The concept of the kinky demand curve is a significant model within the theory of Oligopoly, a market structure characterized by a small number of large firms that dominate the market. Unlike perfect competition, monopolistic competition, or pure monopoly, oligopoly is defined by the strategic interdependence of firms. The actions of one firm, particularly regarding price and output decisions, significantly impact the others. This interdependence makes predicting firm behavior complex, as each firm must anticipate and react to its rivals’ moves. The kinky demand curve model, specifically attributed to Paul Sweezy in 1939, attempts to explain a common observation in oligopolistic markets: price rigidity, or the tendency for prices to remain stable even when cost conditions or demand patterns might suggest a change.

The core idea behind the kinky demand curve is rooted in a specific assumption about how rival firms react to a price change initiated by one firm. Sweezy posited an asymmetric response: rivals are assumed to react differently to a price increase than they do to a price decrease. This strategic asymmetry, driven by self-interest and a desire to maintain market share, leads to a peculiar shape of the demand curve faced by an individual oligopolist, hence the term “kinky.” This model offers a compelling, albeit not universally accepted, explanation for why prices in certain oligopolistic industries might remain sticky for extended periods, even in the face of fluctuating costs or moderate shifts in market demand.

The Concept of the Kinky Demand Curve (Sweezy Model)

The kinky demand curve model, also known as the Sweezy oligopoly model, posits that a firm in an oligopolistic market faces a demand curve that is not smooth but rather has a “kink” at the prevailing market price. This kink arises from the assumption of asymmetric reactions from competing firms to any price change initiated by one firm.

The Upper Segment (Elastic Demand): Let’s consider a firm operating at the current market price (P*) and quantity (Q*). If this firm decides to raise its price above P*, the model assumes that its rivals will not follow the price increase. The rationale is that competitors would perceive an advantage by keeping their prices lower, thereby capturing a larger share of the market from the price-raising firm. Consequently, if the firm increases its price, it will experience a significant loss of customers and market share, leading to a substantial drop in its sales volume. This scenario implies that the demand curve segment above the current price is relatively elastic. A small percentage increase in price leads to a proportionately much larger percentage decrease in quantity demanded. This makes price increases an unattractive strategy for any individual firm, as it would severely erode its revenue and profitability.

The Lower Segment (Inelastic Demand): Conversely, if the firm decides to lower its price below P*, the model assumes that its rivals will follow the price decrease. The logic here is that competitors would not want to lose their market share to the price-cutting firm. If they did not match the price cut, their customers would switch to the firm offering the lower price. Therefore, to prevent a loss of customers and maintain their market share, the rival firms will quickly match the price reduction. When all firms lower their prices together, the price-cutting firm gains very little, if any, additional market share. Its sales volume will increase only slightly, primarily due to the overall market expansion at the lower price, rather than capturing significant market share from rivals. This implies that the demand curve segment below the current price is relatively inelastic. A percentage decrease in price leads to a proportionately smaller percentage increase in quantity demanded. This makes price decreases an unattractive strategy as well, as it would lead to reduced revenues for only marginal gains in sales, potentially triggering a costly price war where all firms end up with lower profits.

The Kink and the Marginal Revenue Curve: The point where these two distinct segments of the demand curve meet is the “kink,” which corresponds to the current prevailing market price (P*) and quantity (Q*). Graphically, the demand curve (D) is steeper below the kink and flatter above it.

Corresponding to this kinky demand curve is a peculiar marginal revenue (MR) curve. Since the demand curve has two distinct slopes, its associated marginal revenue curve will also have two distinct parts. The MR curve for the elastic upper segment will be higher than the MR curve for the inelastic lower segment. Critically, because of the sudden change in slope at the kink, there is a vertical discontinuity or gap in the marginal revenue curve at the quantity corresponding to the kink (Q*). This vertical gap occurs directly below the kink in the demand curve. The upper part of the MR curve corresponds to the elastic segment of the demand curve, and the lower part corresponds to the inelastic segment. The vertical gap signifies that for any quantity change around Q*, the marginal revenue fluctuates abruptly.

Price Rigidity and the Vertical Gap in MR

The primary significance of the vertical gap in the marginal revenue curve lies in its ability to explain price rigidity in oligopolistic markets. In standard microeconomic theory, a profit-maximizing firm produces at the output level where its marginal cost (MC) equals its marginal revenue (MR).

In the Sweezy model, the vertical gap in the MR curve means that the marginal cost curve (MC) can fluctuate considerably without altering the optimal price and quantity. As long as the MC curve intersects the MR curve within this vertical gap, the profit-maximizing output level remains at Q*, and consequently, the profit-maximizing price remains at P*.

  • Impact of Cost Changes: If the firm’s marginal costs increase (MC shifts upwards) or decrease (MC shifts downwards), as long as the new MC curve still intersects the vertical segment of the MR curve, the firm will have no incentive to change its price or output. For example, if costs rise, the firm knows that increasing its price would lead to a significant loss of market share (due to the elastic upper demand segment), which would be worse than absorbing the higher costs at the current price. Similarly, if costs fall, the firm knows that lowering its price would lead to rivals matching the cut, resulting in only a small increase in sales at a lower profit margin (due to the inelastic lower demand segment). Thus, the firm is disincentivized from changing its price in response to moderate cost fluctuations.

This characteristic makes the kinky demand curve model a powerful tool for explaining why prices in certain oligopolistic industries (like gasoline, soft drinks, or cigarettes, where firms are highly interdependent and wary of price wars) tend to be stable for extended periods, even when underlying costs of production or input prices might be changing. Firms appear reluctant to initiate price changes, preferring to absorb cost fluctuations or resort to non-price competitive strategies.

Assumptions of the Sweezy Model

The validity and applicability of the kinky demand curve model rest on several key assumptions:

  1. Non-Collusive Oligopoly: The model assumes that firms do not explicitly collude to set prices or output. Instead, their decisions are based on independent assessments of how rivals will react. This differentiates it from cartel models where explicit agreement exists.
  2. Asymmetric Reaction by Rivals: This is the most critical assumption. It posits that rivals will react differently to price increases versus price decreases. Specifically, they will not follow a price increase but will follow a price decrease. This asymmetry is driven by the desire to gain market share (if one raises price) or prevent losing market share (if one lowers price).
  3. Existence of a Prevailing Price: The model does not explain how the initial price (the kink) is determined. It assumes that there is an existing, established market price from which firms contemplate making changes. This is a significant limitation, as the model only explains price rigidity around an already existing price, not its formation.
  4. Homogeneous or Differentiated Products: While often discussed in the context of relatively homogeneous products (e.g., steel, basic chemicals), the model can also apply to differentiated products where firms compete heavily on price for specific market segments. The key is the interdependence and the perceived reactions of rivals.
  5. No Entry or Exit: The model typically operates in a short-run context where the number of firms in the industry is fixed. It does not account for the dynamics of new firms entering or existing firms exiting the market.
  6. Rational Profit Maximization: Firms are assumed to be rational and aim to maximize their profits, choosing the output level where marginal cost equals marginal revenue.

Implications of the Kinky Demand Curve

The kinky demand curve model has several significant implications for understanding oligopolistic behavior:

  1. Price Stability and Rigidity: As previously discussed, this is the most direct and crucial implication. The model provides a compelling reason why prices in an oligopoly might remain stable for extended periods, even in the face of moderate changes in costs or demand. Firms are locked into the current price due to the fear of negative consequences from either raising or lowering it. This inertia in pricing decisions is a defining feature of some oligopolistic markets.

  2. Non-Price Competition: Since price competition is discouraged by the structure of the kinky demand curve, firms are incentivized to compete through non-price strategies. This includes:

    • Advertising and Marketing: Firms invest heavily in branding, promotion, and marketing campaigns to differentiate their products and attract customers without engaging in price wars.
    • Product Differentiation: Companies may focus on improving product quality, adding new features, offering a wider range of varieties, or enhancing design to make their offerings more attractive than competitors’.
    • Customer Service: Providing superior after-sales service, warranty schemes, and customer support can be a powerful non-price competitive tool.
    • Research and Development (R&D): Innovation and the development of new technologies or products can provide a competitive edge.
    • Distribution Channels: Optimizing supply chains and distribution networks can also be a form of non-price competition. Firms use these strategies to expand their market share and increase profitability without triggering retaliatory price cuts from rivals.

  3. Absence of Predatory Pricing: The inelastic lower segment of the demand curve discourages aggressive price cutting. Since rivals are expected to match price reductions, a firm that initiates a price cut will likely not gain significant market share but will see its profits shrink due to lower margins across the board. This mechanism inherently works against predatory pricing strategies, where a firm would intentionally lower prices to drive competitors out of the market.

  4. Profit Maximization in a Unique Context: While firms still aim to maximize profits where MC=MR, the unique shape of the MR curve, with its vertical gap, means that the equilibrium is “stable” over a wider range of MC values. This implies that firms might be operating at a sub-optimal level in terms of cost efficiency, as they are not forced to adjust prices even if costs change. However, they are still maximizing profits given the perceived reactions of their rivals.

Criticisms and Limitations of the Sweezy Model

Despite its intuitive appeal and ability to explain observed price rigidity, the kinky demand curve model has faced several criticisms and limitations:

  1. Does Not Explain Price Determination: The most significant criticism is that the model only explains why prices are rigid once established, but it does not explain how the initial price (the kink) is determined in the first place. It assumes the existence of a prevailing price, which is a major gap in its explanatory power. This makes it a model of price stability rather than price formation.

  2. Lack of Strong Empirical Support for Asymmetric Reactions: Empirical studies have yielded mixed results regarding the core assumption of asymmetric rival reactions. While some studies have found evidence supporting the kinked demand curve, many others have found little or no evidence of this specific asymmetric behavior. For instance, firms might eventually match price increases if they are driven by common cost shocks (e.g., rising raw material prices across the industry). Moreover, in some markets, firms might not match price cuts if they believe the initiator will eventually revert to the higher price or if they have distinct market segments.

  3. Assumptions Too Simplistic/Unrealistic: The rigid assumption about rival reactions might be overly simplistic. Real-world oligopolies are more dynamic, and rival reactions can vary based on the specific market, the financial health of firms, the nature of the product, and overall economic conditions. Firms might engage in signaling, tacit collusion, or other complex strategies that go beyond the simple “match cuts, ignore raises” rule.

  4. Focus on Price, Not Quantity: The model primarily focuses on price stability. While it implies a stable output at the kink, it doesn’t adequately address how firms adjust quantities in response to demand shifts if the price remains rigid.

  5. Ignores Entry/Exit and Long-Run Dynamics: The model is a static short-run model and does not account for the entry of new firms or the exit of existing ones, which can significantly alter market structure and pricing behavior in the long run.

  6. Alternative Explanations for Price Rigidity: Critics argue that other factors might better explain observed price rigidity in oligopolies:

    • Tacit Collusion: Firms might implicitly agree not to engage in price wars, leading to stable prices without formal agreements. This is often seen in barometric price leadership, where one dominant firm sets the price, and others follow.
    • Cost-Plus Pricing: Many firms use cost-plus pricing methods, adding a fixed percentage markup to their average costs. If costs are stable, prices will also be stable.
    • Menu Costs: The administrative and logistical costs associated with changing prices (e.g., printing new menus, updating price tags, changing software) can discourage frequent price adjustments.
    • Fear of Government Intervention: Firms in highly visible oligopolies might avoid frequent price changes or aggressive price cuts to prevent attracting scrutiny from antitrust authorities.
    • Long-Term Relationships with Customers: Firms might prefer stable prices to maintain good long-term relationships with their customers and avoid the perception of opportunism.

Relevance and Contribution

Despite its criticisms and limitations, the kinky demand curve model by Paul Sweezy remains an important and influential concept in the study of oligopoly for several reasons. It was one of the earliest and most intuitive attempts to explain a specific observed phenomenon—price rigidity—without resorting to explicit collusion, which is often illegal or difficult to maintain.

The model effectively highlights the crucial concept of strategic interdependence among firms in an oligopoly. It demonstrates that a firm’s optimal strategy is heavily dependent on its expectations of how its rivals will react to its actions. This recognition of interdependence is fundamental to understanding oligopolistic behavior. Furthermore, by showing why price competition might be avoided, the model logically leads to an emphasis on non-price competition, such as product differentiation, advertising, and customer service. This insight is highly relevant to understanding the marketing and innovation strategies employed by many firms in concentrated industries.

While not a universal model applicable to all oligopolistic markets, the kinky demand curve provides a valuable framework for analyzing industries where firms exhibit a strong aversion to price changes and are constantly wary of triggering price wars. It serves as a conceptual tool that helps explain why certain industries experience periods of unusual price stability. Its enduring presence in economic textbooks underscores its pedagogical value in illustrating the complexities and strategic nature of decision-making in markets dominated by a few powerful players.

The kinky demand curve model, therefore, provides a compelling explanation for price rigidity in certain oligopolistic markets, stemming from the asymmetric reactions of rival firms to price changes. If a firm raises its price, rivals do not follow, leading to significant loss of market share and elastic demand. If a firm lowers its price, rivals match, leading to minimal gain in market share and inelastic demand. This structure creates a “kink” at the prevailing market price, resulting in a vertical gap in the marginal revenue curve.

This vertical discontinuity in the marginal revenue curve implies that a firm’s marginal cost curve can fluctuate considerably within this gap without altering the profit-maximizing price and quantity. Consequently, firms in such an oligopoly are disincentivized from initiating price changes, leading to the observed price stability. While the model is limited by its inability to explain how the initial price is determined and faces empirical challenges regarding the universality of asymmetric reactions, it remains a significant contribution to oligopoly theory. It effectively illuminates the crucial role of strategic interdependence and highlights the tendency towards non-price competition, such as product differentiation, advertising, and customer service.