TOPIC: WHY IS THERE A KINK IN THE DEMAND CURVE

IN AN OLIGOPOLY MARKET? HOW DOES KINKED

DEMAND CURVE EXPLAIN PRICE RIGIDITY IN
OLIGOPLY?
 OLIGOPOLY
This is a market dominated by a few firms [eg. Banks, Oil
companies ]. The main feature of this market is that the firms
engage in non-price competition as a price war only benefits the
consumer and means loss of profits.
Oligopoly is a kind of market where a few and dominant
sellers, sell differentiated or homogeneous products under
continuous conciousness of rival’s action.

FEATURES OF OLIGOPOLY:

1. A few large firms dominate the market, i.e. they have a

substantial market share.

2. The product may be homogenous or differentiated.

3. The dominant firms have significant market power i.e they can
set their own price.

4. There are significant barriers to entry; entry or exit is difficult.

5. Access to information is limited.

6. There is mutual interdependence among the dominant firms;

this means that competition is personal and each firm recognizes
that its actions affect the rival firms and theirs affect it.

7. Competition is not related to price.

Q.1) WHY IS THERE A KINK IN THE DEMAND CURVE IN AN
OLIGOPOLY MODEL?

Unlike monopolistic competition and pure competition,

oligopolistic competition is hardly anonymous. Because there are
few sellers and each knows the others identity. Every marketing
and production decision needs to take into account the different
possible reactions of competitors. And even if there are no
deliberate decisions under consideration, the oligopoly firm’s
management needs to monitor the activities of the competition and

be prepared to react accordingly.

Competitors are likely to react asymmetrically
with respect to price increases and price decreases initiated by
one of the firms in the market. Given these conditions, competitors
are far less likely to follow a price increase than a price decrease.
It is also obvious that demand would be relatively more elastic
above the current price, but relatively more inelastic below the
current price. This is the reason for the oligopolistic competitor’s
demand curve being bent or kinked.
In the figure above, A represents the price in an oligopoly market.
Above this price, an individual firm is afraid of increasing prices.
The perception is that the competition will not follow a firm’s
price increase. If they do not follow they will get the firm’s
customers and sales. Therefore a price increase would create an
elastic demand curve above price P. If demand is elastic and
prices rise, then total revenue falls.
A price decrease has a similar effect. The reasoning is that if
the competitor does not follow the price cut, firms will entice
customers away from the competitor. Therefore the competition
must follow price cuts or lose customers and sales. As a result a
price decrease would create an inelastic demand curve below
price P. If demand is inelastic and prices decrease, then total
revenue also falls. The firm is in a lose-lose situation. There is no
point above or below P at which a firm can increase revenue.
Hence, price remains rigidly at P which creates a kink in the
demand curve.

Q.2 ) HOW DOES KINKED DEMAND CURVE EXPLAIN PRICE

RIGIDITY IN OLIGOPOLY?

The kinked demand curve model is an attempt to explain the price

rigidity that is often observed in many oligopolistic models. If an
oligopolist raised its price it would loose most of its customers
because other firms in the industry would not follow by raising
their prices. On the other hand an oligopolist could not increase
its share of the market by lowering its price because its
competitors would quickly match cuts. As a result, oligopolists
face a demand curve that has a kink at the prevailing price, and is
highly elastic for price increases but much less elastic for price
cuts. In this model, oligopolists recognize their interdependence
but act without conclusion in keeping their prices constant even in
the face of changed cost and demand condition-preferring instead
to compare on the basis of quality, advertising, service and forms
of non-price competition.
The kinked Demand Curve helps to explain price rigidity that
occurs under Oligopoly. The market price will be fixed at point X.

1) As demand is more elastic above point X any price rise will

result in a fall in total revenue as consumers switch to rival
products.
·2) As demand is less elastic below point X and a fall in price will
mean a fall in total revenue. A price war will develop. Therefore,
competition will take the form of non-price marketing strategies or
product differentiation in order to increase market share.

3) Prices remain stable because of the discontinuity of the MR

curve. Changes in costs between MC1 and MC2 will not affect the
profit maximising level of output or the profit maximising price.
 REFERENCES

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