Question

A Explain and show the kinked demand curve theory. What is its weakness?

B. Show and explain the dominant firm model.

C. Why do firms in a Bertrand lower price to MC?

Answer 1

1. Kinked demand curve model was introduces by Paul. M. Sweezy to explain the rigidity of price in a oligopoly market. The oligopoly firm have the price setting power. instead of going for price output determination, Sweezy deals with the behavior of oligopoly firms. But is reluctant to use it. This is because, it knows that if the firm goes for a price rise, the rivals may not follow it. Then there can have quite large substitution effect and thus the demand become relatively price elastic. So the firm may lose market share and a fall in its total revenue. But on the other had, if it chooses a price cut the rivals will cut their prices too. Then the price change is smaller ans the demand become relatively inelastic.So oligopoly firms must stick to a certain price which all of them have to follow and cannot easily change even if there is a change in the cost conditions. When we club this two demand conditions, one is relatively elastic and the other is relatively inelastic, the total demand curve which is the firm faces will have a kink. Here the firms cannot go for price war. So they may mainly concentrate on non price competition. The main weakness of this theory is that it talks about the price rigidity or stable price in an oligopoly market. But does not explain how determined this stable price or how arrived at the equilibrium point. So it is just a description for the price stickiness and failed to explain it. Another thing is that, there are empirical evidence for oligopoly markets in which the competitors followed a price hike when one of the firm increase its price during the time inflation. So it lacks empirical evidence.
2. In the dominant firm model, it is assumed that there is a dominant large firm with considerable market share and also a small number, say two or three small firms in the market. It is assumed that the total demand in the market is known to the dominant firm. It is also assumed that the dominant firm knows the marginal cost curves of the small firms and so the dominant firm can calculate the total supply by all small firms at each price by adding the individual MC curve of the small firms horizontally. By using this two information, he can derive its own demand curve at each price. That is at each price, the demand of the dominant firm is the rest of the total market demand which is not supplied by the small firms. S1 curve is the aggregate supply curve of the small firms and DD is the total market demand, At P1 price, the supply by dominant firm is zero because the total market demand is supplied by small firms. As price decreases the supply of dominant firm increases and at price P3, the total market demand is catered by the dominant firm because the small firms could not withstand at such a lower price.The dominant firm maximizes his profit at the point where MC=MR. While the small firms are price takers.
3. In a Betrand duopoly model the price is equal to marginal cost. When the firm lower the price, it can gain more market share. To what extent a firm can lower the unit price? It is up to marginal cost. So each of the firms in the Betrand model tries to reduce the unit price to the MC and there by they tries to gain more market share.