Introductory Microeconomics Assessment Two

ECON 10004 ASSIGNMENT TWO

MITCHELL

SU

STUDENT No. 660192 | INTRODUCTORY MICROECONOMICS | SEMESTER 2/2013

PART A QUESTION A An appropriate industry structure concerning the market for airport parking in the city of Melbourne is one of a government created monopoly. Based on the parking schemes for many airports, it is assumed that management rights are leased off by a government entity on a contractual basis and that there is only one contract awarded. The firm has complete control over the supply of parking spaces in the airport and hence can dictate the pricing as shown below.

COSTS AND REVENUE

MC P

B ATC

A DEMAND MR Q1

QMAX

Q2 QUANTITY OF PARKING SPACES

Figure 1 - Conditions of a Monopolistic Firm.

At point A, the intersection between the marginal cost (MC) and marginal revenue (MR) represents the equilibrium and the profit maximizing quantity (QMax). Point B represents the optimal price set for consumers and is reliant on the profit maximizing quantity determined by point A. So as long as point B remains above the average total cost (ATC), the firm remains economically viable.

In the long run, the firm may face decreased revenue from falling demand due to viable substitutes becoming available to the consumer for commuting to the airport. This will push the equilibrium downwards to a point that may potentially be below the ATC. This would make running the firm economically unviable and as such, leaving the industry would become a suitable option. However in saying that, in the long run the firm has the opportunity to adjust supply of parking spaces to offset the lower equilibrium with a lower ATC to counter the effects of competition.

QUESTION B I In the event of an increase in maintenance cost of supplying parking in terms of safety and security and an increase in demand for parking as more people are traveling in recent times, supply is expected to remain constant in the short run as the firm would only be able to act on issues of supply in the long run. As a result, the firm would be unable to act on decreased revenue without raising the per unit price in the short run. However, the rise in costs could be addressed in the long run by increasing the number of parking spaces available, taking advantage of economies of scale.

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AVERAGE COST PER UNIT ($)

LONG RUN AVERAGE COST

P1 P2

Q1

Q2 QUANTITY OF PARKING SPACES

Figure 2 - Result of increasing spaces available in the long run.

As shown in Figure 2, by increasing quantity in the long run, economics of scale would dictate the average cost per unit would decrease to a point where profit could potentially increase to a point comparable to pre cost rising levels. This assumes though that the firm would be willing to absorb decreased revenue or revenue losses in the short run.

QUESTION B II In terms of consumer demand for parking spaces at the airport, it is assumed that it is relatively inelastic and the effect of raising prices to counter falling revenue to increased operating costs would have a minimal effect on demand as in the short run there are not many substitutes available to consumers.

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PRICE PER UNIT ($)

P2 P1

DEMAND Q2Q1 QUANTITY OF PARKING SPACES Figure 3 - Effect of per unit price increase on parking spaces.

As shown in Figure 3, even if a dramatic increase in prices was set by the firm, the losses produced by reduced demand is far outweighed by the overall increase in revenue.

Given an increased demand in people traveling through the airport, a positive externality to Figure 3 would be an increased demand in the need for parking spaces. Hence the demand curve would shift to the right resulting in an even further increase in overall revenue produced from the car park, canceling out all potential demand losses produced from increasing per unit price.

QUESTION B III In the short run and combined with a ‘do nothing’ situation, equilibrium will be expected to remain the same but at the cost of decreased total profit and potentially an overall loss due to a rise in the ATC as shown in Figure 4.

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COSTS AND REVENUE

MC P

ATC2 ATC1

PROFIT LOST PROFIT DEMAND MR QMAX QUANTITY OF PARKING SPACES

Figure 4 - Lost profit in the short run.

As shown in Figure 5, if a dramatic increase in prices was set by the firm, the losses produced by reduced demand is far outweighed by the overall increase in revenue due to an inherent demand inelasticity for parking spaces in the airport. Equilibrium would shift downwards and the profit provided by area B would be lost, but C and D would be gained. Both C and D together are far greater in profit generation when compared to B.

COSTS AND REVENUE

DEMAND

MC ATC2

P2 P1

D

ATC1

A

B

C MR2 Q2

MR1

Q1 QUANTITY OF PARKING SPACES

Figure 5 - Profit gains made by increasing unit price.

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As stated earlier in the long run, it would be possible to increase the overall supply of parking spaces available to consumers. Should prices remain the same and demand consistently increasing as is the case in the premise, the effect of increased profit shown in Figure 5 would be amplified and equilibrium between the MR and MC would shift even lower. However, it is expected that equilibrium would not fall below the ATC curve due to the economies of scale reducing per unit costs.

PRICE PER UNIT ($)

QUESTION C In order for the firm to maximize profit without creating a detriment to social welfare, the firm would need to exploit a consumer’s willingness to pay through price discrimination. In an perfect price discrimination situation like in Figure 6, by exploiting all price ranges of the consumer, the baseline of area A which is bounded by P (Monopoly price) and marginal revenue curve would gain both B (Deadweight loss) and C (Consumer surplus) as the quantity sold would be only limited by the marginal cost and demand curves.

P

C

A B MC D

MR Q2

Q1 QUANTITY SOLD Figure 6 - Benefits of price discrimination in a monopoly.

However, trying to address every possible price point in terms of a consumer’s willingness to pay would not be viable in the context of airport parking. Instead it would be more efficient to create different subgroups of price discrimination to appeal to different consumers.

To take advantage of the consumer surplus present in area C, variable pricing in terms of seasonality and time could be used. Pricing could be increased during peak periods in a year such as school holidays or major events occurring in the local area. On a weekly scale, prices could be further differentiated between weekends and weekdays with weekends being more expensive to take advantage of a consumer’s higher willingness to pay as a result of more people traveling in this period. Another form of price discrimination that would be feasible in the context of an airport car park is the use of bulk purchase discounts. This form of second degree price discrimination would provide an incentive to those willing to use the car park longer by providing a reduction in per day

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usage prices the longer a car is parked there. By offering these lower prices for long term usage of a car park, the deadweight present in area B can be minimized.

PART B Antibiotic resistance is an increasingly common concern with the wider acceptance of antibiotics as the first call of treatment (CDC 2013). As more varying kinds of antibiotics are used as treatment, pathogens are exposed to a wider range of antibiotics and can over time develop a resistance to them via selective breeding. The rate of this is increasing fast enough that the prerogative of simply resorting to another kind of antibiotics is reaching a point of diminishing returns. Eventually over time, only a small range of antibiotics or none at all would prove to be effective.

At the current state of consumption, the free market level quantity of antibiotics being sold is much higher than what would be considered ideal. As social marginal cost (SMC) increases, the rate at which the private marginal benefit (PMB) decreases far slower than what would be the case of the social marginal benefit (SMB). The disparity between the two shown in Figure 7 represents welfare loss and can be seen as the number of pathogens developing resistance to antibiotic strains.

COST AND BENEFIT

SMC

P1 PMB SOCIAL WELFARE LOSS

P2

SMB Q2

Q1

QUANTITY CONSUMED Figure 7 - Social marginal benefit verses private marginal benefit.

The social welfare loss that is occurring as a result of the imbalance present between the PMB and SMB is increases as the SMC rises and without any intervention the rate at which pathogens develop antibiotic resistance would continue to do so at an exponential rate.

An intervention mechanism that could be put in place to limit the consumption of antibiotic to more essential purposes would be to apply an across the board pigouvian tax to the per unit cost of antibiotics.

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PRICE ($)

SMC

PMC WITH TAX

A P2 P1

E

B C

F

PMC

D H

G

D Q2

Q1

QUANTITY CONSUMED Figure 8 - Effects of a pigouvian tax on the cost of antibiotics..

TABLE 1 - EFFECTS OF PIGOUVIAN TAX ON ANTIBIOTICS. BEFORE TAX

AFTER TAX

CHANGE

PRODUCER SURPLUS

+F+G+H

+B+C+F+G

+C-H

CONSUMER SURPLUS

+A+B+C+D

A

-B-C-D

EXTERNALITY

+C+D+E+G+H

-

-C-D-E-G-H

A+B+F-E

A+B+F+C+G

+C+E+G

TOTAL WELFARE

Based on Table 1 and Figure 8, the tax would shift the PMC curve upwards, effectively removing all externalities present, creating an overall benefit in total welfare increase and more crucially a reduction in antibiotics consumption. It is anticipated that this lower consumption would slow the rate at which pathogens are developing a resistance to antibiotic strains.

Although a pigouvian tax would be effective in reducing antibiotics consumption and consequently minimizing the development of antibiotic resistant pathogens, it is not considered the most ideal solution on a social level. Firstly, a tax of this nature has the potential to reduce equity in access to medicines for low income earners, essentially leaving them available to only those who can afford such a high cost. Secondly, in some countries such as Australia, such a tax contradicts medical legislation including the Pharmaceutical Benefits Scheme which provides prescription drugs - which includes a range of antibiotics - free of charge to individuals (Australian Review 2001). In conclusion, a pigouvian tax would only put a strain on society and the individual when put into practice, leaving it to be only sound in theory.

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REFERENCES Australian Review, 2001. "The Pharmaceutical Benefits Scheme: History, current status and postelection prognosis". Accessed October 7 2013. http://www.australianreview.net/digest/ 2001/11/harvey.html CDC (Center for Disease Control), 2013. "Antibiotic Resistance Questions & Answers". Accessed October 7 2013. http://www.cdc.gov/getsmart/antibiotic-use/antibiotic-resistance-faqs.html#e

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