Question

Explain Sweezy's kinked demand curve model? Why does the demand curve have a kink?

Short answer

In summary, Sweezy's kinked demand curve model is a non-collusive oligopoly model that helps to explain price rigidity in the market. The kink in the demand curve arises due to the asymmetry of firms' reactions to price changes, where firms believe that competitors will follow price decreases but not price increases. As a result, the demand curve becomes steeper below the prevailing price and flatter above it, creating the characteristic kink at the prevailing price level. This kinked demand curve model demonstrates that oligopolistic firms have limited incentives to change their prices, resulting in relatively stable prices in the market.

Step-by-step solution

1. Introduction to Sweezy's kinked demand curve model

Sweezy's kinked demand curve model is a non-collusive oligopoly model developed by economist Paul Sweezy. In this model, the demand curve faced by an individual firm is assumed to be kinked, i.e., it has a sharp bend. The model helps to explain price rigidity in oligopolies, where firms tend to change their prices less frequently compared to other market structures.

2. Key features of the kinked demand curve model

The key features of the kinked demand curve model are: - Non-collusive oligopoly: Firms do not coordinate or conspire with one another to set prices or output levels. - Price rigidity: Firms are reluctant to change their prices, resulting in a relatively stable price in the market. - Asymmetry of reactions: Firms are more likely to respond to price increases by competitors than to price decreases.

3. Assumptions of the model

Sweezy's kinked demand curve model is based on the following assumptions: - Each firm believes that competitors will follow if it decreases its price, but will not follow if it increases its price. - The market is in a non-collusive oligopoly setting, where firms are price setters and have some influence over market prices.

4. Explanation and graphical representation of the kinked demand curve model

In the kinked demand curve model, the firm faces two demand curves: - An elastic demand curve (D1) for price increases: If the firm raises its price, competitors will not follow, causing the firm to lose a significant portion of its market share. - An inelastic demand curve (D2) for price decreases: If the firm lowers its price, competitors will follow, and the firm will not gain any significant increase in market share. The kink in the demand curve occurs at the point where these two demand curves intersect. This point represents the prevailing price and quantity in the market. Here's a graphical representation of the kinked demand curve model: [graph showing D1 and D2 intersecting at the kink, labeled P* and Q* for price and quantity]

5. Reason for the kink in the demand curve

The kink appears in the demand curve due to the asymmetric assumption regarding firms' reactions to price changes. Since firms believe that competitors will follow price decreases (and thus not allow them to gain a larger market share) but won't follow price increases (leading to a loss of market share), the demand curve becomes steeper below the prevailing price and flatter above it. This creates a sharp bend or kink at the prevailing price level in the market. The kinked demand curve helps explain the price rigidity observed in many oligopolistic markets, as it shows that firms have limited incentives to change their prices under these assumptions.

Key concepts

Oligopoly

An oligopoly is a market structure where a few large firms dominate the industry, each with significant control over pricing and market conditions. Unlike perfect competition or monopoly, where many firms or a single entity hold sway, an oligopoly occupies a middle ground, combining traits from both competitive and monopolistic markets. Firms within an oligopoly are well aware of their interdependence, acknowledging that the actions of one firm can substantially impact the others. This mutual awareness often leads to strategic behavior.

Because there are only a few competitors, each with a sizable market share, their strategies, especially regarding pricing and output, can vary widely compared to other market forms. Oligopolistic competition can manifest in various ways, such as through price wars, collusion, product differentiation, and advertising.

Price Rigidity

Price rigidity refers to the phenomenon where prices remain stable and do not adjust quickly to changes in supply or demand. This is particularly noticeable in oligopolistic markets, where firms prefer to maintain current prices rather than adjusting them in response to market pressures. Several factors contribute to this rigidity, including the potential for price wars that can erode profits, the existence of implicit or explicit agreements among firms, and the fear of setting off a negative chain reaction with competitors.

Price rigidity means that even when costs rise or fall, or when demand fluctuates, oligopolistic firms might choose to absorb changes in profit margins to maintain their pricing strategies and the status quo. This stability offers predictability for both firms and consumers, but it can result in inefficiencies within the market.

Non-collusive Oligopoly

A non-collusive oligopoly is an oligopolistic market where firms act independently and competition exists without explicit agreements between firms to fix prices or output levels. Unlike their collusive counterparts, where firms might engage in activities like cartels or price-fixing, non-collusive oligopolists do not coordinate their strategies.

Non-collusive firms often engage in competition through means other than price, like marketing and product innovation, due to the perceived repercussions of price alterations. While collusion might bring higher collective profits, non-collusive behaviour can lead to more dynamic markets and greater consumer benefits due to the innovation and competitive actions it incentivizes.

Asymmetric Reactions

Asymmetric reactions in the context of oligopoly refer to the unequal response of firms to the pricing decisions of their competitors. This concept is a cornerstone of the Sweezy's kinked demand curve model, which posits that firms will react differently to a price increase than they would to a price decrease by a competitor.

When a firm lowers its prices, other firms in the oligopoly are likely to follow in order to maintain their market share, leading to a potentially harmful price war. Conversely, when a firm raises its prices, competitors are less likely to match these higher prices as they can benefit from gaining a larger share of price-sensitive customers. This imbalance in reactions leads to a kinked demand curve, manifesting the reluctancy of oligopolists to alter prices and thus contributing to overall price rigidity in the market.

Implications of Asymmetric Reactions

Understanding asymmetric reactions helps economists and businesses predict market behaviors in oligopolies, aiding in strategizing and policy-making to ensure competitive yet stable market conditions.