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Kinked Demand curve
The Kinked Demand curve theory is an economic theory regarding oligopoly and monopolistic competition. Kinked demand was an initial attempt to explain sticky prices.The kinked demand curve hypothesis is developed by Paul M Sweezy (Paul M Sweezy, Demand Under Conditions of Oligopoly" Joumal of Political Economy, August 1939, reprinted in American Economic Association, Readings in Price Theory).
Kinked demand curve hypothesis is used for explaining the price and output determination under oligopoly with product differentiation.
The kinked demand curve model assumes that a business might face a dual demand curve for its product based on the likely reactions of other fims to a change in its price or another variable.
The kinked demand curve analysis points to the likelihood of a price rigidity in oligopoly when a price reduction is in order and of price flexibility and conditions warrant a rise in price. There is hardly any disposition to lower price when there is a decline in demand or cost, but the price may be raised in response to increased demand or to rising Cost.
The kinky models of oligopoly are described so because they postulate the demand curve or average-revenue curve facing an oligopolist as a curve which has a kink in it at the current level of price as shown in Fig. 4 below. OP is the current price, the demand curve (AR curve) facing the oligopolist is DD' which has a kink at k corresponding to the current price P. Its companion marginal-revenue curve is MR curve which too has rather two kinks in it at A and B. The solid vertical regiment AB over it is described as
the discontinuity gap which is due to the sudden change in the elasticity of the demand curve from just above
the kink at K to just below it. The portion above it is rather elastic while the portion below it is inelastic. In fact, you can derive this type of kinked demand curve from our Fig. 1 above. The point where, in that figure. DD' and dd' intersect, can be taken as the point indicating the current price. You take the portion of dd' curve (elastic curve) above this point and combine it with the portion of DD curve (inelastic curve) below this point and thus you will get an obtuse-angled kinked demand curve like the DKD curve in our Fig. 4 above.
Note that the kinks A and B in the marginal-revenue curve MR as well as the discontinuity gap AB are exactly below the kink K, that is, if you extend the discontinuity gap AB. vertically upwards, it will pass through K. This model
stipulates that the cost conditions of the oligopolist are such that his marginal cost curve MC cuts the marginal-revenue curve in its discontinuity gap marginal revenue is the profit-maximising output and OP is the profit-maximising price. The oligopolist in this model does not experiment with price-output changes. It is because he is assumed to expect a retaliation by his rivals, if he reduces his price and consequently his sales are expected to increase along the less elastic portion of his demand (sales or average-revenue) curve.
Therefore he will not expect to increase his profits by a cut in his price. He will not experiment with an increase in his price either, precisely because int this case he does not expect his rivals to follow him suit. If our oligopolist raises his price, it does not harm his rivals but, on the contrary, is beneficial for them. Hence they are not expected to match any increase in price that out oligopolist may effect. And, the portion of out oligopolist's demand curve above the kink being highly elastic, any increase in his price will reduce his sales
proportionately much more and thus reducing his total revenue too. Hence he will not increase his price. Thus the tendency would be to stick to the current price and output. This explains the rigidity or stickiness of prices under oligopoly. It can be seen from Fig. 4 above that even when the costs of the monopolist increase or decrease and in consequence of which his marginal cost curve shifts up or down, the equilibrium price and output of the oligopolist will not change, provided the shifted MC curve continues to cut the MR curve in its discontinuity gap.
Paul Sweezy has suggested that the obtuse-angled demand curve as postulated in the model of Fig. 4 above is peculiar to periods of depression when there develop buyer's markets because then in most of the industries demand lags behind supply, in such a situation any cut in price by any one of the oligopolists is sure to be retaliated with similar cuts by the other firms also, while any increase in price by one will not be followed by others.
But, argues Sweezy, during periods of boom and prosperity there develop seller's markets as then demand moves ahead of supply. Therefore
producers do not find any difficulty in selling. In this condition a cut in price by one will not be followed by others. This means that the demand curve below the current price will be elastic. On the other hand, an increase in price by any one will be followed by others which means thatthe portion of demand curve above the kink will be inelastic. This behavioural assumption read to boom period will give a reflex-angled kinked demand curve like the one in Fig. 5 this type of demand curve can also be derived form Fig. 1 by continuing the portion of inelastic demand (sales) curve DD' above the point of intersection between DD' and dd' with the lower portion of the elastic of dd.' curve.
In this case also the equilibrium price will be OP and equilibrium output PC which will tend to be rigid so long as the marginal cost curve continues to cut the marginal revenue curve in the discontinuity gap.
It is sometime observed that kinky models of oligopoly explain the rigidity of prices under oligopoly but they do not explain how equilibrium price is determined under oligopoly. This observation is not quite correct because as we
have seen above the kinky models are consistent with the conventional profit- maximising principle of price determination, it is, though a different matter, if the current price is made to be determined by some other principle such as the
“cost-plus” or “mark up” or full-cost principle and then kinky models are relied on to explain the rigidity of prices. We shall consider the full-cost principle of Hall and Hitch in the lesson on the Marginalist Controversy.
The Kinked Demand curve theory is an economic theory regarding oligopoly and monopolistic competition. Kinked demand was an initial attempt to explain sticky prices.The kinked demand curve hypothesis is developed by Paul M Sweezy (Paul M Sweezy, Demand Under Conditions of Oligopoly" Joumal of Political Economy, August 1939, reprinted in American Economic Association, Readings in Price Theory).
Kinked demand curve hypothesis is used for explaining the price and output determination under oligopoly with product differentiation.
The kinked demand curve model assumes that a business might face a dual demand curve for its product based on the likely reactions of other fims to a change in its price or another variable.
The kinked demand curve analysis points to the likelihood of a price rigidity in oligopoly when a price reduction is in order and of price flexibility and conditions warrant a rise in price. There is hardly any disposition to lower price when there is a decline in demand or cost, but the price may be raised in response to increased demand or to rising Cost.
The kinky models of oligopoly are described so because they postulate the demand curve or average-revenue curve facing an oligopolist as a curve which has a kink in it at the current level of price as shown in Fig. 4 below. OP is the current price, the demand curve (AR curve) facing the oligopolist is DD' which has a kink at k corresponding to the current price P. Its companion marginal-revenue curve is MR curve which too has rather two kinks in it at A and B. The solid vertical regiment AB over it is described as
the discontinuity gap which is due to the sudden change in the elasticity of the demand curve from just above
the kink at K to just below it. The portion above it is rather elastic while the portion below it is inelastic. In fact, you can derive this type of kinked demand curve from our Fig. 1 above. The point where, in that figure. DD' and dd' intersect, can be taken as the point indicating the current price. You take the portion of dd' curve (elastic curve) above this point and combine it with the portion of DD curve (inelastic curve) below this point and thus you will get an obtuse-angled kinked demand curve like the DKD curve in our Fig. 4 above.
Note that the kinks A and B in the marginal-revenue curve MR as well as the discontinuity gap AB are exactly below the kink K, that is, if you extend the discontinuity gap AB. vertically upwards, it will pass through K. This model
stipulates that the cost conditions of the oligopolist are such that his marginal cost curve MC cuts the marginal-revenue curve in its discontinuity gap marginal revenue is the profit-maximising output and OP is the profit-maximising price. The oligopolist in this model does not experiment with price-output changes. It is because he is assumed to expect a retaliation by his rivals, if he reduces his price and consequently his sales are expected to increase along the less elastic portion of his demand (sales or average-revenue) curve.
Therefore he will not expect to increase his profits by a cut in his price. He will not experiment with an increase in his price either, precisely because int this case he does not expect his rivals to follow him suit. If our oligopolist raises his price, it does not harm his rivals but, on the contrary, is beneficial for them. Hence they are not expected to match any increase in price that out oligopolist may effect. And, the portion of out oligopolist's demand curve above the kink being highly elastic, any increase in his price will reduce his sales
proportionately much more and thus reducing his total revenue too. Hence he will not increase his price. Thus the tendency would be to stick to the current price and output. This explains the rigidity or stickiness of prices under oligopoly. It can be seen from Fig. 4 above that even when the costs of the monopolist increase or decrease and in consequence of which his marginal cost curve shifts up or down, the equilibrium price and output of the oligopolist will not change, provided the shifted MC curve continues to cut the MR curve in its discontinuity gap.
Paul Sweezy has suggested that the obtuse-angled demand curve as postulated in the model of Fig. 4 above is peculiar to periods of depression when there develop buyer's markets because then in most of the industries demand lags behind supply, in such a situation any cut in price by any one of the oligopolists is sure to be retaliated with similar cuts by the other firms also, while any increase in price by one will not be followed by others.
But, argues Sweezy, during periods of boom and prosperity there develop seller's markets as then demand moves ahead of supply. Therefore
producers do not find any difficulty in selling. In this condition a cut in price by one will not be followed by others. This means that the demand curve below the current price will be elastic. On the other hand, an increase in price by any one will be followed by others which means thatthe portion of demand curve above the kink will be inelastic. This behavioural assumption read to boom period will give a reflex-angled kinked demand curve like the one in Fig. 5 this type of demand curve can also be derived form Fig. 1 by continuing the portion of inelastic demand (sales) curve DD' above the point of intersection between DD' and dd' with the lower portion of the elastic of dd.' curve.
In this case also the equilibrium price will be OP and equilibrium output PC which will tend to be rigid so long as the marginal cost curve continues to cut the marginal revenue curve in the discontinuity gap.
It is sometime observed that kinky models of oligopoly explain the rigidity of prices under oligopoly but they do not explain how equilibrium price is determined under oligopoly. This observation is not quite correct because as we
have seen above the kinky models are consistent with the conventional profit- maximising principle of price determination, it is, though a different matter, if the current price is made to be determined by some other principle such as the
“cost-plus” or “mark up” or full-cost principle and then kinky models are relied on to explain the rigidity of prices. We shall consider the full-cost principle of Hall and Hitch in the lesson on the Marginalist Controversy.
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