The Kinked Demand Curve Model of Oligopoly Pricing

In our previous lesson on oligopoly, we showed how payoff matrices and game theory could be used to analyze the strategic, interdependent behavior of two firms when deciding the price they would charge. In this lesson we take a graphical approach to oligopoly, and seek to explain why prices tend not to fluctuate up or down in oligopolistic markets.

We will look at two firms, Swisscom and Orange, which provide cell service to customers in Switzerland. Why does Swisscom have very little incentive to decrease its prices, and also a strong incentive not to raise its prices? The answer requires us to make assumptions about how the competitor, Orange, would respond to a change in Swisscom’s prices.

What emerges is a kinked demand curve, highly elastic at prices above the current equilibrium and highly inelastic at prices below the current equilibrium. Along with this kinked demand curve comes a kinked marginal revenue curve, with a vertical section. The implication is that even as an oligopolist’s costs rise and fall in the short-run, its level of output and price tends to remain stable.

 

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Intro to Game Theory – The Prisoner’s Dilemma as a Model for Oligopoly Behavior

Two men are in custody for a crime they may or may not have committed: armed robbery. The police have the men in separate cells and have told them the following:

Confess to the crime of armed robbery and we will let you off with a light term of three years in jail with parole after one year.

Remain silent and we will throw everything we have at you, you will get 10 years in jail, because we promise you, your accomplice will talk.

However, if you both remain silent, we have to let you go with a slap on the wrist, just six months in jail for trespassing.

With this information in mind, the men, who are unable to communicate with one another both confess and get three years in jail. Why didn’t they both remain silent, though, and get just six months in jail?

This story is what’s known as the Prisoner’s Dilemma. It is a popular story used by economists to illustrate the challenges faced by non-collusive oligopolistic firms in deciding how to determine what prices to set for their products, whether to advertise or not to advertise, and many other strategic decisions that will affect the level of profits being earned.

The oligopoly market structure, more than any other, requires that firms act strategically, taking into account the decisions of their competitors, on whom they are highly inter-dependent. This lesson will apply the Prisoner’s Dilemma game to two firms deciding whether to charge a high price or a low price for their output, and analyze the most likely outcome in such a game. As we will see, without the ability to collude with one another, the strategic behavior of oligopolistic firms tends to result in an outcome that is not optimal for the sellers, but may benefit consumers.

 

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Monopolistic Competition

Having now studied perfect competition and Pure Monopoly, we will now step back towards the competitive end of the spectrum of market structures and examine monopolistic competition. A monopolistically competitive market is one with many small firms each selling differentiated products. The entry barriers are low, but firms do have some price making power. Since each firm’s output is slightly different from each other firm’s, the individual sellers will face a downward sloping demand curve, much like a monopolist. But since entry barriers are low, the chance of an individual firm earning economic profits in the long-run is small.

This lesson will introduce the characteristics of monopolistic competition and provide a detailed graphical analysis of an individual firm in a monopolistically competitive market. We will look at the market for restaurants, which shows may of the characteristics of the market structure.

In the end we will determine whether monopolistically competitive markets are efficient by examining the firm’s average total cost and its marginal cost compared to the price in the long-run equilibrium.

 

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Price Discrimination and its Effects on Efficiency in Monopolistic Markets

Discrimination is never considered a good thing, is it? Discriminating based on race, gender, or age is usually frowned upon. But in the business world, it is all too common. Consider some of the following example of price discrimination by businesses:

  • Movie theaters: Charge different prices based on age. Seniors and youth pay less since they tend to be more price sensitive.
  • Gas stations: Gas stations will charge different prices in different neighborhoods based on relative demand and location.
  • Quantity discounts: Grocery stores give discounts for bulk purchases by customers who are price sensitive (think “buy one gallon of milk, get a second gallon free”… the family of six is price sensitive and is likely to pay less per gallon than the dual income couple with no kids who would never buy two gallons of milk).
  • Hotel room rates: Some hotels will charge less for customers who bother to ask about special room rates than to those who don’t even bother to ask.
  • Telephone plans: Some customers who ask their provider for special rates will find it incredibly easy to get better calling rates than if they don’t bother to ask.
  • Airline ticket prices: Weekend stayover discounts for leisure travelers mean business people, whose demand for flights is highly inelastic, but who will rarely stay over a weekend, pay far more for a round-trip ticket that departs and returns during the week.

Price discrimination occurs any time a firm with market power charges different prices to consumers based on their willingness to pay or their sensitivity to price changes.

The results of price discrimination are not all bad, either. In fact, such practices usually result in a higher level of output than would be achieved if a firm charged a single price to all consumers. As a result, more people can afford to buy the good in question and a greater level of allocative efficiency is achieved.

This lesson will define price discrimination, outline the conditions necessary for it to occur, and explain the different degrees of price discrimination. We will then illustrate the effect of perfect price discrimination and attempt to conclude whether or not it is good overall for society by looking at the effect it has on consumers and producers.

 

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Natural Monopoly and the need for Government Regulation

In most cases, it can be argued that increased competition in a market will lead to an increase in efficiency, benefiting society and consumers. More competition, it can be argued, puts downward pressure on prices and forces firms to use their resources in a more efficient manner, encouraging firms to reduce their average total costs.

But what if the total demand for a good in a particular market is not high enough to necessitate more than one firm producing the good in question? In other words, what if having more than one firm means that each individual producer will have higher average total costs than a single firm would have? Such a scenario exists if the market demand curve intersects a monopolist’s average total cost curve in the range in which economies of scale are experienced, in other words where ATC it still decreasing. This is known as a natural monopoly.

Such industries exist, particularly in the case of large utilities such as water, electricity, natural gas, sewage and garbage collection. Think about the town you live in: how many firms can you choose to buy your electricity from? The answer is most likely ONE. Would you be better off if the answer were 100? Probably not. Here’s why: If 100 firms competed to provide electricity to your city, no single firm would achieve the economies of scale needed to lower its average total cost to a level that would allow it to provide electricity at the low, desirable rates that you currently pay. With 100 firms providing electricity, each firm would have much higher average costs and therefore would have to charge higher prices to their consumers! Competition would drive the price UP, instead of DOWN, like it is supposed to do, due to the significant economies of scale, namely the huge fixed costs of capital and infrastructure, needed to provide a utility such as electricity.

The problem with natural monopolies is that if they are left unregulated, they will produce much less and charge a price much higher than what is socially optimal (where marginal benefit equals marginal cost). Thus arises the need for regulation. This lesson will explain the theory of natural monopolies and examine the use of subsidies and price controls to promote a more socially optimal outcome in such industries.

After watching this lesson, read and respond to the discussion questions for the following blog post:  Monopoly prices – to regulate or not to regulate, that is the question!

 

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Profit Maximization, Revenue Maximization and PED in Pure Monopoly

A monopolist, having total control over the level of output it produces and the price it charges, will generally be interested in maximizing its profits. But what if a firm decides that it is revenues that should be maximized instead?

This lesson will examine the profit maximization rule as it applies to a pure monopolist, and introduce the revenue maximization rule, which tells a monopolist the quantity it should produce at in order to earn the maximum level of revenues possible. We will examine the level of economic profits earned at one level compared to the other. Additionally, we will look at the price elasticity of demand for a monopolist’s product by revisiting the total revenue test of elasticity.


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Introduction to Pure Monopoly

After studying the theories of perfect competition, we now transition into the opposite extreme in the spectrum of competition between firms. ‘Mono’ means ‘one’ and ‘poly’ means ‘seller’. A monopolistic market, therefore, is one in which only a single seller produces the output for the entire market. Examples of pure monopolies are rare, but they do exist; some examples include:

  • Utility companies, such as water and electricity, in particular towns,
  • Cell service providers in some countries
  • Professional sports teams (the Denver Broncos are the only professional football team in Denver)
  • Microsoft (a near monopolist in PC operating systems)

There have been many monopolies in various markets throughout history, but often such firms get broken up into smaller firms, sometimes due to government intervention aimed at increasing competition to lower prices for consumers.

That brings us to some of the characteristics of monopolistic markets: Besides there being just one seller, such firms are also price-makers, they face a downward sloping demand curve (compared to the PC firm’s perfectly elastic demand), and there are high barriers to entry, enabling monopolists to earn economic profits in the long-run. In addition, the marginal revenue a firm receives for additional units of output is always lower than the price it is selling the output for. This last characteristic may sound mundane, but in fact it is the reason monopolists will always charge higher prices and produce at lower quantities than perfectly competitive markets.

This lesson will introduce some of the characteristics of monopolies and use a demand schedule to derive the demand and marginal revenue curves for a hypothetical monopolistic airplane manufacturer. We will then place cost curves on the graph to determine the profit maximizing quantity a monopolist should produce at, and we’ll briefly examine the level of output and price as it would compare to a perfectly competitive market.

 

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Allocative and Productive Efficiency in Perfectly Competitive Markets

Perfectly competitive markets, as rare as they are in reality, are useful to examine in theory, for they exhibit characteristics that no other market structure will exhibit. Specifically, perfectly competitive markets achieve a level of efficiency not likely to be seen in less competitive markets such as oligopoly, monopoly and monopolistic competition.

Efficiency in Economics is defined in two different ways: allocative efficiency, which deals with the quantity of output produced in a market, and productive efficiency, which requires that firms produce their products at the lowest average total cost possible. In perfect competition, both types of efficiency are achieved in the long-run.

This less will explain in detail what makes perfectly competitive markets economically efficient.

 

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The “Shut-down Rule” – When should a firm shut down to minimize its losses?

A firm in a competitive market may find itself experiencing economic losses if demand for its product falls or if the supply from other firms increases too rapidly. No one likes losing money, but should a firm get out of the market as soon as losses are experienced? Not necessarily.

If the losses a firm experiences are relatively small, it may be better off sticking things out and hoping price rises, returning the firm to a break-even level. However, if losses are greater than the firm’s fixed costs, the firm can actually minimize its losses by shutting down.

This lesson illustrates two situations in which a firm in a perfectly competitive market is earning economic losses. In one case, the losses are less than the firm’s total fixed costs. In another, the firm’s losses exceed its fixed costs, meaning the firm is better off shutting down.

 

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From Short-run to Long-run in Perfectly Competitive Markets

Every firm would love to earn economic profits in the long-run. This is, after all the whole reason firms exist: to earn profits! But in perfectly competitive markets the likelihood of economic profits being earned in the long-run is very low, due to one key characteristic of such markets: the lack of entry barriers.

Likewise, if losses are being earned in the short-run, the ease with which firms can exit the market mean that, most likely, those losses will be eliminated in the long-run. This lesson will explain and illustrate the adjustments that perfectly competitive markets and firms undertake in the long-run in response to the existence of economic profits and losses. As we will see, perfectly competitive firms will, in all likelihood, break even in the long-run once firms have had the chance to adjust to the levels of profits or losses experienced.

 

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Demand, Marginal Revenue and Profit Maximization for a Perfect Competitor

Perfect competition is a market structure in which thousands of identical firms compete to sell identical products, and in which no one firm has any control over the market price. Demand for and supply of the product in the market determines the price that each individual firm faces, and each firm can sell as much or as little output as it desires at the market price.

With these assumptions in mind, we will derive a demand curve for an individual perfect competitor’s output, which we will see is perfectly elastic. Facing the demand determined by the market, an individual firm must decide at what quantity its profits will be maximized. Using the profit maximization rule, any firm should be able to optimize its output to earn the highest per unit profit possible.

This video explains how an individual firm in a perfectly competitive market should decide the best quantity to produce to maximize profits.

 

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Long-run Average Total Cost and Economies of Scale

When a firm has time to expand or reduce the amount of capital and land it employs in its production, it may find its average, per-unit production costs either rising or falling with the amount of capital it uses. This phenomenon is known as economies of scale (or size).

Sometimes, the larger a firm becomes, the more it produces, the lower its average costs of production. On the other hand, it is possible for a firm to become too big for its own good, and experience diseconomies of scale: when producing more output leads to rising average costs.

This lesson distinguishes between a firm’s short-run average total cost and its long-run average total cost, and explains how economies of scale may help a firm achieve lower average costs as it increases its output in the long-run.

 

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The Relationships between Short-run Costs of Production

This lesson will examine the relationships between a firm’s short-run, per-unit costs of production: the marginal costs, average variable and average total costs of production (as well as, although not explicitly, the average fixed cost).

Previous lessons have explored the law of diminishing marginal returns, its effect on the productivity of a variable resource in the short-run (assumed to be labor) and how productivity and costs are related:

This lesson focuses on just the per-unit cost curves, their shapes, and the relationships between them. As you will see, the marginal cost curve, itself shaped by the law of diminishing returns, intersects the average cost curves at their lowest points, which as we will see in later lessons enables producers to choose a level of output at which their per unit production costs are minimized, enabling firms to make decisions that allow them to optimize their output for profit-maximization.

 

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Short-run Productivity, Costs and the Law of Diminishing Marginal Returns

In the last lesson it was shown how the law of diminishing marginal returns affects the productivity of labor as a firm varies the number of workers employed towards the production of its output in the short-run. Due to the fact that capital and land are fixed in quantity, the addition of more workers to a factory will ultimately lead to the marginal product of labor declining, and even becoming negative if too many workers try to squeeze into a limited amount of space and work with a fixed number of tools.

The most significant implication of the law of diminishing marginal returns for a producer is the effect it has on a firm’s costs of production in the short-run. A firm’s variable costs are determined by the productivity of labor, since labor is the primary variable resource. When worker productivity is rising, a firm’s costs are falling; but when the firm begins experiencing diminishing marginal returns, productivity fall and the cost of additional units of output begins to rise.

This lesson illustrates using data and graphs the relationship between productivity and costs in the short-run, and how the law of diminishing marginal returns determines the shapes of the short-run cost curves: marginal cost and average variable cost.

 

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Understanding the relationships between Total, Marginal and Average Product

This lesson is the second in the series on short-run costs of production and the law of diminishing returns. Before watching this video, make sure you’ve seen the last one in the series: THE LAW OF DIMINISHING RETURNS IN A TOY TRUCK FACTORY

In this lesson we will examine the changes in productivity experienced as more labor is added to a fixed amount of capital, measuring not only the total product, but also the marginal and average outputs of labor. Once we have output data in a table, we will graph the TP, MP and AP curve and examine the mathematical relationships between these curves.

Understanding the relationships between a firm’s short-run productivity curves will provide us with a basis for understanding how a firm’s costs of production change as the firm varies its level of output in the short-run.

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The Law of Diminishing Returns in a Toy Truck Factory

The law of diminishing returns is a simple, yet fundamental concept in economics. When the producer of a good wishes to expand its output, in the short-run it may do so by employing more workers or having its existing workers work longer hours. To acquire more capital and technology or to build new factories takes time and money, thus we say that in the short-run, a firm’s plant size is fixed; the only variable resource is labor.

But to what extent can production increase when only the amount of labor employed can change? This video lesson explains the principle of diminishing marginal returns, which says that as additional units of a variable resource (labor) are added to a fixed resource (capital), beyond a certain point the output attributable to additional units of the variable resource will decline. With only a limited supply of technology at their disposal, workers in a factory can only increase their productivity to an extent.

If a firm wishes to expand its production in the long-run, it must acquire more capital in order to allows for continued increases in the productivity of labor. This video will illustrate, using a toy truck factory employing tools and labor, the principle of diminishing marginal returns.

For some lesson ideas and blog posts on Diminishing Returns, check out this page from my blog: Economics in Plain English – the Law of Diminishing Marginal Returns

 

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