The Difference between the Short Run and Long Run Economists and Price Discrimination - Assignment Example

A) Economists are careful to distinguish between the short run and the long run. Carefully explain the difference between the two. Why is it important to make the distinction Make sure you explain the difference between the short run shut down decision and long run shut down decision, and the difference between a short run competitive equilibrium and a long run competitive equilibrium. (B) Describe an industry in which changes in demand and/or costs led to changes that differed significantly in the short run and the long run. (Describe these differences) What accounts for these differences 1.We can view business firms from various points of view: productivity, inputs and outputs or productivity and costs. By studying the latter ie. productivity and cost factors, we can gain a better understanding of supply. For a firm, supply can be described as the quantity to be sold at a determined price. In the short run, we have two major types of cost: fixed and variable. Long-term assets like machinery, infrastructure etc would be termed as fixed costs whereas cost of labour, raw material, transportation costs etc. would be a variable one in the short term. Short term shut down of a business concentrates on cutting the opportunity costs or variable costs. As long as the firm produces something, it will maximize its profits by producing "on the marginal cost curve. "The firm will have to shut down if it cannot cover its variable costs. As fixed costs are anyway going to be incurred, they are not opportunity costs in the short run -- so they are not relevant to the decision to shut down. Even if the company shuts down, it must pay the fixed costs. But the variable costs are avoidable -- they are opportunity costs! So the firm will shut down if it cannot meet the variable (short run opportunity) costs. But as long as it can pay the variable costs and still have something to apply toward the fixed costs, it is better off continuing to produce. When the firm's average total cost curve lies above its marginal revenue curve at the profit maximizing level of output, the firm is experiencing losses and will have to consider whether to shut down its operations. The decisions taken by a firm in such situations is termed as Short-run shut down decisions. Short run equilibrium of a firm can be derived based on the total revenue and total cost and marginal revenue and marginal cost. As firms are price-takers, each firm in an industry tries to maximize its profit by adjusting the output to a level where Marginal Cost (MC) =Marginal Revenue (MR). Profit is the difference between the total revenue obtained from sales and the total cost incurred by the firm. The long run is defined as "a period long enough to make the cost of all inputs variable." This includes, in particular, capital, plant, equipment, and other investments that represent long-term commitments. In the long-run the decisions taken would be only exit decisions. Exit decisions are decisions taken by a firm to leave the market. They are not called as Shut-down decisions. Shut-down is only in the short-run. Long run equilibrium plays a crucial role in deciding the existence of the firm. In the long run there are enough time periods for the firm to cover its losses and earn normal profits. This is because in the long run, all inputs are variable and the firm can have the most profitable level of output i.e. the profit maximization level of output. If firms are perfectly competitive, industry is making short term surplus (profits), more firms will enter the industry. In the long run this will increase the market supply of the product and reduces the market price as well as the profits until all firms in the industry make a normal profit (break even )In the long run equilibrium, the business will be operating at the minimum point on both long - run and short - run average cost curves obtaining full economy of scale. A Walrasian or competitive equilibrium consists of a vector of prices and an allocation such that given the prices, each trader by maximizing his objective function (profit, preferences) subject to his technological possibilities and resource constraints plans to trade into his part of the proposed allocation, and such that the prices make all net trades compatible with one another ('clear the market') by equating aggregate supply and demand for the commodities which are traded. In the short run, there will not be a major possibility of change in technological factors or resource allocations, whereas in the long run, there is a possibility of changes affecting these factors and in turn affecting the competitive equilibrium. (B) In recent years, business travel market has seen a tremendous change with respect to the airline industry. Changes in demand for leisure travel include more short-term breaks and more independent holidays where passengers book flights, car and accommodation by themselves. The reason for the decline in business class travel is the supply led high business fares which stretched the so called "inelastic business class segment" and also the expansion of low cost airlines. Whereas a few years ago, air-travel was seen as a luxury in some countries, today, it has become as common as train or bus travel, thanks to low cost air-carriers. If only the head of the family was using air-travel for official work a few years ago, today, the same budget can accommodate a family of four in a low cost airline. This is affecting the short run competitive equilibrium of the airline industry, whereby the older airline companies and government run companies are not enjoying perfect market conditions because of the stiff competition from low cost or "no frills" airlines. The volume of business for these low-cost airlines may be humungous, but their profit margins are very low or might not even exist. However, in the long run, the low cost airlines, which are already running into huge losses might not even be able to break even and might be forced to shut shop. In such a scenario, the government run airlines would be back in business and market equilibrium would be restored in the long run. 2. When firms have some market power, price discrimination can be a way of increasing profits. Describe the different types of price discrimination. For the case of indirect (i.e., second degree) price discrimination, explain in detail how a firm determines the prices it charges when it faces two (or more) different types of consumers. Make sure you explain why a firm that cannot engage in direct price discrimination must price differently than a firm that can. (B) Describe a price discrimination strategy used by a particular firm. Explain which type of price discrimination this was. What did the firm need to know to design this strategy To what extent was this instance of price discrimination successful and to what extent was it unsuccessful Price Discrimination can be defined as the method of charging different prices for essentially the same good to different buyers. There are three types of Price discriminations. They are, first, second and third degree discrimination. First-degree discrimination - This is the most extreme form of discrimination in which each consumer is charged the maximum price he would be willing to pay for each individual unit consumed. This kind of discrimination can be noticed in the healthcare industry where doctors charge different fees from different patients. Second-degree price discrimination - This is a more practical form of price discrimination. Here firms charge a different price for each set of units sold. Different prices are charged for different blocks or portions of consumption. This kind of price discrimination is followed in the power and telecom industry. The reason behind this is the prices are based on the quantities of output purchased by individual consumers. By doing so, the firms can profit as the quantities used or consumed vary from individual to individual and hence if there is a high consumption by a particular consumer, there is a chance for the firm to earn more profits. Third-degree price discrimination - This is the most common form of price discrimination. Consumers or markets are segmented on the basis of their price elasticity of demand. Often, third-degree price discrimination occurs in the markets that are geographically separated. For example, books published by American publishers are sold in other countries at a lower price than in the U.S. Evidently, buyers in the other countries have greater elasticity' of demand that US buyers. At the same time, the high shipping costs makes it unprofitable for firms to buy in foreign countries and resell in the United States. (B) Whenever we travel, whether by train or flight, it is noticed that adults are charged a different price for the ticket and children are charged a different price. Other similar price discrimination in the same context is that rails some have rail cards entitling them to discounts; others do not. It is cheaper for people who book in advance. This kind of discrimination comes under first-degree price discrimination Second example In a monopolistic market, the price of a product is likely to be higher than in a competitive market while the quantity sold would be less, generating greater profits for the seller. These profits can be increased further if there is price discrimination, in the form of charging higher prices to those segments willing and able to pay more and charging less to those whose demand is price elastic. The price discriminator might need to create rate fences that will prevent members of a higher price segment from purchasing at the prices available to members of a lower price segment. This behaviour is rational on the part of the monopolist, but is often seen by competition authorities as an abuse of a monopoly position, whether or not the monopoly itself is sanctioned. Examples of this exist in the transport industry (a plane or train journey to a particular destination at a particular time is a practical monopoly) where Business Class customers who can afford to pay may be charged prices many times higher than Economy Class customers for essentially the same service. 3.(A)"Perfect competition is efficient, while a situation with a monopoly is not." Explain precisely what is meant by the term "efficient". Why is perfect competition efficient, while a monopolist is inefficient (B) Although Adam Smith extolled the virtues of individual self-interest, there are instances where simply letting each people act in his or her own self-interest, without any interference, does not leave to a desirable outcome for society. Describe a real-world example of this, where the government has interfered to try and obtain a better outcome. Make sure you explain why, before the government interference, individual selfinterest was leading to an undesirable outcome, and to what extent the government intervention has been successful in improving the situation and to what extent it has not been. 3. "Perfect competition is an idealized market structure that achieves an efficient allocation of resources. This efficiency is achieved because the profit-maximizing quantity of output produced by a perfectly competitive firm results in the equality between price and marginal cost. In the short run, this involves the equality between price and short-run marginal cost. In the long run, this is seen with the equality between price and long-run marginal cost at the minimum efficient scale of production." Perfect competition is a kind of market structure where all goods are homogeneous and all firms participate in price determination. The conditions for perfect competition, include: (1) presence of a large number of small firms, (2) identical products sold by all firms, (3) freedom of entry and exit in the industry, and (4) perfect knowledge of prices and technology, These conditions would ideally ensure that perfect competition efficiently allocates resources. The primary role of perfect competition is a market structure that illustrates perfection, or the best resource allocation. However, in a monopolistic market, the price of the product is determined by only one firm or industry. It is felt by economists that monopoly does not efficiently allocate resources. The reason for this inefficiency is found with market control and negatively-sloped demand curve. The negative slope means that the price charged by the monopolistically competitive firm is greater than marginal revenue. As a profit-maximizing firm that equates marginal revenue with marginal cost, the price charged by monopolistic competition is also greater than marginal cost. The inequality between price and marginal cost is what makes monopolistic competition inefficient. The price charged by a monopolistically competitive firm is higher than the marginal cost of production, which violates the efficiency condition that price equals marginal cost. A monopolistically competitive firm is not efficient because it has market control and faces a negatively-sloped demand curve. Because price exceeds marginal cost, the economy gives up less satisfaction from other goods not produced than it receives from the good that is produced. The economy can gain satisfaction by producing more of the good. The demand curve for a market based on perfect competition is a horizontal straight line, while in monopoly the same slopes downwards from left to right. Perfect competition is believed to be efficient when compared to monopoly because there are constant returns to scale. Also, in the case of perfect competition, increase in output is equal to increase in input. (B) To protect the consumers from monopolistic forces in the market, government authorities sometimes control or set prices in the market. They impose a price ceiling on certain products and services, which is the maximum price that can be legally charged for that product or service. A price ceiling is effective if it is set below the price that would otherwise emerge as the market equilibrium price. For example, in India, the prices of petrol are set by the government. The prices of petrol are not supposed to go beyond the price that is set by the government. This kind of price regulation can prevent the petroleum markets from reaching equilibrium in case the rates are set below the market equilibrium rates. Second example In a few developing countries, when the mobile telephony industry was in a nascent stage, private telecom operators were charging exorbitant rentals and rates for both incoming and outgoing calls. With only one or two service providers operating in the industry, it was a monopolistic market, where the consumer was fleeced for the use of goods and services. However, with government authorities waking up to the situation and forming telecom regulatory authorities, this situation changed. Also, as demand for mobile services increased, the number of private operators too increased and the market slowly moved towards perfect competition. Today, the very same service providers who had fleeced the customers are sweating it out to find ways of making, not maximizing profits. There have been cross country mergers, other than offers and discounts to customers, just to make sure the service provider survives in the competitive market. Profits have become marginal, and companies are looking at rural markets to increase their customer base and improve their balance sheets. References 1. Economics for Managers published by ICFAI Center for Management Research. 2. http://www.airport-int.com/categories/airport-marketing/changes-in-demand-for-air-travel.asp 3. http://findarticles.com/p/articles/mi_qa3889/is_200210/ai_n9137062 4. http://www.sfb504.uni-mannheim.de/glossary/walraseq.htm http://www.amosweb.com/cgi-bin/awb_nav.pls=wpd&c=dsp&k=perfect+competition,+efficiency Read More