Page 197 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes Sweezy's Model of Kinked Demand Curve

According to Sweezy, the most distinguishing feature of oligopoly is that an individual firm
does not know (and cannot determine) the exact nature (functional form) of its actual demand
curve because of the uncertainty and indeterminacy of rivals' reactions to its own actions. An
oligopolistic firm is therefore guided in its decisions by the 'imagined' demand curve which is
based on what it expects to be the most likely (probable) reaction of its rivals.
Under oligopoly, a firm expects that when it raises its price, it is most likely that rival firms will
not follow suit by raising their prices. Instead, the rivals will keep their prices constant in order
to increase their sales at the expense of the firm that raises the price. Hence, when a firm
increases its price, its demand is expected to fall much more than it would if its rivals were not
to keep their prices constant. That is, for upward changes in price, a firm's demand is expected to
be highly elastic.
In contrast, when the firm lowers its product price, it is most likely that its rivals will follow suit
because if they did not do so they would lose sales to the firm that lowered the price. Hence,
when a firm reduces its price, its demand is expected to increase much less than would otherwise
have been the case (because its rivals will also reduce their prices). That is, for downward
changes in the price, a firm's demand curve is expected to be less elastic than it would have been
had the firm's rivals not followed suit by reducing their prices.
Consequently, for an oligopolistic firm, the demand curve is highly elastic and gradually falling
for prices above the current or existing price, and for prices below the current price the demand
curve is less elastic and steeply falling.

!
Caution Because of the differences in elasticity (and slope) at prices above and below the
current price, the demand curve of the firm has a corner or a kink at the current or existing
price.
In Figure 12.3 the firm's demand curve is APB, which has a kink or corner at current price P and
output ON. The upward segment AP is relatively more elastic than the downward segment PB.
That is, if e shows the elasticity of AP and e shows the elasticity of PB then e is > e . The
1 2 1 1 2
3 dotted line PB shows the decrease in the firm's demand that would have occurred if the rivals
1
were not expected to keep their prices constant when the firm raised price above P. Dotted line
PA shows the rise in demand if rivals were expected not to follow any fall in price below P.
1
Figure 12.3

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