Price Leadership

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

The first type of price leadership is barometric price leadership. In the barometric price leadership model, a particular firm is better at identifying a change in the market conditions and can adapt to changes efficiently. This allows this firm to position itself as the price leader in the market. The leader firm in the barometric model does not have to be large; a small firm that has adapted itself efficiently according to the changes in the market can be a price leader, too.

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.