After the Economics Lecture (and Jiaguang's amazing drawing) we have learnt what is a kinked demand curve and its use in oligopoly.
I have a paradox concerning this fact.
Imagine that there are (only) two companies monopolizing an (imaginary) product for a market, say, kalodite. Therefore, since rival fails to match price increases but always match price decreases in the market, we can safely assume that the demand curve is considered as being 'kinked' to both firms.
However, there is a more complicated fact: Company A purifies (then sells) the kalodite by a cheap method, while (due to lack of information), company B purifies it by an expensive method. Although both have very high market share and sell at the same price (price stickiness), it is undeniable that Company A and company B have cost differentials, and therefore MC & AC of Company B is higher than that of A.
Assume one day that the price of the material that is VERY essential for the purification of the kaladoite, (known here as garatheum), suddenly shoots up to the moon (and being a mineral, the price of garatheum fluctuates very wildly (and extremely)) and the cost of production of the product of kalodite shoots up as fast as a rocket, and the MC & AC curve shoots up like crazy, such that both Company A & B have no choice but to increase the price.
However, Company B purifies kaladoite with an expensive method, and hence the AVC curve rises above the demand curve, and hence the company earns subnormal and quits the market. (However, being a conglomerate, it can return to the market when the cost of production falls suitably and it can earn some profit).
As a result, the kinked demand curve of company A shows three straight-line sections, with an (relatively) inelastic demand curve at low price, elastic curve at the middle price section, and an inelastic demand curve at a higher price (because it becomes a monopoly and demand is now inelastic.)
We then plot the MR of the doubly-kinked demand curve. As one may draw, the MR falls steeply, rises (vertically) by a dotted line, and then falls gently (corresponding to the elastic section of the AR), drops vertically and then decreases steeply (inelastic section of curve).
[Well, you could try it out!]
As a matter of fact, there is a problem with our assumption now! Our MC curve [if you draw it] CUTS THROUGH 3 POINTS OF THE MR CURVE when MC is rising (once through the large-gradient MR section, through the vertically-rising section, and through the gently-falling section), and so the Company A can produce at three different prices for maximum profit!
What is the problem of this paradox then?
3 comments:
The kinked demand curve theory assumes that competitors match price decreases but not price increases. This has nothing to do with any rival company exiting the market. Hence the upper kink is invalid. No such paradox exists.
hmmm that is a good analysis of the problem.
This are the few logical fallacies that I have made in the paradox:
(1) The lower kink still remains when the price is still set. (Which does not anymore, since the price has already changed, and it should be sticky at the new price, right?)
(2)For the existance of the upper kink, I am not that sure about that (would somebody like to answer that?). We still have to realise that in the diagram, ALL points of the demand curve are still considered as being elastic, as the MR>0 at all points. Therefore to raise revenue at any point of time, companies always have to lower price.
(3) Economies of Scale. Since the MR curve represents short-run cost-of production, the MES (minimum efficient scale) is considered as the same for different factors of production. Since the situation here is assumed to be short-term, the MES is unlikely to change. Therefore, when the MR curve is drawn, it DOES NOT shift leftwards since minimum point is the same!
--> Besides that, it is also known that there is NO fixed demand curve/fixed supply curve for an oligopoly.
(Hopefully that could address some fo the problems that I have made even though they may be wrong. Does anybody want to comment?)
But if company B exits, the market structure completely changes, then why would you still have a kinked demand curve?
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