Non-collusive oligopoly [Independent pricing], and the kinked demand curve hypothesis Notes


Non-collusive oligopoly and the kinked demand curve


Independent pricing [Non-collusive oligopoly]: Independent pricing refers to independent action of each seller within an oligopoly industry. When different firms produce differentiated product, each firm follows an independent pricing policy. Every firm may estimate the reaction and calculation of its rivals and then fix its own price and output.

Cournot’s duopoly model, Bertrand’s duopoly model, Edgeworth’s duopoly model, Chamberlin’s duopoly model and Sweezy’s kinked demand curve analysis explain non- collusive oligopoly.

Independent action of sellers often leads to price wars when a price cut by one seller leads to retaliatory price cutting by other sellers. Independent action may also lead to stability in the long run when the firms become mature and learn by experience and try to avoid price wars unnecessarily. This leads to price stability or price rigidity in the oligopolistic market

Price War: Price war may start when one seller reduces the price of his product in order to increase his sales. When his rivals realize a reduction in their sales, they reciprocate and each tries to undercut the others. This may lead to a price war between different firms and each firm may fix price at the competitive level. This occurs as a result of one firm cutting the prices and others following the same. Let us take two sellers A and B whose price moves are taken along X-axis and Y-axis respectively.






The curve RA, shows the price reaction of seller A to the price move of seller B. Similarly RB indicates the price reaction of B to the price move of A. Suppose seller A charges OA price, then seller B will have to cut his price to OB1 from OB. Now A will react to this by reducing his price to OA1. Next B will react to this fall in A's price by further cutting his price to OB2.This price reduction war between both sellers will continue till point E is reached where A charges OA3 price and B charges OB3 price.

Once the price has fallen to the level of unit cost of production at E point, neither of them will like to cut the price further because in that case total costs would exceed total revenue and will therefore bring losses to both sellers.

If one of the sellers is not earning normal profits, he will leave the industry. And if both are enjoying abnormal profits, some new sellers may enter the industry. Such a possibility is not ruled out in imperfect oligopoly. The only thing is that the new-comer will have to spend much on advertising his product.




Price Rigidity: Oligopolistic prices that remain stable over a period of time are called rigid prices. 

There are a number of reasons for price rigidity in certain oligopoly markets.

1. Individual sellers in an oligopolistic industry learn through experience the futility of price wars and thus prefer price stability.

2. They may be satisfied with the current prices, outputs and profits and avoid any involvement in unnecessary insecurity and uncertainty.

3. They may also prefer to stick to the present price level to prevent new firms from entering the industry.

4. The sellers may boost their sales promotion efforts at the current price instead of reducing it as they may view non-price competition better than price rivalry.

5. Sellers spend a lot of money on advertising their product, so they may not like to raise its price to deprive himself on the fruits of their hard labour or don’t want to indulge themselves in price wars after reducing it. They would stick to the going price of the product.

6. If a stable price has been set through agreement or collusion, no seller would like to disturb it, for fear of unleashing a price war.


The kinked demand curve hypothesis:

It is the kinked demand curve analysis which is responsible for price rigidity in oligopolistic markets.

The kinked demand curve hypothesis was put forward independently by Paul M. Sweezy, an American economist, and by Hall and Hitch, Oxford economists in 1939.

Its Assumptions. The kinked demand curve hypothesis of price rigidity is based on the following assumptions:

There is an established or prevailing market price for the product of the oligopolistic industry at which all the sellers are satisfied.
Each seller's attitude depends on the attitude of his rivals.
Any attempt on the part of the seller to push up his sales by reducing the price of his product will be counteracted by the other sellers who will follow his move.
If he raises the price others will not follow him, rather they will stick to the prevailing price and serve to the customers leaving the price-raising seller.

The demand curve facing an oligopolist, according to the kinked demand curve hypothesis, has a 'kink' at the level of the prevailing price. The kink is formed at the prevailing price level because the segment of the demand curve above the prevailing price level is highly elastic and the segment of the demand curve below the prevailing price level is inelastic. 



The marginal revenue curve associated with a kinked demand curve is discontinuous, or we can say, it has a broken vertical portion. The marginal cost curve passes between the two parts of the marginal revenue curve (the portion AB in the above diagram.) so that changes in marginal cost do not affect output and price. A kinked demand curve KPD, and OPo [or P], the prevailing price in the oligopoly market for the OQ output of one seller. Any increase in price above current price OP will considerably reduce his sales, for the other rivals are not expected to follow his price increase. This is so because the KP portion of the kinked demand curve is elastic, and the corresponding portion KA of the MR curve is positive. Therefore, any price increase will not only reduce his total sale but also his total revenue and profit. On the other hand, if the seller reduces the price of the product below OPo (or P), his rivals will also reduce their prices. Though he will increase his sales, his profit would be less than before. The reason is that the PD portion of the kinked demand curve below P is inelastic and the corresponding part of marginal revenue curve below B is negative. Thus in both the price raising and price-reduction situations the seller is a loser. He would stick to the prevailing market price OPo, which remains rigid, The demand curve KPD has a kink at P which brings a discontinuity in marginal revenue curve from A to B. The size of the gap or discontinuity in the MR depends upon the elasticity of the kinked demand curve. The more elastic the demand curve is to the left of the kink P and more inelastic to the right of the kink, the larger will be the discontinuity AB in the marginal revenue curve. Price will be stable so long as the MC curve cuts the MR curve in the gap (AB). Thus OPo [or P], oligopoly price is determined for the OQ output. Further, even if there are changes in costs, the price will remain stable so long as the marginal cost curve passes through the gap AB in the marginal revenue curve. When the marginal cost curve shifts upward from MC to MC1 due to the rise in the cost or shifts downward from MC to MC2, the equilibrium price and output remain unchanged since the new marginal cost curve MC1 or MC2 also passes through the gap AB.

The kinked demand curve analysis of oligopoly explains stability in price in the case of falling costs or declining demand, whereas, price is likely to rise when either the costs rise or demand increases.


The price will remain unchanged in the case of decrease in demand or declining costs: when the cost of production declines or there is decrease in demand, the price is more likely to remain stable and in this case, segment of the demand curve above the current price will become more elastic because with lower costs there is a greater certainty that the increase in price by an oligopolist will not be followed by his rivals and the segment of the demand curve below the current price will become more inelastic because with the decline in costs, there is greater certainty that the reduction in price by an oligopolist will be followed by his rivals. With the increase in the elasticity of the upper segment and the decrease in the elasticity of the lower segment, the gap in the marginal revenue curve becomes wider and therefore it is most likely that the given marginal cost curve will cross the marginal revenue curve inside the gap or the broken part of MR. Thus, price will remain unchanged in the case of decrease in demand or declining costs.


The Price is likely to rise when either the costs rise or demand increases: When there is a rise in the cost of an industry or In the case of increase in demand, an oligopolist can expect that if he increases the price, his competitors will most probably follow him. Therefore, the upper segment of the demand curve will become less elastic and the angle of the demand curve will become more obtuse. As a result, the gap in the marginal revenue curve will decrease and if this gap decreases much, it is very likely that the marginal cost curve crosses the marginal revenue curve above the upper point A indicating that the equilibrium price will rise and the equilibrium output will fall. Thus, it follows from the kinked demand curve theory that price is not likely to remain stable in the case of rise in cost or increase in demand.



Critical Analysis  of Kinked Demand Curve Theory

It does not explain how the price has been determined: It only explains why once an oligopoly price has been determined, it would remain rigid or stable, it does not explain how the price has been determined. For example, the kink occurs at P because OPo or [P], is the prevailing price. But the theory does not explain the forces that established the initial price OPo.

Price stability may be illusory because it is not based on the actual market behaviour: The oligopolistic seller may outwardly keep the price stable but he may reduce the quality or quantity of the product. Thus price stability becomes illusory. It is not possible to statistically compile actual sales prices in the case of many products that may reflect stable prices for them. It is, therefore, doubtful that price stability actually exists in oligopoly.

It does not apply to the oligopoly cases of prices leadership and price cartels: When price leadership and price cartels exist in oligopolistic markets there is concerted behaviour in regard to the price changes and hence there is no kink in the demand curve in these cases.

In an inflationary period the rise in output prices is not confined only to one firm but is industry-wide: The kinked demand curve analysis is based on two assumptions: first, other firms will follow a price cut and, second, they will not follow a price rise. Stigler has shown on empirical evidence that in an inflationary period, all firms having similar costs will follow one another in raising price. ln Stigler's words: "There is little historical basis for a firm to believe that price increases will not be matched by rivals and that price decreases will be matched." Stigler further points out that cases in oligopoly industries where the number of sellers is either very small or somewhat large, the kinked demand curve is not likely to be there.

However, as pointed out by Professor Baumol, the analysis explains how the oligopolistic firm's view of competitive reaction patterns can affect the changeability of whatever price it happens to be charging.

It is worth noting that ‘kink’ at the current price level is formed due to the uncertainty by the oligopolists and their expectations that their rivals will follow their price-cuts but would not follow any increases in prices by them.


Dr. Swati Gupta

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