Kinked-Demand Theory

it's usually tough to show the demand curve for an oligopoly because there's a lot of variables at play. But let's discuss one theory, the kink demand theory for oligopolies. So like I said, these demand curves for oligopolies um they're not the same across different industries because of two main reasons. First, the diversity of oligopolies. So remember there's no hard and fast rules for the number of firms in a certain oligopoly. There could be two firms, three firms, four or five, right? The number of firms is gonna affect the demand curve and the way it interacts. So the number of firms is going to affect the demand curve in the oligopoly and the interdependence of the firm's this is something that we don't see in any other market structure, right? Monopolies don't show interdependence. They're the only um the only firm in the business perfect competition. The firms have no influence over the price, Right? But this oligopoly is this special beast because the firms react to each other. Right? The firm's affect the decisions of other firms? Okay. They have to react to price changes and things like that. So it's not always easy to predict rival reactions if you drop your prices, are they gonna match your price drop? If you raise your prices? Are they gonna raise their prices right? What's gonna happen? And in that because of that, the profit maximizing price and output is not so easily gauged. So it's not so easy to talk about it on a graph. Okay. Um but what the kink demand theory does is it tries to take the most likely outcomes and show it on a graph to to be able to create a demand curve. So let's go through an example and see how this kink demand theory works. Okay, so Mcdonald's burger queen and Wendy's are rival firms producing black bean burgers in an oligopoly stick environment. If Mcdonald's changes their prices, there are two ways that its competitors could react, right? So now one person's changing their prices. Remember when we talk about oligopolies, a lot of times we talk about game theory and we say if we raise our prices, what's going to happen to our competitors? And we gauge different situations to find our best outcome. But in this situation, what are we gonna see here? So Macdonald is changing their prices. How are their competitors gonna react? There's two things they could do. The competitors could either match the price changes or they can ignore the price changes. Let's go one by one here. If the rivals match the price changes, we're gonna have this steeper, we'll have a steep steep demand curve. So let's go ahead and this yellow line down here, this is our steeper demand curve when the rival matches the price changes. So why is it steeper? Well, let's think about the two situations. If the price decreases, there's no advantage gained, right? If we decrease our price and our rivals decreased their price. Well, we're not going to gain an advantage over them, we're still gonna have um, similar prices in the competitors and the consumers, i so they're gonna stick with their favorite brands. However, since there's lower prices, well, we're gonna have a slight increase in overall quantity in the in the industry. So if you'll notice what's happening here, right, just like we would expect if there's if we're at this point and we lower our prices, right? If this is a price here and quantity here, well, if we've got lower prices, well, at this lower price, what happens? We sell a higher quantity, right? A lower price and a higher quantity, just like we're used to with demand. Um But what happens with the price increase is that if we increase our price and our other firms increased their price? Well, in our industry, everything is the same. But there's gonna people that leave our industry altogether, consumers leave our industry altogether. They'll say, I'm not gonna buy black beans, I'll go buy a regular burger instead. I'm going to give up being a vegan because these prices have gotten too high and I'll go to regular restaurants rather than these special restaurants with black bean burgers. Right? So in those cases we're gonna lose quantity, right? Maybe we're here, we increase our prices and we're going to end up at this point, where were we have a higher price but a lower quantity exchanged, Right? So that's something that we can expect, um And we've got these this steeper curve from that Now, what about if rivals ignore our price changes? So what's gonna happen in that situation is we're gonna have a shallower demand curve will have the shallower grain curve that I have on the graph. So what happens with a price decrease if we decrease our price and the competitors don't match it? Well, we've got an advantage, right? We have an advantage now. Right? So what's the difference here? Notice if we decrease our price? So let's say we decrease our price that much. Look how much more quantity we get right compared to the shallow the shallow curve, right? Where it was a much smaller increase when we decreased our price, we get a smaller increase in quantity. Well, in this case we're stealing uh customers from our competitor because our prices lower in our industry. Well, we're gonna get a big advantage there, right? So we'll see a large increase in our quantity when we've got a price decrease that our competitors don't match. Right? So, remember, we're looking at what what our competitors do in these situations. So the final situation is where we increase our price and our competitors don't match. Well, that's gonna suck for us, right? Because we increase our price. So we were here and we increase our price. Well, look what happens to our quantity. It goes way down, right? Our quantity goes way down because we increased our price and that's because the other companies burger queen and Wendy's they're stealing our customers right there offering a similar product. Um But they didn't increase their price. Now our customers are gonna go purchase from them instead. So that's why we end up when the rival ignores our price changes on this steeper demand curve, right? A more elastic demand curve? Where in in the price matching, we have the steeper demand curve rather than, excuse me, the shallow demand curve when they ignore our price changes. Alright, So I know that's a lot of information. But where am I getting with this? Where does this lead to the kink demand theory? So what this tells us is that we're gonna take the most likely event in these cases. So what's most likely we're gonna think about a price increase and a price decrease. If we were going to increase our price. Well, are our rivals are better off ignoring it, right? Just like we said, if we increase our price, well, our customers are gonna go over to them, right? Our customers are gonna buy from them instead. So our competitors are likely going to ignore our price increases. So that's what's gonna happen here. The competitors are gonna ignore our price increases. But if we decrease our price, well, they're gonna want to match that, right? Because what we saw is if we decrease our price, we're gonna gain an advantage over them if they don't match us. So what they're gonna do is they're gonna match us when we decrease our price? So we're gonna gain customers from other industries? So there's gonna be a slight increase in our quantity, but we're not going to gain an advantage over our competitors are direct competitors. Okay. So that's what the kink demand theory says that there's gonna be two outcomes if we decrease our price. Our competitors are gonna match us, if we increase our price, our competitors are gonna ignore us. So that leads us to have this kinked demand curve and it's called kink because it has this kink in it. There's a spot where it changes like that. Okay, So that's what we have on the right hand graph here, notice what I've done. I've taken this portion of the graph right here, and this portion of this graph right here to create our kinked demand curve. So this blue line that we have here notice I've shaded out the other portion of the line. This is our kinked demand curve. This is the demand curve for the oligopoly. Alright, so notice what we have is what we have an increase in prices. Well, we've got the steeper or the shallower curve where we're gonna lose a lot of quantity and when we decrease our prices. Well, our competitors are gonna match us and we're not gonna lose as we're not gonna gain as much because they're matching us there. Okay. So how does this relate to our other discussions? Remember when we talked about our demand curve, we also had our marginal revenue curve and our marginal cost curves. So, remember how are marginal revenue curves looked in our other examples, it's gonna be similar here. We're gonna have a marginal revenue curve that goes down something like this here. But notice what's gonna happen since it's kinked since it has two different slopes are marginal revenue is going to have two different slopes and it's gonna look something like this actually. So, it's actually a pretty interesting shape that we get in our marginal revenue curve. Where at this point, so at this point, this is our current current uh price and quantity. So that's the current level of production there. Um remember that's where the market has stabilized is at that point. So, if we were to increase or decrease our prices, our competitors would react with ignoring or matching the price changes. So this is what generally happens is that we're kind of stuck at that price because of this. So, we're gonna have this marginal revenue curve here and we'll have our marginal cost curve somewhere uh going through there. So like marginal, So that's the red line being our marginal revenue and then we'd have our marginal cost. Right? So we would want our marginal cost to be something like that marginal cost going there, or anywhere in here. Right, What if our marginal cost was anywhere in here at any of these points? Well, we would we would not change production even if our marginal cost went up within that range, we wouldn't change our level of production because that would affect our our total profit. Right? We want to keep where are marginal revenue equals marginal cost. And anywhere within this range, we're going to keep the same level of production if the marginal cost starts getting too high somewhere over here, Well, we would have a new level of production over here, right? Where we would want to produce instead, and that would affect our our competitor decisions and everything like that. So, this is where it gets a little bit complicated, right? But we don't need to go that deep into it. The main thing we want to notice about this king demand curve. The main takeaway here is that it makes prices inflexible, right? It makes us not want to change our price from this point, because if we were to increase prices, that's going to affect us negatively. If we decrease our prices or our competitors are gonna match us and we're not gonna gain too much, we're gonna have lower prices and lose profit in that case as well. So, the conclusions related to this model first is that shift in marginal cost that we just saw, right? Any shift in marginal cost within this range is not gonna affect production when we saw in other situations when we were in, let's say, perfect competition or um, monopolies or monopolistic competition. If there's a change in marginal cost, well, that's gonna touch the marginal revenue at a different point, it's gonna change our level of production as long as we stay within this range. Well, we're not going to affect our production at all. It's not going to affect, will not affect price and quantity anywhere between those two marginal revenue sections. Okay. And that main takeaway right here, this price inflexibility, right? Prices are generally gonna be stable in oligopolies due to the demand and cost size of the kink. Right? Where we're at this point where we've stabilized at this current price and quantity and if we were to make any changes, well, that's going to have big effects on our competitors decisions, our demand curve, everything's gonna be changing. So things are generally gonna stay pretty stable in a oligopoly environment. So even if the cost changed dramatically, right? As we saw in this situation where we have different levels of marginal cost, the firm still may have no reason, may still have no reason to change its prices. Okay, So, uh, that's, that's a big deal here. Um, the main thing here is, is noticing that there's that kink and there's that inflexibility in the prices. However, you're not going to be tested so heavily on this theory, it's more likely that you just have to know those main takeaways, right? To notice that we've got this kink and that's because of our competitor decisions, like we saw with game theory. All right. So nothing too crazy here. I know it was a bit complicated. Um, just make sure you understand those big takeaways. If anything, just rewatched that last example that we just went through and how we derived, uh, the demand curve there. Cool. Alright, let's go ahead and move on to the next video.