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.

Key concepts

Oligopoly Market

An oligopoly market is a type of market structure where a few large firms dominate the market. This limited number of firms means that each one is aware of the actions of the others, which significantly affects their strategic decisions. This awareness leads to a mutual interdependence where the market actions of one firm impact the revenue and competitiveness of others.
In an oligopoly, firms are wary of competition because becoming overly aggressive in marketing or price changes could lead to a price war, eroding profits for everyone involved. To have a balance, they often act in a tacitly cooperative manner - matching prices, advertising, or production levels. This cooperation, however, is not overtly collusive and is more about strategic interactions.

Key features of an oligopoly market include:

• Few dominant firms
• High barriers to entry, making it difficult for new competitors to enter
• Products might be identical or differentiated
• Pricing strategies are interlinked with competitors' actions

Oligopolies are prevalent in industries like telecommunications, airlines, and automobiles. Understanding this market structure helps explain the behaviors and strategies within the kinked demand curve model.

Price Rigidity

Price rigidity refers to the phenomenon where prices in a market remain constant despite changes in supply or demand conditions. This is particularly evident in oligopolistic markets where price changes can lead to unpredictable and undesirable competitive reactions.
The kinked demand curve model is a theory that seeks to explain why prices might become rigid in an oligopoly. According to this model, once a firm sets its price, it might not have any incentive to alter it, even if costs or demand changes occur. This is because of the anticipated reaction of rival firms, which might cause undesirable outcomes for the firm initiating a price change.

• Price Increase: Not matched by competitors, leading to loss of market share.
• Price Decrease: Quickly matched by competitors, meaning little to no gain in market share.

This results in a stable price at the kink of the demand curve, causing firms to experience price rigidity. As a consequence, the price remains static as no firm wants to decrease prices and lose profits, nor increase prices to lose customers.

Elastic Demand Curve

The concept of elasticity in demand describes how sensitive the quantity demanded of a good is to a change in its price. In the context of the kinked demand curve model, the demand curve elasticity varies above and below the current price level, explaining the kink.
A demand curve is called elastic when a small change in price results in a relatively large change in the quantity demanded. In an oligopoly, if a firm raises its prices, other firms might not follow. Here, the demand is elastic because customers switch to competing products, significantly reducing the firm’s market share and revenue.
Conversely, when a firm lowers its prices, other firms quickly match the drop to maintain their market share, leading to a less elastic demand curve. A small change in price in this case does not significantly increase the quantity demanded as competitors replicate the price cut, keeping market shares stable.

Critical points include:

• Elastic portion: Occurs during a price increase, where firms face steeper demand curves.
• Less elastic portion: Occurs during a price decrease, where the demand curve flattens.

Understanding elasticity in the kinked demand curve is essential to grasp why firms behave cautiously when contemplating price changes in an oligopoly market.