There are two versions of the kinked demand curve model. One is called the Sweezy version and the other is called the Hall and Hitch version. Both models were conceived independently in 1939. The essential difference between these two versions is that Sweezy’s model is based on the marginalist approach, with the hypothesis that even an oligopolistic firm aims at profit maximisation. In contrast, the Hall and Hitch version rejects the marginalist approach of profit maximisation. It argues that, under oligopoly, firms aim at ‘fair’ profit and follow the full cost principle in determining the price.
Sweezy’s Model of Kinked Demand Curve
According to Sweezy, the most distinguishing feature of oligopoly is that an individual firm does not know (and cannot determine) the exact nature (functional form) of its actual demand curve because of the uncertainty and indeterminacy of rivals’ reactions to its own actions. An oligopolistic firm is therefore guided in its decisions by the ‘imagined’ demand curve which is based on what it expects to be the most likely (probable) reaction of its rivals.
Under oligopoly, a firm expects that when it raises its price, it is most likely that rival firms will not follow suit by raising their prices. Instead, the rivals will keep their prices constant in order to increase their sales at the expense of the firm that raises the price. Hence, when a firm increases its price, its demand is expected to fall much more than it would if its rivals were not to keep their prices constant. That is, for upward changes in price, a firm’s demand is expected to be highly elastic.
In contrast, when the firm lowers its product price, it is most likely that its rivals will follow suit because if they did not do so they would lose sales to the firm that lowered the price. Hence, when a firm reduces its price, its demand is expected to increase much less than would otherwise have been the case (because its rivals will also reduce their prices). That is, for downward changes in the price, a firm’s demand curve is expected to be less elastic than it would have been had the firm’s rivals not followed suit by reducing their prices.
Consequently, for an oligopolistic firm, the demand curve is highly elastic and gradually falling for prices above the current or existing price, and for prices below the current price the demand curve is less elastic and steeply falling.
Hall and Hitch Version of Kinked Demand Curve
The Hall and Hitch model of the Kinked demand curve is based on an empirical survey of a sample of 38 well managed firms in England. The survey was conducted by these two Oxford economists to find out how firms in the real world determine price and output.
The principal findings of the study were as follows:
In the real world, most manufacturing firms operate in oligopolistic markets.
Contrary to what is assumed by economic theory, in reality oligopolistic firms do not know their demand curve because of uncertainty regarding their rivals’ reaction. They do not therefore know their marginal revenue curve. Since most large firms tend to be multi-product firms, they also do not know the marginal cost curve. Thus in the real world, firms cannot determine equilibrium price and output by marginalist calculations, i.e., by equating marginal revenue and marginal costs.
Oligopolistic firms in reality determine their price on the basis of the full cost principle. They charge that price which not only covers variable and fixed costs but also yields a fair profit margin. The full cost is the sum of average variable cost (AVC) and average fixed cost (AFC) at normal output level and a predetermined percentage of this sum added for ‘fair’ (reasonable) profit. In short, according to this principle Price = Full cost = (AVC + AFC) at Normal Output + ‘Fair’ profits as a percentage of (AFC + AVC).
The demand curve has a kink at the price which is equal to full cost price. If a firm charges a price higher than full cost, its rivals will not follow suit but will keep their prices constant. Hence, for prices higher than the full cost price, the demand curve of an oligopolist has high elasticity. If the firm charges a price lower than full cost price, its rivals will follow suit by lowering their prices. Hence, for prices less than the full cost price, the oligopolist’s demand curve has relatively low elasticity.
Oligopolistic firms adopt full cost pricing rule because it not only covers AFC at normal output but also earns a reasonable rate of profit. The objective of oligopolistic firms is to have long run stable profits and a ‘quiet life’, free from uncertainities. If profits exceed what is regarded as a ‘reasonable’ or ‘fair’ rate, it may attract new entrants and accusation of ‘excessive’ profits from customers as well as distributors. Both these consequences will cause instability of long run profits and make life difficult (unquiet) for firm’s decision makers. Similarly, charging a price below full cost will be considered ‘unethical’ by competitors and create a threat of price war. Also, it is difficult to raise price later to the full cost level. Thus, for oligopolistic firms, price tends to remain rigid or sticky at the full cost level, and short run changes in costs and demand will not cause changes in the oligopolistic price.