Question

Suppose there is an increase in the monthly fire insurance premium that department stores have to pay. Assume that department stores are a competitive industry.

A. In the short-run, will the prices of goods sold at department stores increase or remain unchanged? (Explain your answer using cost curves for the individual firm, and supply and demand curves for the industry.)

B. In the long-run, how will the prices of goods sold at department stores change? (Explain your answer using cost curves for the individual firm, and supply and demand curves for the industry.)

Answer 1

Since the isurance premium is a fixed cost even if it is paid monthly or annually. It does not increase or decrese with the increase in the volume of sales. For example if the firm is paying Rs. 10000/- per month for fire insuarance it remains fixed throughout the year. The premium does not increse or decrease with the increase or decrese of the firm's sales. During shortrun fixed cost remain constant irrespective of increse or decrese of the production/sales of the firm. The premium is not fixed according to the volume of sales. It is covering whole products kept in the store for sales. Whether it is 1000 units or 10000 units the premium paid will remain constant.

In shortrun the firm will have no tendancy to change price of the product. It will adher to the prevailing price. So the increase in fire insuarance premium may not affect the price decision of the firm. The firm sells the product at a price which is determined by the forces of market supply and demand. Under competitive industry the firm will not have a tendacy to alter their prices. If an individual firm increse its price the conusmers will buy the product from another firm where the product is available at a lower price. Thus the firm's demad curve shifts to downward pushing the price back to the former level. Therefore all competitive firms in the industry will accept the ruling price which is determined by the intersection of demand and supply curves of the industry. Thus during shortun one price prevails in the market. Firms have no tendancy to alter their prices. The determination of price in the industry in shortrun is illustrated in the following figure.

In the above figure the price of the induvidual firm increases from P to P1. Consequently the quantity demanded decreased and AR shift form AR to AR!.. Thus the reduction in demand pull down the prince from P to P1. Therefore during shortrun the a single firm will have no tendancy to change its price.

The situation in a firm after increse in price of the product due to increase in fire insurance premium is illustrated in the following figure:

In shortrun the firm may earn abnormal, normal profit or suffer loss depending on the cost conditions. If the increse in insurance premium shift the SATC above the AR the firm suffer loss or if the SATC is below the AR curve the firm suffer loss. If they are egual only normal profit

In longrun the firm can change the price according to the cost variation. Here the firm fix a price which is equal to the longrun marginal cost. The longrun equlibrium of a form under perfect competitionis AR=MR since all the factors can be changed in longrun. The longrun equllibrium of the firm and industry is illustrated in the following figure.

In the longrun market situations market price changes in proportion to the changes in market suppy and demand. The firm adjust their outpu according to the variation in market demand and supply.

The market supply consist of supply made by all the firms together at the ruling price. The firm adjust their outpput according to the changes in market supply and demand. The firm is flexible so as to meet the changing requirments of the industry. They can contract or expand their volume of output in accordance witht the change in demand condition.

In short the increase in insurance premium will not influence the price of the firm in shortrun.