A demand curve with two distinct segments which have different elasticities that join to form a corner or kink. The primary use of the kinked-demand curve is to explain price rigidity in oligopoly. The two segments are: (1) a relatively more elastic segment for price increases and (2) a relatively less elastic segment for price decreases. The relative elasticities of these two segments is based on the interdependent decision-making of oligopolistic firms.
The kinked-demand curve is a demand curve comprised of two segments, one that is relatively more elastic, which results if a firm increases its price, and the other that is relatively less elastic, which results if a firm decreases its price. These two segments are joined at a corner or “kink.” This demand curve is used to provide insight into why oligopoly markets tend to keep prices relatively constant.
The more elasticity segment of the kinked demand curve exists because other firms in the industry are unlikely to match price increases of an oligopolistic firm. The result is a loss of market share and big decreases in quantity demand. The less elasticity segment of the kinked demand curve exists because other firms in the industry are very likely to match price decreases of an oligopolistic firm. The result is no gain in market share and relative small increases in quantity demanded.
Consider what might happen to OmniCola, a firm operating in the hypothetical Shady Valley soft drink industry.
- Should OmniColan increase its price by 20 cents a can, then competing firms (Juice-Up, Super Soda, et. al.) are likely to keep their prices unchanged. In so doing, OmniCola loses customers to the competition, resulting in a large decrease in quantity demanded and a loss of market share. Hence small changes in price result in relatively big changes in quantity demanded–demand is more elastic.
- Alternatively, if OmniCola decreases its price by 20 cents a can, then competing firms are very likely to match this lower price. They do so to stay competitive with OmniCola and avoid the loss of their own customers. As such, OmniCola is unlikely to gain any market share. While the lower market price of soft drinks might increase quantity demanded in the overall market, the increase in quantity demanded for OmniCola is modest. Hence larger changes in price result in relatively smaller changes in quantity demanded–demand is less elastic.
For insight into the kinked-demand curve, consider the interdependent behavior of OmniCola and its competitors in the oligopolistic Shady Valley soft drink market reflected by the exhibit presented below. This diagram will eventually display the demand curve for OmniCola, but for now it displays only the going market price of $1 per can. At this price, 10,000 cans of OmniCola are sold each and every month.
The key questions underlying the derivation of the kinked-demand curve are: How much OmniCola is sold at a lower price, such as $0.80 per can? How much is sold at a higher price, such as $1.20 per can? These two questions can be answered by considering two separate demand curves facing OmniCola–one if market share is constant, the other if market share changes.
Constant Market Share
|Kinked OmniCola Demand|
First, consider the demand for OmniCola if the price changes, but the market share does not. That is, any change in OmniCola’s price is matched by an equal change in all competitor prices such that buyers have no reason to switch from one soft drink to another. The only change in OmniCola’s quantity demanded results from a change in the quantity demanded in overall the market. That is, the higher or lower price induces buyers to switch between soft drinks and another good like coffee.
To reveal OmniCola’s constant market share demand curve, click the [Constant Share] button. Notice that the demand curve is moderately steep. Notice also that this demand curve goes through the current price and current quantity point of $1 per can and 10,000 cans.
The key with this demand curve is its relative steepness. And while slope and elasticity are not the same, the RELATIVE steepness of this demand curve indicates that it is not very elastic. It IS elastic, as opposed to inelastic, just not very elastic.
For example, a decrease in the price of OmniCola from $1 to $0.80 increases the quantity demanded from 10,000 cans to 14,000 cans. Using the midpoint formula, this is a price elasticity of demand of 1.5.
Variable Market Share
Second, consider the demand for OmniCola if the price and market share both change. That is, competitors do NOT match any change in OmniCola’s price. Buyers are inclined to switch between OmniCola and other soft drinks. If OmniCola raises its price, then it loses market share. If OmniCola lowers its price, then it gains market share.
This means that any OmniCola price change triggers two changes in quantity demanded. One is a change that occurs because the price of OmniCola changes relative to other non-soft-drink products. That is, buyers switch between coffee and OmniCola. The second change occurs because of substitutions between OmniCola and other soft-drinks. That is, buyers switch between OmniCola and other soft drinks, including Juice-Up, Super Soda, or Frosty Grape.
To illustrate OmniCola’s variable market share demand curve, click the [Variable Share] button. Notice that the demand curve is relatively flat. Notice also that this demand curve goes through the current price, current quantity point of $1 per can and 10,000 cans.
The key with this demand curve is its relative flatness. And once again while slope and elasticity are not the same, the RELATIVE flatness of this demand curve indicates that it is relatively more elastic.
For example, an increase in the price of OmniCola from $1 to $1.20 decreases the quantity demanded from 10,000 cans to 5,000 cans. Using the midpoint formula, this is a price elasticity of demand of 3.7.
The Kinked Curve
Portions of these two demand curves come together to form the kinked-demand curve. But which portions? To find out, consider the importance of interdependent decision-making in oligopoly. With a few large firms, the actions by one oligopolistic firm tends to have a big impact on other firms. This is particularly true for prices. Any OmniCola price change affects the sales of Juice-Up, Super Soda, and other firms in the industry.
Each firm is aware of this fact. If OmniCola should lower its price, it gains market share from other firms in the industry if they do not keep pace. Knowing this, other firms reduce prices along with OmniCola. As a result, OmniCola has a bit of an increase in quantity demand, with more soft drinks sold market-wide, but it retains its market share. For price decreases, the constant market share demand curve is the relevant demand curve facing OmniCola. Click the [Price Decrease] button to highlight this segment.
However, should OmniCola raise its price, other firms in the industry benefit by keeping their prices constant. OmniCola loses market share as former OmniCola drinkers opt for Juice-Up, Super Soda, and other brands. For price increases, the variable market share demand curve is the relevant demand curve facing OmniCola. Click the [Price Increase] button to highlight this segment.
Putting these two segments together generates the kinked-demand curve, which can be highlighted by clicking the [Kinked Curve] button. For OmniCola prices above $1 and quantities less than 10,000 cans, the demand curve is more elastic. For prices below $1 and quantities greater than 10,000 cans, the demand curve is less elastic.
A Disjointed Marginal Revenue Curve
The profit-maximizing decision for any firm with market control requires a marginal revenue curve. The marginal revenue curve associated with a kinked-demand curve is not like most marginal revenue curves. In fact, it contains three distinct segments. One is associated with the upper more elastic segment. One is connected to the lower less elastic segment. And one that arises from the kink that joins the two.
To reveal the disjointed, three-part marginal revenue curve, click the [Marginal Revenue] button in the exhibit. The three segments are:
- Top Segment: The flat top portion of the marginal revenue corresponds to the more elastic demand generated by price increases above $1 and for quantities less than 10,000 cans.
- Bottom Segment: The steep bottom portion of the marginal revenue corresponds to the less elastic demand generated by price decreases below $1 and for quantities greater than 10,000 cans.
- Middle Segment: The vertical middle segment connecting the top and bottom segments that occurs at the output quantity of 10,000 cans corresponds with the kink of the curve.
The vertical segment is the key feature of this marginal revenue curve. This vertical segment exists at the initial 10,000-can quantity. A range of marginal revenue values exist at this single quantity. This means that profit-maximizing equality between marginal revenue and marginal cost can also occur for a range of marginal cost values AT THE SAME QUANTITY.
However, because this 10,000-can quantity is associated with the initial $1 price, then profit maximization can also take place for a range of marginal cost values AT THE SAME PRICE.
This vertical segment is what helps to explain rigid prices for oligopoly. Because profit-maximizing firms equate marginal cost with MARGINAL REVENUE, if marginal revenue can take on a range of values at the initial quantity AND PRICE, then marginal cost can also take on a range of values. In particular, marginal cost can increase or decrease without inducing a profit-maximizing oligopoly to change price or quantity.