One characteristic of oligopolies is that they are interdependent. How can we show that interdependent behaviour? The kinked demand curve can map out the behaviour of firms in an oligopoly. Eager to learn more? After reading this explanation you will understand what the kinked demand curve is and you will be able to explain the concept with its assumptions and limitations to non-economists.
What is the kinked demand curve?
The kinked demand curve was developed by American economist Paul Sweezy and has become crucial in oligopoly theory. It illustrates the interdependent behaviour of firms in oligopolistic market structures.
The kinked demand curve illustrates the interdependence of firms in an oligopoly market.
The reason why there is a kink in the demand curve is that there are two demand curves: one that is inelastic and one that is elastic. The kink occurs when both demand curves intersect each other.
As you can see in Figure 1 below, at the kink, the MR curve is vertical. The MC curve intersects the MR curve in that vertical section.
Fig. 1 - The kinked demand curve
This model shows how firms in this market suffer from price rigidity when they choose to increase or decrease their prices.
You have seen why firms don't want to change their prices but you can also use the kinked demand curve to explain why firms don’t need to change their price by looking at the MR curve.
Fig. 2 - Kinked demand curve with change in MC curve
As you can see in the figure above, the MR curve has a vertical discontinuity at Q1. If costs change within this vertical gap, assuming that the oligopolist is a profit maximising firm (producing at MC=MR), they will always charge a price of P1. So they don’t need to change their prices.
Remember, this only applies as long as costs change within this vertical discontinuity.
Impact of a price increase
As you can see in Figure 3, an increase in price from P1 to P2 causes the quantity demanded to decrease from Q1 to Q2, which is proportionally more than the increase in price. Consumers’ demand is price elastic and is sensitive to the price changes. Other firms in the market will not follow this behaviour, and keep their price at P1, undercutting that firm.
Fig. 3 - Price increase with kinked demand curve
The firm that increased its price will experience a decrease in market share because of the loss in quantity demanded, and this will also decrease its total revenue.
Impact of a price decrease
As you can see in Figure 4, a decrease in price from P1 to P2 causes the quantity demanded to increase from Q1 to Q2, which is proportionally less than the price reduction. Other firms will follow this behaviour and also cut their prices, resulting in a price war. Total revenue will decrease, and over time, there will be no change in market share.
A price war is when firms repeatedly cut prices below that of competitors to offer the lowest price in the market.
Fig. 4 - Price decrease with the kinked demand curve
In both cases, increasing or decreasing prices doesn’t benefit firms in an oligopoly market. They don’t gain any market share from changing a different price. This shows the rigidity of prices in this market structure.
We can come to two conclusions from the previous observations of the kinked demand curve:
- Non-price competition: as it is not rational for firms to compete with prices, it is rational for them to compete through non-price strategies. Firms will try to spread awareness of the company and their products through branding and advertising in an attempt to make consumers purchase regularly. This will increase their market share and in the long run their profits.
- Collusion: to break interdependence, firms may try to collude. If they collude, they no longer have to worry about what their competitors are doing. Together they can fix prices to maximise their profits.
Characteristics of the kinked demand curve
As the kinked demand curve is used to illustrate the behaviour of firms in an oligopolistic market, it has the same characteristics as an oligopoly. These are:
Interdependence: firms make decisions based on rival firms as they are affected by the decisions of each firm in this market.
Few firms dominate the market: there is a high concentration ratio which is greater than 50% market share.
High barriers to entry and exit: the main barriers to entry and exit are large start-up costs, sunk costs, brand loyalty, and economies of scale.
Non-price competition: firms can’t compete through prices because these are rigid. Firms must compete in non-price strategies such as advertising, branding, etc. to gain market share.
Assumptions and limitations of the kinked demand curve
The kinked demand curve has a few assumptions. The assumptions made are also its main drawbacks.
Some assumptions and limitations are:
There is an initial price in the market, but there is no explanation as to why this price was set.
Rival firms will not follow an attempt to increase their prices but will react when a rival firm decreases theirs.
In theory, it isn’t rational for firms to increase or decrease prices, but in the real world, firms still decrease prices to gain consumers and increase market share.
It doesn’t explain the mechanism of establishing the kink in the demand curve.
Doesn’t include the possibility of firms colluding within the market.
The kinked demand curve can explain the behaviour of firms within an oligopoly market structure to some extent. Some economists see it as incomplete and insufficient. However, this theory is the closest to explaining the complex oligopolistic market.
The kinked demand curve examples
There are many examples that show the kinked demand curve in practice. Let’s look at two.
1. The petrol market. Consumers are very price sensitive to any change in the price of petrol.
One petrol station called ‘Cheap Petrol’ increases their price. Consumers will buy petrol from other stations. ‘Cheap Petrol’ will experience a decrease in market share because of the loss in quantity demanded and see a fall in their total revenue. If ‘Cheap Petrol’ decides to decrease their price, other petrol stations will follow that behaviour and cut prices in order to stop consumers from buying petrol at ‘Cheap Petrol’. This will result in a price war. In the overall market, there will be no change in any firm’s market share. Consumers benefit from lower prices, increasing their consumer surplus, but all firms experience a decrease in total revenue.
2. The supermarket industry.
If Tesco increases its prices, consumers will shop at cheaper supermarkets. Tesco’s market share will decrease, and it will experience a fall in total revenue. However, if Tesco decides to cut prices, other supermarkets will follow suit and cut prices too. Consumers benefit from cheaper prices, but supermarkets will experience less total revenue and profits.
Tesco spent £1 billion on store revamps and price cuts in 2014 to fight back against the discounts offered in Lidl and Aldi. This resulted in a fall in Tesco’s sales by 3.8%.
This is why many supermarkets compete with each other through non-pricing strategies like branding, advertising, loyalty cards, etc. This way they increase their market share, total revenue, and profits.
The Kinked Demand Curve - Key takeaways
- The kinked demand curve helps economists illustrate interdependence in an oligopoly market.
- From the kinked demand curve, we can see that it is not rational to increase or decrease prices.
- To compete in such a market structure, firms must compete through non-price strategies in an attempt to increase market share.
- Interdependence could cause firms to collude so that they no longer have to worry about what their competitors are doing and can maximise profits.
- As the kinked demand curve is used to illustrate the behaviour of firms in an oligopolistic market, it has the same characteristics as an oligopoly.
- The kinked demand curve has a few assumptions and limitations that cause some economists to view the theory as incomplete and insufficient.
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