Therefore, although the kinked demand curve model cannot explain the process of price determination, it can well explain why the prices are sticky in an oligopolistic market. A feature of many oligopolies is selective price wars. Thus there is a, discontinuity at the level of output of 9,000 units where the kink in the demand curve appears. However, if firms collude, they can agree to restrict industry supply to Q2, and increase the price to P2. What if one of the firms decided to cut its price to 80p a litre? Conversely, a price decrease will lead to a reaction by the other companies.
There is little incentive to raise or lower price. When there is a rise in cost of industry an oligopolist can reasonably expect that his increase in price will be followed by the others in the industry. There are different diagrams that you can use to explain Oligopoly markets. A formal agreement formed among competing organizations is known as cartel. The goal of a cartel is for the few firms in the industry to join together and, effectively, form a monopoly. The price is reduced to below cost price, a definite loss leader, so that the competitor cannot cope.
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! The consequence is that the firms have little to gain from a price increase as they will lose market share to the other companies that do not change their price. Basically, it is where one firm cuts its price, the others follow and perhaps cut theirs by a little bit more, and so on. Or is it just a coincidence that the prices are similar in the food retailing industry, the electrical goods retailing industry and the new car market? Constant Market Share If the market share was constant see Figure 2 , Pepsi prices changed and Coca-Cola matched the change as well, buyers would not have reason to switch from a brand to another one. Because of this kinked shape, the profit maximizing level of output is exactly at the kink. At the same time, decreasing the price will cause will cause revenues for all companies to go down simultaneously. Following are the assumption of a kinked demand curve: i. Therefore, to understand the kinked demand curve model, it is important to note the reactions of rival organizations on the price changes made by respective oligopolistic organizations.
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. It can also expect other firms not to match an increase in price because of their desire to increase their sales at its expense. Assuming that overall demand is unlikely to rise substantially, all three firms will find that the rise in demand for their petrol is proportionately small compared with the proportionate fall in price, so their revenues fall. But they are expected to follow price rises only slowly and partially since they are eager to increase their market share. But, there is an incentive for firms to exceed quota and increase output.
This indicates that the firm will maximise its profit by producing 9,000 units at the industry-wide price of Rs 10. In such a case, the organization that has raised its prices would lose some part of its market share. On the other hand, with lower cost the segment of the demand curve below the current price will become more inelastic because with the decline in costs, there is then greater certainty that the reduction in price by an oligopolist will be followed by his rivals. The main weakness with this model is that it is not a theory of price determination. Summary We explained the kinked demand curve model of oligopoly.
However, kinked demand curve model is criticized by various economists. Implication of the Kinked Demand Curve Model: The most important implication of the kinked demand curve model is that in oligopolistic market structure firms could experience substantial shifts in marginal costs and still not vary their prices. The points of intersection E 1 and E 2 are the equilibrium levels of the organizations, A and B, respectively. More recently, we have seen firms diversify to attract custom supermarkets offering banking and insurance services and some have even started to offer shopping 'on-line' using the Internet. In the event of increase in demand, an oligopolist can expect that if he initiates the increase in price, his competitors will most probably follow him.
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. If the cost of production rises along with a shift in the demand curve, then also, profit maximisation may not require the firm to change the price of its product. They try to set a price that is low enough to put new entrants off, but hopefully still high enough to make some sort of profit. There is hardly any disposition to lower the price when there is decline in demand or in costs, but the price may be raised in response to increased demand or to rising cost. We shall see presently that, because of this asymmetric reaction pattern of the rivals, the demand curve of each firm would have a kink at the prevailing price of its product. The Quantity Qm will be split between the firms in the cartel. But some of the countries involved were otherwise relatively poor.
Assumptions of the Kinked Demand Curve Model 2. The target was probably 'The Independent', but they seem to have survived. Collusion is illegal and firms can be fined. If they collude, they make £8m. Monetarist, Keynesian, and New Classical Economics.