Kinked demand

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 underly basic supply and demand models. Kinked demand was an initial attempt to explain sticky prices.

Theory

"Kinked" demand curves have in common with traditional demand curves that they are 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 decreases.

Formulation

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 apply to oligopoly markets and promotes a kinked demand curve.

From Queen's College in Oxford, Robert L. 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."

Criticism

Others such as George Stigler 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.

Quotation|New classical economists, lead by Chicago’s George Stigler, worked to discredit thekinked demand models. Stigler first argues that the kinked demand models are not useful, asHall and Hitch’s model only explains observed phenomenon and is not predictive. He furtherexplains that the kinked demand analysis only suggests why prices remain sticky and does notdescribe the mechanism that establishes the kink and how the kink can reform once priceschange. Stigler also asserts that the model is unnecessary because Chicago theory alreadyincluded allowances for short-run sticky prices due to collusion, menu costs, and regulatory orbureaucratic inefficiencies in markets|Elmore, Kautz, Walls et al.|Kinked Expectations, Working Paper Stanford University

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 [D.K. Osborne, “A Duopoly Price Game,” "Economica" n.s. 41, no. 162 (1974): 157-175]
*A Theory of Dynamic Oligopoly, Price Competition, Kinked Demand Curves, and Edgeworth Cycles [Eric Maskin and Jean Tirole, “A Theory of Dynamic Oligopoly, Price Competition, Kinked Demand Curves, and Edgeworth Cycles,” "Econometrica" 56, no. 3 (1988):571-599.]
* Competition in the Aluminium Industry 1945-58 [M.J. Peck, "Competition in the Aluminium Industry 1945-58", (Cambridge: Harvard University Press, 1961).]
*The Kinked Demand Curve: A Game-Theoretic Approach [ V. Bhaskar "The Kinked Demand Curve: A Game-Theoretic Approach," "International Journal of Industrial Organization" 6, (1998): 373.]

Elmore, Kautz and Walls et al. suggest in their working paper that studies of the airline industry, which exhibits canonical features of oligopolistic pricing, will indicate strategic interaction rather than kinked demand. [ Elmore, Kautz, Walls et al. [http://www.stanford.edu/~bwalls/Kinked%20Expectations.pdf "Kinked Expectations"] , Working Paper, Stanford University. ]

References

* Bhaskar, V. 1988. "The Kinked Demand Curve: A Game-Theoretic Approach" "International Journal of Industrial Organization" Vol. 6, pp. 373-384.

* Hall, R. and Hitch, C. 1939. "Price Theory and Business Behaviour" "Oxford Economic Papers" Vol. 2, pp. 12-45.

* Maskin, E. and Tirole, J. 1988. "A Theory of Dynamic Oligopoly, II: Price Competition, Kinked Demand Curves, and Edgeworth Cycles" "Econometrica" Vol. 56, pp. 571-599.

* Osborne, D. 1974. "A Duopoly Price Game" "Economica" Vol. 41, pp. 157-175.

* Peck, M. 1961. "Competition in the Aluminium Industry: 1945-58." Harvard University Press, Cambridge.

* Reid, G. 1981. "The Kinked Demand Curve Analysis of Oligopoly: Theory and Evidence." Edinburgh University Press, Edinburgh.

* Stigler, G. 1947. "The Kinky Oligopoly Demand and Rigid Prices" "The Journal of Political Economy" Vol. 55, pp. 432-449.
* Stigler, G. 1978. "The literature of economics: the case of the kinked oligopoly demand curve" "Economic Inquiry" Vol. 16, pp. 185–204.

* Sweezy, P. 1939. "Demand Under Conditions of Oligopoly" "The Journal of Political Economy" Vol. 4, pp. 568-573.

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 Perspective"s 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"