Question

This question asks you to consider the market for cab rides in Metropolis. The city is currently served by several cab companies, each who own multiple cabs and hire drivers to operate them. The number of cab companies is sufficiently high to consider the market perfectly competitive.

a) The industry is currently in long-run equilibrium. Using two diagrams, one to represent the market for cab rides, and a second to represent the costs of a typical cab company, illustrate the current price, quantity and profits of a typical cab company. Explain why you have drawn the curves as you did.
b) To reduce traffic in Metropolis, city managers have reduced the number of parking spaces in the city. This has reduced the number of people who bring their own cars into the city, and increased demand for cab rides. Show how this affects the market equilibrium, price, and profits immediately after the policy takes affect. Using one diagram for the cab ride market and a second for a typical cab company, illustrate below.
c) Will the scenario you have described in part (b) be a stable long-run equilibrium? Why or why not? Once again using separate diagrams for both the industry and a typical cab company, illustrate the long run equilibrium for cab rides in Metropolis.
d) To avoid the possibility you discuss in (c), cab companies lobby for licensing rules that prohibit new entry. They argue that, to avoid new congestion problems, only drivers approved by the city should be allowed to operate cabs. Moreover, they argue that the number of approved drivers should equal to the number of drivers operating before the number of parking spaces was reduced. How would that change your answer to part (c)? Why?

Answer 1

In the long-run equilibrium, a typical cab company in a perfectly competitive market will earn zero economic profits. If the number of parking spaces in the city is reduced, the demand for cab rides increases, resulting in higher prices and profits in the short run. However, in the long run, new entry and competition will drive down prices and profits back to zero. If cab companies lobby for licensing rules to restrict new entry, the long-run equilibrium may be disrupted, allowing existing companies to earn positive profits.

Step-by-step explanation:

The cab ride market in Metropolis is perfectly competitive, which means that there are multiple cab companies in the market and no single company has enough market power to influence the price. In the long-run equilibrium, a typical cab company will be earning zero economic profits. This is illustrated in the market diagram with the demand and supply curves intersecting at the equilibrium price and quantity. In the typical cab company diagram, the average total cost curve (ATC) will intersect with the marginal cost (MC) curve at the minimum point of the ATC curve.

When the city reduces the number of parking spaces, the demand for cab rides increases, resulting in an increase in the equilibrium price and quantity in the market diagram. The typical cab company will now be earning positive economic profits, as the price is above the ATC curve. In the cab company diagram, the price will be higher than the intersection of the ATC and MC curves, indicating positive profits.

In the long run, the scenario described in part (b) may not be a stable equilibrium. As new cab companies enter the market to take advantage of the positive profits, the supply of cab rides will increase, causing the price to decrease. This will eventually drive the profits back to zero. This is illustrated in the market diagram with the shift in the supply curve and the decrease in price. In the cab company diagram, the price will fall to the intersection of the ATC and MC curves, resulting in zero profits.

If cab companies are able to lobby for licensing rules that restrict new entry, the scenario described in part (c) would change. With restricted entry, the market would not reach the long-run equilibrium, as new firms are prevented from entering to drive down prices. The existing cab companies would continue to earn positive profits, as the price would remain above the intersection of the ATC and MC curves in the cab company diagram.