Kinked-Demand Theory and Oligopoly Pricing

Kinked-Demand Theory for Oligopolies

Introduction to Oligopoly Demand

Oligopolies are market structures characterized by a small number of firms whose decisions are interdependent. The demand curve faced by each firm in an oligopoly is not uniform across industries, due to differences in the number of firms and the nature of competition. The kinked-demand theory explains how price and output decisions are influenced by the reactions of rival firms.

• Diversity of Oligopolies: The demand curve varies depending on the number of firms and the degree of interdependence.

• Interdependence: Firms must consider how rivals will react to changes in price or output, making demand estimation uncertain.

• Difficulty in Predicting Rival Reactions: Firms cannot easily forecast competitors' responses, complicating price and output maximization.

Kinked-Demand Curve: Theory and Construction

The kinked-demand curve model combines two possible reactions of rival firms when a firm changes its price. It is based on the assumption that rivals will match price decreases but not price increases.

• Price Decrease: If a firm lowers its price, rivals are likely to match the decrease to maintain market share, resulting in a relatively inelastic demand below the current price.

• Price Increase: If a firm raises its price, rivals may not follow, causing the firm to lose sales to competitors. Demand above the current price is relatively elastic.

• Kinked Shape: The demand curve has a 'kink' at the current price, reflecting the change in elasticity due to rival reactions.

Example: Consider three rival firms (e.g., Burger Queen, Windy's, and another) selling similar products in an oligopolistic market. If one firm changes its price, the others may either match the change or keep their prices constant, affecting the original firm's sales and demand curve.

Marginal Revenue and Price Stability

The kinked-demand curve leads to a discontinuous marginal revenue (MR) curve, which has important implications for price stability in oligopolies.

• Marginal Revenue Curve: The MR curve has a vertical segment at the kink, corresponding to the discontinuity in the demand curve.

• Price Rigidity: Changes in marginal cost (MC) within the vertical segment of the MR curve do not affect the profit-maximizing price and output. This explains why prices in oligopolies tend to be stable, even when costs fluctuate.

• Equation: The profit-maximizing condition is $MR = MC$, but with a kinked-demand curve, small shifts in MC may not lead to price changes.

Example: If the MC curve shifts but remains within the discontinuous segment of the MR curve, the firm has no incentive to change its price, resulting in price stability.

Summary Table: Kinked-Demand Theory Features

Feature	Description
Demand Elasticity Above Kink	Relatively elastic; rivals do not match price increases
Demand Elasticity Below Kink	Relatively inelastic; rivals match price decreases
Marginal Revenue Curve	Discontinuous at the kink; vertical segment
Price Stability	Prices tend to remain stable despite changes in marginal cost

Conclusions and Applications

The kinked-demand theory provides a framework for understanding price rigidity in oligopolistic markets. Firms are reluctant to change prices due to uncertain rival reactions and the structure of the demand and marginal revenue curves. This model is particularly relevant in industries where a few firms dominate and competitive responses are difficult to predict.

Additional info: The kinked-demand theory is a classic model in microeconomics, often used to explain observed price stability in real-world oligopolies such as airlines, fast food chains, and automobile manufacturers.