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Economics: Kinked-Demand Curve Model

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About this Lesson

  • Type: Video Tutorial
  • Length: 4:22
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 47 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Other Market Models (14 lessons, $26.73)
Economics: Oligopoly (3 lessons, $5.94)

This video lesson will help you to understand the kinked-demand curve model. It will cover when this type of demand curve is seen and why. Taught by Professor Tomlinson, this video lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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We've seen that monopoly faces a downward-sloping demand curve. And a perfectly competitive firm has a perfectly elastic demand curve. What does the demand curve look like for a firm that's in an oligopoly? Remember an oligopoly is a small number of firms watching each other's every move, interacting strategically. Like in the airline industry - what does the demand curve for air travel look like for one particular airline?
Consider here we are with Airline A, and Airline B, C, and D are watching its every move; they're all trying to second-guess what each other might do next, with respect to the price they charge for their tickets, and the quantity of tickets they sell each week. Suppose the initial situation is that Airline A is charging a price of $200.00 a ticket, and selling about 10,000 tickets a week. What does the demand curve look like for Airline A's tickets? Well, if Airline A were to decide to raise its price to try to get more revenue from each customer, probably Airline B, C, and D would not follow suit, because if they hang back, and keep their prices constant at around $200.00, they can get a bigger market share as price-sensitive customers defect from Airline A and jump to B, C, or D instead.
This was the idea that Paul Sweezy had whenever he came up with his kinked-demand curve, that if a firm starts with an initial situation and raises its price, they're likely to lose a lot of customers, because rival firms will hang back, keep their prices low, and tempt customers away. On the other hand, Sweezy says, if Firm A were to decide to lower the price of its airline tickets, probably all of the other firms would follow suit. There would be a big decline in price, and Firm A would not add nearly as many customers as it might expect, because of retaliation from its rival.
This kinked-demand curve is a graph to describe this strategic interaction. When you see a kinked-demand curve, it's a way of saying that a firm can expect that rivals will not follow it when it takes its price upwards, but rivals will retaliate and follow suit if it should cut prices. The kink occurs at the point where we begin - the initial situation, the original price and quantity. What does the marginal revenue curve look like for a firm that has a kinked-demand curve? Well, the marginal revenue curve, you'll recall, lies below and is steeper than the demand curve, because as you lower your price, you're losing revenue on all of the inframarginal units - the tickets you could have sold at the higher price.
So the marginal revenue curve is going to look like this down to the point of the kink, at which point it immediately changes slope and is going to have a discontinuity and start up again further down the page. This marginal revenue curve tells the change in revenue that this airline can expect if it adds an extra passenger, sells an additional ticket. So if we put the marginal cost curve in here, we're going to be able to predict where Firm A is going to choose to operate - where marginal revenue equals marginal cost - which will usually occur somewhere in this discontinuity.
Well, now this is all starting to seem kind of technical, and you might very well ask the question, "What determined this original point anyway? What determined the location of this kink in the demand curve? How did we get to this original price and this original quantity?" That's a great, because the model doesn't tell that, and that's one of the criticisms of it. It's really a story about how firms in an oligopoly respond to each other's moves, but it doesn't do an especially effective job at telling us how the kink gets established to begin with, how we arrive at the original situation. It also doesn't tend to match what we actually observe; empirical data doesn't confirm this theory. The theory, like a lot of theories, is a good story; it's logically consistent, it even has kind of a compelling, sensible element to it. But it's not nearly sophisticated enough to really explain the kind of strategic interaction we get in oligopolies; so we'll have to consider some alternative explanations.
Other Market Models
Oligopoly
Understanding the Kinked-Demand Curve Model Page [1 of 1]

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