Price Rigidity: The Kinked Demand Curve Model

In very competitive markets, such as those for wheat and other agricultural commodities, prices are very sensitive to changes, in demand and supply. In such markets prices change almost by the minute. However, in many oligopolistic markets such as those for tires, toothpaste and breakfast cereals, prices tend to be unresponsive to changes in demand or changes in marginal costs of production.

Price rigidity in oligopolistic markets can occur if individual firms believe that their rivals won't match a price increase but will match a price decrease. Under, such circumstances, the demand curve as seen by any particular firm have a strange shape.

For example, suppose the market price of chocolate bars is 75 cents. Assume the few firms in the industry think the demand for their product will be very elastic, if they raise their price, because they expect their rivals to maintain their own prices instead of increasing them. However, these firms conjecture that demand will be less elastic if they lower their price because they expect rival firms to follow their price cuts.

Entry-Limit Pricing

Firms in an oligopolistic market may set prices in order to make it unprofitable for potential new entrants into the market to actually begin selling. To accomplish this objective, firms in the market do not necessarily set a price that maximizes their current profits. Instead, they are forward looking enough to forgo current profits in order to keep new entrants from entering the market and putting downward pressure on future profits.

Firms either collude or follow the lead of another firm in setting prices to achieve the objective of discouraging entry. To achieve this objective, they estimate the minimum possible long-run average cost of any potential entrants in the market. They also presume that any potential entrant will take the price set by existing firms is one that will be maintained.

Entry-limit pricing shows how the fear of new entrants into the market can provide profit-maximizing sellers currently in the market with the incentive not to exercise their monopoly power.

Advertising under Oligopoly

In oligopolistic markets, individual firms consider the reactions of their rivals before engaging in advertising and other promotional expenses. An oligopolistic firm can substantially increase its market share by advertising only if rival firms do not retaliate with advertising campaigns of their own.

There is some evidence that advertising in oligopolistic industries is carried beyond the point that would be justified by profit maximization. Advertising in oligopolistic industries apparently tends to raise costs without significantly increasing any one firm's market share. Rival firms merely cancel out the effect of each other's advertising.

There is also evidence that advertising in the soap and detergent industry does little more than cancel out the effect of rival firms' promotional messages. It is possible that such firms prefer nonprice competition to the alternative of a price war. They may believe that promotional efforts can provide them with temporary increases in profits if rivals lag in reacting.

Other studies have found that advertising does contribute to profits. Such studies indicate that the higher the ratio of advertising expenditures to sales in an industry the higher the industry profit rates. Insofar as higher profits indicate monopoly power, this implies that advertising leads to more monopoly control over price. It is unclear, however, whether increased advertising causes higher profits or higher profits cause more advertising.