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Why is there a kink in the market demand curve of oligopolists?

Explain price
rigidity of the Kinked Demand Curve.

Ans : A business might face a dual demand curve for its product based on the likely reactions
of other firms to a change in its price or another variable. The assumption is that firms in an
oligopoly are looking to protect and maintain their market share and that rival firms are
unlikely to match another's price increase but may match a price fall. i.e. rival firms within
an oligopoly react asymmetrically to a change in the price of another firm.

If a business raises price and others leave their prices constant, then we can expect quite a
large substitution effect making demand relatively price elastic. The business would then lose
market share and expect to see a fall in its total revenue.

If a business reduces its price but other firms follow suit, the relative price change is
smaller and demand would be inelastic. Cutting prices when demand is inelastic leads to a fall in
revenue with little or no effect on market share.

These elastic and inelastic portions of demand curve form kink as shown in figure.

Due to this in oligopoly market structure several firms compete with each other for greater share of the
market. They compete with each other in terms of:

Quality

Product Design

Advertisement, and
Services

Price Rigidity Explanation

Kinked demand curve hypothesis was put forward by Paul M. Sweezy an US economist (Harvard
University) and by Hall and Hitch of British economists ( Oxford). The main content of the theory which
is it explaining the price rigidity.

Generally two types of oligopoly are there like pure and differentiated oligopoly. In pure oligopoly all
products are homogenous, at the same time in differentiated oligopoly all products are not homogenous
but substitutable.

In the case of homogenous product, if a firm raise the price all the customers will leave to others. So, the
demand will be a highly elastic one.

In the case of differentiated oligopoly, if a firm raise the price a large amount of customers may leave and
choose the products of others. At the same time there may be few customers, they may not leave because
they may addicted or like the product than produced by others. So, the demand not be a perfectly elastic
one.

Here the kinked demand curve hypothesis is explaining on the basis of differentiated oligopoly market.
Which also explain how price rigidity existing in a oligopoly market.

It can be explain with the help of the Figure showing below.


In the figure DD is the market demand curve having less elasticity and dd is the demand curve of
individual firms having high elasticity. Here the demand curve of a monopolist become dkD where a
kink can be seen at point k. further output and price are determined on the basis of point k. that is
OP is the price and OQ is the quantity of output.

Since each firm producing substitutable commodity they compelled to sell at a price by analyzing the
prices of rival firms even all of them are produces at different costs. So, cost of each firm will differ from
one to another. Now, Marginal Revenue (MR) curve will 'ABCD'. Where the vertical portion BC will be a
discontinuity gap. Because equilibrium is determined at a point Marginal Revenue (MR) equals Marginal
Cost (MC). Since each firms occur various costs and selling at a same price level (earning normal profits)
MR curve having a discontinuity.

Price Rigidity

As per the assumption or feature of oligopoly market, there exist price rigidity. There is no any chances
for wide disparity in prices between each firms. Based on the figure, let us analyze how price rigidity
existing. The point of kink (k) will be the equilibrium price and output. Now, there are two chances in
changes in price. 1) price raise 2) price reduction

1) Price raising

In the demand curve, upper part of of point k (that is dk) showing high elasticity. When a single firm
raise its price, almost all customers will leave to other firms. So, the firm who increase price, will suffer
losses. The high elasticity of the upper segment of the demand curve showing that an increase in price by
a single firm will reduce its sales in largely.

2) Price reduction

In the demand curve, the lower segment kD, showing a less elasticity. Suppose a single firm reduces its
price all the customers will move to him. But all other firms will reduce prices immediately, then only
they can exist in the industry. The reason for the less elasticity is that, a reduction in price by a single firm
will lead to reduce the price of all firms. So, price reduction creates a small increase in sales.

Conclusion

The kinked demand curve hypothesis is developed by economists especially P.M. Sweezy is to explain
the determination of output and prices in a oligopoly market. The theory also explain the price rigidity in
oligopoly market. But there is a chance to increase in price when the costs are increased. But it can not
done by a single firm. All the firms can change it as a gang or by creating collusion.