Saturday, April 28, 2007

Kinked Demand Curve

This is for after Test 2. But when we pick up our discussion of Oligopoly we will be looking at the Kinked Demand Curve. The empirical fact that the kinked demand curve is trying to explain is why do prices in Oligopolies tend to remain constant?

Basically we are assuming that there are two elasticities. At higher prices (low quantity) the curve is relatively elastic. This means that an increase in P will lower TR (because other firms will not follow suit with a price hike). Thus prices do not tend to rise. However, at lower prices we have a relatively inelastic demand curve. This means that if prices fall below a certain point TR does not increase.

Yet firms do tend to match price decreases because they do not want to lose market share to the competition. Thus, if prices do start to fall, they tend to fall very quickly. We call this a "price war" in economics and there have been examples in the past. This article, on the price war between Burger King and McDonald's, is an excellent example of this. I have also heard about price wars between Cereal Brands and, of course, the current price war among HDTV's, which have come down substantially in price. The price war between McDonald's and Burger is interesting in that the prices came down on a day by day basis.

1 comment:

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