Chapter 12: Problem 4

The Kinked demand curve model attempts at explaining as to why prices are rigid or sticky.

Short Answer

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Answer: In the Kinked demand curve model, prices tend to be rigid in oligopolistic markets because firms are hesitant to change their prices due to concerns about rival reactions. If a firm increases its price and rivals do not follow, the firm will lose sales. Conversely, if a firm lowers its price and rivals match the decrease, the firm gains no advantage and may even see reduced profits. Therefore, firms have an incentive to maintain prices at the current equilibrium to avoid risks associated with price changes.

Step by step solution

1. Understanding the Kinked demand curve model

The Kinked demand curve model assumes that each firm in an oligopolistic market faces two different demand curves - one for price increases and another for price decreases. This is because each firm's competitors are likely to react differently to price changes. When a firm increases its price, competitors may not follow suit, resulting in a loss of customers for the price-increasing firm. This leads to a more elastic demand curve for price increases. Conversely, when a firm lowers its price, competitors are more likely to match the price decrease to avoid losing customers, leading to a less elastic demand curve for price decreases.

2. The demand curve's 'kink'

The kink in the demand curve model is the point where the two demand curves - one for price increases and another for price decreases - meet. At this point, the firm has balanced its pricing to be competitive while also avoiding rival reactions that could lead to unnecessary price wars. This is the equilibrium price which the firm will likely maintain, as changing from this price level would lead to either lost sales due to uncompetitive pricing or increased competition that erodes profits.

3. Price rigidity in the Kinked demand curve model

Price rigidity, or price stickiness, refers to the phenomenon of prices remaining stable for extended periods despite fluctuations in market conditions, such as supply or demand changes. In the Kinked demand curve model, this rigidity stems from the fact that firms are hesitant to change their prices due to concerns about rival reactions. If a firm increases its price and its rivals do not follow, the firm will lose sales. On the other hand, if a firm lowers its price and rivals match the decrease, the firm gains no advantage and may even see reduced profits. Therefore, firms have an incentive to maintain prices at the current equilibrium to avoid risks associated with price changes.

4. Implications of the Kinked demand curve model

The Kinked demand curve model provides insight into why prices may remain stable in oligopolistic markets, even during periods of supply and demand changes that would typically cause prices to fluctuate. This price stability can benefit consumers, as frequent price changes can lead to uncertainty and volatility in the market. However, the model also implies that firms in oligopolistic markets may be more focused on maintaining stable prices rather than increasing efficiency, innovation, or cost reductions, which could ultimately result in less overall market growth and dynamism.

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