The Kinked Demand Theory

The model was devised by Paul Sweezy in the 1930s and is based on how a firm perceives its demand curve. There are 2 demand curves in this model, D1 and D2. The firm only knows for sure one point on its demand curve and that is the point at which it is currently located (P*Q*). 

 

The degree of elasticity in demand for an oligopoly firm depends on the subsequent action of its competitors, i.e. whether or not they will change prices in line with the incumbent firm. Therefore the firm will have 3 demand curves with varying degrees of elasticity. One demand curve (D2 which is more elastic) shows the demand curve for the firm if its competitors were not to change price. Obviously it would be more elastic as consumers may switch to the close substitutes of other oligopoly firms.

 

The other demand curve (D1 – more inelastic) is the demand curve which would arise if competitors’ tacitly colluded (set the same price, or near enough, as other firms in the oligopoly market). 

The kinked demand curve can therefore be derived from the 2 demand curves. The firm currently knows its point on the demand curve (P*Q*), if its price was to increase then competitor firms are unlikely to also increase their prices instead opting to increase their market share by picking up the firms’ customers. Hence they will ignore the price change and so the kinked demand curve will include the D2 curve from P* to the price axis. Conversely if the firm reduces its prices then competitors are likely to have to do the same in order for them to not lose customers. Therefore the kinked demand curve will also incorporate the D1 curve from P* downwards.

 

Evaluative points of the model is that there is no explanation of how we initially arrived at the point P*Q*. The theory also only deals with price competition between oligopoly firms and doesn’t take into account what would occur if non-price competition was occurring. It also assumes a fixed response by competitor firms, that they will definitely keep their prices constant if one firm increases its prices and that they will definitely lower their prices if another firm does the same, this may not always be the same as firms may react in different ways. For example if one firm increased its prices it may be beneficial for the firm to do the same if it receives more profit from doing this than it would from taking extra custom from the other firm. 

Price Stability

As shown on the kinked demand curve if an oligopoly firm raises its prices it risks losing market share unless its competitors also increase their price. If it lowers its price then its competitors will presumably follow and hence the result will just be a fall in profit with very little change to the market shares. This theory; that firms are unlikely to increase or decrease prices unless following suit; can be proven by game theory.

The pay-off matrix above shows that firm A and firm B can either raise prices or leave the prices unchanged. The reason why the matrix isn’t symmetrical is because in any market one firm is likely to be more dominant than another, and so it will have more customers and hence a change in prices may lead to a fall in customers but this may not be as dramatic as if the firm were smaller and had a smaller initial customer base to begin with. The matrix shows a zero-sum game where one players gain is another’s loss. Firm B has a dominant strategy to leave prices constant as it can make a max of £3million and a minimum of £0 million compared to a loss of £9 million or a loss of £1 million. Firm A however, doesn’t have a dominant strategy (its play safe strategy would be to keep prices constant) but because it knows Firm B will play constant prices it will also play constant prices and make £0 million profit as oppose to a loss of £3 million. Therefore the outcome will be constant prices.

Firms are also likely to keep their prices constant as oppose to reducing them as many economists believe them to be risk-averse. If one firm reduces its prices then the competitor firm will have to do the same in order to retain its market share; however it is unlikely to initiate this price war because it could lose it. If one firm reduces its prices it knows that its competitor will have to do the same and so they will both lose out, therefore they stay neutral and keep prices constant.

Collusion

The above example assumes that the 2 firms don’t (or cant) communicate with each other; if they could then they would both agree to produce at a low output so that they both earn a higher profit (if they didn’t communicate both would produce a high output and hence earn £5,000 in profit whereas £7,000 is a greater profit).

If they could communicate then they may form a cartel in which they would both agree to produce at a low output in order to maximise their individual and joint profits. However there is a risk that one of the firms would cheat in order to make even more money. If they both agreed to produce at a low output, then if one firm ‘cheated’ and produced at a high output they could make a profit of £10,000 whilst the other firm would only make £1,000.

It is also illegal in many countries around the world to form a cartel. In the UK the OFT (Office of Fair Trading) can fine firms up to 10% of their turnover for every year the cartel has been operating. This results in collusion being rare due to the costs if found and the risk that the other firms in the cartel will cheat. Other punishments include fines, and imprisonment for the employees found to have negotiated or been aware of the collusion. However OPEC (Organisation of Petroleum Exporting Countries) has been operating for a long time and has a successful monopoly on petrol.

There are conditions which may increase the formation of cartels or a degree of collusion between firms. The greatest factor is how easily a firm in the cartel can monitor other firms in order to ensure that they are keeping to the cartel agreement (i.e. not selling more output than specified). Therefore if there are only a few firms in the cartel then it would be easier to monitor. Also if the firms are producing similar goods then they both have an equal footing. During an economic boom it may be harder to monitor market shares of firms as most will be expanding.

Despite cartels being illegal the gains from collusion may outweigh the risks and hence result in firms working together. As well as agreeing to fix prices and output firms may work together in other capacities such as by participating in joint research and development projects or sharing technological information.

Firms may also split markets up between them, although this reduces competition it may result in lower costs for a firm. For example this could happen in the aviation industry with firms agreeing to run particular routes and hence not have to both be running the same route.

Overt collusion is where a cartel is obvious in its operations, for example OPEC, which isn’t in the jurisdiction of EU or UK authorities, overt cartels are rare. More common is covert collusion, where firms meet in secret to fix prices and output.

Tacit collusion is also a more common phenomenon with firms avoiding to compete on price despite their being a formal agreement or any communication. If there is no agreement between firms then this practise isn’t illegal. Tacit collusion can take the form of price leadership in which a dominant firm sets a price and other firms follow its example. Another form is barometric price leadership, when one firm increases its price and waits to see if its competitors follow suit. If they do not then the firm will lower its prices back down again.

Price Competition vs. Non-Price Competition

Price Competition

In reality most firms do not know the exact shape of their revenue and cost curves and hence have to find alternative ways of coming up with a pricing strategy. One method is cost-plus pricing (mark-up pricing) whereby firms calculate their average costs at the given output level and add a mark-up in order to make a profit. Firms that have a lot of competition tend to have a smaller mark-up than ones which have less competition or in markets where there are differentiated products.

Price Wars

Firms wish to avoid price wars and this can be seen from the kinked demand curve model as a reduction in prices is likely to be matched by rivals, leaving all firms in the oligopoly market with lower profits but unchanged market share. Therefore this is likely to only benefit consumers. However firms may have to increase their prices (after the war) in order to recoup some of their losses.

If this is the case then it could be believed that firms in an oligopoly market would never undertake price wars. However it could be argued that they occasionally may if they believe they can gain more customers from rivals whilst the rivals are contemplating their strategies. When the price war ends and prices return to their original level the firm hopes it will retain the customers it has gained.

Price wars may also be engaged to force a competitor out of the market and hence in the long-run create a monopoly firm in the market. This would be detrimental to consumers as they would have less choice in the long run and may also be charged monopoly prices. Therefore they would benefit from the low prices in the short run but in the long run will have less choice.

Predatory Pricing

Predatory pricing is a strategy where firms set prices below their average variable costs in order to force a rival out of the market. This is illegal in the UK and the EU.

Legally a firm is said to be undertaking predatory pricing if a firm were to set the price below average variable costs as economically this is below the shut-down price and there is no benefit here except to drive out competitors and force them to shut-down.

In the short term, consumers can benefit from these very low prices. But in the long-run the incumbent firm is likely to regain its losses by then putting prices back to a profit maximising level. It may be possible that the threat of predatory pricing alone may deter entry by new firms.

Limit Pricing

If the incumbent firm is making large supernormal profits then this may encourage new entrants to the industry and hence reduce the incumbent firms’ supernormal profits. Limit pricing can be conducted to prevent this.

For limit pricing to occur it is assumed that the incumbent firm has a cost advantage over potential new entrants which may include economies of scale. It is conducted by firms in an oligopoly in order to limit the entry of new firms into the industry. They set a price that is high enough for them to make a supernormal profit but low enough to put new entrants off. Unlike predatory pricing it is usually a temporary measure and isn’t a loss leader.

In the graph to the left the incumbent firm would set a price below CNE but above CI. New entrants would make a loss but the incumbent firm is still able to maintain a supernormal profit.

The incumbent firms are still able to make a profit as they have economies of scales which new firms don’t (this is an assumption for limiting pricing to be able to occur). In the short run a firm will make lower profits if it is limit pricing but in the long run it should make greater supernormal profits as it won’t have increased competition (as the limit pricing ought to have reduced any potential new competition) and it will also have a more inelastic demand curve.

Non-Price Competition

Non-price competition is an initiative by a firm to increase brand loyalty, sales and market share, without doing so through price discounting. This is important in market situations of monopolistic competition and oligopolies.

This can include; club-cards, advertising, imitation of products, buy-one-get-one-free offers, fair-trade, extended warranties, improved quality, convenience/accessibility, customer service, branding, sponsorship, endorsements, vouchers, opening times and interest free payments.

A marketing campaign may be less expensive than a price war and may increase market share. Other competitors may also increase their advertisement in response but theirs may not be as effective. However if it is successful then the firm could lose market share. This increased advertising may even lead to an expansion of the market as a whole. Such an advertising campaign may make the demand curve more inelastic but only if it is successful. By conducting such campaigns costs will increase which may lead to lower supernormal profits (something which shareholders may protest at; however if the advertising is successful then revenues will also increases and hence supernormal profits may rise).

 In order to make their demand curve more inelastic firms may try to develop a strong brand. The firm can then charge a premium price on its branded product and see a rise in profits without a fall in demand. It is also very difficult for competitors to try to compete with branded goods as consumers relate to brands. Because strong brands can be difficult and expensive to create firms may choose to buy developed and popular brands off of other firms.

Other Deterrence Strategies

Advertisement

Advertising can be considered a fixed cost because its budget isn’t directly linked with the volume of output the firm sells or produces. If incumbent firms spend a lot on advertisement then it may be more difficult for new firms to become established in a market as they will also need to advertise heavily to attract consumers. Firms may also spend a lot trying to develop a well-known brand that creates customer loyalty. This should make the demand curve for inelastic as consumers don’t wish to substitute the branded good and so will pay a premium for it. To achieve this brand recognition firms may have to invest a lot of money into the design and make sure the quality of their product and service is high. These costs are also sunk costs and may deter entry by new firms.

Research and Development

Another way to deter entrance into a market is to conduct a lot of research and development. Although this is expensive it can lead to the creation of innovative new products which, when patented, means competition cannot copy. Firms may therefore be able to gain a monopoly on a market by investing in R&D. Research and development is another example of a fixed cost and is also sunk (although some of the research and patents could potentially be sold on, likewise a successful brand could also be sold on). 

Page last updated on 20/10/13