Showing posts with label Demand Curve. Show all posts
Showing posts with label Demand Curve. Show all posts

Law of Demand: Higher the price, the smaller the quantity demanded

Law of Demand


The law of demand is one of Alfred Marshall’s many contributions to economic theory. The demand varies inversely with price. The lower the price, the larger the quantity demanded. Similarly, the higher the price, the smaller the quantity demanded. This inverse relationship between price and quantity demanded is often called the Law of Demand. This law may be stated as – “Other things being equal, the higher the price of a commodity, the smaller is the quantity demanded and lower the price, the larger the quantity demanded.”

This law is based on The Law of Diminishing Marginal Utility. According to this law, when a man consumes more and more of a commodity, the utility from latter units declines. Hence, at a given time in given market, people will not buy more of a commodity unless its price becomes lower. The lower price induces the persons already buying to buy more and other persons to start buying.

The law of demand is based on several assumptions:
  1. Taste and preference of the consumer remain constant.
  2. Prices of substitutes and complements remain constant.
  3. Consumer’s income is fixed and constant.
  4. The size of the population is unchanged.
  5. There is no change in distribution of income and wealth.
Demand Schedule
Price ($)
Quantity
12
10
8
6
4
2
2
3
5
7
10
14

A demand schedule shows the relationship between two variables, price and quantity. To be more precise, it indicates the quantity demanded by the consumer at each price. As shown in the demand schedule, when price per unit is $12, the quantity demanded is 2 units, when price falls to $10, $8, $6 and $4 per unit, the quantity demanded increases to 3, 5, 7 and 10 units respectively.

This law can also be illustrated with the help of a diagram known as demand curve. When the demand schedule is displayed geometrically, it is called demand curve. The demand curve also shows the price-quantity relation as the demand schedule.

Law of Demand

In figure, OX axis represents quantity demanded and OY axis represent price. DD is the demand curve. The demand curve has been constructed on the basis of the demand schedule. It shows that when price is $12 per unit, the quantity demanded is 2 units. When the price falls to $10, the quantity demanded increases to 3 units. When the price further falls to $8, the quantity demanded increases to 5 units and so on.

The slope of a demand curve is negative. It always slopes downwards from left to right. It implies that when the price of a commodity falls, the quantity demanded of that commodity increases.

Causes of Demand Curve Sloping Downwards

The demand curve slopes downwards to the right due to the following reasons:
  1. Law of Diminishing Marginal utility: According to this law, as a consumer consumes more and more of a commodity, the marginal utility of the commodity goes on declining. Hence, people demand more only when the price falls.
  2. Income effect: When the price of a commodity falls, there is an increase in the real income or purchasing power of people. Hence, they are able to buy more of that commodity.
  3. Substitution effect: When the price of a commodity falls, it becomes cheaper than other commodities. So people buy more of this goods or substitute this goods for other.
  4. New consumers: When the price of a good fall, new consumers who did not buy before due to inability to buy also buy. So, the demand for the commodity increases. As for example, the transistors made in Khasa of China has decreased considerably. As a result of this, many people have started to buy transistors.
  5. Put to less important uses: When a commodity becomes cheaper, people are inclined to put them to less important uses. Hence, the demand increases when the price of a commodity falls.

Exceptions to the Law of Demand

There are several limitations to the law of demand, which are as follows:
  1. Judged by price: This exception is associated with the name of T. Veblen and his doctrine of conspicuous consumption. If consumers measure the commodity entirely by its price, they will buy less of the commodity when the price falls, and more when the price rises. As for example, the demand for diamond for personal use or premium priced beer. The demand for diamond by rich falls when price decrease.
  2. Giffen Goods: The other exception is associated with the name of Robert Giffen. According to him, a rise in the price of bread causes to buy more bread, not less. Because, the wage earners subsist on the diet mainly on bread. When its price rises, they have to spend more money for a given quantity of bread. So, to maintain their intake of food, they buy more bread at higher price. According to Watson and Getz, these two exceptions to the law of demand are quite important.
  3. Price exception: To quote Watson and Getz again, the other exceptions to the law of demand are only apparent not real. When the consumers expect the price to fall even further, they do not buy more even if the price is lower. Likewise, when the consumer expect further rise in price, they buy more even if the price is higher.
  4. Articles sold under two brand name: The article may be sold under two brand names at the same time. The consumers buy more of the higher-priced brand than the lower-priced brand even though the articles are more or less identical. But the consumers think that the two brands are different. The two brands are taken as two different commodities.
  5. If shortage is feared: If people feel that the commodity is going to be scarce in future, they buy more of it even if the price is high. As for example, when people feel that cooking gas or kerosene is going to be of short supply in future, they buy more even if price is high.
  6. Out of fashion: If the commodity goes out of fashion, people do not buy more even if the price falls, as for example, people do not buy bell-bottom pants or pointed shoes these days even if their prices are lower relatively. Because, their use has gone out of fashion.
  7. Customs and tradition: The law of demand may not hold goods due to customs and traditions. As for example, the demand for clothes, goat increase during Dashain festival even if the prices are too much higher.
  8. Change in season: The law of demand may not hold good due to the change in season. The demand for umbrella does not rise even if price falls during winter season. Likewise, the demand for ice cream, Coca-Cola does not rise during winter even if price is substantially reduced.
  9. Necessaries of life: The necessaries of life are the things that the people cannot do without. Hence, even if the price of rice increases, the demand does not decrease.
  10. Change in income: If the income of people increase, they do not reduce demand for the commodities even if the price rise. On the contrary, if their income decreases, they reduce the demand even if the price of commodities falls.

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Derivation of Market Demand Curve and Shift in Demand Curve

Derivation of Market Demand Curve


An individual demand curve shows the demand of only an individual. But it is necessary to have the knowledge of total demand of all the consumers in market to explain the market behavior. The market demand schedule is derived from individual demand schedule by summing up the demand of all consumers at a particular price. The market demand schedule is prepared after deriving the total demand at different prices. This schedule when converted into a figure is called market demand curve. According to R. G. Lipsey –“the market demand curve is the horizontal sum of the demand curves of all the households in the market.”

The market demand curve shows the relationship of total quantity demanded with price. The price of other commodities, total household income, distribution of income and taste of consumers are assumed to be constant.


The quantity of sugar demanded by three consumers and the total market demand at different prices has been presented in the table below:

Individual and Market Demand Schedule
Price ($ per kilo)
Demand of A (Kilo per month)
Demand of B (Kilo per month)
Demand of C (Kilo per month)
Market Demand (Kilo per month)
2
4
6
8
10
12
40
30
24
18
14
10
45
35
30
20
15
13
18
16
13
12
11
8
103
81
67
50
40
31

A market demand curve is derived by the horizontal summation of the demand curves of all individuals in the market. The market demand curve has been presented in the figure below. It is derived on the basis of the above table.

Market Demand Curve

In the figure, DM is the market demand curve. The market demand curve is derived by summing up the individual demand curves. The market demand curve of a commodity can be derived by joining the points of quantity demanded at different prices.


Shift in Demand Curve

At first, it is necessary to distinguish between shifts in the demand curve and movement along a given demand curve.

Shift in Demand Curve

The distinction between these two kinds of demand change is very important. According to David Begg and others, “Movement along the demand curve represents consumer adjustment to changes in the market price. Shifts in demand, by contrast, represent adjustment to outside factors (other prices, income, tastes) and lead in turn to changes in equilibrium price and quantity”. The change in quantity demanded may occur only due to the change in the price of the commodity concerned. This makes a consumer move from one point of same demand curve. The change in quantity demanded due to the reasons other than price of the commodity causes shift in the entire demand curve.

In the figure, when demand curve is D, price is OP, the quantity demanded is OQ. Now suppose that the demand for the commodity increases. As a result of this, the demand curve shifts to the right in the form of D1. The quantity demanded increases from OQ to OQ1 at the same price. Likewise, if the demand falls, demand curve shifts to the left in the form of D2. The quantity demanded decreases from OQ to OQ2 at the same price. The change in demand leads to the change in equilibrium point. Hence, the shift in the demand curve changes the equilibrium price and quantity in the market. This can be shown only by using supply curve.

In general, when price of a commodity increases, less is demanded. But if demand increases, people buy more even if price rises. If the demand has increased due to increase in income, people buy more even at higher price. According to Watson and Getz, “A demand curve is like a still picture. Behind the price-quantity relation are always the tastes of buyers, their incomes, and the prices of substitute and complementary commodities. When they change, the demand curve changes, shifting to the right or to the left. Demand curves are thus in constant motion, motion picture would be far better than still photographs”.

Factors Causing the Shift in Demand Curve


The changes in demand causes shift in the demand curve. The changes in demand are caused by changes in income, tastes and prices of related goods such as substitutes and complements. The causes of changes in demand has been shown in the following table.

Causes of Change in Demand
Demand Increase
Demand Decrease
1. Consumer desires become stronger
2. Consumer incomes rise
3. Price of substitutes rise
4. Price of complements fall
1. Consumer desires become weaker
2. Consumer incomes fall
3. Price of substitutes fall
4. Price of complements rise.

The factors causing the shift in demand curve are as follows:

1. Price of related goods: The demand for a commodity and the price of related goods have two types of relationships. A fall in the price of a commodity may increase or decrease the demand for other commodity. If the fall in the price of one goods leads to the fall in the demand for other commodity, those goods are called substitutes. As for example, when price of coffee falls, the demand for tea falls. When price of coffee falls, consumers buy more of coffee and buy less of its substitute, tea. In case of substitutes, the demand for a commodity varies directly with the price of substitutes.

If the fall in price of a commodity leads to the rise in demand for other commodity, those goods are called complements. Because if the price of a commodity falls, more of it is consumed and the complementary goods is also consumed more. This kind of relationship exists in the goods that should be consumed together. As for example, pen and ink, car and petrol, shoe and shoelaces.

2. Consumer Incomes: The quantity demanded of a commodity changes with the change in consumer incomes. In general, when income increases, people demand more of a commodity. If the demand increases with the increase in income, such goods are called normal goods. On the contrary if the demand decreases with the increase in income, such goods are called inferior goods. Most goods are normal goods. The inferior goods are typically cheap. As consumer incomes rise, they spend less in cheaper goods like inferior quality rice.

3. Consumer tastes and fashion: The tastes and fashion of consumers change from time to time. If the consumer taste for a particular commodity increases, the demand for that commodity increases. On the other hand, if the taste decreases for that commodity, the demand for that commodity decreases. As for example, the taste for kurta-paijama among Nepalese women has increased these days, which has increases the demand for them. Likewise, the fashion for mini-skirts has reduced the demand for textile materials.

In past, the tastes and fashion were shaped by convenience, custom, and social attitudes. But they can be changed by advertisement and increase in knowledge.

4. Technological progress: The new commodities produced due to technological progress reduce the demand for old commodities. As for example, the demand for piano has declined and that of radio, television has increased. The supply of electricity has reduced the demand for kerosene mantles.

5. Change in size and composition of population: The increase in population increase the demand for goods and services. The scarcity of water at Kathmandu, and appreciable rise in price of food grains is due to high growth of population. Likewise, the change in composition of population also changes the demand for goods. The increase in female population leads to increase in demand for saris, lipsticks, and ornaments.

6. Change in distribution of income: The change in distribution of income in favor of the poor people increases the demand for many things. If the distribution of income is concentrated on rich, the demand for luxuries will be high.

7. Taxation policy: If the taxes are levied deliberately to reduce the demand for commodity, the demand will fall. Since few years back wines, beers and tobacco have been heavily taxed so as to reduce consumption. Similarly, high import taxes are levied on luxury goods such as motorcar, television, and video deck simply to reduce demand.

8. Change in real income: The increase in quantity of money increases the price level. This reduces the real income of people. Consequently people buy less due to fall in purchasing power. The increase in real income may have little effect on necessaries like foodstuffs. But it may considerably increase the demand for luxuries and semi-luxuries.

9. Expectations: If the people feel future shortage of commodity or rise in price, the demand will increase at present.

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|| Demand || Theory of Demand: desire, willingness and ability to pay for a commodity

Meaning of Demand


Demand is not the same as desire or need. Demand for a commodity means desire, willingness and ability to pay. For example, a poor man's desire and willingness to pay for a car is not demand since he does not have ability to pay. Similarly, a person's ability to pay for a car is not demand since he does not have willingness and desire to buy a car. The demand for any commodity is the desire for that commodity baked by willingness and ability to pay. Thus, demand means effective demand, in the sense of being able and willing to buy. Only this affects the volume of sales. 

According to Fredric Benham, "The demand for anything, at a given price is the amount of it which will be bought per unit of time at that price."

In the words of Pappas and Brigham, "The term demand is defined as the number of units of particular goods or service that consumers are willing to purchase during a specific period and under a given set of conditions."

According to Milton H. Spencer, "Demand is the quantity that will be purchased of particular commodity at various prices, at a given time and place."

Thus, demand is always defined with reference to a particular time and given values of variables on which it depends. Two things should be noted in the definition:

First, demand always means demand per unit of time. The time period might be a month or year. We must specify the period for which the commodity is being demanded. The statement that demand for ghee in Kathmandu is 1000kg at Rs. 50 per kg, has no significance unless we state clearly the period for which this quantity is being demanded.

Second, the condition on which the things is demanded should be specified. The conditions would include the price of the good in question, price and availability of competitive goods, expectations of price changes, income, tastes and preference, advertising expenditures and so on. The demand for the product depends on all these factors. For example, the term demand has no significance unless it is related to price. The statement that the weekly demand for ghee in Kathmandu is 1000kg is meaningless unless we specify the price at which the quantity is being demanded by the customers of Kathmandu. The demand may be fairly small if the price is high.

Derivation of Individual and Market Demand Curve

The process of derivation of individual and market demand curve has been explained as follows:

Derivation of Individual Demand Curve


The individual demand schedule is a schedule of prices of commodity and the demand for the commodity made by an individual. Similarly, individual demand curve is the schedule of different quantities of goods demanded by an individual at different prices. The demand schedule shows the relationship between the prices of the commodity and the quantity demanded. The individual demand (for sugar) schedule has been presented in table below:

Individual Demand Schedule
Price ($ Per kg)Quantity Demanded (kg per month)
2
4
6
8
10
12
14 
10
7
5
3
2

As shown in the table, the quantity demanded of sugar at price $2 per kg is 14 kg, at $4 is 10kg, at $6 is 7kg, and so on. It shows that the quantity demanded increase with fall in price.

The individual demand curve is derived on the basis of this demand schedule. The individual demand curve DD has been derived in the following figure on the basis of above table.


In the given figure, OY axis represents price of sugar and OX axis represents quantity demanded DD is the demand curve. It shows that the quantity demanded is 14kg at price $2, 10kg at $4, 7kg at $6, 5kg at $8 and so on. In this way, the demand curve shows the relationship between price of the commodity and quantity demanded. According to R. G. Lipsey, "The demand curve for a commodity shows the relation between its price and a quantity a household wishes to purchase per period of time."

The demand curve has the following characteristics:
  • Traditionally, the price level is shown along the vertical axis and the quantity demanded is shown along the horizontal axis.
  • The demand curve may show the demand of an individual or the group of consumers in the market.
  • The demand curve assumes that there is no change in the value of other relevant variables. This means that the prices of other goods, income of the consumers and taste of consumers are assumed to be constant.
  • In general, the demand curve has negative slope, or the demand curve slopes downwards. This means that people demand more at lower prices.

The law of demand implies this. But there are two exceptions to this:
a) The situation of snob appeal – as for example, the expensive jewelry are demanded more at higher prices, but demanded less at lower prices due to the fall in snob appeal. 

b) The situation in which consumers judge quality by price – as for example, if the consumers do not have ability to judge the quality of the products directly, they use price as the quality. Hence, demand may fall when price falls.

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Peak Load Pricing | Peak Load and Off Peak

There are certain non-storable goods, e.g. electricity, telephones, transport, security services etc., which are demanded in varying measures during the day as well as night. For example, consumption of electricity reaches its peak in day time. It is called ‘peak load’ time. It reaches its bottom in the mid-night. This is call ‘off peak’. Electricity consumption peaks in daytime because all business establishments, offices and factories come into operation. Electricity consumption decreases during nights because most business establishments are closed and household consumption falls to its basic minimum. In terai, demand for electricity peaks during summer season due to use of fans, ACs and coolers, and it declines to its minimum level during winters. Similarly, consumption of telephone services is at its peak at day time and at its bottom at nights. During Dashain festival, the demand for bus and air travel services rises to its peak in Nepal.

A technical feature of such products is that they cannot be stored. Therefore, their production has to be increased in order to meet the ‘peak load’ demand and reduced to ‘off peak’ level when demand decreases. The excess production in ‘off peak’ period could be stored and supplied during the ‘peak load’ period. But this cannot be done. Besides, given the installed capacity, their production can be increased but at an increasing marginal cost (MC).

Pricing of goods like electricity is problematic. The nature of the problem in a short run setting is depicted in the figure. The ‘peak load’ and ‘off load’ demand curves are shown by Dp and DL curves, respectively. The short run supply curve is given by the short run marginal cost curve, SMC. The problem is ‘how to price electricity?’



Peak Load Pricing of Electricity

As shown in figure, if the price of electricity is fixed in accordance with peak load demand, OP3 will be the price and if it is fixed according to off load demand, price will be OP1. If a ‘peak load’ price (OP3) is charged uniformly in all seasons, it will be unfair because consumers will be charged for what they do not consume. Besides, it may affect business activities adversely. If electricity production is a public monopoly, the government may not find it advisable to charge a uniform ‘peak load’ price.

On the other hand, if a uniform ‘off load’ price (OP1) is charged, production will fall to OQ2 and there will be acute shortage of electricity during peak hours. It leads to ‘breakdowns’ and ‘load-shedding’ during the peak load periods, which disrupt production and make life miserable. This is a regular feature in terai, the capital city of Nepal. This is because electricity rates in terai are said to be one of the lowest in the country.

Alternatively, if an average of the two prices, say P2 is charged, it will have the demerits of both ‘peak load’ and ‘off load’ prices. There will be an excess production to the extent of AB during the ‘off load’ period, which will go waste as it cannot be stored. If production is restricted to OQ1, price P2 will be unfair. And, during the ‘peak load’ period, there will be a shortage to the extent of BC, which can be produced only at an extra marginal cost of CD.

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Firm determines the best level of output and price for products | Joint products in fixed proportions of one to one

The firm determines the best level of output and price for products that are jointly produced in fixed proportion.

Joint products result from production processes that naturally yield multiple products. A decision to run the production process automatically produces the entire product group. For example, the processing of sugarcane results in a by-product called bagasse, which is the residue of the cane stalk after the juice has been squeezed out. By-products may be used, or sold or otherwise disposed of. Bagasse, for example, is burned to make steam to generate electricity. By-products that cannot be used or sold create a problem (and a cost) of disposal. The proportion of joint products may be either fixed or variable.

Joint Products in Fixed Proportions of One to One


Since there is only one production process, there is no economically sound to allocate costs to the individual products. The demand curves, however, can be and usually are quite different for the main product and the by-products. Determination of the optimal output and prices involves optimization of the total marginal revenue from all products in relation to marginal cost. We shall explain the procedure with the help of figure.

In the figure, it depicts two cases of the joint products A and B produced in the fixed proportion 1:1. In order to maximize profit, we must find the level of production at which MRT = MC; however, there is a complication; neither product may be sold beyond the quantity where its individual MR < 0. This is because of negative marginal revenue, means we would be losing money on each unit sold. In both panels, MRs = 0 at QM units of joint production.


The step-by-step procedure for determining optimal output and price goes as follows:

Step 1: Develop or obtain the demand function for Product A (DA on the figure) and it is related to marginal revenue (MRA).

Step 2: Develop or obtain the demand function for By-product B (DB on the graphs) and it is related to marginal revenue (MRB).

Step 3: Add MRA and MRB to obtain MRT.

Step 4: Obtain the total cost function and take its derivate to get marginal cost, MC.

Step 5: Observe the value of Q at which MRB = 0 (QM on the graphs).

Step 6: Observe the level of Q at which MRT = MC (QC on the graphs).

Step 7: Compare QC to QM. If QC ≤ QM, then the optimal output and sales level for both products is QC. 

This condition is illustrated on Panel A. Go to step 9.

Step 8: If QC > QM, as illustrated on Panel B, then the maximum quantity of By-product B that can be sold is QM. To find the optimal quantity of the main product A, find the level at which MRA = MC. This is at Q3 on Panel B. Of course, Q3 units of By-product B will also be produced but the quantity Q3 – QM will be dumped, destroyed or otherwise disposed of, because selling it means losing money on every unit sold. In the past, the cheapest method of disposal has too often been indiscriminate dumping. Legal and environmentally sound disposal methods may incur additional costs. These additional costs can be quite substantial, and thus provide a powerful incentive to find new uses and new markets for the unwanted product.

Step 9: Use the demand functions of A and B to find the prices at which the optimal quantities may be sold. Thus, in both panels, Product A would sell for PA, and By-product B would sell for PB.

Joint Product in Fixed Proportions Other Than a One-to-one Ratio


If the joint products are produced in fixed proportions other than 1:1, we must first remember that the cost function pertains to output of the main product. Therefore, we want to establish a ratio of 1x, where x is the number of units of By-product per unit of the main product. For example, suppose that the demand and cost functions remain the same for Product A and By-product B of the previous example, but the production technology changes so that the production ratio becomes QA:QB = 2:3.

We note that the ratio 2:3 is the same as the ratio 1.0:1.5. Hence QA = Q and QB = 1.5QA. By making appropriate substitutions of 1.5 QA for QB and vice versa, the procedure described above for a 1:1 ratio can be followed.

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Concept of Oligopoly and Kinked Demand Curve Model

Price rigidity under oligopoly in terms of kinked demand curve
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.

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:
  1. The rival firms follow the price changes, both cut and hike; 
  2. The rival firms do not follow the price changes;
  3. 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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