Price Leadership

It is an important form of collusive oligopoly price leadership comes into

existence through taint or formal agreement. Price leadership is of four types
a) Low cost price leadership
b) Dominant price leadership
c) Barometric price leadership
d) Exploitative price leadership

a) Low cost price leadership: For maximizing profit the firm with lower
cost of production sets a lower price than the high cost firms. Since the
product is similar the high cost firms will not be able to sell their product at
higher price and will be forced to accept the price set by the low cost firm. The
low cost price leadership is explained with the help of figure 4.2. For explaining
the lowest price leadership let us assume that there are two firms in the
market namely A & B selling homogeneous product & have equal share in
market. Firm A has the lower cost of production and firm B has higher cost of
production.

Figure 4.2: Low cost price leadership

Total demand in the market is DD and each firm is facing demand DAR. MR is
marginal revenue curve of each firm MCa is marginal cost of firm A and MCb is
marginal cost of firm B.

At point Ea, MR=MCa and firm A will maximize profit by producing OQa output
and selling it at price OPa. Firm B on the other hand will produce OQb output
and sell at price OPb as its profit will be maximum. As the two firms are selling
homogeneous products they cannot different prices in the market. Moreover, a
firm selling at higher price will loose the customers. In this situation, firm A &B
will reach an agreement and firm A, the low cost firm will lead the price. After
accepting the price, firm B will sell output equal to that of firm A at price OPa.
Total output of the two firms is OQa + QaQ = OQ which is equal to the market
for the good at price OPa. Firm A is price leader it will maximize profits with
this price output combination. Firm B is the follower and thus it will not be
making maximum profit at this price and output.

b) Price Leadership by dominant firm: A dominant firm is the one which has
a large share of the market. It has a number of small firms as its followers.
The dominant price leadership model rests on the following assumptions.
Dominant firm knows the total market demand for the product.
It also has the knowledge about the marginal cost curves of the small
firms and total supply by small firms at various prices.
Which this knowledge it can estimate the supply of the product by the small
firms at various prices and derive its own demand curve.
Figure 4.3 a and b: Dominant price leadership

Dominant price leadership is explained with the help of figure 4.3. In the figure
DD is the market demand curve and SS is the supply curve by small firms. OP
is the market equilibrium price at which the demand is PE and the entire
demand is met by the supply by the small firms. At price OS, total demand is
ST and supply by the small firms is zero. When market price is Op the demand
for leaders product is zero and at price OS the leaders demand is ST. This
knowledge is used by the dominant firm to derive the demand for its products
as shown by curve ARd in figure 4.4 b MRd is the marginal revenue curve of
the dominant firm. The dominant firm will maximize its profit at price OPd by
selling OQ output as MR=MC at point Ed. Output OQ is equal to GH. At price
OPd total market demand is PdH of which GH is supplied by dominant firm
and PdG is supplied by the follower firms i.e small firms. The profit maximizing
price OPd is set by the dominant firm but it has to make sure that the small
firms produce PdG output. If small firms produce more or less than this
output, the dominant firm will be posed to a non-profit maximizing position.

c) Barometric price leadership: It is a leadership by an old, experienced,

largest and most respected firm. Such firm leads the price by protecting the
interests of all the firms in the market. It sets the price by assessing market
 conditions with regards to demand, cost of production and competition from
other products etc.

d) Exploitative price leadership: In this form of price leadership the large or

dominant firm leads others by following aggressive price policies and
compels other firms to follow the price set by it. Such firms can go to the
extent of threatening to compete others out of market.