Non-collusive oligopoly: the kinked demand curve

Oligopoly is more complex than the other market models. Therefore, there are several models of
oligopolistic behaviour, which share the following characteristics:

• There is a small number of large firms. The term ‘oligopoly’ derives from the Greek word ολιγοπω′λιο
meaning ‘few sellers’. Oligopolistic industries are dominated by a small number of large firms, though in
any one industry the firms are likely to vary in size.

• There are high barriers to entry. All the barriers to entry discussed under monopoly are relevant to
oligopoly. They include economies of scale, making it very difficult for new firms starting on a small scale
to compete due to very high costs (for example, the aircraft and car industries); legal barriers such as
patents (the pharmaceutical industry); control of natural resources (such as oil, copper, silver);
aggressive tactics such as advertising or threats of takeovers of potential new firms. An additional
barrier to entry in oligopoly involves high start-up costs (the costs of starting a new firm) associated with
developing a new or differentiated product. Many established oligopolies spend enormous sums on
product differentiation and advertising, making it difficult for new firms to match such expenditures.

• Products produced by oligopolistic firms may be differentiated or homogeneous (undifferentiated).

• There is mutual interdependence. Firms in perfect and monopolistic competition, due to their large
numbers in an industry, behave independently of each other, so when they make decisions such as how
much to produce they do not take the possible actions of other firms into consideration. By contrast, the
small number of firms in oligopolistic industries makes the firms mutually interdependent; decisions
taken by one firm affect other firms in the industry, so they depend on each other. If any one firm
changes its behaviour, this can have a major impact on the demand curve facing the other firms.
Therefore, firms are keenly aware of the actions of their rivals.

Strategic behaviour and conflicting incentives !

Explain why interdependence is responsible for the dilemma faced by oligopolistic firms—whether to
compete or to collude.

Mutual interdependence has important implications for the behaviour of oligopolistic firms:

• Strategic behaviour. Strategic behaviour is based on plans of action that take into account rivals’
possible courses of action. It is similar to playing a card game, or chess, where individual players’ actions
are based on the expected actions and reactions of their rival(s). Strategic behaviour of oligopolistic
firms is the result of their mutual interdependence. For example, a firm plans a course of action X
assuming its rivals will follow one policy, and it plans course of action Y assuming its rivals follow a
different policy. Under oligopoly, firms planning their strategies make great efforts to guess the actions
and reactions of their rivals in order to formulate their own strategy.

• Conflicting incentives. Firms in oligopoly face incentives that conflict, or clash with each other:

Incentive to collude – the term collusion refers to an agreement between firms to limit competition
between them, usually by fixing price and therefore lowering quantity produced. By colluding to limit
competition, they reduce uncertainties resulting from not knowing how rivals will behave, and maximise
profits for the industry as a whole.

Incentive to compete – at the same time, each firm faces an incentive to compete with its rivals in the
hope that it will capture a portion of its rivals’ market shares and profits, thereby increasing profits at
the expense of other firms.

Clearly, firms in an industry cannot both collude and compete; they must do one or the other.

Non-collusive oligopoly: the kinked demand curve

In the real world, prices of oligopolistic industries tend to be rigid or ‘sticky’; once a particular price is
reached, it tends to be relatively stable (it sticks) over long periods of time. Moreover, in situations when
prices do change, they tend to change together for all the firms in an industry. While price rigidities can
be easily explained by collusive oligopoly, they also appear in situations of non-collusive oligopoly,
where oligopolistic firms do not agree, whether formally or informally, to fi x prices or collaborate in
some way.

The kinked demand curve is a model that has been developed to explain price rigidities of oligopolistic
firms that do not collude, and is illustrated in Figure 7.25. In this model, firms do not make formal or
informal agreements with each other on how to fix or co-ordinate prices. Instead, their pricing
behaviour is strategic, and is strongly influenced by their expectations of how rival firms
will react if they undertake a price change. These expectations are reflected in the kinked (i.e. not
straight) demand curve facing each firm, as shown in the figure. Note that corresponding to the kinked
demand curve is a broken marginal revenue curve; the break in MR occurs exactly at the point of the
kink in the demand curve, and is a reflection of the abrupt drop in marginal revenue at the point where
the demand curve suddenly bends.

Imagine three firms, A, B, and C, each producing output Q1 and selling it at price P1; this price–quantity
combination is point Z at the kink of the demand curve. We want to see why the fi rms perceive the
demand curve facing them as having this peculiar shape.

Say that firm A considers a price change, but before changing (increasing or decreasing) its price, it tries
to predict how firms B and C will react, and what will be the consequences of their reaction. Firm A’s
reasoning is as follows:

• If I raise my price, what will B and C do? They are unlikely to increase their price, because if they
continue to sell at P1, many of my customers will leave me and start buying from B and C. Therefore, B’s
and C’s market share will increase, and mine will fall. I should therefore not increase my price. My
demand curve is relatively elastic above P1, because for any price increase I will face a relatively large
decrease in sales and revenues, and my profits may fall (though not all my customers will leave me
because of my differentiated product).
• If I drop my price, what will B and C do? They are likely to drop their price as well, because if they do
not, I will capture a large portion of their

sales, and I will be better off at their expense. But if they drop their price, I will capture only a small part
of their market shares. My demand curve is relatively inelastic below P1, because for any price decrease
I will have only a small increase in sales and revenues, and my profits may fall. I should therefore not
drop my price.

• I should therefore not change my price, and should continue selling at P1.

This line of reasoning is the same for all three fi rms, A, B and C.

This simple model illustrates three important points:

• Firms that do not collude are forced to take into account the actions of their rivals in making pricing
decisions. Otherwise they risk lowering their revenues and profits, which in turn could lead to price
instability. The kinked demand curve model illustrates the interdependence of oligopolistic firms.

• Even though the firms do not collude, there is still price stability. Firms are reluctant to change their
price because of the likely actions of their rivals, which could result in lower profits for the firm initiating
price changes.

• Firms do not compete with each other on the basis of price. They do not try to increase their sales by
attracting customers through lower prices. A lower price not only invites price cuts by rivals, with
resulting lower profits for all the firms, but also risks setting off a price war if some firms overreact with
price cutting.

Figure 7.25 also shows that the non-colluding firms’ price and output decision is consistent with a whole
range of different costs. MC1 is the upper limit and MC2 is the lower limit of marginal costs that are
consistent with producing output Q1 and selling this at price P1, by use of the MC = MR profit-
maximising rule. This is the result of the broken portion of the MR curve.

In the kinked demand curve model, each fi rm perceives the demand curve it faces to be elastic for
prices above P1 and inelastic for prices below P1. If one fi rm raises its price above P1, the others will not
follow; if it lowers its price below P1, the others will match the price decrease. In either case, the fi rm
will be worse off. Therefore, no fi rm takes the initiative to change its price, and they all remain ‘stuck’ at
point Z for long periods of time.

However, the model is subject to limitations:

• It cannot explain how the firms arrived at point Z, the point of the kink in the demand curve.

• It is inappropriate as an explanation of oligopolistic pricing behaviour during periods of inflation, when