# The Kinked Demand Curve Model

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## The Kinked Demand Curve Model

Remember that there are many different models that try to explain the behaviour of oligopolistic firms. This is the only diagrammatical one that you need to know for A level. Other features of oligopoly will be covered in the next sub-section.

As mentioned previously, firms in oligopoly are interdependent. They monitor each other's actions closely because any action by one firm will directly affect the others. This model tries to explain why we see so much price rigidity in oligopoly. Have you noticed that nearly every petrol station charges more or less the same price for a litre of unleaded? This model should explain why.

Assume that the price of a litre of unleaded petrol is 85p. This is the price charged by all three firms in your area. If one of the three firms put their price up to 90p a litre, what would happen next? Most people would buy their petrol from one of the other two firms. The price-raising firm will experience a large proportionate drop in sales relative to the proportionate rise in price, and so a drop in revenue. It will have found that the demand for its petrol following the price rise was very elastic. This is because the other two firms knew that they would gain extra sales if they left their price at 85p, so they did not follow the price rise.

What if one of the firms decided to cut its price to 80p a litre? Most consumers would try and buy their petrol from the cheaper firm. The other two firms know this is going to happen following the price cut, so they match the price cut (see price wars later). Assuming that overall demand is unlikely to rise substantially, all three firms will find that the rise in demand for their petrol is proportionately small compared with the proportionate fall in price, so their revenues fall. Demand is very inelastic following a price cut.

Hence, all three firms face a demand curve that is elastic (quite flat) above 80p and inelastic (fairly steep) below 80p. There is little incentive to raise or lower price. There has to be a kink in the demand curve at price 80p.

This first diagram shows the revenue curves and how they are derived. You can see the black AR curve with the kink at point A. This demand curve is relatively flat above A and relatively steep below A. As a result of the kink in the demand curve, the MR curve has a discontinuity in it - it jumps suddenly from point B to point C. This makes sense if you remember how all marginals and averages are linked. A substantially lower MR can only explain the sudden change in direction of the AR curve.

The dotted red lines help to explain. You can see where the AR and MR curves have come from. In particular, you can see where and why point C starts where it does. Note that the kink is the equilibrium, which in our example is the 80p litre of petrol.

Another way of explaining why the price tends to remain at 80p can be seen in the diagram above. Using the good old profit maximising condition, MC = MR, you can see that this occurs for all marginal cost curves between MC1 and MC2. So, for quite a large spread of cost levels, the firm will maximise profits at price 80p and quantity Q1.

The diagram can also be used to explain why the price of petrol does tend to rise eventually. If there is a substantial rise in costs, shifting the MC curve above position MC2, then MC = MR will occur further up the MR curve and the price will rise above 80p. In the real world, we see this happening when the government increase petrol duties every year in the Budget, and in the first half of the year 2000, oil price rose substantially, causing all petrol retailing firms to raise their price. Notice, though, that when the price does rise, it then settles at the higher price for a while at all petrol stations (is collusion going on?)! Basically, the kinked demand curve model still holds, it's just that the kink (point A) has shifted up a bit. All this price rigidity means that firms do not compete on price, so they have to resort to non-price competition (see later).

The main weakness with this model is that it is not a theory of price determination. In other words, how does one arrive at the initial price and quantity? Also, we assumed (with petrol) that demand in the market, as a whole was inelastic. If demand was elastic, then the situation where all three firms drop their price might result in an increase in revenue for each firm. Surely, though, the market would reach saturation point eventually. A point must come where a given fall in price causes a smaller (proportionate) rise in demand, and so revenues would fall.

#### Other features of oligopoly

Collusion

Businesses hate uncertainty. Unfortunately, there is a lot of uncertainty in oligopoly. Firms need to know how other firms are going to act, and how they will react to their own strategies. This is very difficult, so firms in oligopoly often avoid this uncertainty by colluding. This means getting together and making an agreement about quantities produced and, therefore, prices. Some cartels (an informal agreement) are very open, the classic example being OPEC. They were very powerful in the 70s, less so in the 80s and 90s (oil is not so important to industry nowadays), but have managed to show that they still matter in 1999/2000, forcing the price of a barrel of oil up to \$30 (a doubling in one year).

The goal of a cartel is for the few firms in the industry to join together and, effectively, form a monopoly. The shared profit will be higher than if the firms were competing with each other. The big problem, of course, is the fact that it is tempting for a member of the cartel to cheat! This tended to happen in oil particularly. Agreements to restrict output (or extraction) of oil meant that the price rose, which was good for the oil producing countries. But some of the countries involved were otherwise relatively poor. It is tempting to increase output and sell as much of it as you can at the higher price before everyone else cottons on. Of course, once the culprit is spotted, everyone cheats and the agreement falls apart. The 1999/2000 agreement is unusual in that all the countries involved seem to be keeping to it!

Of course, most cartels, formal or secret, are illegal. It is an attempt by the firms in an oligopolistic situation to eliminate any competition, which is bad for the consumer. In the UK, collusion of any kind was outlawed in the 1956 Restrictive Trade Practices Act. So, there are no formal cartels in the UK anymore (although there used to be allowed cartels in the cement industry and the book industry), but it is difficult to believe that the heads of major firms in oligopolistic markets do not 'converse' with each other on occasion. Or is it just a coincidence that the prices are similar in the food retailing industry, the electrical goods retailing industry and the new car market? Hmmmm!

Non-price competition

This is an important aspect of oligopoly because, as we have seen with the kinked demand curve model, price competition is difficult. If you do Business Studies A level as well, you have probably heard of the 4 Ps marketing mix. Product (that appeals), Price (difficult to vary significantly), Promotion (advertising, marketing, etc.) and Place (having a good distribution, good retail outlets, etc.)

Quality is an important area of competition. All family saloon cars are similar today, but which ones have air-conditioning fitted as standard?

Branding is immensely important. Firms with established brands can easily charge a premium on their products. This is why advertising is so important.

There are many other tricks of the trade: free gifts; BOGOF (buy one get one free); quality of after sales service; changes in packaging; free delivery; loyalty cards (especially with the supermarkets) and discounts (like the petrol vouchers).

More recently, we have seen firms diversify to attract custom (supermarkets offering banking and insurance services) and some have even started to offer shopping 'on-line' using the Internet.

Limit and predatory pricing

Limit pricing is where the firms in oligopoly try to set a price that limits the entry of new firms into the industry. They try to set a price that is low enough to put new entrants off, but hopefully still high enough to make some sort of profit. It is temporary and not really designed to be a loss leader, unlike predatory pricing, where, as the title suggests, the goal is to kill off an existing competitor. The price is reduced to below cost price, a definite loss leader, so that the competitor cannot cope. Once the competitor has left the market, the price can be raised back up to the old level and there are more customers to go round! In recent years, it appears that the quality newspaper market is a good example. Certainly, 'The Times' newspaper cut its price to very low levels. The target was probably 'The Independent', but they seem to have survived. One does wonder, though, how low the profits must be in that cut-throat market.

Price wars

There is not much to say here. Basically, it is where one firm cuts its price, the others follow and perhaps cut theirs by a little bit more, and so on. A war develops! Obviously, the motive is to protect, or increase, market share at the expense of immediate profits. Often this is the result of a broken collusive agreement (or cartel). In recent years, we have seen price wars in the following industries: newspapers (see above), fast food (McDonald's verses Burger King), mobile phones (especially between the four main networks) and package holidays.