Why prices in an oligopoly can stay put, and the model’s limits. Not required by every specification: use it for evaluation.
Picture four petrol stations at the same crossroads, each with its price on a big sign that every driver can see. Their prices are almost always the same, and they rarely change, even when one station’s costs go up a little.
If one station put its price up and the others did not follow, what would happen? And if it cut its price?
Petrol stations in a town all charge about the same price, and it rarely changes.
One station thinks about raising its price. What is the main risk?
If it raises its price and the others do not follow, drivers simply go elsewhere. If it cuts its price, the others match it and it gains few customers. Either way, changing price does not pay, so prices stay put.
An extension model for oligopoly. The firms charge P*. The kinked demand model asks one question: how will rivals react if this firm changes its price?
If it raises its price, rivals do not follow: they are happy to take its customers. So demand above P* is elastic. A small price rise loses a lot of sales, so total revenue falls.
If it cuts its price, rivals follow to protect their sales. So demand below P* is inelastic. A price cut wins few extra customers, so total revenue falls here too. Put the two together and demand has a kink at P*: moving price either way loses revenue, so the firm does not want to change it.
Check: A firm cuts its price and its rivals match the cut. What happens to its total revenue?
Because rivals match, quantity rises by a smaller proportion than the price falls. Demand is inelastic, so total revenue falls.
Each part of demand has its own MR, falling twice as steeply. They do not join up: at Q* there is a jump.
Teacher tip: Draw MR in two pieces, each twice as steep as its own part of demand. The break sits directly below the kink, at Q*. Never join the two pieces with a sloping line.
That vertical jump is a gap, or discontinuity, in MR, directly below the kink.
Check: Why does MR have a gap below the kink?
The flatter, elastic part of demand has one MR and the steeper, inelastic part has another. At the kink the firm jumps from one to the other, leaving a vertical gap.
Finally MC, the Nike tick, passing through the gap. Profit is maximised where MC = MR, so output is Q* and the price is P*. That is the whole model: demand kinked at the current price, MR with a gap, and MC through the gap.
Now use it. Costs rise, say the price of fuel, and MC shifts up to MC2. It still passes through the gap, so the profit-maximising output is still Q* and the price is still P*. Costs have changed, but the price has not. Economists call this price rigidity: prices are sticky.
You can see this in real markets: petrol stations, supermarkets and phone networks often keep the same prices for long periods, even when their costs move. Instead of risking a price war, they compete in other ways: loyalty schemes, advertising, new products. That is non-price competition, and the kinked demand curve is one reason for it.
Check: MC rises but stays within the gap in MR. What happens to the profit-maximising price?
MC = MR still happens at Q*, because MC is still in the gap, so the price read from demand is still P*.
Good evaluation to add in.
They drew MR as one straight line. Each part of demand has its own MR, so MR has a gap below the kink. Without the gap, the model cannot explain sticky prices.
Explain why prices in an oligopoly may be sticky, and give one limitation of this explanation.
In an oligopoly each firm must predict how its rivals will react. If one firm raises its price, rivals are unlikely to follow, because they gain its customers. Demand above the current price is therefore elastic, and the firm loses a lot of revenue.
If it cuts its price, rivals match the cut to protect their sales, so demand below the current price is inelastic and the firm gains little. Demand is kinked at the current price, and the two sections of MR do not join, leaving a vertical gap directly below the kink. As long as MC passes through this gap, the profit-maximising price and output stay the same, even if costs change. So prices tend to be sticky.
**Evaluation:** however, the model does not explain how the price at the kink was reached in the first place, and when all firms face the same cost increase, such as a rise in fuel prices, they often raise prices together.
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