The kinked demand curve model assumes that a business might face a dual demand curve for its product based on the likely reactions of other firms to a change in its price or another variable
The assumption is that firms in an oligopoly are looking to protect and maintain their market share and that rival firms are unlikely to match another's price increase but may match a price fall. I.e. rival firms within an oligopoly react asymmetrically to a change in the price of another firm.
If a business raises price and others leave their prices constant, then we can expect quite a large substitution effect making demand relatively price elastic. The business would then lose market share and expect to see a fall in its total revenue.
If a business reduces its price but other firms follow suit, the relative price change is smaller and demand would be inelastic. Cutting prices when demand is inelastic leads to a fall in revenue with little or no effect on market share.
The kinked demand curve model makes a prediction that a business might reach a stable profit-maximising equilibrium at price P1 and output Q1 and have little incentive to alter prices.
Recent examples of price wars include the major UK supermarkets, price discounting of computers in China and a price war between cross channel speed ferry services. Price competition is frequently seen in the telecommunications industry.
Changes in costs using the kinked demand curve analysis
One prediction of the kinked demand curve model is that changes in variable costs might not lead to a rise or fall in the profit maximising price and output. This is shown in the next diagram where it is assumed that a rise in costs such as energy and raw material prices leads to an upward shift in the marginal cost curve from MC1 to MC2. Despite this shift, the equilibrium price and output remains at Q1. It would take another hike in costs to MC3 for the price to alter.
There is limited real-world evidence for the kinked demand curve model. The theory can be criticised for not explaining why firms start out at the equilibrium price and quantity. That said it is one possible model of how firms in an oligopoly might behave if they have to consider the responses of their rivals.
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