Question

1. Suppose the company White Cabs is the sole authorised operator of taxicabs in Fairville, a city of about two million people.

a) With the aid of a revenue-cost diagram, explain and illustrate the company's decisions with regard to output (how much service it provides) and price. What kind of market structure are you assuming here? Would you expect White Cabs to make super-normal (or above-normal, or economic) profit? Briefly explain the latter concept.

NOTE: Please explain the answer in detail. And the diagram should be very neat. Thank you!

Answer 1

Assuming that White Cabs charges the same price across all segment of the customers and across the city, we can safely assume that the total revenue of White Cabs is directly proportional to the demand. In economics terms, the demand curve is horizontal (the other one is called downward sloping curve, where revenue increases till a maximum and then starts to decrease as the quantity demanded decreases). Also, as stated, white cabs is the sole authorized operator in fairville. This makes the market a monopoly. Hence, horizontal demand curve and monopoly constitute our market structure.

Below is the graph.

Lets assume that on an average, White Cabs earns $10 per ride. Since the population is 2million, I have capped the number of rides (Q, horizontal axis in the graph) there, for the purpose of the graph. Revenue (demand*$10) is on the vertical axis.

There are 2 curves in the graph- total revenue and total cost. Lets talk about the total revenue. As discussed above, the revenue is directly proportional to demand and fixed. Hence, for total revenue, we get a straight line- we earn higher revenue the higher the demand.

The total cost curve is slightly more complicated. First thing to notice is that it doesnt start at zero. Thats because of fixed costs. There must be some costs associated with buying the cars, legal and approval costs etc. These are one time costs which must be incurred before the business can start. I have assumed them to be around ~2million. Hence the Total cost curve starts at that point.

Next, you will notice that initially the total cost curve if flatter initially and starts becoming sharper and sharper as demand increases. Thats because initially labor (drivers) are easily available and at good prices. As demand increases, supply constraints increase and more and more must be paid to hire more drivers. Hence, the costs increase as demand increases.

The main question is- how much service will the company provide? It will the amount of service where it maximizes its profit, and profit is simply total revenue-total cost. Wherever these two curves are most apart in the graph, thats how much service White cabs will provide. I have marked the same in the graph as Q_m.

We would expect White Cabs to make super-normal profit. That is because its a monopoly. Super-normal profit is when a firm earns more profit than what it wouldve got in market equilibrium. If there were more operators in Fairville, they wouldve driven prices down- towards where Marginal Cost equals Marginal Revenue. This is not the case in Fairville because of the monopoly and hence it earns Super-normal profits.