The Kinked Demand Curve
This is a demand curve, which explains the market behavior of a firm in oligopoly. The kinked demand curve is drawn on the following conditions and assumptions. There is an established market price set through price leadership at which all sellers are satisfied. Individual sellers' attitudes depend on the attitudes of their rivals. The industry is a mature one with or without product differentiation.
If one firm lowers the price, other firms will also do so in order to retain their shares of the market.
If one firm raises its price, other firms may not follow but rather stick to the prevailing price and the firm which initiated the price rise will lose customers.
Therefore, the demand curve ( kinked) and the marginal revenue curve of an oligopolistic firm can be drawn as below.
When the two demand curves AB and BD are joined, they make a kinked demand curve. The kink is the corner at point B.
Because of the two demand curves, the marginal revenue curve is also broken into two. The two MR curves are separated by a gap CE. When the firm increases its price above OP1, its market share reduces hence the reduction in its subsequent MR would be large above OP1, when the firm reduces the price. Below Op, its market share remains constant and therefore the gain in MR is less below OP1.
Equilibrium of the firm is therefore attained where MC=MR. The MC meets the MR in the discontinuous gap CE.
This is the shortrun situation of a firm under oligopoly market structure.