Price Rigidity – The Kinked Demand Curve:
There may be price rigidity under oligopoly market on account of the accepted price stability
by the firms.
The price rigidity is found under the oligopoly on account of the following reasons:
(1) When the firms under oligopoly make an understanding not to follow the price war
because it does not favour none of them.
(2) When an oligopoly industry has attained the maturity and thinks that price war will not
benefit the industry as a whole.
(3) The oligopolist may follow the policy of price rigidity so that the entry of other firms is
discouraged.
(4) All firms have experienced under the oligopoly market that when one firm reduces the
price other firms will also reduce the price.
(5) All the firms are experienced that the non-price competition will benefit them rather
following the policy of price reduction.
(6) Kinked demand curve analysis brings the price rigidity under the oligopoly market.
(7) Price rigidity is followed because the object of profit can be attained through the
maximisation of sales rather than the reduction of price under the oligopoly market.
The price rigidity or the kinked demand curve under oligopoly can be explained with
the help of the following diagram:
The demand curve of the firm is DLAR while output is OQ. If the firm increases its price
from OP then the sales of the firms are reduced because other firms are not following the
policy of increasing price because the DL part of demand curve is highly elastic and any
increase in the price will reduce its quantity demanded. The marginal revenue of the firm is
DS which is positive. The increase in price will not only reduce its revenue but also the
volume of its profit.
Contrary to it, if the firm follows the policy of reducing its price other firms will also follow
the same policy. It will increase the sales of the firm but the profit will be reduced because
the demand curve LAR is less elastic and its marginal revenue curve is TMR which is
negative after the point L1. Thus neither the increase nor the reduction in the price will
benefit the firms under this situation. Thus the market price will be stable at OP price.
The demand curve DLAR is kinked at L point and the marginal revenue curve of the firm
DSTL/MP is discontinued between S and T point of the demand.
The discontinuity of demand curve will spend upon the elasticity of DL and LAR part of the
demand curve.
Firm under oligopoly market structure will not change its prices even though the cost and
demand conditions have undergone change. There will be no change in price and output till
the marginal cost curve of the firm cuts its discontinued part of marginal revenue curve. The
discontinued part of marginal revenue is ST and the output remains OQ and price is rigid at
OP level.
Kinked Demand Curve and Price Determination:
Oligopolistic market structure is marked by an indeterminate demand due to uncertain rival’s
actions and reactions. Hence, a conventional demand curve cannot represent the demand
pattern. A unique kinked market demand curve is usually constructed to show the demand
behaviour of an oligopolistic firm. This was developed in the late 1930s by the American
economist Paul Sweezy. This is an example of non-collusive model of oligopoly.
Such a kinked demand curve has been drawn in Figure-13.1.
It can be discussed as follows:
i. The kink will be formed at a price-output combination where the firm will prefer to operate.
Given the curve, firm has found its kink at point R at which it follows a price OP and sells
output OQ. One can see that the upper part of kink (SR) shows a relatively elastic demand
while its lower part (RT) shows a relatively inelastic demand. This implies that the firm will
not gain much if it lowers the price but will lose significantly if it raises the price. Therefore,
the firm will resist any movement, to the extent possible, from the point R (kink) on the
demand curve.
ii. Suppose, to increase its market share the firm lowers the price from OP to OP1. As per the
demand curve, the firm’s sale would grow marginally to OQ1. The firm will not be able to
push the demand much as the rival firms will immediately retaliate by lowering their
respective prices as well. As such, the expected advantage for the firm under consideration
will be nullified making the demand curve inelastic. The firm will reduce its profits as the
total revenue (price multiplied by quantity) will fall owing to a lower price.
iii. On the other hand, suppose the firm target at increasing per unit profit by raising its price
from OP to OP2. It will result into a fall in demand to OQ2 since the rival firms will not
follow the suit as they will gain out of it. Hence, the firm will lose the market share adversely
affecting its profit line.
iv. One can see, therefore, that the firm under consideration losses under both the
circumstances, whether it raises or lowers the price. Realizing this, the firm will stick to the
kink, to the extent possible. This is called as price rigidity under oligopoly. The firm has no
incentive to change its price, as it will lead to a decrease in the firm’s revenue.
v. Such behaviour of the firms under the oligopolistic market structure is attributable to their
interdependence. Based on this, we can argue that the firms will make all out efforts to stick
the price level. The kinked demand curve though indicates such a price-rigidity but unable to
show how such a price will be determined.
Given such a demand curve, the MR curve will also not be a conventional one. It will be
discontinued curve breaking at the point of kink on the demand curve, as shown in Figure
13.2.
The MR curve in the above figure has two part EF and GH. It shows that MR is positive
across the elastic portion of the demand curve while negative across the inelastic portion.
Between the two parts, there is a gap (between F and G) which shows a sudden shift from
positive to negative MR. The MC curve will pass through this gap justifying OP price.
If the cost of production increases and MC curve shift upward, it will not make any dent on
price so far it remains within the gap FG. In other words, a marginal change in cost will be
absorbed by the firm itself. This has been shown in Figure-13.3 in which an increase in cost
has led the MC curve to shift from MC1 to MC2. Despite this, there is no change in output
level and price of the firm since the increase in marginal cost is within the gap of MR curve.
However, if the MC curve rises beyond the gap, the firm will be forced to raise the price. It is
very much possible that rival firms may also face similar cost rising scenario and hence all
the firms may collude in hiking their respective prices without a fear of retaliation from each
other. Such a hike in price will not affect their relative positions and their respective market
shares may not be affected due to such a move.
It is clear from the above that determination of price and output level in Oligopoly is difficult
due to interdependence of the firms.
