Question

The kinked demand curve theory attempts to explain why an oligopolistic firm a. has relatively large advertising expenditures. b. fails to invest in research and development \((\mathrm{R} \& \mathrm{D})\) c. infrequently changes its price. d. engages in excessive brand proliferation.

Short answer

The kinked demand curve theory attempts to explain why an oligopolistic firm infrequently changes its price. This is due to the price rigidity caused by the firms' reluctance to change prices, fearing that price increases will be matched by competitors, while price decreases will not lead to a significant increase in demand. Therefore, the correct answer is option c.

Step-by-step solution

Option a: Advertising expenditures

This option suggests that oligopolistic firms have large advertising expenditures. While it may be true that firms in an oligopoly invest heavily in advertising, it is not a direct consequence of the kinked demand curve theory. The theory primarily focuses on pricing behavior, not advertising. So, this option is not the correct answer.

Option b: R&D investment

This option indicates that oligopolistic firms fail to invest in research and development. The kinked demand curve theory does not specifically address R&D investments. It is mainly about pricing behavior, so this option is not the correct answer.

Option c: Infrequent price changes

This option suggests that oligopolistic firms change their prices infrequently. The kinked demand curve theory explains that firms in an oligopoly are cautious about changing their prices, as they fear that price increases will be matched by competitors while price decreases will not lead to a significant increase in demand. This behavior results in price rigidity, where firms are reluctant to change their prices. Therefore, option c correctly associates the kinked demand curve theory with infrequent price changes.

Option d: Brand proliferation

This option implies that oligopolistic firms engage in excessive brand proliferation. Brand proliferation can be a strategy employed by firms in an oligopoly to differentiate their products, but it is not directly related to the kinked demand curve theory. The theory is primarily concerned with pricing behavior, not brand proliferation. So, this option is not the correct answer. In conclusion, the kinked demand curve theory attempts to explain why an oligopolistic firm infrequently changes its price, which corresponds to option c.

Key concepts

Oligopolistic Pricing

Oligopolistic pricing is a key component of how firms within an oligopoly set their prices. An oligopoly is a market structure where a few large firms dominate the market. This leads to interdependent pricing decisions. Each firm must consider the possible reactions of its competitors when setting its prices.

In an oligopoly, firms might choose to follow a common price leader, which is typically the dominant firm in the market. This leader might set a price that other firms follow. However, the kinked demand curve theory offers a different perspective. It implies that once a price is established, firms become reluctant to change it.

The reason for this reluctance is because any change in price might trigger a chain reaction:

• Price Increase: If one firm increases its price, others might not follow, causing the firm to lose its market share.
• Price Decrease: Alternatively, a price decrease might be matched by competitors, reducing profit margins without gaining significant additional market share.

This leads to price rigidity, where prices remain stable over time despite changes in cost or demand.

Price Rigidity

Price rigidity is a phenomenon where prices remain unchanged even when there's a shift in demand or costs. In oligopoly markets, this is explained by the kinked demand curve.

The kinked demand curve suggests that firms perceive demand elasticity differently over different parts of the curve. Specifically, they believe that any decrease in price will not lead to proportionally higher demand due to competitors matching price cuts. Conversely, any increase in price is likely to lead to significant loss in customers as other firms maintain lower prices.

This asymmetry results in a kink in the demand curve at the prevailing price, causing firms to maintain stable pricing to avoid unfavorable outcomes.

The kinked demand curve also implies that firms in an oligopoly tend to focus more on non-price competition, such as improving the quality of their goods or services, rather than altering prices to compete.

Oligopoly Market Structure

An oligopoly is a market structure defined by a small number of firms controlling the majority of market share. This results in high barriers to entry, either through start-up costs or legal restrictions, making it difficult for new competitors to enter the market.

The key characteristics of an oligopoly include:

• Interdependence: Firms must consider the reactions of their competitors when making pricing and investment decisions.
• Non-price Competition: Companies often resort to non-price competition such as advertising and product differentiation, since price changes can adversely affect the market stability.
• Barriers to Entry: High barriers protect the firms' market share and control over the industry's pricing dynamics.

Due to these conditions, oligopoly firms are particularly adept at leveraging strategies that include shared insights among competitors, forming tacit collusions, and maintaining price rigidity to maximize collective benefits without explicit agreements.