Price Leadership Definition
Price Leadership refers to a situation where the dominant firm sets up the price of goods or services in the market. It generally happens when the goods are homogeneous, i.e., there is no difference in the goods or services provided by different firms. Therefore, customers don’t have a preference and choose the lowest price. Such a model is usually seen in the Oligopolistic market, where competition is less.
Table of contents
- Price leadership occurs when a dominant firm sets the price for goods or services in the market, typically in an oligopolistic market with homogeneous products. Customers have limited choices, often opting for the lowest price.
- Three types of price leadership exist: barometric, where the firm with the best market information sets the price; collusive, where firms collaborate to set prices collectively; and dominant, where the leading firm unilaterally sets the price.
- Price leadership is often used by a strong firm to establish its presence in the market. Following price leadership and avoiding price wars can benefit smaller firms.
The optimal level of output and price is the point where the Marginal CostMarginal CostMarginal cost formula helps in calculating the value of increase or decrease of the total production cost of the company during the period under consideration if there is a change in output by one extra unit. It is calculated by dividing the change in the costs by the change in quantity. Curve will intersect the Marginal RevenueMarginal RevenueThe marginal revenue formula computes the change in total revenue with more goods and units sold." The value denotes the marginal revenue gained. Marginal revenue = Change in total revenue/Change in quantity sold. curve. In the above Diagram, Company A is the leader, and Company B is a small firm in the same industry. As Company A is the leader, they have achieved economies of scaleEconomies Of ScaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. , and you can see that for this reason, the Marginal Cost line of A is below B.
The demand for both firms is the same in the economy with no product differentiationProduct DifferentiationProduct differentiation refers to making a product look attractive and different from other products in the same class. Marketers highlight the distinguishing features in the product commonly through packaging or a good design, which helps communicate the benefitting factors to the shoppers.. So Marginal Revenue is also the same. Now Marginal Revenue of firm A is cutting the Marginal Cost at a much lower point. So the optimal output is “O,” and the optimal price is “P” for firm A. As the price is less than P1, which is optimal for Firm B; still firm B will have to follow price P instead of P1. It is price leadership by Firm A.
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Types of Price Leadership
There are three types of price leadership:
#1 – Barometric
It is quick adaptable. Once a firm discovers a sudden efficient, cost-effective way of production due to research or discovery, it starts to follow it and reduces its prices. To compete with the firm, other firms start following the same production schedule and minimize price as the firm is not big enough, so the leadership is short-lived. Big firms soon take over the price.
#2 – Collusive
These are agreements formed by a few dominant firms in the market. Other small firms are forced to follow as they can’t win with the dominant firms. Price leadership mainly arises due to a reduction in operation costs, but this kind of arrangement is not legal if the public is not benefiting from the agreement.
#3 – Dominant
It is a kind of monopoly. It occurs in an economy where a single firm is large enough to dominate the market. The dominant firm controls the price, and it gets really difficult for small firms to sell similar services or goods to compete. There are times when dominant firms lower prices to such a level that the small firms can’t survive and exit. Then the dominant firm increases the prices at its free will. It is illegal. The government should always check whether the dominant firm is killing competition.
Price Leadership Example
- Indian Telecom Company (Reliance JIO) gave a free Internet and calling facility more than six months after its launch. The existing telecom providers were charging for both Internet and calling.
- Previously customers used to limit internet usage to 2GB per month. After the launch of JIO, they started using unlimited data daily. It was a revolution. The calling was made entirely free.
- It led to a huge change in the telecom industry of INDIA. Several small providers started Merging to survive or exit from the market.
- Slowly, when JIO started charging cheap rates from customers every month, other providers had to follow the pricing mechanism of JIO to survive. It is an example of price leadership.
- The market should be an oligopolyOligopolyAn oligopoly in economics refers to a market structure comprising multiple big companies that dominate a particular sector through restrictive trade practices, such as collusion and market sharing. Oligopolists seek to maximize market profits while minimizing market competition through non-price competition and product differentiation. . That is, there should be very few firms in the market. One firm among them should be big enough to control the price.
- The products should be homogeneous. It means that different firms will produce similar goods or services. So the customers will not have a preference and will go towards the less costly.
- The cost of productionCost Of ProductionProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. for a particular firm should be less to dominate the price.
- It reduces price warsPrice WarsA price war is a competition among the competitors of the business in lowering the price of their products to gain an advantage over their competitors in price and capture a greater market share. It is used as one of the strategies to increase the business firm's revenue and increase the market share.. In price leadership, small firms follow the price of the dominant firms, so they are not engaged in a price war to gain market share, which reduces the profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. for all firms.
- If a market leader increases the price and another small firm follows it, it will increase the probability for all the small firms and the big firm. So small firms are enjoying the price set by the leaders.
- When the dominant firm decreases the price and other firms follow, buyers gain from the low prices. It helps to increase savings as money is saved.
- Most smaller firms can’t survive with the defined price by the leaders. It reduces competition, and chances of monopoly arise.
- If the price is increased and other firms follow, then buyers lose. So it isn’t nice for the consumers.
- As the profitability of the smaller firms decreases, the employees’ salary is affected, and the future sustainability of the firm is in question, which will lead to more unemployment in the economy.
Price Leadership is often followed when a strong firm tries to show its presence in the market. Following price leadership and not engaging in a price war is beneficial for small firms. There should be regulations to control price leadership if the motive behind the price leadership is a monopoly or to charge higher prices from buyers.
Frequently Asked Questions (FAQs)
In a market with price leadership, a dominant firm sets the price, and other firms in the industry generally follow its pricing decisions. Consumers may be affected by price leadership in several ways. If the leading firm raises prices, other firms may follow suit, leading to higher prices across the industry. Conversely, if the leading firm lowers prices, it may trigger a price war, temporarily benefiting consumers with lower prices.
In a cartel, independent firms collaborate to fix prices, production levels, or market shares, often illegally, to maximize joint profits. Cartels act as a single entity, setting prices collectively. On the other hand, price leadership involves a dominant firm, known as the price leader, setting the price for the industry, and other firms follow its pricing decisions voluntarily, without a formal agreement.
Price leadership is commonly observed in a type of oligopoly known as “Dominant Firm Oligopoly.” In this market structure, one firm holds a significant market share and has considerable influence over market conditions.
This has been a guide to what is Price Leadership & its Definition. Here we discuss the types of price leadership and their advantages and disadvantages. You can learn more economics from the following articles –