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Difficulty: Very hardOligopoly: Characteristics, Types, and Price Interdependence

A dominant firm operating in a non-collusive oligopoly currently sells its product at a prevailing market price of P0=N4,000P_0 = \text{N}4,000. The price elasticity of demand for its product is ∣Ed∣=2.8|E_d| = 2.8 for prices above P0P_0, and ∣Ed∣=0.35|E_d| = 0.35 for prices below P0P_0. If an automated production process reduces the firm's marginal cost from MC1=N2,500MC_1 = \text{N}2,500 to MC2=N2,100MC_2 = \text{N}2,100, and this new marginal cost line continues to intersect the vertical gap in the marginal revenue curve, how will the firm adjust its price and output to maximize profits?

  1. Maintain both the current price at N4,000\text{N}4,000 and the existing output level, because the marginal cost shift remains within the discontinuous segment of the marginal revenue curve.Answer
  2. B
    Lower the market price below N4,000\text{N}4,000 and expand output to exploit the decrease in marginal cost.
  3. C
    Raise the market price above N4,000\text{N}4,000 to maximize profit along the elastic segment of the demand curve.
  4. D
    Reduce output while keeping the price constant at N4,000\text{N}4,000 to equate marginal revenue to the lower marginal cost.

Answer

The firm will maintain both its current price at N4,000\text{N}4,000 and its existing output level because the marginal cost reduction occurs entirely within the vertical discontinuity of its marginal revenue curve.
Under Paul Sweezy's kinked demand curve model, non-collusive oligopolists assume rivals will match price cuts but ignore price increases. This asymmetry creates a kink in the demand curve at the prevailing price and a corresponding vertical gap in the marginal revenue curve. Any change in marginal cost that stays within this gap leaves the profit-maximizing output and price unchanged, accounting for rigid prices in oligopolistic markets.

Step-by-Step Solution

1
Analyze the demand curve structure based on rival behavior assumptions.
Above P0=N4,000P_0 = \text{N}4,000, demand is elastic (∣Ed∣=2.8|E_d| = 2.8) because rivals do not follow price increases. Below P0P_0, demand is inelastic (∣Ed∣=0.35|E_d| = 0.35) because rivals match price cuts.
Asymmetric rival responses create a kinked demand curve at the prevailing price P0P_0.
2
Determine the impact of the kinked demand curve on the Marginal Revenue (MRMR) curve.
The abrupt drop in price elasticity at P0P_0 creates a vertical gap (discontinuity) in the MRMR curve directly below the kink point.
MRMR is derived from demand elasticity; a sudden drop in elasticity causes a step down in MRMR values at that specific quantity.
3
Evaluate the effect of the reduction in Marginal Cost (MCMC).
The shift from MC1=N2,500MC_1 = \text{N}2,500 to MC2=N2,100MC_2 = \text{N}2,100 occurs within the vertical boundaries of the MRMR gap.
Since the MCMC curve still passes through the vertical MRMR gap, the condition MR=MCMR = MC remains fulfilled at the same output and price level, demonstrating organizational price rigidity.

Key Concept

Price Rigidity and Discontinuous Marginal Revenue in Oligopoly
Estimated Time:2m 0s
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Topics

Oligopoly: Characteristics, Types, and Price Interdependence

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