Kinked demand curve

Definition

The kinked demand curve is a model used to describe the price-setting behavior of firms in an oligopoly. It suggests that a firm facing a kinked demand curve will experience different price elasticity depending on whether it raises or lowers its prices. This results in a stable market price where firms are reluctant to change prices, anticipating that rivals will not follow suit if they increase prices, but will follow if they decrease prices.

5 Must Know Facts For Your Next Test

1. The kink in the demand curve represents the point where the price elasticity of demand changes, indicating that consumers are more sensitive to price increases than to price decreases.
2. Firms in an oligopoly often choose not to compete on price due to the potential for price wars, which is why the kinked demand curve is a useful representation of their behavior.
3. If a firm raises its prices above the kink point, it is likely to lose customers to competitors, leading to a relatively elastic demand in that region.
4. Conversely, if a firm lowers its prices, it is likely that competitors will match the price reduction, leading to inelastic demand and limited gain in market share.
5. The kinked demand curve model helps explain why prices in oligopolistic markets tend to be sticky and resistant to change.

Review Questions

• How does the kinked demand curve illustrate the pricing strategies of firms operating in an oligopoly?
  • The kinked demand curve shows that firms in an oligopoly face a unique pricing strategy due to their interdependence. When a firm considers raising its prices, it anticipates that rivals will not follow, leading to a loss of customers and thus facing elastic demand. On the other hand, if it lowers its price, competitors are likely to match this move, resulting in less gain in market share and experiencing inelastic demand. This dynamic creates a reluctance to change prices, leading to price stability in such markets.
• Analyze how the concept of price rigidity is linked to the kinked demand curve and its implications for market competition.
  • Price rigidity is deeply connected to the kinked demand curve as it explains why firms often avoid changing prices even when market conditions fluctuate. The kinked shape indicates that any attempt by one firm to raise prices would lead to significant losses because consumers would switch to competitors. Conversely, lowering prices might not yield additional customers since competitors would match those lower prices. This interplay leads firms to keep prices stable, affecting competition by discouraging aggressive price strategies and focusing instead on non-price competition methods.
• Evaluate the role of game theory in understanding the strategic decisions of firms regarding the kinked demand curve.
  • Game theory plays a crucial role in analyzing how firms make strategic decisions in relation to the kinked demand curve. It provides a framework for understanding how firms anticipate the reactions of their competitors when considering price changes. The kink itself reflects an equilibrium where firms recognize that their pricing decisions will provoke responses from rivals, shaping their strategy accordingly. By using game theory models like Nash equilibrium, we can evaluate how firms optimize their pricing strategies while considering potential outcomes based on competitor behavior, ultimately influencing market stability and pricing structures within oligopolies.

Related terms

Oligopoly: A market structure characterized by a small number of firms that have significant market power and influence over pricing.

Price Rigidity: The phenomenon where prices remain stable despite changes in demand or cost, often due to strategic interactions among firms.

Game Theory: A mathematical framework for analyzing strategic interactions among rational decision-makers, often used to model competitive behaviors in economics.