The Kinked Demand Curve Model of Oligopoly Pricing

In our previous lesson on oligopoly, we showed how payoff matrices and game theory could be used to analyze the strategic, interdependent behavior of two firms when deciding the price they would charge. In this lesson we take a graphical approach to oligopoly, and seek to explain why prices tend not to fluctuate up or down in oligopolistic markets.

We will look at two firms, Swisscom and Orange, which provide cell service to customers in Switzerland. Why does Swisscom have very little incentive to decrease its prices, and also a strong incentive not to raise its prices? The answer requires us to make assumptions about how the competitor, Orange, would respond to a change in Swisscom’s prices.

What emerges is a kinked demand curve, highly elastic at prices above the current equilibrium and highly inelastic at prices below the current equilibrium. Along with this kinked demand curve comes a kinked marginal revenue curve, with a vertical section. The implication is that even as an oligopolist’s costs rise and fall in the short-run, its level of output and price tends to remain stable.

To order practice activities on this and other lessons from the Econ Classroom, click here.

For student revision guides and teacher PowerPoints, click here.

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