Price Leadership Under Oligopoly
Price Leadership and its importance under Oligopoly
Price leadership is a feature of oligopolistic situation. One firm assumes the role of a leader and fixes the price of a product or the entire industry. Price leadership can be seen when most or all of the firms in an industry decide to sell their product at a price fixed by one among them. The other firms in the industry follow this price.
These price followers simply accept the price fixed by the price leader and adjust their output to this price. The price leader may be the biggest firm in the industry or it may be a firm with the lowest cost of production. Its leadership may be established as a result of price-war in which it emerges as the winner. Independent pricing by each firm in the industry is rarely seen in the oligopolistic situation. Instead there will be some agreement among the various firms with regard to the price that is to be charged.
The agreement among these rival firms may be formal or informal. There may be a formal agreement among the various firms to follow the price fixed by a leader chosen from among them. Or there may be only an informal understanding among themselves.
Determination of Profit-maximizing price by Price Leader
The price and output decisions are illustrated in the above figure. Here it is assumed that there are only two firms A and B and firm A has a lower cost of production than B. These two firms are producing homogeneous products and are having equal share in the market.
Thus these firms face the same demand curve which will be half of the total market demand curve. DD is the demand curve facing each firm which is half of the total demand curve for the product. MR is the marginal revenue curve of each firm. MC, is the marginal cost curve of firm A and MC2 is the marginal cost curve of the firm B.
As the firm A has a lower cost of production than the firm B, MC, is drawn below MC2. If the price is fixed independently each firm will fix a price at which MC=MR. Then price of A would have been OP and B would have been OP.
But in the oligopolistic market the firm B cannot make maximum profit by fixing the price as OP, The firm B is to fix its price as OP, the price the low cost firm A has fixed. Firm B can sell its product only if it accepts its price as OP, the lower price. While A makes maximum profit, B is to be satisfied with a lower profit. Thus firm A is price leader and firm B has to follow it.