Cost-leadership Model describes cases in oligopoly market where the firms produce a homogeneous product. Cost of production is different for different players. The lowest cost producer determines its profit-maximizing price and the other players accept that price irrespective of the price that maximises their own profit.
For the sake of simplicity, let us start with a duopoly market. The market can be divided equally by the two firms. There can be another possibility – market shares are different for different firms. First, we consider the duopoly with equal market share.
Assume that the total market demand curve is given as ARM. Suppose, two players, firm L and firm F constitute the market. Since the two players are equally sharing the market, demand for each firm will be half of the total demand. Since the total demand is given as ARM, half of its market share is represented as AR.
The corresponding marginal revenue curve is represented by MR. It is important to note that AR and MR represent average and marginal revenue curves of firm L (Leader) or firm F (Follower) since both of them possess the same market share. Assume, Firm L is a cost leader meaning that it can produce the same product at a lower cost per unit than Firm F.
Average and marginal cost curves of the low-cost producer (i.e., firm L) are represented as ACL and MCL respectively. Similarly, ACF and MCF represent average and marginal cost curves of firm F. Note that the cost curves of the low-cost producer lies below the cost curves of the relatively high cost producer (i.e., firm F).
The low-cost producer’s profit-maximizing point is ‘a’ where MR intersects MCL. Point ‘a’ determines the profit-maximising output and price of firm L as Q and P respectively. For firm F, P1 is the profit-maximising price, since MCF (MC of firm F) and MR intersect at point ‘b’ indicating profit- maximising output and price of firm F as Q1 and P1 respectively. It is clear from the diagram that P1>P.
Since the product is homogeneous in nature, only the minimum price (price set by the lowest cost producer) will prevail and no firm will be able to sell its product at a price which is above the minimum price. Firm F is no exception.
So firm F will have to charge P price though that does not maximize its profit. In this model, since the low-cost firm sets the price and the high cost firm accepts that irrespective of his own profit maximizing price, the former is called the leader while the latter is termed as the follower.
Thus, in this model it is observed that the low-cost firm (the leader) sets the price depending on its own cost and the high cost firm (the follower) accepts that price. Since demand curve and marginal cost curve are identical for these two firms, and they charge the same price, the output of both the firms will be equal.
Therefore, at price OP, both of them produce OQ level of output. In other words, the total market (OQM) is shared equally (as OQ and Q Q M) by the leader and the follower.