key term - Kinked demand curve

Definition

The kinked demand curve is a model used to describe the pricing behavior of firms in an oligopoly, illustrating how demand for a product can change based on competitor pricing. It suggests that if one firm lowers its price, others will follow to maintain market share, resulting in a relatively inelastic demand curve below the kink, while if a firm raises its price, competitors do not follow, leading to a more elastic demand curve above the kink. This dual behavior creates a kink at the prevailing market price, reflecting the strategic interdependence among firms.

5 Must Know Facts For Your Next Test

1. The kinked demand curve model illustrates why prices in an oligopoly may remain stable despite changes in costs or demand.
2. Firms in an oligopoly face a dual demand curve: it is elastic above the kink and inelastic below it, indicating differing consumer reactions to price changes.
3. The model explains why price competition is limited; firms are hesitant to change prices due to potential revenue losses from losing market share.
4. Kinked demand curves arise from the assumptions of mutual interdependence and strategic behavior among firms in an oligopoly.
5. This concept helps to explain phenomena like price wars and the reluctance of firms to engage in aggressive price competition.

Review Questions

• How does the kinked demand curve illustrate the pricing behavior of firms in an oligopoly?
  • The kinked demand curve highlights how firms in an oligopoly react to pricing changes by competitors. When one firm lowers its price, others tend to follow, creating an inelastic segment of demand because customers will switch to lower-priced alternatives. Conversely, if a firm raises its price, competitors typically do not follow suit, resulting in a more elastic demand response as consumers can easily switch to cheaper alternatives. This interdependence leads to price stability within oligopolistic markets.
• Discuss how the concept of price rigidity relates to the kinked demand curve and its implications for firms' pricing strategies.
  • Price rigidity is closely related to the kinked demand curve as it demonstrates why prices tend to remain stable in oligopolistic markets. Firms recognize that changing prices could lead to unfavorable outcomes; lowering prices may initiate a price war, while raising them could result in losing customers. Therefore, the kinked demand curve illustrates how firms prefer maintaining existing prices despite shifts in costs or market conditions. This understanding influences their pricing strategies, prioritizing stability over aggressive competition.
• Evaluate the effectiveness of the kinked demand curve model in explaining real-world oligopolistic behavior and pricing strategies.
  • The kinked demand curve model is effective in explaining certain aspects of oligopolistic behavior, particularly regarding price stability and firms' reluctance to change prices. However, its limitations arise from oversimplifications; it assumes that all firms have identical cost structures and does not account for factors like product differentiation or external market influences. Additionally, real-world situations may involve collusion or price leadership strategies not captured by this model. Thus, while useful, it should be considered alongside other models and frameworks for a comprehensive understanding of oligopoly dynamics.

Related terms

Oligopoly:

A market structure characterized by a small number of firms that have significant market power and influence over price and output decisions.

Price Rigidity: The tendency for prices to remain stable despite changes in demand or cost conditions, often seen in oligopolistic markets.

Collusion: An agreement among competing firms to set prices or output levels in order to maximize collective profits, often at the expense of consumer welfare.