Price leadership occurs when a pre-eminent firm (the price leader) sets the price of goods or services in its market. This control can leave the leading firm’s rivals with little choice but to follow its lead and match the prices if they are to hold on to their market share. Price leadership is common in oligopolies, such as the airline industry, in which a dominant company sets the prices and other airlines feel compelled to adjust their prices to match.
Price leadership has a greater impact on goods or services that offer little differentiation from one producer to another. Price leadership is also apparent where levels of consumer demand make a particular price selected by the market leader viable because consumers are drawn from competing products. Price leadership is assumed to stabilize prices and maintain pricing discipline. In general, effective price leadership works when
- The number of companies involved is small
- Entry to the industry is restricted
- Products are homogeneous
- Demand is inelastic, or less elastic
- Organizations have a similar long-run average total cost (LRATC)
LRATC, an economics metric, is the minimum or lowest average total cost at which a firm can produce any given level of output in the long run, when all inputs are variable.
- Price leadership is when a pre-eminent company sets the price of goods or services, and the other firms in its market follow suit.
- There are three primary models of price leadership: barometric, collusive, and dominant.
- Price leadership is commonly used as a strategy among large corporations.
Types of Price Leadership
In business economics, there are three primary models of price leadership: barometric, collusive, and dominant.
The barometric model occurs when a particular firm is more adept than others at identifying shifts in applicable market forces—like a change in production costs—which in turn allows it to respond most efficiently—by initiating a price change, for instance. It is possible for a firm with a small market share to act as a barometric leader if it is a good producer, and attuned to trends in its market. Other producers follow its lead, assuming that the price leader is aware of something that they have yet to realize. However, because a barometric leader has very little power to impose its decisions on other firms in the industry, its leadership might be short-lived.
The collusive price-leadership model may emerge in an oligopoly as a result of an explicit or implicit agreement among a handful of dominant firms to keep their prices in mutual alignment. The smaller firms follow the price change initiated by the dominant firms. This practice is most common in industries where the cost of entry is high, and the costs of production are known. Such agreements can be illegal if the effort is designed to defraud the public. There is a fine line between actual collusion, which is unlawful, and price leadership—especially if the price changes are not related to changes in operating costs.
The dominant model occurs when one firm controls the vast majority of market share in its industry. The leading firm is flanked by small firms that provide the same products or services, but which cannot influence prices. Often the dominant company ignores the interests of the smaller companies. Therefore, dominant price leadership is sometimes referred to as a partial monopoly. A drawback of this model is that the leader might engage in predatory pricing by lowering its prices to levels that smaller firms cannot sustain. Such practices that are aimed at hurting smaller companies are illegal in most countries.