Economics Online Tutor
Oligopoly: The Kinked
Demand Curve
Firms in oligopoly face a downward sloping demand curve. If they lower their
price, the quantity demanded increases; and if they raise their price, the
quantity demanded decreases.

Because the demand curve is downward sloping, firms will have to lower the
price on all units sold in order to sell more units. This means that the marginal
revenue (MR) curve lies below the demand curve.

If one firm decides to lower its price, other firms in the market are likely to
match the lower price in order to prevent a loss of market share.

The result would be that the firms' market shares will stay roughly the same.
The lower prices may induce some new customers into the market, but firms
will not be able to “steal” customers away from their competitors if all firms
match the lower price.

In this situation, the demand curve is inelastic.

If one firm decides to raise its price, the other firms in the market are not as
likely to react with similarly raised prices. With a downward sloping demand
curve, firms will see a chance to gain market share as customers choose the
lower priced substitutes.

In this situation, the firm that raises its price will lose customers to the
competition.

The demand curve is highly elastic for the firm that raises its price.
In effect, two demand curves exist. One that is inelastic, and one that is
highly elastic. Each demand curve has only one relevant segment. The
inelastic segment is only relevant when the price decreases below the
current price. The elastic segment is only relevant when the price
increases above the current price.

The effective demand curve would be the combination of these two
relevant segments. It would be a curve that is relatively flat at prices
above the current price, and relatively steep at prices below the current
price.

A kink forms at the current price.

This price, where the demand curve kinks, would have been determined
by the demand at the profit maximizing quantity. The profit maximizing
quantity is always determined by the quantity where marginal revenue is
equal to marginal cost.

Because the demand curve has a kink, and the marginal revenue curve
lies below the demand curve, the marginal revenue curve would have a
gap where the two segments of the demand curve meet. That is, at the
kink, or the profit maximizing price.

Profit is maximized at the same price and quantity combination as long as
the marginal cost curve crosses the marginal revenue curve anywhere
within this gap.

If variable costs change, a profit maximizing oligopolist will not change
price or quantity as long as the marginal cost curve crosses the marginal
revenue curve within this gap.

The kinked demand curve model does not explain all behavior in oligopoly,
but the gap in the marginal revenue curve helps to explain why firms in
oligopoly change prices rather infrequently.
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