Price leadership Model

Oligopoly
Types of price leadership
Price leadership by a low cost firm
Price leadership by the dominant firm
Barometric price leadership
Exploitative or aggressive price leadership
Types of price leadership
Price leadership by low cost firm
Assumptions
1. Each of the two firms has equal share in
the market (demand curve facing each firm
will be the same and will be half of the total
market demand curve of product)
Low cost firm
D (Market demand)
d (Firm demand)
MR
O
$
Q per year
Each of the two
firms has equal
share in the
market
2. There are two firms, A and B. the firm A
has a lower cost of production than B.
3. The product produced by the two firms is
homogeneous so that the consumers have
no preference between them.


Low cost firm
MCa
AC
a

D (Market demand)
d (Firm demand)
MR
O
P
$
Q per year
MC
b

AC
b

the firm A has a lower
cost of production than
B.

MCa
AC
a

D (Market demand)
d (Firm demand)
MR
M Q
total

P
O
$
Q per year
The firm A will maximize it's
profit by selling output OM and
setting price OP
MC
b

MCa
AC
b

AC
a

D (Market demand)
d (Firm demand)
MR
M Q
total

H
P
N
O
The firm B's profit will
be maximum when it
fixes price OH and
sells output ON.
Since the two firms are producing a
homogeneous product, they cannot charge
two different prices.
Because the profit maximizing price OP of
firm A is lower than the profit maximizing
price OH of firm B, firm A will dictate the
price to the firm B and will emerge as a price
leader and firm B will follow.
Low cost firm
MC
b

MCa
AC
b

AC
a

D (Market demand)
d (Firm demand)
MR
M Q
total

P
O
Both firms will
charge price OP
and sell OM
There exists price leadership by a dominant
firm which has a large share of market with
a number of smaller firms as followers each
of them has a small share of market.
Assumptions
Dominant firm knows the total market
demand
Dominant firm knows the marginal cost of
the smaller firms whose lateral summation
yields the total supply by the small firms
at various prices.
Dominant firm
Total Market demand
(Supply of small firms)

MC
Q per year
$
O
D

MC
Q per year
$
Q per year
$
P
1

With these information,
the leader can obtain his
demand curve.

Leader demand
Demand
fulfilled by
small firms
O
D

MC
Q per year
$
Leader demand
MR
MC
The dominant firm will maximize
it's profit by selling output OQ
and setting price OP
Q
P
O
Demand
fulfilled by
small firms
O
Q per year
P
Dominant firm have to ensure that the small
firms will produce only the remainder of
demand (not more) otherwise the dominant
firm will be pushed to a non-maximizing
position.
This implies that if price leadership is to
remain, there must be some definite market
sharing agreement.
Dominant firm
All firms agree to follow the price change
made by a firm which supposedly has good
knowledge of the market conditions and thus
can forecast future happening in the market
better than others.
Followers are not required to make
continuous costs on demand calculations.
Barometric price leadership
Dominant firm compel the other firms in the
industry to follow him in respect of price.
Such a firm will often initiate a move
threatening to compete the others out of the
market if they do not follow him in setting
their prices.
Aggressive price leadership