‘Price leadership is an alternative cooperative method used to avoid tough competition’. Comment.

‘Price leadership is an alternative cooperative method used to avoid
tough competition’. Comment.


Answer. Price leadership is an observation made of oligopolic business behavior in
which one company, usually the dominant competitor among several leads the way in
determining prices, the others soon following.
When business conditions permit, the price leader will raise prices with the expectation
that the others will follow. The practice of price leadership prevails in many industries:
automobiles, breakfast cereals, beer, steel and bank loans are among the many goods
and services that are usually priced in this manner.
On the surface, it looks as though the effect of price leadership is the same as the
effect of the fixing of prices by a cartel or a trust. But there is a fundamental difference.
The trust or cartel assigns production quotas to its members in order to keep
production down. Competition does not exist in any form. Oligopolies that follow a price
leader do not engage in price competition, but they still contest for market share with a
variety of forms of non-price competition. Pepsi and Coke each spend billions on TV
ads designed to entice the consumer to switch cola brands, but those expensive ads
never mention price.
An example. Company A has two principal competitors and a number of smaller niche
players. The niche players serve focused geographic areas or offer specialty products
or services to unique segments of the customer base. Company A is a premium priced
producer and is a price leader. Each time it raises or lowers prices, its competitors also
make a price move. If Company B has a current price which is 90% of Company A, then
when Company A lowers its price Company B will adjust proportionally. Thus Company
B will still have a price 90% of Company A. The reverse occurs when Company A takes
a price increase.
PRICE LEADERSHIP- AVOIDING TOUGH PRICE COMPETITION
Price Leadership: Changing a price is always a dangerous practice for an oligopoly. If
the firm lowers the price, its competitors are also likely to lower theirs, then all will
suffer from lower profits. On the other hand, raising prices may lead to a loss of market
share unless competitors also raise their prices. In many industries, one firm (usually
the largest) is accepted by the others as the price leader. The price leader will be the
first to adjust prices to new conditions (higher labor costs, lower raw materials costs,
etc.) and the others will fall into line. Of course this arrangement is entirely informal and
unwritten - since any actual agreement to follow such a practice would violate the
antitrust laws.
Price Setting: But on what basis does the price leader set prices? The interplay of
supply and demand forces so beloved by neoclassical economists loses its cogency as
a theory of prices when 1) there is too little competition to force prices to equal
marginal costs and marginal benefits through a Darwinian struggle; 2) costs per unit fall
with increased output as the firm is able to spread its fixed costs over a larger number
of units; and 3) demand is itself subject to manipulation by the firm through advertising.
Institutionalists and Post-Keynesians claim that the structure of oligopoly leads to a
form of administered pricing. The price leader will use its average cost as a basis for
price setting. Prices will be set at a level which achieves a target level of operating
profits. This target level will be sufficient to enable the firm to self-finance expansion
without the need to issue new stock or to borrow amounts of money that might threaten
the firm's independence. Rather than constantly move the price up and down in order
to sell as many units as the firm is capable of producing at a profit, the firm will normally
adjust its output in order to maintain its target price. When this form of administered
pricing is combined with the normal tendency of firms to expand, one result is that firms
will usually have more production capacity than they use. When demand increases,
they will increase output rather than prices.
Enforcement of Price Leadership In the economic as in the political arena, leadership
will occasionally be challenged. Sometimes the mere threat of lowering prices suffices.
In 1989, Miller and Coors tried to expand their market shares by discounting their
premium beers. Anheuser-Busch, with 41 percent of the U.S. beer market, simply
issued a press release:
We cannot permit a further slowing in our volume trend... [the company will take]
appropriate competitive pricing actions to support our long-term market share growth
strategy.
Actually the Anheuser statement is simply a warning to competitors that if they do not
stop discounting they will face a costly battle which they will certainly lose.
But sometimes actual price reductions are necessary. In the late 1960s, Chrysler tired
to break away from the pricing pattern then set by General Motors. But GM was a
larger and more efficient producer and was not about to abandon its price-leader role.
So GM lowered prices below the cost of production in those lines in which Chrysler was
competitive. Thus Chrysler was left with a lower margin per vehicle sold but was still
unable to expand its market share. When GM raised their prices again in 1971 Chrysler
quickly followed. Chrysler also filed suit charging GM (and Ford) with predatory pricing,
but Ford and GM were acquitted due to lack of evidence.
Predatory Pricing A large or diverse firm that can stand temporary losses can cut its
prices below the cost of production until it runs competitors out of business or
establishes its price leadership. Then it can raise prices again. This is illegal. But it is
very hard to prove, since normal competitive pressures can lead to prices set
temporarily below the cost of production.
SOME PRICE LEADERSHIP MODELS
Barometric price leadership: The barometric price leadership is not a dominant firm.
One firm in a group of firms of more or less comparable size comes to pay the role of
price leader, not because of its dominant position in the market but because other firms
regard its actions as a suitable barometer of changing market conditions. They are
willing to follow its policies in the belief that competitive disturbances are minimized by
so doing. But the actual powers of a barometric price leader are greatly restricted by its
realization that other firms will follow him only with reasonable limits.
Two simplified models of price leadership:
Suppose there are only firms in the industry and they have assigned half of the market.
Furthermore, suppose that they are producing homogeneous products, but one firm
has lower costs that the other. The price and output policies of the two firms differ
because of the different cost of the two firms.
This can be illustrated with the following figure:
DD presents the market demand curve and dd represents the firms demand curve. The
firm 1 fixes the price at op 1 and its level of output is OM1 where as the firm 2 fixes its
price at op 2 and produces OM2 amount of output. The firm 2 has comparatively
advantageous position than the firm 1 because of its lower cost. Hence, the firm 2
becomes the price leader.