The kinked demand curve facing an oligopoly assumes
a. that a price increase will decrease total revenue
b. that a price decrease will decrease total revenue
c. that competitors will follow a price reduction
d. that competitors will not follow a price increase.
e. all of the above
The correct answer and explanation is:
The correct answer is e. all of the above.
The kinked demand curve model is a concept used in oligopoly theory to describe how firms in an oligopolistic market behave with respect to price changes. In an oligopoly, there are few firms, and each firm’s decisions are influenced by the actions of competitors. The kinked demand curve specifically shows how a firm may face a different price elasticity of demand depending on whether it raises or lowers its prices.
- Price increase and decreased total revenue: If a firm in an oligopoly raises its price, it is assumed that its competitors will not follow suit. As a result, consumers will switch to cheaper alternatives offered by the competitors. This leads to a significant loss in market share, and total revenue for the firm will fall. This is the reason for the downward sloping portion of the demand curve above the kink.
- Price decrease and decreased total revenue: If a firm lowers its price, competitors will likely follow suit and also reduce their prices. This means that the firm will not gain a significant advantage from the price reduction. In fact, since the price reduction is across the board, the firm’s revenue might actually decrease because it is now selling at a lower price, but the increase in quantity sold may not be enough to offset the price drop. This results in a less elastic demand curve below the kink.
- Competitors not following price increases: The kinked demand curve assumes that competitors will not follow a price increase, which leads to the firm losing market share and revenue when it raises prices.
In summary, the kinked demand curve illustrates that firms in an oligopoly face a situation where price increases lead to reduced revenues due to competitors not following the price hike, while price reductions do not lead to much gain due to competitors matching the price cut. Thus, firms tend to avoid drastic price changes and prefer to compete in other ways, such as through non-price competition.