Columbia University

Graduate School of Business

Managerial Economics (B6006)

Classes 15-17

Industry Analysis:
Issues in Market Power

I. Introduction
All (or most of) the advanced industrial societies put severe legal restrictions on market power
and have institutions in charge of guaranteeing the competitive nature of the market place (called
Antitrust Commissions or Agencies). However, having a monopoly does not by itself constitute a
violation of the law. Superior products, business acumen and so on are legitimate reasons for the
acquisition of market power. Patents are, for instance, pervasive legal arrangements that,
forbidding the imitation of a product or technology, create barriers to entry and, thus, market
power. Therefore, simplifying, monopolization is forbidden unless it is not the product of
innovation.

Why?

New products and technologies enhance the welfare of consumers. The legislation in many
countries is aimed at protecting consumer welfare. If a monopoly is not the outcome of
innovation activity, it is going to harm the consumers’ welfare by restricting trade and increasing
price.

In the US, lots of corporations have been investigated for violations of the anti-monopoly laws
(The Sherman Act). To wit: Alcoa, IBM, ATT and Microsoft have all struggled with the antitrust
laws. Furthermore, mergers between companies resulting in a decrease of competition are not
usually allowed; see, e.g., Staples and Office Depot in 1997.

Why does the government want to limit the power of monopolies? Why does it want sometimes
to break them down into smaller firms? What business strategies can a manager of a monopoly
adopt, or be forced to adopt, and with what consequences for its profits, its customers and for the
likelihood of government intervention?

In this handout we want to clarify the welfare issues related to the different forms of industrial
organization. We are going to argue that, for standard technological processes:
1) competitive markets are efficient;
2) market power generates efficiency losses.

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The core of the discussion must evaluate the benefits to customers, and then to society at large,
of a given industrial structure. In order to do that, we use the notion of consumer surplus. We
first go back to this concept and explain why it is a measure of the benefits customers get from
purchasing objects and services from firms.

II. Measuring a consumer’s satisfaction with a purchase

The basic idea here is that we are going to get a rough dollar measure of consumer satisfaction
after the purchase. Actually, what we want to measure is the change in satisfaction that has
occurred because of the purchase. We will not factor in customer service satisfaction (although
this could be easily done, it is just an inessential detail at this point), but only refer to the value to
a buyer of the purchase made, in terms of the price paid and the evaluation she gives to the
object –i.e., the “utility” of having the object. We already argued that buyers are willing to
purchase a product only if the price does not exceed a certain value, their reservation price.
Recall that the reservation price for a buyer is the maximum price at which the individual is
willing to purchase the product. Therefore, this must be the dollar equivalent of what satisfaction
the buyer will receive from having the object. We go over this idea once more, to understand
how to relate it to the change in satisfaction a consumer experiences after a purchase.

Reservation prices and satisfaction

For instance, you walk into a store and you see some trendy, nice trousers. You try them on and
they look great on you. Then, you look at the price tag and you see a $200+ on them. At this
point, some of you may react by saying ‘This is too expensive for me’. What you mean is that
the dollar value to you of having the trousers is below $200+. Notice that this dollar value is
what you could call the satisfaction of going from having 0 such pants to 1 pair (or from 1 to 2
pairs, if you already had one!). We rarely actually pin down what this value is, but nevertheless
we have a rough idea. This dollar value can be called the “utility” of having one (additional) pair
of trousers, and it is the maximum price you would like to pay for them.

Change in satisfaction or consumer surplus

On the other hand, some other customers may react with surprise: ‘Wow! Only $200+! I thought
they’d be selling them at a much higher price, such nice, sleek pants!’ Then, you’d go ahead and
purchase them, thinking you really came out with a bargain deal! Not only you got the pants you
wanted, but you paid so little (to you) for them. Your satisfaction from the purchase is then given
by the utility of having this one (additional) pair of pants, as well as by the money you ‘saved’ in
the purchase: the difference between what the trousers are worth to you, and how much you
actually paid them.

Now let’s be careful. True, you got the pants you wanted, but you had to pay for them. Hence,
you go home with more pants, but less money. The change in satisfaction must be the difference
between these two:

change in satisfaction from purchase = ‘utility’ from having the product – price paid for it

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So in fact, the change in your level of satisfaction from the purchase is just the savings you
consider to have made because they sold the pants to you so cheap. Since the ‘utility’ from
having the product is what we called its reservation price, the change in satisfaction must be

change in satisfaction from purchase = reservation price – price paid

In fact, if you had paid exactly your personal dollar value, you’d be totally indifferent between
having the trousers or not: true, you would get them, but you’d give up money you could have
spent elsewhere, and you’d give up exactly as much money as you could spend on movies,
drinks at a bar, a book you really like…all this is exactly equivalent to you, let’s say, to having
the pants. So, if you paid a price exactly equal to your reservation price, after the purchase you’d
be as happy as you were before (this of course must include the value to you of the time spent
shopping).

Economists call this change in satisfaction the individual consumer surplus. As you see, it does
measure the dollar value of a change in satisfaction to a consumer from having purchased the
product.

Now, if we want to measure the benefit to all consumers from the purchase of a product, we need
only simply sum the individual consumer surpluses across consumers. The nice thing is that we
do not care if Mary thinks suede trousers make her ‘happy’, and Sue thinks they make her
‘happy, happy, happy!’ We have measured these people happiness in dollars, which are dollars
for everyone, and we can therefore sum them without the risk of making comparison across
levels of individual happiness (which would be like summing apples and oranges…).

So let’s go back to the department store where the trendy trousers were sold. At the door, we
register each customer having purchased the pants on their way out, and say we ask them to tell
us how much they feel they saved while they bought the trousers at the store. Each customer will
give us a dollar amount corresponding to reservation price less the price paid, or their consumer
surplus. Let’s say that 10 customers today bought these pants, and their perceived savings were
as listed below (already ranked):

Customer #1 2 3 4 5 6 7 8 9 10
Savings $30 20 5 5 4 3 2 2 1 1

Then, consumer surplus in this case would be equal to the sum of all these ‘savings’, or 30 + 20
+ 2*5 + 4 + 3 + 2*2 + 2*1 = $73 . If the price was P = 228, then we can compute the implicit
reservation prices, and draw a demand graph for trousers, as follows

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 P 258

248
233
232
231
230
229

P = 228

1 2 3 4 5 6 7 8 9 10 # customers

The shaded area corresponds to the total consumer surplus in this market.
When the number of consumers is very large, and the demand curve is continuous, the consumer
surplus is easily computed as the area below the demand and above the price paid by the
consumers.

III. Assessing the value of an industrial organization

Given a market is organized with an industrial structure where one, few or many firms are
operating, how do we measure the benefits that are generated by production and exchange in that
market?

We know already how to measure the benefits to the firms: we measure them in terms of profits
made by producing and selling the product. Now we also have a measure of the benefits that
accrue to the consumers: it is the consumer surplus.

So given an equilibrium in the market, we can answer the question: What benefits do our
firms/managers bring to society, or to the market participants, at least?

The answer is: consumer surplus plus the firms’ profits.

Maximizing market participants’ benefits and efficiency

We can also ask a more ambitious question: Is this way of producing and selling –i.e.,
exchanging the product- maximizing the benefits for everyone, both firms and consumers (or
sellers and buyers)?

To answer, it’s enough to verify that there is no other way to set price or quantity produced that

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would give rise to higher total benefits. We then say that an industrial organization is efficient.

When assessing the efficiency of an organization, we need to verify that there is no other way to
set price or quantity produced that would give rise to higher benefits to market participants.

To illustrate the logic of the analysis, we will consider as an example the production in an
industry with technologies that give rise to constant, although nonzero, marginal and average
costs of production, i.e.,

MC(Q) = AC(Q) = constant

These are industries such as producing consumer durables (refrigerators, air conditioners, basic
home computers, and so on…). These are sectors in which no major innovation occurs, and
where firms dispose of a standard technology that can be replicated to produce at any scale of
activity with the same unit costs.

We will assess the efficiency of this industry for two types of situations or market organizations:
perfect competition and monopoly.

First, we look at the perfectly competitive case.

IV. Efficiency of perfect competition

We go back and take a look at the picture of a short-run equilibrium under perfect competition
(but careful: here, like in the NYC taxicab example, the supply is flat).

P
10

D
Tc

S = MC = AC = 5
P*

Q* = 10 Q

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A qualitative look at the picture for now is enough. The equilibrium price and quantity are given
by P* and Q*, respectively. Right now, the benefits to the market participants are given by the
consumer surplus triangle Tc, and the profits are Πc = 0.
So total benefits are equal to Tc (+ Πc = 0).

It may help you fix the ideas to read the example with the following numbers:
- the market demand curve is Qd = 20 – 2p;
- MC = AC = 5.
Then, the industry supply is perfectly elastic at p = MC = 5. The inverse demand is p = 10 - .5Qd. At
equilibrium, demand equals supply, or P* = 5 = 10 - .5 Q*, which gives Q* = 10.
Consumer surplus is the area of the shaded triangle (below the demand curve and above the flat line MC
= 5, between quantities of 0 and 10): height (5) x side (10) / 2 = 25 = Tc.
So, total benefits in this market are currently $25.

In order to verify whether or not the market is efficient, we try to find a different way to produce
and price the product. To further simplify things, let’s make the following assumption: each
consumer in this market only purchases one unit of the product. Nothing we say depends on this,
but it helps keeping a story in mind.

Let’s consider first just increasing the output to Q’, Q’ > Q*. In order to increase the volume of
sales, we have to decrease the price from P* to P’, P’ < P. Thus, since P*=AC=MC, the price P’
is below the AC and the firm is, therefore, realizing losses. The size of this losses is then equal to
(P’-AC)Q’, i.e., the sum of areas I, II and II in the picture below.

MC = AC
P*
III
I II
P’

Q* Q’ Q

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Evidently, this maneuver reduces the welfare of the firm. However, there is an opposite force
pushing toward an increase of social welfare. Since the price has decreased and the sales
expanded, the consumer surplus increased. The size of this increase is equal to the sum of the
areas I and II in the picture below. Thus, the increase in consumer surplus less than compensates
the losses of the firm. The net loss is equal to area III in the picture below.

We have shown that increasing output is not going to make things better for our market
participants. What about reducing it?

Consider a reduction in output to Q”, Q” < Q*. Evidently, the price of the product rises from P*
to P”, P” > P*. As a consequence, there will be a reduction in consumer surplus (as well as a
reduction in the number of costumers) equal to the sum of the areas I and II in the picture below,
but, since the price is now above the average cost, firm are realizes positive profits, equal to the
sum of the areas I . Once again the overall effect is to reduce social welfare. The size of the dead-
weight loss is equal to the area II, as illustrated by the picture below.

P”

I II
MC = AC
P*

Q” Q* Q

Conclusion: We could not find any other way to organize this market that would make market
participants happier. Therefore, the competitive industry (or free market) system of production
and exchange is efficient.

The efficiency of the competitive markets is quite a striking result. Firms are only profit-
maximizers and consumers behave looking at their own self-interest as expressed by their

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reservation prices. Apparently, nobody seems to care very much about nobody else.
Nevertheless, competitive markets reach an efficient allocation of resources.a

Let’s just add one obvious comment: efficiency says nothing about the distribution of happiness.
By no means the market system is equitable, in the sense of treating everyone the same, for
example. If this is not already obvious, think about the surplus the highest evaluation and the
lowest evaluation buyers are getting: they are obviously different. Not to mention that a low
willingness to pay is likely to be correlated to a low income, other things equal. Now, those who
do not purchase the product are those with a low willingness to pay.

V. Monopoly and efficiency

Let’s now study the same market with only one firm, a monopolist using the same technology as
the possibly thousands of competitive firms that were operating in the industry up to now.

Since the technology has constant returns to scale, i.e., constant unit costs of production, this will
not alter the marginal or average cost that the monopolist will face. In this market, production
can be organized equivalently with one gigantic producer, or many tiny firms, without affecting
costs.

Let’s examine the efficiency of this monopoly now. Again, a qualitative look at the now familiar
picture will suffice.

The manager of the monopolistic firm will choose a scale of activity QM so that MR(QM) = MC,
and charge a price PM off the demand curve.

For the welfare analysis, refer to the simple graph below.

As we know, we can measure the benefits to market participants as the consumer surplus,
corresponding to the area TM, plus the firm’s profits, corresponding to the area ΠM. Total
benefits are then given by TM + ΠM.

You can see immediately that TM + ΠM < Tc !

The area DW which represents the difference is called the deadweight loss of the monopoly. The
monopoly will produce less in equilibrium than a perfectly competitive industry, and will charge
a higher price. Consumers will have less surplus for themselves, and this is enough to show that
perfect competition is not dominated by a monopoly and that monopoly is inefficient.

a
The conclusion changes when we consider public goods and/or external effects generated by production and
consumption on the society welfare (like for instance, pollution, congestion and so on…). See below.

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 P
10

TM
PM
= 7.5 D
ΠM
DW
MC = AC

MR

QM = 5 Q* Q

Again, we can compute numbers to measure this. Recall that for the demand Qd = 20 – 2p, MR(Q) = 10 –
Q, and from MR(Q) = MC we get 10 – Q = 5, or QM = 5, while PM = 7.5. Now, profits are
ΠM = 7.5 x 5 – 5x5 = 12.5.
Consumer surplus is the area of the triangle below the demand curve and above PM between 0 and 5, or:
height (2.5) x side (5) / 2 = 6.25 = TM.

Now the total benefits are TM + ΠM = 6.25 + 12.5 = 18.75

But total benefits under perfect competition were Tc = 25.
The difference is the deadweight loss, DW = 6.25.

Conclusion: The monopoly is inefficient.

VI. Remarks on what to do to improve things

1. Although perfect competition is better than monopoly, it does not mean that increasing
competition in an industry is going to be saluted with happiness by everyone. Think
about the monopolist himself, who sees profits reduced and, eventually, vanished.
2. From what we know from price discrimination, if a monopoly is already in a position to
perfectly price discriminate, than the resulting market outcome will be efficient. As we
saw earlier, it gives an output Q* = 10 such that P(Q*) = 5 = MC, just exactly what it
would happen under perfect competition. The obvious difference is that now the firm is
appropriating all the gains from trade, and consumers get nothing. Now you see why
price discrimination is not usually advocated by consumer groups.

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 3. There is another way to get the monopoly to achieve the level of output which is
efficient, that is, Q*. Just force the monopolist to price the product at the marginal cost.
This is called in business practice marginal cost pricing. The only problem with marginal
cost pricing is (aside from the fact that managers can hide the true costs of production)
that often monopolies that are in such a position in mature industries are natural
monopolies. That is, they enjoy ever-decreasing average costs, like in the following
picture

AC

MC
P*
D

Q* Q

Now you see the problem. By forcing the monopolist to charge a price equal to marginal
cost, we are forcing them to make losses (as MC < AC!). Who’s paying for this? Well, it’s
not customers. It’s the owners…usually the taxpayers, if the firm is publicly owned.

In fact, when the technology defining the production process of an industry displays
economies of scale of this kind, i.e., ever decreasing average costs, perfect competition
cannot arise if we leave it to the market forces themselves to sort out good and bad firms. So
it is no surprise that forcing the monopolist to behave like a perfectly competitive firm does
not work.

Reminder: all we have said applies to relations between firms and consumers, but also
applies to relations among different units of the same firm. Any division or service in a
large corporation enjoying market power relative to other divisions will create
inefficiencies within the organization.

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 Externalities and public goods
I. Introduction

It is commonly believed that free markets allocate resources efficiently. We have illustrated this
phenomenon by showing that (perfectly) competitive markets maximize economic surplus, thus
are efficient: perfect competition maximizes the welfare of the participants in the markets.

There are, however, a variety of circumstances where allowing sellers and buyers to interact
freely through the market will result in market inefficiency. The first is when there are ever
decreasing average costs. We have already seen that this will be incompatible with perfect
competition, and will leave only one firm —or at most, one leader and few satellites— in the
market, resulting in the exercise of market power. Market power, we also saw, generates
inefficiencies measured by the dead-weight loss (from monopolization). The objective of these
notes is to present and analyze another major source of such inefficiency, namely externalities,
and the related economic phenomenon of public goods.

Aside from allowing further exploration of market efficiency, the notions of externalities and of
public good will also be useful in understanding various strategic management and
organizational issues.

Economists equate the “problem” of externality or public good with that of “missing markets”.
We will show why this missing market gives rise to market inefficiency, and we will debate what
solutions can improve society’s welfare.

First, let’s clear up the terminology.

II. Externalities and public goods

An externality is an economic activity (of production or consumption) that has a direct impact
onto someone else’s consumption or production (i.e., satisfaction from consumption, or profits
from production).

Intuitively speaking, there is an externality when, in addition to the product that is being
produced by sellers or consumed by buyers, there is an additional by-product that is being
consumed. The word “consumed” might be misleading, because this by-product can be
something bad (e.g., pollution produced as a by-product of electric energy), or good (e.g., the
increased health benefit to my child when OTHER kids in his class get immunization shots
against a contagious disease).

Notice that in both examples the by-product was neither bought nor sold in any market exchange.
That’s why economists equate the “problem” of externality with that of “missing markets”. The
source of the problem, therefore, is that there is a “good” (or a “bad”) being produced and/or
consumed outside the market system.

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Consider the following examples:

Driving a car (−, consumption).

Producing electric energy (−, production)
Obtaining education (+, consumption)
Immunization (+, consumption)
Writing software (+, production)

Consider the first two items. What do they have in common and what they do not? Driving cars
generates greenhouse gases. Similarly, the production of energy by, for instance, a coal power
plant, generates toxic gases. This is the common aspect. Both activities produce an external
effect, the emission of gases, which, by polluting the environment, reduces the welfare of
everybody. This is a negative externality.
The difference is that in the first example the external effect is (mainly) caused by the consumers
using (driving) the car, while, in the second, by the producers of the energy. Hence, we talk
about a negative consumption externality and a negative production externality, respectively.

The next two items, on the other hand, are examples of positive, and consumption, externalities.
The second example, of immunization, was already discussed above. As for the first, it is
commonly believed that not only those who receive (basic) education benefit from it (indirectly).
My child benefits from interacting with more educated and well behaved kids, we all prefer that
our neighbors and fellow citizens are more educated, thus making better choices when casting
their votes in the political arena or in any other activities that are likely to affect us all. In other
words, not only the direct consumer of education benefits from her getting education.

Notice how this effect is very different from the education consumed by my lawyer during her
studies at law school. It’s true that I benefit from her education, but this benefit is exchanged in a
market transaction (I pay my lawyer her fees) and, therefore, is not considered an externality!

Last but not least, writing computer software creates a positive production externality: the firm
first developing some software finds some computer code that allows other firms to (better)
produce their own software. Or simply, within the same firm the search routine-writing division
produces an input that can then be sold by the database software producing as well as by the
search engine producing divisions.

This last is also an example of public good, that is, a good that can be consumed by a user
without compromising its consumption opportunity by others.

Here the good produced is software code, consumption corresponds to use (as input) by a
software developer. The good is produced by the first firm designing some software, who uses
the developed new code; the code is then used by other firms again, to develop their own

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software. The by-product of production is now the code. While there is a market for the product,
that is, for the software, there is no market for the code itself.

Other examples of public goods are bridges, subway rides, airports, lighthouses, and so on.
While all these examples involve goods or services owned by a state or government, the software
code example shows that sometime public goods can be produced by private individuals or
firms. This is typically the case of knowledge-based products: software, drugs, CDs, DVDs,
lecture notes, books, design clothing, special legal contracts, asset pricing models, medical tests,
and so on, all involve a public good dimension. In fact, it is not difficult to argue that even many
standard consumption goods require know-how to be produced. The knowledge or information
used to design, discover, create a product, service or process, once encoded into the actual object
for sale can potentially be reproduced by everyone, and so it is a public good: when EMI sells a
music CD by no means —other then by legal force— it can exclude other people from writing
and playing the same music.

A question and an answer

The question that we want to investigate is if and how the presence of external effect affects the
efficiency properties of competitive markets. Among other things, a negative answer could have
a powerful policy implication. If externalities do not affect efficiency, then there is no conflict
between the self-interest of consumers and profit maximizing firms, and the welfare of society at
large. Economic policy cannot increase social welfare and it should be limited to distributional
issues, if any.b However, we are going to reach an opposite conclusion:

In the presence of external effect or public goods, competitive markets work inefficiently.
Production or consumption is too high when externalities are negative, and too low when
externalities are positive (or there are public goods that are privately provided).

In order to make this problem explicit we will focus on the problem of pollution generated by
automotive vehicles.

III. Efficiency and externalities: Car driving and pollution

To make the analysis as simple as possible we simplify (by a lot) the situation. Thus, rather than
talking about demand for cars, we talk about demand for gasoline. It is evident that the two are
closely related. After all we buy cars to use them, i.e., to consume gasoline. The external effect is
clear. Burning gasoline produces greenhouse gases that pollute the environment. The main harm
is to human health: poor air quality increases respiratory problems and cause premature
mortality. In addition, greenhouse gases affect the climate, creating damages to agriculture, and
flooding problems to coastal regions. Economists have attempted to estimate, in monetary terms,
the damages caused by the pollutants generated by the consumption of one gallon of gasoline. As
you can easily imagine, there is much dispute concerning the correct number.

b
By “distributional issues” we refer to policies that are aimed at re-distributing wealth (e.g., transferring money
from the rich to the poor), as opposed to policies that are aimed at improving efficiency.

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In fact, hard core environmentalists would argue that such damages cannot be given a monetary figure, if
not infinity. Many people feel that way regarding smoking, say. If you believe that the damage of such
activities is so large that no monetary value can be attached to it, while the benefits are perhaps large but
limited, then the discussion in economic terms ends here. It’s obvious that even competitive markets for
gasoline, by polluting, would be inefficient: the efficient solution is to ban driving cars altogether. Very
few people would feel this way though.

Taking a more reasonable route, and using as an estimate a high-damage scenario, the cost of
pollution puts it around 80 cents per gallon. We round it up to $1. This is the number that we are
going to use in the discussion below.

Before we start the discussion we need to clarify one more aspect of the problem. The
automobile industry (and for what matters, the gasoline market) is not perfectly competitive. In
the analysis that follows we deal with a competitive market. Although not entirely precise, think
that the inefficiencies that we are going to uncover add to the inefficiencies generated by the
presence of market power.

An Intuitive Explanation
The outcome (e.g., price and quantity) of a market is the result of the interaction between
consumers and producers. Obviously, the market outcome and its welfare properties are
ultimately determined by the behavior of the participants. We have already talked at length about
firms. However, we did not say much about consumers. Economists assume that individuals
(consumers) are selfish. This is an assumption that applies to economic behavior and that has to
be carefully understood and scrutinized in the context of externalities. Let us try to make the
point with an example.

I am a driver who needs to buy one gallon of gasoline. My reservation price is, for
conversational sake, $3. $3 is the monetary value of the increase in my welfare generated by the
consumption of 1 gallon of gasoline. Is the selfishness assumption equivalent to saying that
people do not care about the environment? Not at all.

In principle, it is possible that I care about the environment and that, therefore, my reservation
value reflects this concern. However, selfishness means that my reservation price does not reflect
the fact that my consumption of gasoline reduces the welfare of everybody else.

Let us repeat the same idea with different words. When I consume gasoline there is a “private”
effect on my welfare measured by my reservation price. My welfare depends on my use the car
as well as by my personal concern about the environment. However, my consumption of
gasoline, via its effect on the environment reduces the welfare of everybody else. It is this
“social” effect that a selfish individual does not take into account. Of course, there might be
people that take the “social effect” partially or entirely into account. What we are ruling out is
the possibility that everybody in the market economy takes the social effect into account and in
its exact measure.

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For evidence of selfishness, if you ever needed some, just think of what may happen if a chain smoker
who consumes three packs of cigarettes a day is sitting next to you in a Parisian café. While he’s smoking
already the physically possible maximum number of cigarettes in a day (essentially one cigarette every
other minute), he’s very unlikely to stop smoking and internalize the nuisance is creating to you,
nonsmoker, by his consumption.

If the selfishness assumption is taken for granted, the problem emerges quite clearly. The market
is populated by selfish consumers and profit-maximizing firms. The producers of gasoline look
at their marginal cost. The latter takes into account all the costs of the inputs. However, it does
not take into account the $1 external cost. Neither consumers, nor producers internalize the social
cost. In a sense, consumers overestimate the value of consuming (only looking at their own
private benefit), or reservation price, and producers underestimate the cost of producing, i.e., the
marginal costs. But even unselfish consumers may not care about the environment like others,
therefore they fail to consider the value of clean air from the others’ viewpoint.

A More Formal Analysis

Suppose that all producers of gasoline-cars have the same cost structure. Thus the supply curve
in Figure 1 below is just the sum of identical marginal cost curves. The demand for gasoline
curve is a familiar decreasing curve. The shaded area F represents the overall profits (excluding
fixed costs), while the shaded area C is the consumer surplus.

Why does F represent revenues – variable costs?

That total revenue PE QE is the area of the corresponding rectangle in the figure is familiar reasoning by
now. What’s new is that the area below the supply is variable cost. To see why this area is variable costs,

15
observe what the MC graph tells you. It says that the first unit produced costs you MC(1) more than the
previous one. Since the previous is zero, then the first point on the MC curve, MC(1) represents actually
the cost of producing the first unit (net of the fixed costs), i.e., MC(1) = VC(1). Then, moving to the
second unit, the corresponding MC(2) is the additional cost of producing the second unit. Summing,
MC(1) + MC(2) = VC(2), the variable cost of producing two units, and so on. So, the variable costs of
producing Q units is MC(1) + MC(2) + …MC(Q) = VC(Q). Now, the ‘summing’ operation when it’s
done for infinitesimal units becomes computing the area below the curve MC.

However, this time the consumer surplus must be correctly interpreted as the sum of the private
welfare of the market participants excluding any external effect.

Measuring total benefits

The monetary evaluation of the (negative) external effect is −for sake of simplicity, as we said−
$1 times the number of gallons sold in the market. It is, therefore, equal to the area of the
rectangle L, in Figure 2 below, which is equal to 1*QE E . That represents a welfare loss to entire
society. Thus, the net welfare of society is equal to the (private) economic surplus minus the
social cost generated by the external effect. In the picture below the distance between the point A
on the demand curve and the point B on the supply curve is exactly $1. Hence, the area of the
rectangle L is the monetary evaluation of the social cost.

In the third picture below we subtract the area L from the private economic surplus (areas C plus
F in Figure 1). Now, the shaded areas DW appear in this third graph. Total benefits or social
welfare is equal to the area C’, plus the area F’ minus the areas DW.

16
That is to say, we claim that the ‘pollution loss’ areas DWs should and can be avoided: we can
obtain for society another level of driving hours that generates C’ and F’, but not the DWs.
So the question now is whether there is any other level of production where the total social
welfare (taking into account the external effect) is higher, and if yes, at what level of production
social welfare will be maximized?

A thought experiment
Consider now figure 4 below: Qs is chosen to be the level of gasoline production such that the
difference between buyers evaluation (the price you read off the demand curve) and producers
cost (the price you read off the supply curve, i.e., the marginal cost) is just equal to the external
social cost, $1.

We argue that Qs is the socially desirable (efficient) level of production. It is the level of
production that maximizes the social surplus, i.e., the difference between the economic private
surplus and the external cost.

The optimal level of production, from society point of view, is Qs. Why? The reason is
straightforward (but you might still have to think a little bit about it before it becomes obvious):
The increased welfare to society from increasing production of gasoline by one gallon is the
difference between what consumers are willing to pay (on the margin) for this additional unit,
MINUS the marginal cost of producing this additional gallon, MINUS the external cost of this
gallon:

PC – PF – 1

17
By construction, at Qs this net value is exactly zero! Increasing or decreasing production by one
unit cannot change welfare to market participants.

By contrast, let’s see what happens at other levels of production Q, and show they cannot be
welfare maximizing.
Since the difference PC – PF decreases as we increase Q, while the external cost is constant and
equal to one, producing past the level Qs will have an external cost of $1, greater than the
difference between willingness to pay and the marginal cost, which will be LESS than $1: You
would see the two red DW triangles start to appear again, subtracting from total benefits
achieved at Qs, and reducing production by one unit will increase total benefits.

On the other hand, it is now obvious that producing below Qs will result in a decline in total
benefits. Fewer consumers can buy gasoline, or each one buys less gasoline, and less pollution is
generated. However, since the difference PC – PF will be higher than at Qs, while the social cost
of pollution will be the same, $1, the effect of an increase in production toward Qs will be
positive and make total benefits increase. Consumer surplus as well as profits for firms will go
up more than pollution costs if we increase production by one unit.

Hence, only at Qs we do not want to change the level of production of gasoline, and this is the
welfare maximizing production level.

Now, just observe that the competitive market outcome entailed a higher level of production,
therefore a lower level of welfare.

18
Conclusion: in the presence of externalities, competitive markets are inefficient.

The market economy produces too much output, and therefore too much pollution, so it is
inefficient.

As a useful, alternative way to arrive at the same conclusion, we can write the so called Marginal
Social Cost curve (MSC) by adding the marginal external cost (here, of $1) to the private
marginal cost of production (here, equal to the supply curve):

Observe that at the welfare-maximizing choice of output, we are equating the marginal benefit of
driving (measured by the price paid by the last guy who drives, MB = PC) to the marginal social
cost of driving, equal to the private cost, or cost of producing gasoline, MC = PF, plus the
external cost of $1. Geometrically, in the presence of an externality the socially optimum level of
driving or gasoline consumption is given by MB = MSC, and not by MB = MC. Also observe
that the deadweight loss incurred in an unregulated market is equal to the triangle DW. It is not
too difficult to see this is exactly the same area we measured earlier as the two DWs. Now it is
naturally interpreted as the social cost of producing the extra output QE – QS which is over and
above the extra benefit of such production, i.e., above the demand or MB curve.

IV. Private provision of public goods, and inefficiency

We will briefly and informally discuss why, similarly to the case of externalities, there are
inefficiencies in the presence of public goods. For the sake of keeping with the previous

19
discussion of CO and SO² pollution, we suppose that a technology exists which allows a
substantial reduction in pollution.

For example, a special ventilation system can be built in the tunnels that ease traffic in the
region. By filtering exhaust gases, it allows a substantial fall in greenhouse gases emission into
the atmosphere. Once the ventilation is built, everyone benefits from its pollution abating
activity: my benefiting from its activity does not preclude yours.

There is a large cost of producing the system, estimated at 5 billion dollars, which needs to be
covered.

Suppose that a (competitive) market was in place to finance the project by selling shares, which
would sell at a price p. By purchasing shares in the ventilation project, each individual would
make a contribution to its construction.

Obviously, it is efficient to build the special ventilation systems if and only if the sum of all
the private benefits is above the 5 billion dollar cost. Nevertheless, this is seldom going to be
the market outcome. Let’s see why.

Each individual’s benefit is equal to their value of abating pollution, a benefit which is in general
independent of other individuals’ benefits (as before, individuals may be environmentally
conscious; all is needed for the conclusions to go through is that they won’t all exactly take the
“social effect” entirely into account). Therefore, only those individuals whose private benefit of
contributing will be above or equal to the share price p will contribute to the ventilation (i.e.,
purchase shares). Rank individuals according to such private benefits, from highest to lowest. On
the other hand, the price cannot be below the AC of the ventilation system. Result: only those
individuals with the highest private benefit will have it above or equal to p, everyone else will
have it lower, and won’t purchase the project shares, making the original project unfeasible.

Perhaps a lesser quality version of the system will be built, based on the contributions of those
who purchase the shares of the project. Everyone else won’t contribute and still will benefit from
it: there is free riding, as only few individuals pay for the special ventilation, while all benefit
from it, and the level of public good production (quality, in this case) will be lower than what is
socially beneficial.

Now you can see that the same problem of inefficiency we had with pollution externalities arises
here, though here it takes a different name: free riding.

At this junction, it seems natural to think of this as a public project, whose construction is assigned to the
public administration and is financed through taxes.

The construction of the special ventilation and the amount of taxes to finance it must be approved by
taxpayers, who can vote on the project. To simplify let’s assume that every household in the local area
will be asked to pay the same and equal tax for the construction of the ventilation systems. If 10 million is
the number of households in the area, 5 billion/10 M = 500 dollars will then be the cost of the ventilation

20
to each household, if the project is carried out. To further simplify, let’s assume that one household = one
individual taxpayer/voter.

Again, those taxpayers whose private benefit will be above the $500 tax cost will vote for the project,
those with a lower benefit won’t. Since the project can be carried out only if all 10 million people living
in the area vote for it, it is clear that the project has no chance of getting voted. However, it is well
possible that the sum of the private benefits of all households in the area largely surpasses the cost of
building the ventilation. It then would be socially efficient to build the ventilation, and yet this is likely
not going to happen.

In fact, even voters among those with a low private benefit are producing a positive externality on all
other individuals in the area if they decide to vote for the project: by voting for the project they would
make the project feasible to all citizens in the area. However, they don’t perceive the whole social benefit
of their action.

The conclusion would change if the approval was based on some portion of the total population in the
area, for example 5 million people by majority rule. Now the project would go through unless more than
50% of the population had private benefits below the tax cost. However, …now it could then be the case
that the ventilation project is approved even if it is socially not beneficial: the sum of all individual
benefits could very well be below 5 billion dollars, and yet the project would go through because half of
the population would put the burden of the cost also onto the other half. Having commuters pay an extra
toll for the use of the tunnels won’t solve the problem either. Making the tax dependent on the private
benefit on the other hand would be a way out, but not an easy one: now taxpayers would have an
incentive to understate their benefit to pay a lower tax. Things have to be cleverly designed (if you are
interested, google Vickrey – Grove – Clark mechanism!).

V. Property Rights (and Taxes)

Now we turn to possible solutions to the externality inefficiency problem. We will look at
business solutions to the inefficiency, and also at government interventions (taxes). Keep in mind
that we will be totally agnostic about the implementation aspects of a government policy.

Property rights, and a market for clean air

As we already discussed above, a classical economist approach to the externality problem is to

view the failure of the market economy as generated by the lack of markets. The missing market
in the scenario under analysis is the one for “clean air.” Let us therefore try to organize a market
for clean air.c
The first problem that we have to solve is to decide who owns the “clean air.” For example, the
US government regulates the amount of sulfur dioxide emission by electricity generation
facilities with resalable licenses to pollute. The government has decided the level of licenses
based on an amount of pollution that it will permit.

How about gasoline pollution?

c
Clean air is a “good”. Alternatively, it is possible to think about a missing market for a “bad”,
namely polluted air, where the producer has to pay the “consumer” or the “consumer” has to pay
the producer for NOT producing.

21
In our contest, the government could assign to each consumer a given amount of clean air
property rights and open a market where these property rights are traded. Identify property rights
on clean air with permission of burning 1 gallon of gasoline. The government endows each
consumer with units of this permission. Let’s call them coupons. In order to buy a gallon of
gasoline, each consumer must pay the market price for gasoline and as well as give one coupon
(for instance to the gasoline pumps). In addition, consumers can buy and sell coupons on the
“clean air” market.

How many coupons?

We make some simplifications. They do not change the conclusions, but they make the argument
much sharper. Let’s assume that there are 300 million people. Suppose that every consumer is
the same. Go back to the market equilibrium presented in Figure 1, when there are no property
rights on “clean air”. Let’s assume that in equilibrium, the market price (PE) equal to $1.6/ per
gallon, and output is 15 billions gallons per week. Since there are 300m consumers, the per-
capita consumption of gasoline is 50 gallons a week. The socially efficient output, Qs, is 9
billions, say, or equivalently, 30 gallons per consumer. The price PC at which consumers are
willing to buy 30 gallons per person is $2.5/per gallon. At the socially efficient output, the
marginal cost PF is $1 below, equal to $1.5, as we have explained. The government, therefore,
endows with 30 coupons each consumer.
P

Figure 5
S

C’
2.5

1.6 L’
1.5
F’

Q
9B 15B

How is this maneuver going to affect the functioning of the market? Each consumer can sell the
coupons or use them to purchase gasoline. Drivers can also buy extra coupons if they want to
buy more than 30 gallons. Thus, the effective price of 1 gallon of gasoline paid by the consumers
is the price of the coupon plus the market price of gasoline.

22
We characterize now the outcome of the market economy with clean air property rights. Observe
that a coupon price of $1, and a price of gasoline of $1.5 are competitive equilibrium prices.

Indeed, if the coupon price is $1, the effective price paid by the consumers is $2.5, $1 of coupons
plus $1.5 of market value. Each consumer wants to purchase only 30 gallons of gasoline per
week at these prices, or 9 billion gallons total. On the other side, firms produce at the output
where their marginal cost coincides with $1.5, the gasoline market price.d Hence, the total output
of gasoline is 9 billions, equal to the demand for gasoline at these prices. Similarly, the demand
for coupons is equal to the supply (in fact, since each consumer is the same, there is no trade of
coupons on this market; this is where we used the simplification). The social desirable output Qs
is achieved. Firms profits are F’, while total consumer surplus is C’ plus the value of the coupons
given to them by the government. The latter is equal to L’, the social cost of the external effect.
Thus, the total market welfare is F’ plus C’. Obviously, the dead weight loss is zero.

By assigning the property rights for “clean air” to the consumers the government is achieving
through the maximum welfare discussed earlier.

We should to mention two alternative property rights assignment mechanisms that still
implement the socially desirable output Qs, but achieve different welfare distributions.

1) The government assigns the coupons to the firms. In addition to the cost of producing
gasoline, each firm has to give a coupon to some agency, for each gallon of gasoline
produced.
2) The government sells coupons to the consumers (or to the firms), at the prevailing
competitive price on the “clean air” market. In this scenario, the property rights are
assigned neither to the consumers nor to the firms, but to the government.

We do not study in details 1) and 2). It suffices to say that with 1) we achieve the same level of
welfare that we previously got when consumers were entitled to coupons, except that now the
distribution of the benefits is different. The market price of gasoline will now be $2.5 under
scenario 1).
In particular, when the government owns the coupons, the total size of the external cost is
collected by the government under the form of revenues paid by the consumers (or the firms).
The government can use this money to clean the air, to compensate firms for the reduction in
profits (compared with the free market outcome without coupons), or to compensate consumers.
In different words, the government, by redistributing the proceeds of the coupons, can achieve
any distribution of welfare.

Conclusion
The substance of this discussion is the following: The market economy does not work because
the economic process uses (and damages) a resource (the environment) that neither consumers

d
The sellers of gasoline must, of course, give back to the government a coupon for each gallon
that they sell.

23
nor firms own. By assigning property rights over the environment to the market participants, the
market economy prices correctly the resource used in the economic process thereby eliminating
any efficiency.

Taxes, and more

Of course at this stage we are totally silent about the organizational complexity and the costs
associated with the creation of a market for property rights. If these costs are taken into account,
a tax policy may be preferable. The government can introduce a sale tax of $1 per gallon to be
paid by the consumers, or a production tax of a $1 paid by the firms.

In the case consumers pay the gasoline tax, for each quantity of gasoline purchased, the price the
consumer pays is $1 higher than the market price. It is like the demand curve for gasoline shifted
down by 1, so that the effective demand has an intercept lower by 1 (has ‘shifted to the left’).
The new competitive equilibrium price is $1.5, what firms get from selling gasoline. Consumers,
however, pay a higher price. Profits are equal to F’, consumer surplus to C’.

In the case producers pay the tax, their marginal costs go up by one dollar, and it pushes the
supply curve up by 1. The market price will be $2.5, but firms only get $1.5 net of the
government tax. You can easily convince yourself that, for total welfare and efficiency, it is
irrelevant who pays the tax. The tax proceeds will be equal to the value of the external effect, the
output equal to its socially desirable value.

Coupons or taxes seem in this context to solve the problem. What is the big deal then? One of the
consequences of all the interventions we have discussed is to increase the effective price paid by
consumers and reduce the profits of the firms. Without taxes or property rights, consumers paid
$1.6. In all other scenarios, they pay de facto $2.5.

Quite obviously, it is not the case that all consumers are equal. The demand for gasoline has two
key (and socially and politically undesirable) features: it is price inelastic; and the share of the
gasoline cost over disposable income of the households is decreasing in the latter. In different
words, poor people spend, as percentage of their income, more money for gasoline. Thus, all the
solutions that we have discussed before have the unpleasant feature of being regressive. In
different words, the burden of the external cost is more heavily borne (as a percentage of their
income) by low-income households. In a situation like this, there is a tension between equity and
efficiency.

Worse than this, it may be the case that those who are supposed to pay (the tax, the coupons)
cannot afford at all to do so. That is, what if consumers must consume some food, pay rent for
lodging, and cannot go below a minimum expenditure on these items? Then they will be unable
to make the tax payments and will be consuming even less than what is optimal. In this case, it’s
not going to be indifferent who pays the tax. Putting the burden of the adjustment toward the
socially efficient outcome on consumers is not going to work. Fortunately, in many
circumstances firms have the opportunity to substitute out of pollution-intensive production

24
processes for less polluting ones. Technological improvements may cost less to firms than
pollution fees or taxes, and firms may be able to reduce pollution through technological change.

VI. Market power and innovation.

Monopolies and the extra profits that go with them may be the necessary evil to induce people to
undertake risky investment projects, to innovate, and so on. In the previous part, we considered
industries which were in some sense already mature, so these benefits were not there. Here, we
look briefly at this problem.

The discovery of new products and technology is probably the most important element that fuels
growth and enhances consumer welfare. Important industries (e.g., telecommunication,
computer, pharmaceutical) are characterized by a fast pace of technological and product
innovations. Simplifying (a lot) the situation, we can think that innovation/production takes place
as follows.

First, there is a large cost associated to the design of the product. Furthermore, sometimes, e.g.,
in the pharmaceutical industry, the outcome of this initial investment is uncertain. The company
may or may not be able to find the new product or it may or may not be the first in the R&D race
with its competitors.

The second common feature of these industries is a very low marginal cost of production. This
yields a declining AC curve and the presence of large economies of scale before innovation takes
place. Moreover, AC curves for all firms are flat at almost zero after the cost of innovation has
been paid by one of them and innovation is successful, since the idea, design, or discovery
behind the innovation can often be reverse-engineered from the product. As we already
mentioned, there is a public good component in the output of these knowledge-based industries,
the information or knowledge itself.

The presence of large fixed costs is already a problem, as firms will strive for large volumes of
production once the new product is in place, and this creates a trend toward one big firm to
dominate the market. The fact that marginal costs of production are almost zero creates a second
problem, since firms will try to free ride on the benefits of innovation by one of them, by freely
copying the successful product or process, and then compete with each other.

We can imagine two different ways of organizing these industries. In the first, that mimics the
actual current organization, firms that have successfully innovated are given property rights over
their discoveries in the form of patents, copyrights, and so on. Hence, they are granted the
possibility of creating a monopoly around the innovation. In the second, the innovation is not
protected and anybody willing and able to copy it can do it. What is better for the consumers?
The problem is easily understood in two steps. We think backward. Suppose that the innovation
has already taken place.

Start with the second form of organization. Then, we can imagine that the firm that has
successfully innovated is going to enjoy profit for a short period of time. The lack of legal

25
barriers together with the ability of other firms to copycat the innovation at zero cost will foster
entry and eventually reduce the profits to zero.

In the first form, the granted legal protection creates a barrier to entry and thus protects the
profits of the innovator.

It is unquestionable that after the innovation it would be socially desirable to foster as much
competition as possible, thereby selecting the second form. Indeed, as we have shown before,
monopoly power creates a positive dead-weight loss, i.e., it destroys social welfare.
However, the central issue is in the first step of the analysis. Namely, is it more likely that
innovation takes place in the first or in the second form of organization? The answer is clearly
(and unfortunately) that innovation is more likely in the second form. The reason is obvious. The
innovative process requires big initial, non-recoverable and risky investments. The incentive to
undertake these investments comes from the possibility that successful innovation generates
large future sales, hence profits that must repay the fixed cost as well as provide the correct
remuneration for risky activities. Unfortunately, in absence of entry barriers it is easily seen how
other firms will free ride on the innovator, and it is hard to imagine how these profits could be
generated. Investment in innovating activities will be too low if at all present, and the benefits
from innovation would disappear.

26