Question

Draw the demand and marginal revenue curves. Draw a vertical line at the market price. To the left of the vertical line, show the demand and marginal revenue curves for the firm before the elasticity shifted. To the right, show the demand and marginal revenue curves for the more inelastic assumption. Where does the kink in the demand curve occur? What happens to the marginal revenue curve?

Answer 1

The figure has a kink which establishes a price that is sticky at P*. The two demand curves D, and D, are drawn in a way that D2 is said to be more elastic because a price change is not matched by the rival firms. Similarly demand D1 is less elastic because a price cut Price is easilv matched. The more inelastic demand curve is relevant when rivals will match any change in the price level. Market operates at a kink where price is P* and quantity is q*. There is a discontinuity in the marginal revenues because of a gap between two values MR1 and MR2 signalling that marginal cost can rise between this discontinuous portion of marginal revenue and still the industry will charge the same price. The behaviour of rivals and the discontinuity of MR which allows marginal cost to hover up and down within the range of MRs, is the reason for price rigidity. Hence price is rigid and sticky at p*. The corresponding quantity determined in the model is therefore q* because of price rigidity. MC2 D2 MC1 R2 MR1 DI fe Quantity