Low-Cost-Driven Leadership: A Theory for Price Dispersion in Competitive Markets

We consider markets where a large number of firms offer homogeneous products. Despite the competitive nature of these markets, there is extensive practical evidence for the price dispersion phenomenon, i.e., the homogeneous products are sold at different prices. We propose a new theory to explain this phenomenon. Our game-theoretical model indicates that the existence of price leadership driven by the low-cost advantage results in persistent and large price dispersion. Furthermore, we show that the market leader and all followers (with one exception) are able to make positive profits in such competitive markets, which explains the remarkable co-existence of a large number of firms in homogeneous-product markets. Finally, our results indicate that the leader has to lower her price as followers become more efficient in the interests of gaining higher profits, resulting in a wider range of prices and, thus, a larger degree of price dispersion.