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 maximize 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.
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 the 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 maximize profits by equating their marginal cost and marginal revenue. The same profit-maximizing 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.
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.
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.