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Micro Economics

Notes materials or labour rise, profits will get squeezed and when these costs fall, the benefit of lower

input costs will not be passed on to the consumers.
Thus the Sweezy model of Kinked demand curve under oligopoly explains why prices of

oligopolistic firms are inflexible and fail to reflect short run changes in variable costs of raw

materials and wages.
The principal shortcoming of the Sweezy model is that it does not explain how the existing or
current price is determined, and this is a criticism that Sweezy accepts.
13.3.2 Hall and Hitch Version of Kinked Demand Curve

The Hall and Hitch model of the Kinked demand curve is based on an empirical survey of a
sample of 38 well managed firms in England. The survey was conducted by these two Oxford

economists to find out how firms in the real world determine price and output.
The principal findings of the study were as follows:

1. In the real world, most manufacturing firms operate in oligopolistic markets.

2. Contrary to what is assumed by economic theory, in reality oligopolistic firms do not know
their demand curve because of uncertainty regarding their rivals’ reaction. They do not
therefore know their marginal revenue curve. Since most large firms tend to be multi-

product firms, they also do not know the marginal cost curve. Thus in the real world,

firms cannot determine equilibrium price and output by marginalist calculations, i.e., by
equating marginal revenue and marginal costs.
3. Oligopolistic firms in reality determine their price on the basis of the full cost principle.

They charge that price which not only covers variable and fixed costs but also yields a fair

profit margin. The full cost is the sum of average variable cost (AVC) and average fi xed cost
(AFC) at normal output level and a predetermined percentage of this sum added for ‘fair’

(reasonable) profit. In short, according to this principle Price = Full cost = (AVC + AFC) at

Normal Output + ‘Fair’ profits as a percentage of (AFC + AVC).

Example: If normal output is 1000 units, total fixed and total variable costs at this

output are ` 8000 and 2000, respectively, and fair profit is considered to be 10 per cent, then
full cost price = 8 + 2 + 1 = 11 `/Unit.
4. The demand curve has a kink at the price which is equal to full cost price. If a fi rm charges
a price higher than full cost, its rivals will not follow suit but will keep their prices constant.
Hence, for prices higher than the full cost price, the demand curve of an oligopolist has
high elasticity. If the firm charges a price lower than full cost price, its rivals will follow

suit by lowering their prices. Hence, for prices less than the full cost price, the oligopolist’s
demand curve has relatively low elasticity.
5. Oligopolistic firms adopt full cost pricing rule because it not only covers AFC at normal

output but also earns a reasonable rate of profit. The objective of oligopolistic fi rms is to

have long run stable profits and a ‘quiet life’, free from uncertainities. If profi ts exceed
what is regarded as a ‘reasonable’ or ‘fair’ rate, it may attract new entrants and accusation
of ‘excessive’ profits from customers as well as distributors. Both these consequences will

cause instability of long run profits and make life difficult (unquiet) for fi rm’s decision

makers. Similarly, charging a price below full cost will be considered ‘unethical’ by

competitors and create a threat of price war. Also, it is difficult to raise price later to the full

cost level. Thus, for oligopolistic firms, price tends to remain rigid or sticky at the full cost
level, and short run changes in costs and demand will not cause changes in the oligopolistic
price.

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