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Economic Theory and Application Essay

1. The following graph: (not able to recreate, but in the text), shows a firm with a kinked demand curve a. What assumption lies behind the shape of this demand curve? The kinked demand curve assumes that other firms will follow price decreases and will not follow price increases. For instance, in an oligopoly model, based on two demand curves that assumes that other firms will not match a firm’s price increases, but will match its price increases. The kinked demand curve model of oligopoly implies that oligopoly prices tend to be “sticky” and do not change as much as they would in other market structures given the assumptions that a firm is making about the behavior of its rival firms. Kinked demand was an initial attempt to explain sticky prices. It is an economic theory regarding oligopoly and monopolistic competition.

b. Identify the firm’s profit-maximizing output and price. In Figure 9.1 in the textbook, the firm’s profit-maximizing output and price is when there is an increase in price over the average marginal cost (the difference between p1 and the point vertically down from there that cuts the MC curve) Profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this definition. The total revenue total cost method relies on the fact that profit equals revenue minus cost, and the marginal revenue – marginal cost method is based on the fact that total profit in a perfectly competitive market reaches its maximum point where marginal revenue equals marginal cost. c. Use the graph to explain why the firm’s price is likely to remain the same, even if marginal costs change. If marginal costs increase or decrease within the discontinuous range of the marginal revenue curve, the point at which marginal revenue equals marginal cost will remain the same.

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Thus, price and output do not change, even though costs (and profits) are different. Marginal cost is the additional cost of producing an additional unit of output. Marginal cost shows the changes in costs as output changes. Total variable costs change as the level of output varies but total fixed costs are constant regardless the level of output. Therefore, total fixed costs do not influence the marginal costs of production and actually average fixed costs decreases continuously as more output is produced. Because total fixed cost is constant, average fixed cost must decline as output increases ad spreads the total fixed cost is constant over a larger number of units of output. Both average variable cost and average cost first decrease and then increase.

2. Some games of strategy are cooperative. One example is deciding which side of the road to drive on. It doesn’t matter which side it is, as long as everyone chooses the same side. Otherwise, everyone may get hurt.

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