The cost


Open up a standard microeconomics textbook and, most likely, you will read a passage like this:

A competitive market, sometimes called a perfectly competitive market, has two characteristics:

  • There are many buyers and many sellers in the market.
  • The goods offered by the various sellers are largely the same.

As a result of these conditions, the actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given.

An example is the market for milk. No single buyer of milk can influence the price of milk because each buyer purchases a small amount relative to the size of the market. Similarly, each seller of milk has limited control over the price because many other sellers are offering milk that is essentially identical. Because each seller can sell all he wants at the going price, he has little reason to charge less, and if he charges more, buyers will go elsewhere. Buyers and sellers in competitive markets must accept the price the market determines and, therefore, are said to be price takers.

In addition to the foregoing two conditions for competition, there is a third condition sometimes thought to characterize perfectly competitive markets:

  • Firms can freely enter or exit the market.

(This excerpt was taken from Gregory Mankiw’s Principles of Economics. Mankiw, by the way, was the Chairman of the Council of Economic Advisors in Bush the younger’s administration.)

Suppose we accept these assumptions. What follows? Textbooks, at this point, introduce the concept of “marginal cost”. This is the additional cost associated with making an additional unit to sell. Notably, it does not include any “fixed”, or one-time, cost that does not scale with the number of units sold. So, to take the case of the market for milk, the fixed costs are high (the land, the machinery, the labor cost, etc.), but the marginal costs are much lower (the additional land needed for an additional cow, the additional labor needed to milk it, etc.).

A key conclusion of microeconomics is that, in a competitive market, the price at which goods are sold should equal the marginal cost of making that good. A price listed for a gallon of milk in the supermarket should, roughly speaking, be the same as the cost for a farmer to extract his 10,001st gallon of milk from his cows. (I say “roughly” because there are other marginal costs besides the farmer’s, such as the marginal cost for the shipper, the wholesaler, the grocer, etc. which get incorporated into the sticker price.)

What is remarkable is how salutary this situation is for the consumer. The only way the price could be lower is if someone (the farmer, the shipper, etc.) were losing money in the process. (And, to be clear, this often does happen in real markets; your Uber ride is so cheap only because VCs are willing to lose billions of dollars in the short-term.) Conversely, if the price were higher, an existing seller could lower their price, undercutting the market while still making a profit, or a new seller might enter the market, sensing an opportunity to compete on price. Competitive markets produce a happy, stable equilibrium in which consumers receive what is arguably the best price they could receive. And, from this conclusion follows another: any efforts to regulate the market introduce distortionary pressures that nudge the equilibrium away from this happy place. By intervening in a competitive market, the government only makes the situation worse. Q.E.D.

So why is it that when we read about markets in the newspapers, they seem to operate so differently?

Here’s one example:

Last month, a lobbyist approached Kyle Davison, a North Dakota state senator, with an unusual proposal: a law to stop Apple and Google from forcing companies in their state to hand over a share of their app sales.

Mr. Davison, a Republican, was focused on bills related to a $200,000 literacy program and birth records for the homeless. But he was intrigued by the lobbyist’s arguments that the tech giants were hurting small businesses, and he thought such a law could attract tech companies to North Dakota. So he introduced it.

Supporters of the bill said it would help smaller companies and only hurt Apple and Google’s revenues. Apple’s chief privacy engineer, Erik Neuenschwander, testified that the bill “threatens to destroy iPhone as you know it.”

The North Dakota bill focuses on Apple’s and Google’s practices of taking a cut of up to 30 percent from many app sales on smartphones, a policy that brought the companies a combined $33 billion last year, according to estimates from Sensor Tower, an app data firm.

Some smaller companies have argued that Apple and Google force app makers to pay an artificially high fee only because of their sheer dominance. The two companies’ software underpins nearly all of the world’s smartphones.

An Apple spokeswoman said most iPhone apps are free and didn’t pay any commission. She added that most of the North Dakota companies that shared revenue with Apple earned less than $1 million a year from their apps, meaning they pay Apple 15 percent of some sales, rather than 30 percent. Apple lowered its rate for smaller companies last year amid scrutiny of its App Store policies.

There was something very interesting noted in the last paragraph. Did you catch it? Apple used to charge a 30% fee for all apps. Now it charges “only” 15% for smaller apps. In a competitive market, such price changes should not be possible, at least without fundamental changes in the cost structure (technological innovation, etc.). Furthermore, according to Mankiw, “At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit.” Apple, of course, is one of the most profitable companies in the world. The price change from 30% to 15% hardly affected its bottom line at all. And even if they extended the fee reduction to all apps, not just smaller ones, the same would be true.

We have come a long way from the microeconomics parable of the struggling dairy farmer, ever wary of being undercut on price, and the contented consumer, relying on the invisible hand to push prices inexorably down. These two types of markets seem to bear very little resemblance to one another.

At this point, you might say: look, everyone knows that Apple and Google are monopolies, or at least oligopolies. The market of app stores does not have free entry and exit. Because we have violated the fundamental assumptions of competitive markets, why would we expect an analysis of competitive markets to be applicable here? Why did we spend the last 1000 words analyzing a strawman?

I would argue that the problem is much deeper than monopolies, unless we want to stretch the meaning of that term beyond its typical use. In my view, “marginal cost” has almost nothing to do with prices in most markets that people care about, regardless of their monopoly status. If the concept is almost completely irrelevant, why does it continue to be emphasized?

Let’s take another example, this time from healthcare.

When a woman gets a caesarean section at the gleaming new Van Ness location of Sutter Health’s California Pacific Medical Center, the price might be $6,241. Or $29,257. Or $38,264. It could even go as high as $60,584.

The rate the hospital charges depends on the insurance plan covering the birth. At the bottom end of the scale is a local health plan that serves largely Medicaid recipients. At the top are prices for women whose plans don’t have the San Francisco hospital in their insurers’ network.

The nation’s roughly 6000 hospitals have begun to reveal the secret rates they negotiate with insurers for a range of procedures. The data offer the first full look inside the confidential deals that set healthcare rates for insurers and employers covering more than 175 million Americans. The submissions also illuminate how widely prices vary – even for the same procedure, performed in the same facility – depending on who is paying.

Hospitals, for their part, set prices that can have little bearing on the actual cost or value of a service. They often operate without knowing the cost of procedures, unlike other industries that closely track and manage expenses, said David Cutler, an economist at Harvard University who studies healthcare spending. Hospitals instead set prices based on their own targets for overall margins and according to what the market will pay, he said.

The hospital industry (and healthcare market in general) has undergone increasing consolidation over the last few decades. Yet it would be an abuse of language to suggest that it is a monopoly, or even an oligopoly. As the article mentions, there are 6000 hospitals in the U.S. If prices in hospitals are unmoored from their fundamental costs, to the point that no one actually knows what the cost even is, there must be another reason.

When someone needs to go to a hospital, they don’t comparison shop. If I’m having a heart attack, I won’t call up various hospitals, asking for the best rate. I will go to my neighborhood hospital and expect the doctors to save my life. Even if I’m having an elective procedure, my choice of hospitals is highly constrained, both by geography and by my insurance provider. This is akin to monopoly – there is effectively only one seller available – but it has little to do with market concentration.

The same is true for many other markets. There are only a few credit card companies that most consumers use to make payments, only a few cable and internet companies that provide service in your area, only a few airlines that fly between Grand Rapids and Phoenix, only a few email providers that your friends won’t laugh at you for using (I’m talking about you, Yahoo).

Imagine we decided to rectify these ersatz monopolies and make them into competitive markets. What would this look like? I would have dozens of hospitals within a few miles of me, each covered by my insurance provider. There would be hundreds of options available to me for making a non-cash payment at a restaurant. Tens of internet providers would have cables running to my apartment building, and I could switch between them at will. Dozens of airlines would fly between Grand Rapids and Phoenix. Many virtual stores would exist through which I could download my favorite app. And so on.

Would anyone find this state of affairs desirable? It would lead to a woeful overprovisioning of goods and services, an incredible waste of time and energy and money and resources. It is true that dozens of local hospitals would solve, or at least ameliorate, the problem of the cost of a Caesarean section. But wouldn’t a better solution be to simply have the “right” number of hospitals in the country, such that everyone is near at least one, and have each one charge a reasonable rate for medically necessary procedures?

As I’ve mentioned before, few people actually want choice in and of itself. Choice is useful only insofar as it guarantees a low price and decent standard of service. I simply do not care if there are 1, 10, 100, or 1000 airlines flying between the location where I currently am and the location where I would like to be. I simply want one good option: one that charges a fair price and does not cram me into a seat like a sardine.

When you think about it, what I am describing is a public utility. We do not expect dozens of companies to supply water, electricity, gas, or internet to your house, and rely on the consumer to keep them honest by switching between them. But the concept, I would argue, extends well beyond these conventional examples. Having a store to download apps and process payments is a utility, in the virtual ecosystem of an iPhone. A platform for processing non-cash payments is a utility. A transportation service, whether driving or flying, is a utility. And, finally, a place that treats your wounds and makes you feel better is a utility.

If we have established that many (most?) important markets are actually utilities, then the reason why marginal cost does not matter is obvious. The markets under scrutiny are those in which the buyers are captive. It is almost impossible to lose money as a seller in such a market (although some companies try!). So the question is not about costs, but rather about distribution of profits or surpluses: how the pie should be divided up.

And that distribution is completely arbitrary. To return, for the last time, to our App Store example, we have established the necessity of something like the App Store for app developers to make a living, and we have established the absurdity of having a competitive market in App Stores. Consumers are willing to pay billions of dollars for and within apps; because revenues are large, and marginal costs are almost nonexistent, profit is guaranteed. The question then becomes how to distribute it: whether 90%, or 30%, or 15%, or 3% will go to Apple. From Apple’s perspective, it doesn’t matter. It will be profitable regardless. And the same logic applies to taking an essential flight, or resisting a rate hike from your internet provider, or forking over $6,241 or $60,584 for a C-section. In practice, the “market” decides the prices by comparing the relative power of the two parties: your insurance company (or, god forbid, you) vs. your hospital, the app developer vs. Apple. (“Hospitals instead set prices…according to what the market will pay”) But it doesn’t have to be that way. We can set the distribution as we see fit and use the government to enforce our decision. But the first step, I would argue, is to put down the microeconomics textbook.


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