Wednesday, 15 February 2017

Oligopoly - Kinked Demand Curve

A question and answer on a 9 mark Kinked Demand Curve question.

Using a diagram, explain how the kinked demand curve can explain price stability in some oligopoly markets {9}.

In an oligopoly firms have some ability to set their own price; however the vast majority of firms do not use this as a way to be more competitive. This is due to interdependence. Interdependence is when a firm's decisions are made considering the likely reaction of other firms within the same industry. The kinked demand curve explains this well. If we make assumptions that the firm settles at price P at Q, we can use this as a base point to prove reasons for price stability. If a firm was to increase their price to P1 at Q1; then in turn another firms reaction would be to hold their prices as they will be able to collect and gains some market share as a result of the other firms price increase. This is because at that point the demand curve is (AR) is elastic and therefore if there is a price increase it would consequently result in the loss in sales which could mean lower revenue. However if the firm was to reduce prices to P2  at Q2; the other firms would react to this by also reducing their prices in order to prevent a loss in market share. This is because demand (AR) at this point is inelastic so there may be small increases in sales however there would still be a loss in revenue. Due to the interdependent behaviour prices stay stable and firms focus more on non-price strategies to be competitive.
Furthermore there are no profit maximisation points unless MC=MR, so as a result prices will be stable or rigid. A stable profit maximising level/equilibrium at P and Q will provide little incentive to alter prices. Periods of relative price stability are called price rigidity. Prices would stay settled even if there was an increase in MC as there would be no change in the profit max level MC=MR. Hence the reason why prices stay relatively stable in an oligopoly market.

This question got 9/9 marks and is a solid answer .
  • Make sure that you use plenty of keywords like in the above essay. The more you use the more likely that your answer will be put in a higher level( meaning more marks!)
  • Use lots of connectives to structure your work so it flows better.( Avoid words such as also and furthermore as it can break up your chains of analysis unless you are starting a new point!)
  • Also use plenty of your own economic knowledge ( examiners love this!!)
  • And refer to the question constantly

I hope that this has been helpful and good luck in any upcoming exams :) !

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