Price Leadership is a model of collusive oligopoly under which one firm sets the price and others follow it. Thus, one producer acts as a price leader and others follow him. The price set by the leader firm is followed by others either because there is a formal or secret agreement to this effect or that following the price leader may be in their own self interest. Price leadership may be various forms such as (i) price leadership by a low cost firm, (ii) price leadership by dominant firm and (iii) barometric price leadership wherein the oldest, most experienced or the most respected firm assumes the role of price leader. The price leader sets the market price according to the MR = MC equilibrium principle and others simply adopt the price set by him.
A low cost firm is one whose per unit cost (AC) is lowest among all the firms. So, this firm has the highest competitive power and can drive other firms out of the market if they choose to compete with it. The other firms also realize this position and therefore, instead of competing with it, they find it both profitable and suitable to follow the price set by the low cost firm.
The dominant firm may sometimes act as a price leader and fix the market price which has to be adopted by others. The dominant firm is a very big firm having a large share of the total market while a large number of smaller firms taken together have a smaller share in the total market demand. Thus, the dominant firm is in a position to influence the market price by changing its own supply. To avoid competition with this firm, other firms have no alternative but to accept the price set by the dominant firm.
The dominant firm sets the market price on the principle of its own profit maximisation, where its own MR = MC. It produces the equilibrium level of output so decided and leaves the rest of the market to the followers, who adjust their output and supply accordingly to the price set the dominant firm.
It is not necessary that under the price leadership model of oligopoly, the price leader must either be a low cost firm or dominant firm. It maybe so that a firm has achieved reputation, being a very old in the market and hence most experienced and widely respected. Such a firm may assume the role of a custodian for protecting the interest of all the firms in an industry and, therefore, works as a price leader. This firm assesses the changed market conditions with regard to the demand for the product of that industry, competition from the related products, changes accordingly. The other firms simply follow this firm on the assumption that this firm indicates the pulse of the market. This barometric firm – it is a change in market trends is believed to be the custodian of all the firms in the industry.SUBMIT ASSIGNMENT NOW!