What is {term}? Price Leadership

Price leadership is when a leading firm in its sector determines the price of goods or services. This can leave the leader's rivals with little choice but to follow its lead and match the 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.

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. Price leadership is also apparent where consumer demand levels make a particular price selected by the market leader viable because consumers are drawn 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 its 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 mutual alignment. This is more common in industries where the cost of entry is high and the costs of production are known. Such agreements can be illegal if the effort is designed to defraud the public. For example, in 2012, Apple was accused of colluding with e-book publishers to artificially inflate product prices.

The dominant firm model occurs when one firm controls the vast majority of the market share within an industry. As the dominant firm adjusts prices, any smaller firms within the segment must follow suit to retain 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 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 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 eventually be forced to close their doors.