Definition of Price Leadership
Price leadership is a situation where one company, usually the dominant one in its industry, sets prices which are closely followed by its competitors. This firm is usually the one having the lowest production costs, and so is in a position to undercut the prices charged by any competitor who attempts to set its prices lower than the price point of the price leader. Competitors could charge higher prices than the price leader, but this would likely result in reduced market share, unless competitors could sufficiently differentiate their products.
Price leadership is not in the best interests of customers when the price leader sets prices higher than would have resulted under a normal level of competition. However, the reverse is usually the case, where the price leader uses its production and purchasing volume to continually drive down prices - which must be matched by any competitors who want to remain in the industry.
For price leadership to exist at a high price point, there needs to be tacit collusion between the main competitors in the industry. This is not the case when price leadership drives down the price point, since competitors have little choice but to match the low prices.
The following are conditions under which price leadership can exist:
- Collusion. Competitors tacitly agree to follow the price leadership of one company.
- Overwhelming market share. If one company has by far the largest market share in the industry, its much smaller competitors have no choice other than to follow its lead on prices.
- Trend knowledge. One company may be unusually good at spotting industry trends, so the other companies in the industry find it easier to follow its pricing leadership than to spend time and money to develop the same level of knowledge. This is known as barometric price leadership.
Advantages of Price Leadership
The following is an advantage of the price leadership method:
- High profit margin. If a company can set high price points and competitors are willing to follow those price points, then the company can earn inordinately high profits.
Disadvantages of Price Leadership
The following are disadvantages of using the price leadership method:
- Defensive effort. There are several reasons why an industry may accept a particular company as its price leader, several of which involve having to monitor competitors and take reactive steps if they do not follow the company's price leadership position.
- Complacency. A company that successfully exercises price leadership may become complacent and not keep its cost structure sufficiently lean to allow it to still earn a profit if a price war develops.
Evaluation of Price Leadership
Being the price leader is an excellent position to be in, but there can only be one price leader in an industry, so it is an option available to few firms. Instead, most companies must concern themselves with finding a market niche that they can defend with adequate product differentiation or high service levels.