of changes in demand or cost conditions. The model assumes that if an oligopolist
cuts its prices, competitors will quickly react to this by cutting their own
prices in order to prevent losing market share. On the other hand, if one firm
raises its price, it is assumed that competitors do not match the price rise, in
order to gain market share at the expense of the first firm. In this case the
demand curve facing a firm would be much more elastic for price increases
than for price reductions. This results in the kinked demand curve shown in
Figure 8.11. It should be noted that this is not a ‘true’ demand curve as defined
in Chapter 3, since it no longer assumes that other things remain equal, apart
from the price charged by the firm. If the price charged falls below P0, it is
assumed that other firms react to this and reduce their own prices. We might
call it an ‘effective’ demand curve.
The kink in the demand curve causes a discontinuity or break in the MR curve.
The consequence of this is that if the marginal cost function shifts from the
original function MC1 upwards or downwards within the range from MC2 to
MC3, then the profit-maximizing output will remain at Q0 and the price will
remain at P0, since the MC curve passes through the MR curve in the vertical
break. Similarly, if the demand curve shifts from D1 to D2, the MR curve will shift to
the right to MR2, but the original MC curve will still pass through the vertical break.
This means that the profit-maximizing output will increase from Q0 to Q1, but the
price will remain the same at P0. The reason for this is that the vertical break
occurs below the kink in the demand curve, which is at the prevailing price P0.
The above model can be criticized on three main grounds:
1 It takes the prevailing price as given; there is no attempt to explain how this
prevailing price is determined in the first place.