Price Leadership

Assume you are an airline firm and try to make a profit like all other firms. In economics, the profit depends on the prices of the products or services and their costs. But what determines the prices of products or services? Who decides on the overall prices of airline tickets? The answer depends on the market structure. In a monopolistic market structure like an airline industry, generally, the leading firm has the influence to determine the price. But how does it work exactly?

In this article, you will learn all about the price leadership strategy, different types of price leadership, and its characteristics. Ready to learn? Continue reading!

Price Leadership Strategy

Price leadership strategy is a very important strategy for firms in the market. When can we see a price leadership strategy? When a leading firm in a given industry has a major influence in the market and can determine the price of products or services for the whole market, then there is a price leadership in the market. The firm that has this influence is the price leader in the market. This phenomenon is usually seen in oligopolistic market structures, where there are only a few large firms that dominate the market.

Price Leadership Definition

The type of market structure in which a firm sets the prices for the industry as a whole and other small firms have to follow this price level is called price leadership.

The firm that acts as the price leader of the market is usually the one that has the lowest production costs. Thanks to the low level of production costs, the price leader has the opportunity to undercut the prices and thus set the price at a low level that is not optimal for other firms with higher production costs. The competitor firms need to charge at similar lower levels of price as the price leader even though it is not optimal for them. However, if they increase their price level, they can sell fewer of their products or services. This would increase the price leader's market share and lowers the profit of the competitor firms in the long run. Therefore, they follow the price leader's price level.

The competitor firms try to prevent this situation by differentiating their products. For instance, in a food market where the price leader set a lower level price than the production costs of a small firm, a small firm can try to differentiate its products by focusing on vegetarian food options and have some market share in its target market.

Characteristics of Price Leadership

There are several characteristics of price leadership. Price leadership is more likely to be seen in industries where there is a limited number of active firms in the market and there are high barriers to entering the market. Furthermore, the demand is usually high and inelastic. In other words, there are no large changes in demand with an increase in price since consumer demand for a specific product is very high. Because of that, the firm that produces the demanded specific product becomes the price leader in the market.

Since these characteristics define the oligopolistic market structures, price leadership is very common in the oligopolistic market structure. In oligopolies, a few large firms dominate the market and other active firms have very small market shares. The firms that have small market shares do not influence the market and have to follow the price that the leading firm(s) set in the market.

Price Leadership Example

Let's take a look at a price leadership example. The airline industry is a good example of a price leadership strategy. The airline industry has usually had an oligopolistic market structure since there are high barriers to entry due to the high costs of the industry. In the airline industry, the leading firm that has a significant market share usually sets the price in the market using its market power. In that case, other small airline firms have to adjust themselves to that price level, which is not always possible. Therefore, the firm that is behaving as the price leader continues to protect its influence in the market.

Types of Price Leadership

There are three types of price leadership that can be found in markets: barometric, collusive, and dominant as seen in Figure 1.

Barometric Model

After this firm adapts to the changed market conditions first and positions itself as the market leader, other competitor firms have to follow its lead since other firms would assume that the leading firm already knows more about the market conditions compared to their knowledge. However, the leading firms in the barometric model usually have little power to influence others in the long run and their influence is generally only effective for short periods.

Collusive Model

The second type of price leadership is collusive price leadership. In the collusive price leadership model, we usually see the characteristics of an oligopolistic market structure. In an oligopolistic market structure, a few dominant firms collude with each other and set the price of the products or services available in the market. Other smaller firms need to adjust their price level according to these dominant firms.

The collusive price leadership model can be seen mostly in markets where there are high barriers to entry. If there are high barriers to entering the market, the dominant firms that are already active in the market can protect their market share more easily since it is less likely that new firms will enter the market.

The agreement between the dominant firms can be explicit or implicit. If this collusive behavior of dominant firms aims to defraud the public, then this model is considered illegal. In the cases where the price changes are not related to the operating or production costs, then it is likely that it is considered illegal.

Dominant Model

The third type of price leadership is dominant price leadership. In the dominant price leadership model, there is usually one dominant firm and other small firms are active in the industry. Even though other small firms produce similar products or services, only the dominant firm that controls the majority of the market has the influence to set the prices.

Since the dominant firms have the majority of the market share, the dominant price leadership model is similar to a partial monopoly. In that model, the dominant firm can lower the prices to a level where other small firms can't compete. This pricing strategy is called predatory pricing and forces the small firms to leave the market in the long run. Since this dominant price leadership model hurts the competitiveness in the market and does not allow small firms to be active in the market, this model is considered illegal in most countries.

Advantages and Disadvantages of Price Leadership

There are advantages and disadvantages of price leadership in a market. The main advantage of price leadership for price leaders is to have higher profits due to the ability of price leaders to set the price level. Since other firms have to follow the price level that the price leader sets, the price leader can set the price in a way that maximizes its profit. If the price leaders choose to set a high level of price and others follow this level, not only the price leader but all competitive firms would benefit from the price leadership and get higher profits. However, this is a disadvantage for customers since they have to pay higher prices for the same quality of products or services.

Another advantage might be the higher quality or new features. Since the price leader can set the price level so that it can maximize its profits, the price leader can use some of the profit to re-invest in research for product developments, new features, or higher quality products. This also benefits the customers who are fine with paying higher prices for premium products.

In the price leadership model, unfair competition might be an issue. Since price leaders can also set the prices at lower levels, the small firms might incur losses in the long run. Thus, the price leaders would increase their market share even more, which is an advantage for them. However, for the small firms that have to leave the market, this is a great disadvantage.

The last point could be the reduced price wars. In markets that have many companies with similar market shares, it is likely that there are price wars between competitors to increase their market share. However, in the price leadership model, one or a small number of firms dominate the market and it is less likely for other firms to engage in price wars since they try to protect their market share. Therefore, they will try to adjust the prices that are set by the price leader and follow the price leader's strategy.