Price Leadership- Meaning, Types and Price-Output Determination Under Low cost Price Leadership and Domanant Firm Price Leadership
Price Leadership
Price Leadership: Price leadership is an
important form of collusive oligopoly. It
takes place when there is only
one dominant firm in the industry, which sets the price and others follow it.
Sometimes, an agreement may be developed among oligopoly firms of an industry to
assign a leadership role to one of them. There is a tacit or formal agreement
among the firms to sell the product at a price set by the leader- firm of the
industry. If the products are homogeneous, a uniform price is set. In case of
differentiated products also prices can be uniform. If there is any change in
price, the leader-firm announces from time to time, and the other firms follow
him. Price leadership works effectively
when the products are homogeneous and all the firms have identical cost curves.
There are various types of price leadership.
1- There is the barometric
price leadership in which there is
no leader-firm but an experienced, and largest firm assumes the role of a
custodian who protects the interests of all. He assesses the market conditions
with regard to the demand for the product, cost of production, competition from
the related products etc. and sets a price which is best for all the firms in
the industry. This barometric firm only initiates a reaction to changing market
situation, which other firms may follow it if they find these reaction in their
interest.
2-There is the dominant
price leadership where one big firm, the largest in the industry, dominates
the market like a monopolist. This dominant firm wields a great influence over
the market for the product, while other firms are small and are incapable of
making any impact on the market. As a result, the dominant firm estimates its
own demand curve and fixes a price which maximizes its own profits. The other
firms which are small having no individual effects on the price of the product,
follow the dominant firm and accept the price set by it and adjust their output
accordingly. Dominant price leadership is sometimes termed-as partial monopoly as
the interests of other firms are ignored by the dominant firm. This type of price
leadership is most commonly seen in the industry.
3-There is the aggressive or exploitative price leadership
in which a dominant firm establishes leadership by following aggressive
price policies by fixing the profit maximization price for itself and compels
other firms to follow the prices set by it. Such a firm will often initiate a
move threatening to compete the others out of market if they do not follow it
in setting their prices.
4- There is a low-cost firm price leadership where the
low-cost firm sets a lower price than the profit-maximizing price of the
high-cost firms. Thus, the high-cost firms are forced to agree to the lower
price set by the low-cost firm. The low-cost price leader has to ensure that
the price which he sets must yield some profits to the high-cost firms too.
Price-Output Determination under Low-Cost Price Leadership:
An oligopolistic firm
having lower costs than the other firms is in a position to set a lower price
which the other firms have to follow, and becomes the price leader. There are following
assumptions which make the analysis very simple:
1- There are two firms, A
and B. The firm A has a lower cost of production than firm B.
2- The product produced by both firms is homogeneous so that the
consumers have no preference between them.
3-Each of the two firms has equal share in the market. That’s why
demand curve facing each firm will be the same and will be half of the total
market demand curve of product.
Each firm is facing demand curve df [it is representing the market
MR curve also] which is half of the total market demand curve DD for the
product. MR is the marginal revenue curve of each firm. ACa and MCa are the
average and marginal cost curves of firm A, and ACb and MCb are the average and
marginal cost curves of firm B. Cost curves of firm A lie below the cost curves
of firm B as firm A has a lower cost of production than firm B. The firm A is
in equilibrium at point E where its
marginal cost is equal to the marginal revenue and will maximize its profits by
selling output OM at price OP. Firm B's profits will be maximum when it fixes
price OH and sells output ON as its MCb and MR intersects each other at point F.
From the diagram it is clear that profit-maximizing price OP of firm A is lower
than the profit-maximizing price OH of firm B. Since the two firms sell a
homogeneous product, they cannot charge two different prices. Because the price
OP of firm A is lower than the price OH of firm B, firm A will emerge as a
price leader and firm B will be compelled to follow.
Firm B after having accepted firm A as the price leader will
actually charge price OP and it will also sell OM because both the firm share
the half market and the demand curve facing each firm is the same. Thus, both
the firms will charge the same price OP and sell the same amount (OM). The
total output of the two firms will be OM + OM = OQ which will be equal to the
market demand at price OP. At OP price firm A, the price leader, will maximize its
profits as it is lower cost firm while the
firm B will not be making maximum profits with this price-output combination
and it will be smaller than firm A because its costs are greater than firm A.
Price-Output Determination Under Price Leadership by the Dominant
Firm:
When there is one large dominant firm and a number of small firms in the industry. The dominant firm fixes the price for the entire industry and the small firms sell the product at the price set by dominant firm. It will select that price which brings more profits to itself. This model is based on the following assumptions:
- The dominant firm has complete control over the market price.
- All other firms act like perfect competitors. Their demand curves are perfectly elastic for they sell the product at the dominant firm's price.
- The dominant firm alone is capable of estimating the market demand curve for the product.
- The dominant firm is in a position to predict the supplies of other firms at each price set by it.
Since each firm sells
its product at the price set by the dominant firm, its demand curve is
perfectly elastic at that price. we assume that the dominant firm knows the
total market demand curve for the product and also knows the marginal cost
curves of the smaller firms whose lateral summation yields the total supply of
the product by the small firms at various prices. This implies that from its
past experience the dominant firm can estimate the likely supply of the product
by the small firms at various prices. With this information, the leader can
obtain his demand curve.
In the diagram, in panel
(A) DD is the market demand curve for the product and Sm is the supply curve
the product of all the small firms taken together. At each price the leader
will be able to sell the part of the market demand not fulfilled by the supply
from the small firms. Thus, at price P1, the small firms supply the whole of
the quantity of the product demanded at that price. Therefore, demand for
leader’s product is zero. At price P2, the small firms supply P2C and therefore
the remaining part of CT of the market demand will constitute the demand for the
leader's product. The demand for leader’s product has been separately shown in
panel (b) by the DL curve. P2Z in panel (b) is equal to C T in panel (a). At
price P3, the supply of the product by the small firms is zero. Therefore, the
whole market demand SU will have to be satisfied by the price leader.
Likewise, the other point of the demand curve for the price leader can be
obtained. In panel (b) the MRL is the marginal revenue curve of the price
leader corresponding to his demand curve dL. AC and MC are his average and
marginal cost curves. The dominant price leader will maximize his profits by
producing output OQ and setting price OP [or HQ]. The followers, that is, the
small firms will charge the price OP and will together produce PB. [PH in panel
(b) equals BS1 of panel (a).
Price leadership
involves many difficulties in the real world. First, sometimes his estimates
proves to be incorrect about the reactions of his rivals to price changes and
it creates difficulty in the success of leadership. Second, when a price leader
fixes a higher price than the followers would prefer, then it will induce the
rivals to make secret price cuts by increasing number of concessions and
discounts which will adversely affect the sales of the price leader.
Third, the rivals
charge the same price set by the leader but try to increase their share of the
market by increasing the advertisement expenditure, as a result, the price leader has also to indulge in non-
price competition to prevent the fall in its sales and may not be able to maintain his leadership for
a long time.
Further, there is another limitation for the price leader to fix a high price of his product. Sometimes, a high price fixed by the price leader will attract new competitors into the industry which may not accept his leadership
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