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Kinked Demand

One early model held that oligopolies face kinked residual demand curves (Hall and Hitch 1939; Sweezy 1939). In Sweezy's version, an oligopolist believes its rivals quickly match price reductions but follow price increases only slowly and incompletely. [This model can be presented as a best response by a firm to a rival's strategy of "match price reductions but ignore price increases."] Each firm faces a demand curve that is more elastic above a price, p*, than it is below that price, as shown in Figure 6.1.

Figure 6.1 Kinked Demand Curve Model

If firms face such demand curves, the price, p*, is profit maximizing for any marginal cost curve (MC) that cuts the vertical section of the marginal revenue curve (MR). For example, p* is the profit-maximizing price for both MC1 and MC2 in Figure 6.1. The kinked demand theory of oligopoly behavior predicts that prices are likely to remain unchanged for small changes in costs.

Unfortunately, this theory is silent on how price is initially set and, hence, does not explain price levels. At best, it explains why price does not change in response to moderate shifts in cost. In response to large shifts in cost, the theory predicts that price should change, although it provides no guidelines as to how the new price level is set.

Stigler (1947) found no empirical evidence of asymmetry in the reaction of oligopolists to price changes by rivals. Moreover, the theory predicts that there will be no kink (the prices become more flexible) when the oligopolists collude. Stigler's evidence contradicted this hypothesis too. Finally, the theory predicts that large shifts in costs cause prices to change whereas small shifts do not. Stigler also rejected this prediction. As a result, the original kinked demand theory is largely discredited. Some recent models determine the price level and have the property that residual demand curves have kinks (Salop 1979, Schmalensee 1982, Chapter 8).

SOURCES:

Bowley, Arthur L. 1924. The Mathematical Groundwork of Economics. Oxford: Oxford University Press.

Hall, R.L. and C.J. Hitch. 1939. "Price Theory and Business Behavior." Oxford Economic Papers 2:12-45.

Salop, Steve C. 1979. "Monopolistic Competition with Outside Goods." Bell Journal of Economics 10:141-56.

Schmalensee, Richard. 1982. "Product Differentiation Advantages of Pioneering Brands." American Economic Review 72:349-65.

Stigler, George J. 1947. "The Kinky Oligopoly Demand Curve and Rigid Prices." Journal of Political Economy. 55:432-49.

------. 1964. "A Theory of Oligopoly ." Journal of Political Economy 72:55-59.

Sweezy, Paul M. 1939. "Demand Under Conditions of Oligopoly." Journal of Political Economy 47:568-73.

© 2000 Dennis W. Carlton and Jeffrey M. Perloff. Reprinted by permission.





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