Kinked Demand Curve, is an oligopoly model. Paul M. Sweezy and Hall and Hitch develop this model. Through the analysis of kinked theory of demand in oligopoly market, the author attempted to prove that price and output tend to stabilize and do not change under oligopolistic conditions and trends.
Kinked Demand Curve
Price cuts match price cuts, but price hikes do not correspond to price increases, which is the assumption based on this model. The reason is quite simple: the price increase could result in a drastic sales decrease. However, a price reduction can attract new customers. It means that the price initially remains at similar levels for a more extended period.
In the oligopoly model, only a few companies exist in the industry. The kinked demand curve represents an instance of collaboration in partial form. The primary reason for its creation was to explain why stable prices could characterize the oligopolies, but not in a typical way.
Assumptions of Kinked Demand Curve
The following are the assumptions that have to follow for Kinked Demand Curve theory for price rigidity:
- There are a few companies within the oligopolistic sector.
- The product made by one company is an exact substitute for other firms’ products.
- The product is of the same high quality. There isn’t any differentiation in the product.
- There are no advertising expenses.
- There is a regular price in the marketplace for the product that all sellers are happy with it.
- The attitudes of their competitors determine each seller’s attitude.
- Any attempt of a seller to drive up sales by reducing the cost of his product will be challenged by other sellers following the seller’s move.
- If the seller raises the price, other customers aren’t likely to follow. Instead, they will stick with the current price and serve the customer who is not the seller.
- A marginal cost curve runs through the dotted part of the marginal revenue curve, ensuring that any changes in marginal cost don’t affect output cost.
The Kinked Demand Curve: Explanation
According to research, prices are more rigid for extended periods in various oligopolistic industries. The rate of change is often constant in price, even when costs decrease for the firm. Various explanations have to present under Oligopoly to explain this rigidity of price. Out of these explanations, American economist Sweezy provides the most well-known hypothesis, the kinked demand curve hypothesis.
On the basis of the kinked demand curve hypothesis, the curve facing an oligopoly is kinked at the current price level. The kink is evident at the current price level because the demand segment above this point tends to be very elastic. Below that level, the segment is usually inelastic. dD, a Kinked Demand Curve with P Kink points is illustrated in figure 6.22.
OP displays the current price, and OQ illustrates what the company produces and how it sells its output. The top segment dP is elastic, while the lower segment of PD of the Demand curve DD appears to be inelastic. That is due to the specific reaction pattern to the competition ascribed to the Kinked Demand Curve Hypothesis.
According to the beliefs of each oligopolist, cutting down the price to a lower level will force his competitors to follow his lead and decrease prices, whereas increasing the price above the prevailing price levels will make rivals not follow him to increase the price.
That is because when an oligopolist cuts prices on its products, its competitors may think that they are not following the model, resulting in losing customers. Customers will then move to purchase the goods from companies that have lower prices.
To keep clients, the companies reduce their prices. It makes the upper portion of the curve for demand flexible. In contrast, the company’s price increase can result in an enormous reduction in sales because a price increase could cause the withdrawal of customers and then to competitors who will welcome new customers and gain sales.
So, the happy rivals will not motivates to increase their price. Much of the value is lost to the oligopolist that raises the price of its products and refrains from price increases. That is the oligopolist behavior—the lower inelastic part of the demand curve.
Therefore, every oligopolist will likely remain at the current price after considering that there is no advantage in altering it or the development of kinks will be present at the current price. Thus, Keynes’s demand curve theory can help explain stiff or sticky prices.
Critiques of Kinked Demand Curve
The critiques of kinked demand curves explains in the following motives:
1. It Doesn’t Provide a Way to Explain How the Prevailing Price is Determined
The kinked demand curve provides a clear explanation of why and how prices are fixed and remain constant in the marketplace. That is why it only explains the half-truth, not the complete further explanation. Hall and Hitch provide another variation of the kinked demand curve that explains how the current prices decide according to demand and supply. It is, however, not a legitimate explanation, either.
2. It Doesn’t Explain the Determination of Price-Output
Companies behave in concerted ways in a collusive Oligopoly. Under this kind of Oligopoly, there is no kink in the firm’s demand curve.
3. Kinked Demand Curve Theory applies to Depression only
When demand decreases in line with an inverse demand curve, the price probably stays steady. However, this only happens when there is an increase in demand, i.e., the price will stay the same. So, it is possible to say that this model is valid only in depression and not during the boom. The demand curve’s kink could change depending on the boom’s conditions.
4. The Reason for Price Rigidity Explains in Differential Oligopoly.
This theory can explain price rigidity only in differentiated Oligopolies. However, its use only sometimes provides guarantee in differentiated Oligopoly also. The marginal cost curve’s position vertically of the kinked demand curve may not be large enough to allow that marginal cost curve to pass through it.
What is the Kinked Demand Curve?
The kinked demand curve is a model used to describe how firms in an oligopoly react to price changes by their competitors. The model suggests that firms will not respond to small price changes by their competitors but will respond to large price changes. It results in a kinked demand curve, with a sharp change in price at the point where firms start to respond to price changes.
What is the Major Point of the Kinked Demand Theory?
The major point of the kinked demand theory is that firms in an oligopolistic market face a kinked demand curve. It means a discontinuity in the demand curve at the current market price. The kinked demand theory explains why prices in oligopolistic markets are relatively stable.
What does the Kinked Demand Curve Model Assume?
The kinked demand curve model assumes that firms in an oligopolistic market will not compete on pricing but will maintain a price slightly above the marginal cost of production.