Sometimes, it is observed that one firm establishes itself as the industry leader, sets price of its own product and the other firms accept the price set by the leader.
This particular phenomenon is referred to as Price Leadership. Price leadership originates from the leader’s cost efficiency, marketing strength etc.
Before describing the model, let us start with an assumption that there are eleven firms in a particular industry, out of which ten are comparatively smaller than one firm, which is the dominant firm. The demand for the dominant firm’s product is determined by the difference between total market demand and total supply of ten smaller firms.
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In pannel (a) of figure 12.3, DD represents the total market demand for the product and SS represents total supply of ten small firms.
Below the equilibrium point E in panel (a) (i.e. at any price lower than Rs. 60/ unit) total market demand exceeds total supply of ten firms, which creates a gap between DD and SS curves [Panel (a) of figure 12.3], This gap arises due to shortfall of supply and can be treated as total demand for product to be offered by the eleventh firm i.e., the dominant firm.
In panel (b) of figure 12.3, the demand of the dominant firm (represented by dd) is determined by measuring the gap between DD and SS below point ‘E’ i.e., that part of the total demand, which cannot be met by the total supply of ten small firms. For example, at price Rs. 60/unit, total market demand for the product equals total quantity supplied by the ten small firms.
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As a result, at Rs. 60/unit the demand facing the dominant firm will be zero. When price falls to Rs. 50/unit, total market demand increases from 30 units to 40 units, but aggregate supply of ten suppliers reduces from 30 units to 20 units, causing a shortfall of supply by 20 units. This {(40 – 20) units =} 20 units is the demand for the dominant firm’s product.
This exercise is to be performed in order to determine excess demand and if the quantities of excess demand corresponding to each price level are joined, the demand curve ‘dd’ for the dominant firm is obtained. In other words, below point E, the gap between DD and SS of panel (a) will be equal to the gap between ‘dd’ and the vertical axis of panel (b).
Now, let us find out the profit maximising price and output combination of the leader. The demand curve ‘dd’ obtained is also the AR curve of the dominant firm. From the AR curve we can easily find out MR curve.
The marginal cost curve of the dominant firm is denoted by MC. Profit maximising conditions for a dominant firm in oligopoly are same as perfect competition or monopoly, i.e.,
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(i) MC = MR
And (ii) slope of MR < slope of MC
Here at point ‘a’ in diagram 12.3, both the conditions for profit maximisation are satisfied and profit maximising output and price for the dominant firm is determined as 20 units and Rs. 50/unit respectively. Once the profit maximising price of the leader is determined, the followers will also accept it. This means that ten small firms will also charge Rs. 50/unit for their products.