Further, it is worth mentioning that the oligopolist confronting a kinked demand curve will be maximising his profits at the current price level. According to Hall and Hitch, equilibrium price is determined by average cost including normal profits , that is, by the tangency between average cost curve and the demand curve, as shown in Fig. Competition in the Aluminium Industry: 1945-58. Game Theory looks at the behaviour of firms when there is interdependence. Firms are not Short-Term Profit maximisers. All of the above are harmful effects of oligopoly.
The kinked-demand curve explains why firms in an oligopoly resist changes to price. Likewise, the kinked demand curve theory explains that even when the demand conditions change, the price may remain stable. On the other hand, with lower cost the segment of the demand curve below the current price will become more inelastic because with the decline in costs, there is then greater certainty that the reduction in price by an oligopolist will be followed by his rivals. Peck, Competition in the Aluminium Industry 1945-58, Cambridge: Harvard University Press, 1961. The two market demand curves intersect at point b. If economies of scale are steep for an industry, then smaller firms will aggressively compete on price to increase their market share, so that they can earn reasonable profits. It is worth mentioning that the marginal revenue curve associated with a kinked demand curve is discontinuous, or in other words, it has a broken vertical portion.
If one firm raises its price, the others probably will not follow, since that will allow them to take market share from the price changer. Another shortcoming of the kinked-demand oligopoly theory is that it does not apply to the oligopoly cases of prices leadership and price cartels which account for quite a large part of the oligopolistic markets. Criticisms of the Kinked Demand Curve Model: There are two main criticisms of the kinked demand curve model. Some oligopolies have a very high concentration ratio, allowing them to act more like a monopoly, while other industries have a much lower concentration ratio, thus, making it more difficult to determine the best pricing strategy, since the number of possible responses by competitors is increased. Another possible barrier to collusion is that if prices are maintained too high, then it may allow new entrants into the industry that will provide more competition, or, smaller firms that did not have much market power can cut prices and increase production to grab market share. Most modern economies prohibit collusion, since it is against the public interest, although there are some exceptions.
Kinked Demand Curve The Kinked demand curve suggests firms have little incentive to increase or decrease prices. However, price wars are self-limiting, since they will often lead to losses. But what the other firms will actually do will probably depend on the direction of the price change. The firm under consideration is presently charging this price. . Indeed, the likelihood of a successful collusion decreases as the number of firms increases. But it fails to explain how the industry-wide price was established in the first place.
The oligopolist maximizes profits by equating marginal revenue with marginal cost, which results in an equilibrium output of Q units and an equilibrium price of P. So they will have a tendency not to change the price at all. The Kinked Demand Curve Analysis of Oligopoly: Theory and Evidence. This will be particularly true if the economies of scale are not that steep, since high prices can allow the entrance of new competitors who will be able to survive on a small market share. On the other hand, if the barriers are low, then the oligopolist will set low prices to prevent new firms from entering the industry or to promote the exit of its competitors. Firms look up to one dominant firm to set prices. However, it is much more difficult for an oligopoly to determine at what output it can maximize its profit.
Hitch on the other hand. Why the Kink in the Demand Curve? Classical economic theory assumes that a profit-maximizing producer with some market power either due to or will set equal to. This is illustrated in Fig. Kinked-Demand Theory of Oligopoly As mentioned above, there is no single theory of oligopoly. This indicates that the price will remain unchanged in the case of decrease in demand. In some cases, oligopolistic firms may engage in a price war, where each firm charges a successfully lower price to gain market share.
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. In some oligopolies, there may be an element of price leadership. Thus, rigid prices are explained in this way by the kinked demand curve theory. The other thing it doesn't explain is that when the economy changes significantly, especially when there is high inflation, then the firms of an oligopoly do change prices often. Princeton: Princeton University Press, 2004.
Why Price Rigidity under Oligopoly? Prices do change in Oligopolistic markets much more often than this model suggests. Eventually the firms will capitulate and return to the practice of following the price leader. Assumptions of the Kinked Demand Curve Model : This model was developed independently by Prof. The oligopolist's market demand curve becomes less elastic at prices below P because the other oligopolists in the market have also reduced their prices. Technology can also diminish the pricing power of oligopolies by producing better products, by lowering the fixed costs of developing a product, and by opening markets to more competitors.
But in periods of boom and inflation when the demand for the product is high and increasing, the price is likely to rise rather than remaining stable. However, the reaction pattern of the rivals, as given by assumption v , is able to explain why the prices would not tend to change, i. On the basis of the above discussion, we may conclude that in the kinked demand curve model of oligopoly, the firm would not consider it profitable or rational to change the prevailing price of its product because of the assumption v relating to the reaction pattern of its rivals. Article shared by : 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. Along with this kinked demand curve comes a kinked marginal revenue curve, with a vertical section.
Oligopolies, like monopolies and , also have excess capacity. Kinked-Demand Theory Consider a firm in an oligopoly that wants to change its price. This Kindle ebook has all the articles on microeconomics on this website as well as all of the images, but no ads, and you can read it offline on any device with the Kindle app. The competitive reaction pattern assumed by the kinked demand curve oligopoly theory is as follows: 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. Fourth, in the model under discussion, the firm may not have to change the price of its product, even if its cost of production rises. Sweezy, an American economist, and by Hall and Hitch, Oxford economists.