Model Answer
0 min readIntroduction
Oligopoly, a market structure dominated by a few large firms, is a common feature of modern economies. Unlike perfect competition or monopoly, oligopolistic markets exhibit strategic interdependence, where each firm’s actions significantly impact its rivals. This interdependence often leads to price rigidity, a phenomenon known as ‘price stickiness’. This stickiness is counterintuitive to standard economic theory, which predicts prices to adjust rapidly to changes in supply and demand. Several models attempt to explain this behavior, with the Kinked Demand Curve model being the most widely recognized. This answer will detail the Kinked Demand Curve model and its explanation for price stickiness in oligopolistic markets.
Understanding Oligopoly and Price Stickiness
Oligopoly is characterized by a few dominant firms, significant barriers to entry, and either homogeneous or differentiated products. The key feature is the interdependence of firms; a price change by one firm is likely to provoke a response from others. Price stickiness refers to the tendency of prices to remain relatively constant even when underlying economic conditions change. This is often observed in industries like automobiles, steel, and petroleum.
The Kinked Demand Curve Model
Developed by Paul Sweezy in 1938, the Kinked Demand Curve model attempts to explain this price stickiness. The model is based on the following assumptions:
- Firms in an oligopoly are aware of their interdependence.
- Competitors will not match a price increase but will match a price decrease.
- The demand curve facing the oligopolist is elastic above the current price and inelastic below it.
The Demand Curve
The demand curve is ‘kinked’ at the prevailing market price. Above the kink, the demand curve is relatively elastic because if a firm raises its price, competitors are unlikely to follow, leading to a significant loss of market share. Below the kink, the demand curve is relatively inelastic because if a firm lowers its price, competitors will likely match the decrease, resulting in only a small gain in market share.
The Marginal Revenue Curve
The corresponding marginal revenue (MR) curve is discontinuous at the kink. This discontinuity arises because of the different elasticities of the demand curve above and below the kink. The MR curve is relatively flat over a wide range of output, meaning that a firm can alter its output without significantly changing its marginal revenue.
Price Stickiness Explained
The discontinuity in the MR curve explains price stickiness. If the firm’s marginal cost (MC) falls, it will increase output, but because the MR curve is flat, this increase in output will not lead to a price decrease. Conversely, if MC rises, the firm will reduce output, but again, the flat MR curve prevents a price increase. Therefore, within a certain range of cost changes, the firm can adjust its output without altering the price. This is why prices tend to remain ‘stuck’ at the prevailing level.
Other Models Explaining Oligopoly and Price Stickiness
While the Kinked Demand Curve model is popular, other models also explain price stickiness in oligopolies:
- Collusion: Firms may explicitly or tacitly collude to maintain prices. Cartels, like OPEC, are examples of explicit collusion.
- Price Leadership: One dominant firm sets the price, and others follow.
- Game Theory: Models like the Cournot and Bertrand models demonstrate how strategic interactions can lead to stable prices.
Limitations of the Kinked Demand Curve Model
Despite its popularity, the Kinked Demand Curve model has several limitations:
- It doesn’t explain how the initial price is determined.
- The assumption that competitors will match price decreases but not increases is not always valid.
- Empirical evidence supporting the model is mixed.
Conclusion
The Kinked Demand Curve model provides a plausible explanation for price stickiness in oligopolistic markets by highlighting the strategic interdependence between firms. While the model has limitations, it remains a valuable tool for understanding price behavior in industries dominated by a few large players. The model’s relevance is particularly strong in industries where brand loyalty and product differentiation are significant. Further research incorporating game theory and behavioral economics can provide a more nuanced understanding of pricing strategies in oligopolistic environments.
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.