Kinked Demand Curves and Advertising

Kinked Demand Curves (by Paul Sweezy):

1671_kinked demand curves.jpg

Another hypothesis about how oligopolistic rivals may respond says that rivals match price cuts but do not respond to price increases. In this situation, an oligopolist believes that it will not gain much in sales if it lowers its price, because rivals will match the price cuts, but it will lose considerably if it raises its price, since it will be undersold by rivals who do not change their prices. The demand curve face such an oligopolistic appears kinked. The curve is very steep below the current price, p1 , reflecting the fact that few sales are gained as price is lowered. But it is relatively flat above that price, indicating that the firm loses many customers to its rivals, who refuse to match the price increases.

The figure also presents the MR curve, which has a sharp drop at the output level corresponding to the kink. Why does the MR curve have this shape, and what are the consequences? Consider what happens if the firm wants to raise output by one unit. It must lower its price by a considerable amount since, as it does so its rivals will match that price.

Accordingly, the MR it garners is small. If the firm contemplates cutting back on production by one unit, it needs to raise its price only a little since rivals will not change their price. Thus, the loss in revenue from cutting back output by a unit is much greater than the gain in revenue from increasing output by a unit. With a flat demand curve and price and MR are close together.

The drop in MR means that at the output at which the drop occurs, extra revenue lost from cutting back production is much greater than the extra revenue gained from increasing production. This has one significant implication. Small changes in MC, from MC1 to MC2, have no effect on output or price. Thus, firms that believe they face a kinked demand curve have good reason to hesitate before changing their price.

Advertising (Non-price competition):

1) Types of Advertising:

• Persuasive advertising of experience goods: focusing on image making for the company
• Informational advertising of search goods: focusing on information of products

2) Optimal Advertising Model:

TR = TR(Q, α ), where α ≥ 0 (advertising expenses)
π = TR(Q, α ) − TC(Q) −α . To solve for Q*andα * that can maximize profit, FOCs will be:

327_optimal advertising model.jpg

Can you interpret the result?

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