Kinked Demand Curve

 The kinked demand curve was first used by Paul.M.Sweezy to explain price rigidity.
 A kinked demand curve occurs when the demand curve is not a straight line but has a different
elasticity for higher and lower prices.
 When a firm increases its price, the rival firms do not follow it by increasing their prices in turn
this increases its market share. When a firm reduces its price rival firms immediately follows it
by decreasing their prices. If they do not do so, customers go to the firm which is offering at
lower price. This is the fundamental behavior of the firms in an oligopoly market. Let us
understand the unique characteristic feature of kinked demand curve.

 The demand curve in oligopoly has two parts :

1) Relatively elastic demand curve
2) Relatively inelastic demand curve as shown in the graph below. In oligopoly market firms are
reluctant to change prices even if the cost of production (or) demand changes

 Price rigidity is the basis for the kinked demand curve. Each firm faces demand curve kinked at
the currently prevailing price.
 At higher prices demand is highly elastic, whereas at lower prices it is inelastic.

 From the graph we can understand that OP is the given price. There is a kink at point K on
demand curve (DD). Therefore DK is the elasticity segment and KD is the inelastic segment.
 There is a change in the slope of the demand curve at K. At this situation the firm follows the
prevailing price and does not make any change in it because rising of price would contract sales
as demand tends to be more elastic at this stage.
 I would also fear losing buyers due to competitor’s price who have not raised their prices. On
the other hand lowering of price would imply an immediate retaliation from the rivals on
account of close interdependence of price, output movement in the oligopoly market.
Therefore the firm will not expect much rise in sale with price reduction.

 The average revenue curve and the demand curve (DD) of an oligopoly firm have a kink. The
kinked average revenue curve implies a discontinuation in the marginal revenues curve. It
explains the phenomenon of price rigidity in oligopoly market.

 The price output level that maximizes the profits for a firm is derived from the equilibrium
point, which lies at the intersection of the MC and the MR curves.
 The price output combination can remain optimal at the kink even though the MC fluctuates
because of the associated gap in the MR curve. This is shown in the graph. The profit
maximizing price OP and output combination of OQ remains unchanged as long as MC
fluctuates between MC1 and MC2 that is between A and B. Hence there is price rigidity- it
means OP does not change. It is concluded that once a general price level is reached it remains
unchanged over a period of time in oligopoly market.

 The logic of the kinked demand curve is based on

 A few firms dominate the industry

 Firms wish to maximize profits
 Impact of price rise

 If a firm increases the price, then it becomes more expensive than rivals and therefore,
consumers will switch to its rivals.
 Therefore for a price rise, there is likely to be a significant fall in demand. Demand is,
therefore, price elastic.
 In this case, of increasing price firms will lose revenue because the percentage fall in demand
is greater than the percentage rise in price.

 Impact of price cut

 If a firm cut its price, it is likely to lead to a different effect. In the short term, if a firm cuts
price it would cause a big increase in demand and therefore would lead to a rise in revenue.
The firm would gain market share.
 However, other firms will not want to see this fall in market share and so they will respond by
also cutting price to follow the first firm. The net effect is that if all firms cut price – the
individual firm will only see a small increase in demand.
 Because there is a ‘price war’ demand for a firm is price inelastic – there is a smaller
percentage rise in demand.
 If demand is inelastic and price falls, then revenue will fall.

 Prices stable

 If the kinked demand curve is true, the firm has no incentive to raise price or to cut price.

 Example of a kinked demand curve in practice

 One possibility is the market for petrol. It is homogenous and consumers are price sensitive.
 If one petrol station increased the price there would be a shift to other petrol stations.
 However, if one petrol station cuts price, other firms may feel obliged to follow suit and also
cut price – therefore a price cut would be self-defeating for the first firm.

 How realistic is the kinked demand curve in practice?

 In many oligopolies, firms may have a degree of brand differentiation. Mobile phone
companies can increase the price but consumers are willing to pay because the price is not the
dominant factor. Some petrol stations may increase price and not see elastic demand because
they have the best location.
 Firms may not want to defend market share. Rather than getting pulled into a price war, some
firms may not respond to price cut but concentrate on non-price competition to retain an
advantage.

 Other examples of the kinked demand curve

 It is not just in an oligopoly where there is potential kinked demand curve.

 In the market for an addictive drug like cocaine. If the price is cut, it may encourage first-
time users to try. However, once addicted, if the price rises, then demand will be price
inelastic (they will be willing to pay the higher price to get their drug fix)
KINKED DEMAND CURVE - OVERVIEW