Question

Subject Economics:

QUESTION TWO:

2.1 Explain the kinked demand curve theory of an oligopoly. Include in your answer a discussion of a contemporary oligopoly.

Answer 1

In the kinked demand model, an oligopolist selects its profit-maximizing price and quantity. The other oligopolists also do the same. Once these prices have been established, they are held RIGID. The assumptions are that each firm believes the others will match of follow price cuts but none will follow a price increase by a firm.

Suppose the four firms in an oligopoly for cosmetics, have set prices and $40, $45, $42 and $46.None of the firms will change the price. If it is contemplating a price cut, the others too will lower prices. Thus, the firm will not get too many more customers making the demand very inelastic and steep. If the firm raises price, no one else will raise theirs thereby the firm raising the price will lose many customers. That will leave the original demand curve very price-elastic and flat.

Hence, a kink forms at the price. The demand curve is very steep below the price and flat along the ceteris paribus demand above it.

Thus, the industry will have many such kinks and they remain as long as the firms assume the reactions to the price change

will take place.

There are many oligopolies in our world starting with the oil industry to the makers of commercial jet aircraft. Presumably, both

Boeing and AirBus have kinks on their demand curves and their prices remain and have remained rigid for sometime. In the oil

industry the oligopoly consists of OPEC, the US, Russia, NIgeria which produce a combined output of 70% of the total. OPEC is

a cartel and it with the other players routinely adjusts price of crude.