Question

Faceblock, Gargle+, and SnapHat 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

Understand Kinked-Demand Theory

The kinked-demand theory suggests that in an oligopoly, firms face a demand curve with a 'kink.' This kink occurs at the prevailing market price. Above this price, demand is more elastic because a price increase will lead to a significant loss of customers to competitors. Below this price, demand is less elastic because a price decrease is unlikely to attract many new customers from competitors, who will also lower their prices.

Determine Demand Elasticity Above Current Price

According to kinked-demand theory, above the current price, Faceblock's demand curve is relatively more elastic. This means that raising prices will likely cause a large decrease in quantity demanded, as customers can easily switch to buying from competitors who have not changed their prices.

Determine Demand Elasticity Below Current Price

Below the current price, the demand is less elastic. This is because lowering prices does not substantially increase the quantity demanded. Even if Faceblock reduces its price, competitors are likely to match this reduction, leading to little gain in market share.

Conclude the Correct Answer

Since Faceblock's demand is more elastic above the current price and less elastic below it, the answer is that the demand curve is more elastic above the current price than below it. Thus, option (a) is correct.

Key concepts

Oligopoly

An oligopoly is a market structure characterized by a small number of firms that dominate an industry. In such markets, the actions of one firm can significantly impact the others. This interconnected presence creates a strategic environment where each firm must carefully consider the potential reactions of its competitors before making decisions, such as changing prices or adjusting production levels.

Some key features of oligopolies include:

• Few Dominant Firms: Typically, a handful of large firms control a significant portion of the market share.
• High Barriers to Entry: New firms may find it difficult to enter the market due to high setup costs or strong existing brand loyalty.
• Interdependence: The decisions made by one firm affect the outcomes and strategies of the competing firms.
• Potential for Collusion: Firms may collaborate (formally or informally) to set prices or output levels, although this is often regulated by laws to prevent unfair competition.

Understanding oligopolies helps explain why price competition is limited and why strategic thinking about pricing involves considering the responses of competitors.

Elasticity

Elasticity, in economics, measures how sensitive the quantity demanded or supplied of a good is to a change in price. It is a crucial concept that helps businesses and economists understand how changes in market conditions can affect demand or supply levels.

There are two main types:

• Price Elasticity of Demand: This indicates how much the quantity demanded changes in response to a price change. High elasticity means consumers are very responsive to price changes, while low elasticity indicates they are less responsive.
• Price Elasticity of Supply: This measures the responsiveness of the quantity supplied to a price change.

In the context of the kinked-demand theory, elasticity plays a special role. Above the kink, the demand is more elastic, and a price increase results in a more than proportional drop in quantity demanded. Conversely, below the kink, demand is less elastic, meaning that a decrease in price will not lead to a significant increase in quantity demanded, as competitors may also lower their prices.

Demand Curve

The demand curve is a graphical representation showing the relationship between the price of a product and the quantity demanded. Traditionally, it slopes downward from left to right, reflecting the inverse relationship between price and quantity demanded. However, in the case of the kinked-demand theory, the curve has a distinct 'kink.'

The kink in the demand curve occurs at the market's current price point. Here's what happens around this kink:

• Above the Kink: The curve is more elastic, meaning consumers will respond with a significant change in quantity demanded if prices rise.
• Below the Kink: The curve is less elastic, indicating that quantity demanded has a muted response to price decreases.

This kinked shape arises because firms in an oligopoly are highly aware of competitor actions, leading to different elasticity above and below the prevailing market price.

Market Price

Market price is the current price at which a good or service can be bought or sold in a marketplace. In an oligopoly, setting the market price involves strategic decision-making due to the limited number of competing firms.

Key factors influencing market price include:

• Competitive Behavior: As firms in an oligopoly are few, each firm’s pricing strategy can affect the market price and potentially trigger reactions from competitors.
• Supply and Demand: While an oligopoly limits competitive pressure, the basic supply and demand laws still play a role in determining the market price.
• Cost of Production: Firms must consider their production costs to ensure pricing strategies remain profitable while being competitive.

The concept of a kinked-demand curve directly ties in with market price, as the 'kink' itself represents the current market price. A firm's pricing decisions above or below this point are influenced by anticipated competitor responses, making strategic pricing critical in maintaining market position.