Friday, November 9, 2007





Price leadership is an important form of collusive oligopoly. One firm sets the price and others follow it. Who will be the price leader is set either formally or tacitly as an informal understanding between oligopolists.

Types of price leadership:

1. Price Leadership by a low cost firm: Low cost firms set the price. Often it is lower than the profit maximizing price of a high cost firms. So high cost firms will not be able to sell their products at a higher price.
2. Price leadership by the dominant firm: Here the price leader is the firm that has the largest market share in the industry. The other firms are small and so incapable of making any impact on the market. Sot eh dominant firm fixes a price that maximizes its own profits and the followers accordingly adjust their output.
3. Barometric price leadership: Here the price leader is an old, experienced and maybe the largest firm in the market. This firm assesses changes in market conditions and modifies price to the best interest of all firms in the industry.
4. Exploitative or aggressive price leadership: Here a very large or dominant firm establishes its leadership through aggressive price leaders that compel others to follow. Such a firm’s market behavior contains the threat of ejecting out other firms in the industry if they do not follow suit.

Price output determination under low cost price leadership:

The following assumptions are made to simplify the analysis:

(a) There are two firms A and B. Firm A has a lower cost of production than B.
(b) The product produced by the two firms is homogenous. So consumers have no preference between them.
(c) Each firm has an equal share in the market and so demand curve facing each firm is the same.

Illustration and explanation:

(See figure 37.2, page 752, Advanced Economic Theory: Microeconomic Analysis by H L Ahuja)

· d = firm’s demand curve. Half of the total market demand curve D.
· MR = marginal revenue of each of the two firms.
· ACA, MCA, ACB & MCB = Average costs and marginal costs of firms A and B respectively. As per assumption (1), the above cost curves of firm A lies below the cost curves of firm B.
· OM & OP = profit maximizing output price of firm A at a point where MCA = MR.
· ON & OH = profit maximizing output and price of firm B at a point where MCB = MR.

As profit maximizing price OP of firm A is lower than that of firm B, in a price war firm A will succeed over firm B. Due to this possibility firm A will emerge as price leader and firm B as price follower. At this juncture firm B being a price follower will also charge OP price and sell OM quantity of output. The total output of industry will OM + OM = OQ. Firm A will be maximizing its profits while firm B will not be making maximum profits. This is because at OP price and OM output, MC = MR for firm A while it is not the case for firm B. In case the products of the price leader and price followers are differentiated then the prices between them will be different. However the difference will be less and have a definite pattern that will be followed by the firms.

Price leadership by the dominant firm:

This situation is a case of one firm being the dominant one as a result of its large market share with followers being smaller firms with a small share of the market. In order to analyze price leadership of this kind the following assumptions are made about the dominant firms:

(a) The dominant firm knows the total market demand curve for the product.
(b) The dominant firm knows the MC curves of smaller firms. Its lateral summation is the total supply curve at various prices.

(See figure 37.3,page – 753, Advanced Economic Theory: Microeconomic Analysis by H L Ahuja)

· DD = Market demand curve for the product.
· At P1 = small firms supply the full quantity demanded. So demand for leader’s product is zero.
· At P2 = P2C is small firms supply and CT market demand is price leader’s demand.
· DL = Demand curve of price leader.
· P2Z = CT of panel A.
· P3 = price at which small firms’ supply is zero and full market demand P3U covered by price leader.
· MR1 = marginal revenue curve of price leader corresponding to demand curve dL.
· OQ (PH) = profit maximizing output of dominant price leader.
· OP = price charged by small firms who are price followers and together produce PB quantity.

In order to maximize profits, the dominant firm not only has to ensure followers charge the profit maximizing price OP, but also has to ensure they produce and sell PB amount of the produce. Otherwise the price leader will have to cover the deficit due to undersupply by price followers and incur additional cost or have excess finished good inventory if followers produce more than their share. This means dominant price leadership would prevail only if there is a definite market sharing agreement among the firms in the industry.

Difficulties of price leadership:

Self and independent study by students. (Advanced Economic Theory: Microeconomic Analysis, by H L Ahuja).

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