THE KINKED DEMAND THEORY OF OLIGOPOLY

It has been observed that many oligopolistic industries exhibit an appreciable degree of price rigidity or stability. That is, in many oligopolistic industries prices remain sticky or inflexible, and there is no tendency on the part of the oligopolists to change price of the commodity by them even if the economic conditions undergo a change. Many explanations have been given for this price rigidity under oligopoly and most popular explanation is the so-called kinked demand curve hypothesis. The kinked demand curve hypothesis was put forward independently by Paul M Sweezy, an American economist, and by Hall and Hitch, Oxford economists.

In explaining price and output especially under oligopoly with product differentiation economists often use the kinked demand hypothesis. This is because in case of oligopoly with product differentiation when a firm raises its price, all customers would leave it because some customers are intimately attached to it due to product differentiation. As a result, the demand curve facing a firm under differentiated oligopoly is not perfectly elastic. On the other hand, under oligopoly without product differentiation, when a firm raises its price, all its customers would leave it so that demand curve facing an oligopolist producing homogeneous product may be perfectly elastic. Further, under oligopoly without product differentiation, there is a greater tendency on the part of the firms to join together and form a collusion, formal or tacit, and alternatively to accept one of them as their leader in selling their price. No doubt, kinked demand curve has a special relevance for differentiated oligopoly, it has also been applied for explaining price and output under oligopoly without product differentiation.


The demand curve facing an oligopolist, according to the kinked demand curve hypothesis, has a ‘kink’ at the level of prevailing price. It is because the segment of the demand curve above the prevailing price is highly elastic and the segment of the demand curve below the prevailing price is less elastic. Thus, according to Sweezy, if an oligopolist raised its price, it would lose most of its customers because the other firms in the industry would not match the price increase. On the other hand, an oligopolist could not increase its share of the market by lowering its price, since its competitors would immediately match the price reduction. As a result, according to Sweezy, Oligopolists face a demand curve that is highly elastic for price increases and less elastic for price reductions.


Because of the firm’s demand curve is kinked, the marginal revenue curve is discontinuous (the bottom part of the marginal revenue curve corresponds to the less elastic part of the demand curve as shown by the solid portions of each curve). As a result, the firm’s cost can change without resulting in a change in price. As shown in the following figure marginal cost could increase but still equal marginal revenue at the same output level, so that price stays the same.

The two different types of reaction of the competitors to a change in price can be explained from the above figure;

(a) Price reduction

If the oligopolist reduces its price level OP in order to increase his sales, the competitors will follow the same from the fear of a loss in the sales. Since the competitors quickly follow the reduction in price by an oligopolist, he will gain in sales only very little. His sales will increase not at the expense of his competitors but because of the rise in total quantity demanded due to the reduction in price of the good. In fact each will gain in sales to the extent of a proportionate share in the increase in total quantity demanded. Very small increase in sales of an oligopolist following his reduction in price below the prevailing level means that the demand for him is inelastic below the prevailing market price. Thus the segment kD of the demand curve which lies below the prevailing price OP is inelastic. It shows that very little increase in sales can be obtained by a reduction in price by an oligopolist.

(b) Price increase

If an oligopolist raises his price above the prevailing level, there will be substantial reduction in his sales. This is because, as a result of the rise in his price, many of his customers will withdraw from him and will go to his competitors who will welcome them and will gain in sales. These happy competitors will have therefore no motivation to match the price rise. The oligopolist who raises his price will be able to retain only those customers, who either have a strong preference for his product (if the products are differentiated) or who cannot obtain the desired quantity of the product from the competitors because of their limited productive capacity. Large reduction in sales following an increase in price above the prevailing level by an oligopolist means that demand for increases in price above the existing one is highly elastic. In the figure the segment ‘dk’ of the demand curve which lies above the current price level ‘OP’ is elastic showing a large fall in sales if a producer raises his price.

Price Rigidity

From the above explanation we can conclude that an oligopolist confronting a kinked demand curve will have no incentive to raise its price or to lower it. Since the oligopolist will not gain any larger share of the market by reducing his price below the prevailing level, and there will be substantial reduction in sales if he increases his price above the prevailing level, he will be extremely reluctant to change the prevailing price. Thus price rigidity can be explained with the help of the kinked demand curve theory.Although the kinked demand curve model is attractively simple, it does not really explain oligopolistic pricing. It says nothing about how firms arrived at price P and why they didn’t arrive at some different price. It is useful mainly as a description of price rigidity rather than as an explanation of it.