Ch12: Firms in Perfectly Competitive Markets – HubbardOBrienEconomics.com Blog

Solved Problem: Do Firms Always Raise Their Prices When Their Costs Go Up?

Supports: Microeconomics and Economics, Chapter 12, and Essentials of Economics, Chapter 9.

The entrance to the Lincoln Tunnel, which connects New Jersey to Midtown Manhattan. (Photo from the Associated Press via the New York Times.)

This spring, New York City will begin charging an additional fee—referred to as a congestion price or congestion toll—on vehicles entering the borough of Manhattan below 60^th Street. The purpose of the fee is to reduce the congestion and pollution that additional vehicles cause when driving in that part of the city. (Note that the fee can be thought of as Pigovian tax because it is intended to address a negative externality caused by driving a vehicle. We discuss Pigovian taxes in Microeconomics and Economics, Chapter 5, Section 5.3, and in Essentials of Economics, Chapter 4, Section 4.5.)

Trans-Bridge Lines operates buses between the Lehigh Valley in Pennsylvania and Manhattan. The firm will have to pay a fee of $24 each time one of its buses enters Manhattan. An article in the (Allentown, PA) Morning Call quotes the president of Trans-Bridge Lines as objecting to the fee: “It doesn’t make sense and punishes bus operators who are part of the solution to the congestion problem.” However, the article also notes that “Trans-Bridge is not considering fare increases at this time.”

If Trans-Bridge’s cost of providing bus service between the Lehigh Valley and Manhattan increases by $24 per bus, shouldn’t the firm raise the price it charges passengers? Does the failure of Trans-Bride to raise ticket prices following the enactment of the fee mean that the firm isn’t its maximizing profit? Briefly explain.

Solving the Problem

Step 1: Review the chapter material.This problem is about what costs firms take into account when determining the profit-maximizing price to charge in the short run, so you may want to review Microeconomics or Economics, Chapter 12, Section 12.2, “How a Firm Maximizes Profit in a Perfectly Competitive Market” (Essentials of Economics, Chapter 9, Section 9.2)

Step 2: Answer the two questions by explaining what type of cost the $24 fee is and whether the fee should affect the profit-maximizine price Trans-Bridge Lines should charge passengers for a ticket on a bus going to Manhattan. The fee is a flat $24 per bus and, so, it doesn’t change with the number of passengers on a bus. Therefore, the fee is a fixed cost to Trans-Bridge. Trans-Bridge should set the price of a ticket so that the last ticket sold on a bus increases the firm’s marginal cost and marginal revenue by the same amount. Because the $24 fee doesn’t change the marginal cost (or the marginal revenue) to the firm of transporting another passenger, the fee doesn’t change the firm’s profit-maximizing price. The answer to the first question in the problem is that an increase (or decrease) in a firm’s fixed cost won’t cause the firm to change its profit-maximizing price in the short run. The answer to the second question follows from the answer to the first question: That Trans-Bridge isn’t raising the price of a ticket following the enactment of the doesn’t mean that the firm isn’t maximizing profit.

Extra credit: Note that in the answer we refer to Trans-Bridge’s decision in the short run. It’s possible that the $24 fee will cause Trans-Bridge to suffer an economic loss on at least some of the bus trips it offers during different times during the day. As we discuss in Microeconomics and Economics, Chapter 12, Section 12.4 (Essentials of Economics, Chapter 9, Section 9.4), in that case, Trans-Bridge will continue to offer those bus trips in the short run, but, if nothing else changes, it will stop offering the trips in the long run.

The Economics of Sneaker Reselling

Buying athletic shoes and reselling them for a higher price has become a popular way for some people to make money. The mostly young entrepreneurs involved in this business are often called sneakerheads. Note that economists call buying a product at a low price and reselling it at a high price arbitrage. The profits received from engaging in arbitrage are called arbitrage profits. One estimate puts the total value of sneakers being resold at $2 billion per year.

Why would anybody buy sneakers from a sneakerhead that they could buy at a lower price online or from a retail store? Most people wouldn’t, which is why most sneakerheads resell only shoes that shoe manufacturers like Nike or Adidas produce in limited quantities—typically fewer than 50,000 pairs. To obtain the shoes, shoe resellers use two main strategies: (1) waiting in line at retail stores on the day that a new limited quantity shoe will be introduced, or (2) buying shoes online using a software application called a bot. A bot speeds up a buyer’s checkout process for an online sale. Typical customers buying at an online shoe site take a few minutes to choose a size, fill in their addresses, and provide their credit card information. But a few minutes is enough time for shoe resellers using bots to buy all of the newly-released shoes available on the site.

In addition to reselling shoes on their own sites, many sneakerheads use dedicated resale sites like StockX and GOAT. These sites have greatly increased the liquidity of sneakers, or the ease with which sneakers can be resold. In effect, limited-edition sneakers have become an asset like stocks, bonds, or gold because they can be bought and sold in the secondary market that exists on the online resale sites. (We discuss the concepts of primary and secondary markets for assets in Macroeconomics, Chapter 6, Section 6.2 and in Microeconomics and Economics, Chapter 8, Section 8.2.)

An article in the New York Times gives an example of the problems that bots can cause for retail shoe stores. Bodega, a shoe store in Boston, offered the limited-edition New Balance 997S sneaker on its online site. Ten minutes later, the shoe was sold out. One of the store’s owner was quoted as saying: “We got destroyed by bots. It was making it impossible for our average customers to even have a shot at the shoes.” Although the store had a policy of allowing customers to buy a maximum of three pairs of shoes, shoe resellers were able to get around the policy by having shoes shipped to their friends’ addresses or by having a group of people coordinate their purchases. An article on bloomberg.com described how one reseller along with 15 of his friends used bots to buy 600 pairs of Adidas’s Yeezy sneakers from an online site on the morning the sneakers were released. Adidas has a rule that each customer can buy only one pair of its limited-edition shoes, but the company has trouble enforcing the rule.

Shopify and other firms have developed software that retailers can use to make it difficult for resellers to use bots on the retailers’ sites. But the developers of bot software have often been able to modify the bots to get around the defenses used by the anti-bot software.

In contrast with owners of retail stores, Nike, Adidas, New Balance, and the other shoe manufacturers have a more mixed reaction to sneakerheads using bots scooping up most pairs of limited-edition shoes shortly after the shoes are released. Like the owners of retail stores, the shoe manufacturers know that they risk upsetting the typical customer if the customer can only buy hot new shoe releases from resellers at prices well above the original retail price. But an active resale market increases the demand for shoes, just as individual investors increased their demand for individual stocks when it became possible to easily buy and sell stocks online using sites like TD Ameritrade, E*Trade, and Fidelity. So manufacturers benefit from knowing that most of their limited-edition shoes will sell out. One industry analyst singled out “The durability of Nike’s … ability to fuel the sneaker resale ecosystem ….” as a particular strength of the company. In addition, manufacturers may believe that the publicity about limited edition shoes rapidly selling out may spill over to increased demand for other shoes the manufacturers sell. (In Microeconomics and Economics, Chapter 10, Section 10.3 we note that some consumers may receive utility from buying goods that are widely seen as popular and fashionable.)

In the long run, is it possible for sneakerheads to make a profit reselling shoes? It seems unlikely for the reasons we discuss in Microeconomics and Economics, Chapter 12, Section 12.5. The barriers to entry in reselling sneakers are very low. Anyone can list shoes for sale on StockX or one of the other resale sites. Waiting in line in front of a retail store on the day a new shoe is released is something that anyone who is willing to accept the opportunity cost of the time lost can do. Similarly, bots that can be used to scoop up newly released shoes from online sites are widely available for sale. So, we would expect that in the long run entry into sneaker reselling will compete away any economic profit that sneakerheads were earning.

In fact, by the summer of 2022, prices on reselling sites were falling. In just the month of June, the average price of sneakers listed on StockX declined by 20 percent. Resellers who had stockpiled shoes waiting for prices to increase were instead selling them because they feared that prices would go even lower. And new limited-edition shoes were taking longer to sell out. According to an article in the Wall Street Journal, “A pair of Air Jordans released on July 13 [2022] that might have once vanished in minutes took days to sell out from Nike Inc.’s virtual shelves.” One reseller quoted in the Wall Street Journal article indicated that entry was the reason that prices were falling: “You don’t want prices to go down, but they’re going down anyways, just because of how many people are selling in general.”

Although a seemingly unusual market, sneaker reselling is subject to the same rules of competition that we see in other markets.

Sources: Inti Pacheco, “Flipping Air Jordans Is No Longer a Slam Dunk,” Wall Street Journal, July 23, 2022; Shoshy Ciment, “Sneaker Reselling Side Hustle: Your Guide to Making Thousands Flipping Hyped Pairs of Dunks, Jordans, and Yeezys,” businessinsider.com, May 3, 2022; Teresa Rivas, “A Strong Sneaker-Resale Market Is Another Boon for Nike,” barrons.com, May 24, 2022; Curtis Bunn, “Sneakers Are So Hot, Resellers Are Making a Living Off of Coveted Models,” nbcnews.com, October 23, 2021; Daisuke Wakabayashi, “The Fight for Sneakers,” New York Times, October 15, 2021; and Joshua Hunt, “Sneakerheads Have Turned Jordans and Yeezys Into a Bona Fide Asset Class,” bloomberg.com, February 15, 2021.

Are Economic Profits a Sign of Market Power?

Cecilia Rouse, chair of the Council of Economic Advisers. Photo from the *Washington Post*.

An article in the Washington Post discussed a debate among President Biden’s economic advisers. The debate was over “over whether the White House should blame corporate consolidation and monopoly power for price hikes.” Some members of the National Economic Council supported the view that the increase in inflation that began in the spring of 2021 was the result of a decline in competition in the U.S. economy.

Some Democratic members of Congress have also supported this view. For instance, Massachusetts Senator Elizabeth Warren argued on Twitter that: “One clear explanation for higher inflation? Giant corporations are exploiting their market power to further raise prices. And corporate executives are bragging about their higher profits.” Or, as Vermont Senator Bernie Sanders put it: “The problem is not inflation. The problem is corporate greed, collusion & profiteering.”

But according to the article, Cecilia Rouse, chair of the President’s Council of Economic Advisers (CEA), and other members of the CEA are skeptical that a lack of competition are the main reason for the increase in inflation, arguing that very expansionary monetary and fiscal policies, along with disruptions to supply chains, have been more important.

In an earlier blog post (found here), we noted that a large majority of more than 40 well-known academic economists surveyed by the Booth School of Business at the University of Chicago disagreed with the statement: “A significant factor behind today’s higher US inflation is dominant corporations in uncompetitive markets taking advantage of their market power to raise prices in order to increase their profit margins.”

One difficulty with the argument that the sharp increase in inflation since mid-2021 was due to corporate greed is that there is no particular reason to believe that corporations suddenly became more greedy than they had been when inflation was much lower. If inflation were mainly due to corporate greed, then greed must fluctuate over time, just as inflation does. Economic writer and blogger Noah Smith poked fun at this idea in the following graph.

It’s worth noting that “greed” is one way of characterizing the self-interested behavior that underlies the assumption that firms maximize profits and individual maximize utility. (We discuss profit maximization in Microeconomics, Chapter 12, Section 12.2, and utility maximization in Chapter 10, Section 10.1.) When economists discuss self-interested behavior, they are not making a normative statement that it’s good for people to be self-interested. Instead, they are making a positive statement that economic models that assume that businesses maximize profit and consumers maximize utility have been successful in analyzing and predicting the behavior of businesses and households.

Corporate profits increased from $1.95 trillion in the first quarter of 2021 to $2.40 trillion in third quarter of 2021 (the most recent quarter for which data are available). Using another measure of profit, during the same period, corporate profits increased from about 16 percent of value added by nonfinancial corporate businesses to about 18 percent. (Value added measures the market value a firm adds to a product. We discuss calculating value added in Macroeconomics, Chapter 8, Section 8.1.)

There have been mergers in some industries that may have contributed to an increase in profits—the Biden Administration has singled out mergers in the meatpacking industry as having led to higher beef and chicken prices. At this point, though, it’s not possible to gauge the extent to which mergers have been responsible for higher prices, even in the meatpacking industry.

An increase in profit is not by itself an indication that firms have increased their market power. We would expect that even in a perfectly competitive industry, an increase in demand will lead in the short run to an increase in the economic profit earned by firms in the industry. But in the long run we expect economic profit to be competed away either by existing firms expanding their production or by new firms entering the industry.

In Chapter 12, we use Figure 12.8 to illustrate the effects of entry in the market for cage-free eggs. Panel (a) shows the market for cage-free eggs, made up of all the egg sellers and egg buyers. Panel (b) shows the situation facing one farmer producing cage-free eggs. (Note the very different scales of the horizontal axes in the two panels.) At $3 per dozen eggs, the typical egg farmer is earning an economic profit, shown by the green rectangle in panel (b). That economic profit attracts new entrants to the market—perhaps, in this case, egg farmers who convert to using cage-free methods. The result of entry is a movement down the demand curve to a new equilibrium price of $2 per dozen. At that price, the typical egg farmer is no longer earning an economic profit.

A few last observations:

The recent increase in profits may also be short-lived if it reflects a temporary increase in demand for some durable goods, such as furniture and appliances, raising their prices and increasing the profits of firms that produce them. The increase in spending on goods, and reduced spending on services, appears to have resulted from: (1) Households having additional funds to spend as a result of the payments they received from fiscal policy actions in 2020 and early 2021, and (2) a reluctance of households to spend on some services, such as restaurant meals and movie theater tickets, due to the effects of the Covid-19 pandemic.
The increase in profits in some industries may also be due to a reduction in supply in those industries having forced up prices. For instance, a shortage of semiconductors has reduced the supply of automobiles, raising car prices and the profits of automobile manufacturers. Over time, supply in these industries should increase, bringing down both prices and profits.
If some changes in consumer demand persist over time, we would expect that the economic profits firms are earning in the affected industries will attract the entry of new firms—a process we illustrated above. In early 2022, this process is far from complete because it takes time for new firms to enter an industry.

Source: Jeff Stein, “White House economists push back against pressure to blame corporations for inflation,” Washington Post, February 17, 2022; Mike Dorning, “Biden Launches Plan to Fight Meatpacker Giants on Inflation,” bloomberg.com, January 3, 2022; and U.S. Bureau of Economic Analysis.ec

Are Plant-Based Eggs the Wave of the Future?

In Chapter 12 of the textbook, we discuss developments over the years in the intensely competitive egg market. Many of the 65,000 egg farmers in the United States have continued to produce eggs using traditional methods. But some egg farmers have adopted cage-free methods that allow chickens to have sufficient room to move around. Using cage-free methods increases a farmer’s costs but some consumers are willing to pay more for these eggs. More recently, some egg farmers have turned to selling “pastured eggs” laid by chickens that are allowed to roam freely outside. Raising pastured eggs has even higher costs than raising eggs using cage-free methods, but pastured eggs also sell for higher prices.

As consumer willingness to spend on eggs produced in ways that involve more humane treatment of chickens increases, we’d expect that egg farmers will adapt by embracing these methods. But in 2021, a development occurred in the egg market that was much more difficult for egg farmers to respond to. Some consumers have been moving away from animal products to plant-based replacements. These consumers have a variety of concerns about animal products: Some consumers have ethical concerns about consuming any animal products, others believes consuming these products may have negative health effects, while others are concerned by what they believe to be the negative effects of farming on the environment.

Many people are familiar with the Impossible company’s “impossible burger,” a hamburger made from soy and potatoes rather than from beef. But it’s less well known that several companies have begun selling eggs made from plants. San Francisco-based Eat Just, Inc. has begun selling in the United States eggs made from mung beans and in October 2021 was authorized to begin selling these eggs in Europe. The Swiss firm Nestlé under its Garden Gourmet brand has also begun selling in Europe eggs made from soy. Nestlé’s eggs are sold in liquid form and are primarily intended as a substitute for natural eggs in cooking.

As of late 2021, plant-based eggs have captured only a tiny slice of the egg market. But if their popularity should increase significantly, it will be bad news for egg farmers. While many egg farmers have been able to adapt to changes in how they produce eggs, they lack the specialized equipment to produce plant-based eggs or access to the distribution and marketing resources necessary to sell them.

The market for eggs may be about to be disrupted in a way that will force many egg farmers out of the industry.

Sources: Corinne Gretler and Thomas Buckley, “Nestlé Tests Plant-Based Frontier With Vegan Eggs and Shrimp,” bloomberg.com, October 6, 2021; Aine Quinn, “Fake Eggs From Mung Beans Get Closer to Reality in Europe,” bloomberg.com, October 20, 2021; Jon Swartz, “Eat Just’s Plant-Based Egg Products to Come to Another 5,000 Retail Outlets,” marketwatch.com, September 2, 2020; Deena Shanker, “Faux-Egg Maker Eat Just Raises $200 Million More in Latest Round,” bloomberg.com, March 3, 2021; and Jon Emont, “Real Meat That Vegetarians Can Eat,” wsj.com, March 6 2021.

Solved Problem: Why Is Starbucks Closing Stores in New York City?

Supports: Econ Chapter 12, Section 12.4, “Deciding Whether to Produce or Shut Down in the Short Run,” and Section 12.5, “‘If Everyone Can Do It, You Can’t Make Money at It’: The Entry and Exit of Firms in the Long Run”; and Essentials: Chapter 9, Section 9.4 and Section 9.5.

Solved Problem: Why Is Starbucks Closing Stores in New York City?

In May 2021, many businesses in the United States began fully reopening as local governments eased restrictions on capacity imposed to contain the spread of Covid-19. An article on crainsnewyork.com discussed the decisions Starbucks was making with respect to its stores in New York City. Starbucks intended to keep some stores open, some stores would be permanently closed, and “about 20 others that are currently in business will shutter when their leases end in the next year.” Analyze the relationship between cost and revenue for each of these three categories of Starbucks stores: 1) the stores that will remain permanently open; 2) the stores that will not reopen; and 3) the stores that will remain open only until their leases expire. In particularly, be sure to explain why Starbucks didn’t close the stores in category 3) immediately rather than waiting until the their leases expire.

Source: Cara Eisenpress, “Starbucks Closing Some City Locations as It Moves to a Smaller, Pickup Model,” crainsnewyork.com, May 19, 2021.

Solving the Problem

Step 1: Review the chapter material. This problem is about the break-even price for a firm in the short run and in the long run, so you may want to review Chapter 12, Section 12.4, “Deciding Whether to Produce or to Shut Down in the Short Run,” and Section 12.5, “‘If Everyone Can Do It, You Can’t Make Money at It’: The Entry and Exit of Firms in the Long Run.”

Step 2: Explain why stores in category 1) will remain permanently open. We know that firms will continue to operate a store if the revenue from the store is greater than or equal to all of the store’s costs—both its fixed costs and its variable costs. So, Starbucks must expect this relationship between revenue and cost to hold for the stores that it will keep permanently open.

Step 3: Explain why Starbucks will not reopen stores in category 2). Firms will close a store in the short run if the loss from operating the store is greater than the store’s fixed costs. Put another way, the firm won’t be willing to lose more than the store’s fixed costs. We can conclude that Starbucks believes that if it reopens stores in category 2) its loss from operating those stores will be greater than the stores’ fixed costs.

Step 4: Explain why Starbucks will operate some stores only until their leases expire and then will shut them down. If a firm’s revenue from operating a store is greater than the store’s variable costs, the firm will operate the store even though it is incurring an economic loss. If it closed the store, it would still have to pay the fixed costs of the store, the most important of which in this case is the rent it has to pay the owner of the building the store is in. By operating the store, Starbucks will incur a smaller loss than by immediately closing the store. But recall that there are no fixed costs in the long run. The stores’ leases will eventually expire, eliminating that fixed cost. So, in the long run, a firm will close a store that is incurring a loss. Because Starbucks doesn’t believe that in the long run it can cover all the costs of operating stores in category 3, it intends to operate them until their leases expire and then shut them down.

Solved Problem: Why Will No One Buy This Farm?

Supports: Economics: Chapter 12 – Firms in Perfectly Competitive Markets (Section 12.5); Microeconomics: Chapter 12, Section 12.5; and Essentials: Chapter 9, Section 9.5

Solved Problem: Explaining Entry and Exit

An article in the Pittsburgh Post-Gazette had the headline: “The Last Harvest: Beaver County Organic Farm Closes after Failure to Find Successor.” The article discusses the decision by a 71-year old famer to close down his organic vegetable farm after failing to find a buyer for it despite a 10-year search. Several people, including his four adult children, considered purchasing the farm but in end none did so. His only requirement in selling the farm was that the buyer use the land to grow organic crops. The famer was puzzled by his inability to find a buyer because “There’s money in organics.” The article notes that: “In a U.S. Department of Agriculture study, organic food products generally commanded a [price] premium exceeding 20% over conventionally grown vegetables.”

a. Does the fact that organically grown vegetables sell for prices that are 20 percent higher than the prices of conventionally grown vegetables mean that growing organic vegetables will earn a farmer a larger economic profit than growing vegetables using conventional methods? Briefly explain.

b. Is it likely that the requirement that a buyer had to agree to use the land only to grow organic vegetables affected the inability of the farmer to find a buyer? Briefly explain.

c. What is the likeliest explanation for the farmer being unable to find a buyer for his farm?

Source: Khris B. Mamula, “The Last Harvest: Beaver County Organic Farm Closes after Failure to Find Successor,” Pittsburgh Post-Gazette, January 3, 2021.

Solving the Problem

Step 1: Review the chapter material. This problem is about the reason that firms exit an industry, so you may want to review Chapter 12, Section 28.2 “If Everyone Can Do It, You Can’t Make Money at It.”

Step 2: Answer part a. by discussing whether the fact that organic vegetables sell for higher prices than conventionally grown vegetables means that growing organic vegetables will earn a farmer a larger economic profit than growing vegetables using conventional methods. Profit depend on costs as well as prices. We’ve seen in this chapter that organic growing methods typically have higher costs than conventional growing methods. Therefore, the fact that organic vegetables sell for higher prices than conventionally grown vegetables doesn’t guarantee that farmers selling organic vegetables are earning an economic profit. In fact, in the long run we would expect that entry and exit will ensure that the price farmers sell vegetablesfor will just equal the average cost of growing them, whether the vegetables are grown organically or conentionally. In other words, in the long run the higher price of organic vegetables will just offset the higher cost of growthing them and farmers will earn a zero economic profit whichever method they use to grow vegetables.

Step 3: Answer part b. by explaining whether the farme’s requirement that the farm be used only to grow organic vegetables affected his difficulty in finding a buyer. Generally when a firm exits a market, as this farmer is exiting the market for organic vegetables, the firm’s resources will be sold and used for other purposes. For example, when the market for renting videos collapsed, the buildings video rental stores had been in were used for other purposes. (A former Blockbuster video store near where one of the authors lives was converted into a tire store.) Or a resaurant serving Italian food may close and the tables, chairs, and ovens may be used by a restaurant serving Thai food that opens in the same building. By insisting that his farm only be used for growing organic vegetables, the farmer limited the number of buyers who would be interested in buying it. Anyone who wanted to use the land to grow vegetables using conventional methods or wanted to use it for a nonagricultural purpose would not buy the farm.

Step 4: Answer part c. by discussing the likeliest reason that the farmer was unable to find a buyer for his farm. We would expect that someone wanting to sell a firm that is earning an economic profit would have no trouble finding a buyer if the price being asked would allow a buyer to also earn an economic profit on the buyer’s investment. That the farmer in this article couldn’t find a buyer after 10 years of searching is an indication that a buyer of the farm at the price he was asking would at best break even. As noted in the answer to part b., that the farmer wouldn’t allow a buyer to use the land for any purpose other than organic farming reduced the number of potential buyers.

COVID-19 Update – Solved Problem: When to Re-Open Disney World during a Pandemic?

Supports: Econ (Chapter 12 – Firms in Perfectly Competitive Markets (Section 12.4); Essentials: Chapter 9 (Section 9.4)

Solved Problem: When to Re-Open Disney World during a Pandemic

In mid-March 2020, during the Covid-19 pandemic, the Walt Disney Company closed its Walt Disney World theme park in Orlando, Florida. In late May, the company announced that with the approval of the Florida government it would reopen Disney World in mid-July. An article in the Wall Street Journal noted that the company’s costs would increase because employees would need to reduce the likelihood of visitors contracting the virus while in the park by taking measures such as additional cleaning of the parks and checking the temperatures of customers. At the same time, the company’s revenue would likely fall because fewer people were expected to buy tickets to the park or to stay in the company’s hotels. When asked about these issues, Disney CEO Bob Chapek stated that, “We would not open up until we could cover our variable costs ….” If Disney covers its variable costs of operating Disney World, can the company be certain that it will earn an economic profit? If not, why would the company open the park?

Source: Erich Schwartzel, “Disney World to Reopen Gradually Starting July,” Wall Street Journal, May 27, 2020.

Solving the Problem

Step 1: Review the chapter material. This problem is about the break-even price for a firm in the short run and in the long run, so you may want to review Chapter 12, Section 12.4 “Deciding Whether to Produce or to Shut Down in the Short Run.”

Step 2: Answer the first question by explaining the circumstances under which a firm earns an economic profit. To earn an economic profit, a firm’s revenue must be greater than all of its costs—both its fixed costs and its variable costs. So, Disney covering its variable costs is not enough for the company to earn an economic profit if it is not also covering its fixed cost.

Step 3: Answer the second question by explaining why Disney is better off opening Disney World even if it is only covering its variable cost. With the park closed, Disney is earning no revenue but still has to pay the fixed costs of the park. These fixed costs include the opportunity cost of the funds the company’s shareholders have invested in the park, fire and other insurance premiums, and the cost of the electricity necessary to power lights and security systems. If the park remains closed, Disney will suffer an economic loss equal to its fixed cost. If the park is opened and Disney earns enough revenue to cover the variable costs of operating the park—including the salaries of employees operating rides and working in restaurants, the higher utility costs, and the costs of increased cleaning necessitated by the virus—Disney will reduce its loss to an amount smaller than the value of its fixed costs, even though the company will not be earning an economic profit. In this circumstance, Disney will be better off opening the park than keeping it closed. In general, as we’ve seen in the chapter, firms will be willing to operate in the short run if they can earn revenue at least equal to their variable costs. Note, though, that in the long run, Disney would need to cover all of its costs of operating the park to keep it open.

COVID-19 Update – How Will the Coronavirus Pandemic Affect the Airline Industry?

Supports: Chapter 12 in Economics and Microeconomics – Firms in Perfectly Competitive Markets; Essentials Chapter 9.

SOLVED PROBLEM: HOW WILL THE CORONAVIRUS PANDEMIC AFFECT THE AIRLINE INDUSTRY?

During the coronavirus pandemic, many airlines experienced a sharp decline in ticket sales. Some airlines responded by cutting ticket prices to very low levels. For example, in early March, Frontier Airlines was offering round-trip tickets from New York City to Miami for $51 (compared to over $200 three months earlier). As one columnist in the Wall Street Journal put it, the price of many airline tickets was “cheaper than dinner or what you’ll spend on Ubers or taxis.”

Briefly explain whether it was likely that the price Frontier was charging was high enough to cover the average total cost of a flying an airplane from New York City to Miami. Why was Frontier willing to accept such a low price? Would the airline be willing to accept such a low price in the long run?
Some airlines believed that even after the pandemic was over, consumers might not be willing to fly on planes as crowded as they were prior to the pandemic. Accordingly, airlines were considering either flying planes with some rows kept empty or reconfiguring planes to have more space between rows—and therefore fewer seats per plane. Briefly explain what effect having fewer seats per airplane might have on the price of an airline ticket.

Sources: Jonathan Roeder, “NYC to Miami for $51: Coronavirus Slump Leads to Steep Airfare Discounts,” bloomberg.com, March 5, 2020; and Scott McCartney, “There Are Plenty of Coronavirus Flight Deals Out There, But Think Before You Buy,” Wall Street Journal, March 25, 2020.

Solving the Problem

Step 1: Review the chapter material. This problem is about the break-even price for a firm in the short run and in the long run, so you may want to review Chapter 12, Section 12.4 “Deciding Whether to Produce or to Shut Down in the Short Run” and Section 12.5 “‘If Everyone Can Do It, You Can’t Make Money at It’: The Entry and Exit of Firms in the Long Run.”. In Hubbard/O’Brien, Essentials of Economics, it is Chapter 9.

Step 2: Answer part a. by explaining why even though a ticket price of $51 was unlikely to cover the average total cost of the flight, Frontier Airlines was still willing to accept such a low ticket price—but only in the short run. As we’ve seen in Section 12.5, competition among firms drives the price of a good to equal the average total cost of the typical firm. Assuming that ticket prices prior to the pandemic equaled average total cost, then the low ticket prices in the spring of 2020 must have been below average total cost. We have also seen, though, that firms will continue to produce in the short run provided they receive a price equal to or greater than average variable cost. For a particular flight, the fixed cost—primarily the cost of aviation fuel and the salaries of the flight crew—is much greater than the variable cost—additional meals served, somewhat more fuel used because more passengers make the plane heavier, and possibly an additional flight attendant needed to assist additional passengers. So, the $51 ticket price may have been enough for Frontier to cover its average variable cost. The airline would not accept such a low price in the long run, though, because in the long run it would need to cover all of its costs or it would no longer fly the route. (Note: In the short run, an airline might have another reason to continue to fly planes on a route even if it is unable to cover the average total cost of a flight. The contracts that airlines have with airports sometimes require a specified number of flights each day in order for the airline to retain the right to use certain airport gates.)

Step 3: Answer part b. by explaining the effect that having fewer seats per airplane would have on airline ticket prices. For an airline to break even on a flight, its total revenue from the flight must equal its total cost. Flying fewer seats per plane will not greatly reduce the airline’s cost of the flight because, as noted in the answer to part b., most of the cost of a flight is fixed and so the total cost of a flight doesn’t vary much with the number of passengers on the flight. But flying half as many passengers—if every other row is left empty—will significantly decrease the revenue the airline earns from the flight. To increase revenue on the flight, the airline would have to increase the price of a ticket. We can conclude that if airlines decide to fly planes equipped with fewer seats, ticket prices are likely to rise. Note that if on some routes the demand for tickets is price elastic, raising the price will reduce revenue and the airline will be unable to cover its cost of flying the route.