Question

In the kinked demand curve model, why do firms match only price decreases and not price increases?

Short answer

Answer: In the kinked demand curve model, firms in an oligopolistic market face different incentives when increasing or decreasing prices. When firms increase prices, they face a steeper and more elastic demand curve, as they assume rivals will not follow suit, leading to a significant loss in market share and revenue. On the other hand, when firms decrease prices, they anticipate rivals will quickly match the price decrease, resulting in a flatter and less elastic demand curve. This means that there will be no significant change in market share or profits, as all firms will lower their prices. Consequently, this model leads to price rigidity, as firms are more likely to maintain their prices at the current level despite changes in cost conditions, since increasing prices will result in a loss of market share and decreasing prices will not lead to significant gains in market share.

Step-by-step solution

Understand the Kinked Demand Curve Model

In the kinked demand curve model, firms in an oligopoly market face two different demand curves for their products: one when they increase prices and another when they decrease prices. If a firm increases its price, it faces a steeper and more elastic demand curve because consumers will quickly switch to rival products. However, if a firm decreases its price, it faces a flatter and less elastic demand curve because its rivals will quickly match the price decrease to avoid losing market share. This results in a kinked demand curve where the kink occurs at the current market price.

Analyze Firms' Incentives in the Kinked Demand Curve Model

In the kinked demand curve model, firms have different incentives when it comes to increasing or decreasing their prices. Let's analyze the incentives in detail: 1. In case of price increase: If a firm increases its price, it assumes that its rivals will not follow suit. Hence, the firm will face a steeper and more elastic demand curve, leading to a significant loss in market share and revenue, as consumers switch to the rival products. This disincentivizes the firm from raising its price. 2. In case of price decrease: If a firm decreases its price, it anticipates that its rivals will immediately match the price decrease in order to avoid losing market share. As a result, the demand curve faced by the firm is flatter and less elastic after the price decrease. Thus, the firm's profit and market share will not change significantly as all the firms have followed the price drop. Therefore, firms are more likely to match price decreases to maintain their market share.

Price Rigidity and Kinked Demand Curve Model

The kinked demand curve model results in price rigidity, which means that prices in the market tend not to change even when costs change. This is because firms in the market are aware that price increases will lead to a loss in market share as rivals will not increase their prices and price decreases will not result in a significant increase in market share as rivals will match the price drop. Consequently, firms are more likely to maintain their prices at the current level. An important implication of the kinked demand curve model is that it helps explain the observed price rigidity in some oligopolistic markets, where prices tend to remain stable despite changes in cost conditions.