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Kinked Demand Curve Theory of Oligopoly

Kinked Demand Curve

Kinked Demand Curve

It is impossible to find a single generalised solution to the problem of oligopoly pricing. This is because of the difficulty of knowing the exact position of the demand curve facing a firm under oligopoly. This in turn is due to the fact that the effect of a given price changes by a seller on the demand for his product depends very much on the reaction of his rivals.

It has been observed that in many oligopolistic industries, prices remain sticky or inflexible for a long time they tend to change infrequently, even in the face of declining costs. Many explanations have been given for this price rigidity under oligopoly and the most popular explanation is “Kinked demand curve hypothesis” given by an American Economist Sweezy.

The demand curve facing an oligopolist, according to the Kinked demand curve hypothesis; has a ‘Kink’ at the level of the prevailing price Kink is formed at the prevailing price level because the segment of the demand curve above the prevailing price level is highly elastic and the segment of the demand curve below the prevailing price level is inelastic.

Each oligopolist believes that if he lowers that price below the prevailing level, its competitors will follow him and will accordingly lower prices, whereas if he raises the price above the prevailing level, its Competitors will not follow its increase in price.

This is because when an oligopolist lowers that price of its product its competitors will feel that if they do not follow the price cut, their customers will run away and buy, from which has lowered the price, in order to maintain their customers they will also lower their prices. Then the upper portion of the demand curve is price elastic. On the other hand if a firm increases the price of its product there will be a substantial reduction in its sales because as a result of the rise in its price; its customer will withdrawn from it and go to its competitors which will welcome the new customers and will gain in sales. The oligopolist who raises its price will lose a great deal.

Each oligopolist will, thus adhere to the prevailing price seeing no gain in changing it and a kink will be formed at the prevailing price. Thus, rigid or sticky prices are explained according to the kinked demand curve theory.

Price and output decisions in an oligopolistic market Economists have developed various models concerning price output determination under price leadership on the basis of certain assumptions regarding the behaviour of the price leader and his followers. Because of independence, an oligopolistic firm cannot assume that its rival firms will keep their price and quantities constant, when’ it makes changes its price its rival firms will retaliate or react and change the prices which in turn would affect the demand of the former firm. Therefore, an oligopolistic firm cannot have a sure and definite demand curve, since it keeps shifting as the rivals change their prices in reaction to the price changes made by it. Now when an oligopolist does not know his demand curve, what price and output he will fix cannot be ascertained by economic analysis. However, economists have established a number of price output models for oligopoly market depending upon the behaviour pattern of the members of the group.

Since a wide variety of behaviour patterns becomes possible, a large variety of models depending upon different assumptions about the behaviour of the oligopolistic group have been evolved. A few important things among these are as under-

  1. Some economists have assumed that oligopolist firms ignore interdependence. When interdependence disappears from decision – making of the oligopolistic firms; the demand curve facing the oligopolist becomes determinate and can be ascertained. Once the demand curve becomes determinate, we can easily find the equilibrium price and output of a particular oligopolist firm by equating its marginal revenue with its marginal costs.
  2. The second approach to the problem of oligopoly is to assume that a price and output problem of oligopoly is to assume that an oligopolist is able to predict the reaction pattern and counter moves of his rivals. In connection various oligopoly is models based on different assumptions regarding the particular reaction pattern of the rivals have been propounded.

The third approach to oligopoly problem assumes that oligopoly firms realising their interdependence will pursue their common interest and will form collusion; formal tacit that is they will enter into an agreement and work in pursuit of their common interests. They will jointly act as monopolists and fix their prides in such a way their joint profits are maximum.

A variant of this approach is that firms in an oligopoly would accept one firm, as a leader and would follow him in setting prices such a firm will either be dominant low cost firm producing a very large proportion of the total product or an old experienced respectable firm assuming the role of a custodian which protects the interest of all firms whatever price is charged by leader firm is generally accepted by the follower firms who adjust their output accordingly.

The fixing of price under oligopoly market situation is not an easy task and involves a number of assumptions regarding the behaviour of oligopolistic group.

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