Archives For kinked demand

Smoothing Demand Kinks

Steve Salop —  4 April 2011

One criticism of the unilateral effects analysis in the 2010 Merger Guidelines is that demand curves are kinked at the current price.  A small increase in price will dramatically reduce the quantity demanded.  One rationale for the kink is that people over-react to small price changes and dramatically reduce demand.  As a result of this behavioral economics deviation from standard rational behavior, it is claimed, merging firms will not raise prices when the merger increases the opportunity cost of increasing output.  (The opportunity cost increases because some of the increased output now comes from the new merger partner.)  It has been argued that such kinks are ubiquitous, whatever the current price is.  For some recent views on this issue, see the recent anti-kink article by Werden and the pro-kink reply by Scheffman and Simons.

A story in today’s New York Times nicely illustrates one of the problems with the kinked demand story.  Instead of raising prices, consumer products firms can and commonly do raise per unit prices by reducing package sizes.  Changes in package sizes do not create a disproportionate reaction, perhaps because they are less visible to busy shoppers.   Whatever the reason, this smaller package size raises the effective price per unit while avoiding the behavioral economics kink.  Of course, this is not to say that firms never raise prices; they do.  Moreover, even a kink did exist for reasons grounded in behavioral economics or menu costs, any kink likely is just temporary.  In contrast, a merger is permanent.

It is for these reasons that this kinked economics has gotten much traction in the current debate.  But, these presumptions do not mean that kinked economics arguments can never be raised in a merger.  If there were evidence of a low pass-through rate of variable cost into higher prices over a significant period of time, that evidence would be relevant to a more refined analysis of upward pricing pressure.