What is price leadership?
Price leadership occurs when a pre-eminent company (the price leader) sets the price of goods or services in its market. This control can leave the competitors of the leading firm the choice, but to follow its example and match prices if they want to maintain their market share. Price leadership is common in oligopolies, such as the airline industry, where a dominant firm sets prices and other airlines feel compelled to adjust their prices accordingly.
Learn more about Price Leadership
Price leadership has a greater impact on goods or services that offer little differentiation from one producer to another. Price leadership also arises when consumer demand levels make a price chosen by the market leader viable because consumers are from competing products. Price leadership is expected to stabilize prices and maintain price discipline. In general, effective price management works when
- The number of companies involved is low
- Entry into industry is restricted
- The products are homogeneous
- Demand is inelastic or less elastic
- Organizations have a similar long-term average total cost (LRATC)
LRATC, an economic measure, is the minimum average or lowest total cost at which a firm can produce a given level of output in the long term, when all inputs are variable.
Key points to remember
- Price leadership is when a preeminent company sets the price of goods or services, and other companies in its market follow suit.
- There are three main models of price leadership: barometric, collusive and dominant.
- Price leadership is commonly used as a strategy by large companies.
Types of price leadership
In business economics, there are three main models of price leadership: barometric, collusive and dominant.
The barometric model occurs when a particular firm is more adept than others at identifying changes in applicable market forces – such as a change in production costs – which in turn allows it to respond more effectively – by initiating a price change, for example. It is possible for a company with a small market share to act as a barometric leader if it is a good producer and attuned to market trends. Other producers follow his example, assuming that the price leader is aware of something they have not yet achieved. However, because a barometric leader has very little power to impose its decisions on other companies in the industry, its leadership could be short-lived.
The collusive model of price leadership can emerge in an oligopoly following an explicit or implicit agreement between a handful of dominant firms to maintain their prices in mutual alignment. Small companies follow the price change initiated by the dominant companies. This practice is more common in industries where the cost of entry is high and the costs of production are known. Such agreements may be illegal if the effort is aimed at defrauding the public. There is a fine line between actual collusion, which is illegal, and price leadership, especially if the price changes are not linked to changes in operating costs.
The dominant model occurs when a company controls the vast majority of its industry’s market share. The leading company is flanked by small companies that provide the same products or services, but cannot influence prices. Often the dominant business ignores the interests of small businesses. Therefore, the dominant price leadership is sometimes called a partial monopoly. One drawback of this model is that the leader could indulge in predatory pricing by lowering its prices to levels that small businesses cannot afford. Such practices aimed at harming small businesses are illegal in most countries.
Other considerations on price leadership
- Increased profitability. If firms in a particular market follow a price leader by setting higher prices, all producers in that market should benefit as long as demand remains stable.
- Fewer price wars. If companies of similar size constitute a particular market, without price leadership, price wars could ensue as each competitor tries to increase their market share.
- Better quality products. Increasing profits often means more revenue for companies to invest in research and development (R&D) to design new products and deliver more value to customers.
- Interdependence instead of rivalry. When companies in the same market choose a parallel price structure instead of underestimating themselves, this promotes a positive environment conducive to growth for all companies.
- Unfair to small businesses. Small businesses trying to match a leader’s prices may not have the same economies of scale as the leaders, which could make it difficult for them to maintain constant price reductions, and even survive in business.
- High prices for customers. In any price leadership model, it is the sellers who will benefit from increased revenues, not the consumers. Customers will have to pay more for items they used to get less before sellers conspire to raise prices.
- Could lead to abusive practices. Rival organizations may not keep up with the leader’s prices – choosing instead to engage in aggressive promotional strategies such as discounts, money back guarantees, free delivery services, and installment payment plans.
- A gap in benefits. If it costs the leader less to produce the same product than it costs a follower, then the leader would set lower prices, which would result in a loss for the follower.
Real-world example – Southwest Airlines
Price leadership is a common strategy for increasing the revenues and profits of large companies.
Southwest Airlines Co.
Southwest Airlines (LUV) is an undisputed price leader. Since its creation, the company’s mission has been to offer the most competitive flights on the market, and it has not deviated from this objective. At the end of 2020, the company recorded 45 consecutive years of profitability.
How is the Southwest retaining its role as price leader?
Because the airline industry is extremely competitive, volatile and sensitive to the economy, it is difficult to become a price leader in this field. In addition to being consistently profitable, Southwest has even gained market share from its competitors. Southwest offers the lowest prices possible by being more efficient in its operations.
- Purchasing the same airframe brand (Boeing) helps Southwest reduce its maintenance and training costs.
- The average age of the Southwest fleet is around 12 years. So the company can modernize its planes efficiently and save money by not having to buy new ones as often.
- Southwest has always been a no frills airline. They never sold food or offered other amenities. The carrier passes these savings on to customers in the form of more advantageous solutions.
- Rather than trying to be everything for everyone, Southwest has focused on catering to consumers who want cheap, quick and painless combat plans.
- Southwest flight crews begin cleaning an aircraft before passengers have finished disembarking. This speed ensures quick turnaround times at the door, which in turn means more revenue for the business.
- The company has also stepped up its boarding process as Southwest understands that it only earns money when its planes are in the air.
- Southwest only offers non-stop point-to-point service. Because airports with more point-to-point flights generally have less air traffic than others, Southwest can plan more trips, which minimizes downtime and maximizes employee productivity.
- Instead of trying to fly everywhere at the expense of efficiency, Southwest Airlines focuses on excellence in the cities it serves.
Among the first ULCCs
Southwest Airlines was one of the first very low cost carriers (ULCC). As such, the company has long fought giant rivals like American (AAL), Delta (DAL) and United (UAL). However, the growth of a new breed of ULCC has opened the second level of competition for the Southwest. These newer discounters, such as JetBlue (JBLU), Spirit (SAVE) and Frontier (FRNT), will compete with Southwest on its territory and on a large scale.