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The second model of oligopoly is called the Cournot model. Augustin Cournot’s model of oligopoly states that given all other firms’ production, a single firm chooses the best possible amount to produce. The more the other firms produce, the less the single firm will want to make. The other firms are also acting the same way, so as the single firm produces more, the other firms will produce less. Eventually, they will all be producing a quantity such that any change in any firm’s production will lower each individual firm’s profit. Typically, this quantity will be more than a monopolist’s quantity and less than a perfectly competitive market’s output. Critics of this model note that each firm takes the other’s production as a given, and, in reality, firms are much more strategic and anticipate other firms’ behaviors. The third model is the kinked demand curve model. This model argues that there is a single firm dominating the market, and if the firm lowers its price, other firms will also lower their prices. But if the firm raises prices, other firms will not raise prices. Graphically, the demand curve is "kinked" at price P*, which is the price of the dominant firm. This is shown in the figure below:
If the dominant firm raises its price and competing firms do not, the dominant firm will lose a lot of business to the lower priced rivals; demand is very elastic (the segment labeled d1) for price increases. If the dominant firm lowers its price, all the competitors will follow, and there will not be large quantity increases. Thus, the demand is inelastic (the segment labeled d2) for price decreases. There is a kink in the demand curve at P*, the optimal price. Note that the kink in the demand curve implies that the marginal revenue is no longer continuous (a connected line). At the quantity q*, the MR has a “gap” from point A to point B. This means that there is a rather large range in which the MC could shift without causing a change in the optimal quantity or price. The kinked demand curve model appeals to common sense. If the big firm lowers prices, other places seem to follow, but it never seems to happen the other way. The problem with the theory is the determination of P*. Why is the price at P* to begin with? Also, critics have argued that the assumption that rivals follow price cuts and ignore increases is oversimplified, that real-world oligopolists are much more strategic. To better understand the kinked demand curve, try the following Active Graph exercise: Active Graph Level 1: A Kinked Demand Curve Oligopoly Model
For even more practice in understanding the kinded demand curve, try the following Active Graph Level Two exercise: Active Graph Level 2: Kinked Demand Curve Model
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