Question

1. explain the Kinked Demand model of Oligopoly.

2. why monopolistic firms spend money on product differentiation and advertising when it only adds to costs?

Answer 1

1. Kinked Demand Model of Oligopoly- The kinked demand curve of oligopoly was developed by Paul M. Sweezy in 1939. Instead of laying emphasis on price-output determination, the model explains the behavior of oligopolistic organizations.

The model advocates that the behavior of oligopolistic organizations remain stable when the price and output are determined. This implies that an oligopolistic market is characterized by a certain degree of price rigidity or stability, especially when there is a change in prices in downward direction.

To understand the kinked demand curve model, it is important to note the reactions of rival organizations on the price changes made by respective oligopolistic organizations. There can be two possible reactions of rival organizations when there are changes in the price of a particular oligopolistic organization. The rival organizations would either follow price cuts, but not price hikes or they may not follow changes in prices at all.

The assumption of a kinked demand curve:

i. Assumes that if one oligopolistic organization reduces the prices, then other organizations would also cut their prices

ii. Assumes that if one oligopolistic organization increases the prices, then other organizations would not follow increase in prices

iii. Assumes that there is always a prevailing price.

2. Advertising is all about explaining to people, or making people believe, that the products of one firm are differentiated from the products of another firm.

In the framework of monopolistic competition, there are two ways to conceive of how advertising works: either advertising causes a firm’s perceived demand curve to become more inelastic or advertising causes demand for the firm’s product to increase

In either case, a successful advertising campaign may allow a firm to sell either a greater quantity or to charge a higher price, or both, and thus increase its profits.