price leadership

Topic 7.8 – Differing Objectives and Policies of Firms (Cambridge International AS & A‑Level Economics 9708)

1. Price Leadership

1.1 Definition

Price leadership occurs in an oligopolistic market when one firm (the leader) sets the market price and the other firms (the followers) adjust their own prices to match it. The leader is usually perceived to have a size, cost or information advantage.

1.2 Types of Price Leadership

1.3 Conditions for Emergence

1. Homogeneous product or very close substitutes.
2. Few firms – an oligopolistic market.
3. High transparency of price changes (prices are observed quickly).
4. A firm perceived to have superior information, cost advantage or market power.

1.4 Economic Rationale

The kinked‑demand model predicts price rigidity: followers believe rivals will match price cuts but not price rises. By allowing a single firm to set the price, the industry avoids a destructive price war.

Profit for a follower after the leader sets price P_L:

where MC is the follower’s marginal cost and Q the output chosen at that price.

1.5 Numerical Illustration

The 5 % cut reduces industry profit by £2,500, showing the risk to followers if the leader mis‑gauges demand.

1.6 Advantages

• Reduces uncertainty about competitors’ pricing.
• Stabilises market price and avoids costly price wars.
• Can raise short‑run industry profit relative to pure competition.

1.7 Disadvantages / Potential Problems

• May be interpreted as tacit collusion – attracts antitrust scrutiny.
• If the leader mis‑interprets demand, all firms suffer losses.
• Followers may resist price cuts, creating “price rigidity”.
• Prices are often above marginal cost → allocative inefficiency.

1.8 Welfare, Efficiency & Equity Implications

• Allocative inefficiency: P > MC creates a dead‑weight loss; consumer surplus falls.
• Distributional impact: Higher prices benefit producers but reduce welfare for price‑sensitive consumers, raising equity concerns.

1.9 Policy Implications

• Competition authorities assess whether price leadership is a form of illegal collusion.
• Key tests: market share of the leader, evidence of coordinated price changes, and impact on consumer welfare.
• If the leader abuses a dominant position, regulators may intervene under the EU/UK Competition Acts.

1.10 Real‑World Example – UK Supermarkets (early 2000s)

Tesco, the market leader, introduced price cuts on staple items. Within weeks Sainsbury’s, Asda and Morrisons matched the cuts, illustrating dominant‑firm price leadership.

1.11 Suggested Diagram

2. Price Discrimination

2.1 Definition

Charging different prices to different consumers for the same product when the price differences are not due to differences in marginal cost.

2.2 Types and Quantitative Examples

2.3 Conditions Required

1. Market power – the firm faces a downward‑sloping demand curve.
2. Ability to segment the market (different price elasticities or willingness to pay).
3. Prevention of resale between segments (or effective legal/technological barriers).

2.4 Welfare Effects

• If done efficiently, price discrimination can increase total welfare by moving output closer to the socially optimal level (P = MC) for some segments.
• Producer surplus rises; consumer surplus may fall for high‑price segments, raising equity concerns.

2.5 Policy Considerations

• Generally legal unless it results from an abuse of dominant position or discriminates on protected grounds.
• Authorities examine whether discrimination forecloses competition or harms a protected class of consumers.

2.6 Suggested Diagram (Third‑Degree Discrimination)

3. Price Skimming

3.1 Definition

Setting an initially high price for a new product and then gradually lowering it over time as market saturation increases and cost reductions are realised.

3.2 When It Is Used

• New, innovative products with few close substitutes (e.g., smartphones, gaming consoles).
• Firms with strong brand power or patents that protect the product from immediate imitation.
• When the firm wants to recover high R&D costs quickly.

3.3 Diagram (Price‑Skimming Curve)

3.4 Welfare & Efficiency

• Initial price > MC creates a dead‑weight loss, but the high price can finance innovation.
• As price falls, the market moves closer to allocative efficiency, increasing consumer surplus for later adopters.

3.5 Policy Issues

• Generally not a competition concern unless the high price is used to exploit a dominant position in a market with no realistic substitutes.
• Consumer protection agencies may monitor for unfair pricing of essential goods.

4. Limit Pricing

4.1 Definition

A strategic price set by an incumbent firm low enough to make market entry unattractive to potential rivals, even though the price may still be above marginal cost.

4.2 Motive

• Deterrence of entry by signalling that post‑entry profits will be low.
• Preservation of long‑run monopoly or dominant‑firm profits.

4.3 Conditions for Success

1. Incumbent enjoys a cost advantage (lower MC) or has excess capacity.
2. Potential entrants face high fixed costs or demand uncertainty.
3. Incumbent can credibly sustain the low price for a sufficient period.

4.4 Diagram (Limit Pricing)

4.5 Welfare & Policy

• Creates allocative inefficiency (price > MC) and reduces consumer surplus.
• May be challenged under competition law if the incumbent holds a dominant position and uses limit pricing to foreclose competition.

5. Predatory Pricing

5.1 Definition

Setting price below marginal cost (or below an appropriate average cost) with the intention of driving rivals out of the market, after which the firm raises price to recoup losses.

5.2 Short‑Run vs Long‑Run Outcomes

• Short run: Predator incurs losses; rivals may be forced to exit if they cannot sustain the low price.
• Long run: With rivals eliminated, the predator raises price above the competitive level, earning monopoly profits.

5.3 Conditions for Feasibility

1. Incumbent has deep pockets or a lower marginal cost.
2. Barriers to entry are high, so re‑entry after exit is unlikely.
3. The price cut is severe enough to make rivals’ continuation unprofitable.

5.4 Diagram (Predatory Pricing)

5.5 Legal & Policy Issues

• Predatory pricing is illegal in many jurisdictions when the firm holds a dominant position and the conduct is likely to substantially lessen competition.
• Authorities assess intent, price‑cost relationship, and market structure before intervening.

6. Relationship Between Price Elasticity of Demand and a Firm’s Revenue

6.1 Key Principle

For a single‑price firm, total revenue (TR) moves in the opposite direction to price when demand is elastic, and in the same direction when demand is inelastic.

6.2 Analytical Summary

6.3 Graphical Illustration

7. Welfare, Efficiency & Equity Implications of the Pricing Policies

• Price Leadership, Limit Pricing, Predatory Pricing: P > MC ⇒ allocative inefficiency, dead‑weight loss, reduced consumer surplus.
• Price Discrimination: Can increase total welfare when it moves output closer to the socially optimal level, but may reduce consumer surplus for high‑price segments.
• Price Skimming: Initial dead‑weight loss is offset over time as price falls; helps recoup R&D costs, potentially fostering innovation.
• Equity: Higher prices (leadership, limit pricing, predatory pricing) benefit producers but harm price‑sensitive consumers; price discrimination can be progressive (e.g., student discounts) or regressive (e.g., senior‑citizen surcharges).

8. Policy Implications (Competition Law & Regulation)

• Authorities examine market share, price‑setting behaviour, and consumer impact to decide whether conduct breaches competition law.
• Key tests for illegal collusion or abuse of dominance:
  1. Is there a dominant firm?
  2. Is the conduct likely to substantially lessen competition?
  3. Is there evidence of coordinated or predatory behaviour?
• Remedies may include:
  • Fines or penalties.
  • Orders to cease the conduct.
  • Structural remedies (e.g., divestiture) or behavioural remedies (price‑cap orders).

9. Key‑Concept Box – Mapping to the Syllabus

10. Summary

Price leadership, price discrimination, price skimming, limit pricing and predatory pricing are strategic tools used by firms in oligopolistic markets. Each policy can enhance firm profits and market stability, but they also raise important welfare, efficiency and equity questions. Understanding the conditions under which each strategy is viable, the underlying economic rationale, and the relevant competition‑law framework equips students to analyse real‑world markets and to evaluate the appropriate role of government in promoting competitive outcomes.