The Kinked Demand Curve Model of Oligopoly Pricing

[Music] in today's lesson we're going to examine a model for oligopoly behavior known as the kinked demand curve model in a previous lesson we introduced the market structure of oligopoly and talked about how game theory and payoff matrix is could be used to analyze the behavior of oligopolistic firms you recall that an oligopoly is a market with a few dominant firms in which the outcome of any individual firms behavior is dependent not only on that firm's behavior but also on the behavior of its competitor for this reason we say that oligopolistic markets are highly interdependent the firms in these markets are very interdependent on one another today we're going to be looking at the market for cellular phone plans in Switzerland this is a market with only a couple of dominant firms notably Swisscom and orange we'll be looking at the demand for Swiss coms cellular plans at a range of prices ranging from $100 to $10 per month first we're going to make some assumptions about oligopoly pricing behavior so looking at the right side of the screen here let's make a few assumptions about the behavior of oligopolists when it comes to determining their prices for example in the market for Swiss cellular plans the monthly rate currently is approximately 60 dollars per month for a sell plan and we're going to assume that at this price of $60 Swisscom sells approximately 5,000 plans a month so we'll put an original equilibrium price and quantity on our graph of 5000 sell plans at a price of $60 per month what we want to know is what will happen to the demand for Swisscom sell plans if Swisscom lowers its price and what would happen to demand for Swisscom sell plans if Swiss come raised its price now in order to determine how consumers will respond to price changes from the equilibrium price of $60 we must try to predict what Swiss comms primary petter orange will do in response to a change in price for Swiss come sell plans so let's make some assumptions over here we're going to assume that if Swisscom lowers its price orange will also lower its price now why is this very likely to occur why would orange lower its price in response to a decrease in price by Swisscom well this has to do with oligopoly behavior of course orange is revenues and profits depend as much on the price that Swisscom charges as they do on the price that orange charges and vice versa the same is true for Swisscom the reason therefore that we should assume that orange will decrease its price in response to a lower price from Swisscom is that orange will not want to lose market share in case Swisscom decreases its price therefore price decreases will be matched now that's going to play a very important role when we draw the demand curve the Swisscom faces the implication here is that demand for Swisscom will be highly inelastic below $60 why do we say Dumanis highly inelastic well it's because we assume that the competitor orange will also lower its price therefore Swisscom cannot hope to gain a significantly larger market share by decrease in its price what would happen on the other hand is Swisscom chose to raise its price how would orange the primary competitor respond to a price increase by Swisscom that's the next question we're going to answer if Swisscom raises its price we should probably assume that orange will keep its price at $60 in other words orange will ignore a price increase by Swisscom why should we make this assumption why would the oligopolistic firm orange ignore price increase by Swisscom well this is the rational thing for orange to do if swiss comes price increases we can assume that orange will capture much of the market share since oranges price remains low it is perfectly rational for orange to ignore price increases by Swisscom and match price decreases if Swisscom unilaterally raises its price of a monthly cellphone plan many many of Swiss comms customers will switch over to orange orange will not raise its prices Swisscom does because orange stands to benefit from the increase in demand for its sell plans in the face of an increase in price by its competitor Swisscom so we can say the demand for Swisscom will be highly elastic at a price above sixty dollars by elastic we mean that a particular percentage increase in price above sixty dollars will result in a much larger percentage decrease in the quantity demanded due to the fact that consumers will switch over to orange in large numbers so we've made a couple of important assumptions about the pricing behavior of oligopolistic firms price decreases will be matched price increases will be ignored with these assumptions in mind we can derive a demand curve for Swiss columns cellular plans we're starting out at a price of $60 let's look at the assumptions we've made and determine how demand will change if Swiss come lowers its price and if Swisscom raises its price so starting with the first bullet point here that orange will not want to lose market share if Swisscom decreases its price therefore price decreases will be matched demand for Swiss con will be highly inelastic below $60 this implies that if for example orange lowered its price to $40 the increase in quantity demanded will be very small because we should assume that orange or the competitor will also lower its price so let's assume that the quantity demanded only grows from 5,000 to 6,000 customers following a price decrease this means that the demand curve will be highly inelastic below a price of $60 on the other hand if Swisscom raises its price we should assume that orange will keep its prices $60 and therefore demand for Swisscom will be highly elastic at a price above $60 orange will ignore a price increase therefore if Swisscom were to raise its price from sixty to seventy dollars let's say the quantity demanded will fall dramatically let's assume the quantity demanded Falls from 5000 cell plants per month to only 1,000 cell plants per month following a price increase this means that demand is highly elastic above $60 what we end up with when we draw a demand curve based on these assumptions is what we call a kinked demand curve you can see that at any price other than the equilibrium price of $60 demand will slope very steeply below $60 in other words demand will be inelastic however demand will slope very gently above $60 demand will be relatively elastic now the slope of this demand curve is based on our assumptions of how orange will respond to price changes by Swisscom price decreases will be matched in order to maintain market share but price increases will be ignored in order to capture customers who will switch from Swisscom to orange following an increase in price by Swisscom so based on our assumption of the kinked demand model we can make some predictions about how orange and Swisscom will determine the prices for their cellular plans we should assume that orange will have very little incentive to lower its price for sell plans let me illustrate why we want to know how would revenues be affected if Swisscom or orange were to lower the price I'm going to shade an area on this graph which represents total revenues at a price of $60 viscom must decide whether or not lowering its price will improve its total revenue well let's see what happens if suits come were to lower its price to $40 the quantity demanded would only grow by 1,000 units which is a very small increase in quantity demanded in fact the percentage increase in quantity would only be 20% following a 30% decrease in their price this means that Swiss comms total revenues would actually be smaller represented by the green rectangle following a decrease in the price it would not be in Swiss coms interest to lower its price to $40 since the firm's total revenues would fall but providing more cell service would cause the firm's total costs to increase unequivocally Swiss coms profits would be less at $40 than they would be at $60 therefore it is not in the firm's best interest to lower its price due to the fact that the competitor will match the price decrease so what about a price increase could Swisscom benefit by raising its price clearly that would not be the case an increase in price from 60 to 70 dollars would once again cause total revenues to fall the blue rectangle represents Swiss coms total revenues at a price of $70 Swiss coms total revenues would decrease if it raised its price Swiss coms total revenues would decrease if it lowered its price what we see therefore is that there is a tendency for the price in an oligopolistic market to be very sticky to remain steady at the equilibrium level oligopolists have no strong incentive to raise or lower their prices what we end up with is a kink demand curve which is highly inelastic below the equilibrium price and highly elastic above the equilibrium price now to complete our graph we should add marginal revenue curves to this graph we know that marginal revenue deep diminishes at twice the rate that price does therefore an oligopolist will face a marginal revenue curve that is also kinked and actually has two different segments to it well we end up with is two marginal revenue curves one that accompanies the highly elastic range of demand and one that slopes twice as deeply as the highly inelastic range of demand and since this demand curve and the marginal revenue curves that go with that come in two segments there is essentially a vertical range of marginal revenue here we have our kinked demand and marginal revenue curves the implication of the vertical range of marginal revenue is that even if in oligopolists marginal costs were to increase significantly in the short run the oligopolists profit maximizing level of output would not change the profit maximization rule says that firms should produce where MC equals M R as we can see following an increase in marginal costs the MC equals M R quantity and price do not vary from 5,000 sale plans at a price of $60 this lesson has introduced the kinked demand curve model of oligopoly pricing kinked demand is based on the assumptions that we've outlined on the right here price decreases will always be matched in an oligopolistic market since competitors do not wish to lose market share therefore demand will be highly inelastic below whatever price currently exists in the market price increases however will be ignored since the competitor in the face of rising prices from its competitor stands to gain a significant amount of market share by keeping its price stable at the original equilibrium what we end up with therefore is a stable equilibrium in oligopolistic markets firms tend not to want to raise or lower their prices due to the assumptions that we've made here and this can be illustrated on a kink demand in marginal revenue curve which has a vertical range of marginal revenue implying that even as the firm's costs rise or fall in the short-run an oligopolistic firm will be very hesitant to change the level of output and the price that it charges charges for its products this lesson and the previous lesson on oligopoly in which we outlined how game theory can be used to analyze oligopoly behavior should provide a pretty thorough Roah toolkit for analyzing and evaluating the behavior of oligopolistic firms game theory and path matrices and the kinked demand curve model both imply that oligopolistic markets tend to achieve equilibrium at which price and quantity tend not to vary in the game theory model we could also analyze other behaviors such as advertising offering discounts or opening stores in various locations all different decisions that oligopolistic firms must make by considering the response of their competitors and how the competitors response will affect the firm in questions total revenues or its profits

Channel: Jason Welker

Views: 60,046

Rating: 4.931232 out of 5

Keywords: kinked demand curve, oligopoly, theory of the firm, non-price competition, microeconomics, ib economics, AP Microeconomics

Id: gM1rbI64uec

Length: 14min 5sec (845 seconds)

Published: Thu Mar 22 2012