Suppose that there are 1,000 hot-pretzel stands operating in Toronto. Each stand has the usual U-shaped average total cost curve. Both the market demand curve and the supply curve for pretzels are linear, and the market for pretzels is in long-run competitive equilibrium.
a) Illustrate the current equilibrium in a two-part diagram with the entire market in one part and an individual pretzel stand in the other.
b) Now the city decides to restrict the number of pretzel-stand licences, reducing the number of stands to only 800. Show in a diagram what effect this action will have on the market and on an individual stand that is still operating.
c) Suppose that the city decides to impose an annual lump-sum licence fee on each of the 800 licence holders. Show in a diagram how this fee will affect the number of pretzels sold by an individual stand, and the stand's profit.
d) The city wants to raise as much licence fee revenue as possible and also wants to ensure that 800 pretzel stands remain in the city. Show in a diagram the optimal amount of licence fee.
e) Return to part (c) and suppose that the city imposes a licence fee of, say, $0.10 per pretzel sold, instead of an annual amount. Show in a diagram how this fee will affect the number of pretzels sold by an individual stand, and the market price and quantity.
f) Apart from raising revenues, why might a city government want to regulate an industry such as this?
a) To illustrate the current equilibrium, we need to understand the market demand and supply curves. Let's assume that the market demand curve for pretzels is downward-sloping, indicating that as the price of pretzels decreases, the quantity demanded increases. The market supply curve, on the other hand, is upward-sloping, indicating that as the price of pretzels increases, the quantity supplied increases.
In the market diagram, we can plot the quantity of pretzels on the horizontal axis and the price on the vertical axis. The market demand curve will slope downwards, while the market supply curve will slope upwards. The equilibrium point is where the demand curve intersects the supply curve, representing the price and quantity at which the market is in balance. In this case, it represents the price and quantity at which the market for pretzels is in long-run competitive equilibrium.
In the individual stand diagram, we can plot the same price and quantity axes. The average total cost curve for each stand is U-shaped, indicating that the average cost of producing pretzels decreases initially, reaches a minimum, and then starts increasing. The lowest point of the U-shaped curve represents the average total cost at which the pretzel stand can produce its output most efficiently.
b) When the city restricts the number of pretzel-stand licenses to 800, the number of stands operating in the market decreases. As a result, the market supply curve shifts to the left because there are fewer suppliers. In the market diagram, this shift will lead to a decrease in the equilibrium quantity of pretzels and potentially an increase in the equilibrium price, depending on the elasticity of demand.
In the individual stand diagram, the restriction on licenses will not directly affect the U-shaped average total cost curve of the remaining stand. However, with fewer stands in the market, the individual stand's market share may increase, which could potentially allow it to charge a higher price and increase its profit margin.
c) If the city imposes an annual lump-sum license fee on each of the 800 license holders, it will have an impact on the number of pretzels sold by an individual stand and its profit. The license fee will act as an additional fixed cost for the stand, increasing its average total cost curve. In the individual stand diagram, this will shift the U-shaped average total cost curve upward, making it more costly for the stand to produce each unit of output.
As a result, the individual stand will have to increase the price of its pretzels to cover the additional cost, which will likely lead to a decrease in the quantity of pretzels sold. The stand's profit will depend on the extent of the increase in price compared to the decrease in quantity sold.
d) To determine the optimal amount of license fee, the city wants to raise as much revenue as possible while ensuring that 800 pretzel stands remain in the city. In this case, the city needs to strike a balance between maximizing revenue and avoiding excessive license fees that could drive some stands out of business.
In the diagram, the optimal amount of license fee will be where the additional revenue from the fee is maximized while still maintaining 800 stands. This point can be determined by finding the price and quantity combination that keeps the market supply curve intersecting with the demand curve at the equilibrium quantity of 800 stands.
e) If the city imposes a license fee of $0.10 per pretzel sold instead of an annual amount, it will directly affect the number of pretzels sold by an individual stand and the market price and quantity. This fee acts as a variable cost for the stand, increasing the marginal cost of producing each additional unit of pretzel.
In the individual stand diagram, the license fee will shift the U-shaped average total cost curve upward, making it more costly for the stand to produce each pretzel. This will lead to a higher price being charged by the stand to cover the increased costs. As a result, the quantity of pretzels sold by the stand will decrease.
In the market diagram, the increase in marginal cost for individual stands will lead to a decrease in the market supply curve. This shift will result in a higher market price and a lower equilibrium quantity of pretzels.
f) Apart from raising revenues, a city government might regulate an industry like this for various reasons. Some potential reasons could include:
1. Health and safety concerns: The government may want to regulate the industry to ensure that health and safety standards are met, such as proper food handling and preparation practices.
2. Market fairness: The government might intervene to prevent monopolistic behavior or unfair market practices to ensure a level playing field for all pretzel stands and prevent exploitation of consumers.
3. Quality control: Regulations can be put in place to maintain product quality and prevent the sale of substandard products that could harm consumers or tarnish the reputation of the industry.
4. Environmental considerations: Regulation might be implemented to address any potential negative environmental impacts associated with the pretzel stands, such as waste disposal or energy consumption.
5. Economic stability: The government may regulate the industry to avoid market failures or economic disruptions, ensuring the stability and sustainability of the industry.