Question

The kinked demand curve theory suggests four possible outcomes. How are they similar to the four outcomes in a game theory matrix with two firms and two prices?

Answer 1

Above demand curve is kinked.

This is in case of Oliogopoly with few sellers.

1. If one seller increase price, then others will not follow and thus the decrease in quantity is much higher than the increase in price.

2. If one seller decrease price, then others will follow and thus the increase is quanity is not much compared to decrease in price.

So, the main outcome is that the firms are not going to change the prices. As decrease in prices will create economic loss(lower margins) and increase in prices will also create economic loss(higher decrease in quantity).

Game theory matrix can be related to this.

		B
		Increase Price	No change
A	Increase Price	EP, EP	EL, EP
No change	EP, EL	0,0

EP - Economic Profit

EL - Economic Loss

0 - No Profit No Loss

Nash equillibrium in this scenario is 0,0

While the best case is EP, EP

This is because, if one seller increase the price other may not. So there is a threat of economic loss.

To avoid economic loss fear, no seller is going to increase the price.