The Australian National UniversityThe Australian National University Inaugural “Trevor Swan Inaugural “Trevor Swan Distinguished Lecture in Distinguished Lecture in

Economics”Economics”

““Something Old and Something Something Old and Something New: Durability, Quality and New: Durability, Quality and

Innovation–the Market Structure Innovation–the Market Structure Irrelevance Principle after 36 Irrelevance Principle after 36

Years, and a Simple Explanation Years, and a Simple Explanation for the Equity Premium Puzzle”for the Equity Premium Puzzle”

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Trevor Winchester Swan AOTrevor Winchester Swan AO

Born 14th of January 1918 to George and Clara Swan (nee Born 14th of January 1918 to George and Clara Swan (nee Grant). Grant).

Died of cancer on January 15th, 1989. Died of cancer on January 15th, 1989. His academic brilliance shone through earlyHis academic brilliance shone through early Gifted in piano, singing, acting and debatingGifted in piano, singing, acting and debating Ability to recall verbatim vast amount of literature Ability to recall verbatim vast amount of literature Part-time student Sydney University- University medal 1940Part-time student Sydney University- University medal 1940

1943-1945: second Keynesian econometric model ever built1943-1945: second Keynesian econometric model ever built Answered “What if” questionsAnswered “What if” questions What public policy might have preserved Australia from the What public policy might have preserved Australia from the

Great Depression?- 52% exchange depreciationGreat Depression?- 52% exchange depreciation Colin Clark in Colin Clark in EconometricaEconometrica, 1949, praised use of real units, 1949, praised use of real units

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Trevor and Pat SwanTrevor and Pat Swan

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10 Equation Macro-Economic Model10 Equation Macro-Economic Model

Method of estimation for 10 equation model, 1928-1939:“The method of evaluating the functional relationships of the system is necessarily empirical. Nevertheless, in view of considerable error margins in many of the available statistics, and the great possibilities of misleading results being produced by multi-collinearity in the time-series, it has been thought wise wherever possible to impose certain a priori conditions on the shape of the functional relationships. Subject to these conditions, linear or curvilinear regression lines have been fitted graphically to the data plotted as a scatter diagram.”

Instead of econometric packages and fast computers slide rules were “hi tech” and were exceedingly portable!

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Trevor’s 45 Degree Cross Adjustment to Trevor’s 45 Degree Cross Adjustment to Keynesian Equilibrium from Swan (1989)Keynesian Equilibrium from Swan (1989)

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““Nugget” Coombs on TrevorNugget” Coombs on Trevor

-“one of the very best theoretical economists we -“one of the very best theoretical economists we have ever produced in Australia”. “His have ever produced in Australia”. “His theoretical grasp of the structure of the theoretical grasp of the structure of the economy, his mastery of statistical techniques, economy, his mastery of statistical techniques, his gift of lucid exposition and his incredible his gift of lucid exposition and his incredible capacity for work made him the effective capacity for work made him the effective mainspring of the War Commitments Committee” mainspring of the War Commitments Committee” (Rowse, 2002, p. 157).(Rowse, 2002, p. 157).

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ANUANU

Youngest Chair appointment at age of 32 in 1950Youngest Chair appointment at age of 32 in 1950 Continued to advise Sir Robert Menzies until 1956Continued to advise Sir Robert Menzies until 1956 Played a decisive role in the 1961 “short-sharp-shock” that Played a decisive role in the 1961 “short-sharp-shock” that

so devastated the economy that Menzies only survived the so devastated the economy that Menzies only survived the election of that year by one seat and handful of votes-so election of that year by one seat and handful of votes-so much for advice from economists!much for advice from economists!

Next ten or more years were ones of high employment and Next ten or more years were ones of high employment and low inflationlow inflation

Paper foreshadowing Mundell in 1953 on policy Paper foreshadowing Mundell in 1953 on policy instruments and targetsinstruments and targets

Assumed Australia as a “small country” could Assumed Australia as a “small country” could notnot influence terms of tradeinfluence terms of trade

Introduced notion of “real” exchange rate between traded Introduced notion of “real” exchange rate between traded and non-traded goods and non-traded goods

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Trevor in his officeTrevor in his officeIn accepting the Chair at ANU he ended up in the same building at the same desk as at In accepting the Chair at ANU he ended up in the same building at the same desk as at

Post-War ReconstructionPost-War Reconstruction

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All economists long to be loved, All economists long to be loved, including Trevor. Despite best efforts, including Trevor. Despite best efforts,

not all succeed all the timenot all succeed all the time

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ANUANU

Internal-external balance paper-1955Internal-external balance paper-1955 Modelled diagrammatically the supply and demand for Modelled diagrammatically the supply and demand for

traded and non-traded goods to achieve full employment traded and non-traded goods to achieve full employment and price stability to complete the Keynesian system for a and price stability to complete the Keynesian system for a small trading nationsmall trading nation

Extended by Wilf Salter and Max CordenExtended by Wilf Salter and Max Corden Trevor’s 1956 Growth Model became famous as the Solow-Trevor’s 1956 Growth Model became famous as the Solow-

Swan Neoclassical Growth ModelSwan Neoclassical Growth Model Robert Solow’s paper was written independently at the Robert Solow’s paper was written independently at the

same timesame time Robert Solow received the Nobel Prize for his work on Robert Solow received the Nobel Prize for his work on

growth theory in 1987growth theory in 1987

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Trevor’s Internal and External Balance and Trevor’s Internal and External Balance and Zones of Economic UnhappinessZones of Economic Unhappiness

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Trevor’s 1956 Growth ModelTrevor’s 1956 Growth Model

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Growth ModelGrowth Model

10% savings rate leads to steady-state growth of 1% with 10% savings rate leads to steady-state growth of 1% with output–capital ratio of 0.1output–capital ratio of 0.1

5% savings leads to the same steady-state growth of 1% and 5% savings leads to the same steady-state growth of 1% and same zero growth in per-capita income but higher output-same zero growth in per-capita income but higher output-capital ratiocapital ratio

Only technical change raises real living standards in long-runOnly technical change raises real living standards in long-run Also explored Ricardian and Malthusian outcomes and a Also explored Ricardian and Malthusian outcomes and a

range of puzzles involving capital relating to Wicksell and range of puzzles involving capital relating to Wicksell and Joan RobinsonJoan Robinson

Awarded inaugural Distinguished Fellow of the Economics Awarded inaugural Distinguished Fellow of the Economics Society by Bob Hawke in 1987Society by Bob Hawke in 1987

Became an Officer of the Order of Australia in the Became an Officer of the Order of Australia in the bicentennial year, 1988bicentennial year, 1988

Member of the Board of the Reserve Bank, 1975-1985Member of the Board of the Reserve Bank, 1975-1985

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Trevor on Reserve Bank BoardTrevor on Reserve Bank Board

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Receiving Officer of Order of Australia Receiving Officer of Order of Australia AwardAward

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Trevor’s “Letter from New Delhi”Trevor’s “Letter from New Delhi”Suddenly it is summer and the jackal howldeep in the jungle which is suburban scrub. In the cool nights too they used to howl(pleasuring in the dome of Ferozshah, playing jackal to his Ozymandias)to keep themselves warm . Soonwith the rains their cadence will falloutjackalled by the tawny nullah coursesthat scurry for the Jumna’s holy gorgingalms and ashes, rinds and shucks, water for the taps of Delhi.Now in the summer do the jackals howlwantonly, dreaming of a five-year plan?If I were a jackal I’d howl to show my jackalness. Here a lifted voice, is answered in brick and plaster by a thousand tonguesnone human but the wallah’swhose cherry-ripe betels his lips. If Iwere a jackal mortality would be my friendand only the vultures my enemy. I could live on the killings of my friendand howl without shame.

““How Well has the Market Structure How Well has the Market Structure Irrelevance Principle for Durability, Irrelevance Principle for Durability,

Product Quality and Innovation Withstood Product Quality and Innovation Withstood the Test of Time?”the Test of Time?”

Peter L. SwanPeter L. Swan23 May 200623 May 2006

UNSWUNSW

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Market Structure Irrelevance PrincipleMarket Structure Irrelevance Principle

Rent extraction by a single- or multi-product monopolist Rent extraction by a single- or multi-product monopolist should be as painless as possibleshould be as painless as possible

Durability determined only by Wicksell’s (1934) Condition Durability determined only by Wicksell’s (1934) Condition for minimising the total cost of providing the servicefor minimising the total cost of providing the service

A monopolist should produce identical product range, A monopolist should produce identical product range, quality choice and innovation timing as equivalent quality choice and innovation timing as equivalent competitive industry competitive industry See Swan (1970, 1971a, 1971b, 1972) and Sieper and Swan (1973)See Swan (1970, 1971a, 1971b, 1972) and Sieper and Swan (1973)

Attracted great deal of interest and support over last 30+ Attracted great deal of interest and support over last 30+ yearsyears Feature of major textbooks: Tirole (1988), Carlton and Perloff Feature of major textbooks: Tirole (1988), Carlton and Perloff

(1994) and Shy (1996)(1994) and Shy (1996) Surveys: eg. Schmalensee (1979), and Waldman (2003) who Surveys: eg. Schmalensee (1979), and Waldman (2003) who

identifies the major contributors on durable goods over the last identifies the major contributors on durable goods over the last three decades as Coase (1972), Akerlof (1970), Swan (1970, three decades as Coase (1972), Akerlof (1970), Swan (1970, 1971a) and Sieper and Swan (1973)1971a) and Sieper and Swan (1973)

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Why is this important?Why is this important?

Has very important implications for competition Has very important implications for competition policy, trade practices, ownership of natural policy, trade practices, ownership of natural monopolies, and regulation of monopoliesmonopolies, and regulation of monopolies Means that such policies need only focus on the Means that such policies need only focus on the

tendency of monopolies to charge too much as a tendency of monopolies to charge too much as a consequence of producing too littleconsequence of producing too little

Do not have to be concerned with a whole myriad Do not have to be concerned with a whole myriad of issues over “planned obsolescence”, quality, of issues over “planned obsolescence”, quality, innovation, etc. and trying to “micro-manage” innovation, etc. and trying to “micro-manage” monopoly behaviour.monopoly behaviour.

From both theoretical and empirical perspectives From both theoretical and empirical perspectives concerns some of the most interesting issues in concerns some of the most interesting issues in microeconomicsmicroeconomics

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Logical Error in Early Findings on Optimal Logical Error in Early Findings on Optimal DurabilityDurability

Early authors-Martin (1962), Kleiman and Ophir Early authors-Martin (1962), Kleiman and Ophir (1966), Levhari and Srinivasen (1969) and (1966), Levhari and Srinivasen (1969) and Schmalensee (1970)Schmalensee (1970)

All contained “analytical proof” that profit maximising All contained “analytical proof” that profit maximising monopolist would produce less durable goods than monopolist would produce less durable goods than under competition in long-run equilibriumunder competition in long-run equilibrium Nature of logical error pointed out by Swan (1970, Nature of logical error pointed out by Swan (1970,

1971a) and more generally by Sieper and Swan 1971a) and more generally by Sieper and Swan (1973)(1973)

All assumed that the initial conditions on the All assumed that the initial conditions on the problem of obtaining long-run equilibrium could be problem of obtaining long-run equilibrium could be varied in the interests of future profitabilityvaried in the interests of future profitability

Monopolies have “time machines” that enable them Monopolies have “time machines” that enable them to undo past decisions by turning back time to undo past decisions by turning back time

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Conclude that Irrelevance Principle has Conclude that Irrelevance Principle has withstood over three decades of relaxation withstood over three decades of relaxation

of assumptions largely intactof assumptions largely intact Dynamic inconsistency problem-relax perfect Dynamic inconsistency problem-relax perfect

foresight assumptionforesight assumption Allow secondhand and reproduction marketsAllow secondhand and reproduction markets Imperfect capital markets and taxesImperfect capital markets and taxes Choice of product quality in non-durability Choice of product quality in non-durability

dimensionsdimensions Heterogeneous consumersHeterogeneous consumers Technological innovationTechnological innovation Other applicationsOther applications Empirical testsEmpirical tests

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1.1. Dynamic Inconsistency ProblemDynamic Inconsistency Problem

Problem posed and solution provided by Homer Problem posed and solution provided by Homer 3,000 years ago: Ulysses bound to mast while 3,000 years ago: Ulysses bound to mast while listening to the singing of the Sirens!listening to the singing of the Sirens!

Contrast optimal seller of a “costless” durable Contrast optimal seller of a “costless” durable will a lease strategy-both optimally produce to will a lease strategy-both optimally produce to equate marginal revenue to zero in initial period. equate marginal revenue to zero in initial period.

Seller now recognises can exploit remaining Seller now recognises can exploit remaining demand by producing more-the Siren song. Since demand by producing more-the Siren song. Since does not own the good is not concerned by losses does not own the good is not concerned by losses inflicted on early buyers. Buyers anticipating this inflicted on early buyers. Buyers anticipating this refuse to pay more than zero for goodrefuse to pay more than zero for good

Renting monopolist is time-consistent as bears Renting monopolist is time-consistent as bears full losses from excessive productionfull losses from excessive production

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1.1. Dynamic Inconsistency ProblemDynamic Inconsistency Problem

Coase (1972) conjectures that monopolist will produce Coase (1972) conjectures that monopolist will produce competitive stock-give it away at a “zero” price “in a competitive stock-give it away at a “zero” price “in a twinkling of an eye”twinkling of an eye” Competition policy redundant-monopolist socially Competition policy redundant-monopolist socially

optimumoptimum Many innocent-sounding strategies such as lease or Many innocent-sounding strategies such as lease or

reduce durability are anti-competitive -disguised means reduce durability are anti-competitive -disguised means to “commit” to an output plan-competition policy even to “commit” to an output plan-competition policy even more important!more important!

Sieper and Swan (1973)-a “selling” monopolist with Sieper and Swan (1973)-a “selling” monopolist with “common foresight” will never give away his product-“common foresight” will never give away his product-prefers to rent or lease (foresight is perfect). With any prefers to rent or lease (foresight is perfect). With any “generalised” imperfect foresight-except zero foresight- “generalised” imperfect foresight-except zero foresight- durability decision cost-minimising (competitive).durability decision cost-minimising (competitive).

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1.1. Formal Proofs and a Tractable ModelFormal Proofs and a Tractable Model

Stokey (1981) and Gul et al (1986) provide rational Stokey (1981) and Gul et al (1986) provide rational expectations models-formal “proof” of the Coase expectations models-formal “proof” of the Coase conjecture as the period length goes to zero-no conjecture as the period length goes to zero-no commitment-competition law redundantcommitment-competition law redundant

Bulow (1982, 1986) works with a simple two-period Bulow (1982, 1986) works with a simple two-period tractable modeltractable model Costly ways to precommit: -inefficient technology with low fixed Costly ways to precommit: -inefficient technology with low fixed

costs and high marginal costs;-inefficiently lower durability; rental costs and high marginal costs;-inefficiently lower durability; rental has advantage of not being inefficienthas advantage of not being inefficient

both IBM and Xerox had falling rental/sales ratios that are now both IBM and Xerox had falling rental/sales ratios that are now quite lowquite low

Kahn (1986) and Driskell (1997) shows that rising Kahn (1986) and Driskell (1997) shows that rising marginal cost and some depreciation sufficient to marginal cost and some depreciation sufficient to postpone instant achievement of competitive outcomepostpone instant achievement of competitive outcome

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1.1. A myriad alternatives to inefficient A myriad alternatives to inefficient durability reduction provide support for durability reduction provide support for

irrelevance principleirrelevance principle Ausubel and Deneckere (1989, 1992) –solution to Ausubel and Deneckere (1989, 1992) –solution to

bargaining game can be close to static monopoly-bargaining game can be close to static monopoly-private information about costs leads to low-cost private information about costs leads to low-cost firms signalling high costs and low sales firms signalling high costs and low sales probability-sale but with rental-like outcome.probability-sale but with rental-like outcome. Regulatory focus on Coase conjecture leads to poor Regulatory focus on Coase conjecture leads to poor

public policy with regulatory bans on leasing (eg. public policy with regulatory bans on leasing (eg. UnitedUnited StatesStates vv. . United Shoe Machinery CorpUnited Shoe Machinery Corp.).)

Bagnoli, Salant and Swierzbinski (1989) replace Bagnoli, Salant and Swierzbinski (1989) replace continuum of consumers with a finite number to continuum of consumers with a finite number to obtain Pacman (perfect dynamic discrimination). obtain Pacman (perfect dynamic discrimination). See Morch von der Fehr and Kühn (1995) and Dudley See Morch von der Fehr and Kühn (1995) and Dudley

(1995) for qualifications.(1995) for qualifications.

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2.2. Increasing CostIncreasing Cost

Sieper and Swan (1973) introduce rising marginal costs Sieper and Swan (1973) introduce rising marginal costs due to fixed capacity-in nearly every imaginable case due to fixed capacity-in nearly every imaginable case there is no difference in durability choice over market there is no difference in durability choice over market structurestructure

Kamien and Schwartz (1974) contend that monopolist Kamien and Schwartz (1974) contend that monopolist will always produce lower durability goods but logical will always produce lower durability goods but logical flaws exposed by Swan (1977) and Auernheimer and flaws exposed by Swan (1977) and Auernheimer and

Saving (1977)Saving (1977) Abel (1983) shows that any cost function satisfying the Abel (1983) shows that any cost function satisfying the

generalised separability specification, generalised separability specification, ff((XgXg((DD)), where )), where XX is output, is output, DD is durability, and both is durability, and both gg((DD) and f(.) are ) and f(.) are arbitrary differentiable functions, generates the arbitrary differentiable functions, generates the

irrelevance result.irrelevance result.

f Xg D

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2.2. Secondhand and Reproduction Secondhand and Reproduction MarketsMarkets

White (1971) argued that if secondhand cars are White (1971) argued that if secondhand cars are imperfect substitutes for new ones that a monopolist imperfect substitutes for new ones that a monopolist would produce new cars of lower durabilitywould produce new cars of lower durability

Swan (1972b) showed that this argument is false for Swan (1972b) showed that this argument is false for the large class of homothetic demand function, the large class of homothetic demand function, including linear, log, CES, where demand is modelled including linear, log, CES, where demand is modelled as vertical sum from new and secondhand marketsas vertical sum from new and secondhand markets

Schmalensee (1974), Parks (1974), Su(1975) provide Schmalensee (1974), Parks (1974), Su(1975) provide incentive for rental via increased supply of incentive for rental via increased supply of maintenance effort. Esteban-Llobat (2005) propose maintenance effort. Esteban-Llobat (2005) propose option to buy. Careful ones will exerciseoption to buy. Careful ones will exercise

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2.2. Learned Hand’ celebrated judicial Learned Hand’ celebrated judicial ALCOA caseALCOA case

Hand concluded monopoly due to virgin control. Swan Hand concluded monopoly due to virgin control. Swan (1980) finds empirically Hand correct as ALCOA (1980) finds empirically Hand correct as ALCOA reduced supply of virgin in response to recyclersreduced supply of virgin in response to recyclers

Suslow (1986a) found empirically ALCOA retained Suslow (1986a) found empirically ALCOA retained monopoly due to limited substitutability of scrap for monopoly due to limited substitutability of scrap for virginvirgin

No one finds support for Coase contention that price No one finds support for Coase contention that price driven to marginal costdriven to marginal cost

Lieberwitz (1985) finds unauthorised photocopy has Lieberwitz (1985) finds unauthorised photocopy has not harmed academic journalsnot harmed academic journals

Besen and Kirby (1989) extend Swan’s ALCOA model Besen and Kirby (1989) extend Swan’s ALCOA model to unauthorised photocopyingto unauthorised photocopying

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3.3. Imperfect Capital Markets and TaxesImperfect Capital Markets and Taxes

Barro (1972) and Ramm (1974) consider consumers Barro (1972) and Ramm (1974) consider consumers with higher discount rate than producer-claim with higher discount rate than producer-claim monopoly will reduce durabilitymonopoly will reduce durability

Raviv and Zemel (1977) claim that an income tax will Raviv and Zemel (1977) claim that an income tax will reduce monopoly durability below the monopoly levelreduce monopoly durability below the monopoly level

Swan (1981) shows that an income tax can be used to Swan (1981) shows that an income tax can be used to model differences in discount rates, as in Barro and model differences in discount rates, as in Barro and Ramm. Recognising the after-tax cost of capital is Ramm. Recognising the after-tax cost of capital is ii =(1-=(1-ττ))rr, where , where ττ is the tax rate, is the tax rate, rr is the pre-tax cost is the pre-tax cost of capital, correction of R&Z error leads to market of capital, correction of R&Z error leads to market structure irrelevance result under Samuelson’s structure irrelevance result under Samuelson’s (1964) income tax(1964) income tax

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4.4. Monopoly Choice of Product Quality in Monopoly Choice of Product Quality in Non-Durability DimensionsNon-Durability Dimensions

Swan (1971b, 1972b)-first attempt to address quality Swan (1971b, 1972b)-first attempt to address quality issue -sufficient conditions for multi-product monopolist issue -sufficient conditions for multi-product monopolist to exactly duplicate product range of to exactly duplicate product range of nn competitive competitive industries, industries, nn is potential number of products or qualities is potential number of products or qualities Condition on the Condition on the nn price functions, price functions, FFii =a =aii++ffii((xx11, , xx22,…, ,…,

xxnn, , yy), is ), is ffii(.) homogeneous of degree (.) homogeneous of degree vv in product in product outputs, outputs, xxi i > 0 or > 0 or xxii=0. Monopoly output vector =0. Monopoly output vector proportional to competitive: proportional to competitive: xxii

mm = [1/(1+= [1/(1+vv)])]1/v1/vxxiic c for for vv > >

-1, so monopoly output always less than competitive, -1, so monopoly output always less than competitive, unless both zerounless both zero

Includes all regularly estimable systems of demand Includes all regularly estimable systems of demand curves including linear, log-linear, and CES. curves including linear, log-linear, and CES. Intuitively, consumers worse off under monopoly, so Intuitively, consumers worse off under monopoly, so income effects should not be too important for market income effects should not be too important for market structure irrelevance to holdstructure irrelevance to hold

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4.4. Monopoly Choice of Product Quality in Monopoly Choice of Product Quality in Non-Durability DimensionsNon-Durability Dimensions

Swan (1972b)- required utility function is Swan (1972b)- required utility function is u u = = uu[[gg((xx11, , xx22,…, ,…, xxnn), ), yy], where ], where gg((xx11, , xx22,…, ,…, xxnn), ), homogeneous of degree homogeneous of degree vv, is an aggregation , is an aggregation function or quantity index of aggregate monopoly function or quantity index of aggregate monopoly output, output, gg((xx11

mm, , xx22mm,…, ,…, xxnn

mm), is vector of monopoly ), is vector of monopoly outputs or qualities, and outputs or qualities, and gg((xx11

cc, , xx22cc,…, ,…, xxnn

cc), vector of ), vector of competitive industry outputs, and competitive industry outputs, and yy is a composite is a composite good with unitary price.good with unitary price. Results also extend to product and process Results also extend to product and process

innovation as the monopolist is always a innovation as the monopolist is always a smaller scale version of the multi-product smaller scale version of the multi-product group of competitive industriesgroup of competitive industries

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4.4. Mussa and Rosen (1978) Model of Mussa and Rosen (1978) Model of Quality and Price DiscriminationQuality and Price Discrimination

Consumers buy one unit, distribution of preferences Consumers buy one unit, distribution of preferences over population of consumers, over population of consumers, uu = = yy + + θθqq – – p, p, where where yy is composite good, is composite good, θθ is preferences, is preferences, qq is quality, and is quality, and pp is priceis price -“separating” as opposed to “pooling” equilibrium. --“separating” as opposed to “pooling” equilibrium. -

Price-discriminating monopolist systematically Price-discriminating monopolist systematically reduces quality below optimum competitive amount reduces quality below optimum competitive amount for all low valuation consumers for all low valuation consumers θθ < < θθmaxmax

Model extended by a host of people, Itoh (1983), Model extended by a host of people, Itoh (1983), Donnerfield and White (1988), Tirole (1988), Kim Donnerfield and White (1988), Tirole (1988), Kim and Kim (1996), Wauthy (1996) but Acharyya (1998) and Kim (1996), Wauthy (1996) but Acharyya (1998) points out that mostly conclusion is flawed as points out that mostly conclusion is flawed as solution is “pooling” with the monopolist producing solution is “pooling” with the monopolist producing a single optimal quality, not separating a single optimal quality, not separating discriminatory solutiondiscriminatory solution

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4.4. Saving (1982) Model of QualitySaving (1982) Model of Quality

Solves for the optimal quality of a single good with Solves for the optimal quality of a single good with multiplicatively separable price (inverse demand) multiplicatively separable price (inverse demand) function, function, pp = = V V ((qq) ) HH[ [ W W ((qq) ) XX], ], VV′ (′ (qq)>0 marginal )>0 marginal value of quality, value of quality, qq, , W W ((qq), ), W‘ W‘ ((qq)>0, adjusts units of )>0, adjusts units of output, output, XX, into quality adjusted units of consumption, , into quality adjusted units of consumption, W W ((qq) ) XX. Utility in quality-adjusted units, . Utility in quality-adjusted units, uu = = vv [ [WW ( (qq) ) XX] + ] + yy , where , where yy a composite good with unitary price, is a composite good with unitary price, is maximised maximised subject to budget constraint subject to budget constraint mm = [ = [pp//VV ( (qq)] [)] [WW ((qq) ) X X ]+]+yy , where [ , where [pp//VV ( (qq)] is price of quality-adjusted )] is price of quality-adjusted consumption, to give the inverse demand function above.consumption, to give the inverse demand function above.

With constant returns to scale for competitive industry, With constant returns to scale for competitive industry, ∂∂pp/∂ /∂ qq = [ = [VV'( '( qq)/)/VV( ( qq)] )] LL ( (qq) , where ) , where LL ( (qq) is industry ) is industry average cost with respect to quality. For monopoly, average cost with respect to quality. For monopoly, ∂∂MRMR/∂ /∂ qq = [ = [VV'( '( qq)/)/VV( ( qq)] )] LL ( (qq), where ), where MRMR denotes denotes marginal revenue. marginal revenue.

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4.4. Saving (1982) Model of QualitySaving (1982) Model of Quality

Since competitive price equals monopoly marginal Since competitive price equals monopoly marginal revenue, monopoly and competitive quality choices revenue, monopoly and competitive quality choices are the same. Saving shows that for a durable with life are the same. Saving shows that for a durable with life qq, a special case with , a special case with WW ( (qq) = ) = q, q, this is my Swan this is my Swan (1970) result with durability independent of market (1970) result with durability independent of market structure.structure.

If If qq represents the reliability of a good such that represents the reliability of a good such that service service XX, is yielded with probability , is yielded with probability qq and nothing and nothing with probability (1 - with probability (1 - qq). If consumers are risk neutral ). If consumers are risk neutral then then pp = = qq HH ( (qq XX) so that ) so that VV ( (qq) = ) = q q andand W W ((qq)) = q = q and and once again the result is invariant to market structure.once again the result is invariant to market structure.

Let income depend on the time it takes him to acquire Let income depend on the time it takes him to acquire X units of and item, m (q) = m – q X. Monopoly and X units of and item, m (q) = m – q X. Monopoly and competitive choice of acquisition time, and hence competitive choice of acquisition time, and hence quality, are the samequality, are the same

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5. 5. Heterogeneous ConsumersHeterogeneous Consumers

Salop’s (1977) noisy monopolist exploits dispersion in Salop’s (1977) noisy monopolist exploits dispersion in prices, durabilities, etc. Despite being costly, it aids prices, durabilities, etc. Despite being costly, it aids price discriminationprice discrimination

Basu’s (1987) model is quite similar to Mussa and Basu’s (1987) model is quite similar to Mussa and Rosen except that it refers to frequency of replacement Rosen except that it refers to frequency of replacement of (say) a toothbrush when sold to diverse consumers. of (say) a toothbrush when sold to diverse consumers. By lowering durability in a costly fashion, price By lowering durability in a costly fashion, price discrimination is aided. Likewise, Waldman (1996a) and discrimination is aided. Likewise, Waldman (1996a) and Huang, Yang and Anderson (2001). Bond and Lizuka Huang, Yang and Anderson (2001). Bond and Lizuka (2004) find evidence that the textbook price increases (2004) find evidence that the textbook price increases over the life of the edition. Their model requires some over the life of the edition. Their model requires some consumers to value the old edition for this surprising consumers to value the old edition for this surprising result to occur. All these models are potentially subject result to occur. All these models are potentially subject to Acharyya’s (1998) criticism that profits are likely to to Acharyya’s (1998) criticism that profits are likely to be higher with pooling.be higher with pooling.

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6.6. Technological InnovationTechnological Innovation

There is even a bigger literature arguing that There is even a bigger literature arguing that monopolies either delay or fail to innovate with monopolies either delay or fail to innovate with respect to process and product innovations. In fact, respect to process and product innovations. In fact, it was so obvious that a monopolist that had it was so obvious that a monopolist that had incurred sunk costs perhaps not yet ‘amortised’ incurred sunk costs perhaps not yet ‘amortised’ would not want to destroy himself by innovation, would not want to destroy himself by innovation, whereas a competitor with nothing to lose would whereas a competitor with nothing to lose would

Against entrenched views at the time, Salter (1960) Against entrenched views at the time, Salter (1960) and Hirshleifer (1971) argued that for the and Hirshleifer (1971) argued that for the monopolist, marginal revenue replaces the monopolist, marginal revenue replaces the competitive price and earns just the competitive competitive price and earns just the competitive return. Hence would expect monopolist to innovate return. Hence would expect monopolist to innovate at same time.at same time.

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6.6. Technological InnovationTechnological Innovation

Swan (1971b, 1972a) -a monopolist will not suppress Swan (1971b, 1972a) -a monopolist will not suppress any related product or quality that meets separability any related product or quality that meets separability and homothesticity conditions. Scale or size does not and homothesticity conditions. Scale or size does not affect relative demands or costs, the monopolist is just a affect relative demands or costs, the monopolist is just a smaller scale version of the group of equivalent smaller scale version of the group of equivalent competitive industries producing identical related competitive industries producing identical related products and not producing (products and not producing (ii..ee., suppressing) same ., suppressing) same “would-be” products. Not concerned that a new partial “would-be” products. Not concerned that a new partial substitute will hurt existing monopoly as output already substitute will hurt existing monopoly as output already constrained and new output a fraction of what a constrained and new output a fraction of what a competitor would add competitor would add

We observe “sleeping patents” (Gilbert and Newbery, We observe “sleeping patents” (Gilbert and Newbery, 1982) but only because protect monopoly against 1982) but only because protect monopoly against competitive entry. Entry would not be viable if all competitive entry. Entry would not be viable if all related products produced under competitive conditionsrelated products produced under competitive conditions

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7.7. Other Applications of Market Other Applications of Market Irrelevance ModelIrrelevance Model

Shy and Stenbacka (2004) extend “irrelevance” Shy and Stenbacka (2004) extend “irrelevance” to risk of bank failures. Standard argument is to risk of bank failures. Standard argument is that competition leads to risk taking and bank that competition leads to risk taking and bank failurefailure

Courville and Hausman (1979) extend to product Courville and Hausman (1979) extend to product reliability and warranty termsreliability and warranty terms

Dynamic consistency of revenue from money Dynamic consistency of revenue from money creation investigated by Auernheimer (1974), creation investigated by Auernheimer (1974), Kydland and Prescott (1977) (Nobel Prize, 2004), Kydland and Prescott (1977) (Nobel Prize, 2004), Sargent (1977), Calvo (1978), Swan (1987)Sargent (1977), Calvo (1978), Swan (1987)

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8.8. Empirical Tests Empirical Tests

Swan, 1982, examinations choice of product life for Swan, 1982, examinations choice of product life for light bulbs by General Electric’s , GE, control over light bulbs by General Electric’s , GE, control over the U.S. lamp industry from 1913 to 1945 and finds the U.S. lamp industry from 1913 to 1945 and finds that indeed life is optimal. In recent years a cartel that indeed life is optimal. In recent years a cartel has replaced GE as the controlling influence and life has replaced GE as the controlling influence and life is now too short for most bulbs because falling cost is now too short for most bulbs because falling cost of power means a longer-life filament that is less of power means a longer-life filament that is less energy efficient is called for. Better still, use a new-energy efficient is called for. Better still, use a new-design florescent bulb with a much higher capital design florescent bulb with a much higher capital cost but long-life and great energy efficiency. cost but long-life and great energy efficiency. Numerous conspiracies are alleged (see Avinger, Numerous conspiracies are alleged (see Avinger, 1981) but few are real, ie, there are quite justifiable 1981) but few are real, ie, there are quite justifiable reasons, eg. reducing life of flash lamp bulb to make reasons, eg. reducing life of flash lamp bulb to make battery life longer and flashlight overall cost lower.battery life longer and flashlight overall cost lower.

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9.9. ConclusionsConclusions

1. Dynamic inconsistency -relax perfect foresight -no 1. Dynamic inconsistency -relax perfect foresight -no empirical or other evidence durability reduced to aid empirical or other evidence durability reduced to aid dynamic consistencydynamic consistency

2. Secondhand markets- ALCOA, journals, no harmful 2. Secondhand markets- ALCOA, journals, no harmful effects effects

3. Imperfect markets- no effect on durability3. Imperfect markets- no effect on durability 4. Choice of product quality-no effect4. Choice of product quality-no effect 5. Heterogeneity-may aid price discrimination 5. Heterogeneity-may aid price discrimination 6. Technological innovation-no evidence6. Technological innovation-no evidence 7. Other applications- risk and banking, money supply7. Other applications- risk and banking, money supply 8. Empirical -GE light bulb monopoly -bulbs of correct 8. Empirical -GE light bulb monopoly -bulbs of correct

lifelife 9. Market structure irrelevance principle valid-much 9. Market structure irrelevance principle valid-much

wider applicability than critics imaginedwider applicability than critics imagined