Answer to Question # 2 on Last Month’s Pop Quiz

by Don Boudreaux on June 1, 2011

in Competition, Complexity & Emergence, Economics, Prices

The 2nd question on the pop quiz was this:

Suppose that engineers at BMW invent a new machine that dramatically increases BMW’s efficiency at producing automobiles and, thus, causes BMW’s production costs to significantly fall.  As a result, BMW expands its output and lowers its prices.  But also, BMW patents this new machine; only BMW can use it.  What is the most likely consequence of this particular invention on the prices that General Motors, Ford, Toyota, and other auto makers charge for the automobiles they produce?
a. no change in the prices of non-BMW automobiles
b. the prices of non-BMW automobiles will fall
c. the prices of non-BMW automobiles will rise
d. there’s insufficient information to answer this question

…..

The correct answer is b – the prices of non-BMW automobiles will fall.

Even though BMW invented the new, cost-reducing machine and even though BMW patents it (and, hence, BMW alone is allowed to use this machine), because BMW automobiles are substitutes in many people’s minds for automobiles produced by companies such as G.M. and Toyota, G.M., Toyota, and other automakers will have to reduce their prices in response to BMW’s lower prices.

The economic rule in play here involves that of substitute goods, which states that good B is a substitute for good A if, as the price of good A changes, the demand for good B changes in the same direction.  So if B is a substitute for A, if the price of good A falls, the demand for B will fall, causing the price of B also to fall.

When the price of A falls (in this example, because of a cost-reducing new technique used by A‘s producer), the quantity demanded of A rises; consumers buy more units of A than they did before the price of A fell.  With consumers shifting into A, they shift away from buying other goods and services; those goods and services whose demands noticeably fall as a result of the fall in the price of A are substitutes for A.

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{ 73 comments }

MikeP June 1, 2011 at 3:46 pm

I would say that if the choice “there’s insufficient information to answer this question” appears on an econ question, it is usually the right answer.

In particular, the response by non-BMW manufacturers may be a mix of (a) go out of business and (b) go for the upscale market, which will lower the supply of non-BMW automobiles and make their prices rise.

“Dramatic” and “significant” are big words. If the once-competitors can no longer compete, they are not substitutable.

Hari MIchaelson June 1, 2011 at 4:03 pm

Don,

I would agree, but BMW patent’s their innovation. You may or may not have a position on IP. However, for those of us that see IP as a government enforced monopoly; your question on what happens to prices is hard to answer. Do you mean short term or long term? On a long enough horizon prices will fall not matter what BMW does. Short term competitor prices may fall, but if the innovation is great enough BMW may use its government monopoly to put its competitors out of business and then raise their prices. Since you have already placed the government into the equation, economic rules become distorted.

Maybe GM and Toyota can’t compete at the new profit margins because of the patent. Perhaps they teeter on the edge of bankruptcy because their business model uses ongoing credit because the FED depreciates the currency. Maybe GM lobbies congress to tax BMW’s “foreign” cars so they don’t have to compete.

I think the addition of patents in this question really changes the scenario. By adding the government into the equation, you are essentially asking us to determine how government involvement will impact prices. And if BMW can get a patent from the government why can’t GM and Toyota get subsidies. They lower their prices, but tax payers pay indirectly with taxes instead of directly with higher car prices.

As a libertarian, my general rule of thumb is government involvement = higher costs.

If you eliminate the patent from the equation, your answer is spot on. But with government involvement I think D (you need more information) is the only correct answer.

Don Boudreaux June 1, 2011 at 4:05 pm

You write: “if the innovation is great enough BMW may use its government monopoly to put its competitors out of business and then raise their prices.”

It’s easy to imagine all sorts of things that are possible. Is this outcome plausible? Not to me. Can you name me one historical incident of such a thing happening?

PrometheeFeu June 1, 2011 at 6:02 pm

I think the key here is economists’ favorite phrase: “On the margin”. It is unlikely that all of BMW’s competitors will go out of business. But some are probably pricing very close to MC with little room to drop their prices. Those companies would probably be unable to remain competitive and would shrink or disappear completely. This would not necessarily be the obvious cause since the companies that fail would be those who would be the ones already behind.

I think Hari’s insight about government action raising prices compared to what they would be without government action is probably correct in this case. For GM to survive BMW’s price drop, GM has to also develop production techniques so they can match BMW’s price drop. (Let’s stay with the substitutes assumption we started with) However let’s imagine the absence of patents: In that case, BMW uses GM’s innovations and vice versa dropping the prices even lower.

Hari MIchaelson June 1, 2011 at 8:08 pm

Isn’t the point of economics is that it is NOT easy to imagine situations that defy supply, demand, and pricing? I’m not saying that it is plausible that my example would occur; I’m simply saying its possible because the government is involved.

It is my impression that the purpose of this question is to illustrate that innovation and competition lead to a drop in price. It is, as you point out, the law of supply and demand. (For the sake of this argument we can say the different brands are “perfect” substitutes for each other.)

The problem is that “price” changes when the government is involved. In a free market, the cost of an item is best represented by its price. In this quasi-free market, the ticket price is not an accurate reflection of cost to the consumer. You have to include taxes at the very least. BMW is appropriating tax dollars to enforce its patent. Even a pro-IP position must recognize this is an additional cost to the consumer.

The profit/loss, free-market system does not require us to calculate unseen costs. We know, through economic theory, that this is the most optimal situation for the circumstances. However, when the government gets involved, things change. Now you have to calculate hidden costs, like taxes.

What if the government granted monopoly halted the innovation of a different company that was researching similar methods as BMW? In a free market, they both could use their innovations, and real prices would drop. The “what if” arguments are only effective if government is involved. The only events unseen in a free market are ones that fail. BMW’s innovation doesn’t restrict the actions of its competitors in a free market. In this scenario, BMW and the US govt. do restrict the competition.

By introducing the patent element into the scenario, you create a situation in which a host of unseen costs could occur.

“Can you name me one historical incident of such a thing happening?”

In my haste, I worded my post poorly. You are right showing my hypothetical was more theory than reality. However, what about health care? There are health care innovations everyday, and the price goes up. If you’re on medicare, the “price” is zero. We all understand that the true price of health care is hidden in taxes and inflation. Your example is not nearly as government controlled as health care, but it is still government intervention to a lesser degree.

As Hayek points out, its impossible to make calculations in a government market. How can D (you need more information) be incorrect?

Hari MIchaelson June 1, 2011 at 8:24 pm

Let me clarify something. I’m intending to be fanciful. I don’t think a valid argument is…”a hurricane hits japan, destroying Toyota, and allowing BMW to raise prices.” I’m using an element included in the question, namely the government’s intervention in the market.

Ron H. June 3, 2011 at 1:47 pm

Wow! Talk about unintended consequences! Hari, you are making this more complicated than it needs to be. Perhaps including the word ‘patent’ was ill advised, and I’m sure Don will not make that mistake again, considering the can of worms it has opened..

Please substitute “black box” for the word patent, and the concept of competitive advantage can be preserved without anyone going off the tracks.

Ken June 1, 2011 at 4:37 pm

Amplifying Professor Boudreaux’s response: It would have to be some innovation, to be sufficient to address the various marginal utilities of so many consumers that all competitors would be driven to the wall. Substitutes need not be exact substitutes — they need merely (okay, I’m simplifying) leave the buyer at least as well off after the exchange as any other option would.

W.E. Heasley June 1, 2011 at 4:04 pm

Sticking with my original answer:

(e) General Motors, Ford, Toyota will become rent seekers looking for subsidies of one kind or another to either lower price or subsidize operations or subsidize profit margins. -Or – General Motors, Ford, Toyota hire Ian Fletcher to author a book entitled “Unfair BMW and Why We Need Tariffs”. Fletcher will go onto lobby Congress for tariffs and eventually marry Lady Gaga

Ron H. June 3, 2011 at 1:50 pm

That’s too much reality for me. :-)

Nemoknada June 1, 2011 at 4:12 pm

(d). If BMW is run by Steve Jobs, the prices of other cars will adjust to maximize profits, if possible, which might not be any adjustment at all if the loss of margin would outweigh the gain in sales. Then a company run by Bill Gates will invent a competing device and license it to everyone. Then prices will drop, and BMW will wish it had done the same thing.

Then Steve will invent the iDrive – no, wait, BMW already did that…

vikingvista June 1, 2011 at 4:42 pm

What about:

E. BMW’s competitors are forced out of business or bought up by BMW which increases their profits further, allowing them to buy up other industries until they are the only company in the world and everyone must forever work 20 hours/day at subsistence wages while all the wealth in the world flows to the fat cat head of BMW.

Did I get that one right Marxiots?

LowcountryJoe June 1, 2011 at 4:56 pm

“Did I get that one right Marxiots?”

No! It’s close, though. But in the long term, the patented technology becomes significantly less important because the Chevy Volt [and any other zero emission automobiles to be manufactured] become mandated while all the other internal combustion cars become prohibited.

Michael June 1, 2011 at 5:05 pm

They weren’t Marxiots–they were Luddites. ;o)

vikingvista June 1, 2011 at 6:44 pm

Luddiots.

yet another Dave June 1, 2011 at 6:56 pm

Marxonic Luddiots

Slappy McFee June 1, 2011 at 5:02 pm

From an Econ 103 point-of-view (which I believe was the class) the concept being asked matches the answer. I still say that there are more variables involved.

Michael June 1, 2011 at 5:17 pm

If you were to take the example as a case study (even a hypothetical one) you’d be right–you would have to consider the market the vehicles are sold in, control for the class of vehicle (I suspect Bimmer’s technology boost wouldn’t affect the price of trucks–BMW doesn’t make any) and a whole host of other factors that aren’t worth mentioning.

But it’s important to keep in mind that Don is asking about the relationship between the demand for an item and the price of a substitute product and not the details of such an advance in technology.

Forests, trees, and all that.

Slappy McFee June 1, 2011 at 5:07 pm

Question tho: Why would BMW not keep the new margin and become more profitable? Why is there automatically an assumption that they want to lower the price since their customers were already meeting the previous price? Then again, nevermind, Econ 103.

BZ June 1, 2011 at 8:00 pm

I’m with you there in Econ 101, but I’ll take a stab.

The temptation to use the technology to produce more cars is too great — at the margin they can increase their profits by selling X more cars at a slightly lower price.

Eric Hammer June 2, 2011 at 10:13 pm

Indeed, their marginal cost curve shifts down and right due to the new tech., and as a result their profit maximizing level of production increases while prices fall to support demand at that level.

I rather dislike thinking of it in those terms, but that’s the general idea. I like your description a good bit better BZ, as BMW probably doesn’t know exactly what the demand curve for their products looks like, or will look like over time, and so is more likely to just gradually lower price until they start seeing a reasonable increase in profit compared to output. I.e. when the growth of profit relative to the growth of volume slows down. Talking in terms of curves that intersect at specific points seems to gloss over just how fuzzy the whole process is in reality, I think.

Sebastian Oberhoff June 1, 2011 at 5:11 pm

Demand for non-BMW automobiles is likely to decline while supply is likely to remain stable, thus the only possible result can be a lowering of non-BMW cars costs (b). Unless of course nobody but BMW continues manufacturing cars. In that case changes in the price of those nonexistent cars would be hard to measure, since their demand- and supply curves won’t intersect. This may seem like a silly scenario but for the sake of completion I’m still hesitant to dismiss it, which would force answer d)

andy June 1, 2011 at 5:26 pm

Hi Don,
I agree with your analysis except that it presumes that just because BMW’s production costs have gone down then BMW will lower their prices (subsequently forcing the other manufacturers to lower their prices in response).

I agree that it might be LIKELY that BMW will lower their prices but this is not necessarily so….will depend on many factors such as BMW corporate strategy, their attitudes to pricing etc.

I don’t think you can say with any certainty that BMW will lower their prices forcing other manufacturers to lower their prices. Given your analysis requires a presumption (that BMW will lower their prices) I think answer D is correct.

best regards – Andy

yet another Dave June 1, 2011 at 6:53 pm

From the test question:

As a result, BMW expands its output and lowers its prices. [emphasis added]

Dan June 2, 2011 at 12:15 pm

And you assume BMW will be happy at profits X and not want to make any make any More money. They will see opportunity to make more money and are unlikely to allow that opportunity to slip by.
Would love to read about the example of a business passing up on opportunity to expand that is at the same level as a ‘BMW’.

brotio June 2, 2011 at 5:09 pm

Let’s say this innovation saves BMW $15,000-per-unit. If BMW cuts prices by $10,000-per-unit, that will still net them $5,000 more per car. If their sales stay the same, they have still greatly improved profits. Most here think this price cut will also cause a dramatic boost to BMW sales, further increasing profits. Either way, BMW has cut prices and still became more profitable.

Dan June 2, 2011 at 7:54 pm

Indeed! But, they could add 3 grand in features and still take an extra 2 grand. This extra 3 grand in features is likely to sell more vehicles. Sorry, but all of the hypothesizing aside, BMW is likely to sell more vehicles and the competition will be forced to react with lowered pricing and/or more perks to the consumer.

brotio June 3, 2011 at 7:01 pm

…and the competition will be forced to react with lowered pricing and/or more perks to the consumer.

So, (B) is the correct answer.

Seth June 1, 2011 at 5:52 pm

“When the price of A falls (in this example, because of a cost-reducing new technique used by A‘s producer)” -DB

I thought the price of A fell because BMW decided to expand output, the cost-reducing new technique just allowed them to expand output.

Jeremy June 1, 2011 at 6:27 pm

Seth,

Other economists may disagree with me on this one, but I always teach my students that price determines output, not the other way around. I can increase output all I want, but if I don’t change price, I won’t sell any of my additional output, ceteris paribus.

Charles June 1, 2011 at 6:00 pm

If the context of the question had been “In a graduate seminar focusing on secondary and tertiary effects of innovation and government regulation” many of the arguments listed here and on the original posting would be perfectly valid. In the context of an introductory economics course the same arguments are less than perfectly valid. Part of picking the ‘right’ answer on a test is considering the context in which the question was presented.

Hari MIchaelson June 1, 2011 at 8:15 pm

I respectfully disagree Charles. It is the duty of the professor to frame the question in a way that matches class context. Especially given the nature of multiple choice where you are limited to your options. Also, consider this answer from an Econ 103 student:

Student “D. In our class we haven’t covered the effects of government intervention through intellectual property law, so I need more information.” ;)

rpl June 2, 2011 at 9:17 am

Novice Professor: “I don’t write trick questions. You can safely assume that all the information needed to answer the question is in the problem statement. The `not enough information’ answer is appropriate when given the facts of the problem there are competing, opposite effects and you can’t say which one is larger. Even then, the `additional information’ you need is not obscure knowledge from outside the class curriculum; it’s quantitative values for the magnitudes of the effects involved. May this lesson serve you well on future tests.”

Veteran Professor: “Wrong. I also didn’t tell you the phase of the moon, the tide tables for the month, or the going price of freshly-cut tea leaves in China. Not everything we don’t cover is germane to the problem. In fact, most of it isn’t. May this lesson spare you further embarrassments like the one you’ve inflicted on yourself here.

Needless to say, it takes about 2 or 3 semesters of dealing with college kids to progress from the former to the latter. (I made it in 1, but I’m told I’m an outlier that way ;-)

Bill Woolsey June 4, 2011 at 7:57 pm

RPL;

LOL!!!!!!

Dan June 2, 2011 at 12:20 pm

Answer B………. If answer is D with explanation, then credit can be awarded. This is silly. But, in context of what is learned in a 103 class, I would think the answer is B.

Eric Hammer June 2, 2011 at 10:24 pm

Those sorts of questions and assumptions always make me nuts though. Some people go into Econ 103 knowing how to spell economics and not much more, and so don’t have any other context, but then again as many or more go in with all sorts of context gained from their own reading and experience. Those students are then penalized for considering other possibilities that are quite accurate in the real world.

I think there is a bit of danger in a field like Economics in writing questions that implicitly say “Ignore reality, just run with what I told you.”
Then again, it may well be that econ by its very nature is too complicated for easy multiple choice question creation. Short essay might be superior.

In this case I agree that the “most likely” result is that all other companies lower prices, but too often professors write exams that ignore relevant issues in favor of “Inflation goes up, employment goes up!” type rules.

Dan June 2, 2011 at 11:02 pm

I remember my Prof. In econ 100′s allowing for explanations. He suggested to bring in a piece of paper and if you wish to explain yourself, Feel free to do so. Credit will be given on the merit of your total answer.

Eric Hammer June 3, 2011 at 9:57 am

Sounds like a fine teacher to me! Even if it doesn’t get you any points, he would get a better understanding of his student’s misunderstandings. It has to be nearly impossible to guess just what people are thinking when they answer multiple choice questions, or even whether they just guessed at random.

Ron H. June 3, 2011 at 2:07 pm

No,

Student: B – not D. “I n our class we haven’t covered the effects of government intervention through intellectual property law, so I’m not to consider that such things even exist. “

Ron H. June 3, 2011 at 2:25 pm

If every possibility is to be considered, then there’s no need for different economics classes, such as 101, 103, etc. One class could cover it all.

bc June 1, 2011 at 7:31 pm

All of this assumes that BMW would reduce its prices substantially. I would think that BMW, being a premium brand, would probably reduce its prices slightly to edge their premium competitors but keep out of the mid-range market.

richard June 1, 2011 at 11:17 pm

Don,

I don’t understand. You say that non-bmw companies would lower their price. However, that would mean that they currently produce above cost price. Otherwise lowering the price would be a money loosing business and the non-bmw companies would go out of business.

I think the car industry is very competitive. No car company can command a significant premium.

So I would say:
- Non-bmw prices would stay the same
- The volume of non-bmw would reduce
- Some car companies will go bust

Ron H. June 3, 2011 at 2:22 pm

richard,

If non-BMW companies were NOT currently selling at above their costs, they would already be out of business. Please ignore taxpayer bailouts for purposes of this discussion.

To avoid those things you list that lead to “Some car companies will go bust”, they would be forced to lower prices in an attempt to maintain market share. It might or might not be enough to keep them afloat. They also might try very hard to find ways to lower their costs. All of this is good for consumers.

Chrispy June 2, 2011 at 12:56 am

I think it’s worth considering what would happen to all old BMW factories and workers. I suspect the other car companies would hire the now idle workers (perhaps at lower wages) and buy up the unused factories. This should expand their output and lower costs.

Matt N June 2, 2011 at 8:53 am

I get the point, although I think some folks have a valid argument with (d) in that we know nothing of the competing auto-makers’ profit margins. Suppose BMW could reduce prices so much that it exceeds the ability of the competitors to reduce their prices and maintain a competitive price point?

However I also don’t think it’s as simple as believing the competitors are just going to throw up their hands and say, “shucks — our costs are too high — time to give up!” I think there would at least be a ferocious amount of innovation driven* by the added competition that would allow at least some products to remain competitive.

(* side-issue: what amount of innovation could overcome the drag caused by the government-protected auto worker unions?)

I’d also like to throw out another possibility that I didn’t see mentioned yet (although perhaps it violates the scenario): BMW licenses the technology to its competitors. They could do so for, say, 50% of the cost-saving value the technology provides, thereby creating an additional revenue stream at virtually no cost (only cost being potential future losses due to increased competition). Seems like this might be a somewhat likely scenario given the negligible barrier to entry. That is, is your corporate strategy to spend years, perhaps decades, in a high-return but high-risk effort, competing directly in a bid for dominance that might never materialize? Or do you opt for a low risk strategy that provides immediate, zero-cost returns directly against your competitors, with the trade-off being that you _might_ lose out in net profits in the long term?

Ron H. June 3, 2011 at 2:38 pm

Matt,

(* side-issue: what amount of innovation could overcome the drag caused by the government-protected auto worker unions?)

The answer is “Not likely ANY amount, in the long run”. See GM and Chrysler for examples, and Ford for a close call.

I’d also like to throw out another possibility that I didn’t see mentioned yet (although perhaps it violates the scenario): BMW licenses the technology to its competitors.

So, BMW could become a technology company, and quit making cars altogether. Interesting idea.

Actually, we might find that when the technology is licensed, in a very short time, all other car makers would manage to invent similar technology that didn’t infringe BMW’s patent.

Dustin Santos June 2, 2011 at 11:00 am

Well it is clear of course that the main problem here is assumming that other car brands are substitutes for BMW. If you can not know this for sure, at least not for all car brands then there would be insuficcient information to answer the question. Another big asummption is that prices between BMW and other non luxury cars like Toyota, Nissan an alike are already high and close to those of a luxury car like BMWs. If prices are compared before BMWs innovation one might even find that this brand and others compete in different markets, hence are not substitutes. Maybe for an Econ 102 class the correct answer is B but never if the analysis goes deeper.

Dan June 2, 2011 at 12:29 pm

The cheapest BMW is at $ 28,000. Most Chevy vehicles start at $20,000. I feel safe in assuming the new BMW technology that significantly reduces costs will take business from Chevy unless the Aveo is a really popular and huge profit making vehicle for Chevy.

It’s not.

Hasdrubal June 2, 2011 at 11:55 am

Doesn’t b.) assume a sloped demand curve? (which is surely true of the auto industry.) Would it be different result in a competitive market with a flat demand curve?

Say a wheat farmer develops a new hybrid which yields more per acre. He produces at a lower cost per bushel, but cannot produce enough to move the market. Doesn’t the farmer then make a profit until enough other producers innovate to lower the market price?

mark June 2, 2011 at 1:52 pm

Forgive me for not reading through all 30+ comments — this point may have been made already.

Pricing has as much, or more, to do with marketing as production efficiency. We assume that BMW would lower their prices as a result of improvements in production efficiency. Doubtful. BMW is positioned as a premium brand; lowering their prices skewer their brand. Playing armchair CEO — they would leave prices alone, and pocket increased profits, which they could then invest in more R&D and marketing, thus increasing market share in their niche. This might force some competitive response from Cadillac, Lincoln, Mercedes, etc., but to say they would all drop their prices in knee-jerk fashion is to ignore marketing considerations.

yet another Dave June 2, 2011 at 3:50 pm

RTFQ

We assume that BMW would lower their prices…

vs.

As a result, BMW expands its output and lowers its prices.

There is no assumption – it is part of the question as stated. In other words, it is a given. The question is what happens as a result of what is given.

mark June 2, 2011 at 4:45 pm

Ok, taking as given that BMW would lower prices. I’ll assume further that, given the new production technology, the lower prices as much as the improved production efficiencies will allow and maintain their ROI.

If I’m Mercedes, I’d sit and watch. I’d consider an advertising strategy that might not-so-subtly link lower prices with lower quality, and point out that Mercedes is expensive, and you get what you pay for.

In other words, I think it’s doubtful that marketers for other premium brands are going to match the price cuts in lockstep.

Dan June 2, 2011 at 7:43 pm

I have little doubt that Mercedes would enter a lower priced vehicle into marketplace touting their newest innovative technology that allows for the same quality but at lowered costs. They could just add more additional features to turn the buyers heads in their favor for the snobs.

SheetWise June 2, 2011 at 7:00 pm
Tony Fernandez June 2, 2011 at 8:19 pm

Why would BMW even lower their prices? They have the patent and so can produce at a lower cost at current prices. Unless competition forces them to lower prices, they have no incentive to lower their profit margin.

Vance Armor June 3, 2011 at 12:59 am

I can’t believe Don is defending patents, which are nothing other than state-sponsored violent interferences prohibiting voluntary exchange. I still believe that Don is incorrect on this one. The effect of the patent, as history has shown, for example, in the case of Microsoft, is for the patent to create economic rents for the holder of the patent. The redistribution of economic welfare from the consumers to the patent holder is not a perfect redistribution, and the loss of market competition among those not holding the patent, but who would otherwise compete without the violent governmental interference protecting the patent holder, creates the conditions for price hikes, and much lower total sales, among producers who are NOT homogenous competitors but slightly non-homogenous competitors, leaving them at an extreme disadvantage, and the consuming public at a modicum of a long-term disadvantage due to the lack of rivalry — and thus, accompanying lack of price competition — among these near-substitute competitors. Don demonstrates the “substitution effect” by only looking at the short run and failing to see how patents hurt consumers in the long run.

Vance Armor June 3, 2011 at 1:04 am

Would someone please explain to me, how, in any industry that is not a declining cost industry (e.g. police protection within certain parameters) a violent state intervention prohibiting capitalist acts between consenting adults leads to lower costs for the consumer? I cannot defend patents under any circumstances.

MikeP June 3, 2011 at 9:17 am

The lower costs in the posed question are yielded by the invention, not the patent. The patent simply prohibits anyone else from lowering their costs using the same invention.

Regardless, your indignation on a statement of facts in an exam question is odd. The phrasing of the question neither hails nor denigrates patents.

And while you or I or maybe even Don might think that patents generally mean higher costs, those who contend that patents make sense would argue that the invention might never have been pursued without the monopoly rents it would yield and the lower costs of the exam question would never have occurred. It is certainly not self-evident one way or the other.

Tony Fernandez June 3, 2011 at 11:01 am

What’s not self-evident is that BMW would lower its prices just because of the invention. Gains in productivity would only tend to lower prices if competition necessitated it. Otherwise, without the competition, the companies would just take the higher profit margin and run with it. If competition is not forcing BMW to lower its prices, then where is the incentive for BMW to do that?

MikeP June 3, 2011 at 12:08 pm

The incentive is increased total profits.

Even taking what you say as a given — something there is no evidence of companies ever doing, incidentally — BMW could leave their current product line at the same price and reap the cost improvement entirely as profit while opening up new lines that don’t compete with their current line and reap new profit on those. Those new lines must be offered at lower prices than they would have charged had they opened them without the innovation, or they would already be offering those lines.

The main point: BMW would not give up more profit just to maintain a greater profit margin.

Vance Armor June 3, 2011 at 10:56 pm

I think Tony Fernandez makes better sense. The rent seeker will run with his rent. A market competitor’s newly “invented” economic rent does not cause the price of near-competitors’ products to fall. Subjectivist economics tends to show that the “substitution effect” greatly harms the competitors. First, with the invention. Second, with the patent. The patent does not “force” added rivalry compelling the competitors to lower their prices — they are simply lopped out and left bleeding with a smaller market share and forced to sell at higher prices to cover higher average marginal costs. They have higher AMC because in order to stay in competition they have to compensate for the state’s protection of their rival’s new invention in some way. Prices cannot stay below AMC for too long.

MikeP June 3, 2011 at 11:05 pm

Say that BMW does not patent the invention, but instead keeps it a carefully guarded secret so that no one else can replicate it.

Wouldn’t the outcome be the same?

Vance Armor June 3, 2011 at 11:03 pm

Defenders of patents will argue that the patent “spurs” innovation by driving the competitors to come up with ways to patent their own inventions to stay in the market, but this argument fails, I think, most generally, because of the high transactions costs in the patent process and the uncertainty of obtaining either a new invention or the state’s imprimatur of a patent that is marketable. I like the research that the German economic historian Eckhart Hoffner showed about literacy rates in Germany versus England in the early nineteenth century. In England, there were strong copyright laws and a highly litigious legal climate concerning copyright infringement. Books were expensive and were the leisure of the upper class. In Germany, on the other hand, there were almost no copyright laws, books were printed and sold with abandon and the population’s literacy rate was very high and books were generally much cheaper on average than in England.

Vance Armor June 3, 2011 at 11:05 pm

I’m sorry to be so stubborn. I am not satisfied with Don’s answer to question # 2.

Vance Armor June 4, 2011 at 9:07 am

MikeP says, “Suppose that BMW does not patent the invention but keeps it a closely guarded secret, wouldn’t the outcome be the same?” No. The problem with your supposition is that the higher quality of the “secret” is revealed in the market through the innovation. This would, ceteris paribus, lower prices among competitors, but the patent creates the opposite effect in terms of long term average marginal costs of competitors, and thus, prices. Prices must stay above AMC in the long run or else the supplier must exit the market. Unless you believe that somehow the patent will lead to lower AMC for all competitors, including BMW, in the long run, which it will not.

MikeP June 4, 2011 at 11:38 am

The higher quality of the secret is revealed in the market through the innovation, but the secret itself might not be. The end result is exactly the same as if it were patented: competitors do not have the innovation.

Indeed, if it is quite an excellent secret — e.g., the recipe for Coca-Cola — competitors won’t have the innovation for well over 17 years and your argument about long run AMC flips and the patent starts looking better for the competitors.

Vance Armor June 4, 2011 at 9:15 am

I find it very interesting how “defenders of capitalism” almost always wind up defending state action for those in a privileged position (in this case, the “innovator”) that inhibits others from making transactions (in this case, simply copying BMW’s innovation and selling it on the open market).

Vance Armor June 4, 2011 at 9:23 am

Here’s the problem with patents: The innovator hires a lawyer(s) and a patent engineer(s). They make an application with the patent office, which is staffed by taxpayer subsidized bureaucrats. These taxpayer subsidized bureaucrats then decide, based upon their omniscience, whether the invention qualifies as a new invention that is marketable. Once all of the lawyers and engineers are paid — all of these transactions costs that those of us among the hoi polloi cannot afford — the patent is granted. The government — the federal government! — then lends its support through its judicial power to coerce anyone from copying this innovation and selling it in the market. Don thinks this system lowers long term average marginal costs, and thus prices, among products similarly situated in the market. Don is mistaken. I’m sorry for being tendentious.

Vance Armor June 4, 2011 at 9:48 am

Don asks Hari Michealson if there is a historical example of a government patent holder using the patent to monopolize a market and keep its rivals out of business. Well, yes, Microsoft. Well, yes, just about fifty thousand drugs that Big Pharm rips off the public through their lawyers, lobbyists and patent experts. I noticed that with Obamacare that Big Pharm got a lot of patent extensions for pharmaceuticals in the fine print of the 2800 page bill. The next time a cancer patient complains to you about having to pay three thousand dollars for an injection shot in the gluteus maximus, just tell them that this three thousand dollars is the price that the “free market” commands, because, after all, long term average costs are lowered by our glorified innovators who rightly are “entitled” to the patents they obtain due to their “hard work” and “Lockean creations.” Did any of you know that Big Pharm has a 100% tax CREDIT on all R & D research? Unbelievable. No industry has been able to obtain that from the Ways and Means Committee.

Vance Armor June 4, 2011 at 9:55 am

It is a matter of political philosophy and jurisprudence, I think. Defenders of patents have a crude understanding of property rights. The jurisprudential history of patents is indistinguishable in common law England from the jurisprudential history of monopolies. The king granted patents for the new inventions to obtain fealty and to bestow protection upon the innovator just as the king granted monopolies for those selling more mundane products – and for the very same reasons.

Vance Armor June 4, 2011 at 10:21 am

MikeP makes a distinction between “invention” and “patent.” He contends that Don’s question is neutral with regard to the patent. It is not. Don’s question asks whether the prices of BMW’s competitors will fall or rise — with the patent. In the long run, their prices will rise, not fall. Let’s take this example. Suppose I make an innovation in the sale of orange juice. I have somehow determined that if I add a certain benign chemical into the orange juice it tastes much better and eases problems with acid reflux among consumers having that problem. I send a letter to a friend, the Terminator, who is seven feet tall and armed with automatic machine guns, about my innovation and I instruct him, with a payment, to shut down the businesses of all orange juice sellers who add this benign chemical into their orange juice. Due to my innovation more consumers are buying my product. Prices of orange juice fall — in the short run due to the rivalry of competitors. My competitors are frantic. A few of them learn of my secret. They start to copy it. My seven foot tall friend, the Terminator, starts to intimidate them and they temporarily back off and go back to selling orange juice without the benign chemical. I am the only seller of the better brand of orange juice. I make a lot of money, and, I have the freedom to raise my prices where my total revenues are increased by raising my price, even above the price of orange juice of the status quo ante, now that the intimidation has taken effect. Consumers have abandoned my rivals to a large extent and I am reaping in enormous economic rents. My rivals expend huge sums trying to get around my seven foot tall Terminator and they devise ways to outfox the Terminator who enforces my “patent.” Long term average costs are higher among all competitors. These average costs are long term because the Terminator does not go away. He is always there. If my competitors cannot obtain any profit where the price of their product exceeds long term average costs, they exit the market altogether. Prices are higher in the long term than they would be without the Terminator. Long term prices are also higher than the status quo ante due to the continuation of my monopoly privilege and the continuing high transactions costs my competitors suffer from having to devise schemes to outwit the Terminator.

Vance Armor June 4, 2011 at 10:34 am

All of this points to the general problem with statism. We get a lot of neat products on the market, and wonderful drugs that can help cancer patients, and they are generally priced through the roof because of state interference in the market (through the patent system). Long term average costs of “drugs” are higher, much higher, due to the patent system despite all of the “innovations.” Don’s domain of discourse is “cars” in his question. What if the domain of discourse of his question were “drugs?” Would he still believe that prices of the competition would fall?

Davor Mance June 6, 2011 at 3:41 am

BMW products are luxury products and have their own demand curve.
If that demand curve is normally downward sloping and ELASTIC, than, Don’s answer is correct.
If, on the other hand the demand curve is INELASTIC, any price reductions will have the consequence of decreasing revenues and profits.
It is a non-sequitur to assume the demand curve is elastic, especially for a car that expensive. Where does the elastic part of the curve beginn? Or, by how much must the BMW reduce the price to enter the elastic part of the demand curve? The answer is probably: by that much so that it ceases to be a luxury brand and starts making losses as do many other non-luxury automakers begging for governmental bail-outs.
I once did a research for a german brewery and found out that, that specific bier had an inelastic demand curve, and although they increased their productivity by investing in new machinery, they could increase their profits by INCREASING their prices to MC=MR, and simultaneously, non influencing other prices or quantities because they were a luxury brand, and those who drank that bier did not drink any other, the price increase was covered in the reduction of consumption of some other good (or saving) and not bier in general.
So, I would say:
d. there’s insufficient information to answer this question,
because the question really doesn’t say anything about the SUPPLEMENTARITY between BMW products and other manufacturers, and other CROSS-ELASTICITIES. By how much will the change in BMW prices influence the market of other auto producers’ prices and quantities or will instead influence the market for diamonds, luxury watches or yachts?

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