Kinked Demand Curve

Definition

A kinked demand curve is a model used in the theory of oligopoly to explain how firms in an oligopolistic market set their prices. It suggests that the demand curve faced by an oligopolistic firm has a 'kink' at the current market price, leading to a discontinuity in the firm's marginal revenue curve.

5 Must Know Facts For Your Next Test

1. The kinked demand curve model assumes that firms in an oligopoly will not raise prices because they fear losing market share, but they will lower prices to match competitors.
2. The kink in the demand curve occurs at the current market price, where the firm's demand becomes more elastic (responsive) above the kink and less elastic below the kink.
3. The discontinuity in the marginal revenue curve at the kink point leads to price rigidity, as firms are hesitant to change prices for fear of triggering a price war.
4. The kinked demand curve model explains why oligopolistic firms often maintain stable prices over time, even in the face of changing market conditions.
5. The kinked demand curve theory suggests that firms in an oligopoly will focus on non-price competition, such as advertising, product differentiation, and customer service, to gain a competitive advantage.

Review Questions

• Explain how the kinked demand curve model relates to the pricing behavior of firms in an oligopolistic market.
  • The kinked demand curve model suggests that firms in an oligopolistic market will be reluctant to raise prices, as they fear losing market share to competitors. However, they will be willing to lower prices to match or undercut their rivals. This leads to a 'kink' in the demand curve at the current market price, where the demand becomes more elastic above the kink and less elastic below it. The discontinuity in the marginal revenue curve at the kink point then creates price rigidity, as firms are hesitant to change prices for fear of triggering a price war.
• Analyze how the kinked demand curve model explains the tendency for oligopolistic firms to maintain stable prices over time.
  • The kinked demand curve model suggests that oligopolistic firms will be reluctant to raise prices due to the fear of losing market share, but they will be willing to lower prices to match or undercut their competitors. This leads to a discontinuity in the marginal revenue curve at the kink point, which creates price rigidity. Firms are hesitant to change prices because they know that a price increase will result in a significant loss of sales, while a price decrease will trigger a response from rivals, potentially leading to a price war. As a result, oligopolistic firms tend to maintain stable prices over time, even in the face of changing market conditions, in order to avoid disrupting the industry's delicate balance of power.
• Evaluate how the kinked demand curve model influences the competitive strategies of firms in an oligopolistic market, beyond just pricing decisions.
  • The kinked demand curve model not only explains the pricing behavior of oligopolistic firms, but also shapes their broader competitive strategies. Since the model suggests that firms are reluctant to change prices, they are more likely to focus on non-price competition to gain a competitive advantage. This can include strategies such as product differentiation, advertising, customer service, and innovation. By differentiating their products or services, firms can create a more inelastic demand for their offerings, reducing the incentive to engage in price competition. Similarly, advertising and customer service can help build brand loyalty and customer retention, further insulating firms from the need to compete solely on price. The kinked demand curve model, therefore, encourages oligopolistic firms to pursue a range of competitive strategies beyond just pricing decisions, in order to maintain their market position and profitability.

Related terms

Oligopoly: A market structure characterized by a small number of firms that are interdependent, meaning the decisions of one firm can significantly impact the others.

Marginal Revenue: The change in total revenue resulting from a one-unit increase in the quantity sold.

Price Rigidity: The tendency for prices to remain unchanged despite changes in market conditions, such as shifts in supply or demand.