Just like firms in any other market structure, the oligopolist produces at quantity where MR=MC to maximise profits. But, the MR curve corresponding to the kinked demand curve is discontinuous at output OQ1 and this discontinuity is represented by the vertical gap. Consequently, there is no single point of intersection between the MR and MC curves. This means that an oligopoly’s costs must change considerably before it is forced to alter its output or price i.e. producers will remain status quo if costs vary between MC1 and  MC3. Thus, if the initial marginal cost curve is assumed to be at MC1, then a rise in costs to MC2 or even MC3 would result in no change in price and output i.e. prices remain rigid.


The kinked demand model has its limitations though. Price rigidity may also be due to other factors, besides the explanation provided by the model. The kinked demand curve helps to explain why oligopoly prices are stable even without collusion among firms. But, it does not explain how the existing price OP1 is arrived at. However, price increases do occur as they did during the inflationary periods of 1970s and early 1980s in the advanced economies. Similarly, the retail petrol stations have recently been hiking pump prices in response to escalating oil prices.

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PES measures the degree of responsiveness of the quantity supplied for a good to a change in the price of the good itself, ceteris paribus

PES for manufactured goods such as computers, clothing and books is generally higher than price elasticity of supply for agricultural goods such as grains, corn and cotton, due to:

Availability of Stock

Firms with larger availability of stocks are more able to respond to price changes. Hence, supply of durable goods such as computers, clothing and books is more price elastic than the supply of perishable goods. This is because perishable goods (e.g. agricultural goods) cannot be stored for long periods of time. Given an increase in price of vegetables, producers cannot increase the quantity of vegetables supplied to the markets easily as they are unable to draw from their stocks / inventories.

The larger the availability of stocks, the larger the increase in quantity supplied that firms will be able to bring into the market, accounting for the larger PES value.

Time Period

Firms can better respond to price changes by altering their quantity supplied if a longer time period was allowed.

e.g. agricultural goods have long gestation period –> producers have lesser ability to respond quickly to price changes.


Existence of Spare Capacity

Firms may have the capacity to increase production when existing capacity is not fully utilised.

Should the firms be already operating close to full capacity, it will be difficult for them to increase quantity supplied in response to a price rise. Therefore, the greater the spare capacity, the higher is the PES and the more price elastic the supply.


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  • BOP deficit could be caused by Current Account deficit possibly due to import expenditure (M) exceeding export revenue (X)
  • This could be due to a relatively higher rate of inflation in the country relative to other countries. This could be due to increases in cost of production, such as strong increase in wages or fall relative productivity levels.
  • Cost of producing goods and services and hence the price at which they are sold is higher, making it less price competitive in international markets as they are now more expensive than the trading partner’s domestically produced goods. Quantity demanded for exports decreases as foreigners switch from that country’s exports to domestically produced goods or to exports from other countries. Assuming demand for exports is price elastic, quantity demanded for exports decreases more than proportionately, hence export revenue (X) falls.
  • Also, demand for imports rises as locals switch from domestically produced goods and services to imports, which are now relatively cheaper.
  • Hence import expenditure (M) rises. Decrease in X and increase in M cause net export revenue (X-M) to fall.


  • Current Account deficit could also be caused by an appreciation of the exchange
  • When the currency appreciates, price of exports in foreign currency increases, making exports less price competitive in international markets. Quantity demanded for exports decreases as foreigners switch to domestically produced goods or to exports from other countries.



  • At the same time, price of imports in domestic currency decreases, making imports more price competitive in the domestic market. Quantity demanded for imports increases as locals switch from domestically produced goods to imports.
  • Assuming the ML condition holds whereby the sum of the price elasticise of export and import is more than 1, (PEDx + PEDm > 1), net export revenue, (X-M) will fall


  • Current account deficit could be brought about by a country experiencing a faster rate of economic growth than the countries it exports to. These would be the case if growth is being generated from domestic sources – i.e. there is a domestic consumption boom or increase in government expenditure, rather than increase in net exports.
  • An increase in NY will result in domestic consumers demanding more goods and services for consumption, both those which are domestically produced and imports. As a result there will be an increase in import expenditure
  • As other countries experience a slower rate of growth, export revenue is not increasing as much. As a result, there is a fall in (X-M)


Body (Capital and Financial Acct Deficit) 

  • BOP deficit could be caused by capital and financial account deficit, brought about by a net 
outflow of short or long term capital.
  • A net outflow of short-term capital could be brought about by a decrease in relative interest rates, as this means that financial institutions are now able to obtain higher returns on their funds in other countries. This would lead to less short-term capital inflows and/or a more short-term outflow.

A net outflow of long-term capital, in the form of Foreign Direct Investment (FDI) would also cause a BOP deficit. There would be net decrease in FDI flows if the profitability of investment falls. This could result from government policies becoming less favourable, for example a withdrawal of preferential tax concessions or grants. This results in multi-national corporations (MNCs) moving their investments to other countries offering more preferential treatment. It could also be brought about by a deterioration of the investment climate in general. For example, a strengthening in trade union power resulting in more strikes and/or wage demands will induce firms to seek more attractive investment destinations abroad.

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A private good is one that has the characteristics of both rivalry and excludability. Since it is rival, the consumption by one would deprive the consumption by another. For instance, when a vacancy in the school is filled up, there is one place less for potential applicants, as the same place cannot be offered to someone else. Moreover, since the good is excludable, it is not prohibitively costly to confine the benefits to a selected group of people. Using the same example, a person who is not willing to pay or who does not meet the minimum grade requirement can easily be excluded from attending the school.

On the other hand, a public good is one that has the characteristics of non-rivalry and non-excludability. Examples of such goods are national defence and flood control. Non-rivalry in consumption means the consumption by one person need not diminish the quantity consumed by anyone else given the level of production. Consider the example of national defence, once an armed force is built, the same amount of protection to the citizens will not be reduced when there are new citizens. Non-excludability means it is impossible, or prohibitively costly to confine the benefits of the good once produced to selected persons. Using the same example, it is not possible to confine the benefits of protection from missile attack from people living even within miles away.

A private good is different from a public good based on the rivalry and excludability in consumption. As a public good is non-rival, this implies that marginal cost of serving an additional user is zero. The non-excludability of public good implies that free-rider problem will arise. Thus, a public good must be provided by the government. However, a private good can be provided by private enterprises as well as the government.

A private good fulfills the characteristics of rivalry and excludability. Rivalry in consumption means that consumption of a good by an individual will reduce the availability and the amount for consumption by other individuals. Excludability in consumption means that consumption of a good can be excluded if the individual does not pay.

An example of a private good is a can of drink. If a can of drink is consumed by one, someone else is deprived of the same can of drink and will not be able to quench his thirst. This shows that the consumption of the can of drink is rival. At the same time, the can of drink is excludable. This means that consumers who do not pay for the can of drink will not be able to enjoy it. In reality, there are countless examples of private goods and services such as computers, cars, food & beverages, haircutting services and tour services.

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