The Kinked Demand Curve Theory
In an oligopolistic market, firms do not have a fixed demand curve. The demand curve changes when the competitors change the price/quantity of the product. Yet, the oligopolist must know their demand curve to maximise profits. Economists, thus, have developed many price-output models to explain the oligopoly market behaviour.
The two most popular ones of them are- kinked demand curve theory and cartel theory. Here, in this blog, we will discuss the kinked demand curve at length. The kinked demand curve theory is a theory about oligopolistic and monopolistic competition. It was brought forward by Paul Sweezy as the first attempt to explain sticky prices.
The kinked‐demand theory of oligopoly describes the high degree of interdependence that exists among the firms that form an oligopoly. The market demand curve faced by each oligopolist is determined by the output and price decisions of the other firms in the oligopoly. This is the considerable contribution of the kinked‐demand theory.
Kinked Demand Curve Definition
Like traditional demand curves, kinked demand curves are downward sloping. As the name suggests, the kinked demand curves have a ‘kink’. This kink is nothing but a discontinuity at a concave bend and this kink is what sets it apart from the traditional demand curves. Now let's find out why these kinks exist in the first place.
For a long time, it has been observed that prices are mostly "sticky" in oligopolistic markets. Prices remained inflexible even when costs fell. This drove both economists and industrialists crazy. Economists racked up their brains all day but could not explain this strange phenomenon. Not to mention, this was extremely bad for business. In came Sweezy, an American economist with his kinked demand curve theory. Then, economists and industrialists cheered alike.
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Sweezy said that every firm has two market demand curves for its product. At high prices, the firm faces a relatively elastic market demand curve. If the prices are low, the firm faces a relatively inelastic market demand curve. The two demand curves intersect at a point, such as c. This point c is exactly where the kink lies. Point c gives the equilibrium price and quantity.
As explained above, an oligopolist faces a kinked demand curve because he faces competition from other oligopolists. Suppose oligopolist A increases his price above the equilibrium price, but the other oligopolists do not increase their prices. So, the consumers flock to the other oligopolists in the market to buy lower-priced goods. Thus, at higher prices, Oligopolist A faces an elastic demand curve and loses business.
The exact opposite thing happens when Oligopolist A decreases his price below the equilibrium price. The other oligopolists follow his pricing decision. Each oligopolist, thus, matches his competitor's price. So, consumer demand for each oligopolist's product becomes less elastic. The kinked demand theory thus illustrates the high interdependence level of oligopolistic firms.
We know that firms in perfectly competitive markets maximise profits by equating their marginal cost and marginal revenue. The same profit-maximising condition holds for firms in oligopolistic markets too.
For perfectly competitive firms, any change in the marginal cost or marginal revenue is adjusted by a corresponding change in the price/quantity of the product. The same, however, cannot be done for oligopolistic firms. Due to the "kink" in their demand curves, the marginal cost curve or marginal revenue curve could change without changing the price/quantity of the product.
It has been observed in many oligopoly markets that prices remain rigid for a very long time. Even in the face of reducing costs, they change infrequently. In order to explain the reason behind this price rigidity under oligopoly, an American economist Sweezy came up with the kinked demand curve hypothesis.
The model for an oligopoly is one of the examples of a kinked demand curve. In an oligopolistic market, the kinked demand curve hypothesis illustrates that the firm faces a demand curve with a kink at the level of prevailing price. Accordingly, the curve is less elastic below the kink and more elastic above the kink, which means that the response to a price decrease is more than the response to a price increase. The concept of the kinked demand curve is based on the firms who wish to gain more profits and the firms who’re dominating the industry.
Impact of Price Rise
Consumers may switch to its rivals in case a firm increases the price, then it becomes more expensive than rivals.
There is likely to be a notable fall in demand for the rise in price. And therefore, demand is price elastic.
In that event, increasing-price firms will lose revenue because of the fact that the percentage fall in demand is greater than the percentage rise in price.
Impact of Price Cut
It will lead to a different scenario if a firm cuts its price. In the short term, if a firm cuts its price, it would cause a big rise in demand. Hence, this would lead to an increase in revenue. Eventually, the firm would gain market share.
Although, other firms will respond by also cutting prices to follow the first firm because of the obvious fact that they will not want to see this fall in market share. Hence, if all firms cut prices, the individual firm will only see a small rise in demand.
There is a significantly small percentage rise in demand because the price war demand for a firm is price inelastic.
In case the demand is inflexible and the price falls, then revenue will fall.
Prices Stable
The firm has no incentive to raise the price or to cut price if the kinked demand curve is true.
Drawbacks of Kinked Demand Curves
Ever since its inception, the kinked demand curve theory has received its fair share of criticisms as well. First, it does not explain the mechanism of establishing the kink in the demand curve. It also does not state how the kinked demand curve is reformed when price/quantity changes. Most of the time, other oligopolists follow pricing decisions when one oligopolist increases the price. The theory, however, does not consider this possibility. Finally, the kinked‐demand theory does not consider the possibility that oligopolists might collude while setting price and quantity.
So, we can see that the kinked demand curve theory can explain the oligopolistic market behaviour only to some extent. It has been deemed incomplete and insufficient by many economists ever since its foundation. Later, the birth of the cartel theory covered many of its drawbacks. Although back in 1939, the kinked demand curve theory came closest to explaining the puzzling oligopolistic market.
Key Points
A kinked demand curve takes place when the demand curve is not a straight line but has a different elasticity for higher and lower prices.
One of the examples of a kinked demand curve is the model for an oligopoly, which suggests that prices are inflexible. Those firms will face different effects for both increasing price or decreasing price.
The kink in the demand curve takes place because rival firms will behave in a different way to price cuts and price increases.
Hence, the kinked demand curve is said to be characteristic of an oligopoly.
Fun Fact
Kinked demand curves do not exist only in oligopolistic markets. The cocaine market has a kinked demand curve but it is not an oligopolistic market. The price of cocaine, an addictive drug, is generally very high. Hence its demand curve is pretty elastic. So, when the price of cocaine decreases, many people try it for the first time. And once these "new" users get addicted, they will continue to use cocaine even when the price increases again. Therefore, the demand for cocaine will then be inelastic. Hence, cocaine has a kinked demand curve as the kink lies in between the inelastic and elastic demand curves. Thus, the cocaine demand curve is a kinked demand curve example.
FAQs on Kinked Demand Curve: Meaning and Applications
1. What is the main assumption of the Kinked Demand Curve Theory?
Every oligopolistic firm assumes the following two things:
When a firm lowers the price below the equilibrium level, then the competitors will lower their prices.
When a firm increases the price above the equilibrium level, then its competitors do not change their prices.
We know, an oligopolistic firm faces a demand curve with the kink at the equilibrium price level. When an oligopoly increases the price above the equilibrium level, the competitors maintain their prices. Hence, the consumers buy the product from the competitors at a lower price. If an oligopolist lowers the price below the equilibrium level, the competitors lower their prices too. This ensures that competitors do not lose customers.
2. What is the Kinked Demand Curve Model?
The kinked demand curve model predicts that a firm might reach a stable profit-maximising equilibrium price and equilibrium output level. Once a firm reaches the equilibrium price and output level, it will have little incentive to alter its price and output. Even if the equilibrium price and output levels are disturbed, the market will re-adjust to reach the equilibrium price and output again.
This model predicts that there will be periods of price stability under an oligopoly. This will occur when firms will concentrate on non-price competition to strengthen their market position and raise their supernormal profits. This is how we can explain the kinked demand curve.
3. What are the examples of the Kinked Demand Curve?
A kinked demand curve takes place when the demand curve is not a straight line but has a different elasticity for higher and lower prices. The following are examples of the Kinked Demand Curve.
One possibility is the market for petrol, which is homogenous and consumers are price sensitive.
In case, one petrol station increased the price, there would be a significant shift to other petrol stations.
Although, if one petrol station cuts price, other firms may feel obliged to follow suit and also cut price. Hence, a price cut would be self-defeating for the first firm.
4. Explain the kinked‐demand theory.
The kinked‐demand theory is said to be an incomplete theory of oligopoly for several reasons. One of the primary reasons is that it does not describe how the oligopolist finds the kinked point in its market demand curve. There is no possibility in the kinked‐demand theory that price increases by one oligopolist are matched by other oligopolists. This practice has been frequently observed. Also, the kinked‐demand theory does not take into account the possibility that oligopolists collude in setting output and price. The possibility of collusive behaviour is illustrated in the alternative theory called the cartel theory of oligopoly.
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