Kinked demand curve

Definition

The kinked demand curve is a model used to describe the price-setting behavior of firms in an oligopoly. It illustrates how a firm's demand curve is more elastic above a certain price level and less elastic below it, creating a 'kink' at the prevailing market price. This structure reflects the idea that firms are reluctant to change prices due to competitors' reactions, leading to price rigidity in an oligopolistic market.

5 Must Know Facts For Your Next Test

1. The kinked demand curve assumes that if a firm raises its price, competitors will not follow, resulting in a loss of market share, while if it lowers its price, competitors will match the decrease, leading to reduced profits for all firms.
2. This model explains why firms in oligopoly often avoid changing prices, instead opting for non-price competition like advertising or product differentiation.
3. The kink in the demand curve represents the prevailing market price; above this price, demand is elastic, and below it, demand is inelastic.
4. Firms facing a kinked demand curve may experience a gap in marginal revenue because of the different elasticities above and below the kink.
5. The concept highlights how interdependence among firms in an oligopoly can lead to a stable pricing environment despite changing costs or demands.

Review Questions

• How does the kinked demand curve illustrate the interdependence among firms in an oligopolistic market?
  • The kinked demand curve highlights interdependence by showing how one firm's pricing decisions affect others. If a firm raises its price, it risks losing customers as competitors maintain lower prices. Conversely, if it lowers its price, competitors are likely to match the reduction, leading to decreased profits for all. This understanding of mutual reactions reinforces the tendency for firms in an oligopoly to keep prices stable rather than engage in aggressive competition.
• Analyze how price rigidity in oligopolies affects market dynamics and consumer behavior.
  • Price rigidity caused by the kinked demand curve leads to stable prices, which can result in less uncertainty for consumers. When prices do not fluctuate frequently, consumers can predict costs more accurately and make informed purchasing decisions. However, this stability can also limit consumer choices since firms may focus on non-price competition rather than adjusting prices to reflect changes in production costs or consumer preferences.
• Evaluate the implications of the kinked demand curve model on antitrust policies and regulatory frameworks within oligopolistic industries.
  • The kinked demand curve model has significant implications for antitrust policies by illustrating how collusion or tacit agreements among firms can stabilize prices. Regulators must be cautious when assessing market behavior since such stability might disguise anti-competitive practices. Understanding this model can guide policymakers in crafting regulations that promote competition and prevent firms from engaging in practices that reduce market efficiency or harm consumer welfare while balancing the need for fair pricing mechanisms.

Related terms

Oligopoly: A market structure characterized by a small number of firms that dominate the market, where each firm's decisions can significantly impact the others.

Price Rigidity: The phenomenon where prices remain stable and do not change easily despite shifts in supply or demand, often seen in oligopolistic markets.

Cartel: A formal agreement between competing firms to control prices or limit production to increase their collective profits, often leading to a kinked demand curve.