9781118041581

Price Competition 367

FIGURE 9.3

Optimal Output with

Kinked Demand

If the demand curve is

kinked, the firm’s

marginal revenue

curve has a gap at

quantity Q*.

to lower marketwide prices.) In other words, when it comes to price reductions,

demand is relatively inelastic. Conversely, suppose the firm raises its price above

P*. By holding to their present prices, rival firms can acquire market share from

the price raiser. If the other firms do not follow, the firm will find its sales falling

precipitously for even small price increases. In short, demand is elastic for price

increases. This explains the demand curve’s kink at the firm’s current price.

In view of kinked demand, the firm’s profit-maximizing price and quantity

are simply P* and Q*. This is confirmed by noting that the firm’s marginal rev-

enue curve in Figure 9.3 is discontinuous. The left part of the MR curve corre-

sponds to the demand curve to the left of the kink. But MR drops discontinuously

if price falls slightly below P*. The presence of the vertical discontinuity in MR

means that P* and Q* are optimal as long as the firm’s marginal cost curve

crosses MR within the gap. The dotted MC curve in the figure shows that marginal

P*

Demand

MC

MC′

MR

Q*

Dollars per Unit of Output

Output

c09Oligopoly.qxd 9/29/11 1:32 PM Page 367