(Q).Define oligopoly. Why firms under oligopoly face a kinked demand curve?

(ANS)

The word Oligopoly is derived from two Greek words 'Oligi' meaning 'few' and 'Polein' meaning
'to sell.

Oligopoly is a market structure characterized by a small number of firms that dominate the
industry. In an oligopoly, there are typically just a few large firms that compete with one another
for market share. Due to the limited number of competitors, each firm's actions can have a
significant impact on the market and the behavior of other firms.

Firms under oligopoly face a kinked demand curve because of the interdependent nature of
their decision-making. The kinked demand curve theory suggests that in an oligopolistic market,
firms anticipate and react to the behavior of their rivals. This theory was developed by
economist Paul Sweezy in the 1930s and expanded upon by other economists.

The kinked demand curve is characterized by two distinct segments. The upper segment of the
demand curve is relatively elastic, meaning that a price increase by one firm will cause a
significant loss in market share as customers switch to other competitors with lower prices. On
the other hand, the lower segment of the demand curve is relatively inelastic, indicating that a
price decrease by one firm will not result in a proportionate increase in market share.

                 (( Make Daigram here!!))

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.

The following figure shows a kinked demand curve dD with a kink at point P.

From the figure, we know that

*The prevailing price level = P

*The firm produces and sells output = OM

*Also, the upper segment (dP) of the demand curve (dD) is elastic.

*The lower segment (PD) of the demand curve (dD) is relatively inelastic.

This difference in elasticities is due to an assumption of the kinked demand curve hypothesis.

In an oligopolistic market, the kinked demand curve hypothesis states that the firm faces a
demand curve with a kink at the prevailing price level. The curve is more elastic above the kink
and less elastic below it. This means that the response to a price increase is less than the
response to a price decrease. Hence, the correct answer is option A

The kinked demand curve arises due to a few key assumptions and strategic behaviors
exhibited by firms in an oligopoly:

Price rigidity: Firms under oligopoly often hesitate to change prices. They fear that a price
increase will lead to a significant loss in market share, as competitors may not follow suit and
maintain lower prices. Conversely, a price decrease may not result in gaining a proportionate
market share since other firms may match the price decrease, leading to a price war and
reduced profitability for all.

Mutual interdependence: In an oligopoly, firms closely monitor and respond to the actions of
their rivals. They consider how their competitors might react to their own price changes. If one
firm lowers its price, others may follow suit to prevent losing market share. Similarly, if one firm
raises its price, others may not follow to avoid sparking a price war.

Non-price competition: Oligopolistic firms often engage in non-price competition, such as

advertising, branding, product differentiation, and innovation. This allows firms to compete
without relying solely on price adjustments and can help maintain market share.

Assumptions of the kinked demand curve: The kinked demand curve theory assumes that
demand is relatively elastic above the prevailing price and relatively inelastic below it. This
assumption is based on the idea that consumers are more sensitive to price increases than
price decreases. Consequently, firms face a demand curve with a pronounced kink at the
prevailing price level.

The kinked demand curve reflects the strategic behavior of firms in an oligopoly and the
market's inherent uncertainty. It suggests that firms perceive a certain "price stickiness" and
adjust their prices less frequently due to the expected reactions of their competitors. This leads
to a gap in the marginal revenue curve at the prevailing price, causing the kink in the demand
curve.

Overall, the kinked demand curve under oligopoly demonstrates how firms' strategic interactions
and the anticipation of their rivals' reactions can shape their pricing decisions. The theory
highlights the complexities and challenges faced by firms operating in an oligopolistic market
structure, where the actions of each firm can have profound implications for the entire industry.

Game theory and strategic behavior: The kinked demand curve can be analyzed through the
lens of game theory. Firms in an oligopoly are engaged in a strategic game where they
anticipate and react to the actions of their competitors. Each firm considers the potential gains
and losses associated with its pricing decisions and the possible responses of other firms. This
strategic behavior leads to a situation where firms are hesitant to deviate from the prevailing
price, resulting in the kinked demand curve.

Price leadership: In some oligopolistic markets, one dominant firm may act as a price leader,
and other firms follow its pricing decisions. The price leader sets the price, and the other firms
adjust their prices accordingly. The kinked demand curve theory can explain the stability of
prices under such price leadership. If the price leader changes its price, other firms may adjust
their prices to match the change, reinforcing the kinked demand curve pattern.

Uncertainty and stability: The kinked demand curve theory also addresses the issue of
uncertainty in oligopoly markets. Firms often face uncertainty regarding their competitors'
reactions to price changes. This uncertainty leads to a stable market outcome, as firms are
hesitant to make significant price adjustments due to the potential risks involved. The kinked
demand curve reflects the stability that arises from the expectation of a specific price range
within which firms prefer to operate.

Profits and barriers to entry: The kinked demand curve theory suggests that oligopolistic firms
can earn substantial profits in the long run. The theory assumes that the kinked demand curve
results in a relatively stable price and quantity equilibrium. This stability, combined with
non-price competition and barriers to entry, allows firms to maintain their market positions and
earn economic profits. Barriers to entry, such as high capital requirements, technological
superiority, or strong brand recognition, contribute to the persistence of oligopoly and the
potential for sustained profitability.
Criticisms and alternative theories: While the kinked demand curve theory provides insights into
the behavior of firms under oligopoly, it has faced some criticisms. Critics argue that the theory
may oversimplify the complexities of oligopoly behavior and fails to account for factors such as
collusion and strategic entry deterrence. Alternative theories, such as the Cournot model,
Stackelberg model, and Bertrand model, offer different perspectives on oligopoly behavior and
provide additional explanations for pricing and output decisions.

Real-world examples: Oligopoly markets can be found in various industries, such as

telecommunications, automotive, aircraft manufacturing, and soft drinks. For instance, in the soft
drink industry, Coca-Cola and PepsiCo dominate the market and engage in non-price
competition through extensive advertising, product differentiation, and brand loyalty. Their
pricing decisions often reflect the kinked demand curve pattern, with a reluctance to significantly
deviate from prevailing prices.