Kinked demand curve

Definition

A kinked demand curve is a graphical representation of the demand faced by firms in an oligopoly, characterized by a distinct kink at the prevailing market price. This kink arises because firms believe that if they raise prices, their competitors will not follow, leading to a loss in market share, while if they lower prices, competitors will match the price decrease, resulting in minimal gain in market share. This behavior creates a situation where the demand curve is more elastic above the current price and less elastic below it.

5 Must Know Facts For Your Next Test

1. The kinked demand curve suggests that firms in an oligopoly may be reluctant to change prices due to the anticipated reactions from competitors.
2. Above the kink, the demand curve is more elastic because a price increase leads to a significant drop in quantity demanded as consumers switch to competitors.
3. Below the kink, the demand curve is less elastic since price decreases do not significantly increase quantity demanded due to rivals matching the lower price.
4. This model helps explain price stability in oligopolistic markets, as firms prefer to maintain their prices rather than engage in potentially damaging price wars.
5. The kinked demand curve model illustrates the interdependence of firms in an oligopoly, highlighting how their pricing strategies are influenced by competitors' actions.

Review Questions

• How does the kinked demand curve illustrate the behavior of firms in an oligopoly when faced with price changes?
  • The kinked demand curve shows that firms in an oligopoly have different elasticities of demand above and below the current price. When a firm raises its price, it anticipates that competitors will not follow suit, leading to a loss of customers. Conversely, if a firm lowers its price, competitors are likely to match that reduction, resulting in little gain in market share. This leads to price rigidity, where firms prefer to keep prices stable despite changes in costs or market conditions.
• Analyze how the kinked demand curve model contributes to understanding price rigidity in oligopolistic markets.
  • The kinked demand curve model helps explain why prices tend to be stable in oligopolistic markets despite shifts in supply and demand. The unique shape of the curve indicates that firms expect their competitors to react differently depending on whether prices are increased or decreased. As a result, firms avoid changing prices unless there are significant changes in costs or other factors that necessitate a change. This behavior leads to a reluctance among firms to engage in competitive pricing strategies, reinforcing price stability within the market.
• Evaluate the implications of the kinked demand curve on consumer welfare and market efficiency within oligopolistic industries.
  • The kinked demand curve can have mixed implications for consumer welfare and market efficiency. On one hand, price rigidity may protect consumers from extreme price fluctuations that can occur in more competitive markets. However, it can also lead to higher prices than would be seen under perfect competition due to reduced competition among firms. Additionally, this model indicates that oligopolistic firms may have less incentive to innovate or improve efficiency since they can maintain profits without aggressive competition. Ultimately, while some stability is beneficial for consumers, it may also hinder overall market efficiency and innovation.

Related terms

Oligopoly:

A market structure dominated by a small number of firms, where each firm's decisions affect the others and where barriers to entry can be significant.

Price Rigidity: The tendency of prices to remain stable even in the face of changing supply and demand conditions, often seen in oligopolistic markets.

Cartel: An agreement between competing firms to coordinate their production and pricing strategies to maximize joint profits, often leading to higher prices for consumers.