What it is:
Price leadership is the act of setting the price for a good or service in an industry.
How it works (Example):
Let's assume that Company XYZ manufactures windshield wipers. It is one of five windshield manufacturers in the country, but its products have the widest distribution. As a result, Company XYZ charges only $10 for a wholesale ABC wiper; its competitors charge $13 or more for virtually the same thing. Company XYZ is a price leader in windshield wipers.
Accordingly, XYZ's competitors often have to play defense rather than offense: that is, they might need to drop their prices down to $10 in order to compete and keep their market share. If they can afford it, they might even drop below $10 in an effort to scoop up more market share (which may cost a lot). As you can see, Company XYZ sets the price level, and all its competitors can do is react to it.
Why it Matters:
Price leadership is common in oligopolies, such as the airline industry, whereby a price leader sets the price and all the other competitors feel compelled to lower their prices to match. The trick, however, is that a fine line exists between collusion (which is illegal), predatory pricing (also illegal) and price leadership -- especially if the price changes are not related to changes in operating costs.
Clearly, price leadership is usually a challenge for companies that aren't price leaders, because they are in the position of either defending their higher prices or, at a minimum, reacting to the strategies of another company. In many cases, smaller competitors do not have the same economies of scale as the price leaders and thus can't survive constant price declines.