Kinked Demand Curve - Sweezy Model:
In an oligopolistic market situation, due to rivalry among the firms, any one lowering the price is interpreted by others as an attempt to eliminate their profit. Therefore, other firms also respond by cutting their prices as well. This chain of price cuts is called a price war. In the model by Sweezy, we would analyse what happens when the firms behave in the manner described above.
Each firm in an oligopolistic market faces two demand curves D1D1 and D2D2 as shown in Figure. D1D1 is the demand curve that a particular oligopolist faces on the assumption that others do not change their prices and D2D2 has been drawn on the assumption that if one firm changes the price, then all others also change theirs.
Suppose A is the current position of the firm with price P0 and quantity produced Q0. If the firm raises price, the rivals will not follow a similar course, since they stand to gain by capturing the sales of this firm. However, if it reduces price, other respond by matching the price reduction. Thus, the demand curve that the firm faces is given by the segment D1D1 to the left of A and the segment of D2D2 to the right of A. The relevant demand curve is given by D1AD2, which has a kink at A.
The marginal revenue curve corresponding to the kinked demand curve is shown in Figure. MR1 is the marginal revenue corresponding to D1D1 and MR2 is the marginal revenue curve corresponding to D2D2. To the right of Q0 the demand curve is given by the segment of D2D2 and hence the marginal revenue given by the corresponding segment of MR2. At the quantity Q0 there is a sudden drop in marginal revenue, from the point B to point C in Figure. The marginal revenue curve for the kinked demand curve in Figure is given by the line EBCF in Figure. See that there is some range within which changes in the firm's marginal cost will not result in changes in price and quantity. This is shown in Figure. Note that both for MC1 and MC2, the price and quantity given by the equilibrium condition MC = MR are the same. Hence, the price is "sticky", and the model is also known as the "sticky price model".
The kinked demand is derived on the assumption that price increase by one of the oligopolistic firm is not followed by others but price reductions.