💸principles of economics review

key term - Kinked Demand Curve

Definition

A kinked demand curve is a model used in oligopoly markets to explain the pricing behavior of firms. It suggests that firms in an oligopoly will maintain their current price due to the fear of retaliation from competitors, resulting in a non-linear, kinked demand curve.

5 Must Know Facts For Your Next Test

  1. The kinked demand curve model suggests that firms in an oligopoly will maintain their current price to avoid a price war with competitors.
  2. The kink in the demand curve occurs at the current market price, where the upper portion of the curve is more elastic (price-sensitive) and the lower portion is less elastic (price-insensitive).
  3. Firms in an oligopoly are reluctant to raise prices due to the fear of losing market share, but they are also hesitant to lower prices because competitors will likely match the price decrease.
  4. The kinked demand curve model explains why oligopolistic firms often exhibit price rigidity, as they are unwilling to change prices and risk retaliation from competitors.
  5. The kinked demand curve model assumes that firms have complete information about their competitors' pricing strategies and that they will respond accordingly to maintain their market share.

Review Questions

  • Explain how the kinked demand curve model is used to describe pricing behavior in oligopoly markets.
    • The kinked demand curve model suggests that firms in an oligopoly will maintain their current price to avoid a price war with competitors. The kink in the demand curve occurs at the current market price, where the upper portion of the curve is more elastic (price-sensitive) and the lower portion is less elastic (price-insensitive). Firms are reluctant to raise prices due to the fear of losing market share, but they are also hesitant to lower prices because competitors will likely match the price decrease. This pricing behavior leads to price rigidity, as firms are unwilling to change prices and risk retaliation from competitors.
  • Analyze the assumptions underlying the kinked demand curve model and how they contribute to the model's explanatory power.
    • The kinked demand curve model assumes that firms in an oligopoly have complete information about their competitors' pricing strategies and that they will respond accordingly to maintain their market share. This assumption of interdependence and mutual awareness of pricing decisions is crucial to the model's ability to explain the price rigidity observed in oligopolistic markets. Additionally, the model assumes that firms are unwilling to engage in a price war, as they fear losing market share to their competitors. These assumptions help the kinked demand curve model capture the strategic interactions and decision-making processes of firms in an oligopoly, which ultimately lead to the characteristic kink in the demand curve and the resulting price rigidity.
  • Evaluate the limitations of the kinked demand curve model and discuss alternative theories or models that may better explain pricing behavior in oligopoly markets.
    • While the kinked demand curve model provides a useful framework for understanding pricing behavior in oligopoly markets, it has several limitations. The model assumes that firms have complete information about their competitors' pricing strategies, which may not always be the case in reality. Additionally, the model does not account for the possibility of collusion or other strategic interactions among firms, which can significantly impact pricing decisions. Alternative theories, such as the game theory approach and the contestable markets model, may better capture the complex dynamics of oligopolistic markets. These models consider factors like information asymmetry, barriers to entry, and the potential for firms to engage in strategic behavior beyond just pricing decisions. By incorporating a more comprehensive understanding of the competitive landscape, these alternative theories can provide a more nuanced explanation of pricing behavior in oligopoly markets.