Thus there is a, discontinuity at the level of output of 9,000 units where the kink in the demand curve appears. In the kinked demand curve model, it is assumed firms wish to maximise profits. But there is a major drawback in the theory. Analysis of the Kinked Demand Curve Model. The firm under consideration is presently charging this price. We may note here that although the demand curve has shifted to the right, it has kept the price of its product unchanged, resulting not necessarily in the unfulfilment of its profit maximising goal.
Assume that the price of a litre of unleaded petrol is 85p. Peck, Competition in the Aluminium Industry 1945-58, Cambridge: Harvard University Press, 1961. As mentioned previously, firms in oligopoly are interdependent. Now it expects that if it raises the price to Rs. Let us suppose that initially the price of the product of the firm is p 1 or Op 1 and the demand for the product is q 1 or Oq 1 If the firm now increases its price from p 1, the rival firms would keep their prices unchanged according to assumption v of this model. It has been observed that many oligopolistic industries exhibit an appreciable degree of price rigidity or stability. The dotted red lines help to explain.
All this price rigidity means that firms do not compete on price, so they have to resort to non-price competition see later. A fall in total revenue under unchanged cost conditions is equivalent to a fall in total profit. When price leadership and price cartels exist in oligopolistic markets there is concerted behaviour in regard to the price changes and hence there is no kink in the demand curve in these cases. If the oligopolist increases its price above the equilibrium price P, it is assumed that the other oligopolists in the market will not follow with price increases of their own. Readers Question: To what extent does the kinked demand curve model explain price rigidity in oligopoly? Or is it just a coincidence that the prices are similar in the food retailing industry, the electrical goods retailing industry and the new car market? Because of the competitors quickly following the reduction in price by an oligopolist, he will gain in sales only very little.
The other two firms know this is going to happen following the price cut, so they match the price cut see price wars later. Why Price Rigidity under Oligopoly? As a result, demand curve facing a firm under differentiated oligopoly is not perfectly elastic. Similarly, the marginal revenue that the oligopolist actually receives is represented by the marginal revenue curve labeled adef. Further, it is worth mentioning that the oligopolist confronting a kinked demand curve will be maximising his profits at the current price level. There is hardly any disposition to lower the price when there is decline in demand or in costs, but the price may be raised in response to increased demand or to rising cost. And in spite of the fact that it can sell 1,000 more units, its total revenue will fall from Rs. Such an analysis has been made by Paul Sweezy in 1939.
Non-price competition This is an important aspect of oligopoly because, as we have seen with the kinked demand curve model, price competition is difficult. Therefore, for a price cut, demand is price inelastic. 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. A point must come where a given fall in price causes a smaller proportionate rise in demand, and so revenues would fall. If one of the three firms put their price up to 90p a litre, what would happen next? There is little incentive to raise or lower price. This concept was propounded by Prof. Basically, it is where one firm cuts its price, the others follow and perhaps cut theirs by a little bit more, and so on.
First, it does not explain how the oligopolist finds the kinked point in its market demand curve. Psychological pricing suggests in the real world firms seek to set prices which are psychologically attractive to customers. At least those where you assume all firms have essentially the same cost of inputs. The Kinked Demand Curve Analysis of Oligopoly: Theory and Evidence. Stigler also asserts that the model is unnecessary because already included allowances for short-run sticky prices due to collusion, menu costs, and regulatory or bureaucratic inefficiencies in markets. In our previous lesson on oligopoly, we showed how payoff matrices and game theory could be used to analyze the strategic, interdependent behavior of two firms when deciding the price they would charge.
It follows from the above discussion that the larger the difference between e, and e 2, i. The oligopolistic firm, therefore, has every incentive to hold prices where they are. Unfortunately, there is a lot of uncertainty in oligopoly. Sweezy on the one hand and Profs. In this lesson we take a graphical approach to oligopoly, and seek to explain why prices tend not to fluctuate up or down in oligopolistic markets.
We saw above how the kinked demand curve theory of oligopoly provides an explanation of price rigidity under oligopoly. These happy competitors will have therefore no motivation to match the price rise. This makes sense if you remember how all marginals and averages are linked. If you do Business Studies A level as well, you have probably heard of the 4 Ps marketing mix. When the price is likely to change and when it is likely to remain inflexible in the face of changing costs and demand conditions is explained below: 1 Decline in Costs: When the cost of production declines, the price is more likely to remain stable. The main weakness with this model is that it is not a theory of price determination. Example: Coke and Pepsi, same price and same range of products.