Question

Faceblock, Gargle+, and MyMace are rival firms in an oligopoly industry. If kinked-demand theory applies to these three firms, Faceblock’s demand curve will be: a. More elastic above the current price than below it. b. Less elastic above the current price than below it. c. Of equal elasticity both above and below the current price. d. None of the above.

Short answer

a. More elastic above the current price than below it.

Step-by-step solution

Understanding Kinked-Demand Theory

The kinked-demand curve theory suggests that in an oligopoly, a firm faces a demand curve that is more elastic above the current price and less elastic below it. This occurs because rival firms are likely to match price decreases but not price increases.

Analyzing the Options

Given the kinked-demand curve, if Faceblock raises its price, rivals will not follow, resulting in a loss of many customers, i.e., the demand is more elastic. However, if Faceblock lowers its price, rivals will also lower their prices to maintain market share, resulting in fewer additional customers, i.e., the demand is less elastic below the current price.

Choosing the Correct Answer

Based on the analysis, the correct answer is (a) More elastic above the current price than below it, which aligns with the basic principle of the kinked-demand theory in an oligopolistic market.

Key concepts

Kinked-Demand Theory

The Kinked-Demand Theory is a fascinating concept in oligopoly markets, where a few large firms dominate. This theory suggests that each firm faces a demand curve with a distinctive "kink." This occurs because rival firms in an oligopoly are likely to react to changes in pricing in strategic ways.
- **Above the Kink:** If a firm increases its price, competitors won't necessarily follow. This is because competitors aim to attract customers who find the increased prices unattractive. As a result, the demand above the kink is more elastic. Customers are sensitive to price increases and shift to other providers.
- **Below the Kink:** If a firm lowers its price, competitors will likely decrease their prices as well to maintain their competitive position and market share. Therefore, the demand below the kink is less elastic as consumers won't significantly increase their consumption due to all firms having similar prices.
The kinked-demand theory vividly captures the strategic interactions between firms that result in stable prices in oligopolistic markets, avoiding price wars that nobody wants.

Elasticity

Elasticity measures how much the quantity demanded of a good changes when its price changes. In the context of the kinked-demand theory, elasticity plays a crucial role.
- **Price Increase:** The concept above the kink demonstrates high elasticity. This means that a small price increase can lead to a significant reduction in the quantity demanded because consumers find the higher prices less appealing and switch to competitors.
- **Price Decrease:** Underneath the kink, elasticity is lower. A price reduction doesn't dramatically increase demand because competitors also lower their prices, decreasing the relative attractiveness of switching to a lower priced firm.
Understanding elasticity helps firms anticipate how consumers will respond to price changes, guiding strategic pricing decisions within an oligopoly. By examining the elasticity at various points on the demand curve, firms can adjust to maintain optimal profitability.

Price Strategy

Price Strategy in oligopoly markets is significantly shaped by kinked-demand theory. Companies must carefully consider their price moves because it affects their demand and market position.
- **Avoiding Price Wars:** Oligopolists tend to avoid significant price cuts since rivals match these cuts, leading to widespread reduced profit margins across the industry. Maintaining stable prices is often a preferred strategy.
- **Strategic Price Increases:** Firms also hesitate to increase prices due to high elasticity above the kink, risking losing a considerable customer base to competitors.
- **Maintaining Market Share:** Pricing strategies are highly influenced by the desire to maintain or slightly grow market share without provoking aggressive competition responses.
Firms focus on non-price competition, such as product differentiation and advertising, to reinforce their market position without engaging in destructive price competition.

Market Share

In an oligopoly, market share becomes a critical focus because the few companies in the industry are intensely competitive. Companies aim to control as much of the market as possible to secure better bargaining power and profitability.
- **Impact of Price Changes:** Market share is impacted by price strategies. An increase in price might lead to a loss of market share if competitors do not follow, due to consumers' elasticity of demand. Conversely, if a firm lowers its prices, rivals often do the same, which means the competition remains unchanged though profits may be reduced.
- **Strategic Actions:** To bolster market share, firms might focus on improving product quality, innovation, or branding to make their offering more attractive in ways other than price.
By carefully balancing these actions, oligopolistic firms strive to strengthen their market share, ensuring their competitive edge while avoiding price wars that can damage the entire market segment.