The kinked demand curve is an economic model used to explain price stability in oligopoly markets, where a few large firms dominate the kinked demand curve. It shows why prices often remain unchanged even when costs or demand conditions fluctuate.
Kinked Demand Curve
This concept is especially useful for understanding industries like airlines, telecom, and gasoline markets, where firms are highly interdependent.
Basic Idea of the Kinked Demand Curve
The model suggests that a firm believes its competitors will react differently depending on whether it raises or lowers prices:
- If a firm raises prices, competitors will not follow, causing it to lose customers.
- If a firm lowers prices, competitors will match the cut, leading to a price war.
Because of this behavior, firms tend to avoid changing prices.
Shape of the Curve
The kinked demand curve has a distinctive shape:
- It is more elastic above the current price (price increase leads to large loss of customers)
- It is less elastic below the current price (price cuts are matched by competitors)
This creates a “kink” at the current market price, where demand behavior changes sharply.
Why Prices Become Stable
The most important implication of the model is price rigidity.
Even if:
- production costs increase
- demand changes
- or market conditions shift
firms may still keep prices unchanged because changing them is risky.
Example: Petrol Station Market
Imagine several petrol stations in the same city:
- If one station raises its price, customers will switch to others.
- If one station lowers its price, others immediately match it.
As a result, all stations keep prices almost identical for long periods.
Key Assumptions of the Model
The kinked demand curve is based on a few assumptions:
- Few dominant firms (oligopoly market)
- Firms are aware of each other’s actions
- Price competition is more likely than product competition
- Firms prefer price stability over risky changes
Limitations of the Kinked Demand Curve
While useful, the model has some weaknesses:
- It does not explain how the initial price is set
- It ignores possible cooperation or collusion
- It may not apply in highly dynamic markets
- It lacks strong empirical proof in all industries
Conclusion
The kinked demand curve explains why prices in oligopoly markets often remain stable even when economic conditions change. It highlights how firms’ expectations of competitor behavior can strongly influence pricing decisions, leading to a situation where price rigidity becomes the norm.
If you want, I can also create a diagram explanation, comparison with monopoly vs oligopoly pricing, or exam revision notes for this topic.