Profiting from the Long Run

184 Part III: Market Structures and the Decision-Making Environment

The theory stresses mutual interdependence by describing how firms respond to any price change your firm may make. If your firm lowers price, the theory assumes that everyone lowers price to avoid losing customers and market share. So, if you lower price, you won’t sell much more. On the other hand, if you raise price, none of your rivals will raise price. As a result, many of your customers will switch to one of your rivals. You’ll lose a lot of sales.

Figure 11-1 portrays the situation that exists with a kinked demand curve. The top panel of the graph illustrates the demand curve your firm faces. The current profit-maximizing quantity and price are q0 and P0, respectively. Note that the profit-maximizing quantity corresponds to marginal revenue intersects marginal cost, and price is determined based upon where the quantity q0 hits the demand curve.

If your firm decreases price, you assume that all your rivals will also decrease their price in order to avoid losing customers. The portion of your firm’s demand curve associated with a price decrease is less elastic. Your demand curve is steeper and quantity demanded is less responsive to a decrease in price. That’s because your firm is unable to steal customers from rival firms that also lower their product’s price. This less-elastic demand is represented by the steeper curve labeled dB in the upper panel of Figure 11-1. Because this demand curve is relevant only for price decreases and quantities above q0, it’s a solid line only for prices below P0. (The dotted section of the line for prices above P0 isn’t relevant.)

The marginal revenue curve associated with dB is the steeper curve labeled MRB. Again, only the portion of the marginal revenue curve above q0 is relevant and illustrated with a solid line.

For a linear, straight-line demand curve, marginal revenue always begins at the same point on the vertical axis and is twice as steep as the demand curve.

If your firm increases price, you assume none of your rivals increase their prices. Your customers are likely to switch to buying the product from your rivals that are relatively cheaper after your price increase. The portion of your firm’s demand curve above P0 is likely to be more elastic; quantity demanded is more responsive to a price increase. This segment of the firm’s demand curve is represented by the flatter line dA above P0 and to the left of q0.

The marginal revenue curve associated with dA is the flatter curve labeled MRA.

The kink in the firm’s demand curve at P0 and q0 introduces a discontinuity in the marginal revenue curve. The solid segments of the marginal revenue curves MRA and MRB don’t touch. This discontinuity is connected by the solid vertical segment in the marginal revenue curve.