Kinked demand
Encyclopedia
The kinked demand curve theory is an economic theory
regarding oligopoly
and monopolistic competition
. When it was created, the idea fundamentally challenged classical economic tenets such as efficient markets and rapidly changing prices, ideas that underlie basic supply and demand
models. Kinked demand was an initial attempt to explain sticky
prices.
s are similar in that they are both downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity
at the bend - the "kink." Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue
curve.
Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly
or monopolistic competition
) will set marginal costs equal to marginal revenue
. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity.
The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price-elastic for price increases and less so for price falls.
The two seminal papers on kinked demand were written nearly simultaneously in 1939 on both sides of the Atlantic. Paul Sweezy
of Harvard College published "Demand Under Conditions of Oligopoly." Sweezy argued that an ordinary demand curve does not apply to oligopoly
markets and promotes a kinked demand curve.
From Queen's College
in Oxford, Robert Lowe Hall and Charles J. Hitch
wrote "Price Theory and Business Behavior," presenting similar ideas but including more rigorous empirical testing, including a business survey of 39 respondents in the manufacturing industry.
Hall and Hitch further present a hypothesis for the initial setting of prices; this explains why the "kink" in the curve is located where it is. They base this on a notion of "full cost" - marginal cost
of each unit plus a percent of overhead costs or fixed costs with an additional percent added for profit. They emphasize the importance of industry tradition in history in determining this initial price, noting further, "An overwhelming majority of the entrepreneurs thought that a price based on full average cost…was the ‘right’ price, the one which ‘ought’ to be charged."
have argued against kinked demand. His primary opposition is summarized in a Working Paper out of the Stanford University
Economics Department by seminal authors Elmore, Kautz, Walls et al.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
regarding oligopoly
Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers . The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι "few" + πόλειν "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others...
and monopolistic competition
Monopolistic competition
Monopolistic competition is imperfect competition where many competing producers sell products that are differentiated from one another...
. When it was created, the idea fundamentally challenged classical economic tenets such as efficient markets and rapidly changing prices, ideas that underlie basic supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
models. Kinked demand was an initial attempt to explain sticky
Sticky (economics)
Sticky, in the social sciences and particularly economics, describes a situation in which a variable is resistant to change. Sticky prices are an important part of macroeconomic theory since they may be used to explain why markets might not reach equilibrium right away. Nominal wages are often said...
prices.
Theory
"Kinked" demand curves and traditional demand curveDemand curve
In economics, the demand curve is the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule...
s are similar in that they are both downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity
Discontinuity
Discontinuity may refer to:*Discontinuity , a harmless irregularity in a casting*Discontinuity in geotechnics is a plane or surface marking a change in physical or chemical properties in a soil or rock mass...
at the bend - the "kink." Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue
Marginal revenue
In microeconomics, marginal revenue is the extra revenue that an additional unit of product will bring. It is the additional income from selling one more unit of a good; sometimes equal to price...
curve.
Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly
Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers . The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι "few" + πόλειν "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others...
or monopolistic competition
Monopolistic competition
Monopolistic competition is imperfect competition where many competing producers sell products that are differentiated from one another...
) will set marginal costs equal to marginal revenue
Marginal revenue
In microeconomics, marginal revenue is the extra revenue that an additional unit of product will bring. It is the additional income from selling one more unit of a good; sometimes equal to price...
. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity.
The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price-elastic for price increases and less so for price falls.
Formulation
Paul Sweezy
Paul Marlor Sweezy was a Marxist economist, political activist, publisher, and founding editor of the long-running magazine Monthly Review...
of Harvard College published "Demand Under Conditions of Oligopoly." Sweezy argued that an ordinary demand curve does not apply to oligopoly
Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers . The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι "few" + πόλειν "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others...
markets and promotes a kinked demand curve.
From Queen's College
The Queen's College, Oxford
The Queen's College, founded 1341, is one of the constituent colleges of the University of Oxford in England. Queen's is centrally situated on the High Street, and is renowned for its 18th-century architecture...
in Oxford, Robert Lowe Hall and Charles J. Hitch
Charles J. Hitch
Charles J. Hitch was Assistant Secretary of Defense from 1961 to 1965. He was president of the University of California from 1967 to 1975....
wrote "Price Theory and Business Behavior," presenting similar ideas but including more rigorous empirical testing, including a business survey of 39 respondents in the manufacturing industry.
Hall and Hitch further present a hypothesis for the initial setting of prices; this explains why the "kink" in the curve is located where it is. They base this on a notion of "full cost" - marginal cost
Marginal cost
In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good...
of each unit plus a percent of overhead costs or fixed costs with an additional percent added for profit. They emphasize the importance of industry tradition in history in determining this initial price, noting further, "An overwhelming majority of the entrepreneurs thought that a price based on full average cost…was the ‘right’ price, the one which ‘ought’ to be charged."
Criticism
Others such as George StiglerGeorge Stigler
George Joseph Stigler was a U.S. economist. He won the Nobel Memorial Prize in Economic Sciences in 1982, and was a key leader of the Chicago School of Economics, along with his close friend Milton Friedman....
have argued against kinked demand. His primary opposition is summarized in a Working Paper out of the Stanford University
Stanford University
The Leland Stanford Junior University, commonly referred to as Stanford University or Stanford, is a private research university on an campus located near Palo Alto, California. It is situated in the northwestern Santa Clara Valley on the San Francisco Peninsula, approximately northwest of San...
Economics Department by seminal authors Elmore, Kautz, Walls et al.
Contemporary reformulation
Game theory and models of strategic interaction have largely replaced kinked demand to explain price dislocations and slowly adjusting prices. For further information see:Reading on contemporary applications
- A Duopoly Price Game
- A Theory of Dynamic Oligopoly, Price Competition, Kinked Demand Curves, and Edgeworth Cycles
- Competition in the Aluminium Industry 1945-58
- The Kinked Demand Curve: A Game-Theoretic Approach
Further reading
- Bhaskar, V., S. Machin and G. Reid "Testing a Model of the Kinked Demand Curve." The Journal of Industrial Economics 39, no. 3 (March 1991): 241-254.
- Borenstein, Severin. "Evolution of U.S. Airline Competition." The Journal of Economic Perspectives 6, no. 2 (Spring 1992):45-73.
- "Economic focus: Sticky situations," The Economist, 11 November 2006, 88.
- Elmore, Kautz, Walls et al."Kinked Expectations", Working Paper, Stanford University.
- Greenwald, B., J.E. Stiglitz. "Keynesian, New Keynesian and New Classical Economics." Oxford Economic Papers, n.s., 39, no.1 (March 1987): 119-133.
- Jones, Kit. An Economist Among Mandarins: A biography of Robert Hall (1901-1988). Cambridge: Cambridge University Press, 1994.
- Meister, J. Patrick. "Oligopoly: An In-Class Economic Game." The Journal of Economic Education, vol. 30, no. 4. (Autumn, 1999): 383-391.
- O'Brien, D.P. The Classical Economists Revisited. Princeton: Princeton University Press, 2004.
- Primeaux, Walter J. and Mark R. Bomball. "A Re-examination of the Kinked Oligopoly Demand Curve." The Journal of Political Economy 82, no. 4 (1974): 851-62.
- Primeaux, Walter J. and Mickey C. Smith. "Pricing Patterns and the Kinky Demand Curve." The Journal of Law and Economics 19, no. 1 (1976):189-99.
- Rothschild, K. W. "Price Theory and Oligopoly." The Economic Journal 57, no. 227 (September 1947): 299-320.
- "Round Table on Monopolistic and Imperfect Competition." American Economic Review 27, no. 2. (June 1937): 324-326.
- Sawyer, Malcolm. "Post-Keynesian and Marxian Notions of Competition: Towards a Synthesis." In Competition, Technology and Money: Classical and Post-Keynesian Perspectives, ed. Mark A. Glick, 3-22. Brookfield, VT: Edward Elgar Publishing Co., 1994.
- Sen, Debapriya. "The Kinked Demand Curve Revisited." Economics Letters 84 (2004):99-105.
- Simon, Julian L. "A Further Test of the Kinky Oligopoly Demand Curve." The American Economic Review 59, no. 5, (1969): 971-975.
- Smith, Victor E. "Note on the Kinky Oligopoly Demand Curve." Southern Economic Journal 15, no.2, (1948): 205-210.
- Stein, Jerome L. Monetarist, Keynesian, and New Classical Economics. Oxford: Basil Blackwell Publishing, 1982.
- Managerial Economics. "G S Gupta"