The Costs and Benefits of Monopoly

In this video, we explore the costs and benefits of monopolies. We cover how monopolies and patents breed deadweight loss, market inefficiencies, and corruption. But we also look at what would happen if we eliminated patents for industries with high R&D costs, such as the pharmaceutical industry. Eliminating patents in this case may result in less innovation and, specifically, fewer new drugs being created. We also consider some of the tradeoffs of patents and look at alternative ways to reward research and development such as patent buyouts and using prizes to foster innovation.

Microeconomics Course: http://mruniversity.com/courses/principles-economics-microeconomics

Ask a question about the video: http://mruniversity.com/courses/principles-economics-microeconomics/costs-benefits-monopoly-pharmaceutical-companies#QandA

Next video: http://mruniversity.com/courses/principles-economics-microeconomics/introduction-price-discrimination

♪ [music] ♪

- [Alex] In our final talk
in monopoly,

we're going to discuss
the costs of monopoly,

but also the potential benefits.

The major costs of monopoly
is that compared to competition,

monopoly is inefficient.

It leads to a loss in the gains
from trade or a deadweight loss.

Let's remind ourselves
about the gains from trade

under competition
and then we can compare

with monopoly.

Here we'll simplify
with a flat supply curve,

a constant cost industry.

In this case the total gains
from trade go to consumers

in this blue area right here.

Now let's see what the total gains
from trade or total welfare

is under monopoly.

We choose exactly
the same demand curve

and the same constant cost curve.

We find the profit maximizing price
and quantity in the usual way.

Consumers, not surprisingly,
get less under monopoly

since the price is higher.

Now some of what the consumers lose
is transferred to the monopolist

in terms of profit, and as far
as an economist is concerned,

at least someone is getting
these gains from trade.

So the transfer is neutral.

What's bad however,
is that total welfare falls

under monopoly
because no one gets this area,

the deadweight loss.

These are trades that from a social
point of view are beneficial.

The demanders are willing to pay
more than what would be the cost

of producing these goods.

These trades, however,
don't happen.

Even though they're socially
beneficial they don't happen

because they aren't profitable,
they aren't privately beneficial.

Think of a movie theater
that is half empty.

Surely there are some people
out there who would value

watching the movie at more
than its marginal cost, about zero.

So why doesn't the movie theater
lower the price to these people?

Because to do so it would have
to lower the price to everyone

and that would reduce
total profits.

So the basic lesson is this.

Consumers buy a good
so long as the value to them

exceeds the price.

Under competition, price
is equal to marginal cost,

so consumers will buy every unit
such that the value to them

is a greater
than the marginal cost.

That's efficient.

Under monopoly, consumers
also buy so long as the value

to them is greater than the price,
but since price is greater

than marginal cost,
we get too few units produced.

We get a loss
in the gains from trade.

Let's remind ourselves
what deadweight loss

looks like in practice.

GSK prices Combivir
at $12.50 per pill.

The marginal cost is 50 cents.

The deadweight loss is the value
of the trades that do not occur

because price is greater
than marginal cost.

Some people would be willing
and able to pay $10 per pill

or $4, or even $1 per pill
and those prices

would more than cover
the cost of producing those pills.

But those trades don't occur

because they aren't
profitable to GSK.

Many monopolies around the world
are born of government corruption.

In Indonesia, Tommy Suharto,
the president's son,

was given the highly profitable
clove monopoly.

He used the profits
from that monopoly

to buy Lamborghini.

Not a Lamborghini --
he bought the entire company.

These kinds of monopolies
are unredeemed.

They have costs
and no social benefits at all.

Some monopolies however,
do have countervailing benefits.

Consider what would happen
if the U.S. eliminated patents

for pharmaceuticals.

Competition, it's true,
would drive down the price

of existing drugs to marginal cost,
as happens today

as soon as patents expire,
usually within 10 to 15 years

after the drug first enters
the market.

But it costs about
a billion dollars

to bring the average new drug
to market in the United States,

and R&D costs are not included
in marginal cost.

As the saying goes,
it costs about a billion dollars

to create the first pill,
50 cents to create the second pill.

50 cents is the marginal cost,
the cost of an additional pill,

but to bring that first pill
to market costs

about a billion dollars.

If price were quickly pushed
down to marginal cost,

firms would not be able
to recover their R&D costs,

and the result would be
fewer new drugs.

Once the drug is created,
the patent, the monopoly,

creates inefficiency,
we get too few units produced.

But the patent increases
the incentive to produce

the new drugs in the first place.

So there's a trade-off.

More monopoly
reduces static efficiency,

the quantity produced,
but can increase

dynamic efficiency, the incentive
to do research and development.

This trade-off applies
to other goods

with high development cost,
not just pharmaceuticals.

Information goods,
goods like music, movies,

computer programs,
new chemicals, new materials,

new technologies.

These typically have high
development costs

and low marginal cost
of production.

And that suggests there may be
possible benefits to patent

or copyright protection.

More generally for these types
of goods there's a policy trade-off

which we always want
to keep in mind.

That is lower prices today
may generate fewer new ideas

in the future.

Nobel prize winning
economic historian, Douglas North,

for example, has argued,
"The failure to develop

systematic property rights
in innovation

up until fairly modern times
was a major source

of the slow pace
of technological change."

Is there a better way
of navigating this trade-off?

Perhaps.

Suppose that the government
bought up a pharmaceutical patent

for its total monopoly profits
and then they ripped the patent up.

Competitors would enter
and drive the price of the drug

down to marginal cost,
thus we would have

static efficiency.

At the same time,
since the government

was paying firms
their monopoly profits,

we would still have lots
of incentive to do research

and development --
dynamic efficiency.

Thus we could have
the best of all worlds.

Of course, there may be
some downsides as well.

Higher taxes to pay
for the patent also have

their own deadweight loss,
and it might be difficult

to say exactly
how much a patent is worth.

And there could be
possible corruption.

Nevertheless, this is an idea
we're thinking about,

and perhaps worth
experimenting with.

Prizes are another way
of navigating the trade-off.

As with patent buyouts,
the idea is that a firm

is offered up front its R&D costs.

But the government
only pays the firm

if it achieves a certain goal.

And if that goal is achieved,
the technology goes

into the public domain
and could be used by anyone.

SpaceShipOne, for example,
won $10 million

for being the first privately
developed manned rocket

capable of reaching space
and returning

in a short period of time.

And prizes are being used
more often.

The government set up a prize
for better light bulbs,

for example,
and that worked quite well.

There's also a third way
of navigating the trade-off.

You may have noticed, for example,
that so far we've assumed

that the monopolist
must charge the same price

to everyone.

Is this necessarily true?

In some cases,
the monopolist can charge

different prices
to different people --

price discrimination.

As we'll see in the next chapter
and set of lectures,

price discrimination explains a lot
about how products are priced

and it also has some costs
and some benefits

which we'll be discussing.

See you then, thanks.

- [Narrator] If you want
to test yourself,

click "Practice Questions."

Or if you're ready to move on,
just click "Next Video."

♪ [music] ♪