Price Leadership

What is 'Price Leadership'

Price leadership is when a firm that is the leader in its sector determines the price of goods or services. This approach can leave the leader's rivals with little choice but to follow its lead and match these prices if they are to hold onto their market share. Alternatively, competitors may also choose to lower their prices in the hope of gaining market share as discounters.

BREAKING DOWN 'Price Leadership'

The impacts of price leadership are more apparent in goods or services that offer little differentiation from one producer to another and also have consumer demand levels that make the particular price selected by the market leader viable based on the potential to attract consumers away from competing products. There are three primary categories of price leadership: barometric, collusive and dominant firm.

Types of Price Leadership

The barometric model occurs when a particular firm is more adept at identifying shifts in applicable market forces, allowing it to respond more efficiently within the market sector. If the company is known for having skill in this area, other producers follow its lead under the assumption that the price leader is aware of something that they have yet to realize.

The collusive model occurs when a few dominant firms agree to keep their prices in alignment with one another. This is more common in industries where the cost of entry is high and the costs of production are generally known. Such agreements can be illegal if the effort is designed to defraud the buying public, as demonstrated by the accusation, made in 2012, that Apple colluded with e-book publishers to inflate product prices artificially.

The dominant firm model occurs when one firm controls the vast majority of the market share within an industry. As the dominant firm adjust prices, any smaller firms within the segment must follow in order to maintain the small amount of market share they currently possess.

Price Leadership and Increased Profitability

In cases where the price leader raises prices, the effects of price leadership can be positive since its competitors are justified in raising prices higher based on the actions of the price leader. If all prices rise, the increase can be instituted without the significant threat of losing market share to competing products. In fact, higher prices may improve profitability for all firms as long as overall consumer demand remains relatively steady.

Potential Negatives of Following Price Leaders

More commonly, undisputed market leaders, such as the big-box retailers, use their operating efficiencies to mark down prices relentlessly. This forces smaller rivals to lower prices as well in order to retain market share. Since these smaller firms often do not have the same economies of scale as the price leaders, this attempt to match the leader's prices may lead to mounting losses over a prolonged period, to the point where they may be forced eventually to close their doors.