Q5Managerial Economics & Financial Accounting
Question
Using suitable diagram, explain the kinked demand curve under Oligopoly.
Answer
The kinked demand curve explains price rigidity in oligopoly, assuming competitors will match price cuts but ignore price increases.
The Kinked Demand Curve model (developed by Paul Sweezy) explains why prices in an oligopolistic market (like airlines or telecom) tend to remain rigid and sticky, even if costs change.
The Assumption of Asymmetric Reaction: The model assumes a firm expects two different reactions from its rivals: 1. Price Increase: If the firm raises its price above the current market price, rivals will not follow suit to steal its customers. Therefore, the demand curve above the current price is highly elastic (flat). The firm will lose massive market share. 2. Price Decrease: If the firm lowers its price, rivals will immediately match the cut to prevent losing their market share. Therefore, the demand curve below the current price is highly inelastic (steep). The firm gains very little.
Because of these dual assumptions, the demand (AR) curve has a sharp "kink" exactly at the prevailing equilibrium price. Because of the kink in the AR curve, the Marginal Revenue (MR) curve has a vertical discontinuous gap. This gap allows marginal costs to fluctuate up and down without forcing the firm to change its optimal price or output.