Kinked-Demand Theory: Videos & Practice Problems

The kinked demand curve in oligopoly is a model that explains price stability in markets where a few firms dominate. It suggests that if a firm lowers its price, competitors will match the price decrease to avoid losing market share, resulting in a steeper demand curve. Conversely, if a firm raises its price, competitors will ignore the increase, leading to a shallower demand curve. This creates a 'kink' in the demand curve, indicating that prices are inflexible. The kinked demand curve shows that firms are unlikely to change prices because the potential gains from lowering prices or the losses from raising prices are minimized by competitors' reactions.

The kinked demand theory explains price rigidity in oligopolistic markets by illustrating how firms react to each other's pricing strategies. If a firm lowers its price, competitors typically match the decrease, leading to a steeper demand curve and minimal gain in market share. If a firm raises its price, competitors often ignore the increase, resulting in a shallower demand curve and a significant loss of market share. This creates a kink in the demand curve, making prices inflexible. Firms are discouraged from changing prices because the potential benefits of lowering prices or the drawbacks of raising prices are offset by competitors' reactions, leading to stable prices.

The main assumptions of the kinked demand curve model are: 1) Firms in an oligopoly are interdependent and react to each other's pricing strategies. 2) If a firm lowers its price, competitors will match the price decrease to avoid losing market share, resulting in a steeper demand curve. 3) If a firm raises its price, competitors will ignore the price increase, leading to a shallower demand curve. 4) The demand curve has a kink at the current price level, indicating price inflexibility. 5) Marginal revenue curves reflect the kink, showing that shifts in marginal cost within a certain range do not affect production levels, emphasizing the unique interdependence of firms in oligopolistic markets.

The kinked demand curve affects marginal revenue in an oligopoly by creating a discontinuity in the marginal revenue curve. Due to the kink in the demand curve, the marginal revenue curve has two different slopes, reflecting the different elasticities of demand above and below the kink. This results in a gap or vertical segment in the marginal revenue curve at the kink point. Consequently, shifts in marginal cost within this range do not affect the firm's production level or price, leading to price rigidity. Firms are less likely to change prices because the marginal revenue remains stable within the kinked range, emphasizing the interdependence of firms in an oligopolistic market.

The implications of the kinked demand curve for price competition in oligopolies are significant. The model suggests that prices are rigid and unlikely to change because firms anticipate competitors' reactions. If a firm lowers its price, competitors will match the decrease, resulting in minimal gain in market share and a steeper demand curve. If a firm raises its price, competitors will ignore the increase, leading to a significant loss of market share and a shallower demand curve. This creates a kink in the demand curve, making firms reluctant to change prices. As a result, price competition is minimized, and prices remain stable, leading to less aggressive pricing strategies in oligopolistic markets.