Managerial Economics: Price Leadership in an

Oligopoly
By Robert J. Graham from Managerial Economics For Dummies
The Stackelberg model of oligopoly within managerial economics illustrates one firms
leadership in an oligopoly. In the Stackelberg model, the leader decides how much output
to produce with other firms basing their decision on what the leader chooses.
Another common form of leadership is for the leading firm to set price. Rival firms then use
the same price for their products. However, as is always the case in oligopoly, the leading
firm must take into account the behavior of its rivals.
The leading firm that initially sets price is called the dominant firm. The firms that use the
price set by the dominant firm are typically smaller in size and called following
firms. Markets for steel and agricultural implements have been observed to operate in this
manner.
The theory of price leadership represents a combination of monopoly behavior on the
dominant firms part and perfectly competitive behavior on the part of following firms.
The illustration below shows price leadership. The market has a downward-sloping
demand curve labeled D. A crucial point: The dominant firm must take into account that its
following firms satisfy part of that market demand. Because the following firms act as price
takers, their marginal revenue curve is the price set by the dominant firm.
To maximize profits, the following firms produce where price/marginal revenue equals
marginal cost. Therefore, each following firms supply curve corresponds to its marginal
cost curve, and the aggregate supply curve for all following firms is the horizontal
summation of the marginal cost curves. This horizontal summation of marginal cost is
represented by the curve MCf.
In the illustration, the dominant firms demand curve, dd, is derived from the market
demand and the aggregate supply curve for the following firms. The dominant firm simply
subtracts the quantity provided by the following firms from the quantity demanded in the
market to determine its quantity demanded.
In other words, the dominant firms demand curve equals the market demand curve minus
the sum of the following firms marginal cost curves, MCf.
Given the linear relationships, the dominant firms marginal revenue curve,MRd, is twice as
steep as its demand curve. The dominant firm maximizes profit by producing the quantity
of output that corresponds to marginal revenue, MRd, equals marginal cost, MCd. This
output level is qd.

The dominant firm determines price by going from the quantity qd up to its demand
curve, dd. Thus, the dominant firm sets the price at Pd.
As already noted, following firms are price takers. The dominant firms pricePd is the price
that all following firms charge for every unit of the product they sell. For the following firms,
the dominant firms price becomes their marginal revenue, Pd = MRf. The following firms
then maximize profit by setting marginal revenue, MRf, equal to marginal cost, MCf. In
aggregate, the following firms produce qf of output.
For the market, consumers pay a price of Pd and consume the quantity Q. The quantity
consumed Q equals qd plus qf.
The market demand for an oligopoly characterized by price leadership is

where Q is the market quantity demanded and P is the goods price in dollars.

The aggregate marginal cost for the following firms is represented by

where MCf is the horizontal summation of marginal cost for the following firms and qf is
the aggregate quantity produced by the following firms.
The dominant firms marginal cost curve is

where MCd is the dominant firms marginal cost in dollars and qd is the quantity produced
by the dominant firm.

In order to determine the goods market price and the quantity of the good produced by the
dominant firm and the following firms, you take the following steps:
1.

Derive the dominant firms demand curve.

Note that the market quantity demanded Q equals:

2.

Rearrange the following firms aggregate marginal cost curve to get

3.

Substitute P for MCf in the equation from Step 2.

This substitution is allowed because following firms produce where price equals
marginal cost in order to maximize profit.

4.

In the Step 1 equation, substitute the market demand equation for Qand the
equation for qf from Step 3.
This step generates the equation for the dominant firms demand curve.

5.

Rearrange the equation in Step 4 to solve for P as a function of qd.

This form is converted to the total revenue equation in the next step.

6.

Determine the dominant firms total revenue equation.

Remember, total revenue equals price multiplied by quantity.

7.

Determine the dominant firms marginal revenue equation.

Take the derivative of total revenue with respect to qd.

8.

Determine the dominant firms profit-maximizing quantity of output.

Set the dominant firms marginal revenue equal to the dominant firms marginal cost
and solve for qd.

9.

Substitute qd equals 800 into the dominant firms demand curve in order to
determine the price established by the dominant firm.

The dominant firm produces 800 units of output and charges a price of $14.
10.

Determine the following firms aggregate quantity of output.

Following firms are price takers, so the dominant firms price is the following firms
marginal revenue.

11.

Determine the market quantity demanded.

Substitute 14 for price P in the market demand equation.

So the dominant firm produces 800 units of output at a price of $14. The following
firms produce an aggregate of 1,500 units. The market quantity demanded given a
price of $14 is 2,300 units the same as qd plus qf.
In the price leadership model, only the dominant firm has monopoly power only the
dominant firm can set price.