Certainly, 'The Times' newspaper cut its price to very low levels. If one of the three firms put their price up to 90p a litre, what would happen next? Sweezy has tried to prove the point that the normal situation faced by an oligopolistic firm is one in which it can expect other firms in the industry to watch any price reductions it may make in order to protect their sales and share of the market. It is comprised of two segments, one which is more elastic, which results if a firm increases its price and the other that is less elastic, which results if a firm decreases its prices. Therefore demand is elastic for price increases. The greater the difference in the two elasticities, the greater the length of the discontinuity.
Large reduction in sales following an increase in price above the prevailing level by an oligopolist means that demand with respect to increases in price above the existing one is highly elastic. Price wars There is not much to say here. And in spite of the fact that it can sell 1,000 more units, its total revenue will fall from Rs. As has been explained above, in the context of decreased demand, price in kinked demand curve theory is likely to remain sticky. In particular, it does not explain how the price is set. Very small increase in sales of an oligopolist following his reduction in price below the prevailing level means that the demand for him is inelastic below the prevailing price.
There are different diagrams that you can use to explain Oligopoly markets. In particular, you can see where and why point C starts where it does. Kinked demand curve limitations In the above kinked demand curve example we put the kink at a certain price and quantity. Other features of oligopoly will be covered in the next sub-section. All family saloon cars are similar today, but which ones have air-conditioning fitted as standard? The model does not explain how these prices have been determined. Therefore, price and output would remain stable.
Similarly, the marginal revenue that the oligopolist actually receives is represented by the marginal revenue curve labeled adef. See: Collusion and game theory Game theory is looking at the decisions of firms based on the uncertainty of how other firms will react. Conversely, a price decrease will lead to a reaction by the other companies. Once the competitor has left the market, the price can be raised back up to the old level and there are more customers to go round! Assume that the price of a litre of unleaded petrol is 85p. Why Price Rigidity under Oligopoly? Stigler also asserts that the model is unnecessary because already included allowances for short-run sticky prices due to collusion, menu costs, and regulatory or bureaucratic inefficiencies in markets.
Under collusion, organizations are involved in collaboration with each other to take combined actions for keeping their bargaining power stronger against consumers. At the same time, decreasing the price will cause will cause revenues for all companies to go down simultaneously. New classical economists, led by , worked to discredit the kinked demand models. Non-price competition This is an important aspect of oligopoly because, as we have seen with the kinked demand curve model, price competition is difficult. Instead of laying emphasis on price-output determination, the model explains the behavior of oligopolistic organizations.
Kinked demand curve explained What is the kinked demand curve model? This is because, as the firm reduces or increases the price of its product, the prices of the products of other firms remaining constant, the product of the firm becomes relatively cheaper or dearer, respectively, than those of the other firms. Since the oligopolist will not gain a large share of the market by reducing his price below the prevailing level, and will have substantial reduction in sales by increasing his price above the prevailing level, he will be extremely reluctant to change the prevailing price. Most consumers would try and buy their petrol from the cheaper firm. What if one of the firms decided to cut its price to 80p a litre? It has been observed that many oligopolistic industries exhibit an appreciable degree of price rigidity or stability. The oligopolist's market demand curve becomes less elastic at prices below P because the other oligopolists in the market have also reduced their prices. Assumptions of the Kinked Demand Curve Model : This model was developed independently by Prof. These two different types of reaction of the competitors to the increase in price on the one hand and to the reduction in price on the other make the portion of the demand curve above the prevailing price level relatively elastic and the lower portion of the demand curve relatively inelastic.
Often this is the result of a broken collusive agreement or cartel. At point Y, the organization would achieve maximum profit. Variable Market Share If the price and market share both changed and competitors did not match the price change, buyers would switch to other soft drinks. Thus there is a, discontinuity at the level of output of 9,000 units where the kink in the demand curve appears. Analysis of the Kinked Demand Curve Model. In this lesson we take a graphical approach to oligopoly, and seek to explain why prices tend not to fluctuate up or down in oligopolistic markets.
The big problem, of course, is the fact that it is tempting for a member of the cartel to cheat! This point requires a little elucidation. However, barriers to entry are less than monopoly. This means getting together and making an agreement about quantities produced and, therefore, prices. Such an analysis has been made by Paul Sweezy in 1939. This difference in elasticities is due to the particular competitive reaction pattern assumed by the kinked demand curve hypothesis. In oligopolistic market there are few big sellers and large number of sellers for example car industry few car makers but large no. This indicates that the firm will maximise its profit by producing 9,000 units at the industry-wide price of Rs 10.
The Quantity Qm will be split between the firms in the cartel. In recent years, we have seen price wars in the following industries: newspapers see above , fast food McDonald's verses Burger King , mobile phones especially between the four main networks and package holidays. The kinked demand curve model seeks to explain the reason of price rigidity under oligopolistic market situations. On the other hand, if the organization increases the price, the competitor organizations would also cut down their prices. In other words, cartel can be defined as a group of organizations that together make pricing and output decisions.
Commenting upon kinked demand curve theory Prof. In other words, each oligopolist will adhere to the prevailing price seeing no gain in changing it. But they are expected to follow price rises only slowly and partially since they are eager to increase their market share. Therefore, in order to retain their customers they will be forced quickly to match the price cut. The goal of a cartel is for the few firms in the industry to join together and, effectively, form a monopoly. Thus, there is no motivation for increasing or decreasing prices. Firms need to know how other firms are going to act, and how they will react to their own strategies.