Every firm in an oligopoly market is faced with a Kinked Demand Curve, the kink being at that point on the demand curve which corresponds to the prevailing common price accepted by all the firms at which they sell their output. This common price or prevailing market price is such that none of the individual oligopolistic firms would make any change in it even when there might be some small variations in their production costs. There is thus a rigidity or stickiness about this price. None of the oligopolistic producers have either the will or the incentive to change this price. The main factors which contribute to price rigidity in an oligopoly market are discussed below:
Firstly under oligopoly each seller is faced with a Kinked Demand Curve. The point of kink divide the demand or AR curve into two distinct parts. The upper part, the part to the right of the kink is highly elastic portion of the demand curve. The lower part or the portion of demand curve to the right of the kink is less elastic. The market price corresponds to the point of the kink.
The price that corresponds to the point of kink K on the demand curve AKD. This price is accepted by every firm and no one is willing to change it. Every firm knows that if it raises the price above OP, the rival firms will not raise the price of their product. The firm which raises the price will thus lose many of its customers to the rivals and it may not be able to make any additions to its revenue; rather its total revenue may become smaller than before. On the other hand, if a firm reduces its prices to attract more customers, the others, faced with the prospects of losing their customers, also make a marketing cut in price. This firm, therefore, does not gain much from a price reduction. Thus each firm under oligopoly, faced with the Kinked Demand Curve is extremely reluctant to change the prevailing price. Therefore, there is rigidity or stickiness of the prevailing price under oligopoly.
Secondly, since the oligopolistic firm is maximizing its profits at the prevailing market price, they have no incentive to change it. The marginal cost surve MC of the oligopolistic firm passes through the gap EF in the marginal revenue curve giving OQ quantity as the profit maximizing level of output. But beyond OQ, MR > MC and hence additional units add more to cost than to revenue and thus not worth producing. Since, profits are being maximized at that level of output and price which corresponds to the kink, the oligopolist is not interested in changing the price.
Thirdly, small variations in cost do not disturb oligopoly equilibrium. Even when marginal cost rises from MC to MC’ or falls to MC”, the equilibrium level of output and price remains the same, as all these curves pass through the gap EF in the marginal revenue curve. Thus, the profit maximizing output remains OQ whether the marginal cost increases or decreases by small amounts. However, when the rise in cost is substantial so that marginal cost curve intersects marginal revenue at a point above E, there is a case for price rise.
Fourthly, the price remains same even when there are small changes in the demand curve facing the individual producers. When the demand curve is kinked, an upward or downward shift in the demand curve only affects quantity produced and not the price level so long as marginal cost curve passes through the range of discontinuity or gap in the new marginal revenue curve.
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