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Explain the kinked demand curve

The Kinked Demand Curve theory is a concept used in economics to explain price stability in oligopolistic markets, where a few large firms dominate. This theory suggests that in such markets, the demand curve a firm faces for its products has a distinctive kinked shape due to the expected reactions of competitors to changes in price. Here's how it works: Above the Kink In this portion of the curve, if a firm increases its price, it's expected that competitors will not follow suit. Since the other firms keep their prices constant, the price-increasing firm will lose a significant market share. Therefore, the demand curve above the kink is relatively elastic, meaning consumers are very responsive to price increases. Below the Kink Conversely, if a firm lowers its price, it is expected that competitors will also lower their prices to maintain their market share. In this scenario, the price-reducing firm gains little to no increase in market share because all firms reduce their prices. Therefore, the demand curve below the kink is relatively inelastic, indicating consumers are less responsive to price decreases. The "kink" in the curve occurs at the current market price. The key implication of this model is that there is little incentive for firms to change the price, leading to price rigidity. Firms are reluctant to change prices because doing so either leads to a loss of market share (if they increase prices) or doesn't result in a significant gain in market share (if they decrease prices). This model, however, has its limitations. It assumes that competitors will always react in a particular way to price changes, which might not always be the case. Additionally, it focuses primarily on price competition and overlooks other factors like product differentiation, service quality, and brand loyalty.

Answered by: Nina TEconomics Tutor

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