Price leadership is a fascinating topic for a business leader such as myself. It supplies a frame work in which to understand the market you are in, and it outlines the opportunities or problems that can occur if a single player becomes dominant in a market. This article will explain what Price Leadership is, how it can occur, the categories or types of price leadership and finally comment on price fixing (collusion) which is illegal in most countries. Before we go into this in depth, let us have a short and brief explanation to supply you with an overview of the topic.
What is price leadership?
Price leadership is when a company controls the price of a product in a market. This can be done through dominant price leadership, barometric price leadership or collusive price leadership. In the end, it means that if a price leader increases the price, competitors will follow. If the price leader lowers the prices, the competitors will also decrease their price.
Price leadership definition
Price leadership is when one company has such a dominant position in a market that all or most of the competitors follow the price levels set by this company. The company has in effect become the price leader of the market and set the reference for the commodity or service in the market. Competing, similar, products are perceived as either “slightly more expensive than A” or “a bit cheaper than A”, where A is the dominating company, i.e. the Price leader.
There can be several causes for the dominant position that leads to price leadership, such as:
Price Leadership through Market Share
If a company has a really large market share, competition might change their price in order to follow the market leader. Let´s say there are 101 manufacturers of cars and one of them has a market share of 40% and the others have 6% each of the market. It is very likely that all potential buyers will compare any car option as well as price with the one from the market leader since everybody has heard of it and likely know people who have that car.
Price leadership through Branding
Just like in the case of price leadership through market share, a company can become the price leader through branding. By brand awareness and brand loyalty, the product or service that the company offers is the most well known, and hence the reference point for the buyers or consumers. This means that all competitors need to see their price in relation to the price of the price leader. Essentially, the same dominance in market pricing is achieved without necessarily having the biggest market share.
If competitors need to consider their pricing and position in relation to the dominant company in the examples above, then this dominant company is to be considered as the price leader. For instance:
- Position yourself as a cheap option at “Company A’s price” – 10%
- Position yourself as a luxury car at “Company A’s price” + 10%
If the Price leader increase or decreases their price, the others are likely to follow in order to keep that position, justification and competitive edge they might get by it.
Both of the above situations are easier to establish in an oligopoly situation, i.e. a market with a few competing companies. Essentially, if there are only five companies, it is easier to reach domination either through market share or branding than it likely is in a situation with five hundred companies – competition is simply tougher.
Price Leadership – enabling factors
The presence of the following factors makes it more likely for price leadership in a specific market:
- The number of competitors is small (as mentioned above)
- Demand is not particularly depending on price levels, i.e. the price is inelastic or at least have low elasticity
- Low product differentiation. Since less differentiation in products make them easier to compare, pricing becomes a bigger factor in decision making.
- There is a high threshold to enter the industry, i.e. takes a long time or requires substantial investment for other companies to get established in the same market (a low threshold could that companies enter and exit the market temporarily)
Hence, low product differentiation makes it easier for price leadership to emerge.
Is price leadership illegal?
Please note that price leadership isn’t an agreement or formal arrangement. That would be forming a cartel, which is illegal in most countries. Price leadership is more of an equilibrium pricing point established by all other players following the dominant player in a market.
What are the three types of Price Leadership?
There are three different types of price leadership: Barometric, Collusive and Dominant. All of them are explained below.
1. Barometric price leadership
If a highly efficient company manages to identify market changes and adapt to them better and smarter than their competitors, they essentially become a barometer for market trends. Once other players in the market understand that this, they start following the price adjustments of the proactive company. This is called barometric price leadership and the price leader can even be a small player with a low market share. Their capability of reacting early or even pre-empt changes on the supply as well as the demand side in the market sets them apart. This only works as long as the competitors keep on following along in the price reactions.
2. Collusive price leadership
Collusive price leadership is also called “tacit collusion”. This kind of price leadership emerges when several market players keeps certain price levels. Collusive price leadership normally only occurs in oligopoly markets where costs are normally publicly known and pricing increases or decreases as the costs change. Raw material price increases likely affects all players similarly, and the pricing changes accordingly for instance.
If prices are agreed upon and pushed upwards or kept high despite dropping costs, the purpose is to maximize profit – which isn’t collusive price leadership anymore – it is collusion. Collusion is an arrangement considered illegal in most parts of the world since it ruins free competition.
The latter is also known as price fixing or the creation of a price cartel. See our separate chapter on Price fixing and collusion further below.
3. Dominant price leadership
As the name suggests, the dominant company sets the prices of the product, goods, or services. This dominance is normally achieve by having a very large market share. In such a dominant price leadership position, the leader virtually controls the pricing and all the other players follow along. With an upper hand in size and the ability to survive longer than the smaller competitors, the dominant price leader can drop prices long enough for some competitors to go bankrupt, after which the price leader can increase the prices again. If most or all of the competitors are removed, the price leader would in fact establish a monopoly and would be able to increase the prices much higher than they were before. Dropping prices too low to hurt weaker competitors is illegal in many countries. Dropping prices in this way is sometimes referred to as “predatory pricing”.
Price Leadership, Pros and Cons
Advantages of Price Leadership
- Profitability is higher if price levels are higher. If a price leader sets a relatively high price for others to follow, the profitability would increase for all the involved companies. (A reason why cartels are illegal, see further below.) If the price gets too high, demand is likely to drop, which keeps some balance. Also, if profits are too high, additional competitors will likely show up, potentially disrupting the balance in the market
- Power position vs competition. The price leader could temporarily lower the price causing others to follow. The price leader is likely to survive longer if it has the highest market share. Furthermore, the price leader has the opportunity to increase the price again as needed. However, this can create a new price point and it might be difficult to increase the price all the way up again after a long period of reduced pricing. With such a move, the price leader could make life very difficult for the competitors.
- Fewer price wars. If all parties continue to follow the price leader, there is less risk of damaging price wars. After all, the price leader is used to some competitors having lower prices, they still get a lot of business though, otherwise they wouldn’t be in the position of price leadership.
- Product quality might improve. Higher profits would enable additional expenses on research and development. Perhaps more importantly, the low frequency of price wars means there are less reasons to sacrifice quality in order to reach lower costs enabling lower prices.
Disadvantages of Price Leadership
- Higher costs for customers. If the market allows for price leadership and this keeps the prices unnecessarily high, i.e. the backside of the first advantage above, it means that customers and consumers are paying more than they would have under different market conditions. This is of course a disadvantage to the people and companies that buy the products.
- Unfair for smaller companies. The backside of the Power position of the price leader described above is of course that the weaker companies suffer in such a situation. They might be unable to match the prices of the pricing leader since they lack economies of scale.
Price fixing or collusion – illegal price leadership
Price fixing is when two or more competitors strike an agreement to regulate prices among themselves. Collusion is another name for price fixing. The law in most countries require that companies establish and create their own pricing independently in order to avoid price fixing schemes. Fixing prices makes it possible to over charge for a product or a service since there are no cheaper alternatives, and the participants in the price fixing scheme can pocket additional profits as a consequence.
Price fixing schemes are not just about fixing prices. There are other actions or agreements that can be made in order to create a similar situation – allowing inflated pricing due to lack of competition.
- Dividing sales territories between each other
- Taking turns participating in bids and tenders
- Limiting the supply in the market and thus driving prices upwards
The fines are extremely severe for companies that get penalized for price fixing.
Price Leadership in a Duopoly
A duopoly is an oligopoly situation where only two suppliers are dominating a certain market. Monopoly, as you might already know, is when one player fully dominates a market. If the duopoly colludes on pricing, the end result would be similar as in a monopoly situation, competition is virtually taken away.
If the products are similar enough and both companies target profit maximization, price leadership in a duopoly can emerge. Essentially, if one of the companies start to follow the pricing of the other, pricing will no longer be a factor of competition. They will then share the market without underbidding each other, thus maximizing profits. However, this is not the only possible outcome and there are many different theoretical models and approaches to price leadership in a duopoly, two of them mentioned briefly below. One of the models lead to a joint market dominance and the other one leads to a price war where one company ends up having a monopoly.
Duopoly price leadership: The Cournot model
This type of duopoly model describes lack of competition in a duopoly. As both companies aim for maximizing their profits and price there product accordingly, they will end up reaching an optimum volume where both maximizes their market share and profitability at the same price. This will remove competition, but pricing stays more reasonable than in a monopoly where one actor can do as it pleases.
Duopoly price leadership: The Bertrand Duopoly model
In this model, the two players in the duopoly have similar products and consumers are expected to buy from the supplier with the lowest price. In theory, this will result in a price war where both companies underbid each other to gain the largest market volume. The company with the lowest marginal cost would end up the winner obtaining a monopoly in the end.
Cost leadership vs price leadership
Price leadership and cost leadership are sometimes misunderstood to be the same concepts, despite that being very far from the truth.
Cost leadership is when a company manages to have the lowest cost of operation in the market, i.e. becoming the most effective on what they do. A company in a cost leadership position, a theoretically and practically drop prices so much that all other suppliers in the market are making a loss while the cost leader still is profitable.
Being the cost leader does not constitute a reason in itself to start a price war. In lieu of a price war, the cost leader will simply have a higher profit than its competitors.