What type of conjecture is involved in the existence of kinked demand curve? Do you think that kinked demand curve model is a price determination model in an oligopoly market? Justify your answer.

The Conjecture: Mutual Interdependence

The fundamental conjecture underlying the kinked demand curve model is mutual interdependence. This means that each firm in an oligopoly believes that its pricing decisions will significantly affect the sales of its competitors, and vice versa. Firms assume that rivals will react to their price changes, but the nature of that reaction is asymmetric. This asymmetry is the core of the model.

The Kinked Demand Curve Explained

The kinked demand curve postulates that the demand curve faced by an oligopolist is not a smooth, continuous curve, but rather has a ‘kink’ at the prevailing market price. This kink arises from differing elasticities of demand above and below the current price:

• Above the prevailing price: If a firm raises its price, competitors are assumed to maintain their prices. This leads to a relatively elastic demand curve for the firm raising prices, as consumers will switch to the cheaper alternatives offered by rivals.
• Below the prevailing price: If a firm lowers its price, competitors are assumed to match the price cut to avoid losing market share. This results in a relatively inelastic demand curve for the firm lowering prices, as the price cut doesn’t significantly increase its sales volume.

This difference in elasticity creates a kink in the demand curve. The corresponding marginal revenue (MR) curve becomes discontinuous, with a vertical gap at the output level corresponding to the kink.

Is it a Price Determination Model?

While the kinked demand curve model effectively explains price rigidity, it is not a robust price determination model. Here’s why:

• Assumptions are questionable: The model relies on strong assumptions about competitor reactions. The assumption that rivals will match price cuts but not price increases is not always valid. Game theory suggests a wider range of possible responses.
• No unique solution: The discontinuity in the MR curve means that the firm can choose to produce any output level within a certain range without needing to change its price. This doesn’t provide a unique price-output equilibrium.
• Doesn’t explain initial price: The model explains why prices might remain stable *after* an initial price is established, but it doesn’t explain how that initial price is determined in the first place.
• Collusion as an alternative: Price rigidity can also be explained by tacit or explicit collusion among firms, which the model doesn’t account for.

Alternative Explanations for Price Rigidity

Several other factors contribute to price stability in oligopolies:

• Tacit Collusion: Firms may avoid price wars through unspoken understandings and signaling.
• Price Leadership: A dominant firm may set the price, and others follow.
• Cost Plus Pricing: Firms may base their prices on their costs plus a markup.
• Game Theory Models: More sophisticated models, like the Cournot and Bertrand models, provide more nuanced explanations of oligopolistic pricing behavior.

Real-World Relevance & Limitations

The model has limited empirical support. While observed price rigidity in industries like automobiles and steel initially seemed to validate the model, subsequent research has shown that price changes do occur, and competitor reactions are often more complex than assumed. The model is more useful as a qualitative explanation of strategic interaction than as a precise predictive tool.