Page 198 - DECO405_MANAGERIAL_ECONOMICS

Unit 12: Oligopoly

Since the elasticity for a change in price above P is more than, and different from, elasticity for Notes
a change in price below P, there are two values of marginal revenue for current price, P. Thus the
marginal revenue curve has a discontinuity or gap at price P. For the upper AP portion of the
demand curve the marginal revenue (MR ) curve is QC and for the lower portion PB, the marginal
1
revenue (MR ) curve is DE.
2
The marginal revenue curve corresponding to APB is shown by QCDE with discontinuity or gap
CD. Note that both e and e have to be greater than 0 for MR and MR to be positive at P.
1 2 1 2
The magnitude (or length) of this gap is given by P(1/e - 1/e ). This follows from the fact that
2 1
MR = P(1–1/e). We find the MR = P(e – )/e and MR = P(e –1)/e .
1 1 1 2 2 2 2
Hence, MR –MR = P(e e –e –e e +e )/e e = P(e –e )/e e = P(1/ e –1/e ). Since e is > e , the gap
1 2 1 2 2 1 2 1 1 2 1 2 1 2 2 1 1 2
MR –MR is positive.
1 2
The marginal cost curve, MC, of the firm passes through the discontinuous gap CD in the
marginal revenue curve QCDE. Though the current existing price, P, is not precisely equal to the
profit maximising equilibrium price (as there is no unique MR at price P), this price P is consistent
with profit maximising, marginalist equilibrium. For output less than ON we find MC is below
marginal revenue and for output more than ON we find MC is above marginal revenue. That is,
MC cuts the discontinuous MR curve from below.

Since, under oligopoly, demand curve is kinked at the existing price (P) and marginal revenue
curve has discontinuity CD at the existing price, any upward or downward shift in the MC curve
will not bring about any change in the current or existing price so long as the new MC curve
passes through the gap (CD) in the marginal revenue curve (QCDE).
In Figure 12.3 the new higher marginal cost curves MC and MC are passing through the gap
1 2
CD with the result that the current price P continues to be consistent with profit maximisation
even while remaining constant at the existing level.

Thus the most important conclusion of Sweezy's kinked demand curve model of oligopoly is
that price remains unchanged and rigid or ‘sticky’ at the existing level P when, in the short run,
the marginal cost increases due to a rise in raw material prices or hike in wages through trade
union pressure.
Thus Sweezy's Kinked demand curve model explains the rigidity or stickness of oligopolistic
prices in the face of short-term increases or decreases in variable input costs. When costs of raw
materials or labour rise, profits will get squeezed and when these costs fall, the benefit of lower
input costs will not be passed on to the consumers.
Thus the Sweezy model of Kinked demand curve under oligopoly explains why prices of
oligopolistic firms are inflexible and fail to reflect short run changes in variable costs of raw
materials and wages.
The principal shortcoming of the Sweezy model is that it does not explain how the existing or
current price is determined, and this is a criticism that Sweezy accepts.

Task Analyse Coke-Pepsi non-price competition and its effect on their market.

12.4 Market Structure and Barriers to Entry

Many factors can contribute to the existence of a particular market structure. However, in the
long run, conditions of entry may be the most important determinant. Difficulties encountered

LOVELY PROFESSIONAL UNIVERSITY 193