Question

What assumptions about a rival's response to price changes underlie the kinked-demand curve for oligopolists? Why is there a gap in the oligopolist's marginal-revenue curve? How does the kinked-demand curve explain price rigidity in oligopoly? What are the shortcomings of the kinked-demand model?

Short answer

The kinked-demand curve suggests firms assume rivals match price cuts but not hikes, creating a MR gap due to demand elasticity changes. This leads to price rigidity, though the model lacks explanation for initial price setting and ignores factors beyond rival reaction.

Step-by-step solution

Understanding the Kinked-Demand Curve

The kinked-demand curve model assumes that each oligopolist believes their rivals will match price decreases but not price increases. This assumption creates a demand curve that is more elastic above the current price (because rivals do not follow price increases) and less elastic below the current price (because rivals do follow price decreases).

Explaining the Marginal Revenue Gap

The kinked-demand curve leads to a discontinuity in the marginal revenue curve. When the demand curve is kinked, the marginal revenue, which is derived from the demand curve, will have a sudden drop or gap at the point of the kink, reflecting the sudden change in the elasticity of demand.

Price Rigidity Explained

The kinked-demand curve model explains price rigidity by suggesting that any change in price will lead to less favorable outcomes for the firm. Due to the non-linear demand and the marginal revenue gap, any increase in price results in a significant loss of market share, while a decrease results in reduced revenue. Consequently, firms maintain the current price to avoid these unfavorable outcomes.

Identifying Model Shortcomings

The kinked-demand model has several shortcomings. It fails to explain how the original price was determined, assumes price changes only react to competitor actions without considering other factors, and doesn't account for product differentiation or market entry by new competitors. Additionally, empirical evidence supporting the model is limited, making it less reliable as a sole explanation for oligopolistic behavior.

Key concepts

Oligopolist Behavior

In the world of economics, oligopolist behavior plays a crucial role in shaping market dynamics. An oligopoly is a market structure where a small number of large firms dominate the industry. These firms are interdependent, meaning each one's actions can affect the others significantly.

In a typical scenario, firms in an oligopoly closely monitor each other's pricing strategies. This is where the kinked-demand curve concept comes into play. The theory suggests that if one firm lowers its prices, competitors will follow to avoid losing market share. However, if a firm raises its prices, others might not match the increase. As a result, firms are hesitant to change prices, which leads to price stability or rigidity.

This behavior is driven by the firms' motivations to maintain their market share and avoid price wars that could harm their profits. Thus, the kinked-demand curve explains why oligopolists might exhibit such seemingly rigid pricing behavior, balancing between competing aggressively and preserving profitability.

Price Rigidity

Price rigidity in oligopolistic markets is a fascinating phenomenon. It refers to the tendency of firms to keep prices stable rather than frequently adjusting them, even when costs or demand fluctuates. The kinked-demand curve model offers a compelling explanation for this behavior.

The model posits that firms face a demand curve that is more elastic for price increases than for price decreases. Should a firm unilaterally decide to increase its prices, it risks losing a significant portion of its customers to rivals who haven't changed their prices. Conversely, if a firm reduces its prices, competitors will likely match the cut, leaving the first firm with the same market share but lower revenue. Consequently, these outcomes discourage firms from changing prices, leading to price rigidity.

In essence, the kinked-demand curve highlights how competitor reactions can create a "sticky" price environment. Prices become stable as firms aim to avoid the negative consequences of deviating from the current price level.

Marginal-Revenue Curve Gap

The marginal-revenue curve gap is a unique feature resulting from the kinked-demand curve. Understanding this gap is essential in grasping why price changes are unfavorable for firms in such markets.

In the kinked-demand curve model, the demand curve experiences a sharp change in elasticity at a specific price. Above this kink, the demand is more elastic (consumers are sensitive to price changes), and below the kink, it is less elastic (consumers are less responsive).

This sudden shift in elasticity causes the marginal revenue curve, derived from the demand curve, to exhibit a gap or discontinuity at the kink. Mathematically, this is because marginal revenue depends on the slope of the demand curve.

• If the demand is elastic, marginal revenue is higher, reflecting potential gains with small price changes.
• If the demand is inelastic, marginal revenue is lower, indicating minimal gains.

Thus, the marginal-revenue gap signifies the potential profit loss/gain depending on the direction of a price change. This discontinuity reinforces the decision of firms to avoid price changes, hence contributing to price rigidity in oligopolistic markets.