Corresponding to MD 1 is the marginal revenue curve labeled MR 1. At low prices, the firm faces the relatively inelastic market demand curve labeled MD 2. Corresponding to MD 2 is the marginal revenue curve labeled MR 2.
The two market demand curves intersect at point b. Therefore, the market demand curve that the oligopolist actually faces is the kinked‐demand curve, labeled abc. Similarly, the marginal revenue that the oligopolist actually receives is represented by the marginal revenue curve labeled adef. The oligopolist maximizes profits by equating marginal revenue with marginal cost, which results in an equilibrium output of Q units and an equilibrium price of P.
The oligopolist faces a kinked‐demand curve because of competition from other oligopolists in the market. If the oligopolist increases its price above the equilibrium price P, it is assumed that the other oligopolists in the market will not follow with price increases of their own. The oligopolist will then face the more elastic market demand curve MD 1.
The oligopolist's market demand curve becomes more elastic at prices above P because at these higher prices consumers are more likely to switch to the lower‐priced products provided by the other oligopolists in the market. Consequently, the demand for the oligopolist's output falls off more quickly at prices above P; in other words, the demand for the oligopolist's output becomes more elastic.
If the oligopolist reduces its price below P, it is assumed that its competitors will follow suit and reduce their prices as well. The oligopolist will then face the relatively less elastic (or more inelastic) market demand curve MD 2. The oligopolist's market demand curve becomes less elastic at prices below P because the other oligopolists in the market have also reduced their prices. When oligopolists follow each others pricing decisions, consumer demand for each oligopolist's product will become less elastic (or less sensitive) to changes in price because each oligopolist is matching the price changes of its competitors.
The kinked‐demand theory of oligopoly illustrates the high degree of interdependence that exists among the firms that make up an oligopoly. The market demand curve that each oligopolist faces is determined by the output and price decisions of the other firms in the oligopoly; this is the major contribution of the kinked‐demand theory.
The kinked‐demand theory, however, is considered an incomplete theory of oligopoly for several reasons. First, it does not explain how the oligopolist finds the kinked point in its market demand curve. Second, the kinked‐demand theory does not allow for the possibility that price increases by one oligopolist are matched by other oligopolists, a practice that has been frequently observed. Finally, the kinked‐demand theory does not consider the possibility that oligopolists collude in setting output and price. The possibility of collusive behavior is captured in the alternative theory known as the cartel theory of oligopoly.