OLIGOPOLY - 4

OLIGOPOLY – 4

SWEEZY’S KINKED DEMAND CURVE MODEL

INTRODUCTION:

In many oligopolistic industries prices remain sticky and inflexible. There is no tendency on the part of firms to change price of the commodity. The Kinked Demand Curve hypothesis helps to explain this situation and explain price as well as output determination in differentiated oligopoly. The kink in the demand curve of this model and the difference in elasticity above as well as below the kink portray a particular competitive reaction pattern assumed in an oligopoly market.

KINKED DEMAND CURVE HYPOTHESIS:

Each oligopolist believes that if he lowers the price below the prevailing level, his competitors will follow him and will accordingly lower their prices, whereas if he raises the price above the prevailing level, his competitors will not follow his increase in price. This type of reaction creates a relatively elastic portion above the kink and a relatively inelastic portion below the kink in the demand curve. (Figure 39.1, page - 774, Advanced Economic Theory - Microeconomic Analysis, H L Ahuja, 15th edition, 2006)

a) Price Reduction: If the oligopolist reduces the price below the prevailing price level, competitors will quickly match the price cut to retain their customers. So the increase in sales of the firm will be a proportionate share of the increase in the total quantity demanded. Hence the demand curve is inelastic below the prevailing price.

b) Price Increase: If an oligopolist raises price, customers will crossover to competitors because the latter will have motivation to match the price increase. So the demand curve for the increase in price above the prevailing one is highly elastic.

PRICE RIGIDITY & EQUILIBRIUM OF FIRM:

Under a rigid pattern of competitive behavior of firm in an oligopoly market will have to attain profit maximizing equilibrium at the point of the kink and under the same conditions: (a) MC = MR & (b) ∂²MC / ∂Q < ∂²MR / ∂²MR / ∂Q.

The MR curve corresponding to the kinked demand curve will be a discontinuous line with a broken vertical portion. Greater the difference in the two elasticity of the kinked demand curve, greater the length of the discontinuity. In fact when the relative elasticity of the upper segment increases, the discontinuous gap in the MR curve also increases. The oligopolist firm will be maximizing profits when the MC equals MR in the discontinuous portion of the MR curve depending on the operational relative cost condition. This happens at the prevailing market price and so there will be no incentive to change the price. In fact even when the marginal cost curve shifts upward due to rise in costs, the equilibrium price and output remain unchanged as the new marginal cost curve passes through the discontinuous portion of the MR curve. (Figure 39.2, page - 775)


CHANGE IN DEMAND & PRICE RIGIDITY:

The kinked demand curve model also shows that even when the demand conditions change the price may remain stable. (Figure: 39.3, page: 775 - KINKED DEMAND CURVE: CHANGE IN DEMAND & PRICE RIGIDITY


INCONSISTENCY OF PRICE RIGIDITY:

Price need not always remain rigid even when costs and demand conditions undergo a change. It is rigid for a decline in costs and decrease in demand because the curve becomes less obtuse. The degree of elasticity and inelasticity increases leading to an increase in the gap of the discontinuous portion of the MR curve. As a result MC = MR in the gap and so at the prevailing price itself. Conversely price is instable for an increase in cost and an increase in demand because the curve becomes more obtuse. The degree of elasticity and inelasticity decreases leading to decrease in the gap of the discontinuous portion of the MR curve. As a result MC = MR in a higher point and price fails to remain sticky or rigid.

CRITICAL APPRAISAL:

1. There is nothing in the kinked demand theory which explains how the prevailing price is determined. It only explains why the price is rigid or stable. However Hall’s & Hitch’s version tries to correct this defect by claiming that firms in oligopoly mostly seek normal profits. (Figure: 39.4, page: 777 – FULL COST PRICING AND KINKED DEMAND CURVE)

2. It does not apply to collusive oligopoly where there is joint behavior about price changes and so there is no kink in the demand curve.

3. It applies only to cases of decrease in demand or cost conditions but not in the case of increase in cost or demand.

4. It applies only to demand conditions in a period of depression while in times of boom or inflation demand is likely to increase and the price is also likely to increase rather remain sticky or rigid. The kind of kink observable in times of boom or inflation. (Figure: 39.5, page: 778 – KINKED DEMAND CURVE DURING BOOM AND INFLATIONARY CONDITIONS)

In the above diagram, the upper segment of the curve dc is less elastic and the lower segment is more elastic. The reason is in times of boom, consumption demand is quite high because all sectors are doing well and everyone is earning appreciable income. So firms expect rivals to follow suit in the case of an increase in price but do not expect the same with respect to decrease in prices. Due to this reversal in the elasticity of the curve the MR curve goes through the following:
· The first segment of the MR curve becomes steeper because the AR curve above the kink has become less elastic.
· The second segment of the MR curve becomes more flat because the AR curve below the kink has become more elastic.
· The discontinuity in the MR curve also reverses with the upper steeper segment being below the lower flatter segment.

The above observations mean that prices in the oligopolist industry will not be sticky or rigid as the MC curve in the diagram cuts the MR curve at two points E and F with a lower profit maximizing output or sale of ON and a higher equilibrium profit maximizing output or sale of OT. It is to be observed that opting for ON market share is compensating volume losses through higher prices i.e. prices higher than OP. Similarly opting for OT market share is compensating price losses I.e. prices lower than OP through volume gains. Although it is difficult to predict which option the oligopolist firms will take up, it is certain that price will not remain sticky or rigid at the kind i.e. at OP prices.

STIGLER’S CRITIQUE OF KINKED DEMAND CURVE MODEL:

George J. Stigler rejects the kinked demand curve hypothesis of oligopoly based on his empirical study which showed that oligopolists do not follow one another’s price rises in inflationary periods. But supports of this model argue there is a conceptual distinction between the kink in the demand and the phenomenon of price rigidity. Here they claim that while the former lacks empirical proof, there is substantial empirical evidence for the latter. This means the oligopolistic firm’s expectation of competitors reaction pattern is a real phenomenon with the exception of collusive oligopoly. They further argue that the kinked demand curve model does not explain how a price balance settles into an oligopolistic industry but once it is settled the model quite validly explains how it will remain stable or sticky or rigid. ( Figure: 39.6 – STIGLER’S CRITIQUE OF KINKED DEMAND CURVE MODEL)


CONCLUSION:

Therefore it can be concluded that kinked demand curve model, be it of Sweezy or Hall & Hitch, does not point at what price there is price rigidity but rather at an industry settled price, wherever it is and which surely would have gone through a process of fluctuations, there is price rigidity – i.e. at the kink of the demand or AR curve.