Price leadership is a form of strategic interdependence between firms in oligopolistic markets. The idea of strategic interdependence is that firms in oligopolistic markets will recognise that the prices they set will influence the prices that other firms set. The typical competition concern is that through repeated interaction, the firms will learn that it is in their self-interest to coordinate with one another to set higher prices than they would in a more competitive market, to the detriment of consumers. Such coordination does not necessarily require explicit communication or agreement between firms and so is often referred to by economists as “tacit collusion” (or “tacit coordination” or “conscious parallelism”).
One way that firms could coordinate is for one firm to play the role of leader (perhaps a dominant or the largest firm) and the other firms to be followers. The leader increases its prices and then the followers increase their prices because they conclude that it is more profitable to do so than not. In effect, the leader creates a rising tide which lifts all of the ships. Price leadership could therefore be viewed as a way of facilitating tacit collusion and/or a symptom of it.
However, without evidence of explicit communication or agreement, distinguishing between potentially harmful leader-follower behaviour of this type and “normal” competitive behaviour is difficult. For example, one might observe that one firm increased its prices and so did other firms at a similar time. But this would not by itself constitute evidence of harmful leader-follower behaviour because all of the firms may simply be responding to a common increase in the cost of their materials or other inputs.
Therefore, a coherent theory of harm based on the apparent presence of “price leadership” must be capable of answering several difficult questions, including:
- Why would a firm want to be a leader rather than a follower?
- How would other firms know who the leader is?
- Why would the other firms want to follow the leader?
After all, a would-be leader faces the risk of being undercut by any rivals that do not follow its lead. Likewise, if it is more profitable to take up the mantle of being a leader, why would any firm prefer to be a follower? Put simply, one needs to explain why and how price leadership could displace normal competition.
There is a rich body of economic literature that has sought to answer these questions and, more generally, the circumstances under which this type of coordinated behaviour is likely to arise. One theme that emerges from the literature is that firms involved in such coordinated behaviour must be able to detect and punish departures from it (for example, by instigating a price war). If the cost of punishment is high enough, followers would have an incentive to follow the leader rather than undercut it, and in doing so price leadership could displace competition.
The economic literature has also considered other forms of strategic interdependence and leader-follower behaviour that could result in supra-competitive prices, but which differ from price leadership. One example is when a leader “overinvests” in its own capacity to discourage followers to invest in their own. This type of behaviour could increase scarcity and therefore market prices.