In the 1930s Sweezy developed the kinked demnd curve in an attempt to explain why prices in oligopolistic industries apparently remained rigid despite moderate changes in cost and demand conditions. Unlike Curnot’s duopolists, the oligopolistics in this model is keenly aware of its rivals and the interdependence of their pricing and output decisions.the setting is a mature oligopolistic industry where price has already been determined, either by independent action or by collusion. We begin by considering one firms expectations about the way its rival will react to a price change it initiates. The firm’s rival has two options: they can match the price change or ignore it. In effect, the oligopolist faces two demand curves shown in above figure. One curve, JdM, reflects the price and out put combinations if rivals match the price changes; the second curve, Ad1, shows the relevant combinations if rival ignore the price changes. Initially we assumes that price is at P1 and output at 0Q1. if the oligopolists were to lower price below P1, none of its rivals matched the price cut, the firm the firm would greatly expand its share of the market ( along Ad1 ), partly its rivals expense. If the firm increased price above P1 , none of its rival followed the firm would lose a large share of the market. Thus the demand curve Ad1, drawn when the firms rivals ignore its price changes, is relatively elastic, but if the oligopolist increase or decrease price, and its rivals match those changes, the changes in sales will be much smaller ( along JdM, ) since all firms in the industry would share any increase or decrease in sales. So this demand curve is drawn relatively inelastic. Our oligopolist, it turns out, is pessimistic about the way it expects rivals to behave. No matter what decision the firm makes, it expects its rivals to react in the least favourable way. If the firm lowers its price below P1, the firm believes its rivals will all match the price cut (so its sales will only increase slightly along JdM, ). If the firm increases price, it believes rivals will ignore the price increase ( so the firm will lose a large share of the market along Ad1 ).given these specific assumptions about the reactions patterns of its rivals, the firm will face a kinked demand curve for its product composed of the AB segment of Ad1 (if the firm increases the price) and the BC segment of JdM, (if the firm lowers price).To determine the profit maximizing price and out put for the firm in this setting, we must firs identify the relevant marginal revenue curve. Both demand curves, Ad1 and JdM, have their own marginal revenue curves, mr1 and mrm . Since the kinked demand curve is composed of segments of two demand curves, so its marginal revenue curve. Recall that at each level of out put marginal revenue curve lies directly below its price. Consequently, the DF segment of the marginal revenue curve mr1 is the marginal revenue curve associated with the AB segment of the kinked demand curve, and the GH segment of the mrm is the marginal revenue curve associated with BC segment of the kinked demand curve. The marginal revenue curve is thus the discontinuous curve DFGH. To maximize profits, the firm will operate at the point where marginal cost equals marginal revenue. Given marginal cost mc1, the firm will operate at Q1, charging price P1. Note that if the marginal cost shifts upward (mc2 ) or downward (mc3 ) between F and G, the firm will not change its price or output. Hence, changing cost conditions in an oligopolistic industry of this type can occur without accompanying changes in price or output.
Drawbacks of the model:
Initially many economists regarded the kinked demand curve model as a general theory of oligopoly, but empirical evidence raised doubts. Stingler, for example, examined seven oligopolistic industries and found little evidence that rival firms were reluctant to match price increase of other firms. Later empirical work lent further support to Stingler’s findings. Moreover, economists have criticized the model on more fundamental grounds: although the kinked demand curve model explains price rigidity when cost and demand conditions change, it does not explain how the original price is determined. One purpose of microeconomic theory is to explain how prices and outputs are determined, and since the kinked demand curve model does not do this, critics claim that it is nothing more than an ex post rationalization of price rigidity. And, in fact, some evidence exist that prices are not really any more “rigid” in oligopolistic markets than they are in other markets.