KINKED DEMAND CURVE SUBMITTED BY – DEBOJIT NATH (23) MBA IST SEMESTER (SEC- A)
The kinked demand curve was first used by
Paul.M.Sweezy to explain price rigidity.
The assumption behind this theory of kinked demand is that each oligopolistic will act and react in a way that keeps condition tolerable for all members of the industry.
Such a situation is most likely to occur where products are quite similar and, therefore their prices almost same.
If one firm is selling at a price lower than that of its competitors, these competitors will be compelled to reduce their prices to match this firm’s price.
On the other hand if one firm decides to sell at a higher price its competitors do not react by raising their price.
So, in the first situation (i.e. Price reduction) the firm does not gain, while the latter the firm loses its customer to its rival.
The oligopoly firm probably realises that it is better to accommodate its rival rather than start a price war.
So in non-collusive oligopoly the prices is tend to be sticky i.e, there is a price rigidity.
The most significant aspect of the solution of an oligopoly situation is the presence of kink in the demand curve of the firm.
The kink shows that price reduction by a firm is followed by its rival(competitors).
Therefore firm will not move away from the kink.
The Key characteristics of an Oligopolistic Market
there are few buyers and large number of sellers
Few firms sell branded products which are close substitutes of each other.
Entry barriers for the other firms are high; the barriers can be due to patents, copyrights, government rules / regulations or ownership of scare resources.
Firms are interdependent for decision making.
Products can be homogenous (standardized) or heterogeneous (differentiated).
The sellers are the price makers and not price takers, since the few sellers mutually dominate the pricing decisions.
In this graph dd’ is the individual demand curve and the firm market- share DD’ intersecting at E.
It is believed that if an oligopolistic reduces his price he expect his competitors will follow the same, while no competitors will follow when he raise the price. The relevant demand curve of the firm is, therefore, dED’ (with a kink at E).
For a price reduction below P, the share of the market demand curve D’E is relevant as the countermoves by the rival will keep the market share of the firm constant.
And, for prices increases above P, the firm goes alone and, therefore, the relevant demand curve for the firm is its own demand curve dE
If price increases are ignored by other firms but price decreases lead to lowering of prices by competitors the firm will face a kinked demand curve as shown to the right, with the kink at the current market price of P*
6 ILLUSTRATION- 1
For finding out the profit maximizing price-output combination, MR curve corresponding to kinked demand dD has been drawn.
MR curve associated with kinked demand curve dD is always is discontinuous
The length of this discontinuity depends upon relative elastics of two segments dk and kD of the demand curve.
Between MR & dD which has a discontinuous gap HR.
When MC curve of the oligopolistic passes through discontinuous HR through point E oligopolist maximizing its profit at prevailing OP price level.
Thus it will no encourage to price changes.
When the marginal cost curves shifts upwards from MC to MC’ due to rise in cost the output remain unchanged since the new MC’ also passes through HR
7 REASONS FOR PRICE RIGIDITY REASON-1 Fig:- Changes in the cost within limits do not affect the oligopoly price
Likewise when demand condition changes the price may remain stable.
The demand for oligopolist from dkD to d’k’D’ the marginal cost curve MC also cuts the new MR’ curve within the gap
Thus same price OP continues to prevail(Mk= M’k’) in the oligopolistic firm
8 CHANGES IN DEMAND DO NOT AFFECT THE OLIGOPOLY PRICE REASON 2
Criticism /drawback…… The kinked demand curve model has been criticised on several counts:-
There are also some other valid explanation for price rigidity, such as nationally advertised prices, catalogued prices, reluctance to disrupt customers relations, and fears that recurrent price cuts may trigger a price war.
The model does not explain how the firm arrive at the kink in the first place.
Conclusion: In conclusion, we can opine that mutual interdependence among the firms and price rigidity are two typical features in oligopoly market. Although the firms are rivals, they are mutually interdependent. No firms likes to resort price change which will harm his business. Hence price competition is not significant is oligopoly market. 10