Briefly and concisely define the following terms and explain their importance in the study of economics

Question

a. excess capacity theorem
b. price leadership
c. kinked demand curve
d. perfectly contestable market

Answer 1

a. The excess capacity theorem applies to the market structure monopolistic competition. In long-run equilibrium, the firm produces at a point along the negatively sloped portion of average cost; therefore, it has capacity which it does not use. This demonstrates inefficiency in the use of resources because price is greater than marginal cost (MU > MC).
b. Price leadership occurs when one firm sets prices and the others follow suit. This is a form of tacit collusion under oligopoly. The price leader is often the largest firm in the industry, but sometimes it may be the most innovative firm. Price leadership reduces the problem of interdependence for oligopolists.
c. The kinked demand curve is produced in a model by the assumptions that oligopolistic rivals will ignore any price increase and match any price decrease from the existing price. Such a model is useful in explaining why oligopolistic prices tend to be sticky, particularly in situations of rising resource costs; and it is also useful in discussing decision making under uncertainty.
d. A perfectly contestable market is one in which entry and exit are costless and unimpeded. Some economists believe that even markets that contain a few relatively large firms may be highly contestable. The constant threat of entry is thought to elicit good performance by the firms in a contestable market.