8.6: Kinked Demand Curve

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Page ID: 210862

Martin Medeiros
Chabot College

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The interdependency between oligopolies creates a bit of dilemma when it comes to demand curves. As you recall from Module 2, the demand curve shows how price changes affect quantity demanded. We know that the change in demand is due to a price change because all other determinants of demand (like tastes, income, etc.) are held constant - Nothing but price can change. See figure 11.

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Figure 11

When it comes to an oligopolist’s demand curve we cannot hold everything constant when price is changed because rivals change behavior. For example, when one firm raises price, other firms will not match the price change in the hopes of luring customers away for their higher priced rival. And when one firm lowers price, other firms will match the price the change to keep their customers from going to the lower priced rival.

So, when price is raised other firms do nothing (in terms of price changes). And when price is lowered other firms will also lower price. A standard demand curve cannot handle this situation (i.e., having something else change when price is changed). We need to have a demand curve that shows the effects of both price changes and rival reactions.

The kinked demand curve is a demand curve that an oligopolistic firm faces in the marketplace. This demand curve shows the effect of both a price change and the rival’s response to that price change. It can show the effect on demand from two simultaneous changes by using two distinct demand curves to form one kinked (i.e., bent) curve. See figure 12.

A graph of a priceDescription automatically generated

Figure 12

D₁ in figure 12 is a demand curve that is relatively flat. A flat demand curve means that customers are more sensitive to price changes when compared to customers who have a steep demand curve. In this case, the reason customers of this oligopolistic firm are relatively price sensitive is because this is the demand curve that exists if rival firms do not match the price changes of this oligopolist. If this firm is the only one in the industry changing price, then customers will have a strong reaction (either buying a lot more when price is lowered or buying a lot less when price is raised).

D₂ in figure 12 is a demand curve that is relatively steep. A steep demand curve means that customers are less sensitive to price changes when compared to customers who have a flat demand curve. The reason customers of this oligopolistic firm are relatively price insensitive is because this is the demand curve that exists if rival firms match all price changes. If this firm is one of many in the industry that change their price (in the same direction) then customers will not have a strong reaction since no one firm stands out (in terms of price).

So, we can use two demand curves to consider both price changes and rivals’ reaction to said price change.

Now, before we further examine the kinked demand curve, I want you to take another look at figure 12 and try to answer this question: Is every part of each demand curve needed? The answer is: No.

It makes sense to assume that rival firms will not follow a firm that raises its price (unless there is some collusion going on). This is because those firms that do not raise price stand a good chance of attracting customers from the higher price rival. If we start at point w in figure 12 and raise the price of this good, then we would not move along segment wy on D₂. So, if we do not need it then let’s get rid of it (see figure 13).

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Figure 13

It also makes sense to assume that rival firms will not stand idly by when a rival firm cuts price and lures away its customers. If, once again, we start at point w in figure 8 and lower the price of this good then we would not move along segment wx on D₁. So, if we do not need it then let’s get rid of it (see figure 14).

A diagram of a lineDescription automatically generated

Figure 14

By eliminating the parts of each demand curve that are not relevant we are left with a demand curve that is bit bent (i.e., kinked)

When one firm raises its price from P⁰ it moves along the flat part of the demand curve. This portion of the demand curve is relatively price elastic (i.e., customers are sensitive to price changes) because no other firms are matching the price hike. This result is bad news for this firm. To explain why it is not a good idea to raise prices we need to revisit the rubber band theory from Module 3. See figure 15.

A diagram of a rubber bandDescription automatically generated

Figure 15

If an oligopolist raised price from P⁰ to P^H it moves along the elastic part of the demand curve. When consumers are sensitive to price changes then any increase will result in a large decrease in demand. This significant decrease in demand results in a drop in total revenue. So, price hikes are not a good idea.

What if the oligopolist lowered price from P⁰ to P^L (see figure 16)?

A diagram of a rubber bandDescription automatically generated

Figure 16

If an oligopolist lowers price from P⁰ to P^H it moves along the inelastic part of the demand curve. When consumers are insensitive to price changes then any decrease will result in a small increase in demand. This insignificant increase in demand results in a drop in total revenue. So, price cuts are not a good idea either.

The kinked demand curve is a simple image that confirms that price-based competition is rare.

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