Discuss the price-leadership model of oligopoly. Is it an adequate explanation?
The Correct Answer and Explanation is:
Correct Answer:
The price-leadership model in an oligopoly is a form of market structure where one dominant firm (the price leader) sets the price for a product or service, and other firms in the industry follow by adopting the same price. This model simplifies price coordination in an industry where formal collusion is illegal or impractical. There are three main types of price leadership: dominant firm leadership, barometric leadership, and collusive leadership.
Explanation:
The price-leadership model is a common form of behavior in oligopolistic markets, where a few large firms dominate the industry. Due to mutual interdependence among firms, direct competition through price-cutting is often avoided to prevent destructive price wars. Instead, firms tend to follow the pricing strategy of a single firm, known as the price leader. This firm could be the largest, most efficient, or most experienced in the market.
In dominant firm price leadership, a large firm with a significant market share sets a price that maximizes its profits, while smaller competitors follow that price, selling whatever quantity the residual demand allows. In barometric leadership, a firm that has a good record of forecasting market trends and adjusting prices first is followed by others. Lastly, collusive price leadership occurs when firms explicitly or tacitly agree to follow one firm’s price to maintain stable profits.
The model offers a practical explanation for price stability in oligopolistic markets. It reduces uncertainty and the risk of price wars, facilitating a form of implicit coordination that is legal compared to formal cartels.
However, the price-leadership model has limitations. It oversimplifies the complexities of real-world competition and assumes that follower firms have no pricing power. It also neglects non-price competition, such as advertising, product differentiation, and service quality. Moreover, in volatile markets, sustaining a leadership structure can be difficult due to changing costs and demand.
In conclusion, while the price-leadership model provides a useful framework for understanding pricing behavior in oligopolies, it is not a fully adequate explanation due to its simplifying assumptions and limited applicability in dynamic market conditions.
