Model Answer
0 min readIntroduction
The kinked demand curve theory, developed by Paul Sweezy in 1939, attempts to explain the price rigidity often observed in oligopolistic markets. Unlike perfectly competitive or monopolistic markets, oligopolies – characterized by a few dominant firms – exhibit a unique pricing behavior. This is because each firm’s pricing decisions are interdependent, heavily influenced by the anticipated reactions of its rivals. The theory posits that firms face a demand curve ‘kinked’ at the prevailing market price, leading to discontinuous marginal revenue curve and thus, price stability.
Understanding Oligopoly and the Kinked Demand Curve
Oligopoly is a market structure dominated by a small number of firms, each possessing significant market power. Key characteristics include:
- Interdependence: Firms are highly aware of each other’s actions.
- Barriers to Entry: Significant obstacles prevent new firms from entering the market.
- Product Differentiation: Products may be homogeneous or differentiated.
The Theory Explained
The kinked demand curve theory assumes that:
- The demand curve is relatively elastic above the prevailing price (P). This is because if a firm raises its price, rivals are unlikely to follow, leading to a significant loss of market share.
- The demand curve is relatively inelastic below the prevailing price (P). This is because if a firm lowers its price, rivals are likely to match the reduction, resulting in only a small gain in market share.
This difference in elasticity creates a ‘kink’ in the demand curve at the current price. Consequently, the marginal revenue (MR) curve becomes discontinuous.
Diagrammatic Representation
Key elements of the diagram:
- D1: Demand curve above the kink (elastic).
- D2: Demand curve below the kink (inelastic).
- P: Prevailing market price.
- Q: Prevailing market quantity.
- MR1: Marginal revenue curve above the kink.
- MR2: Marginal revenue curve below the kink.
- MC: Marginal cost curve.
Implications for Price Rigidity
The discontinuous MR curve has significant implications. If marginal cost (MC) shifts upwards, the firm will not raise its price because it fears losing market share (due to the elastic portion of the demand curve). If MC shifts downwards, the firm will not lower its price because the gain in market share will be limited (due to the inelastic portion of the demand curve). Therefore, the price remains stable despite changes in costs. This explains the observed price rigidity in oligopolistic markets.
Limitations
The theory has been criticized for:
- Its assumptions about the shape of the demand curve are not always realistic.
- It doesn’t explain how the initial price is determined.
- Empirical evidence supporting the theory is mixed.
Conclusion
The kinked demand curve theory provides a plausible explanation for price stability in oligopolistic markets, highlighting the strategic interdependence between firms. While it has limitations, it remains a valuable tool for understanding pricing behavior in industries characterized by a few dominant players. The theory underscores the importance of considering rivals’ reactions when making pricing decisions, a crucial aspect of strategic management in oligopolistic settings.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.