Kinked-Demand Theory - Online Tutor, Practice Problems & Exam Prep

The kinked demand theory explains price stability in oligopolies, where firms react to each other's pricing strategies. If a firm lowers prices, competitors typically match, leading to a steeper demand curve. Conversely, if a firm raises prices, rivals often ignore the change, resulting in a shallower demand curve. This creates a kinked demand curve, indicating price inflexibility. Marginal revenue reflects this kink, showing that shifts in marginal cost within a certain range do not affect production levels, emphasizing the unique interdependence of firms in oligopolistic markets.

Oligopoly:Kinked Demand Theory

It's usually tough to show the demand curve for an oligopoly because there are a lot of variables at play. But let's discuss one theory, the kink demand theory for oligopolies. Oligopolies, they're not the same across different industries because of two main reasons. First, the diversity of oligopolies. So remember, there are no hard and fast rules for the number of firms in a certain oligopoly. There could be 2 firms, 3 firms, 4, 5, right? The number of firms is going to affect the demand curve and the way it's structured, right? Monopolies don't show interdependence. They're the only firm in the business. Perfect competition. The firms have no influence over the price, right? But this oligopoly is a special beast because the firms react to each other, right? The firms 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 going to match your price drop? If you raise your prices, are they going to raise their prices, right? What's going to happen? And because of that, the profit-maximizing price and output are not so easily gauged. So it's not so easy to talk about it on a graph. Okay? But what the kink demand theory does is it tries to take the most likely outcomes and show it on a graph 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 McDonough's, Burger Queen, and Wendy's are rival firms producing black bean burgers in an oligopolistic environment. If McDonough's changes their prices, there are two ways that its competitors could react. Right? So now one person is 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 going to see here? So McDonough's is changing their prices. How are their competitors going to react? There are 2 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 going to have a steeper 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 2 situations. If the price decreases, there's no advantage gained, right? If we decrease our price and our rivals decrease their price, well, we're not going to gain an advantage over them. We're still going to have similar prices in the consumer's eye, so they're going to stick with their favorite brands. However, since there are lower prices, well, we're going to have a slight increase in overall quantity in the industry. So if you'll notice what's happening here, right, just like we would expect that 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. But what happens with the price increase is that if we increase our price and our other firms increase their price, well, in our industry everything's the same, but there's going to be people that altogether. They'll say I'm not going to buy black bean burgers. 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 going to lose quantity. Right? Maybe we're here. We increase our prices and we're going to end up at this point where we have a higher price but a lower quantity exchanged. Right? So that's something that we can expect, and we've got the steeper curve from that. Now what about if rivals ignore our price changes? So what's going to happen in that situation is we're going to have a shallower demand curve. We'll have the shallower green 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 ourprice that much, look how much more quantity we get, right, compared to the shallow the shallow curve, right, where it was a much more Well, in this case, we're stealing customers from Well, in this case, we're stealing customers from our competitor because our price is lower in our industry. Well, we're going to 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 would 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 going to 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, are stealing our customers, right? They're offering a similar product, but they didn't increase their price. Now our customers are going to go purchase from them instead. So that's why we end up when the rival ignores our price changes on a steeper demand curve, right? A more elastic demand curve wherein 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 going to take the most likely event in these cases. So what's most likely? We're going to think about a price increase and a price decrease. If we were going to increase our price, well, our rivals are better off ignoring it. Right? Just like we said, if we increase our price, well, our customers are going to go over to them. Right? Our customers are going to buy from them instead. So our competitors are likely going to ignore our price increases. So that's what's going to happen here. The competitors are going to ignore our price increases, but if we decrease our price, well, they're going to want to match that, right? Because what we saw is if we decrease our price, we're going to gain an advantage over them if they don't match us. So what they're going to do is they're going to match us when we decrease our price. So, we're going to gain customers from other industries. So there's going to be a slight increase in our quantity, but we're not going to gain an advantage over our competitors, our direct competitors. Okay? So that's what the kink demand theory says that there are going to be 2 outcomes. If we decrease our price, our competitors are going to match us. If we increase our price, our competitors are going to ignore us. So that leads us to have this kinked demand curve and it's called kinked 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 going to lose a lot of quantity and when we decrease our prices, well, our competitors are going to match us, and we're not going to lose as we're not going to 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 our marginal revenue curves looked in our other examples? It's going to be similar here. Going to have a marginal revenue curve that goes down something like this here, but notice what's going to happen since it's kinked, since it has two different slopes, our marginal revenue is going to have 2 different slopes and it's going to 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 price and quantity. So that's the current level of production there. 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 kinda stuck at that price because of this. So we're going to have this marginal revenue curve here and we'll have our marginal cost curve somewhere 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 total profit, right? We want to keep where our marginal revenue equals our 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 our competitor decisions and everything like that. So we would have a new level of production over here, right? Where we would want to produce instead and that would affect 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 wanna notice about this kink 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, our competitors are going to match us and we're not going to gain too much. We're going to 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 going to affect production. When we saw in other situations when we were in let's say perfect competition or monopolies or monopolistic competition, if there's a change in marginal cost, well that's going to touch the marginal revenue at a different point. It's going to 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 2 marginal revenue sections. Okay? And that main takeaway right here, this price inflexibility. Right? Prices are generally going to be stable in oligopolies due to the demand and cost sides of the kink, right? Where we're at this point that 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 going to be changing. So things are generally going to stay pretty stable in an oligopoly environment. So even if the cost changes 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, that's a big deal here. 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. Alright. So nothing too crazy here. I know it was a bit complicated. Just make sure you understand those big takeaways. If anything, just rewatch that last example that we just went through and how we derived the demand curve there. Cool? Alright. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the kinked demand curve in oligopoly?

The kinked demand curve in oligopoly is a model that explains price stability in markets where a few firms dominate. It suggests that if a firm lowers its price, competitors will match the price decrease to avoid losing market share, resulting in a steeper demand curve. Conversely, if a firm raises its price, competitors will ignore the increase, leading to a shallower demand curve. This creates a 'kink' in the demand curve, indicating that prices are inflexible. The kinked demand curve shows that firms are unlikely to change prices because the potential gains from lowering prices or the losses from raising prices are minimized by competitors' reactions.

How does the kinked demand theory explain price rigidity in oligopolistic markets?

The kinked demand theory explains price rigidity in oligopolistic markets by illustrating how firms react to each other's pricing strategies. If a firm lowers its price, competitors typically match the decrease, leading to a steeper demand curve and minimal gain in market share. If a firm raises its price, competitors often ignore the increase, resulting in a shallower demand curve and a significant loss of market share. This creates a kink in the demand curve, making prices inflexible. Firms are discouraged from changing prices because the potential benefits of lowering prices or the drawbacks of raising prices are offset by competitors' reactions, leading to stable prices.

What are the main assumptions of the kinked demand curve model?

The main assumptions of the kinked demand curve model are: 1) Firms in an oligopoly are interdependent and react to each other's pricing strategies. 2) If a firm lowers its price, competitors will match the price decrease to avoid losing market share, resulting in a steeper demand curve. 3) If a firm raises its price, competitors will ignore the price increase, leading to a shallower demand curve. 4) The demand curve has a kink at the current price level, indicating price inflexibility. 5) Marginal revenue curves reflect the kink, showing that shifts in marginal cost within a certain range do not affect production levels, emphasizing the unique interdependence of firms in oligopolistic markets.

How does the kinked demand curve affect marginal revenue in an oligopoly?

The kinked demand curve affects marginal revenue in an oligopoly by creating a discontinuity in the marginal revenue curve. Due to the kink in the demand curve, the marginal revenue curve has two different slopes, reflecting the different elasticities of demand above and below the kink. This results in a gap or vertical segment in the marginal revenue curve at the kink point. Consequently, shifts in marginal cost within this range do not affect the firm's production level or price, leading to price rigidity. Firms are less likely to change prices because the marginal revenue remains stable within the kinked range, emphasizing the interdependence of firms in an oligopolistic market.

What are the implications of the kinked demand curve for price competition in oligopolies?

The implications of the kinked demand curve for price competition in oligopolies are significant. The model suggests that prices are rigid and unlikely to change because firms anticipate competitors' reactions. If a firm lowers its price, competitors will match the decrease, resulting in minimal gain in market share and a steeper demand curve. If a firm raises its price, competitors will ignore the increase, leading to a significant loss of market share and a shallower demand curve. This creates a kink in the demand curve, making firms reluctant to change prices. As a result, price competition is minimized, and prices remain stable, leading to less aggressive pricing strategies in oligopolistic markets.