When a firm that is the leader in its sector determines the price of goods or services. Price leadership can leave the leader's rivals with little choice but to follow its lead and match these prices if they are to hold onto their market share. The firms in the oligopolistic industry (without any formal agreement) accept the price set by the leading firm in the industry and move their prices in line with the prices of the leader firm. The acceptance of price set by the price leader firm maximizes the total profits of each firm in the oligopolistic industry.
The basic story in this model is that the dominant firm leaves room for the competitive fringe and therefore profit maximizes according to the “residual” demand curve. Since the fringe of firms behaves like perfect competitors, the sum of their marginal cost curves is essentially their supply curve. It represents the amount that these firms together will want to supply at any possible price.
A microeconomic law that states, all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease, and vice versa. The law of demand says that the higher the price, the lower the quantity demanded, because consumers’ opportunity cost to acquire that good or service increases, and they must make more tradeoffs to acquire the more expensive product. Law of demand explains consumer choice behavior when the price changes.
In the market, assuming other factors affecting demand being constant, when the price of a good rises, it leads to a fall in the demand of that good. This is the natural consumer choice behavior. This happens because a consumer hesitates to spend more for the good with the fear of going out of cash.
Raymond Deneckere and Dan Kovenock (1992) gave a game theoretic foundation of Forchheimer’s model (1908) of dominant firm price leadership in the framework of a capacity constrained Bertrand Edge worth duopoly. According to Forchheimer’s model we have one large firm and many small firms in the market. The large firm is assumed to set the price in the market, while the small firms act as price takers.
The traditional industrial organization literature is very fond of the dominant firm model of price leadership. In this model it is generally assumed that there is one large producer and many small producers, no one of which produces a high enough output to affect price. According to Scherer in 1970, dominant firm price leadership occurs when an industry consists of one firm dominant in the customary sense of the word, controlling at least 50% of total industry output, plus a competitive fringe of firms, each too small to exert a perceptible influence on price through its individual output decisions. With firms in the fringe acting as price takers, the dominant firm is left as the only agent able to set price, and does so by maximizing profit subject to its residual demand curve. It thus, by necessity becomes a price leader. Markham (1951) in his seminal paper concluded on the one hand that price leadership in a dominant firm market is not simply a modus operandi designed to circumvent price competition but is instead an inevitable consequence of the industry’s structure. While on the other hand he stated that in a large number of industries, which do not contain a partial monopolist, the price leader is frequently but not always the largest firm.
Stigler (1947) in his paper, The Kinky Oligopoly Demand Curve and Rigid Prices attaches major important to the dominant firm model of price leadership.
Stigler separates into two types of price leadership, dominant firm price leadership and barometric price leadership. In the former a dominant firm sets the price, allow the minor firms to sell what they wish at this price, and supplies the remainder of the quantity demanded.
Oxenfeldt (1951) stated it when argued, price leadership probably works best and arises most frequently in industries in which a single firm is outstanding by virtue of large size or recognized high quality of management. (Rotemberg and Saloner, 1986) The existence of a large firm facilitates price leadership in several ways, first, a large firm’s price policy exerts a great influence on the sale of its smaller rivals, and consequently the large firm must consider the probable responses of its rivals before setting its own price. In effect, the large firm must think in terms of a price policy for the entire industry.
As indicated above, the notion of price leadership emerges when an enterprise in a market can dictate its price to the other enterprises in the market. (It must be clear, however, that the following enterprises accept the dominant enterprise's price because they believe that it is the best thing to do.) In particular, it was indicated that price leadership emerges in markets when a dominant enterprise appears.
Price Price
MCF = S MCDN
P1 P1
PDN PDN
D MRDN DDN 0 qF Q1 Q2 Quantity 0 qDN Quantity
Supplied Supplied Figure 3.2: Price Leadership Theory (2) By By
Fringe Dominant Firms Firms
Figure 3.1: Price Leadership Theory (1)
There is one dominant firm and a number of fringe firms. Figure 3.1, the horizontal sum of the marginal cost curves of the fringe firms is their supply curve. At P1, the fringe firms supply the entire market. In short, P1 and Q1 define the situation in the industry or market excludes the dominant firm. Figure 3.2, the dominant firm derives its demand curve by computing the difference between market demand, D, and MCF at each price below P1. It then produces the quantity of output at which its marginal revenue equals its marginal cost, this level is qDN (where MRDN = MCDN) and charges the highest price for this quantity of output, which is PDN. PDN becomes the price that the dominant firm sets and the fringe firms take. They equate price and marginal cost and produce qF in Figure 3.1. The remainder of the output produced by the industry, the difference between Q2 and qF, is produced by the dominant firm.
(Roger Arnold, 2005)