Question

According to the theory of the kinked demand curve, if a firm were to lower its price, its competitors would (LO3) a) lower theirs b) raise theirs c) keep theirs the same

Short answer

a) lower theirs

Step-by-step solution

Defining the kinked demand curve theory

The kinked demand curve theory is a model in oligopoly markets, which predicts that a firm will face two different demand curves: one for when it raises its price, and another for when it lowers its price. The key idea behind this theory is that firms within an oligopoly market will react differently to a competitor's price changes.

Firms’ reactions to a price increase or decrease

According to the kinked demand curve theory, if a firm increases its price, its competitors will keep their prices constant, thinking they can gain some market share. However, if a firm lowers its price, its competitors will follow by lowering their prices as well, fearing that they will lose market share to the firm that lowered its price initially.

Choose the correct response from the given options

Given the kinked demand curve theory, when a firm lowers its price, its competitors would: a) lower theirs.

Key concepts

Oligopoly

In an oligopoly, a few firms dominate an entire market. This market structure is distinct because each firm is aware of the actions of the others. Unlike in perfect competition, where many small firms are price takers, oligopolies feature strategic decision-making.

Firms in an oligopoly carefully consider the potential for retaliation when making pricing and output decisions. For example:

• If one firm lowers its prices, competitors might follow to avoid losing customers.
• Conversely, a firm that raises its prices risks losing customers to competitors who maintain lower prices.

The kinked demand curve theory, specifically, captures this dynamic, revealing a world where price cuts by one firm invite immediate matching by rivals, while price increases do not.

Price Competition

Price competition is a primary strategy in oligopoly markets, where firms try to attract more customers by offering lower prices than their competitors. This form of competition can lead to price wars, especially in markets characterized by the kinked demand curve.

In a kinked demand curve scenario:

• Lowering prices leads to immediate and reciprocal actions by competitors to match prices.
• Raising prices, however, is often not matched, allowing competitors to gain a larger share of the market if they keep prices lower.

Therefore, price competition in oligopolies is constrained by the potential reactions of other firms, as each is wary of initiating a price change that could lead to unfavorable outcomes.

Market Share

Market share in an oligopolistic environment refers to the proportion of total sales in the market captured by one firm. Firms in oligopolies often strive to protect or increase their market share because even small shifts can significantly impact profitability.

Actions affecting market share include:

• Lowering prices to attract customers from competitors, thus increasing market share.
• Maintaining or improving product quality and services to appeal to customers.

The kinked demand curve theory illustrates that changes in market share often prompt quick reactions from competitors, who aim to maintain their portion of the market. This creates a stable price environment where significant price changes are uncommon, as firms are reluctant to risk market share.