- Education and Science»
Kinked Demand Curve under Oligopoly
Oligopoly is a market system where large number of buyers contact few sellers to buy goods and services they want. Since it is a market, where every firm highly compete with rival firms, the market is running with the influence of certain conditions. In an oligopoly market, price fixing is very important, because all the rival firms are producing substitutable commodities. So, the market demand and price determination plays a vital role. Generally price remains fixed or rigid in the oligopoly market. Here this hub briefly described how the prices and market demand or outputs are determined with the help of the diagram.
Kinked Demand Curve
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.
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.
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.