Question
A firm observes that when it raises prices, competitors
do not follow, leading to a significant loss of customers, whereas when it reduces prices, competitors quickly match the price cut, resulting in little gain in market share. This pricing behavior gives rise to a discontinuous marginal revenue curve. In which type of market structure is this situation most likely to occur?Solution
The scenario describes the kinked demand curve model, which arises in oligopolistic markets where firms are interdependent. A price increase is not followed by rivals, making demand highly elastic, while a price decrease is quickly matched, making demand inelastic. This creates a kink in the demand curve and a discontinuous marginal revenue curve, leading to price rigidity. The kinked demand curve is as below: 
The logic of the kinked demand curve is based on
- A few firms dominate the industry
- Firms wish to maximise profits
- Perfect competition firms are price takers and do not face kinked demand.
- Monopolistic competition features differentiated products but lacks strong strategic price reactions.
- Monopoly faces a single downward-sloping demand curve without competitor reaction.
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