ABSTRACT
This chapter systematically uses the evidence available from the AQ 1985 on pricing conjectures of SBEs to test a specific model of oligopolistic interaction. The focus is on a kinked demand curve model, and the test methodology adopts the position advanced in Reid (1981) that subjective evidence on price conjectures may be used in testing models of oligopoly. The model is based upon Bhaskar (1988), where oligopolistic price setting is formalized as an extensive form game in which firms can respond without delay to their rivals’ undercutting. Under certain assumptions it can be shown that equilibrium in this game is unique, at a price selected by an endogenously determined price leader. The price leader ensures that its competitors match this price by following a kinked demand curve type of strategy which involves matching price reductions but not price increases. This equilibrium enables firms to earn higher profits than at the Bertrand equilibrium: the kinked demand strategy discourages rivals from deviating from a relatively collusive outcome. This theory does not predict price rigidity, since the equilibrium price selected by the leader would respond to any general increase in costs or demand. However, price-following firms would face demand curves which were kinked at the prevailing price, due to the strategy adopted by the price leader. From an empirical point of view, this is an attractive feature of the theory since it is not falsified by the evidence that goes back to Stigler (1947) that prices are not relatively more rigid in oligopoly. At the same time, the theory is consistent with the evidence on the subjective perceptions of managers which suggests that firms do perceive an asymmetry in their rivals’ responses. The evidence from questionnaires conducted by Wied-Nebbeling (1975) and Nowotny and Walther (1978) shows that a number of firms expected their rivals to match price reductions without matching price increases.l
This chapter uses evidence from the AQ 1985 to test for the presence of an asymmetry in SBEs’ perceptions regarding their rivals’ response. It is not expected that the version of the kinked demand curve theory sketched out above and elaborated below will completely explain the data. It is possible that some of these SBEs are monopolistic competitors for which significant strategic interaction is not important. For others, perhaps a model of
Bertrand competition may be more relevant, especially in markets where information regarding price changes travels slowly. However, it is striking that the data show a marked degree of asymmetry in firms’ perceptions regarding their rivals’ responses. A number of firms expect their competitors to match price reductions without matching price increases in some circumstances. This asymmetry is prima facie inconsistent with models of monopolistic competition or Bertrand pricing, but is consistent with a modified kinked demand theory as expounded in 10.2 below.
