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Explain, using a clearly labelled diagram, the long-run equilibrium of a firm operating under oligopoly conditions - Leaving Cert Economics - Question b - 2018
Question b
Explain, using a clearly labelled diagram, the long-run equilibrium of a firm operating under oligopoly conditions. With reference to the ‘kinked’ demand curve draw... show full transcript
Worked Solution & Example Answer:Explain, using a clearly labelled diagram, the long-run equilibrium of a firm operating under oligopoly conditions - Leaving Cert Economics - Question b - 2018
Step 1
Explain, using a clearly labelled diagram, the long-run equilibrium of a firm operating under oligopoly conditions.
Answer
In the long-run equilibrium of a firm operating under oligopoly conditions, the following points are crucial:
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Equilibrium Analysis: The equilibrium occurs where Marginal Cost (MC) equals Marginal Revenue (MR). The graph showcases this at point E, where the curves intersect, indicating the firm's production level, Q1, and the price level, P1.
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Output and Price Determination: The firm will produce quantity Q1 and sell it at price P1. This is where the firm's MC curve meets the MR, representing the profit-maximizing output.
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Cost Structure: The firm's long-run average cost (AC) curve is depicted, showing that the firm is able to minimize costs while producing at Q1.
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Price Stability and Reaction to Market Changes: Should there be slight changes in price or costs between points E and D, price tends to remain constant at P1 to avoid losing customers, giving the firm price stability in a competitive environment.
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Supernormal Profits: In this scenario, the firm is earning supernormal profits, as average revenue (AR) exceeds average cost (AC) or price at P1, thereby attracting firms into the market.
Step 2
With reference to the ‘kinked’ demand curve drawn in part (i) above, explain the rationale for ‘price rigidity’.
Answer
The kinked demand curve illustrates the rationale for price rigidity in oligopolistic markets effectively:
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Pricing Strategies: When a firm tries to increase its price above P1, it anticipates that rival firms will not follow suit. As a result, the firm will lose customers to competitors who maintain lower prices, leading to a decrease in overall total revenue.
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Price Decrease Reaction: Conversely, if the firm lowers its price to P2, it believes that rival firms will follow suit and lower their prices as well. This reaction diminishes any potential advantage, causing a proportional increase in total demand for the original firm.
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Stability in Pricing: The result is that there is little incentive for firms to change prices, leading to price rigidity. The kink in the demand curve represents a risk-averse strategy where firms prefer to keep prices stable to avoid adverse revenue effects.
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Conclusion: The firm thus remains at price P1, encountering no incentive to rise or drop prices, highlighting the significance of competitive interdependence in oligopolistic markets.