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In oligopoly, each seller knows that if he lowers prices, the few competitors will immediately follow suit and lower their prices, leaving the seller with roughly the same share of the total market but lower profits. However, the seller may be reluctant to raise prices because competitors might not follow this lead. This price rigidity is the essence of Paul Sweezy’s Kinked Demand Curve model of oligopoly. The model is presented below.
The Kinked Demand Curve Model:
The idea that administered prices are flexible upward and not downward is supported by a theoretical analysis of the situation faced by the oligopolistic firm. Such an analysis has been made by Paul Sweezy in 1939. Sweezy has tried to prove the point that the normal situation faced by an oligopolistic firm is one in which it can expect other firms in the industry to watch any price reductions it may make in order to protect their sales and share of the market.
It can also expect other firms not to match an increase in price because of their desire to increase their sales at its expense. These expectations rest on the normal situation of substantial excess production capacity available in the industry. The oligopolistic firm, therefore, has every incentive to hold prices where they are.
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Reductions would be matched quickly, so no one firm could gain. But increases would not be matched, and the firm trying to raise its prices would lose. These expectations are quite equivalent to the existence of a kink or bend in the firm’s demand curve at the prevailing price, shown in Fig. 24.12. Hence the term ‘kinked demand curve’.
A kinked demand curve is made of two segments of a firm’s demand curve, which are separated at the price that has been established in the industry. The demand segment corresponding to lower prices is less elastic than the demand segment corresponding to higher prices.
The reason is that rival producers are expected to match price reductions quickly and fully, since they want to maintain their market share. But they are expected to follow price rises only slowly and partially since they are eager to increase their market share. Fig. 24.12 shows a kinked demand curve that may be faced by a firm in an oligopolistic industry. From Fig. 24.12 we see that the present industry-wide price is Rs. 10.
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The firm under consideration is presently charging this price. Now it expects that if it raises the price to Rs. 12, its sales will fall drastically from 9,000 units to 2,000 units. Consequently, its total revenue will fall from Rs. 90,000 to Rs. 24,000. A fall in total revenue under unchanged cost conditions is equivalent to a fall in total profit. So price increase is not at all desirable in such a situation.
On the other hand, the firm expects that if it reduces the price to Rs. 8, its market share will increase only marginally – from 9,000 units to 10,000 units. And in spite of the fact that it can sell 1,000 more units, its total revenue will fall from Rs. 90,000 to Rs 80 000.
This is because the price cut will be matched by almost all of the firm’s rivals. The kinked demand curve model predicts that usually oligopolists will not find either prospect very attractive. So they will have a tendency not to change the price at all.
Another explanation of the rigidity of oligopoly prices is offered by the abnormal shape of an oligopolies’ marginal revenue curve, when it faces a kinked demand curve. Fig 24.13 shows a hypothetical firm’s kinked demand curve as also its MR and MC curves.
We see that there is a vertical segment of the MR curve at the equilibrium level of output. The AB part of the combined marginal revenue, curve (ABCD) is derived from the more elastic portion of the demand curve (at all levels of output below 9,000 units).
Similarly, the CD portion of the MR curve is derived from the less elastic portion of the demand curve (at output levels above 9,000). Thus there is a, discontinuity at the level of output of 9,000 units where the kink in the demand curve appears.
This discontinuity, which we draw as a vertical segment of the, combined MR curve, is shown by the distance BC. We also see that the MC curve intersects the MR curve from below at point E. This indicates that the firm will maximise its profit by producing 9,000 units at the industry-wide price of Rs 10.
If now its MC increases or decreases, i.e., the MC curve shifts to the left or to the right, the firm’s profit-maximising position will not change, so long as the MC curve continues to intersect the vertical segment of the MR curve. Thus, unless there is a substantial shift of the demand or cost curve, the equilibrium output-price combination (i.e., 9000 units per day at a price of Rs. 10 per unit) will remain unchanged.
Implication of the Kinked Demand Curve Model:
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The most important implication of the kinked demand curve model is that in oligopolistic market structure firms could experience substantial shifts in marginal costs and still not vary their prices. This theoretical result is consistent with Sweezy’s observation that some oligopolistic markets exhibit fairly stable prices.
Criticisms of the Kinked Demand Curve Model:
There are two main criticisms of the kinked demand curve model. The model explains why oligopoly prices are stable. But it fails to explain how the industry-wide price was established in the first place. This point requires a little elucidation.
Though the model explains the reluctance of oligopolists to change prices, it provides no clue as to how the original price was arrived at. It says nothing about how firms arrived at the original price in the first place, and why they did not fix some different prices.
It is useful mainly as a description of price rigidity rather than as an explanation of it. The explanation of price rigidity comes from the prisoner’s dilemma and from firms’ desires to avoid mutually destructive price competition. Second, empirical research has not verified the predictions of the model.
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This is why the analysis presented by Sweezy’s model has been criticised on empirical grounds. Several studies have shown that in an inflationary period, oligopoly firms do often follow one another’s price rises. This is quite contrary to what is assumed by this model.
Moreover, George Stigler has found, from his study of the pricing behaviour of seven oligopolists, that firms in these industries were just as likely to match a price increase by a competitor as they were to follow a rival’s cut in price.
A few empirical studies however, have corroborated the rigidity of oligopoly prices for a short period. The prices of steel and aluminium were found to remain stable in the USA in the second half 7thV 1940s. In spite of these criticisms, Sweezy’s analysis clearly shows how the oligopolistic firm’s view of competitive patterns can affect the changeability of whatever price it happens to be charging.
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