Price Leadership is a scenario where one firm sets the prices, and other companies in that industry follow the same price. The firm that sets the price is usually the firm that is dominant in that industry. Other companies in the industry are free to take their decision, i.e. they may or may not follow the price set by the dominant firm. But, they do follow the dominant firm pricing because if they do not they risk losing their market share, or profitability.
The firm that sets the price is the price leader. The price leadership model is common in industries with oligopolistic market conditions. A good and most popular example of such an industry and situation is the airline industry.
Requisites for Price Leadership
There are many requisites or conditions that are necessary to have a price leadership model. These factors or conditions are:
Large Market Share
Usually, the biggest company in the industry, or the company that has the ability to serve customers in different geographies is the price leader. Or, we can say that one company in the industry should be bigger than others. This size level usually be in all respects like volume, capacity, profits, revenue, finances and so on.
Some firms are better in predicting the demands of the customers or the upcoming trend. So, these firms are better prepared to meet the changes in the demand, or they respond comparatively better to those changes. They may be small firms, but if they have this ability, they could become the price leader. In the short run, others (even bigger firms) will follow the prices set by such a small firm.
If a firm owns any patented technology, then such technology may help it to become a price leader. And definitely geared with such a modern and latest technology any such company can command a premium price from its customers. Other companies would have to follow the prices set by this firm, in order, to boost their profits.
Oligopoly is a conducive market for the price leadership model. This means, there should not be many firms in that industry.
Another important condition for this model is the presence of homogeneous products. This means that all firms in that industry must offer similar products and services.
Types of Price Leadership
Primarily, there are three types of price leadership. These are:
In such leadership, there is usually a firm that is more capable of recognizing the market trends. Thus, such a company is able to adjust to the changes in time, and sets a price that others need to follow.
In such a situation, any company for that matter irrespective of size, may be even a smaller firm becomes a price leader. Other firms in the industry usually follow the price leader assuming that it knows something that they are not aware of. If a small firm is a price leader, then it may be possible that it stays leader only for a short time.
Collusive pricing is a type of price leadership that exists in the oligopolistic industry, or where the cost of entry is very high. In this, the dominant firms in the industry enter into an explicit or implicit agreement over the price. And the smaller players in that industry segment has no option but to follow the dominant firm in the price trend.
Such a type of price leadership could be illegal if the change in the price is not in-line with the change in the operating costs. Or, where the aim of such price control/setting is with a view to defraud the customers. Though it may be very difficult to establish that such an exercise of setting the price is quite illegal. However, it is very difficult to prove that such an act of price setting is illegal.
As is evident, such leadership involves the price setting by a dominant firm. The dominant firm is usually the one with the majority market share. We may also call this as a partial monopoly. In such a model, it is possible that the dominant firm engages in predatory pricing with an objective to drive out smaller firms from the industry. Such type of leadership is illegal in most countries.
Examples of Price Leadership
Let us consider an example to see how price leadership works.
Company A makes windshield wipers, and there are four more companies in the industry that make similar products. However, Company A is the biggest maker and seller of windshield wipers in the country.
Since Company A is the dominant firm it charges only $10 for the product. While the other companies in the industry segment is charging prices in the range of $11 to $13 for a similar product. So, Company A here is the price leader, and other firms have to react to its prices. Other firms, if they want, can follow the price leader and set the price at $10.
Let us try to discuss here a real-world example of price leadership.
India’s newest telecom company Jio very soon became the price leader in the industry. After its launch, the company gave free Internet and calling features to all its customers for a few months.
Prior to Jio, the internet usage per user on average was very less in the country. Jio, however, revolutionized the industry. To compete, many players in the industry went for merger, or quit the market.
Later, Jio ended the freebies and came up with cheap internet and calling plans for the users on a monthly basis. Then other players in the industry also came up with similar pricing plans, in order, to retain their market share. So, Reliance Jio became the price leader. And the other well established and old players in the industry are left with no option but to fall in line and design plans on similar lines. And despite this they could see a migration of customers as well as mergers and amalgamations to remain in the fray.
Advantages and Disadvantages of Price Leadership
Let us now talk about the advantages the Price Leadership offers:
- It helps to eliminate or reduce the price wars. Since smaller companies follow the price set by the bigger firms to maintain (or enhance) their profitability, they do not indulge in price wars.
- If a dominant firm raises the price, it would increase the profitability of that firm. After smaller firms also raise the price of their product, they would also enjoy higher profits. Thus, we can say that such leadership helps to boost the profitability of all companies in the industry.
- Such a model also benefits customers. When the dominant firm reduces the price, and other firms have to follow the same, it leads to saving for the buyers. Above expalained leadership of Reliance Jio is a good example.
- When a dominant firm raises prices, it boosts its profits. The company can re-invest those profits to add more features or make the quality of the products better. This way, price leadership helps to deliver more value to the customers in the long term.
However, there are disadvantages also of price leadership:
- Such type of model is very unfavorable to smaller firms. If the price leader reduces the price, it could make it very difficult for the smaller firms to survive. Because in case smaller firms do not reduce then they will always have a fear of losing their existing customers. And thereby their operations take a critical situation and may end up in losses.
- In case of the price increase by the dominant firm and other smaller firms, the customer is at the losing end. This is because a customer would have to pay more prices for the same product without any value addition.
- If there is a reduction in the price, then it may drive out smaller firms. This may not be good for the economy as it would result in unemployment, dead capital and wastage of resources and so on.
Cost Leadership vs Price Leadership
Many get confuse between these two concepts and consider them to mean the same thing. The two concepts may sound similar, but they are very different from each other.
Cost leadership, as the term implies, is related to the cost of producing the product or service. A cost leader is a company that enjoys the lowest cost of production. Because of its low cost of production, this company can afford to reduce the price of the products and become a price leader.
If other companies do not follow the same, they risk losing the market share. And, if they also reduce the prices, it would lower their profits, or force them into losses.
If a company is a cost leader, it may or may not be enough for it to start a price war. However, it does give the cost leader some advantage in case of a price war.
Like with any other thing, price leadership also has its own advantages and disadvantages. It can both be good and bad for the customers, smaller companies and the economy. Still, there is a need for regulations to keep a check on some specific price leadership, whose purpose is to get more prices from customers without offering them anything new or better.