Economics of the Price Leadership (Dominant Firm) Model
How does price leadership work?
A few elements must exist in an industry for price leadership to be possible:
What is price leadership?
Price leadership occurs when one business has sufficient sway over the marketplace to determine the price of its goods. From this point forward, in order to compete with them, other businesses in their sector must match that price. For instance, if a major eyeglass manufacturer sets the price of their eyeglasses at $50, other eyeglass manufacturers with comparable designs and quality will lower their prices to $50 or less in an effort to continue attracting customers. The major eyeglass manufacturer, the leader in terms of pricing, is followed by other manufacturers.
Some companies use price leadership as their business strategy. They want to gain a sizable market share so they can decide how much to charge for their products or services, adjusting it to maximize their profits. If the business has one of the following benefits, this strategy may be successful:
Types of price leadership
There are three models of price leadership:
Barometric
The barometric model of price leadership describes the situation in which one business anticipates a change in the market and makes an adjustment, leaving other businesses to do the same. For instance, if one business forecasts a rise in production costs and then lowers prices as a result, other businesses in the sector may do the same, assuming that the price leader has knowledge that the rest of the sector does not yet possess. The industry doesn’t have a price leader if the other businesses in it decide not to change their prices.
Given that they have the advantage of being better at predicting market changes, a company can have a relatively small market share and still set the price, which is a distinctive feature of the barometric model. A price leader in this model, however, might only maintain that position for a brief period of time because the barometric model depends on changes in the market to manifest. Once the other industries have responded, a different company might foresee the subsequent change and take the lead in pricing.
Collusive
When businesses with significant market shares agree to set their prices uniformly, this is referred to as the collusive model of price leadership. To compete in the market, smaller businesses must maintain prices that are competitive with the price leader.
Implicit or explicit agreements between the companies to determine the price may exist. However, if the set prices defraud the public, explicit agreements might be against the law. The businesses should set the price in relation to the cost of production and adjust as necessary to avoid this. This model is typically in use in sectors like the airline industry where entry costs are high and production costs are well known.
Dominant
When one company commands a sizable portion of the market and has the power to set prices, leaving the remaining smaller businesses only able to react, this situation is known as the dominant model of price leadership. A partial monopoly is another name for the dominant model.
In this model, the big company can deliberately set the price low so that smaller businesses can’t compete with it and might have to exit the market. Large businesses should exercise caution when setting prices in this manner because it may be deemed predatory by industry professionals and is prohibited by American antitrust laws.
Pros and cons of price leadership
Price leadership has benefits and some challenges. Here are the pros and cons of price leadership:
Higher profits
Smaller businesses will profit more if they follow a price leader who sets a higher price than the previous industry standard and customer demand doesn’t change as a result of the price increase. This means more profitability for the industry. The majority market holder in an industry continues to profit and maintains their market share even if all competitors choose to follow the price lead.
The price leader, though, cannot force rivals to follow its example. Customers may take advantage of the lower prices set by rival businesses, which could result in the price leader losing some market share. Customers might find the additional cost difficult if the majority market holder sets a higher price and its competitors follow.
Increased quality
A company’s capacity to invest in its operations and improve product quality can be increased by aiming for higher profits. Both the business and the customer stand to gain significantly from this. It is also a good way to maintain your market share and your position as the price leader.
When considering reinvesting in their production, businesses should keep an eye on their market for changes in demand to ensure they can continue to generate the necessary profits. Price setters occasionally inflate their costs to match their profits while being unprepared for shifting market trends that may result in declining demand. Before a decline in demand or the onset of a price war, a company can avoid ballooning its overhead costs if it can continue to anticipate changes in the market and its own production costs.
Price wars
If you are the price leader, you can prevent price wars by setting a lower price than your rivals. Due to their smaller operations, companies with smaller shares can lower to your price but probably cannot go lower. This indicates that you can prevent losing market share to a rival who offers lower prices.
Setting a lower price presents a risk because, if competitors do not decide to follow your lead, you could end up losing money. Try to determine whether you can rely on your competitors to follow your lead if you plan to set the price.
Another issue is that there can only be one price leader, so it might be best to refrain from starting a price war by lowering your profits if you do not have a significant enough market share to exert influence over your rivals. Smaller businesses can rely on developing a niche for their goods and services rather than competing on price to secure their position in the market.
FAQ
What does price leadership mean?
Price leadership describes a situation in which other businesses in an industry adopt and follow the prices and price changes set by a dominant firm or a firm that is recognized by others as the leader.
What are the different types of price leadership?
- Barometric model. …
- Dominant firm. …
- Collusive model. …
- Large market share. …
- Trend knowledge. …
- Technology. …
- Superior execution. …
- Profitability.
What are the advantages of price leadership?
In the market, there are several oligopolistic organizations, but one of them is a dominant organization known as a price leader. Advertisements: When there is only one dominant organization in a market, price leadership occurs. This organization sets the price, and the other participants follow it.
