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.


Intro to Game Theory – The Prisoner’s Dilemma as a Model for Oligopoly Behavior

Two men are in custody for a crime they may or may not have committed: armed robbery. The police have the men in separate cells and have told them the following:

Confess to the crime of armed robbery and we will let you off with a light term of three years in jail with parole after one year.

Remain silent and we will throw everything we have at you, you will get 10 years in jail, because we promise you, your accomplice will talk.

However, if you both remain silent, we have to let you go with a slap on the wrist, just six months in jail for trespassing.

With this information in mind, the men, who are unable to communicate with one another both confess and get three years in jail. Why didn’t they both remain silent, though, and get just six months in jail?

This story is what’s known as the Prisoner’s Dilemma. It is a popular story used by economists to illustrate the challenges faced by non-collusive oligopolistic firms in deciding how to determine what prices to set for their products, whether to advertise or not to advertise, and many other strategic decisions that will affect the level of profits being earned.

The oligopoly market structure, more than any other, requires that firms act strategically, taking into account the decisions of their competitors, on whom they are highly inter-dependent. This lesson will apply the Prisoner’s Dilemma game to two firms deciding whether to charge a high price or a low price for their output, and analyze the most likely outcome in such a game. As we will see, without the ability to collude with one another, the strategic behavior of oligopolistic firms tends to result in an outcome that is not optimal for the sellers, but may benefit consumers.


Monopolistic Competition

Having now studied perfect competition and Pure Monopoly, we will now step back towards the competitive end of the spectrum of market structures and examine monopolistic competition. A monopolistically competitive market is one with many small firms each selling differentiated products. The entry barriers are low, but firms do have some price making power. Since each firm’s output is slightly different from each other firm’s, the individual sellers will face a downward sloping demand curve, much like a monopolist. But since entry barriers are low, the chance of an individual firm earning economic profits in the long-run is small.

This lesson will introduce the characteristics of monopolistic competition and provide a detailed graphical analysis of an individual firm in a monopolistically competitive market. We will look at the market for restaurants, which shows may of the characteristics of the market structure.

In the end we will determine whether monopolistically competitive markets are efficient by examining the firm’s average total cost and its marginal cost compared to the price in the long-run equilibrium.