Module IV

Market structure perfect and imperfect competition; monopoly, duopoly, oligopoly;

monopolistic competition, pricing methods under these competitive environments.

Profits

Profit has a number of meanings in economics. At its most basic level, profit is the reward gained by
risk taking entrepreneurs when the revenue earned from selling a given amount of output exceeds the
total costs of producing that output. This simple statement is often expressed as the profit identity,
which states that:

Total profits = total revenue (TR) total costs (TC)

However, the concept of profit needs clarification because there is no standard definition of what
counts as a cost.

Normal profit

In markets which are perfectly competitive, the profit available to a single firm in the long run is
called normal profit. This exists when total revenue, TR, equals total cost, TC. Normal profit is
defined as the minimum reward that is just sufficient to keep the entrepreneur supplying their
enterprise. In other words, the reward is just covering opportunity cost - that is, just better than the
next best alternative. The accounting definition of profits is rather different because the calculation of
profits is based on a straightforward numerical calculation of past monetary costs and revenues, and
makes no reference to the concept of opportunity cost. Accounting profit occurs when revenues are
greater than costs, and not equal, as in the case of normal profit.

To the economist, normal profit is a cost and is included in total costs of production.

Super-normal (economic) profit

If a firm makes more than normal profit it is called super-normal profit. Supernormal profit is also
called economic profit, and abnormal profit, and is earned when total revenue is greater than the total
costs. Total costs include a reward to all the factors, including normal profit. This means that, when
total revenue equals total cost, the entrepreneur is earning normal profit, which is the minimum
reward that keeps the entrepreneur providing their skill, and taking risks.

The level of super-normal profits available to a firm is largely determined by the level of competition
in a market the more competition the less chance there is to earn super-normal profits.

Marginal cost
A typical marginal cost curve with marginal revenue

Profit maximisation

Firms achieve maximum profits when marginal revenue (MR) is equal to marginal cost (MC), that is
when the cost of producing one more unit of a good or service is exactly equal to the revenue derived
from selling one extra unit.

Types of Market Systems

PERFECT COMPETITION

Perfect competition is a market system characterized by many different buyers and sellers. In the
classic theoretical definition of perfect competition, there are an infinite number of buyers and sellers.
With so many market players, it is impossible for any one participant to alter the prevailing price in
the market. If they attempt to do so, buyers and sellers have infinite alternatives to pursue. An ideal
market structure characterized by a large number of small firms, identical products sold by all firms,
freedom of entry into and exit out of the industry, and perfect knowledge of prices and technology.
This is one of four basic market structures. The other three are monopoly, oligopoly, and monopolistic
competition. Perfect competition is an idealized market structure that is not observed in the real world.
While unrealistic, it does provide an excellent benchmark that can be used to analyze real world
market structures. In particular, perfect competition efficiently allocates resources.

Perfect competition a market structure characterized by a large number of firms so small relative to
the overall size of the market, such that no single firm can affect the market price or quantity
exchanged. Perfectly competitive firms are price takers. They set a production level based on the price
determined in the market. If the market price changes, then the firm re-evaluates its production
decision. This means that the short-run marginal cost curve of the firm is its short-run supply curve.

Characteristics
Generally, a perfectly competitive market exists when every participant is a "price taker", and no
participant influences the price of the product it buys or sells. Specific characteristics may include:

Infinite buyers and sellers An infinite number of consumers with the willingness and
ability to buy the product at a certain price, and infinite producers with the willingness and
ability to supply the product at a certain price.
 Zero entry and exit barriers A lack of entry and exit barriers makes it extremely
easy to enter or exit a perfectly competitive market.

Perfect factor mobility In the long run factors of production are perfectly mobile,
allowing free long term adjustments to changing market conditions.

Perfect information - All consumers and producers are assumed to have perfect
knowledge of price, utility, quality and production methods of products.

Zero transaction costs - Buyers and sellers do not incur costs in making an exchange
of goods in a perfectly competitive market.

Profit maximization - Firms are assumed to sell where marginal costs meet marginal
revenue, where the most profit is generated.

Homogenous products - The qualities and characteristics of a market good or service

do not vary between different suppliers.

Non-increasing returns to scale - The lack of increasing returns to scale (or

economies of scale) ensures that there will always be a sufficient number of firms in
the industry.

Property rights - Well defined property rights determine what may be sold, as well
as what rights are conferred on the buyer

Short run Equilibrium

In the short run, perfectly-competitive markets are not productively

efficient as output will not occur where marginal cost is equal to average cost (MC=AC). They are
allocatively efficient, as output will always occur where marginal cost is equal to marginal revenue
(MC=MR). In the long run, perfectly competitive markets are both allocatively and productively
efficient.

In perfect competition, any profit-maximizing producer faces a market price equal to its marginal cost
(P=MC). This implies that a factor's price equals the factor's marginal revenue product. It allows for
derivation of the supply curve on which the neoclassical approach is based. This is also the reason
why "a monopoly does not have a supply curve". The abandonment of price taking creates
considerable difficulties for the demonstration of a general equilibrium except under other, very
specific conditions such as that of monopolistic competition.
In the short run, it is possible for an individual firm to make an economic profit. This situation is
shown in this diagram, as the price or average revenue, denoted by P, is above the average cost
denoted by C .

Long term equilibrium under perfect competition.

If firms are perfectly competitive, industry is making short term surplus

(profits), more firms will enter the industry. In the long run this will increase the market supply of the
product and reduces the market price as well as the profits until all firms in the industry make a
normal profit (break even ). However, in the long period, economic profit cannot be sustained. The
arrival of new firms or expansion of existing firms (if returns to scale are constant) in the market
causes the (horizontal) demand curve of each individual firm to shift downward, bringing down at the
same time the price, the average revenue and marginal revenue curve. The final outcome is that, in the
long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve
will touch its average total cost curve at its lowest point.
Perfect Competition Long Run Equilibrium: Industry

It is the price at which total demand is exactly equal to total supply. Graphically it is the point where
DD curve and SS curve intersect each other.

Graph - Equilibrium Price Determination

In the above graphical diagram, the following points have been observed :-

1. On X axis, quantity demand and supplied per week has been given and on Y axis, price has
been given.

2. Buyers are purchasing more at lower price and vice versa. This negative relationship is shown
by downward sloping DD curve.

3. Sellers are selling more at higher price and vice versa. This positive relationship is shown by
upward sloping SS curve.

4. Rs. 30 is that price at which demand equates supply (300 units). So, Rs. 30 is an equilibrium
price and 300 units is an equilibrium quantity.

5. Suppose, price fails to Rs. 20/-, So this results into increase in demand (as per Law of
Demand) and decrease in supply (as per Law of Supply). Since DD > SS, i.e. because of low
supply, sellers will be dominant and competition will be among buyers, this leads to rise in
price level. (i.e. from Rs. 20 to Rs. 30) Again price will come back at original level i.e.
equilibrium price (Rs. 30).

6. Suppose, supply exceeds demand (DD < SS) now buyers become dominant and competition
will be among sellers. This leads to downfall in price. (i.e. from Rs. 40 to Rs.30). Again price
will come back to original level. i.e. equilibrium price (Rs. 30).

7. Such automatic adjustment by demand and supply forces will keep single price in marker

Definition of 'Imperfect Competition'

mperfect competition is a competitive market situation where there are many sellers, but they are
selling heterogeneous (dissimilar) goods.

Definition: Imperfect competition is a competitive market situation where there are many sellers, but
they are selling heterogeneous (dissimilar) goods as opposed to the perfect competitive market
scenario. As the name suggests, competitive markets that are imperfect in nature.

Description: Imperfect competition is the real world competition. Today some of the industries and
sellers follow it to earn surplus profits. In this market scenario, the seller enjoys the luxury of
influencing the price in order to earn more profits.

If a seller is selling a non identical good in the market, then he can raise the prices and earn profits.
High profits attract other sellers to enter the market and sellers, who are incurring losses, can very
easily exit the market.

There are four types of imperfect markets:

- Monopoly (only one seller) - Oligopoly (few sellers of goods) - Monopolistic competition (many
sellers with highly differentiated product) - Monopsony (only one buyer of a product)

MONOPOLY
A monopoly is the exact opposite form of market system as perfect
competition. In a pure monopoly, there is only one producer of a particular good or service, and
generally no reasonable substitute. In such a market system, the monopolist is able to charge whatever
price they wish due to the absence of competition, but their overall revenue will be limited by the
ability or willingness of customers to pay their price.Monopoly is an extreme form of market
structure. The word monopoly is derived from two Greek words-Mono and Poly. Mono means single
and Poly means 'seller'. Thus monopoly means single seller. Monopoly is a firm of market
organization for a commodity in which there is only one single seller of the commodity.

In short monopoly is a form of market structure where there is a single seller producing a commodity
having no close substitute? Under monopoly there is no rival or competitors. The degree of
competition in monopoly is nil. Thus if the buyers is to purchase the commodity, he can purchase it
only from that seller. The seller dictates the price to consumers. Unlike perfect competition a
monopolist can fix up the price.As monopoly is a form of imperfect market organization, there is no
difference between firm and industry. A monopoly firm is said to be an industry. Thus monopoly
means the absence of competition. There are strong barriers to entry into the industry. As a result,
seller has full control over the supply of the commodity.

Features of Monopoly:

1. One seller and large number of buyers:

Monopoly is a form of imperfect market structure where there is only one seller of a product. A
monopoly firm may be owned by a person, a few numbers of partners or a joint stock company. The
characteristic feature of single seller eliminates the distinction between the firm and the industry. A
monopolist firm is itself 'the industry. Under monopoly there are large numbers of buyers although the
seller is one. No buyer's reaction can influence the price.

2. No close substitute:
Under monopoly a single producer produces single commodities which have no close substitute. As
the commodity in question has no close substitute, the monopolist is at liberty to change a price
according to his own whimsy. Monopoly can not exist when there is competition.

A firm is said, to be monopolist only when it is the single producer and supplier of the product which
have no close substitute. Under monopoly the cross elasticity of demand is zero. Cross elasticity of
demand shows a change in the demand for a good as a result of change in the price of another good.

3. Strong barriers to the entry into the industry exist:

In a monopoly market there is strong barrier on the entry of new firms. Monopolist faces no
competition. As there is one firm no other rival producers can enter the market of the same product.
Since the monopolist has absolute control over the production and sale of the commodity certain
economic barriers are imposed on the entry of potential rivals.

4. Nature of demand curve:

In case of monopoly one firm constitutes the whole industry. The entire demand of the consumers for
a product goes to the monopolist. Since the demand curve of the individual consumers lopes
downward, the monopolist faces a downward sloping demand curve.

A monopolist can sell more of his output only at a lower price and can reduce the sale at a high price.
The downward sloping demand curve expresses that the price (AR) goes on falling ns sales are
increased. In monopoly AR curve slopes downward mid MR curve lies below AR curve. Demand
curve under monopoly la otherwise known as average revenue curve.

The Monopolists Demand Curve

Be careful of saying that "monopolies can charge any price they like" - this is
wrong. It is true that a firm with monopoly has price-setting power and will look to earn high levels
of profit. However the firm is constrained by the position of its demand curve. Ultimately a monopoly
cannot charge a price that the consumers in the market will not bear.

A pure monopolist is the sole supplier in an industry and, as a result, the monopolist can take the
market demand curve as its own demand curve. A monopolist therefore faces a downward sloping AR
curve with a MR curve with twice the gradient of AR. The firm is a price maker and has some power
over the setting of price or output. It cannot, however, charge a price that the consumers in the market
will not bear. In this sense, the position and the elasticity of the demand curve acts as a constraint on
the pricing behaviour of the monopolist. Assuming that the firm aims to maximise profits (where
MR=MC) we establish a short run equilibrium as shown in the diagram below.

Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run
equilibrium as shown in the diagram below.
The profit-maximising output can be sold at price P1 above the average cost AC at output Q1. The
firm is making abnormal "monopoly" profits (or economic profits) shown by the yellow shaded
area. The area beneath ATC1 shows the total cost of producing output Qm. Total costs equals average
total cost multiplied by the output

Price Discrimination

Price discrimination or price differentiation exists when sales of

identical goods or services are transacted at different prices from the same provider. In a theoretical
market with perfect information, perfect substitutes, and no transaction costs or prohibition on
secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of
monopolistic and oligopolistic markets, where market power can be exercised. Otherwise, the
moment the seller tries to sell the same good at different prices, the buyer at the lower price can
arbitrage by selling to the consumer buying at the higher price but with a tiny discount. However,
product heterogeneity, market frictions or high fixed costs (which make marginal-cost pricing
unsustainable in the long run) can allow for some degree of differential pricing to different consumers,
even in fully competitive retail or industrial markets. Price discrimination also occurs when the same
price is charged to customers which have different supply costs.

DUOPOLY

Duopoly (from the Greek duo, two, and polein, to sell) is a type of oligopoly. This kind of
imperfect competition is characterized by having only two firms in the market producing a
homogeneous good. For simplicity purposes, oligopolies are normally studied by analysing duopolies.
What strategies firms follow and their interactions are a key feature of this market structure

A situation in which two companies own all or nearly all of the market for a given
product or service. A duopoly is the most basic form of oligopoly, a market dominated by a small
number of companies. A duopoly can have the same impact on the market as a monopoly if the two
players collude on prices or output. Collusion results in consumers paying higher prices than they
would in a truly competitive market and is illegal under U.S. antitrust law.

MONOPOLISTIC COMPETITION
Monopolistic competition is a type of market system combining elements
of a monopoly and perfect competition. Like a perfectly competitive market system, there are
numerous competitors in the market. The difference is that each competitor is sufficiently
differentiated from the others that some can charge greater prices than a perfectly competitive firm.
An example of monopolistic competition is the market for music. While there are many artists, each
artist is different and is not perfectly substitutible with another artist.

Characteristics features of Monopolistic Competition

The concept of monopolistic competition is more realistic than perfect

competition and pure monopoly. According to Chamberlain in real economic situation both monopoly
and competitive elements are present. Chamberlains monopolistic competition is the blending of
competition and monopoly. The most distinguishing feature of monopolistic competition is that the
products of various firms are not identical but different although they are close substitutes for each
other. Like perfect competition there are a large number of firms but unlike perfect competition the
firms produce differentiated products which are close substitutes of each other.

Under monopolistic competition there is freedom of entry and exit. Thus under monopolistic
competition it is found that both the features of competition and monopoly are present. In India, for
example, we find the monopolistic competition. In India there are a number of manufacturers
producing different brands of tooth paste viz Colgate, Pepsodent. Promise, Close-up, Prudent and
Forhans etc.

The manufacturer of Colgate has got the monopoly of producing it. Nobody can produce and sell
tooth paste with the name Colgate. But at the same time he faces competition from other manufactures
of tooth paste as their products are close substitutes of Colgate tooth paste. Thus we find that
monopolistic competition is the real market structure than either pure competition or monopoly.
Important features of monopolistic competition

1. Existence of large number of firms:

The first important feature of monopolistic competition is that there is a large number of firms
satisfying the market demand for the product. As there are a large number of firms under monopolistic
competition, there exists stiff competition between them. These firms do not produce perfect
substitutes. But the products are close substitute for each other.

(2) Product differentiations:

The various firms under monopolistic competition bring out differentiated products which are
relatively close substitutes for each other. So their prices cannot be very much different from each
other. Various firms under monopolistic competitors compete with each other as the products are
similar and close substitutes of each other. Differentiation of the product may be real or fancied.

Real or physical differentiation is done through differences in materials used, design, color etc.
Further differentiation of a particular product may be linked with the conditions of his sale, the
location of his shop, courteous behaviour and fair dealing etc.

(3) Some influence over the price:

As the products are close substitutes of others any reduction of price of a commodity by a seller will
attract some customers of other products. Thus with a fall in price quantity demanded increases. It
therefore, implies that the demand curve of a firm under monopolistic competition slopes downward
and marginal revenue curve lies below it.

Thus under monopolistic competition a firm cannot fix up price but has influence over price. A firm
can sell a smaller quantity by increasing price and can sell more by reducing price. Thus under
monopolistic competition a firm has to choose a price-output combination that will maximize price.

(4) Absence of firm's interdependence:

Under oligopoly, the firms are dependent upon each other and can't fix up price independently. But
under monopolistic competition the case is not so. Under monopolistic competition each firm acts
more or less independently. Each firm formulates its own price-output policy upon its own demand
cost.

(5) Non-price competition:

Firms under monopolistic competition incur a considerable expenditure on advertisement and selling
costs so as to win over customers. In order to promote sale firms follow definite -methods of
competing rivals other than price. Advertisement is a prominent example of non-price competition.

The advertisement and other selling costs by a firm change the demand for his product. The rival
firms compete with each other through advertisement by which they change the consumer's wants for
their products and attract more customers.
(6) Freedom of entry and exit:

In a monopolistic competition it is easy for new firms to enter into an existing firm or to leave the
industry. Lured by the profit of the existing firms new firms enter the industry which leads to the
expansion of output. But there exists a difference.

Under perfect competition the new firms produce identical products, but under monopolistic
competition, the new firms produce only new brands of product with certain product variation. In such
a law the initial product faces competition from the existing well- established brands of product.

Equilibrium under monopolistic competition

In the short run supernormal profits are possible, but in the long run new firms are attracted into the
industry, because of low barriers to entry, good knowledge and an opportunity to differentiate.

Monopolistic competition in the short run :

As new firms enter the market, demand for the existing firms products becomes more
elastic and the demand curve shifts to the left, driving down price. Eventually, all super-normal profits
are eroded away.
Examples of monopolistic competition
Examples of monopolistic competition can be found in every high street.Monopolistically competitive
firms are most common in industries where differentiation is possible, such as:

The restaurant business

Hotels and pubs

General specialist retailing

Consumer services, such as hairdressing

The survival of small firms

The existence of monopolistic competition partly explains the survival of small firms in modern
economies. The majority of small firms in the real world operate in markets that could be said to be
monopolistically competitive.

The advantages of monopolistic competition

Monopolistic competition can bring the following advantages:

1. There are no significant barriers to entry ; therefore markets are relatively contestable.

2. Differentiation creates diversity, choice and utility. For example, a typical high street in any
town will have a number of different restaurants from which to choose.

3. The market is more efficient than monopoly but less efficient than perfect competition - less
allocatively and less productively efficient. However, they may be dynamically efficient,
innovative in terms of new production processes or new products. For example, retailers often
constantly have to develop new ways to attract and retain local custom.

The disadvantages of monopolistic competition

There are several potential disadvantages associated with monopolistic competition, including:

1. Some differentiation does not create utility but generates unnecessary waste, such as excess
packaging. Advertising may also be considered wasteful, though most is informative rather
than persuasive.

2. As the diagram illustrates, assuming profit maximisation, there is allocative inefficiency in

both the long and short run. This is because price is above marginal cost in both cases. In the
long run the firm is less allocatively inefficient, but it is still inefficient.
 OLIGOPOLY
An oligopoly is similar in many ways to a monopoly. The primary difference is that rather than having
only one producer of a good or service, there are a handful of producers, or at least a handful of
producers that make up a dominant majority of the production in the market system. While
oligopolists do not have the same pricing power as monopolists, it is possible, without diligent
government regulation, that oligopolists will collude with one another to set prices in the same way a
monopolist would.

Characteristic features of oligopolistic market

The term oligopoly is derived from two Greek words, Olegs and 'Pollen'. Olegs means a few and
Pollen means to sell thus. Oligopoly is said to prevail when there are few firms or sellers in the market
producing and selling a product. Oligopoly is often referred to as competition among the few". In
brief oligopoly is a kind of imperfect market where there are a few firm in the market, producing
either and homogeneous product or producing product which are close but not perfect substitutes of
each other. There is no such border line between a few and many. Usually oligopoly is understood to
prevail when the numbers of sellers of a product are two to ten. Oligopoly is of two types-oligopoly
without product differentiation or pure. Oligopoly and oligopoly with product differentiation.

Characteristics of Oligopoly:

1. Interdependence:

The firms under oligopoly are interdependent in making decision. They are interdependent because
the number of competition is few and any change in price & product etc by an firm will have a direct
influence on the fortune of its rivals, which in turn retaliate by changing their price and output. Thus
under oligopoly a firm not only considers the market demand for its product but also the reactions of
other firms in the industry. No firm can fail to take into account the reaction of other firms to its price
and output policies. There is, therefore, a good deal of interdependences of the firm under oligopoly.

2. Importance of advertising and selling costs:

The firms under oligopolistic market employ aggressive and defensive weapons to gain a greater
share in the market and to maximise sale. In view of this firms have to incur a great deal on
advertisement and other measures of sale promotion. Thus advertising and selling cost play a great
role in the oligopolistic market structure. Under perfect competition and monopoly expenditure on
advertisement and other measures is unnecessary. But such expenditure is the life-blood of an
oligopolistic firm.

3. Group behaviour:

Another important feature of oligopoly is the analysis -of group behaviour. In case of perfect
competition, monopoly and monopolistic competition, the business firms are assumed to behave in
such a way as to maximize their profits. The profit-maximizing behaviour on his part may not be
valid. The firms under oligopoly are interdependent as they are in a group.

4. Indeterminateness of demand curve:

This characteristic is the direct result of the interdependence characteristic of an oligopolistic firm.
Mutual interdependence creates uncertainty for all the firms. No firm can predict the consequence of
its price-output policy. Under oligopoly a firm cannot assume that its rivals will keep their price
unchanged if he makes charge in its own price. As a result, the demand curve facing an oligopolistic
firm losses its determinateness.

The demand curve as is well known, relates to the various quantities of the product that could be sold
it different levels of prices when the quantity to be sold is itself unknown and uncertain the demand
curve can't be definite and determinate.

5. Elements of monopoly:

There exist some elements of monopoly under oligopolistic situation. Under oligopoly with product
differentiation each firm controls a large part of the market by producing differentiated product. In
such a case it acts in its sphere as a monopolist in lining price and output.

6. Price rigidity:

Under oligopoly there is the existence price rigidity. Prices lend to be rigid and sticky. If any firm
makes a price-cut it is immediately retaliated by the rival firms by the same practice of price-cut.
There occurs a price-war in the oligopolistic condition. Hence under oligopoly no firm resorts to
price-cut without making price-output decision with other rival firms. The net result will be price
-finite or price-rigidity in the oligopolistic condition.

Kinked demand curve under oligopoly

The kinked demand curve theory is an economic theory regarding

oligopoly and monopolistic competition. When it was created, the idea fundamentally challenged
classical economic tenets such as efficient markets and rapidly changing prices, ideas that underlie
basic supply and demand models. Kinked demand was an initial attempt to explain sticky prices.,
"Kinked" demand curves and traditional demand curves are similar in that they are both downward-
sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend - the
"kink." Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in
the marginal revenue curve.An oligopolist faces a downward sloping demand curve but the elasticity
may depend on the reaction of rivals to changes in price and output.

KINKED-DEMAND CURVE ANALYSIS:

An analysis using the kinked-demand curve to explain rigid prices often found
with oligopoly. The kinked-demand curve contains two distinct segments--one for higher prices that is
more elastic and one for lower prices that is less elastic. Key to this analysis is that the corresponding
marginal revenue curve contains three segments--one associated with the more elastic segment, one
associated with the less elastic segment, and one associated with the kink. A profit-maximizing firm
can then equate marginal cost to a wide range of marginal revenue values along the vertical segment
of the marginal revenue curve. This suggests that marginal cost must change significantly before an
oligopolistic firm is inclined to change price.
The kinked-demand curve analysis of oligopoly builds on the notion of interdependent decision-
making to explain why prices tend to be relative stable or rigid. The key to this analysis is that
Kinked OmniCola Demand

competing firms do not respond in the same way when one firm increases or decreases its price.
Competing firms match price decreases, but not price increases. This means a firm is likely to lose
market share for price increases, but does not gain market share for price decreases. A firm has little to
gain from reducing prices and much to lose form raising prices. As such, the firm is inclined to keep
prices stable.

A Kinked-Demand Summary
The exhibit the right presents a typical kinked-demand curve, and corresponding marginal revenue
curve, facing an oligopolistic firm. This particular curve is that for the hypothetical Shady Valley soft
drink supplier, OmniCola.

Existing Price and Quantity: The initial price is $1 per can and the initial quantity sold is
10,000 cans. The "kink" in the demand curve occurs at this price and quantity. Note that this
analysis does not explain how the existing price and quantity came to be $1 per can and
10,000 cans. It only indicates how the firm reacts given this is the starting price and quantity.

Demand Curve: The demand curve facing OmniCola contains two segments. For prices above
$1 and quantities less that 10,000 cans, the demand curve is more elastic. If OmniColan
increases its price, other firms do not. As such, OmniCola loses market share and sees a
significant decrease in quantity demanded. For prices below $1 and quantities greater that
10,000 cans, the demand curve is less elastic. If OmniCola decreases its price, so too do other
firms. As such, OmniCola does not gain market share and sees only a minimal increase in
quantity demanded.

Marginal Revenue Curve: The marginal revenue curve facing OmniCola contains three
segments. For quantities less that 10,000 cans, the marginal revenue curve is relatively flat.
This segment is derived from the more elastic demand curve segment associated with higher
prices and lesser quantities. For quantities greater that 10,000 cans, the marginal revenue
curve is relatively steep. This segment is derived from the less elastic demand curve segment
associated with lower prices and greater quantities. At exactly 10,000 cans, the marginal
revenue curve is vertical. This segment is associated with the kink of the demand curve that
connects the more elastic segment with the less elastic segment.
Profit Maximization

Profit maximization is achieve with the equality between marginal revenue and marginal cost. The

graph to the right displays the kinked-demand curve for OmniCola and the corresponding marginal
revenue curve. The missing component of this analysis is the marginal cost curve. A click of the
[Marginal Cost] button reveals OmniCola's marginal cost curve.

By design, this marginal cost curve intersects the vertical segment of OmniCola's marginal revenue
curve, at $0.60 and 10,000 cans. In particular, this equality between marginal revenue and marginal
cost generates a profit-maximizing equilibrium at the initial quantity of 10,000 cans. Given the
demand facing OmniCola and given OmniCola's production cost, OmniCola cannot generate any
greater profit than it does by producing 10,000 cans that are sold for $1 each.

Oligopoly making profit

Limits
This kinked-demand curve analysis illustrates why oligopolistic firms might keep prices relatively
rigid. The explanation rests with interdependent decision-making among oligopolistic firms. Higher
prices are not matched by other firms, but lower prices are.

However, this analysis ONLY indicates why prices do not change. It does not explain why or how
prices are established in the first place. Why, for example, is the initial price of OmniCola $1? The
kinked-demand curve analysis offers no insight.

Suppose that OmniCola experiences relatively big increases or decreases in marginal cost such that a
new profit-maximizing price and quantity is selected. What happens to the kink? What happens if
marginal cost changes again?

Is a new kink immediately formed at the 5,000 can quantity and $1.10 price should marginal cost shift
leftward and upward? If production cost increases on Monday, then decreases on Tuesday, does
OmniCola return to the "original" price-quantity combination of $1 and 10,000 or is a "new" rigid
price established at $1.10 and the 5,000 can quantity? If a new kink is not established immediately,
how long does OmniCola need to operate at the 5,000 can quantity and $1.10 price before it becomes
the "initial" price and quantity? A week? A month? A year?

These are the sorts of questions that are NOT answered by the kinked-demand curve analysis. This
analysis only illustrates why prices remain rigid, NOT how prices are determined in the first place.