Price leadership is said to exist when firms fix their prices in a manner dependent upon the price charged by one of the firms in the industry. The firm which takes the initiative in announcing its price charges is called the price leader. All other firms in the industry which either match the leader’s price or some variation thereof are termed price followers.
Price leadership may be either dominant or barometric. Dominant price leadership may occur when the leading firm is powerful enough to set a price which all other firms will be forced to follow. Barometric price leadership occurs when the leading firm is followed merely because the price it sets reflects the market forces and the needs of the other firms in the industry.
Price leadership in action is very much evident in mature and stable industries producing highly standardized product such as steel, oil, cement or building materials. It is, however, also to be found in industries characterized by considerable product differentiation.
The price leadership is generally a leader in all the markets. It may, however, frequently happen that a firm will sometimes follow in some markets and sometimes lead in others. In some industries, the price leadership shifts among major firms but more commonly a single firm remains the price leader for long periods. The price and output decisions have been explained in the following diagram.
Suppose all firms face identical revenue curves as shown by AR = D + MR. But the largest firm or the low cost firm, has its cost curves as shown by AC1 and MC1 whereas all other rival firms smaller in size have their cost curves as shown by AC2 and MC2. The largest firm has the economies of scale and its cost of production is lower than that of other firms.
Given the cost and revenue conditions, the low cost firm would find it most profitable to fix its price at OP2 = LQ2 and sell quantity OQ2. Since at this level of quantity, its MC = MR and hence its profit will be maximum. On the other hand, the high cost firms be in position to maximize their profit at price OP1 and quantity OQ1. But if they charge a higher price OP1, they would lose their customers to the low firm. The high cost firm is therefore forced to accept the price OP2, and recognize the price leadership of the low cost firm. At price OP3, the low cost firm can sell the same quantity OQ1, but it will, of course, make only normal profit.
In practice, price leadership frequently arises due to the following circumstances:
- Lower costs and enough financial resources: One of the firms has a clear advantage in cost or productive capacity and enough financial reserves to stand the losses of a price war without being seriously crippled.
- Substantial share of the market: Often, although not necessarily, the largest firm becomes the leader because it is presumed to have the greatest stage in the welfare of the industry, greater power to enforce followership and the best informed about industry demand and supply conditions and as such best equipped to determine price policy of the entire industry.
- Reputation for sound pricing decisions based on better information and more experienced judgment than what the other firms have: In fact, price leadership frequently arises as a natural growth within an industry due to the successful profit history, sound management and long experience of the price leader in marketing matters. The remaining firms accept the leader because of his ability to coordinate the industry’s growth with that of its members.
- Initiative: Often the company which first develops a product or area retains the price leadership whether or not it retains the largest market.
- Aggressive pricing: Often a company may grab leadership through lower prices and thereby snatch large and profitable markets from conservative rivals.
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