Oligopoly and the Kinked Demand Curve

An oligopoly is a market dominated by a SMALL number of large sellers, so that each firm is keenly aware that its own price or output decisions will visibly affect its rivals, and that rivals are likely to react — this mutual interdependence is the defining feature of oligopoly, absent from every other market structure. Because reactions cannot be predicted with certainty, oligopoly has no single, universally accepted theory of price determination — several different models exist depending on the assumed pattern of rival reaction.

One well-known oligopoly model is Paul Sweezy's kinked demand curve, which explains a commonly observed feature of oligopoly markets: prices tend to stay RIGID (unchanged) for long periods even when costs fluctuate somewhat, rather than adjusting continuously as under perfect competition.

The model assumes a firm believes rivals will react ASYMMETRICALLY to a price change it makes on its own:

• If the firm RAISES its price above the prevailing level, rivals will NOT follow (they are content to keep their own price steady and gain customers from the firm that raised its price) — so the firm faces a highly ELASTIC demand curve for any price rise, losing a large share of its sales.
• If the firm LOWERS its price below the prevailing level, rivals WILL follow immediately (to avoid losing their own market share) — so the firm faces a much less elastic (steeper) demand curve for any price cut, gaining little extra sales because rivals match the cut. …