Resources | Subject Notes | Economics
This section explores how different firm objectives influence their pricing and output decisions, particularly when considering a kinked demand curve. The kinked demand curve is a common model used to illustrate the challenges firms face in responding to changes in market conditions.
The kinked demand curve model posits that consumers' willingness to pay changes differently depending on whether prices increase or decrease. This results in a demand curve that is relatively elastic at low prices and relatively inelastic at high prices, creating a "kink" in the middle.
Firms have various objectives that shape their policies, including profit maximization, market share maximization, growth, and maintaining a certain level of customer satisfaction. These objectives lead to different responses to changes in the market, especially when faced with a kinked demand curve.
A firm aiming for profit maximization will consider the marginal cost (MC) and marginal revenue (MR) at different price levels. With a kinked demand curve, the MR curve is often relatively flat in the middle.
When the price is above the kink (where demand is inelastic), an increase in price will lead to a small increase in total revenue (TR) because demand is not very responsive. However, the increase in quantity sold will be small. Therefore, the increase in total revenue will be less than the increase in total cost (TC), leading to a decrease in profit.
Conversely, when the price is below the kink (where demand is elastic), a decrease in price will lead to a significant increase in total revenue because demand is very responsive. However, the decrease in quantity sold will be significant. Therefore, the increase in total revenue will be less than the decrease in total cost (TC), leading to a decrease in profit.
Consequently, a profit-maximizing firm with a kinked demand curve will tend to maintain the price at the current market price, where MR is closest to MC.
A firm focused on maximizing market share might be willing to accept lower profit margins. They might respond to competitive price cuts by cutting their own prices to maintain or increase their share of the market, even if this reduces their profitability.
With a kinked demand curve, a firm aiming for market share might choose to maintain a price that keeps their demand relatively elastic, allowing them to attract more customers when competitors lower their prices.
A firm with a strong growth objective might prioritize increasing sales volume over immediate profitability. They might be willing to accept lower profit margins in the short term to gain market share and expand their operations.
They might respond to competitive price changes by adjusting their own prices and potentially increasing their marketing efforts to stimulate demand, even if it means temporarily reducing profit margins.
A firm prioritizing customer satisfaction might be less reactive to price changes. They might avoid large price increases that could alienate customers, even if it means sacrificing some profit.
They might focus on maintaining a price point where customers perceive good value, even if it leads to lower profit margins compared to a more aggressive pricing strategy.
The kinked demand curve model highlights the complexities of pricing decisions. It suggests that firms may not always respond rationally to changes in market conditions, particularly when they are constrained by their objectives.
Government policies, such as price controls, can have unintended consequences when considering a kinked demand curve. For example, a price ceiling might lead to reduced output and shortages if the ceiling is set too low.
| Firm Objective | Policy Response to Price Change | Rationale |
|---|---|---|
| Profit Maximization | Maintain current price | MR is closest to MC at the current price |
| Market Share Maximization | Cut prices (potentially) | Maintain or increase demand, attract customers |
| Growth | Adjust prices and marketing | Increase sales volume, expand operations |
| Customer Satisfaction | Avoid large price changes | Maintain perceived value, avoid alienating customers |