeing don’t care about the world; you care about the shareholders of Boeing—and the shareholders of Boeing just got hosed. Don’t expect to keep your seat in the next election.

But now, suppose you think that Airbus is planning on setting a price of $250 million next year anyway. They should know you’ll retaliate, but maybe their current CEO is retiring next year and doesn’t care what happens to the company after that or something. Or maybe they’re just stupid or reckless. In any case, your sources (which, as an upstanding citizen, obviously wouldn’t include any industrial espionage!) tell you that Airbus is going to charge $250 million next year.

Well, in that case there’s no point in you charging $330 million; you’ll lose the market and look like a sucker. You could drop to $250 million and try to set up a new, lower collusive equilibrium; but really what you want to do is punish them severely for backstabbing you. (After all, human beings are particularly quick to anger when we perceive betrayal. So maybe you’ll charge $200 million and beat them at their own conniving game.

The next year, Airbus has a choice. They could raise back to $341 million and give you another year of big profits to atone for their reckless actions, or they could cut down to $180 million and keep the price war going. You might think that they should continue the war, but that’s short-term thinking; in the long run their best strategy is to atone for their actions and work to restore the collusion. In response, Boeing’s best strategy is to punish them when they break the collusion, but not hold a grudge; if they go back to the high price, Boeing should as well. This very simple strategy is called tit-for-tat, and it is utterly dominant in every simulation we’ve ever tried of this situation, which is technically called an iterated prisoner’s dilemma.

What if there are more than two companies involved? Then things get even more complicated, because now we’re dealing with things like what A’s prediction of what B predicts that C will predict A will do. In general this is a situation we only barely understand, and I think it is a topic that needs considerably more research than it has received.

There is an interesting simple model that actually seems to capture a lot about how oligopolies work, but no one can quite figure out why it works. That model is called Cournot competition. It assumes that companies take prices and fixed and compete by selecting the quantity they produce at each cycle. That’s incredibly bizarre; it seems much more realistic to say that they compete by setting prices. But if you do that, you get Bertrand competition, which requires us to go through that whole game-theory analysis—but now with three, or four, or ten companies!

Under Cournot competition, you decide how much to produce Q1 by monopolizing what’s left over after the other companies have produced their quantities Q2, Q3, and so on. If there are k companies, you optimize under the constraint that (k-1)Q2 has already been produced.

Let’s use our linear models again. Here, the quantity that goes into figuring the price is the total quantity, which is Q1+(k-1)Q2; while the quantity you sell is just Q1. But then, another weird part is that for the marginal cost function we use the whole market—maybe you’re limited by some natural resource, like oil or lithium?

It’s not as important for you to follow along with the algebra, though here you go if you want:

linear_Cournot_1

Then the key point is that the situation is symmetric, so Q1 = Q2 = Q3 = Q. Then the total quantity produced, which is what consumers care about, is kQ. That’s what sets the actual price as well.

linear_Cournot_2

The two equations to focus on are these ones:

linear_Cournot_3

If you plug in k=1, you get a monopoly. If you take the limit as k approaches infinity, you get perfect competition. And in between, you actually get a fairly accurate representation of how the number of companies in an industry affects the price and quantity sold! From some really bizarre assumptions about how competition works! The best explanation I’ve seen of why this might happen is this 1983 paper showing that price competition can behave like Cournot competition if companies have to first commit to producing a certain quantity before naming their prices.

But of course, it doesn’t always give an accurate representation of oligopoly, and for that we’ll probably need a much more sophisticated multiplayer game theory analysis which has yet to be done.

And that, dear readers, is how monopoly and oligopoly raise prices.