Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

 
2.2 PRICE LEADERSHIP: 
 
Price-leadership is another form of collusion. In this, one 
firm sets the price and others follow it either because it is 
beneficial to them or because they like to avoid uncertainty 
regarding their competitors' reactions even if they have to depart 
from profit-maximising output position. Price leadership is more 
commonly found than cartels because it allows complete freedom 
to the members as regards their output and selling activities. That 

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is why it is more acceptable to the followers than a complete cartel 
which demands surrendering of all freedom of action to the central 
agency. 
There are various forms of price leadership. The most common 
types are : 
1. Price-leadership by a low cost firm 
2. Price-leadership by a dominant firm 
3. Barometric price leadership. 
2.2.1. Price-leadership by a low cost (efficient) firm : In this 
model, it is assumed that there are two firms in the industry : their 
products are homogeneous ; one firm is more efficient and hence 
its costs are lower than those of the other; each firm is allocated 
half the marks share according to the tacit market- sharing 
agreement. In Fig. 2.1, DD is the market demand curve and dd is 
the demand curve facing each firm. SAC
1
and SMC
2
are the 
average and marginal cost curves of the efficient or low cost firm 
while SAC
2
and SMC
2
are the average and marginal cost curves 
of the less efficient or high cost firm. MR is the marginal revenue 
curve facing each firm. The high cost firm would like to produce 
OX
2
output and charge OP price because it is at this output that 
the firm's MR curve intersects SMC
2
curve. The low cost firm, on 
the other hand, would like to produce OX
1
output and charge OP 
price because it is at OX
1
output that the MR curve intersects 
SMC
1
. This is the profit-maximising output and price for the 
efficient firm. It is evident that the low cost firm will dictate the 
price and the high cost firm will be compelled to follow it. The 
follower can obtain a higher profit by producing a smaller output 
OX
2
and selling it at a higher price OP
2
(it is at this out put that its 
MR SMC
2
) However, he prefers to follow the leader sacrificing 
some of its profits in order to avoid a price war. Such a price war 
can eliminate the high cost firm if price fell sufficient low as not to 
cover its LAC. It should be noted that for the leader to maximise 
his profit, price must be maintained at the level OP and he should 
sell OX
1
quantity. This implies that is assumed that each firm is 
allocated half the market share, therefore OX
1 
+ X
2 
= OX, the 
market demand. 
Although this model of price leadership stresses the fact 
that the leader sets the price and the follower accepts it, it is 
obvious that the firms must also reach agreement on the sharing
of the market. If such an agreement is not reached, the follower 
can accept the price of the leader but produce a quantity smaller 
than that required to maintain the leader's price, and thus force 
the leader to a non-profit maximising output. In this respect, the 
follower is not completely passive. 

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