Kinked Demand Curve

1. Introduction to Kinked Demand Curve

The Kinked Demand Curve Theory explains why prices in an oligopoly remain rigid despite changes in production costs. Proposed by Paul Sweezy, it suggests that oligopolistic firms face two different demand elasticities:

• If a firm raises its price, competitors do not follow → Sharp drop in demand (elastic).
• If a firm lowers its price, competitors also reduce prices → No major increase in demand (inelastic).

This results in a kinked (bent) demand curve, leading to price stability in oligopoly markets.

2. Assumptions of the Kinked Demand Curve Model

1. Few Firms in the Market
   • A small number of firms dominate the industry.
2. Price Interdependence
   • Firms carefully observe and react to competitors’ pricing decisions.
3. Asymmetric Demand Elasticity
   • Demand is more elastic for price increases and less elastic for price decreases.
4. Rigid Prices
   • Firms prefer non-price competition (advertising, branding) over frequent price changes.
5. Gap in Marginal Revenue (MR) Curve
   • Due to the kink, the MR curve has a discontinuous segment, making price changes uncertain.

3. Explanation of the Kinked Demand Curve

The curve consists of two segments:

1. Upper Segment (Elastic Demand)
   • If a firm raises its price, competitors do not increase their prices.
   • Consumers switch to cheaper alternatives, leading to a sharp drop in sales.
   • The demand curve is elastic (flat slope) in this region.
2. Lower Segment (Inelastic Demand)
   • If a firm lowers its price, competitors also reduce their prices to maintain market share.
   • The firm gains a few additional customers as the entire industry lowers prices.
   • The demand curve is inelastic (steep-slope) in this region.
3. The Kink at Market Price (P*)
   • Firms operate at a stable price P* where MR = MC.
   • Small cost changes (MC shifts) do not affect pricing decisions due to the gap in the MR curve.

4. Graphical Representation of the Kinked Demand Curve

Kinked Demand Curve in Oligopoly (Price Rigidity)

Explanation of the Kinked Demand Curve Graph

This graph illustrates how price rigidity occurs in an oligopoly due to different demand elasticities.

1. Kinked Demand Curve (AR – Blue Line)
   • Upper Segment (Elastic Demand): If the firm raises the price, competitors do not follow, leading to a sharp decline in demand.
   • Lower Segment (Inelastic Demand): If the firm lowers the price, competitors also cut prices, so there is no major demand increase.
2. Marginal Revenue (MR – Red Dashed Line)
   • Discontinuous (gap in MR curve) at the kinked point.
   • If MC changes within this gap, the price remains unchanged.
3. Marginal Cost (MC – Black Vertical Line at the Kink)
   • Since MR has a gap, even if MC fluctuates slightly, the firm does not change its price (P*).

5. Key Takeaways

✅ Price rigidity in oligopoly: Firms avoid frequent price changes due to uncertain competitor reactions.
✅ No incentive to raise prices: Demand drops sharply as competitors do not follow.
✅ No gain from lowering prices: Competitors match price cuts, reducing potential benefits.
✅ Non-price competition is preferred: Firms use advertising, branding, and product differentiation instead of price wars.