Kinked Demand Model

The kinked demand model begins with an oligopoly that has two sellers of a homogeneous good. The typical characteristics that constitute an oligopoly are;

• A “few” firms; the concept of “few” means that there are few enough sellers that they recognize their interdependence.

• The output may be homogeneous or differentiated. Primary metals industries are examples of oligopolies with homogeneous goods. Instant breakfast drink mixes are an example of an oligopoly with differentiated products.

• In an oligopoly there are usually significant barriers to entry.

P_x

D

MC

P* Н

AC

Рс К

D

MR AR

0 Q* Qс Q_x

Figure is a graphical representation of the demand and revenue functions of a firm in a oligopoly that is modeled as a kinked demand. The kinked demand model is dependent on the firm believing that the competitor will follow price cuts but not price increases. If there is additional capacity available (firms can increase output without increasing plant size), a price cut will followed. The reasoning is that if the competitor does not follow the price cut, firm will entice customers away from the competitor. Therefore, the competition must follow price cuts or lose customers and sales. The demand function relative to price cuts in inelastic; cut price and TR falls.

The perception is that the competition will not follow a firm’s price increases. If they do not follow they will get the firm’s customers and sales. The demand above the prevailing price is relatively elastic; raise price and TR falls. At the prevailing price, there is a kink in the demand function and an associated gap or discontinuity in the MR. The marginal cost function can rise to MC1 or fall to MC2 with no change in output or price. The kinked demand model of the Great Depression was used as evidence that concentrated markets were rigid and failed to respond to changing conditions. Pro market advocates obviously attached the model and its conclusions.

All models of market structure must be considered as examples. When analyzing a market, it is not a mater of selecting and applying one of the market models presented in principles of microeconomics. You must consider all the relevant characteristics of the firms and the market and then construct a workable model to explain the question

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