Oligopolies and the Kinked Demand Curve Theory

Demand curves in oligopolies are kinked because of price “stickiness” – the phenomenon of prices staying the same – in oligopolistic markets. An oligopoly is comprised of a few mutually interdependent firms, each with a very large share of the market. If a firm raised its prices, all of its customers would turn to its competitors. If a firm lowered its prices, other firms would be forced to follow suit, and all firms would lose revenue. Even when production costs increase, firms in oligopolies resist raising prices. The social implications of price “stickiness” as explained by the kinked demand curve theory are that small cost savings and increases are not passed on to consumers.

Firms in an oligopoly tend to not raise prices because they face a very elastic demand curve above the market price. If a firm were to even slightly increase its prices, it would lose a huge portion of the market to its competitors. Below the market price, demand is inelastic. If a firm lowered its prices, it would not pick up a significant portion of the market because the firms’ mutually interdependent competitors would also have to lower their prices. Firms could gain a small amount in market share initially, but any market gains would be more than offset by what firms would lose in revenue per unit sold. The “kink” in the demand curve is formed by the elastic portion of the demand curve above the market price and the inelastic portion of the demand curve below the market price.

To understand the rationale of the kinked demand curve, it helps to think about its graph. A firm’s demand curve is also its average revenue (AR) curve. Each AR curve has its own marginal revenue (MR) curve, which falls in twice as steep as the AR curve. The “kinked” demand curve for firms in an oligopoly can be looked at as two different demand curves – the elastic demand curve above the kink and the inelastic demand curve below the kink – each with its own MR curve. The different MR curves create a discontinuity, the effect being a vertical portion of the MR curve at the profit-maximizing price and output level. As a result, the MR/marginal cost (MC) relationship is not defined at one specific point, instead, the MC cost curve can fall anywhere in between the vertical gap between the first MR curve and the second MR curve. Smaller increases and decreases in production costs do not change the market price, output level, or the MR/MC relationship. In any other market structure, a change in MC would move along a non-vertical MR curve, which would change the profit-maximizing price/quantity relationship.

Because MC can increase or decrease without altering the profit-maximizing price and output level, smaller cost savings and increases are not passed on to the consumer. There are still costs to society, but the market price does not reflect the relative scarcity or abundance of input resources. When prices in oligopolies do increase, it is because production costs keep rising and firms can no longer afford to keep prices the same forever – and all firms dramatically increase prices at once. At that point, the quantity demanded decreases, output falls, and the demand curve forms a kink around the new profit-maximizing price and output level. Much larger costs (and savings), then, are passed to consumers.