This model is a very interesting one. It explains some phenomena that are happening in oligopolistic type markets. So what does it means? Price leadership is an implicit (invisible) agreement among oligopolists by which they can coordinate prices without involving in price collusion based on secret meeting or formal agreements. This kind of method requires the “dominant firm” (largest or most efficient one) to initiate price changes, so that all other firms more or less will try to follow this leader. In many industries cement, fertilizers, cigarettes, cars and diverse machineries industries practiced this price leadership.
Price leadership in industries suggests that the price leader may use some of the following tactics:
Price changes (infrequent)
Since the price change may create the risk that the rivals won’t follow it, price regulations should be made only infrequently. Price leader shouldn’t respond to daily small increases in costs and demand. Price should be modified just in the case when costs and demand have changed greatly, for example the price of row materials or wages of workers increased rapidly, or government excised higher taxes.
Price leader sometimes communicates higher costs other oligopolistic firms by means of speeches of major executives or press. By publicizing the need to raise the price, price leader seeks other rivals to inform and to agree about price modifications.
Price leader may not always choose the price that maximizes the profits in short-run for the industry, because it wants to block the entry to this industry of new firms. If economies of scale of existing firms are the major barrier, then new firms can pass this obstacle if the existing firms, including price leader, set a high-price for the goods and services they produce. So, new small firms may survive only if the industry sets a very high price. To block the entry of new firms to this oligopolistic market system, this price leader may keep the price bellow short-run maximizing level. This strategy of blocking entry from the new firms is called limit pricing.
Sometime price leadership in oligopolistic market system may end up at least temporarily or may result in price wars. Most price wars sometimes run their course. When the firms realize that low prices are reducing their revenues dramatically, they may “offer” price leadership to other industry’ leading firms. That firms starts to rise prices and other businesses are willing to follow.