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Price leadership Model
OligopolyOligopoly
Types of price leadership Price leadership by a low cost firm Price leadership by the dominant firm Barometric price leadership Exploitative or aggressive price leadership
Types of price leadershipTypes of price leadership
Price leadership by low cost firm Assumptions
1. Each of the two firms has equal share in the market (demand curve facing each firm will be the same and will be half of the total market demand curve of product)
Low cost firmLow cost firm
D (Market demand)
d (Firm demand)MR
O
$
Q per year
Each of the two firms has equal
share in the market
2. There are two firms, A and B. the firm A has a lower cost of production than B.
3. The product produced by the two firms is homogeneous so that the consumers have no preference between them.
Low cost firmLow cost firm
MCa
ACa
D (Market demand)
d (Firm demand)MR
O
P
$
Q per year
MCb
ACb
the firm A has a lower cost of production than B.
MCa
ACa
D (Market demand)
d (Firm demand)MR
M Qtotal
P
O
$
Q per year
The firm A will maximize it's profit by selling output OM and setting price OP
MCb
MCaACb
ACa
D (Market demand)
d (Firm demand)MR
M Qtotal
H
P
NO
The firm B's profit will be maximum when it fixes price
OH and sells output ON.
Since the two firms are producing a homogeneous product, they cannot charge two different prices.
Because the profit maximizing price OP of firm A is lower than the profit maximizing price OH of firm B, firm A will dictate the price to the firm B and will emerge as a price leader and firm B will follow.
Low cost firmLow cost firm
MCb
MCaACb
ACa
D (Market demand)
d (Firm demand)MR
M Qtotal
P
O
Both firms will charge price OP and sell
OM
There exists price leadership by a dominant firm which has a large share of market with a number of smaller firms as followers each of them has a small share of market.
Assumptions Dominant firm knows the total market
demand Dominant firm knows the marginal cost of
the smaller firms whose lateral summation yields the total supply by the small firms at various prices.
Dominant firmDominant firm
Total Market demand
(Supply of small firms) MC
Q per year
$
O
D
MC
Q per year
$
Q per year
$
P1
With these information, the leader can obtain his demand curve.
Leader demand
Demand fulfilled by small firms
O
D
MC
Q per year
$
Leader demand
MR
MC
The dominant firm will maximize it's profit by selling output OQ and
setting price OP
Q
P
O
Demand fulfilled by small firms
O Q per year
P
Dominant firm have to ensure that the small firms will produce only the remainder of demand (not more) otherwise the dominant firm will be pushed to a non-maximizing position.
This implies that if price leadership is to remain, there must be some definite market sharing agreement.
Dominant firmDominant firm
All firms agree to follow the price change made by a firm which supposedly has good knowledge of the market conditions and thus can forecast future happening in the market better than others.
Followers are not required to make continuous costs on demand calculations.
Barometric price leadershipBarometric price leadership
Dominant firm compel the other firms in the industry to follow him in respect of price. Such a firm will often initiate a move threatening to compete the others out of the market if they do not follow him in setting their prices.
Aggressive price leadershipAggressive price leadership
