For a large firm, a change in prices might be expensive. The new catalogues have to be issued; dealers must be informed and so on. The oligopoly model with the kinked demand curve offers an explanation of price rigidity.
This kinked demand curve model of oligopoly price- output behaviour was reported by Paul M. Sweezy in 1939. For instance, the price of steel rails had remained at $ 28 per ton between 1901 and 1916 and at $ 43 per ton between 1922 and 1933 in the USA.
The kinked demand curve hypothesis does not explain price determination under oligopoly; it only explains why, once an oligopoly price has been determined, it will remain rigid or unaltered.
The kinked demand curve and the argument that goes with it describe a pattern of business behaviour such that the firm has no incentive to raise it price or to lower it. The firm’s attitude rests on an estimate of what its rivals will and what they will not do.
The firm believes that though its rivals will not imitate an increase in price, they will follow a price reduction. Acting on this belief, the firm adheres to its price, seeing no change until some upheaval occurs such as a major movement in demand or in costs.
Corresponding to a kink in the demand curve, there will be a discontinuity in the marginal revenue curve.
The length of this discontinuity (xy) depends on the elasticity’s of the two parts of the demand curve. The oligopolies’ demand curve is represented by DKD’ with the prevailing price as OP and output as OM.
The marginal revenue curve is discontinuous because of the kink in the demand curve at K. Hence marginal revenue is represented by the two line segments MRX and MR’Y.
If the marginal cost curve, MC passes through the gap XY in the marginal revenue curve, the most profitable alternative is to maintain the current price output policy.
Profit may not be increased by increasing price, since MR MC and this difference would increase with a price increase. Similarly, profits may not be increased by decreasing price, since MR MC and this difference will also increase with a price decrease.
Therefore, the profit- maximizing level of price and output remains constant for the firm, which perceives itself to be faced with a kinked demand curve, even though costs may change over a rather wide range, for example, MC and MC2.
Similarly, shifts in the demand curve either to the right or to the left may not change the price decision of the firm.
Since the kink is established at the prevailing price, a shift in demand shifts the gap (XY) in the marginal revenue curve to the right or left. If marginal cost still passes through the gap, the prevailing price is maintained, although output will either increase or decrease.
The peculiarity of the diagram of the kinked demand curve is the gap in marginal revenue which comes from the abrupt change from the more elastic to the less elastic parts of the demand curve. The gap is shown by the line XY.
The MC curve intersects the gap, which can be regarded as if it were a vertical section of the marginal revenue curve.
The kinked demand curve model of oligopolistic behaviour, however, has a serious flaw. Although the model provides a theoretical explanation for why stable prices have been observed to exist in some oligopolistic industries, it takes the prevailing price as given and provides no justification for why that price level rather than some other is the prevailing price. Nor does the model explain how a new kink forms around a new price.