What Is Price Leadership?
Price leadership occurs when a pre-eminent firm (the price leader) sets the price of goods or services in its market. This control can leave the leading firm's rivals with little choice but to follow its lead and match the prices if they are to hold on to their market share. Price leadership is common in oligopolies, such as the airline industry, in which a dominant company sets the prices and other airlines feel compelled to adjust their prices to match.
More About Price Leadership
Price leadership has a greater impact on goods or services that offer little differentiation from one producer to another. Price leadership is also apparent where levels of consumer demand make a particular price selected by the market leader viable because consumers are drawn from competing products. Price leadership is assumed to stabilize prices and maintain pricing discipline. In general, effective price leadership works when
- The number of companies involved is small
- Entry to the industry is restricted
- Products are homogeneous
- Demand is inelastic, or less elastic
- Organizations have a similar long-run average total cost (LRATC)
LRATC, an economics metric, is the minimum or lowest average total cost at which a firm can produce any given level of output in the long run, when all inputs are variable.
- Price leadership is when a pre-eminent company sets the price of goods or services, and the other firms in its market follow suit.
- There are three primary models of price leadership: barometric, collusive, and dominant.
- Price leadership is commonly used as a strategy among large corporations.
Types of Price Leadership
In business economics, there are three primary models of price leadership: barometric, collusive, and dominant.
The barometric model occurs when a particular firm is more adept than others at identifying shifts in applicable market forces—like a change in production costs—which in turn allows it to respond most efficiently—by initiating a price change, for instance. It is possible for a firm with a small market share to act as a barometric leader if it is a good producer, and attuned to trends in its market. Other producers follow its lead, assuming that the price leader is aware of something that they have yet to realize. However, because a barometric leader has very little power to impose its decisions on other firms in the industry, its leadership might be short-lived.
The collusive price-leadership model may emerge in an oligopoly as a result of an explicit or implicit agreement among a handful of dominant firms to keep their prices in mutual alignment. The smaller firms follow the price change initiated by the dominant firms. This practice is most 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. There is a fine line between actual collusion, which is unlawful, and price leadership—especially if the price changes are not related to changes in operating costs.
The dominant model occurs when one firm controls the vast majority of market share in its industry. The leading firm is flanked by small firms that provide the same products or services, but which cannot influence prices. Often the dominant company ignores the interests of the smaller companies. Therefore, dominant price leadership is sometimes referred to as a partial monopoly. A drawback of this model is that the leader might engage in predatory pricing by lowering its prices to levels that smaller firms cannot sustain. Such practices that are aimed at hurting smaller companies are illegal in most countries.
Further Considerations of Price Leadership
- Increased profitability. If companies in a particular market follow a price leader by setting higher prices, then all producers in that market stand to profit, as long as demand remains steady.
- Fewer price wars. If companies of similar size comprise a particular market, then without price leadership, price wars could ensue as each competitor tries to increase its share of the market.
- Better-quality products. Increased profits often mean more revenue for companies to invest in research and development (R&D) to design new products and deliver more value to customers.
- Interdependence instead of rivalry. When firms in the same market choose a parallel pricing structure instead of undercutting each other, it fosters a positive environment conducive to growth for all companies.
- Unfair to smaller firms. Small firms who attempt to match a leader's prices may not have the same economies of scale as the leaders, which could make it hard for them to sustain consistent price declines, and even to survive in business.
- High prices for customers. In any price-leadership model, it is the sellers who will benefit from increased revenues, not the consumers. Customers will need to pay more for items that they were used to getting for less before the sellers conspired to raise prices.
- Could lead to malpractices. Rival organizations might not follow the leader's prices—choosing instead to engage in aggressive promotion strategies such as rebates, money-back guarantees, free delivery services, and installment payment plans.
- A discrepancy in benefits. If it costs the leader less capital to produce the same product than it costs a follower, then the leader would set lower prices, which would result in a loss for the follower.
Real World Example—Southwest Airlines
Price leadership is a common strategy to boost revenues and profits among large corporations.
Southwest Airlines Co.
Southwest Airlines (LUV) is a definite price leader. Since its inception, the company's mission has been to offer the most competitively priced flights on the market, and it has not deviated from that goal. Through the end of 2017, the company posted 45 consecutive years of profitability.
How does Southwest maintain its role as price leader?
Because the airline industry is fiercely competitive, volatile, and economically sensitive, it is difficult to become a price leader in that arena. In addition to being consistently profitable, Southwest has even garnered market share from its competitors. Southwest offers the lowest prices possible by being more efficient in its operations.
- Buying the same brand of an airframe (Boeing) helps Southwest to keep its maintenance and training costs low.
- The average age of Southwest's fleet is around 12 years. So, the company can retrofit its planes effectively, and save money by not needing to purchase new ones as often.
- Southwest has always been a no-frills airline. They have never sold food or offered other amenities. The carrier passes these savings on to customers in the form of more low-priced solutions.
- Rather than trying to be all things to all people, Southwest has focused on catering to consumers who want cheap, quick, and painless fight plans.
- Southwest's flight crews begin cleaning a plane even before the passengers have finished disembarking. This speed helps to ensure quick turnarounds at the gate, which in turn means more revenues for the company.
- The company also has escalated its boarding process because Southwest understands that they only make money when their planes are in the air.
- Southwest offers only nonstop, point-to-point service. Because airports with more point-to-point flights typically have less air traffic than others, Southwest can schedule more trips, which minimizes downtime, and maximizes employee productivity.
- Instead of trying to fly everywhere at the expense of efficiency, Southwest Airlines concentrates on becoming excellent in the cities it does serve.
Among the First ULCC
Southwest Airlines was one of the original ultra-low-cost carriers (ULCCs). As such, the company has long battled giant rivals like American (AAL), Delta (DAL), and United (UAL). However, the growth of a new breed of ULCC has opened up the second tier of competition for Southwest. These more recent discounters—like JetBlue (JBLU), Spirit (SAVE), and Frontier (FRNT)—will compete with Southwest on its turf and scale.