Kinked demand curve Lesson aims: To draw and explain the kinked demand curve model To use the kinked demand curve theory to illustrate why prices remain stable in an oligopololistic market

Recap What are the differences between a collusive and non- collusive oligopoly? What is a cartel? What is formal collusion? What is tacit collusion? Why do firms collude with each other? Can you think of any examples where collusion may take place?

Kinked demand curve The kinked demand curve theory is used to explain why prices are stable in an oligopoly It assumes that if a firm, let’s say Firm A increases its prices, the other firms will not, as Firm A will lose market share; If Firm A was to decrease their price, the others would follow, so as not to lose market share to Firm A; But neither firm would gain much extra demand, therefore the demand curve is more elastic for a price rise than a price fall…

Here it is… The demand curve, (and/or AR curve) is kinked around point A (or price 80p) – the demand is more elastic for a price rise than a price fall The MR curve has a discontinuity in it – it jumps suddenly from point B to point C. The MR jumps, as the AR curve has changed direction and become more inelastic (remember that the MR curve is twice the steepness of the AR curve?) MC=MR for a profit maximising firm, therefore the MC curve must cut the MR curve at the profit maximising level of output, Q1. It could be anywhere between points B and C.

Look at Fig.1, p.352 The price starts at P. If the firm were to increase prices to R, they would lose much more demand than by decreasing by the same amount, to S (because of competition) The demand curve is kinked around price P. The AR curve changing direction, kinking around P, produces a discontinuous MR curve; there is a jump in MR between points V and W The MC curve must cut the MR curve between V and W, as a firm produces at MC=MR if it wants to maximise profit, at Q1 If the marginal cost was to rise to MC2, the firm would cover the cost and take less profit, this change doesn’t affect the output Prices, therefore, remain largely stable in an oligopoly

Draw and write an explanation of fig.1

And… Game theory ‘Firm A’ has three strategies; raise prices, reduce prices or keep the price the same If it raises or lowers prices, it will be worse off, as the other firms will react A ‘price war’ is bad for everybody, all firms would reduce prices and therefore profit If a firm increases prices, the other firms should gain market share This idea of strategy is part of game theory Weaknesses in the theory  No real explanation of how the original price is derived  The theory ignores the impact of non-price competition  It assumes that firms will react in a particular way to the actions of one of their competitors – this is not realistic all of the time

Question 1, p.353 Homework – Low- cost flights for Eastern Europe