Question

Explain the rationale for a kinked demand curve for an oligopolist. Explain the benefits and/or consequences to society of this situation.

Answer 1

Oligopoly is a type of imperfect market structure in which there are few firms selling a product so that there is an intense competition among them.Generally the number of sellers are two to ten and exist in markets for products such as automobiles,electronic,soft drinks,air-lines industry etc. Since there are few firms,each firm produces a large share of the market.All the firms are inter-dependent in terms of decision making and they keep the new players out because these industries require high set-up and advertising costs.

The kinked demand curve theory of oligopoly states that a firm faces dual demand curve for its product based on the likely reactions of other firms.A firm in an oligopoly faces a downward sloping demand curve but the price elasticity of demand may depend on the likely reactions of competitors to changes in one firm's price and output.

The assumption of the model-

a) Rivals are assumed not to follow a price increase by one firm and so the firm which increases the price will lose market share and the demand will be relatively elastic and rise in price will result in decrease in revenue.

b) Rivals are assumed to match a price fall by one firm to avoid a loss of market share. In this case the demand will be relatively inelastic and a fall in price will also result in decrease in revenue.

Consider the diagram below-

At first the firms are at equilibrium at Price =P1 and Quantity=Q1. At price D1 the demand curve is elastic above P1 and it is demand inelastic below P1.

If the price is raised to P2 then the likely reaction of other firms is to hold their prices which will cause an elastic demand response to this firm and result in decrease in sales and revenue.

Whereas, if the price is cut below P1 then the likely reaction of other firms will be to follow the price cut and demand will be relatively inelastic which will result in very low benefits in sales and revenue.

If the demand is relatively elastic following a price rise and relatively inelastic following price cut,then the demand curve will be a kinked demand curve represented by ABC.

The MR curve is twice as steep as average revenue and there will be two MR curves in case of kinked demand curve and they will not intersect each other.

The profit maximising equilibrim happens where the MC curve cuts through the gap in the marginal revenue curve

Therefore, in oligopoly firms have price-setting power but they will be reluctant to use it due to their competitors unlikely to match a price rise but very likely to match a price fall.Even when costs change, the oligopoly market is very stable with change in prices.There are still some price wars which happens in an oligopoly market but they are often short lived and the market equilibrium always remains at P1 and Q1 which shows the importance of the kinked demand-curve in an oligopoly market.

The likely benefits that the consumers may derive from this situation would be that the prices remain stable over time.No firm can set the price as the competitors would likely to take action.

If one firm decreases the prices,other firms would also follow and overall prices would decline which would increase the consuer surplus.Also,one firm cannot increase the prices on it's own and so the consumers can be assured that the prices won't go up.

The overall price stability becasue of kinked demand would ensure that there would no sudden increase in prices or rise in inflation which would keep the market stable and competitive which would mean better and standard products with differenciation for the society