Kinked Demand Curve

The curve is hard to draw, so go to this link and print it out. http://wps.aw.com/aw_carltonper_modernio_4/21/5566/1424971.cw/content/index.html Figure 6.1 Kinked Demand Curve Model If firms face such demand curves, the price, p*, is profit maximizing for any marginal cost curve (MC) that cuts the vertical section of the marginal revenue curve (MR). For example, p* is the profit-maximizing price for both MC1 and MC2 in Figure 6.1. The kinked demand theory of oligopoly behavior predicts that prices are likely to remain unchanged for small changes in costs. Unfortunately, this theory is silent on how price is initially set and, hence, does not explain price levels. At best, it explains why price does not change in response to moderate shifts in cost. In response to large shifts in cost, the theory predicts that price should change, although it provides no guidelines as to how the new price level is set. Stigler (1947) found no empirical evidence of asymmetry in the reaction of oligopolists to price changes by rivals. Moreover, the theory predicts that there will be no kink (the prices become more flexible) when the oligopolists collude. Stigler's evidence contradicted this hypothesis too. Finally, the theory predicts that large shifts in costs cause prices to change whereas small shifts do not. Stigler also rejected this prediction. As a result, the original kinked demand theory is largely discredited. Some recent models determine the price level and have the property that residual demand curves have kinks (Salop 1979, Schmalensee 1982, Chapter 8). SOURCES: Bowley, Arthur L. 1924. The Mathematical Groundwork of Economics. Oxford: Oxford University Press. Hall, R.L. and C.J. Hitch. 1939. "Price Theory and Business Behavior." Oxford Economic Papers 2:12-45. Salop, Steve C. 1979. "Monopolistic Competition with Outside Goods." Bell Journal of Economics 10:141-56. Schmalensee, Richard. 1982. "Product Differentiation Advantages of Pioneering Brands." American Economic Review 72:349-65. Stigler, George J. 1947. "The Kinky Oligopoly Demand Curve and Rigid Prices." Journal of Political Economy. 55:432-49. ------. 1964. "A Theory of Oligopoly ." Journal of Political Economy 72:55-59. Sweezy, Paul M. 1939. "Demand Under Conditions of Oligopoly." Journal of Political Economy 47:568-73. © 2000 Dennis W. Carlton and Jeffrey M. Perloff. Reprinted by permission. Pearson Copyright © 1995 - 2010 Pearson Education . All rights reserved. Pearson Addison Wesley is an imprint of Pearson . Legal Notice | Privacy Policy | Permissions Demand Curve The kinked demand curve theory is an economic theory regarding oligopoly and monopolistic competition. When it was created, the idea fundamentally challenged classical economic tenets such as efficient markets and rapidly-changing prices, ideas that underly basic supply and demand models. Kinked demand was an initial attempt to explain sticky prices. "Kinked" demand curves have in common with traditional demand curve that they are downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend - the "kink." Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve. Classical economic theory assumes that a profit-maximizing producer with some market power either due to oligopoly and monopolistic competition will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity. The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price elastic for price increases and less so for price decreases.