3.2. Kinked Demand Model

The kinked demand model begins with an oligopoly that has two sellers of a homogeneous good. 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 (shown as the gap from J to F in Figure). 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.

The function of a market system is to provide the information and incentives that will result in the allocation of relatively scarce resources and goods to their highest valued use within a social system. From an equity perspective we tend to believe that anyone who uses or consumes a good should bear the opportunity costs that result from that use. The price should equal the marginal cost. Rational consumers will buy goods so long as their marginal benefits are greater than or equal to the price they pay. Sellers will produce and offer goods for sale so long as the marginal cost of producing the goods is less than the price they can get. The optimal allocation of resources is characterized by the simple equation: MB = P = MC

Long run equilibrium in purely competitive markets is the ideal and provides the benchmark for market performance. As market power is increased the price tends to rise above the MC suggesting less than an optimal allocation. When price is greater than MC, it should be considered as evidence that something may be amiss. It does not mean that it must be corrected.

Duopolies

We will begin our discussion with an investigation of duopolies. For the following duopoly examples, we will assume the following:

The two firms produce homogeneous and indistinguishable goods.

There are no other firms in the market who produce the same or substitute goods.

No other firms can or will enter the market.

Collusive behavior is prohibited. Firms cannot act together to form a cartel.

There exists one market for the produced goods.