Interfirm Learning and the Kinked Demand Curve

Abstract

The last three chapters have been concerned primarily with duopoly models. In this chapter we apply Bayesian analysis to an oligopoly model known as the kinked demand curve. The kinked demand curve represents a theoretical dilemma that is not uncommon in the social sciences (Stigler 1978). The dilemma concerns the inclusion or the exclusion of the model from the mixed bag represented by the classification “oligopoly theory.” The model has been in the literature for a number of years and is still in an ambiguous position. Sweezy (1939) proposed the model as an explanation of rigid oligopoly prices, which were taken as an empirical observation (see also Hall and Hitch 1939). The basic assumption underlying the kinked demand curve is that rivals will not follow an attempted increase in price by one of the firms but will follow a decrease. The result is that for each firm the portion of the demand curve above the current price is elastic and the portion below the curve is inelastic. Hence, in the firm’s view, the demand curve appears kinked at the current price and the firm has no incentive to modify its price. Because of the paucity of good alternatives, the model was quickly accepted as the theory of oligopoly by many textbook writers. The theory did not explain how oligopoly prices reached a particular level, but it did offer an explanation of their stability.