Sunday, 16 January 2011

Game Theory: Kinked Demand Curve Theory

Game Theory: Kinked Demand Curve
The Kinked Demand theory is a theory of what a oligopolistic firm’s demand curve should look like, it has three main parts. 

The first part is the equilibrium E. It is assumed in this theory that at this equilibrium MC=MR. This is the standard output an oligopolistic firm should operate at. This point can be known as tacit collusion. In order to understand the other two parts to this theory we will explore two scenarios.
Scenario One
Imagine in an oligopolistic industry, if one firm decides to increase the price then the competitors will respond by not changing their price so that they can capture the market share lost the firm who has increased prices. This implies that demand is price elastic. For if it was not then all the other firms would increase prices too. This is why above the price P the demand curve is elastic.
Scenario Two
Imagine now in an oligopolistic market that a firm decides to lower its price. Other rival firms in the market will follow suit to stop the firm from capturing market share and a price war will break through. This implies that demand is inelastic because firms are following suit which means demand will not change much. This is why at an price below P the demand curve is inelastic.
The kinked demand curve shows that firms are better off engaging in non-price competition and in tacit collusion. It is a great way to show how firms loose out by increasing or decreasing their price in an oligopoly.

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