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cost could decrease without changing the firm’s optimal price. (Small shifts in

demand that retain the kink at P* would also leave the firm’s optimal price

unchanged.) In short, each firm’s price remains constant over a range of chang-

ing market conditions. The result is stable industry-wide prices.

The kinked demand curve model presumes that the firm determines its

price behavior based on a prediction about its rivals’ reactions to potential

price changes. This is one way to inject strategic considerations into the firm’s

decisions. Paradoxically, the willingness of firms to respond aggressively to price

cuts is the very thing that sustains stable prices. Price cuts will not be attempted

if they are expected to beget other cuts. Unfortunately, the kinked demand

curve model is incomplete. It does not explain why the kink occurs at the price

P*. Nor does it justify the price-cutting behavior of rivals. (Price cutting may not

be in the best interests of these firms. For instance, a rival may prefer to hold

to its price and sacrifice market share rather than cut price and slash profit

margins.) A complete model needs to incorporate a richer treatment of strate-

gic behavior.

368 Chapter 9 Oligopoly

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STATION 2

An oligopolist’s demand curve is P  30 Q for Q smaller than 10 and P  36 

1.6Q for Q greater than or equal to 10. Its marginal cost is 7. Graph this kinked

demand curve and the associated MR curve. What is the firm’s optimal output? What

if MC falls to 5?

Price Wars and the Prisoner’s Dilemma

Stable prices constitute one oligopoly outcome, but not the only one. In many

markets, oligopolists engage in vigorous price competition. To this topic we

now turn.

A surprising number of product lines are dominated by two firms, so-called

duopolists. Some immediate examples are Pepsi versus Coke, Nike versus

Reebok (running shoes), Procter & Gamble versus Kimberly-Clark (disposable

diapers), and Disney-MGM versus Universal (movie theme parks). When the

competing goods or services are close substitutes, price is a key competitive

weapon and usually the most important determinant of relative market shares

and profits.

A PRICE WAR As a concrete example, consider a pair of duopolists engaged

in price competition. To keep things simple, suppose that each duopolist can

produce output at a cost of $4 per unit: AC MC $4. Furthermore, each

firm has only two pricing options: charge a high price of $8 or charge a low

price of $6. If both firms set high prices, each can expect to sell 2.5 million

units annually. If both set low prices, each firm’s sales increase to 3.5 million

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