Question

Suppose that there are three firms, \(A, B\), and \(C\), in an oligopolistic industry. In analyzing the market, Firm \(\mathrm{A}\) has come to the conclusion that \(\mathrm{B}\) and \(\mathrm{C}\) will follow any price change A initiates. Does the kinked demand curve apply here?

Short answer

The kinked demand curve does not apply in this situation because firms B and C are assumed to follow both price increases and decreases initiated by firm A. This contrasts with the kinked demand curve model, which assumes asymmetric reactions by rival firms, with rivals following price decreases but not price increases.

Step-by-step solution

Understanding the Kinked Demand Curve Model

The kinked demand curve model suggests that in an oligopoly market, the demand curve faced by a firm is not smooth but has a kink at its prevailing price level. This is caused by the asymmetric reactions of other firms to price changes initiated by the firm in question. If the firm increases its price, rivals are assumed not to follow, implying the firm would have to face the elastic (flatter) part of its demand curve. In contrast, if the firm decreases its price, competitors are assumed to follow, forcing the firm to face the inelastic (steeper) part of its demand curve. As a result, the firm has little incentive to change its price because it would lead to either a smaller market share or lower profitability.

Analyzing Firms' Reactions to a Price Change by Firm A

In the given exercise, Firm A assumes that if it changes its price (either increase or decrease), firms B and C will follow the same price change. This is important because it contrasts with the kinked demand curve model, which assumes asymmetrical price reactions by rival firms.

Determine whether the Kinked Demand Curve Model Applies

As we have analyzed the reactions of firms B and C to a price change initiated by firm A, we find that it differs from the assumptions of the kinked demand curve theory. In this scenario, firms B and C follow both price increases and decreases initiated by firm A, contrary to the kinked demand curve theory, which assumes that rival firms only follow price decreases and not price increases. Therefore, the kinked demand curve model does not apply in this situation, as the market behavior differs from the model's assumptions.

Key concepts

Oligopoly

In an oligopolistic market, a few firms have significant control over the entire market. This structure is characterized by a small number of large firms that dominate the industry. Unlike in perfect competition or monopolies, oligopolies present unique challenges and strategic interactions for firms.
The few firms within an oligopoly are interdependent. Each firm's actions affect the others, creating a situation where one firm's decision on pricing or output can influence the entire market. This interdependency leads to strategic behavior, where firms carefully consider the potential reactions of their rivals before taking any market actions.

• There is often significant market power held by the firms.
• Firms may engage in competitive or cooperative strategies.
• Barriers to entry are typically high, preventing new competitors from easily entering the market.

These characteristics make understanding market behavior complex in an oligopoly, as firms must weigh their decisions against potential moves by their competitors. The kinked demand curve model is one example that tries to explain how these firms might react to changes in price.

Price Elasticity

Price elasticity of demand refers to how sensitive the quantity demanded of a good is to a change in its price. In an oligopoly, this concept becomes particularly important due to the potential reactions of competing firms.
Understanding price elasticity helps firms in an oligopoly predict how a change in price might affect both their profit and their position in the market. Because firms in an oligopoly are interdependent, a change in one firm's price not only affects its own quantity demanded but also can induce changes in its competitors' pricing, thus affecting the market as a whole. In the context of the kinked demand curve:

• If a firm raises its prices, it faces an elastic portion of the demand curve because other firms may not follow, leading to a loss of customers.
• If a firm lowers its prices, it faces the inelastic portion of the demand curve since competitors are likely to match the price cut to maintain their market share.

This understanding of elasticity in relation to pricing strategies is crucial for firms aiming to optimize their competitive position and profit in an oligopoly.

Market Behavior

Market behavior in an oligopoly is shaped by the interdependence between firms. Each firm must anticipate how its competitors will respond to changes in pricing, production, and other strategic decisions. This creates a complex web of decision-making, where firms are continuously monitoring and reacting to each other's moves.
A key aspect of market behavior in oligopolies is the strategic decision-making regarding prices. Firms are generally cautious about initiating price changes due to the unpredictability of competitors' reactions. In some cases, firms might engage in price rigidity, avoiding changes to maintain stability in the market. Regarding the kinked demand curve:

• This model suggests that firms will face intense competition when trying to reduce prices, as rivals will likely match any price cuts.
• Price increases are not easily followed because competitors may not raise their prices, leading to a loss in customers.

Understanding market behavior is crucial for firms in oligopolies, as their success largely depends on how well they can predict and adapt to their competitors' actions. Smart strategic adjustments and clear assessments of rivals' likely actions are essential for maintaining a competitive edge.