Question

Some economists have suggested that oligopolists tend to maintain stable prices when there are changes in the demand for their products or in their costs of production. Which of the following models provides an explanation for this type of behavior? Group of answer choices

Centralized cartel

Price leadership

Prisoners' dilemma

Kinked demand curve

Answer 1

This type of behavior in oligopolistic firms is explained by the concept of kinked demand curve.

In oligopolist markets, prices tend to remain inflexible for a very long time. Even in the face of declining costs prices are relatively rigid. American economist Sweezy gave a theory known as kinked demand curve hypothesis to explain the rationale behind this price rigidity under oligopoly.

According to the kinked demand curve hypothesis, the demand curve facing an oligopolist has a kink at the level of the prevailing price. This kink exists because of two reasons:

1. The segment above the prevailing price level is highly elastic.
2. The segment below the prevailing price level is inelastic.

this kink at the prevailing price occurs because of these two behavioral reasons:

1. If a firm lowers the price below the prevailing level, then the competitors will follow him.
2. If a firm increases the price above the prevailing level, then the competitors will not follow him.

When an oligopolist lowers the price of his product, the competitors feel that if they don’t follow the price cut, then their customers will leave them and buy from the firm who is offering a lower price.

Therefore, they lower their prices too in order to maintain their customers. Hence, the lower portion of the curve is inelastic. It implies that if an oligopolist lowers the price, he can obtain very little sales.

On the other hand, when a firm increases the price of its product, it experiences a drastic reduction in sales. consumers will buy the same product from its competitors.

This increases the competitors’ sales and they will have no motivation to match the price rise. Therefore, the firm that raises the price suffers a loss and hence refrains from increasing the price.

This behavior of oligopolists can help us understand the elasticity of the upper portion of the demand curve.

Hence, no firm in an oligopolistic market will try to increase the price and a kink is formed at the prevailing price. This is how the kinked demand curve hypothesis explains oligopolistic firm behavior.

Kinked demand curve:

PRICE M OUTPUT X Fig. 1 : Kinked Demand Curve under oligopoly