The weird thing about oligopolistic markets is that they can behave very differently - either competitively or similar to that of a monopoly - and as such require different models to explain oligopoly behaviour. Our last article assumed a cartel, meaning a group of oligopoly firms collude and form what is functionally a monopoly. But oligopolies don’t always end up like this and can instead compete with each other. This sort of oligopoly market calls for another model, the kinked demand curve.
The primary assumption this model makes is that the firms in the oligopolistic market are interdependent, meaning that the behaviour of one company impacts the behaviour of another company. We explain this in further detail in our intro oligopoly article.
If you run a firm and you naively increase your prices, other firms will keep their respective prices as is in order to steal market share. This means that increasing the price would mean your demand is elastic, since no one else is going to buy from you if they can simply turn to competitors offering the product for cheaper. In other words, they’re sensitive to your change in price.
On the other hand, if you lower your prices, what are your competitors going to do? They don’t want to lose market share and so they will also lower their prices, preferably at or below yours. This means that if you lower your prices, your demand becomes inelastic. Since your competitors are also lowering their prices, not many more customers are going to buy only from you. In a non-collusive oligopolistic market, how other firms react to a given firm’s prices is a huge determinant of demand elasticity. Let’s graph this:
You raise your prices, your competitors don’t, so consumers switch to them. Pretty straightforward, as is the inverse:
You lower your price, your competitors follow suit, and so consumers won’t exclusively buy from you since there are other options at similar prices. Putting together both our elastic and inelastic curves, we have a single kinked demand curve, one with the distinguishing kink in it:
Unlike other economic models we’ve covered, however, the kinked demand curve has been subject to a greater deal of controversy. The first and more subtle criticism is that it doesn’t explain how the oligopoly prices were formed in the first place and instead simply explains the elasticity at given prices. This is why notable critics such as Nobel laureate George Stigler argue that the kinked demand curve isn’t useful.
Stigler also argues that the model assumes that shifts in consumer demand will not affect the price at which the kink occurs. He takes issue with this snuck premise and says that consumer demand increasing or decreasing will have asymmetrical effects on the demand’s elasticity.
According to Stigler, an increase of demand will make the upper branch less elastic and the lower branch more elastic. A decrease in demand will have the opposite effect - increased elasticity in the upper branch and decreased elasticity in the lower branch. The kinked demand curve model doesn’t account for this.
Econ IRL:
Stigler, however, doesn’t stop there. In a 1947 paper, he pointed to several examples in which a given oligopolistic firm raised their prices, but then so did the rival firms. In the steel industry, for example, firms have followed price increases. But the more striking case is when the American Potash and Chemical Corporation decreased their prices by about 26% from the previous year and yet the other firms failed to follow. Both of these instances and several others stand in contrast to the kinked demand curve’s assumption about firm behaviour, leading many economists to criticize it on empirical grounds.
‘Till next time,
SoBasically