What is a Price Leader?
A price leader is a company that exercises control in determining the price of goods and services in a market. The price leader’s actions leave the other competitors with few or no options other than to adjust their prices to match the price set by the price leader.
Price leaders are usually large firms in the industry that incur the lowest production costs and, therefore, are in a position to undercut the prices charged by their competitors. Other players who are not comfortable with the price leader’s prices may still charge higher prices, but it will result in a reduced market share for their goods or services.
Types of price leadership
Price leadership comprises three types, which include:
In the barometric model, a small but efficient company positions itself as a leader in identifying and adapting to changing market conditions better than other firms in the market. Once a company establishes itself as the first to spot market changes, competitors will follow its lead rather than wait to discover the anticipated market changes on their own. They will follow the agile company with the assumption that the firm knows something about the market that the other competitors are yet to realize.
A dominant firm is a company that controls a significant proportion of the market share within an industry. It is surrounded by other small firms that provide the same products or services as the dominant firm. As the firm changes its prices according to the forces of supply and demand, the smaller firms must adjust their prices as well in order to retain the small market share that they control.
However, the dominant company may engage in predatory pricing by lowering their prices to levels that are unsustainable to smaller firms. Such practices that are aimed at hurting the smaller companies are illegal in most countries.
The collusive model is prevalent in oligopoly markets, where a group of market leaders colludes to set prices for products or services. Smaller firms must adjust their prices to match those of the large firms. Collusive models are considered illegal if their purpose is to defraud the public.
Conditions under which price leadership occurs
Several factors contribute to price leadership, including:
Large market share
Large companies often have a large capacity and the ability to serve a substantial number of customers in various locations. They give the company the ability to set prices for the market since it has considerable control over its competitors. The smaller firms will have no choice other than to match their products with those of the price leader if they want to continue enjoying the small market share that they currently hold.
Some companies excel in identifying industry trends that are likely to affect their profitability. They implement preventive measures by adjusting prices to reflect the expected changes in the market. Other industry players that do not have the capacity to identify important trends may choose to match the price leader’s prices rather than invest a lot of money and time to gain the same level of knowledge.
Ownership of a patented technology may influence a company’s decision to charge a premium price for its products or services. The company may want to establish itself as a producer of high-quality products or services that people can trust and buy. Other firms that do not have the technology may lower their prices to prevent the risk of losing market share, even as they try to acquire the technology.
A company may be popular for its better execution methods than its competitors, giving it an opportunity to charge a higher price per unit. The practice is often applicable in industries that bill an hourly rate or on a per contract basis. Customers prefer working with companies that are productive and that deliver quality output on the contracted work, even at a premium price.
Advantages of price leadership
A price leader enjoys the following benefits:
Where the price leader sets high product prices and competitors implement the price changes, then the company and the other players will enjoy high profits as long as consumer demand remains steady. Also, where the competitors replicate the price leader’s actions, it ensures that the price leader does not lose the significant market share it enjoys to the competitors.
Reduces price wars
Where the market comprises companies of the same size, there is likely to be price wars as each competitor tries to increase its market share. However, when one company establishes itself as the market leader, there is likely to be fewer price wars as the small competitors try to safeguard their market share. Instead, they will adjust the prices of their products and services to correspond to the prices set by the price leader.
Better quality products
When a company establishes itself as a price leader, it increases its annual revenues, some of which are used to design new products and improve product quality. Customers want to pay a premium price for a premium product, and the company can only deliver it when its activities are profitable. Profits earned from its current products can be re-invested in research and development to find new ideas that will help the company deliver value to its customers.
Disadvantages of price leadership
A price leader faces the undesirable consequences below:
Price leaders may use operating synergies to mark down their products to levels that are unmanageable by small competitors. Since the small competitors do not enjoy the same operating synergies as the price leaders, they will attempt to lower their prices in a bid to retain their market share. However, where the small firms maintain the low prices over an extended period, they will become unprofitable and eventually fold up.
High product/service prices
When a price leader increases the price of its products or services, the competitors will follow the lead or collude to increase prices. However, the effect of such increases is that sellers will benefit from increased revenues whereas consumers will be compelled to pay more for products and services that they acquired cheaply before the sellers conspired to raise prices.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: