In the year 1939, Paul M. Sweezy, an American economist and R.L. Hall and C.J. Hitch, Oxford economists, published two separate papers on oligopoly. Suprisingly, both the papers developed the same model which is known as kinked demand curve model.
Uniqueness of this model lies in price rigidity, i.e, this model explains why in an oligopolistic market, price of a product/service remains fixed at a particular point. This model relies on two assumptions. These are:
(a) If any firm reduces price of its product, all rival firms follow that strategic posture so as to maintain their respective market shares, but
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(b) The rival firms refrain from increasing their product prices if any firm increases its product price anticipating increase in their market share at the expense of the firm which increases price of its product.
Average Revenue (AR) Curve:
Let us assume that prevailing price of a product is P0 (Figure 12.1). We have assumed that no firm wants to raise the price above P0, because if a firm sets the price above P0 (say, at P1), no rival firm will follow it and consequently, as a result of raising price from P0 to P1, demand for the firm’s product will be reduced by ‘q1q0‘.
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Thus, a slight increase in price results in considerable fall in demand for the product. So, it will be unwise for the oligopolists to raise product price as the change in quantity demanded as a result of change in price will not lead to a better situation from the firm’s point of view.
On the other hand, if any firm sets price below P0 (say, at P2), every firm operating in that industry will also reduce price of their products. In figure 12.1, we observe that reduction in price from PQ to P2 enables a firm to increase sales by ‘q0q2‘.This implies that price cut results in a relatively small increase in sales. The economic interpretation of this is as follows.
When one oligopolist raises the price, the other competitors do not follow his line of action. This change in price drastically reduces sales quantity of that oligopolist, because, the buyers find it cheaper to purchase a similar product (under different brand names) from his competitors. So, apparently, in this kind of a market structure if one firm alone increases price of its product, the demand for its product is expected to come down to zero.
But even in this situation, the oligopolist who raises price of his product still experiences some demand which can be attributed to brand loyalty that the firm enjoys and asymmetric information.
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Similarly, when an oligopolist reduces the price, all its competitors imitate such a price cut and hence the firm who had first initiated price cut does not get the expected benefit in terms of increase in demand.
One point is to be clarified here. In figure 12.1 we see that a reduction in price by ‘P0P2‘ leads to an increse in sales by ‘q0q2‘. But this increase in sales is not gained at the cost of its rivals’ market share. It increases simply because total demand increases as all oligopolists charge lower prices. In other words, total market demand increases as price of the product falls.
Every firm will get a share of it depending on his ability (like expenditure on advertisement, product quality etc.) to attract the new buyers. Thus, ‘q0q2‘ is to be treated as the firm’s share of the extra demand generated by fall in price from P0 to P2. Thus, it is quite clear from the above discussion that no firm operating under oligopoly will be able to reach a better position by deviating from ‘P0‘ in either direction.
This classic analysis provides enough support favouring price rigidity (here at P0). Though the model provides satisfactory explanation behind price rigidity, a major criticism against it is that it only explains rigidity of price at a particular point but doesn’t tell how the initial price is determined at that point – here at ‘P0‘ in figure 12.1.
Marginal Revenue (MR) Curve:
The kink in the demand curve (or AR) implies that there will be a discontinuity (i.e. uv) in the MR curve. The MR curve corresponding to AP segment of AR curve is represented by ‘Au’ and the MR curve corresponding to PP’ segment of AR curve is represented by W.
Price Rigidity:
Kink in the demand curve causes discontinuity in the MR curve. So long as MC passes through any point in the range ‘uv’, the equilibrium
Price will stick to OPQ. Apart from the revenue curves, the cost aspect also provides support to price rigidity. Under oligopoly, different companies manufacture the same product and usually use the same or similar (comparable) technology and similar or same ingredients.
As a result, it is expected that the MCs of different brands of the same product will not be much different from each other and are likely to pass within a narrow range.
So long as MCs corresponding to different technologies pass within the range ‘uv’, price will be determined at P0. In case of other models on different market structures we observe that any change in MC curve leads to a new optimal price. But in this model, due to a gap in the MR curve, price remains fixed despite fluctuations in marginal cost to a certain extent.
Price Rigidity and Profit Maximisation:
The marginal rule tells us that as long as MC passes through the discontinuous segment ‘uv’, both the conditions of profit maximisation i.e.,
(i) MR = MC; and
(ii) The slope of MR is less than that of MC are satisfied and the equilibrium level of price and output are determined as P0 and q0 respectively.
This model also explains why slight fluctuations in demand do not always lead to change in price (figure 12.2). The initial demand curve (AR) of a particular firm, is denoted by dd’d” and the corresponding MR is represented by ‘dabm’.
Now as a result of sudden increase in demand, let us assume that demand curve shifts to the right and takes the form of DD’D”. The corresponding MR curve is represented as ‘Defn’. As long as the MC curve passess through ‘ab’ and ‘ef’, i.e, discontinuous portions of both old and new MR curves (i.e., MR1 and MR2), no change in price will occur. However, profit maximising output level increases from Oq1 to Oq2 as a result of such an increase in demand.