Kinked Demand Curve Analysis

The kinked demand curve is a concept in economics and marketing that explains a certain phenomenon observed in some oligopolistic markets. It describes a situation where the demand curve for a product or service has a “kink” at the current price level, leading to unique implications for price setting and competition. This concept is crucial in understanding how firms behave in oligopolistic markets, where a few dominant firms exist, and the actions of one firm can significantly affect the others.

Origins and Development

The kinked demand curve model was developed independently by Paul Sweezy in the late 1930s as a way to explain the price rigidity often observed in oligopolistic markets. The theory posits that firms in such markets face a dual demand curve: one for price increases and another for price decreases.

Characteristics of Kinked Demand Curve

Kink at the Market Price: The curve consists of two segments with differing elasticities. Above the kink, the demand curve is relatively elastic, meaning that a small increase in price would lead to a significant drop in quantity demanded as consumers switch to competitors’ products. Below the kink, the demand curve is relatively inelastic, meaning that a small decrease in price would not lead to a significant increase in quantity demanded.
Price Rigidity: Because of the kink, firms may be reluctant to change their prices. If a firm increases its price, it risks losing a large market share because the other firms are unlikely to follow the price increase (demand being elastic above the current price). Conversely, if a firm decreases its price, it risks igniting a price war, as other firms are likely to match the price cut to retain their market share (demand being inelastic below the current price). Consequently, prices in oligopolistic markets tend to be sticky.
Strategic Behavior: The kinked demand curve model suggests that firms in an oligopolistic market base their pricing strategies not merely on cost considerations but also on how they expect their competitors to react. This interdependence means that firms are continually engaged in strategic behavior, considering the potential reactions of competitors to their pricing decisions.

Graphical Representation

The typical graphical representation of a kinked demand curve involves plotting the price versus quantity demanded, with the demand curve bending at the current price level. Here’s a step-by-step breakdown of how to derive the curve:

Identify the prevailing market price and quantity. This is the point where the kink occurs.
Draw the demand curve above the kink. This part of the curve is more elastic, indicating that consumers are more responsive to price increases.
Draw the demand curve below the kink. This part of the curve is more inelastic, indicating that consumers are less responsive to price decreases.
Draw the marginal revenue (MR) curve. The MR curve has a discontinuity at the kink, reflecting the abrupt change in the elasticity of demand.

Implications for Business Strategy

Price Stability: The primary implication of the kinked demand curve is price stability within an oligopoly. Firms are likely to maintain stable prices to avoid the uncertainties associated with potential price wars or significant loss of market share.
Non-Price Competition: Since prices are sticky, firms often compete through non-price means such as advertising, product innovations, enhanced customer service, and other value-added features.
Barriers to Entry: The stability provided by the kinked demand curve also results in fewer incentive for new firms to enter the market, thereby maintaining the oligopolistic nature of the market.
Tacit Collusion: Even without explicit agreements, the kinked demand curve can lead to a form of tacit collusion where firms ‘implicitly’ agree on maintaining prices at a certain level to maximize joint profits.

Examples and Real-World Application

While the kinked demand curve model provides a simplified view of pricing strategies, real-world examples can be observed in various oligopolistic industries such as:

Airlines: Major airlines often avoid competing on price, instead offering differentiated services like loyalty programs, extra legroom, and better customer service.
Telecommunications: Leading telecom companies generally maintain stable pricing plans and focus on non-price competitive strategies such as superior network coverage and bundled service offerings.
Automobiles: Automotive manufacturers often keep prices stable while continuously innovating and improving their product features, designs, and after-sales services.
Energy Markets: Utility companies and oil producers tend to have stable pricing despite fluctuations in commodity prices, focusing instead on long-term contracts and service reliability.

Criticisms of the Kinked Demand Curve Model

While informative, the kinked demand curve model has several limitations:

Lack of Empirical Support: There is limited empirical evidence directly supporting the existence of kinked demand curves in all oligopolistic markets.
Simplistic Assumptions: The model assumes that firms only compete on price and overlooks other strategic factors such as capacity decisions, product differentiation, and innovation.
No Consideration for Entry and Exit: The model does not account for new firms entering or exiting the market, which can influence price setting and competitive dynamics.
Static Nature: The kinked demand curve is static and does not consider the dynamic aspects of market competition and economic shocks.

Conclusion

The kinked demand curve is a useful theoretical model that highlights the complexities of pricing strategies within oligopolistic markets. While it underscores the phenomena of price rigidity and strategic interdependence, it also encourages firms and analysts to look beyond price and consider a broader range of competitive strategies. Despite its limitations, the kinked demand curve remains an important tool in microeconomic theory for understanding the nuanced behaviors of firms in imperfectly competitive markets.