Price Leadership Definition
Price Leadership refers to a situation where the dominant firm sets up the price of goods or services in the market. This generally happens when the goods are homogeneous, i.e. there is no difference in the goods or services provided by different firms and 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 very less.
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Explanation
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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.read more 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. read more 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, so 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. read more, 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 as no product differentiation. So Marginal Revenue is also the same. Now Marginal Revenue of firm A is cutting the Marginal Cost of A 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. This is price leadership by Firm A.
Types of Price Leadership
There are three types of price leadership:
#1 – Barometric
This is a quick adaptability. Once a firm discovers a sudden efficient, cost-effective way of production due to research or discovery, then he starts to follow it and hence reduces its prices. Other firms, in order to compete with the firm, start following the same production schedule and minimizes 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 that are 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
This occurs in an economy where a single firm is large enough to dominate the market. This is a kind of monopoly. 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 where the small firms can’t survive and exits. Then the dominant firm increases the prices at his free will. This is illegal. The government should always check whether the dominant firm is trying to kill competition.
Price Leadership Example
- Indian Telecom Company (Reliance JIO) gave a free Internet and calling facility for more than six months after its launch. The existing telecom providers were charging for both Internet and calling during that time.
- 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.
- This led to a huge change in the telecom industry of INDIA. Several small providers started Merging in order to survive or exited from the market.
- Slowly when JIO started charging cheap rates from customers on a monthly basis, then other providers had to follow the pricing mechanism of JIO in order to survive. This is an example of price leadership.
Factors
- The market should be an oligopoly. 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. read more for a particular firm should be less in order to dominate the price.
Advantages
- It reduces price wars. In price leadership, small firms follow the price of the dominant firms, so they are not engaged in a price war in order 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.read more for all firms.
- If a market leader increases the price and another small firm follows it, then it will lead to an increase in probability for all the small firms along with 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, then buyers gain from the low prices. It helps to increase savings as money is saved.
Disadvantages
- Mostly smaller firms can’t survive with the defined price by the leaders. This reduces competition and chances of monopoly arise.
- If the price is increased and other firms follow, then buyers lose. So it is bad for the consumers.
- As the profitability of the smaller firms decreases, so the salary of the employees is affected, and the future sustainability of the firm is in question, which will lead to more unemployment in the economy.
Conclusion
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.
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