Kinked Demand Curve In Oligopoly Assumptions And Critical Thinking

The Kinked-Demand curve theory is an economic theory regarding oligopoly and monopolistic competition. Kinked demand was an initial attempt to explain sticky prices.

Theory[edit]

"Kinked" demand curves and traditional demand curves are similar in that they are both downward-sloping. They are distinguished by a hypothesized concave bend with a discontinuity at the bend - the "kink." Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve.

Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly or monopolistic competition) will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve . In classical theory, any change in the marginal cost structure or the marginal revenue structure will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity.

Formulation[edit]

The two seminal papers on kinked demand were written nearly simultaneously in 1939 on both sides of the Atlantic. Paul Sweezy of Harvard College published "Demand Under Conditions of Oligopoly." Sweezy argued that an ordinary demand curve does not apply to oligopoly markets and promotes a kinked demand curve.

From Queen's College in Oxford, Robert Lowe Hall and Charles J. Hitch wrote "Price Theory and Business Behavior," presenting similar ideas but including more rigorous empirical testing, including a business survey of 39 respondents in the manufacturing industry.

Hall and Hitch further present a hypothesis for the initial setting of prices; this explains why the "kink" in the curve is located where it is. They base this on a notion of "full cost" - marginal cost of each unit plus a percent of overhead costs or fixed costs with an additional percent added for profit. They emphasize the importance of industry tradition in history in determining this initial price, noting further, "An overwhelming majority of the entrepreneurs thought that a price based on full average cost…was the ‘right’ price, the one which ‘ought’ to be charged."

Criticism[edit]

Others such as George Stigler have argued against kinked demand. His primary opposition is summarized in a Working Paper out of the Stanford University Economics Department by seminal authors Elmore, Kautz, Walls et al.

New classical economists, led by Chicago’sGeorge Stigler, worked to discredit the kinked demand models. Stigler first argues that the kinked demand models are not useful, as Hall and Hitch’s model only explains observed phenomenon and is not predictive. He further explains that the kinked demand analysis only suggests why prices remain sticky and does not describe the mechanism that establishes the kink and how the kink can reform once prices change. Stigler also asserts that the model is unnecessary because Chicago theory already included allowances for short-run sticky prices due to collusion, menu costs, and regulatory or bureaucratic inefficiencies in markets.

Contemporary reformulation[edit]

Game theory and models of strategic interaction have largely replaced kinked demand to explain price dislocations and slowly adjusting prices. For further information see:

Reading on contemporary applications[edit]

  • A Duopoly Price Game [1]
  • A Theory of Dynamic Oligopoly, Price Competition, Kinked Demand Curves, and Edgeworth Cycles [2]
  • Competition in the Aluminium Industry 1945-58 [3]
  • The Kinked Demand Curve: A Game-Theoretic Approach [4]

Notes[edit]

References[edit]

  • Bhaskar, V. 1988. "The Kinked Demand Curve: A Game-Theoretic Approach" International Journal of Industrial Organization Vol. 6, pp. 373-384.
  • Hall, R. and Hitch, C. 1939. "Price Theory and Business Behaviour" Oxford Economic Papers Vol. 2, pp. 12-45.
  • Maskin, E. and Tirole, J. 1988. "A Theory of Dynamic Oligopoly, II: Price Competition, Kinked Demand Curves, and Edgeworth Cycles" Econometrica Vol. 56, pp. 571-599.
  • Osborne, D. 1974. "A Duopoly Price Game" Economica Vol. 41, pp. 157-175.
  • Peck, M. 1961. Competition in the Aluminium Industry: 1945-58. Harvard University Press, Cambridge.
  • Reid, G. 1981. The Kinked Demand Curve Analysis of Oligopoly: Theory and Evidence. Edinburgh University Press, Edinburgh.
  • Stigler, G. 1947. "The Kinky Oligopoly Demand and Rigid Prices" The Journal of Political Economy Vol. 55, pp. 432-449.
  • Stigler, G. 1978. "The literature of economics: the case of the kinked oligopoly demand curve" Economic Inquiry Vol. 16, pp. 185–204.
  • Sweezy, P. 1939. "Demand Under Conditions of Oligopoly" The Journal of Political Economy Vol. 47, pp. 568-573.

Further reading[edit]

  • Bhaskar, V., S. Machin and G. Reid "Testing a Model of the Kinked Demand Curve." The Journal of Industrial Economics 39, no. 3 (March 1991): 241-254.
  • Borenstein, Severin. "Evolution of U.S. Airline Competition." The Journal of Economic Perspectives 6, no. 2 (Spring 1992):45-73.
  • "Economic focus: Sticky situations," The Economist, 11 November 2006, 88.
  • Elmore, Kautz, Walls et al."Kinked Expectations", Working Paper, Stanford University.
  • Greenwald, B., J.E. Stiglitz. "Keynesian, New Keynesian and New Classical Economics." Oxford Economic Papers, n.s., 39, no.1 (March 1987): 119-133.
  • Jones, Kit. An Economist Among Mandarins: A biography of Robert Hall (1901-1988). Cambridge: Cambridge University Press, 1994.
  • Meister, J. Patrick. "Oligopoly: An In-Class Economic Game." The Journal of Economic Education, vol. 30, no. 4. (Autumn, 1999): 383-391.
  • O'Brien, D.P. The Classical Economists Revisited. Princeton: Princeton University Press, 2004.
  • Primeaux, Walter J. and Mark R. Bomball. "A Re-examination of the Kinked Oligopoly Demand Curve." The Journal of Political Economy 82, no. 4 (1974): 851-62.
  • Primeaux, Walter J. and Mickey C. Smith. "Pricing Patterns and the Kinky Demand Curve." The Journal of Law and Economics 19, no. 1 (1976):189-99.
  • Rothschild, K. W. "Price Theory and Oligopoly." The Economic Journal 57, no. 227 (September 1947): 299-320.
  • "Round Table on Monopolistic and Imperfect Competition." American Economic Review 27, no. 2. (June 1937): 324-326.
  • Sawyer, Malcolm. "Post-Keynesian and Marxian Notions of Competition: Towards a Synthesis." In Competition, Technology and Money: Classical and Post-Keynesian Perspectives, ed. Mark A. Glick, 3-22. Brookfield, VT: Edward Elgar Publishing Co., 1994.
  • Sen, Debapriya. "The Kinked Demand Curve Revisited." Economics Letters 84 (2004):99-105.
  • Simon, Julian L. "A Further Test of the Kinky Oligopoly Demand Curve." The American Economic Review 59, no. 5, (1969): 971-975.
  • Smith, Victor E. "Note on the Kinky Oligopoly Demand Curve." Southern Economic Journal 15, no.2, (1948): 205-210.
  • Stein, Jerome L. Monetarist, Keynesian, and New Classical Economics. Oxford: Basil Blackwell Publishing, 1982.
  • Managerial Economics. "G S Gupta"
A kink in an otherwise linear demand curve. Note how marginal costs can fluctuate between MC1 and MC3 without the equilibrium quantity or price changing.
Hall and Hitch's graphical illustration of kinked demand
  1. ^D.K. Osborne, “A Duopoly Price Game,” Economica n.s. 41, no. 162 (1974): 157-175
  2. ^Eric Maskin and Jean Tirole, “A Theory of Dynamic Oligopoly, Price Competition, Kinked Demand Curves, and Edgeworth Cycles,” Econometrica 56, no. 3 (1988):571-599.
  3. ^M.J. Peck, Competition in the Aluminium Industry 1945-58, (Cambridge: Harvard University Press, 1961).
  4. ^V. Bhaskar "The Kinked Demand Curve: A Game-Theoretic Approach," International Journal of Industrial Organization 6, (1998): 373.

Under oligopoly, prices and output are indeterminate. Moreover, organizations are mutually dependent on each other in setting the pricing policy.

Therefore, economists found it extremely difficult to propound any specific theory for price and output determination under oligopoly.

In the words of Maurice, “there is no theory of oligopoly in the sense that there is a theory of perfect competition or of monopoly. There is no unique general solution but merely many different behavioral models, each of which reaches a different solution.” Thus, the economists have developed various analytical models based on different behavioral assumptions for determining price and output under oligopoly.

Figure-1 shows different oligopoly models:

Let us discuss different oligopoly models (as shown in Figure-1).

1. Sweezy’s Kinked Demand Curve Model:

The kinked demand curve of oligopoly was developed by Paul M. Sweezy in 1939. Instead of laying emphasis on price-output determination, the model explains the behavior of oligopolistic organizations. The model advocates that the behavior of oligopolistic organizations remain stable when the price and output are determined.

This implies that an oligopolistic market is characterized by a certain degree of price rigidity or stability, especially when there is a change in prices in downward direction. For example, if an organization under oligopoly reduces price of products, the competitor organizations would also follow it and neutralize the expected gain from the price reduction.

On the other hand, if the organization increases the price, the competitor organizations would also cut down their prices. In such a case, the organization that has raised its prices would lose some part of its market share.

The kinked demand curve model seeks to explain the reason of price rigidity under oligopolistic market situations. Therefore, to understand the kinked demand curve model, it is important to note the reactions of rival organizations on the price changes made by respective oligopolistic organizations.

There can be two possible reactions of rival organizations when there are changes in the price of a particular oligopolistic organization. The rival organizations would either follow price cuts, but not price hikes or they may not follow changes in prices at all.

A kinked demand curve represents the behavior pattern of oligopolistic organizations in which rival organizations lower down the prices to secure their market share, but restrict an increase in the prices.

Following are the assumption of a kinked demand curve:

i. Assumes that if one oligopolistic organization reduces the prices, then other organizations would also cut their prices

ii. Assumes that if one oligopolistic organization increases the prices, then other organizations would not follow increase in prices

iii. Assumes that there is always a prevailing price

A kinked demand curve model is explained with the help of Figure-2:

The slope of a kinked demand curve differs in different conditions, such as price increase and price decrease. In this model, every organization faces two demand curves. In case of high prices, an oligopolistic organization faces highly elastic demand curve, which is dd’ in Figure-2.

On the other hand, in case of low prices, the oligopolistic organization faces inelastic demand curve, which is DD’ (Figure-2). Suppose the prevailing price of a product is PQ, as shown in Figure-2. If one of the oligopolistic organizations makes changes in its prices, then there can be three reactions of rival organizations.

Firstly, when the oligopolistic organization would increase its prices, its demand curve would shift to dd’ from DD’. In such a case, consumers would switch to rivals, which would lead to fall in the sales of the oligopolistic organization. In addition, the dP portion of dd’ would be more elastic, which lies above the prevailing price.

On the other hand, if price falls, the rivals would also reduce their prices, thus, the sales of the oligopolistic organization would be less. In such a case, the demand curve faced by the oligopolistic organization is PD’, which lies below the prevailing price.

Secondly, rival organizations will not react with respect to changes in the price of the oligopolistic organization. In such a case, the oligopolistic organization would face DD’ demand curve.

Thirdly, the rival organizations may follow price cut, but not price hike. If the oligopolistic organization increases the price and rivals do not follow it, then consumers may switch to rivals. Thus, the rivals would gain control over the market. Thus, the oligopolistic organization would be forced from dP demand curve to DP demand curve, so that it can prevent losing its customers.

This would result in producing the kinked demand curve. On the other hand, if the oligopolistic organization reduces the price, the rival organizations would also reduce prices for securing their customers. Here, the relevant demand curve is Pd’. The two parts of the demand curve are DP and Pd’, which is DPd’ with a kink at point P.

Let us draw the MR curve of the oligopolistic organization. The MR curve would take the discontinuous shape, which is DXYC, where DX and YC correspond directly to DP and Pd’ segments of the kinked demand curve. The equilibrium point is attained when MR = MC. In Figure-2, the MC curve intersects MR at point Y where at output OQ.

At point Y, the organization would achieve maximum profit. Now, if cost increases, the MC curve would move upwards to MC. In such a case, the oligopolistic organization cannot increase the prices. This is because if the organization would increase the prices, the rival organizations would decrease their prices and gain the market share. Moreover, the profits would remain same between point X and Y. Thus, there is no motivation for increasing or decreasing prices. Therefore, price and output would remain stable.

However, kinked demand curve model is criticized by various economists.

Some of the major points of criticism are as follows:

i. Lays emphasis on price rigidity, but does not explain price itself.

ii. Assumes that rival organizations only follow price decrease, which does not hold true empirically.

iii. Ignores non-price competition among organizations. Non-price competition can be in terms of product differentiation, advertising, and other tools used by organizations to promote their sales.

iv. Ignores the application of price leadership and cartels, which account for larger share of the oligopolistic market.

2. Collusion Model-The Cartel:

In oligopolistic market situations, organizations are indulged in high competition with each other, which may lead to price wars. For avoiding such type of problems, organizations enter into an agreement regarding uniform price-output policy. This agreement is known as collusion, which is opposite to competition. Under collusion, organizations are involved in collaboration with each other to take combined actions for keeping their bargaining power stronger against consumers.

Some of the popular definitions of collusion are as follows:

According to Samuelson, “Collusion denotes a situation in which two or more firms jointly set that prices or output, divide the market among them, or make other business decisions.”

In the words of Thomas J. Webster, “Collusion represents a formal agreement among firms in an oligopolistic industry to restrict competition to increase industry profits.”

Collusion helps oligopolistic organizations in many ways.

Some of the benefits of collusion are as follows:

i. Helps organizations to increase their performance

ii. Helps organizations in preventing uncertainties

iii. Provides opportunities to prevent the entry of new organizations

The agreement of collusion formed may be tacit or formal in nature. A formal agreement formed among competing organizations is known as cartel. In other words, cartel can be defined as a group of organizations that together make pricing and output decisions.

Some of the management experts have defined cartel in the following ways:

According to Leftwitch, “the firms jointly establish a cartel organization to make price and output decisions, to establish production quotas for each firm, and to supervise market activities of the firms in the industry.”

According to Khemani and Shapiro, “Cartels are productive structures involving multiple producers acting in unison that allow producers to exercise monopoly power.”

In the words of Boyce and Melvin, “A cartel is an organization of independent firms, whose purpose is to control and limit production and maintain or increase prices and profits.”

According to Webster, “A cartel is a formal agreement among firms in an oligopolistic industry to allocate market share and/or industry profit.”

Under cartels, the price and output determination is done by the common administrative authority, which aims at equal profit distribution among all member organizations under cartel. The total profits are distributed in proportion as decided among member organizations. The most famous example of cartel is Organization of the Petroleum Exporting Countries (OPEC), which has shared control of petroleum markets.

Let us understand price and output decisions under cartels with the help of an example. Assume that there are two organizations that have formed a cartel.

The price and output decisions of these two organizations are shown in Figure-3:

In Figure-3 (c), AR is the aggregate demand curve of both the organizations and MC curves are the addition of MC1 and MC2 curves of organizations A and B, respectively. The total output of industry is determined according to MR and MC of the industry. In Figure-3 (c), OQ and OP are the equilibrium price and output of the industry.

Now, this output will be allocated among the organizations. This can be done by drawing a horizontal line from equilibrium point E of industry, towards MC curves of organizations A and B. The points of intersection E1 and E2 are the equilibrium levels of the organizations, A and B, respectively. OQ1 is the equilibrium output of organization A and OQ2 is the equilibrium output of organization B. Thus, OQ1 + OQ2 = OQ. These levels of outputs ensure the maximum joint profits of member organizations.

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