Economics Oligopoly Questions Long
The kinked demand curve model is a theory used to explain the behavior of firms in an oligopoly market structure. In an oligopoly, there are only a few dominant firms that control a significant portion of the market. These firms are interdependent and their actions have a direct impact on the market conditions and the behavior of other firms.
The kinked demand curve model suggests that firms in an oligopoly face a demand curve that is kinked or discontinuous at the current market price. This kink arises due to the different reactions of rival firms to price changes. The model assumes that if a firm increases its price, other firms will not follow suit, resulting in a significant loss of market share for the firm that increased its price. On the other hand, if a firm decreases its price, other firms are likely to match the price reduction, leading to a smaller increase in market share for the firm that lowered its price.
The kinked demand curve model is based on the following assumptions:
1. Rival firms will not match a price increase: The model assumes that if a firm increases its price, other firms will not follow suit. This is because firms fear losing market share and believe that increasing prices will not lead to a significant increase in revenue.
2. Rival firms will match a price decrease: The model assumes that if a firm lowers its price, other firms will match the price reduction. This is because firms believe that lowering prices will lead to a larger increase in market share and revenue.
Based on these assumptions, the kinked demand curve model predicts that the demand curve facing a firm in an oligopoly will be relatively elastic above the current price and relatively inelastic below the current price. This means that a firm can increase its price without losing much market share, but if it lowers its price, it will face stiff competition from other firms.
The kinked demand curve model has several implications for the behavior of firms in an oligopoly. Firstly, it suggests that firms in an oligopoly have an incentive to maintain price stability. This is because any deviation from the current price will result in a loss of market share and potential revenue. Therefore, firms are likely to engage in non-price competition, such as advertising, product differentiation, and customer service, to maintain their market position.
Secondly, the kinked demand curve model implies that price wars are unlikely to occur in an oligopoly. Since firms are expected to match price decreases but not price increases, there is a strong incentive for firms to avoid engaging in aggressive price competition. Instead, firms are more likely to focus on maintaining their market share through other means.
Lastly, the kinked demand curve model suggests that oligopolistic firms may experience periods of price stability followed by sudden and significant price changes. This is because firms are hesitant to change prices unless there is a significant change in costs or market conditions. However, once a firm decides to change its price, other firms are likely to follow suit, leading to a sudden shift in market prices.
In conclusion, the kinked demand curve model provides insights into the behavior of firms in an oligopoly market structure. It suggests that firms in an oligopoly face a demand curve that is kinked at the current price, with relatively elastic demand above the price and relatively inelastic demand below the price. This model highlights the importance of price stability, non-price competition, and the likelihood of sudden price changes in oligopolistic markets.