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Difficulty: MediumOligopoly: Characteristics, Types, and Price Interdependence

In an oligopolistic industry characterized by mutual interdependence and non-collusive behavior, a leading firm decides to reduce its product price below the prevailing equilibrium price. According to the kinked demand curve model, how will rival firms react, and what impact does this reaction have on the firm's price elasticity of demand?

  1. Rival firms will match the price reduction, rendering the demand curve inelastic below the prevailing price.Answer
  2. B
    Rival firms will ignore the price reduction, rendering the demand curve highly elastic below the prevailing price.
  3. C
    Rival firms will match the price reduction, rendering the demand curve elastic below the prevailing price.
  4. D
    Rival firms will increase their prices to maintain profits, rendering the demand curve perfectly inelastic below the prevailing price.

Answer

Rival firms will match the price reduction to protect their market share, which makes the firm's demand curve relatively inelastic for price cuts below the prevailing market price.
In Sweezy's kinked demand curve model for non-collusive oligopolies, rival firms display asymmetric reactions. When one firm cuts its price below the prevailing market price, competitors follow suit and match the lower price to prevent their customers from switching. Consequently, the firm initiating the price cut gains negligible additional market share, making the demand curve relatively inelastic below the prevailing market price.

Step-by-Step Solution

1
Analyze rival behavior following a price reduction in a non-collusive oligopoly under Sweezy's kinked demand model.
Rivals fear losing customers to the firm cutting prices, so they immediately match the price decrease.
Matching price cuts is a defensive strategy to retain existing market share.
2
Determine the effect of rival matching on the price elasticity of demand below the prevailing price.
Because all firms lower their prices simultaneously, no single firm gains a competitive advantage in price, resulting in a small percentage increase in quantity demanded relative to the price cut (inelastic demand, Ed<1E_d < 1).
When all competitors lower prices, price elasticity of demand is low (inelastic segment of the kinked demand curve).

Key Concept

Asymmetrical rival behavior and demand elasticity in the kinked demand curve model
Estimated Time:1m 15s
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Topics

Oligopoly: Characteristics, Types, and Price Interdependence

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