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Regarding Paul Sweezy’s Kinked Demand Curve Theory, respond to the following questions:
(i) What is the price elasticity of demand assumed by the kinked demand curve model of oligopoly?
(ii) Discuss the discontinuous form that this model gives the marginal revenue curve.
Understanding the Kinked Demand Curve Theory by Paul Sweezy
The Kinked Demand Curve model, developed by Paul Sweezy, is a significant theory in understanding pricing behavior in oligopolistic markets. It provides insights into why prices in such markets tend to be rigid or sticky.
1. Assumptions about Price Elasticity of Demand
The Kinked Demand Curve model makes specific assumptions about the price elasticity of demand in an oligopoly.
a. Above the Current Price: The model assumes that if a firm raises its price above the prevailing market price, other firms will not follow suit. As a result, the price-elasticity of demand for the firm’s product becomes highly elastic because consumers will switch to the substitutes offered by competitors. This leads to a significant loss in market share and revenue for the firm that increased its price.
b. Below the Current Price: Conversely, if a firm lowers its price below the market level, the model assumes that other firms will match this price cut to avoid losing their market share. Therefore, the price-elasticity of demand becomes inelastic for price reductions, as the firm gains little to no additional market share but earns less revenue per unit sold.
2. The Kinked Demand Curve
The kinked demand curve reflects the aforementioned assumptions about price elasticity.
a. Shape of the Curve: The demand curve is relatively elastic above the current market price and relatively inelastic below it. This creates a kink in the demand curve at the current market price.
b. Implications for Pricing: The kinked demand curve suggests that firms in an oligopoly will experience a significant decrease in total revenue for price increases and only a marginal increase in total revenue for price decreases. This creates a situation where the most profitable option is to maintain the current price, leading to price rigidity in the market.
3. Discontinuous Marginal Revenue Curve
The kinked demand curve leads to a unique shape of the marginal revenue (MR) curve.
a. Shape and Discontinuity: The MR curve corresponding to the kinked demand curve is discontinuous. It breaks or becomes disjointed at the point of the kink. This is because the slope of the demand curve changes abruptly at the kink, reflecting the change in elasticity.
b. Implications for Output Decisions: The discontinuity in the MR curve implies that marginal revenue can vary significantly for a small change in quantity sold around the kink. However, within a range of output levels around the current equilibrium, the MR curve may not intersect the marginal cost (MC) curve. This means that changes in MC within this range do not affect the profit-maximizing level of output or price, further contributing to price rigidity.
Conclusion
The Kinked Demand Curve model by Paul Sweezy provides a compelling explanation for price rigidity in oligopolistic markets. It highlights how assumptions about the price elasticity of demand lead to a kinked demand curve, which in turn results in a discontinuous marginal revenue curve. These characteristics of the model explain why firms in an oligopoly might choose to maintain stable prices despite changes in cost or other market conditions. The Kinked Demand Curve theory remains an important tool for understanding the strategic behavior of firms in oligopolistic markets.