Question

Explain the rationale behind the kinked demand curve used by economists to describe oligopoly.

Short answer

The kinked demand curve is used by economists to describe oligopoly markets, which are characterized by a few dominant firms with significant market power and interdependence among firms. The curve is based on two key assumptions: that firms are reluctant to increase prices due to potential non-followers (leading to elastic demand above the current price), and that firms are also hesitant to decrease prices because competitors are likely to match the price cut (resulting in inelastic demand below the current price). The kink, where these two segments meet, represents the current price and quantity level, illustrating price rigidity in the market. This model suggests that oligopolistic firms mainly compete through non-price dimensions such as marketing and product innovations, due to the unresponsiveness of prices to changes in marginal costs.

Step-by-step solution

Understanding Oligopoly Market Structure

An oligopoly is a market structure where a few firms dominate the industry. These firms are large and have significant market power, which allows them to directly influence market prices. The unique aspect of an oligopoly is the interdependence among firms. Decisions made by one firm have a direct impact on the behavior and decisions of other firms in the market.

Key Assumptions of the Kinked Demand Curve

The kinked demand curve is a graphical representation of the demand faced by an individual firm in an oligopoly market. It is based on the following assumptions: 1. Firms in the oligopoly are differentiated, meaning their products are similar but not identical, allowing each firm to have some pricing power. 2. Each firm is focused on maximizing its profit and will change its price and output levels accordingly. 3. Firms are unlikely to increase prices, as competitors may not follow suit, leading to a loss in market share. Consequently, the demand for a firm's product is relatively elastic above the current price. 4. Conversely, firms are also unlikely to decrease prices, as competitors are more likely to match price cuts to maintain their market share. This results in inelastic demand below the current price of a firm's product.

Formation of the Kinked Demand Curve

Based on the assumptions listed above, we can create a kinked demand curve as follows: 1. Above the current price level, the demand curve is relatively elastic because firms are reluctant to increase prices in fear of their competitors not following suit. This means that a small increase in price would result in a large decrease in quantity demanded. 2. Below the current price level, the demand curve is relatively inelastic because competitors are more likely to match price cuts. Therefore, a small decrease in price results in a smaller increase in quantity demanded. 3. The point where these two segments of the demand curve intersect is called the "kink." This kink represents the current price and quantity level in the market.

Implications of the Kinked Demand Curve

The kinked demand curve model has the following implications for prices and output in an oligopoly market: 1. It suggests that prices tend to be rigid, as firms are reluctant to change their prices due to the potential reactions of their competitors. 2. The kinked demand curve also implies that changes in marginal costs have little effect on prices, as long as the increase or decrease in cost remains within the range of the kink. 3. This model indicates that oligopolistic firms are more likely to compete in non-price dimensions, such as marketing, product differentiation, and innovation, due to the rigidity of prices in the market. In summary, the rationale behind the kinked demand curve in oligopolies lies in the interdependence of firms and their strategic responses to price changes. The resulting kinked demand curve helps explain the rigidity of prices and the tendency for firms to compete in non-price factors in an oligopoly market.

Key concepts

Oligopoly

An oligopoly is a market structure characterized by a small number of large firms that dominate the industry. This limited number of companies means that each one holds significant market power, thereby influencing prices and outputs. Due to the small number of firms, they are highly interdependent, with each firm's decisions impacting the others. This interdependence often leads to competitive strategies that are different from those in more or less concentrated markets. Firms in an oligopoly are usually aware of their influence, which leads them to closely monitor each other's actions. This monitoring ultimately shapes their decision-making processes.

• High barriers to entry are present, preventing new firms from easily entering.
• Product differentiation can occur, although products may often be similar.
• Price setting is strategic because it directly impacts competitors.

These characteristics set the stage for unique market dynamics, such as the kinked demand curve.

Elasticity

Elasticity in this context refers to how sensitive the quantity demanded is to a change in price. It plays a crucial role in the kinked demand curve model, particularly in an oligopolistic market. On the kinked demand curve, elasticity varies depending on the price level:
- Above the current price, demand is relatively elastic. Here, a small price increase results in a significant drop in quantity demanded because firms fear losing customers to competitors who might not increase their prices. - Below the current price, demand is relatively inelastic. A price decrease only slightly raises the quantity demanded, as competitors are likely to follow suit with their own price drops to maintain market share.
This asymmetric elasticity below and above the current price helps explain why firms in an oligopoly might prefer to keep prices stable, even when market conditions change.

Price Rigidity

Price rigidity is a concept integral to the understanding of oligopolies and the kinked demand curve model. It refers to the tendency of prices to remain stable even when other market conditions fluctuate. In an oligopoly, firms are hesitant to change prices because of the unpredictable reactions from competitors: - A price increase might lead to a loss in market share if competitors don't follow the price hike. - A price decrease might trigger a price war, as competitors match cuts to protect their share.
This interdependence and the risk of negative reactions lead firms to avoid frequent price changes. The kinked demand curve suggests that, because of this rigidity, changes in costs (whether rising or falling) often do not result in corresponding changes in price, maintaining stability in the market's price level.

Marginal Cost

Marginal cost refers to the cost of producing one additional unit of output. In the context of the kinked demand curve, changes in marginal cost often have limited impact on pricing. Because of the kink, small cost changes that remain within the range of the kink do not influence the price: - If marginal costs increase slightly, firms do not increase prices to maintain competitiveness, due to fears of losing market share. - Conversely, if marginal costs decrease, firms may not lower prices, preferring to benefit from increased profit margins rather than risking a price war.
This phenomenon means that prices are sticky, staying the same even when marginal costs fluctuate. Such cost changes would have a more pronounced effect in other market structures, but within an oligopoly, the kinked demand curve maintains price stability.

Non-Price Competition

Non-price competition is a critical approach for firms within an oligopoly. Given the rigidity of prices implied by the kinked demand curve, firms often turn to methods other than price to compete and attract customers. Non-price competition can include strategies such as: - Enhancing product quality or adding new features - Increasing marketing and advertising efforts - Offering better customer service - Engaging in extensive branding efforts
These strategies are more viable than price wars, enabling firms to maintain market position and consumer loyalty without altering the price. Non-price competition allows firms to differentiate their products, making them stand out in a market where prices remain relatively stable due to the kinked demand curve dynamics.