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ECON1056 Price Theory Industry Analysis: Airfreight Services Of Autarka Assessment Answer

    ECON1056 Price Theory Industry Analysis

    Introduction

    Decision-makers in government rely on the advice of experts when formulating policy or discharging their statutory responsibilities. In this assignment you will take the role of an expert economist, employed by a government department. An expert economist’s role in the government decision-making process is two-fold:

    • Analysis: Economists use their specialist knowledge and skills to analyse the likely outcomes of policy alternatives. They then evaluate these outcomes against the government’s objectives and statutory obligations.
    • Communication: Economists communicate their findings to ministers and senior public servants, who, in many instances, do not share their specialised knowledge.

    This assignment will assess your aptitudes in both of these domains. You are to conduct an industry analysis based on the scenario detailed in section 2. Then use your analysis as the basis for a brief (a short report) summarising your recommendations and the associated rational1.1 Formatting requirements

    Your assignment must be typed using Microsoft Word, or a similar word processor. Both parts of the assignment should be included in the same document with the brief placed before the industry analysis. The document should have a professional appearance, appro- priate to a government workplace. Format your assignment as follows:

    • Use A4 sized paper with all margins at least 2.5cm.
    • Body text to be 12pt and black. (There is no minimum line spacing.)
    • All pages to be numbered.
    • DO NOT include a cover sheet or table of contents

    1.2 Grading

    There are a total of 100 marks available in this assignment (50 marks for the industry analysis and 50 marks for the brief), and the assignment contributes 40% of your grade for Price Theory. The marks allocated to each step of the industry analysis are detailed in section 3. The marking criteria for the brief can be found in the rubric.

    Scenario

    In the island nation of Autarka, the government holds a monopoly over the provision of airfreight services. Both the general public and business groups regularly complain about high prices and poor quality of service from the government owned monopoly, Autarka Airfreight Services (AAS).

    In response to these complaints, the national government commissioned the competi- tion authority to recommend steps for improving the efficiency of the airfreight market. The commission made two recommendations:

    1. The airfreight services market should be opened up to competition from privately owned firms.
    2. Each firm operating in the airfreight market, including AAS, should be required to pay an annual lump-sum licence fee to the government.

    The competition authority expects that the reforms will lead to a lower cost, higher qual- ity service. The national government of Autarka has pledged to implement all of the commission’s regulations.

    2.1 Industry structure

    The airfreight market is best modelled as Cournot competition. This is because compet- ing firms must hire aircraft and establish distribution networks before offering airfreight services. Demand for airfreight services is,

    P = 42 − 0.2Q,

    where P represents the price of transporting a package, and Q is the total number of packages transported per year, measured in millions of packages.

    At present, AAS charges $30 a package and transports 60,000,000 packages per year. While the firm is inefficient, it manages to return an operating profit of $180,000,000 per year into government revenues.

    The competition authority expects that after implementing the market reforms, all firms in the market (includeing AAS) will be more efficient. Each firm in the market will be able to transport a package at a marginal cost of $6 per package, and face fixed costs of $100,000,000 per year.

    2.2 Your task

    The Minister for Transport has instructed you to recommend an appropriate licence fee for the airfreight market. The minister has three objectives:

    1. Maximise government revenues from the licence fee;
    2. Minimise the cost of airfreight services to consumers, and;
    3. Increase the number of packages transported per year to at least 150,000,000.

    Note that competition policy prevents the government from imposing any other form of market regulation, including price controls or quotas.

    Industry analysis

    For your Industry Analysis you must complete each of the steps detailed below. The required analysis draws on content covered in lectures 6–10 (primarily lecture 9). When completing the steps you must:

    • Type all equations using the ‘Insert Equation’ function (or equivalent).
    • Show all of your working.
    • Include sufficient written description for the reader to follow your process.
    • Use appropriate notation and economic terminology.

    Your audience for the industry analysis is other expert economists who may be required to review your work. There is no page limit for the Industry Analysis.

    3.1 Required steps

    When completing the industry analysis you should assume that firms are engaged in Cournot Competition.

    Step 1: Using the information provided in the scenario, derive a total cost function for a typical firm. Use QA to indicate the number of packages transported by the firm (measured in millions of packages). (4 marks)

    Step 2: Using the cost function from step 1, derive a profit function for the typical firm. Use X to represent the combined number of packages transported by all other firms (measured in millions of packages). (7 marks)

    Step 3: Derive the typical firm’s best-response function. (7 marks)

    Step 4: Find the equilibrium quantity of the typical firm as a function of the total number of firms competing in the market. Use N to represent the total number of firms competing in the market. (6 marks)

    Step 5: Find the equilibrium market quantity and market price as a function of N. (8 marks)

    Step 6: Find the equilibrium producer surplus of the typical firm as a function of N. (8 marks)

    Step 7: Complete any additional calculations that you require to support your recommen- dation. (10 marks)

    The brief

    The purpose of the brief is to communicate your recommendations to the decision-maker who commissioned your analysis. You need to provide enough information for the decision- maker to understand your recommendations, and to reach a decision on the matter at hand. However, senior government officials are extremely busy, so you must be brief.

    • The maximum length for your brief is 2 pages.

    • Any content in excess of 2 pages will not be read or graded.

    When writing the brief remember that it is for a non-expert audience. You must avoid using specialised economic terminology and state everything in ‘plain English’. For example:

    • Terms such as consumer surplus, producer surplus, and deadweight loss, have lit- tle meaning outside of economics and should be avoided. (Note: This is not a comprehensive list.)
    • On the other hand, the significance of terms such as price, revenue, and profit, are generally well understood outside of economics.

    The brief should not include any equations or diagrams. Tables and dollar amounts may be included as appropriate.

    4.1 Template

    You must compose your brief according to the template detailed on the following pages. Instructions for each required element of the brief are included within this template. These instructions are reflected in the requirements of the rubric for the task. Ensure that your brief includes each of the elements detailed in the template, and that you do not reorder, rename, or omit any of these elements.

    Briefing for the (insert decision-maker’s title here)

    Subject: Include a brief but descriptive subject line. Maximum length 1 line.

    Hint: The subject is, in effect, the title of your brief. Compose the subject as you would the title of a report.

    Core Message

    Write an executive summary of the brief. Your core message should consist of three sentences: The first sentence providing a summary of the scenario. The second sen- tence summarising the key rationale for your recommendation. And the third sentence summarising your recommendation(s). Maximum length 5 lines.

    Hint: The statements in the core message should stand on their own. Provide specific information and avoid generalities. The reader should be able to understand the core message without referring to the scenario or the rest of the brief.

    Recommendation

    Concisely state the principal recommendation that arises from your analysis.

    Hint: Your recommendation should be stated as a clear course of action for the gov- ernment to pursue. Be precise. Avoid generalities and ambiguous statements. DO NOT explain or seek to justify your recommendation in this section. DO NOT describe the consequences of your recommendation. DO NOT state conditions or caveats for your recommendation.

    Key Information

    Begin your key information section with a short (1–2 paragraph) outline of the context for the brief (as detailed in the scenario), the problem under consideration, and any additional issues raised.

    Hint: These 1–2 paragraphs should set the scene for the reader. They should provide the reader with sufficient background information to understand the purpose of the brief. DO NOT use these paragraphs to foreshadow, explain, or justify your recommendation(s). Use the remainder of the key information section to present the rationale behind your recommendation(s). You should highlight any trade-offs involved in your recommenda- tion(s), and address any additional issues raised in the scenario. Your rationale should be presented as follows:

    Use subheadings to concisely state the key findings of your industry analysis. The maximum length for a subheading is 2 lines (1 line is preferable).

    • Write a short paragraph following each subheading to briefly explain the finding.

    Taken together, the findings stated in the subheadings should form a logical argument supporting your recommendation(s).

    Hint: Incorporate all information required to support your recommendation(s) in this section, regardless of whether or not the same information has been included elsewhere in

    the brief. Each subheading should be written as a statement of fact. DO NOT include an explanation within a subheading, leave that for the following paragraph. DO NOT assert facts that are unsupported by either the scenario or your industry analysis.

    Financial Implications

    Briefly summarise the direct financial implications of your recommendation(s) (if any) for the Government. Include the precise dollar amounts that come out of your analysis.

    Hint: The financial implications section should provide the reader with easy access to the financial cost and/or benefit of your recommendations to the government. This section is not a substitute for stating the financial implications elsewhere in the brief. Specifically, if the financial implications form a part of the rationale for your recommendation(s), they will need to be included in both the key information section AND the financial implications section. DO NOT use this section to summarise other market outcomes (eg. profit and price). DO NOT use this section to present arguments in support of your recommenda- tion(s). This section must be included even if there are no direct financial implications from your recommendation(s).

    Begin your industry analysis on a new page following the brief.

    Answer

    Briefing for the senior government officials

    Subject: Industry analysis of airfreight services of Autarka 

    Core Message

    The features of airfreight market of Autarka include existence of monopoly, introduction of competition and imposition of annual lump-sum license fee by the government. Also, Autarka economy will benefit greatly from maximizing government revenue from license fee. And it is highly recommended that government of Autarka should endeavour to maximize its revenue from license fee.

    Recommendation

    1 The government of Autarka should provide enabling environment for competition in the industry.

    2 The government of Autarka should endeavour to maximize its revenue from license fee.

    3 The firms operating in the industry should pay annual lump-sum license fee to the government.

    Key Information

    In the scenario presented, it is clear that Autarka Airfreight Services enjoys monopoly power by being the only provider of the services in the airfreight market and as such, the government of Autarka came up with the intention of solving the complains of the consumers by commissioning the competition authority in order to provide avenue for the competition in the industry and also required all the players in the industry to pay annual lump-sum license fee to the government.

    In the light of the above , the minister of transport set three objectives for imposing the annual lump-sum license fee viz-a-viz maximize government revenues from license fee, minimize cost of airfreight services to the consumers and increase the number of packages transported per year to at least 150,000,000.

    Furthermore, the recommendations made were anchored on the following rationale:

    1. The provision of enabling environment for competition.

    This will help in providing quality services, reduce price charge for the airfreight services and also break the monopoly of the Autarka airfreight services

    2. Maximization of government revenues from license fee.

    This will generate more funds to the government both in the short and long run and improve government capabilities in providing essential services for the airfreight consumers

    3. The payment of annual lump-sum license fee

    This payment to the government will surely serve as another source of revenue to the government of Autarka.

    Financial Implications

    The provision of enabling environment for competition will improve government revenues from the airfreight market, reduce price charge for the services, help maximize government revenues from license fee and also provide another source of revenue to the government of Autarka.

    INDUSTRY ANALYSIS

    This analysis involves the analysis of the airfreight services being offered by the Autarka Airfreight Services, a government owned monopoly. In relation to the situation in this industry, government has come up with the decision to encourage competition in the provision of airfreight services and as such this will ensure new entrant into the airfreight industry. In view of this, it is pertinent to highlight the negative effects of monopoly which Autarka Airfreight Services has been enjoying before the government came with the decision to commission the competition authority.

    First, Autarka Airfreight Services has been producing low quality services to the consumers at high prices and this is evident by the complain made by both the general public and the business group. The impact of this is that, Autarka Airfreight Services had been making huge profit at the expense of the consumers that pay high prices for low quality services.

    Second, since it is government owned airfreight services provider, it is certain that entry into the industry had been blocked against other providers since Autarka Airfreight Services started enjoying monopoly created by government and more so, the Autarka Airfreight Services is at the liberty to determine the price in which it will offer its services since it is a price maker and it is the sole provider of the service in the industry.

    Away from the negative impacts of the monopoly of Autarka Airfreight Services, is the recommendation made by the authority to look into the creation of the competition in the airfreight industry. The first recommendation of competition authority is the openness to the privately owned firms to enter into the airfreight services. Hence, it is important that the openness of the industry to competition will bring many benefits into the industry in the following ways:

    1. Break the monopoly being enjoyed by the Autarka Airfreight Services.
    2. Promote efficiency in the delivery of services.
    3. Reduction in the cost being incurred by the consumers in using airfreight services.
    4. Promote quality service delivery.
    5. Promote innovation, research and development.
    6. Bring about improvement in the use of technology in the industry.

    Furthermore, the competition authority also recommended that each firm operating in the industry including Autarka Airfreight Services should pay annual lump-sum license fee to the government. This recommendation is pertinent to the economy of Autarka as a nation. This is because it will bring about more inflow into the revenue coffers of the government of Autarka and this license fee serves as parts of the sources of revenue to the government of Autarka and which will further enhance the financial capability of Autarka government in providing essential services to its citizens.

     ANALYSIS OF INDUSTRY STRUCTURE

    Step 1  : total cost function

    Total cost = Fixed cost + Variable cost

    Where variable cost = marginal cost

    Fixed cost = $100(in million)

    Marginal cost = $6 per package

    Hence, total cost function is given as follow

    Total cost = $100 + 6QA

    Step 2  : profit function

    P = 42 – 0.2X …………………………………………… (1)

    Recall that X = x1 + x2

    Therefore,

    P = 42 – 0.2 (x1 + x2) …………………………………… (2)

    Expand the bracket in the right hand of equation 2

    P = 42 – 0.2x1- 0.2x2………………………………………. (3)

    Total revenue for the first firm is given as 

    TR1 = P x1

    Since 

    P = 42 – 0.2x1- 0.2x2

    Hence,

    TR1 = (42 – 0.2x1- 0.2x2) x1

    Expand the brackets

    TR1 = 42 x1 - 0.2 x12 – 0.2 x1 x2 .....................................(4)

    TC1 = 100 + 6 x1........................................................ (5)

    Where ‘x1’ represents quantity of the first firm

    Profit function of the first firm is given as follow

    Π1 = TR1 + TC1……………………………………….. (6)

    Substitute equations (4) and (5) into equation (5)

    Π1 = (42x1 - 0.2 x12 – 0.2 x1 x2) – (100 + 6 x1)

    Expand the brackets

    Π1 = 42x1 - 0.2 x12 – 0.2 x1 x2  - 100 - 6x1

    Collect the like terms

    Π1 = 42x1 - 6x1- 0.2 x12 – 0.2 x1x2  - 100

    Π1 = 36 x1- 0.2 x12 – 0.2 x1x2  - 100 ………………………… (7)

    Equation (7) is the profit function of the first firm.

     Profit function of the second firm is given as:

    Π2 = TR2 – TC2 ...........................................................(8)

    From equation 3

    P = 42 – 0.2x1- 0.2x2

    Therefore,

    Total revenue for the second firm is given as:

    TR2 = P x2

    TR2 = (42 – 0.2x1- 0.2x2) x2

    Expand the brackets

     TR2 = 42x2 – 0.2x1x2 - 0.2x22 .................................... (9)

    TC2 = 100 + 6x2 ............................................................(10)

    Put equations 9 and 10 into equation 8

    Π2 = TR2 – TC2

    Π2 = (42x2 – 0.2x1x2 - 0.2x22) – (100 + 6x2)

    Expand the brackets

    Π2 = 42x2 – 0.2x1x2 - 0.2x22 – 100 - 6x2

    Collect the like terms

    Π2 = 42x2 - 6x2– 0.2x1x2 - 0.2x22 – 100

    Π2 = 36x2-0.2x1x2 - 0.2x22 – 100 ……………………………….. (11)

    Equation 11 is the profit function of the second firm

    Hence, the profit functions of the two firms are stated as follow:

    Π1 = 36 x1- 0.2 x12 – 0.2 x1x2 - 100

    Π2 = 36x2-0.2x1x2 - 0.2x22 – 100

    Step 3: Best response function 

    Best response function is given as:

    MC = MR

    For the first firm

    MR1 = δtr1/δ x1     where MR1 = Marginal revenue of the first firm

    From equation 4, total revenue of the first firm is given as:

    TR1 = 42 x1 - 0.2 x12 – 0.2 x1 x2

    Hence, take partial derivatives with respect to ‘x1’ in order to obtain 

    MR1.

    Therefore,

    MR1 = δtr1/δ x1 = (42 x1 - 0.2 x12 – 0.2 x1 x2)/ δ x1

    MR1= 42  X 1 X  x11-1  –  0.2 X 2 X x12-1  - 0.2 X 1 X  x11-1 X  x2

     MR1 = 42 – 0.4x1 – 0.2 x2

    Since MC = $6

    Therefore,

    MR1 = MC

    42 – 0.4x1 – 0.2 x2 = 6

    Rearrange the above equation

    42 – 6 = 0.4x1 + 0.2x2

    36 = 0.4x1 + 0.2x2

    Make ‘x1’ the subject of the formula

    0.4x1 = 36 - 0.2x2

    Divide both sides by 0.4

    0.4 x1/0.4 = 36 - 0.2x2/0.4

    x1 = 36/0.4 -  0.2x2/0.4

    x1 = 90 – 0.5 x2

    Best response function of second firm is given as:

    MR2 = MC

    From equation 9, total revenue of the second firm is given as

    TR2 = 42x2 – 0.2x1x2 - 0.2x22

    Hence, take partial derivatives with respect to ‘x2’ in order to obtain 

    MR2.

    MR2 = δtr2/δ x2 = (42x2 – 0.2x1x2 - 0.2x22)/ δ x2

    MR2 = 42x21-1 – 0.2 X 2 X x22-1 - 0.2 X x1  X  x21-1

    MR2 = 42 – 0.4 x2 – 0.2 x1

    Since MC = $6

    Therefore,

    MR2 = MC

    42 – 0.4 x2 – 0.2 x1 = 6

    Rearrange the above equation

    42 – 6 = 0.4 x2 + 0.2 x1

    36 = 0.4 x2 + 0.2 x1

    Make ‘x2’ subject of the formula

    0.4 x2 =36 - 0.2 x1

    Divide both sides by 0.4

    0.4 x2/0.4 = 36 - 0.2 x1/0.4

    x2 = 36/0.4 - 0.2 x1/0.4

    x2 = 90 – 0.5 x1

    Thus, best response function of both firms is given follow as:

    x1 = 90 – 0.5 x2 .................................response function of the first firm

    x2 = 90 – 0.5 x1 ................................. response function of the second firm

    Note that the second firm is perfectly symmetric to first firm.

    Step 4 : EQUILIBRIUM QUANTITY

    x1 = 90 – 0.5 x2 .................................response function of the first firm

    x2 = 90 – 0.5 x1 ................................. response function of the second firm

    Substitute response function of the first firm into that of the second firm

    x2 = 90 – 0.5 …………………………………… (1)

    since x1 = 90 – 0.5 x2, then substitute this into equation one above.

    x2 = 90 – 0.5x1

    x2 = 90 – 0.5 (90 – 0.5 x2)

    x2 = 90 – 45 + 0.25 x2

    Collect the like terms

    x2 - 0.25 x2 = 45

    0.75 x2 = 45

    Divide both sides by 0.75

    0.75 x2/0.75 = 45/ 0.75

    x2 = 60

    To get ‘x1’ put x2 = 60 into response function of the first firm

    x1 = 90 – 0.5 x2

    x1 = 90 – 0.5(60)

    x1 = 90 – 30

    x1 = 60

    STEP 5 : EQUILIBRIUM MARKET QUANTITY

    X = x1 + x2

    X = 60 + 60

    X = 120

    EQUILIBRIUM MARKET PRICE

    P = 42 – 0.2 (x1 + x2)

    P = 42 – 0.2 (60 + 60)

    P = 42 – 0.2 (120)

    P= 42 -24

    P = 18

    STEP 6 : EQUILIBRIUM PRODUCER SURPLUS

    Producer surplus in cournot competition is given as 

    PS = ∫qo  f(q)δq – P0 Q0

    Where P0 and Q0 are equilibrium price and quantity respectively and f(q) is the demand function.

    Therefore P0 = 18,    Q0 = 120, f(q) = 42 – 0.2Q

    Substitute the above values and function into the formula

     PS = ∫120 (42 – 0.2Q) δQ – 120 X 18

    PS = (42Q – 0.2Q1+1/1+1)120 – 0 - 2160

    PS = (42Q – 0.2Q2/2)120 - 0 – 2160

    PS = (42 X 120 – 0.2 X (120)2/2) – 0 – 2160

    PS = (5040 – 2880/2) – 0 – 2160

    PS = (5040 – 1440) – 0 – 2160

     PS = 3600 – 2160

    PS = 1440

    STEP 7: ADDITIONAL COMPUTATION

    The additional computation to support the recommendation is the computation of profit for each firm in the industry.

    For first firm:

    Π1 = TR1 + TC1  

    Where P = 18, x1 = 60

    TR1 = P x1 = 18 X 60 = $1080

    TC1 = 100 + 6x1

    TC1 = 100 + 6(60)

    TC1 = 460

    Π1 = TR1 + TC1

    Π1 = 1080 – 460

    Π1 = $620million

    For second firm:

    Π2 = TR2 + TC2

    Where P =18, Q = 60

    TR2 = P x2 = 18 X 60 = $1080

    TC2 = 100 + 6x2

    TC2 = 100 + 6(60)

    TC2 = 460

    Π2 = TR2 + TC2

    Π2 = 1080 – 460

    Π2 = $620million

    In furtherance to the instruction from minister of transportation, the task involves recommending the appropriate and most efficient license fee for the airfreight market base on the objectives of the minister which include:

    1. Maximize government revenue from license fee
    2. Minimize the cost of airfreight services to the consumers
    3. Increase the number of packages transported per year to at least 150,000,000.

    With respect to the above objectives, it is obvious that all the objectives have their respective pros and cons but the appropriate license fee for the government of Autarka is to maximize government revenue from the license fee. This policy will result in increasing government revenue and reduce government expenditure. In other words, this policy will bring about increase in government revenue generated from airfreight industry, reduce government on airfreight market and lead to more monetary resources at the disposal of Autarka government in providing essential services for the airfreight industry.  

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