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

• Elasticity of Demand: Types of Price Elasticity of Demand

• Pricing decision on the basis of Cost Plus Pricing Theory

• Price Leadership Model

• The Cartel or Collusion Model

• Uses of Price Elasticity of Demand in Managerial Decision-making

Demand Forecasting for the New Products

If a firm is planning to market a new product and does not have past data on which to rely to project sales, it will have to find out and use other means in an effort to predict probable sales.

The special problem of demand forecasting for new products is that since each new product is to varying degrees, different from existing products, there are no directly relevant data available from past sales on which a forecast may be based. The more the new product is likely to be, the greater the problem. In addition, since a considerable amount of money has to be invested in developing and marketing a new product, we have to consider its sales over an extended period to be more precise over the whole of its expected commercial lifetime. It means that we need to estimate:

(i) the number of years for which the product will be sold and

(ii) the level of sales in each of those years.

There are, of course, a number of techniques available for the purpose. However, the choice of a particular technique depends on the circumstances faced by the forecaster.

1. Market Research

The forecaster can carry out market research in various forms. The marketing people may be asked to make different inquiries from the prospective ultimate buyers of the product. On the basis of such inquiries, they may try to discover whether and in what quantities customers are likely to buy the product, using various assumptions as to how, it would be marketed and at what price it would be sold.

This approach is no doubt, direct and practical. It can be applied for forecasting the demand of industrial goods because the buyers’ criteria are more precisely formulated and more stable.

However, this method is highly impracticable in the case of new consumer goods. It is so because the consumer is, for various reasons, unlikely to be able to assess reliably his own buying behavior in the hypothetical situation presented to him.

2. Test Marketing or Sales Experience Approach

It takes the form of a trial run of the product in a part of the intended market in conditions as closely similar to those that are expected to prevail if and when the product is ultimately marketed as are possible.

Frequently, a new product such as soap, toothpaste, food-stuff, etc. is put through test marketing, i.e. tested in a sample market in a bid to determine the probable demand for the product. It may be tasted at a particular price or at several different prices by seeing one or more test markets. From the test market results, a projection can be made regarding regional or national sales. The sales experience usually will give green or a red signal for the product.

This approach has been used with success for a wide range of products. However, the success of this method depends on the availability of a representative product for test marketing. This method is not applicable to the earlier stages of product development.

3. Opinion Sampling Approach

This approach is to bring together in a systematic way the informal judgments of executives, sales people, retailers and perhaps friendly customers as to the product’s probable performance.

Through use of a mail questionnaire, or by making a door survey, one can get some indication of the acceptance of new product. In this case, sampling of the potential customers may be polled directly, or there may be a poll of sources that have a feel of the actual buyer, such as retailers, wholesalers, jobbers and manufacturer representatives. This pool is likely to give some idea of market acceptance and price range.

4. Evolutionary Approach

If the product is supposed to be an improvement or has evolved out of an existing product, it can be assumed that the new product may have the same type of experience as that of an existing product. Color television sets, evolved from black and white sets, the jet engine from the propeller engine in aircraft, are the examples. In this manner, one can easily imagine what the demand for work processors will be in the office equipment industry if they became a nearly completely replacement for the electric typewriter.

5. Substitute Approach

If a new product seems to be a close substitute for a well established product, one can estimate what share of the market the new product may get by replacing some of the existing products. A new textbook may be a substitute for one of the many existing textbooks being used. After knowing the total sales, the producer of the new book may be in a position to estimate.

6. Sales Growth Approach

In the absence of the information about a new product, one may reasonably assume that the sales of the new product will simply displace those of an existing product and continue along the growth of distinct established by it. This is likely to be so when the new product is distinct, improvement on the existing one but not so radically different that buyers have learn to accept it. In the case of industrial investment, we assume that now there need to make any substantial investment in hardware or restraining. Alternatively, for consumer products, no changes in domestic habits or social attitudes and values are required.

No doubt, demand forecasting represents one of the most challenging aspects of business analysis. Continuous research has been going on in this area. The techniques of forecasting are being retired and have been improved enormously in recent years by the advent of computers. However, the use of sophisticated techniques is not enough. It is essential to exercise judgment and experience while carrying out any forecasting exercise. Techniques can only complement judgment and experience.

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• Steps of Demand Forecasting

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• Non-statistical methods that is used to forecast the demand for satellite TV signal decoder

• Process of demand forecasting by the time series analysis

• Factors Determining Elasticity of Demand

• Uses of Price Elasticity of Demand in Managerial Decision-making

Merits and limitations of market studies and experimentation as a method of demand forecasting

An alternative technique for obtaining useful information about a product’s demand function involves market experiments. The firm locates one or more markets with specific characteristics, and then varies prices, packaging, advertising, and other controllable variables in the demand function, with the variations occurring either over time or between markets.

One market experiment technique entails examining consumer behavior is actual markets. The firm may also be able to sue census or survey data to determine how such demographic characteristics as income, family size, educational level and ethnic background affect demand.

Market experimentation procedure utilizes a controlled laboratory experiment where in consumers are given funds with which to shop in a simulated store. By varying prices, product packaging, displays, and other factors, the experimenters can often learn a great deal about consumer behavior. The laboratory experiment, while providing similar information as field experiments has advantages / merits because of lower cost and greater control of extraneous factors. Merits and limitations of market experiments can be shown as below:

Merits of Market Experiments

1. Market experiments are based on actual consumer behavior and not on merely their intentions to buy the commodity. 
2. They provide more accurate returns than those of consumer survey because consumers are asked to make actual decisions regarding their purchase.

Limitations of Market Experiments

1. Market experiments are costly and much time consuming. 
2. If the price rises, the consumers may switch over to the products of the rival firms. If the price reduced to the original level, it may be difficult to regain the lost customers.
3. It is also difficult to select an area, which accurately represents the potential market.
4. Firm cannot control all the factors (i.e. bad weather, economic conditions, occupation situations etc.) that influence demand for a product.
5. The changes in price or adverting to know consumer’s response may go unnoticed by them in such a short period. 
6. The selected consumers may not respond accurately when they know they are a part of an experiment being conducted and their behavior is being recorded.

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• Demand Forecasting

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• Human resource planning is deciding in advance the future requirements of human resource in organization

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• Meaning and Concept of HRP (Human Resource Planning)

• Purpose of Forecasting Demand in a Business Firm

• Demand Forecasting for the New Products

• Process of demand forecasting by the time series analysis

Expert’s opinion survey differ from survey of Sales forces

The different between expert’s opinion and survey of sales forces can be explained as follows:

- A variant of the opinion poll and survey method is said to be expert’s opinion survey. The participants are supplied the responses to previous questions from others in the group by a coordinator or leader of same sort. The leader provides each expert with the responses of the others including their reasons.

In survey of sales forces, information is collected from firm’s sales-representatives or salesmen about their estimates of sales of its product in future.

- Outside experts such as consultant firms, investment analysts, who are professionally trained for the purpose of the forecasting demand, may be asked to estimate demand.

In survey of sales forces, information regarding likely sales is obtained from those who are closest to the market and have an initiate insight to the market.

- Each expert is told about the prediction of other experts and asked in the light of the other’s views whether he/she should revise his prediction about future demand. The experts are again shown each other’s revised forecasts and asked to reconsider their forecasts future till a consensus is reached or until referring the opinion of others.

In survey of sales forces, the responses of the various salesmen or representatives are then aggregated to arrive at total demand forecast for the product.

- Predictions of the demand by experts are not always based on any hard data but they can provide useful information about demand for the product.

Sales forecasts provided by sales representatives are biased either upward or downward. However, as a result of experience, some corrective factors are applied to sales estimates furnished by salesmen.

The merits and limitations of expert’s opinion and survey of sales forces can be explained as below:

Merits of Expert’s Opinion

1. It facilitates the maintenance of anonymity of the respondent’s identity throughout the course. This enables the respondent to be candid and forth right in his view. 
2. It renders if possible to pose the problem to the experts at one time and have their response.

Limitations of Expert’s Opinion

1. Predictions for demand by experts should always be based on some hard data, but they are not based on any hard data. 
2. It is very costly or otherwise not possible to conduct complete enumeration. Outside experts may charge huge fees for giving their opinion.
3. The experts who consider themselves experts may not like to be influenced by the predictions of others on a panel of experts. As a result, there may not be any revision in subsequent rounds of seeking their opinion about other’s forecasts.

Merits of Survey of Sales Forces

1. It is easy and cheap to do. 
2. It has further advantage of increasing the motivation of salesmen to achieve the self-selected target for which they had made a forecast.

Limitations of Survey of Sales Forces

1. Sales representatives may not provide correct forecast. Some sales representatives would like to make too optimistic sales forecast. 
2. Some salesmen would like to make too pessimistic sales forecast so that they get higher payments for exceeding the targets based on their sales predictions.
3. Sales forecasts provided by sales representatives are biased forecast either upward or downward.

  Some Related Links:      

• Demand Forecasting

• Different methods of demand forecasting

• Steps of Demand Forecasting

• Purpose of Forecasting Demand in a Business Firm

• Human resource planning is deciding in advance the future requirements of human resource in organization

• Demand Forecasting for the New Products

• Process of demand forecasting by the time series analysis