🧃intermediate microeconomic theory review

key term - Kinked Demand Curve

Definition

The kinked demand curve is a model used to explain price stability in an oligopoly, characterized by a demand curve that has a distinct 'kink' at the current market price. This kink occurs because firms expect that if they raise prices, their competitors will not follow suit, leading to a loss of market share, but if they lower prices, competitors will match the price drop, reducing their revenues. This results in a unique situation where prices tend to remain stable despite changes in costs or demand, as firms are reluctant to change their prices due to the potential reactions from rivals.

5 Must Know Facts For Your Next Test

  1. The kinked demand curve illustrates how firms in an oligopoly might choose not to compete on price, leading to price rigidity.
  2. Above the kink point, the demand is more elastic because a price increase leads to significant loss of customers to competitors.
  3. Below the kink point, the demand is less elastic since a price decrease does not significantly increase sales due to competitors matching the lower price.
  4. This model helps explain why firms might engage in non-price competition strategies like advertising or product differentiation.
  5. The kinked demand curve is based on the assumption that firms are aware of their rivals' pricing behavior and react accordingly.

Review Questions

  • How does the kinked demand curve model explain price stability in an oligopoly?
    • The kinked demand curve model shows that firms in an oligopoly face a unique situation where they are reluctant to change prices due to anticipated reactions from competitors. If one firm raises its prices, it risks losing customers because competitors will not follow. Conversely, if a firm lowers its prices, competitors will match the decrease, negating any gain in market share. This interdependence creates a scenario where prices tend to remain stable despite shifts in costs or demand.
  • Discuss how the kinked demand curve relates to non-price competition strategies employed by firms in an oligopoly.
    • In an oligopoly characterized by a kinked demand curve, firms often prefer to avoid price competition due to the risk of losing customers or profits. Instead, they may engage in non-price competition strategies such as enhancing product quality, increasing marketing efforts, or improving customer service. By focusing on these aspects rather than adjusting prices, firms can differentiate themselves and maintain customer loyalty without triggering aggressive price wars among competitors.
  • Evaluate the implications of the kinked demand curve for market outcomes and firm behavior in oligopolistic industries.
    • The implications of the kinked demand curve for market outcomes are significant. It leads to price rigidity, meaning that even with cost increases or changes in demand, firms may hesitate to adjust their prices. This can result in inefficiencies where resources are not allocated optimally. Additionally, because firms are focused on strategic interactions rather than price competition, it encourages behavior such as collusion or tacit agreements on pricing. Understanding this behavior helps explain why some markets may remain dominated by a few key players who maintain stable prices while competing through other means.