Question

A New York City cab operator appears to be making positive profits in the long run after carefully accounting for the operating and labor costs. Does this violate the competitive model? Why or why not?

Short answer

The situation may violate the competitive model due to restricted entry and market power.

Step-by-step solution

Understand the Competitive Model

In a perfectly competitive market, firms are price takers and have no control over the market price. In the long run, firms should make normal profits (zero economic profit) because any positive profit would attract new firms, increasing supply and lowering prices until profits are zero.

Identify the Nature of Long-Run Profits

Positive profits, beyond normal profits, imply that the firm is earning more than the opportunity cost of its resources. This suggests that the firm has some advantage or market power that allows it to earn more than a zero economic profit.

Evaluate the Market Conditions for New York City Cabs

The city cab situation might not reflect perfect competition due to factors such as regulation, limited entry (medallion system), and unique service conditions in a large city. These conditions suggest that firms might be able to sustain positive profits even in the long run.

Determine if the Competitive Model is Violated

If the cab operator is earning positive profits and the market is not acting like a perfectly competitive market, it suggests that assumptions of perfect competition, such as unrestricted entry, do not hold. Therefore, this situation might not strictly adhere to the competitive model.

Key concepts

Perfect Competition

Perfect competition is a type of market structure characterized by a high degree of competition among firms. In this scenario, there are numerous small firms that are all competing to sell an identical product.

One of the main features of a perfectly competitive market is that firms are 'price takers'. This means they have no power to influence the price of the product they sell. Instead, the price is determined by the overall supply and demand within the market.

• Many small firms
• Identical products
• Free entry and exit for businesses
• No control over prices

In such markets, the assumption is that firms will only earn enough to cover the opportunity costs of their resources in the long run, resulting in zero economic profit.

However, this theoretical concept is often challenged in real-life scenarios where market imperfections can exist.

Long-Run Profits

Long-run profits refer to the financial gains that a firm may expect after all adjustments have been made, such as changes in production capacity or market entry and exit. In a perfectly competitive market, the long-run equilibrium results in firms earning normal profits, which equates to zero economic profits.

This occurs because any abnormal profits would attract new firms into the market. As the number of firms increases, so does the supply, which drives down the price until firms are no longer making above-normal profits.

• Long-run equilibrium
• Zero economic profit or normal profit
• Market adjustments based on profits

It's important to note that in specific scenarios, like the NYC cab market, long-run profits might deviate from this norm due to unique conditions or restrictions.

Economic Profit

Economic profit measures a company's earnings after accounting for the opportunity costs of all resources used in production. Unlike accounting profits, which consider only explicit costs, economic profit also considers the cost of foregone opportunities.

• Accounts for both explicit and implicit costs
• Opportunity costs reflect alternative uses of resources
• Positive economic profit suggests competitive advantages

In a perfectly competitive market, the expectation is that economic profits are zero in the long run.

However, a company—such as a New York City cab operator—that manages to earn positive economic profits is often experiencing some form of market power. This occurs through barriers to entry, price-setting capabilities, or operational efficiencies that exceed market norms.

Market Conditions

Market conditions describe the environment in which firms operate, including factors like competition level, regulations, and barriers to entry. In perfect competition, the market is characterized by unrestricted entry and exit, ensuring no firm earns excess profits in the long term.

In reality, markets like the NYC cab industry may deviate from these ideals due to specific conditions:

• Regulatory restrictions (e.g., medallion systems for cabs)
• High barriers to entry (e.g., licensing costs)
• Local demand variations (e.g., city-specific transport needs)

These conditions create a less than perfectly competitive environment.

As a result, firms in such settings might enjoy sustained positive profits, despite the theoretical model assumptions of perfect competition.