An often-noted characteristic of oligopoly markets is "sticky" prices. Once a general price level has been established, whether through cartel agreement or some less formal arrangement, it tends to remain fixed for an extended period. Such rigid prices are sometimes explained by what is referred to as the kinked demand curve theory of oligopoly prices. A kinked demand curve is a firm demand curve that has different slopes for price increases as compared with price decreases. The kinked demand curve describes a behavior pattern in which rival firms follow any decrease in price to maintain their respective market shares but refrain from following price increases, allowing their market shares to grow at the expense of the competitor increasing its price. The demand curve facing individual firms is kinked at the current price/ output combination, as illustrated in Figure 11.6. The firm is producing Q units of output and selling them at a price of P per unit. If the firm lowers its price, competitors retaliate by lowering their prices. The result of a price cut is a relatively small increase in sales. Price increases, on the other hand, result in significant reductions in the quantity demanded and in total revenue, because customers shift to competing firms that do not follow the price increase.
Associated with the kink in the demand curve is a point of discontinuity in the marginal revenue curve. As a result, the firm's marginal revenue curve has a gap at the current price/ output level, which results in price rigidity. To see why, recall that profit-maximizing firms operate at the point where marginal cost equals marginal revenue. Typically, any change in marginal cost leads to a new point of equality between marginal costs and marginal revenues and to a new optimal price. However, with a gap in the marginal revenue curve, the price/output combination at the kink can remain optimal despite fluctuations in marginal costs. As illustrated in Figure 11.6, the firm's marginal cost curve can vacillate between MC-y and MC2 without causing any change in the profit-maximizing price/output combination. Small changes in marginal costs have no effect; only large changes in marginal cost lead to price changes. In perfectly competitive grain markets, prices change every day. In the oligopolistic ready-to-eat cereals market, prices change less frequently.
When price cuts are followed but price increases are not, a kink develops in the firm's demand curve. At the kink, the optimal price remains stable despite moderate changes in marginal costs.
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