Question

Question

(a) Price Rigidity can be seen in non-collusive (ie. competitive) oligopoly markets. Illustrate

      and explain a model that can be used to explain this occurrence.

           (30 marks)

      (b) Compare and contrast an oligopoly and a perfectly competitive market in

            relation to output levels produced.

C Explain and illustrate using indifference curve analysis, the income and
      substitution effects if X is an inferior good and the price of X falls.  

D Explain the advantages of opening up factor markets eg. Labour, to international mobility; and detail the re-distribution of income if there is a low wage country and a high wage country prior to the introduction of free international mobility of labour.

Briefly comment on how useful the model is regarding the real world.

Answer 1

(a) It shall be noted that non-collusive oligopoly market is explained with the help of Sweezy's kinked demand curve model. The objective of the analysis is to show that such market structure result in price rigidity.

As per this model, the demand curve is a kinked demand curve. The kink in the demand curve originates from asymmetrical sellers' behavioral pattern. If a seller increases the price charged for the product in oligopoly market, the rival sellers will not follow him, such that the first seller loses a considerable amount of sales due to higher price. However, if the seller reduces the price charged for the product, other firms in the oligopoly market will follow the first firm and escape from losing customer base.

As the result of this behavioral pattern, in the oligopoly market, the firm face kinked demand curve.

Suppose, the initial price of the product in the oligopoly market is OP. If one firm increases the price beyond OP, rival firms will not follow suit. As a result , buyers will shift to products of rival firms who have kept their prices at OP level, causing loss of sales to first firm who increased price beyond OP.

AMC, MC R Output Kinked Demand Curve and Cigopoly Equlbrin

Thus, demand curve portion dE is relatively elastic. On the other hand, if a firm reduces the price of the product below QE, others will follow suit. Thus, demand curve portion ED is relatively inelastic. This behavioral pattern as exhibited in oligopoly market explains that there is price-rigidity.

b) Comparison of Perfect competition & Oligopoly market in relation to output level produced:

Under perfect competition, a change in the marginal cost would result in change in the equilibrium level of output, whereas, in case of non-collusive oligopoly market, change in the marginal cost within a certain range does not affect the equilibrium level of output.

Under Perfect competition, since the firm is the price taker, it only look at the cost side of production to produce equilibrium level of output, whereas in Oligopoly market, the firm observes the reaction from rival firms to produce optimal level of output produced.