Kinked-Demand Theory of Oligopoly

 

As mentioned above, there is no single theory of oligopoly. The two that are most frequently discussed, however, are the kinked‐demand theory and the cartel theory. The kinked‐demand theory is illustrated in Figure and applies to oligopolistic markets where each firm sells a differentiated product. According to the kinked‐demand theory, each firm will face two market demand curves for its product. At high prices, the firm faces the relatively elastic market demand curve, labeled MD ₁ in Figure .

Corresponding to MD ₁ is the marginal revenue curve labeled MR _1. At low prices, the firm faces the relatively inelastic market demand curve labeled MD _2. Corresponding to MD ₂ is the marginal revenue curve labeled MR _2.

The two market demand curves intersect at point b. Therefore, the market demand curve that the oligopolist actually faces is the kinked‐demand curve, labeled abc. Similarly, the marginal revenue that the oligopolist actually receives is represented by the marginal revenue curve labeled adef. The oligopolist maximizes profits by equating marginal revenue with marginal cost, which results in an equilibrium output of Q units and an equilibrium price of P.

The oligopolist faces a kinked‐demand curve because of competition from other oligopolists in the market. If the oligopolist increases its price above the equilibrium price P, it is assumed that the other oligopolists in the market will not follow with price increases of their own. The oligopolist will then face the more elastic market demand curve MD ₁.

The oligopolist's market demand curve becomes more elastic at prices above P because at these higher prices consumers are more likely to switch to the lower‐priced products provided by the other oligopolists in the market. Consequently, the demand for the oligopolist's output falls off more quickly at prices above P; in other words, the demand for the oligopolist's output becomes more elastic.

If the oligopolist reduces its price below P, it is assumed that its competitors will follow suit and reduce their prices as well. The oligopolistic will then face the relatively less elastic (or more inelastic) market demand curve MD ₂. The oligopolies' market demand curve becomes less elastic at prices below P because the other oligopolists in the market have also reduced their prices. When oligopolists follow each others pricing decisions, consumer demand for each oligopolist's product will become less elastic (or less sensitive) to changes in price because each oligopolist is matching the price changes of its competitors.

The kinked‐demand theory of oligopoly illustrates the high degree of interdependence that exists among the firms that make up an oligopoly. The market demand curve that each oligopolist faces is determined by the output and price decisions of the other firms in the oligopoly; this is the major contribution of the kinked‐demand theory.

The kinked‐demand theory, however, is considered an incomplete theory of oligopoly for several reasons. First, it does not explain how the oligopolist finds the kinked point in its market demand curve. Second, the kinked‐demand theory does not allow for the possibility that price increases by one oligopolist are matched by other oligopolists, a practice that has been frequently observed. Finally, the kinked‐demand theory does not consider the possibility that oligopolists collude in setting output and price. The possibility of collusive behavior is captured in the alternative theory known as the cartel theory of oligopoly.

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Conditions for an Oligopolistic Market

 

Oligopoly is the least understood market structure; consequently, it has no single, unified theory. Nevertheless, there is some agreement as to what constitutes an oligopolistic market. Three conditions for oligopoly have been identified. First, an oligopolistic market has only a few large firms. This condition distinguishes oligopoly from monopoly, in which there is just one firm. Second, an oligopolistic market has high barriers to entry. This condition distinguishes oligopoly from perfect competition and monopolistic competition in which there are no barriers to entry. Third, oligopolistic firms may produce either differentiated or homogeneous products. Examples of oligopolistic firms include automobile manufacturers, oil producers, steel manufacturers, and passenger airlines.

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Monopolistic Competition in the Long-run

The difference between the short‐run and the long‐run in a monopolistically competitive market is that in the long‐run new firms can enter the market, which is especially likely if firms are earning positive economic profits in the short‐run. New firms will be attracted to these profit opportunities and will choose to enter the market in the long‐run. In contrast to a monopolistic market, no barriers to entry exist in a monopolistically competitive market; hence, it is quite easy for new firms to enter the market in the long‐run.

The monopolistically competitive firm's long‐run equilibrium situation is illustrated in Figure .

The entry of new firms leads to an increase in the supply of differentiated products, which causes the firm's market demand curve to shift to the left. As entry into the market increases, the firm's demand curve will continue shifting to the left until it is just tangent to the average total cost curve at the profit maximizing level of output, as shown in Figure . At this point, the firm's economic profits are zero, and there is no longer any incentive for new firms to enter the market. Thus, in the long‐run, the competition brought about by the entry of new firms will cause each firm in a monopolistically competitive market to earn normal profits, just like a perfectly competitive firm.

Excess capacity. Unlike a perfectly competitive firm, a monopolistically competitive firm ends up choosing a level of output that is below its minimum efficient scale, labeled as point b in Figure . When the firm produces below its minimum efficient scale, it is under‐utilizing its available resources. In this situation, the firm is said to have excess capacity because it can easily accommodate an increase in production. This excess capacity is the major social cost of a monopolistically competitive market structure.

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Profit Maximization

The monopolist's profit maximizing level of output is found by equating its marginal revenue with its marginal cost, which is the same profit maximizing condition that a perfectly competitive firm uses to determine its equilibrium level of output. Indeed, the condition that marginal revenue equal marginal cost is used to determine the profit maximizing level of output of every firm, regardless of the market structure in which the firm is operating.

In order to determine the profit maximizing level of output, the monopolist will need to supplement its information about market demand and prices with data on its costs of production for different levels of output. As an example of the costs that a monopolist might face, consider the data in Table . The first two columns of Table represent the market demand schedule that the monopolist faces. As the price falls, the market's demand for output increases. The third column reports the total revenue that the monopolist receives from each different level of output. The fourth column reports the monopolist's marginal revenue that is just the change in total revenue per 1 unit change of output. The fifth column reports the monopolist's total cost of providing 0 to 5 units of output. The sixth and seventh columns report the monopolist's average total costs and marginal costs per unit of output. The eighth column reports the monopolist's profits, which is the difference between total revenue and total cost at each level of output.

The monopolist will choose to produce 3 units of output because the marginal revenue that it receives from the third unit of output, $4, is equal to the marginal cost of producing the third unit of output, $4. The monopolist will earn $12 in profits from producing 3 units of output, the maximum possible.

Graphical illustration of monopoly profit maximization. Figure illustrates the monopolist's profit maximizing decision using the data given in Table . Note that the market demand curve, which represents the price the monopolist can expect to receive at every level of output, lies above the marginal revenue curve.

The result of the monopolist's price searching is a price of $8 per unit. This equilibrium price is determined by finding the profit maximizing level of output—where marginal revenue equals marginal cost (point c)—and then looking at the demand curve to find the price at which the profit maximizing level of output will be demanded.

Monopoly profits and losses. The monopoly in the preceding example made profits of $12. These profits are illustrated in Figure as the shaded rectangle labeled abcd. While you usually think of monopolists as earning positive economic profits, this is not always the case. Monopolists, like perfectly competitive firms, can also incur losses in the short‐run. Monopolists will experience short‐run losses whenever average total costs exceed the price that the monopolist can charge at the profit maximizing level of output.

Absence of a monopoly supply curve. In Figure , there is no representation of the monopolist's supply curve. In fact, the monopolist's supply schedule cannot be depicted as a supply curve that is independent of the market demand curve. Whereas a perfectly competitive firm's supply curve is equal to a portion of its marginal cost curve, the monopolist's supply decisions do not depend on marginal cost alone. The monopolist looks at both the marginal cost and the marginal revenue that it receives at each price level. In order to determine marginal revenue, the monopolist must know market demand. Therefore, the monopolist's market supply will not be independent of market demand.

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Demand in a Monopolistic Market

 

Because the monopolist is the market's only supplier, the demand curve the monopolist faces is the market demand curve. You will recall that the market demand curve is downward sloping, reflecting the law of demand. The fact that the monopolist faces a downward‐sloping demand curve implies that the price a monopolist can expect to receive for its output will not remain constant as the monopolist increases its output.

Price‐searching behavior. Unlike a perfectly competitive firm, the monopolist does not have to simply take the market price as given. Instead, the monopolist is a price searcher; it searches the market demand curve for the profit maximizing price. The monopolist's search for the profit maximizing price involves comparing the marginal revenue and marginal cost associated with each possible price‐output combination on the market demand curve.

Declining marginal revenue and price. The monopolist's marginal revenue from each unit sold does not remain constant as in the case of the perfectly competitive firm. The monopolist faces the downward‐sloping market demand curve, so the price that the monopolist can get for each additional unit of output must fall as the monopolist increases its output. Consequently, the monopolist's marginal revenue will also be falling as the monopolist increases its output. If it is assumed that the monopolist cannot price discriminate, that is, charge a different price for each unit of output it produces, then the monopolist's marginal revenue from each additional unit produced will not equal the price that the monopolist charges. In fact, the marginal revenue that the monopolist receives from producing an additional unit of output will always be less than the price that the monopolist can charge for the additional unit.

To understand why, consider a monopolist that is currently supplying N units of output. Suppose the monopolist decides to supply 1 more unit. It therefore increases its supply to N + 1 units of output. The downward‐sloping market demand curve indicates that the new market price will be lower than before. Because the monopolist cannot price discriminate, it will have to sell all N + 1 units of output at the new lower price. This new lower price reduces the total revenue that the monopolist receives from the first N units sold. At the same time, the monopolist will gain some revenue from the additional unit it supplies. The marginal revenue that the monopolist receives from supplying 1 additional unit is equal to the price that it receives for this unit minus its loss in revenue from having to sell N units of output at a lower market price. Thus, the price the monopolist receives from selling N + 1 units exceeds the marginal revenue that it receives from supplying the additional unit of output.

The relationship between marginal revenue and price in a monopolistic market is best understood by considering a numerical example, such as the one provided in Table .

The first two columns of Table , labeled “Output” and “Price,” represent the market demand schedule that the monopolist faces. As the price falls, the market's demand for output increases, in keeping with the law of demand. The third column reports the total revenue that the monopolist receives from each different level of output. The fourth column reports the monopolist's marginal revenue that is just the change in total revenue per 1 unit change of output. Note that the monopolist's marginal revenue is declining as output increases.

Suppose the monopolist is currently producing 2 units of output for which it is receiving a price of $10 per unit and a total revenue of $20 (2 × $10). Now, consider what happens when the monopolist increases its output to 3 units. The price that the monopolist can expect to receive falls to $8 per unit. At this new lower price, the total revenue the monopolist receives for the first two units of output it supplies falls from $20 to $16 (2 × $8), a loss of $4. The monopolist's marginal revenue is equal to the $8 that it receives from the third unit sold minus the loss in total revenue that it receives on the first two units due to the new lower price. Hence, the marginal revenue the monopolist receives from the third unit sold is $8 − $4 = $4, which is below the market price of $8.

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Conditions for Monopoly

In a perfectly competitive market, there are many firms, none of which is large in size. In contrast, in a monopolistic market there is only one firm, which is large in size. This one firm provides all of the market's supply. Hence, in a monopolistic market, there is no difference between the firm's supply and market supply.

Three conditions characterize a monopolistic market structure. First, there is only one firm operating in the market. Second, there are high barriers to entry. These barriers are so high that they prevent any other firm from entering the market. Third, there are no close substitutes for the good the monopoly firm produces. Because there are no close substitutes, the monopoly does not face any competition.

Barriers to entry. A barrier to entry is anything that prevents firms from entering a market. Many types of barriers to entry give rise to a monopolistic market structure. Some of the more common barriers to entry are

1. Patents: If a firm holds a patent on a production process, it can legally exclude other firms from using that process for a number of years. If there are no other production processes that can be used, the firm that holds the patent will have a monopoly.
2. Large start‐up costs: In some markets, firms will face large start‐up costs—for example, the cost of building a new production facility. If these start‐up costs are large enough, most firms will be discouraged from entering the market.
3. Limited access to resources: A monopolistic market structure is likely to arise when access to resources needed for production is limited. The market for diamonds, for example, is dominated by a single firm that owns most of the world's diamond mines.

Natural monopolies. Not all monopolies arise from these kinds of barriers to entry. A few monopolies arise naturally, in markets where there are large economies of scale. For example, a local telephone company's marginal and average costs tend to decline as it adds more customers; as the company increases its network of telephone lines, it costs the company less and less to add additional customers. The telephone company's long‐run average costs may eventually rise but only at a level of output that is beyond the level the local market demands. Hence, in the market for local telephone services, there is a need for only one firm; competition will not naturally arise. Gas, electric power, and other local utilities are also examples of natural monopolies.

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Costs of Monopoly

 

A monopolist produces less output and sells it at a higher price than a perfectly competitive firm. The monopolist's behavior is costly to the consumers who demand the monopolist's output. The cost of monopoly that is borne by consumers is illustrated in Figure . The firm's marginal cost curve is drawn as a horizontal line at the market price of $5.

In a perfectly competitive market, the firm's marginal revenue curve is also equal to the market price of $5. Therefore, total output in a perfectly competitive market will be 5 units. In a monopolistic market, however, marginal revenue and marginal cost intersect at 3 units of output. The monopolist sells its output at $7 per unit—the price on the market demand curve that corresponds to 3 units of output.

The cost to the consumer of a monopolistic market structure is the reduction in consumer surplus that results from monopoly output and price decisions. Under perfect competition, consumer surplus is given by the area of triangle, abd, in Figure . Under monopoly, this consumer surplus is reduced by the area of the trapezoid, fedb. Of this amount, the amount represented by fecb, now accrues to the monopolist; edc is the deadweight loss resulting from the monopolist charging a higher, inefficient price. Consumer losses from monopolistic markets have resulted in legal efforts to break up monopolies and government regulation of natural monopolies.

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Monopoly in the Long-Run

In the discussion of a perfectly competitive market structure, a distinction was made between short‐run and long‐run market behavior. In the long‐run, all input factors are assumed to be variable, making it possible for firms to enter and exit the market. The consequence of this entry and exit of firms was that each firm's economic profits were reduced to zero in the long‐run.

The distinction between the short‐run and the long‐run is not as important in the case of a monopolistic market structure. The existence of high barriers to entry prevents firms from entering the market even in the long‐run. Therefore, it is possible for the monopolist to avoid competition and continue making positive economic profits in the long‐run.

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Short-Run Supply

In determining how much output to supply, the firm's objective is to maximize profits subject to two constraints: the consumers' demand for the firm's product and the firm's costs of production. Consumer demand determines the price at which a perfectly competitive firm may sell its output. The costs of production are determined by the technology the firm uses. The firm's profits are the difference between its total revenues and total costs.

Total revenue and marginal revenue. A firm's total revenue is 

the dollar amount that the firm earns from sales of its output. If a firm decides to supply the amount Q of output and the price in the perfectly competitive market is P, the firm's total revenue is A firm's marginal revenue is the dollar amount by which its total revenue changes in response to a 1-unit change in the firm's output. If a firm in a perfectly competitive market increases its output by 1 unit, it increases its total revenue by P × 1 = P. Hence, in a perfectly competitive market, the firm's marginal revenue is just equal to the market price, P.

Short‐run profit maximization. A firm maximizes its profits by choosing to supply the level of output where its marginal revenue equals its marginal cost. When marginal revenue exceeds marginal cost, the firm can earn greater profits by increasing its output. When marginal revenue is below marginal cost, the firm is losing money, and consequently, it must reduce its output. Profits are therefore maximized when the firm chooses the level of output where its marginal revenue equals its marginal cost.

To illustrate the concept of profit maximization, consider again the example of the firm that produces a single good using only two inputs, labor and capital. In the short‐run, the amount of capital the firm uses is fixed at 1 unit. Assume that this firm is competing with many other firms in a perfectly competitive market. The price of the good sold in this market is $10 per unit. The firm's costs of production for different levels of output are the same as those considered in the numerical examples of the previous section, Theory of the Firm. These costs, along with the firm's total and marginal revenues and its profits for different levels of output, are reported in Table .

Because the price of the good is $10, the firm's total revenue is 10 × total product. The firm's marginal revenue is equal to the price of $10 per unit of total product. Notice that the marginal cost of the 29th unit produced is $10, while the marginal revenue from the 29th unit is also $10. Hence, the firm maximizes its profits by choosing to produce exactly 29 units of output. In choosing to produce 29 units of output, the firm earns $90 ($290 − 200) in profits.

Graphical illustration of short‐run profit maximization. The marginal revenue, marginal cost, and average total cost figures reported in the numerical example of Table are shown in the graph in Figure .

The firm's equilibrium supply of 29 units of output is determined by the intersection of the marginal cost and marginal revenue curves (point d in Figure ). When the firm produces 29 units of output, its average total cost is found to be $6.90 (point c on the average total cost curve in Figure ). The firm's profits are therefore given by the area of the shaded rectangle labeled abed.

The area of this rectangle is easily calculated. The length of the rectangle is 29. The width is the difference between the market price (the firm's marginal revenue), $10, and the firm's average cost of producing 29 units, $6.90. This difference is ($10 × $6.90) = $3.10. Hence, the area of rectangle abed is 29 × $3.1 = $90, the same amount reported in Table . In general, the firm makes positive profits whenever its average total cost curve lies below its marginal revenue curve.

Short‐run losses and the shut‐down decision. When the firm's average total cost curve lies above its marginal revenue curve at the profit maximizing level of output, the firm is experiencing losses and will have to consider whether to shut down its operations. In making this determination, the firm will take into account its average variable costs rather than its average total costs. The difference between the firm's average total costs and its average variable costs is its average fixed costs. The firm must pay its fixed costs (for example, its purchases of factory space and equipment), regardless of whether it produces any output. Hence, the firm's fixed costs are considered sunk costs and will not have any bearing on whether the firm decides to shut down. Thus, the firm will focus on its average variable costs in determining whether to shut down.

If the firm's average variable costs are less than its marginal revenue at the profit maximizing level of output, the firm will not shut down in the short‐run. The firm is better off continuing its operations because it can cover its variable costs and use any remaining revenues to pay off some of its fixed costs. The fact that the firm can pay its variable costs is all that matters because in the short‐run, the firm's fixed costs are sunk; the firm must pay its fixed costs regardless of whether or not it decides to shut down. Of course, the firm will not continue to incur losses indefinitely. In the long‐run, a firm that is incurring losses will have to either shut down or reduce its fixed costs by changing its fixed factors of production in a manner that makes the firm's operations profitable.

The case where the firm is incurring short‐run losses but continues to operate is illustrated graphically in Figure (a). At the market price, P ₁, the firm's profit maximizing quantity is Q ₁. At this quantity, the firm's average total cost curve lies above its marginal revenue curve, which is the flat, dashed line denoting the price level, P ₁. The firm's average variable cost curve, however, lies below its marginal revenue curve, implying that the firm is able to cover its variable costs. The firm's losses from producing quantity Q ₁ at price P ₁ are given by the area of the shaded rectangle, abcd. Despite these losses, the firm will decide not to shut down in the short‐run because it receives enough revenue to pay for its variable costs.

Figure (b) depicts a different scenario in which the firm's average total cost and average variable cost curves both lie above its marginal revenue curve, which is the dashed line at price P ₂. The firm's losses are given by the area of the shaded rectangle, abed. In this situation, the firm will have to shut down in the short‐run because it is unable to cover even its variable costs. As a general rule, a firm will shut down production whenever its average variable costs exceed its marginal revenue at the profit maximizing level of output. If this is not the case, the firm may continue its operations in the short‐run, even though it may be experiencing losses.

Short‐run supply curve. The firm's short‐run supply curve is the portion of its marginal cost curve that lies above its average variable cost curve. As the market price rises, the firm will supply more of its product, in accordance with the law of supply. If, however, the market price, which is the firm's marginal revenue curve, falls below the firm's average variable cost, the firm will shut down and supply zero output.

The firm's short‐run supply curve is illustrated in Figures (a) and (b). Here, the firm's short‐run supply curve is the portion of the marginal cost curve labeled ef. The market short‐run supply curve, like the market demand curve, is simply the horizontal summation of all the individual firms' short‐run supply curves.

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Demand in a Perfectly Competitive Market

The demand and supply curves for a perfectly competitive market are illustrated in Figure (a); the demand curve for the output of an individual firm operating in this perfectly competitive market is illustrated in Figure (b).

Note that the demand curve for the market, which includes all firms, is downward sloping, while the demand curve for the individual firm is flat or perfectly elastic, reflecting the fact that the individual takes the market price, P, as given. The difference in the slopes of the market demand curve and the individual firm's demand curve is due to the assumption that each firm is small in size. No matter how much output an individual firm provides, it will be unable to affect the market price. Note that the individual firm's equilibrium quantity of output will be completely determined by the amount of output the individual firm chooses to supply.

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