Price rigidity in the oligopoly market is best explained by the kinked demand curve.
The oligopoly is a reduced form of monopolistic competition. The term oligopoly has a Greek base and means few sellers, oligopoly as such, refers to markets with small number of large firms, each selling either differentiated or homogeneous product. |
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A few sellers imply a number so small or a few market share of each firm in so large that it can influence the market price. It also implies that each seller commands a sizeable proportion of the total market supply. The products traded by the oligopolists may be differentiated or homogeneous. Accordingly, the oligopoly market may be a heterogeneous oligopoly or a homogeneous (or pure) oligopoly. It seems the following features:
- Sellers are few in number.
- Any of them is of such a size that can increase and decrease in his output will appreciably affect the market price. In fact, the size of each seller’s output in relation to the total supply is the test.
- Each seller knows his competitors individually in each market.
Each oligopolist realizes that any change in his price and advertising policy may lead rivals to change their policies. Hence, an individual firm must consider the possible reaction of the other firms to its own policies. The smaller the number of firms, the more interdependent are their policies. The reactions of rivals will generally be immediate and strong, and tendencies to close collaboration in price determination are appeared.
It is the fewness of sellers that introduces interactions into the price and output decision problem under oligopoly a special form of oligopoly in duopoly, under which only two firms produce a particular product.
Kinked Demand Curve Model
The kinked demand curve model developed by Paul M. Sweezy, has features common to most of oligopoly pricing models. The kinked demand curve analysis does not deal with price and output determination. It seeks to establish that once a price-quantity combination is determined, an oligopoly firm will not find it profitable to change its price in response to a moderate change in cost of production. An oligopoly form believes that if it reduces the price of its product, rival firms would follow and neutralize the expected gain from price reduction. But, if it raises its price, rival firms would either maintain their prices or may even cut their price down. In either case, the price rising firm stands to lose, at least a part of its share in the market. This behavioral assumption is made by all the firms in respect of others. The oligopoly firms would therefore, find it more desirable to maintain their price and output at the existing level.
There are three possible ways in which rival firms may react:
- The rival firms follow the price changes, both cut and hike;
- The rival firms do not follow the price changes;
- Rival firms do not react to price-hikes but they do follow the price-cuts.
Kinked-demand curve is a demand curve with two distinct segments with different elasticities that join to form a kink. The primary use of the kinked-demand curve is to explain price rigidity in oligopoly. The two segments are:
(i) a relatively more elastic segment for price increase and
(ii) a relatively less elastic segment for price decreases.
The relative elasticities of these two segments are directly based on the interdependent decision-making of oligopolistic firms. Interdependence is the guiding behavioral principle of oligopoly firms in which the decision by one firm is both affected by the decisions of other firms and in turn affects the decisions of other firms. Such interdependence is characteristic of oligopoly firms that practice competition among the few. Interdependence is indicated by the kinked-demand curve, game theory, collusion, and mergers. Merger is the consolidation of two separately-owned businesses under single ownership. This can be accomplished through a mutual, “friendly” agreement by both parties, or through a “Hostile takeover,” in which one business gets ownership without cooperation from the other. Mergers fall into one of three classes –
(i) horizontal – two competing firms in the same industry that sell the same products,
(ii) vertical – two firms in different stages of the production of one good, such that the output of one business is the input of the other, and
(iii) conglomerate – two firms that are in totally, completely separated industries.
According to the kinked demand curve model, firm determines the price and output by intersection of MC and MR. But intersecting point lies on the discontinuous segment of MR. In this model, the demand curve faced by oligopolists has kink at the prevailing price. It means, the upper section of the kinked demand curve has higher price elasticity than lower part. Because, each oligopolist believes that if he reduces his price below the prevailing level, his competitors will follow him, and will accordingly lower their prices. So that an oligopolist firm which lowers the price could not increase its share of the market. Whereas if he raises the price above the prevailing level, his competitors will not follow him and they do not increase their price. So, an oligopolist will lose a considerable part of his customers. Because of this, an oligopolist tends to keep prices constant even if the cost and demand conditions are changed. This model is illustrated in figure.
In the figure, dED is the demand curve faced by an oligopolistic firm and has a kink at point E which represents the prevailing market price. Above this point, demand curve dE is more elastic and below this point, it is less elastic. dABMR is the marginal revenue curve of the firm. MR has two segments; the upper segment dA corresponds to the upper part of the demand curve dE. The lower segment BMR corresponds to lower part of kinked demand curve ED. The kink at point E on the demand curve results in discontinuity ‘AB’ in the MR curve. Oligopolist firm can reach equilibrium position and determine the selling price, and quantity and maximize the profit by equating MC with MR. In the given figure, SMC cuts the discontinued segment of MR at point ‘C’ and the firm determines price QE and selling quantity OQ. This QE level of price will not be changed by firm. If SMC curve rises to SMC1 because of increasing costs and SMC curve goes down to SMC2 because of decreasing cost, this will not affect the pricing decision of the oligopolist. These two curves SMC1 and SMC2 allow the firm to fix the price QE and quantity OQ.
We may conclude that an oligopolist faced with a kinked demand curve will be extremely unwilling to change his price. For a fall in his price will cause no large increase in his sales whereas a price increases will cause a substantial decline in his sales. Thus, neither a price increase nor a price reduction will be an attractive proposition for the oligopolist. During inflationary periods, however, oligopoly firms often follow one another’s price increase, to this extent, the kinked demand curve analysis can be said not to hold true.
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