Final answer:
The Kinked Demand model in oligopoly assumes that rival firms will match price reductions but will not follow price increases, leading to a kinked demand curve for the firm.
Step-by-step explanation:
The Kinked Demand model is a theoretical framework used to explain pricing behavior in oligopoly markets, where a small number of large firms dominate the industry. The central assumption of this model revolves around the anticipated reactions of rival firms to changes in prices. Specifically, it posits that in an oligopolistic setting, a firm expects its competitors to match price reductions but ignore price increases. This creates a distinct kink in the demand curve faced by the firm.
When an oligopoly firm contemplates lowering its prices to stimulate increased sales, the Kinked Demand model predicts that rivals will swiftly follow suit to maintain their market share. Consequently, any attempt to gain a competitive advantage through price reductions leads to a situation where the firm experiences a significant drop in the price per unit, without a proportionate increase in sales volume. This phenomenon is attributed to the collective reaction of firms in the oligopoly to resist losing market share, resulting in a stable and rigid lower segment of the demand curve.
Conversely, when the firm contemplates raising prices, the model assumes that rival firms will not match the price increase. As a result, the demand for the firm's product becomes highly elastic, leading to a sharp decline in the firm's sales. In this scenario, competitors maintain their prices, causing consumers to shift their purchases to lower-priced alternatives.
In summary, the Kinked Demand model reflects the strategic interdependence among oligopoly firms, where expectations of rival behavior shape a firm's pricing strategy. The kink in the demand curve, arising from the asymmetrical response to price changes, creates a unique dynamic in which firms face challenges in both reducing and increasing prices without adverse consequences on sales and profitability.