Nature Of Competition Collusion And Pricing Airline Industry Economics Essay

The enactment of the Airline Deregulation Act of 1978 eliminated price and entry regulation of the domestic airline industry. Since then the U.S. airline industry has grown tremendously. The US domestic market competes in an oligopoly landscapes. Hence there is certain level of barriers to competition. For example, control over the computerised reservation systems used by travel agents provided the majors with a powerful weapon for disadvantaging smaller competitors. American Airlines’ “Sabre” system and United’s “Apollo” system together accounted for three-quarters of all national computer reservation systems by the late 1980s. Control of this important avenue for travel agents to make reservations enabled the majors to discriminate against smaller firms in a variety of ways-from instituting “screen bias” favouring the on-screen presentation of the controlling firm’s flights, to charging exorbitant fees to other carriers for displaying their flights on these computer systems (transferring upwards of a half-billion dollars annually from the smallest to the largest carriers).[2]

More recently, the Big Five carriers have joined together to collectively market their tickets online through their Orbitz Web site-an alliance that may enable them to better coordinate their non-competitive oligopoly pricing and to circumvent rules put into place to prevent them from anticompetitive using their computer reservation systems while, at the same time, disadvantaging competing distributors of air tickets.[3]

Predatory Pricing

Furthermore, dominant carriers were suppressing competition through predatory pricing. For example, when Spirit Airlines attempted to penetrate Northwest’s Detroit hub with a one-way Detroit-Philadelphia fare of $49, Northwest Airline responded by slashing its average fare on the route by 71% (from $170 to $49) and scheduling 30% more seats. Once Spirit abandoned the route, Northwest raised its fare to $230 and cut its seat capacity.[36] Similarly, when Frontier Airlines initiated service from Denver (United-dominated hub) to Billings, Montana, it offered an average $100 fare, half the prevailing fare charged by United. United slashed its fare to match Frontier; when Frontier exited the route, United raised its fare above its original level.[37]

Collusion

Collusion is a difficult game to play when the number of conspiring rivals is large. It is hard to keep a hundred firms in line when their cost structures differ, when their production facilities vary, and when some have an incentive to cheat on a price agreement or to violate output restrictions. Numbers make a difference. When numbers are large, conspiracies are difficult to organize, difficult to conceal, and difficult to enforce.

However, public policy faces a serious challenge in oligopolistic industries like the case of the Airline industry where major carriers eschew outright collusion and rely instead on a course of conduct characterised as “tacit collusion,” or “recognition of mutual interdependence” to resemble the effects of outright conspiracy. The mechanics of tacit collusion is apparent particularly in an oligopoly market dominated by a few major players. Each carrier naturally recognises the mutual interdependence between it and its rivals.

Carrier X knows that it if were to cut price in order to increase its market share, its aggression would immediately be detected by carriers Y and Z, which would respond with retaliatory price cuts of their own. Market shares would be unaffected, but all carriers would now operate at lower prices and profits. Henceforth, Carrier X cannot expect to increase its market share or revenue at the expense of its rivals. It cannot afford to calculate in terms of maximising its own profits in isolation but instead must constantly ask whether a particular decision on price or output will be not only in its own self-interest, but also in the best interests of its rivals.

By recognising mutual oligopolistic interdependence, it must be concerned with group profits and group welfare. In other word, under oligopoly landscape, independent, aggressive, genuinely competitive behaviour is perceived as counterproductive-an “irrational” strategy for the individual carrier. In an oligopoly, groupthink will influence a carrier’s strategy when it is contemplating price increases as it cannot act alone. In other word, groupthink replaces the calculus of individual advantage, and each carrier must behave as a “responsible” member of the oligopoly group rather than as a reckless, self-seeking competitor. In oligopolies, this recognition of mutual interdependence may extend to non-price competition.

For example, if carrier A refrains from aggressive price competition but seeks to increase its market share through aggressive innovation program, it cannot expect its rivals to sit idly by. It must expect them to increase their research efforts as a simple matter of self-defence, thereby nullifying its expected gains. Anticipating such retaliation which could erode oligopoly profits- carrier A might refrain from innovation for the same reasons it would avoid price-cutting. Rationality again commands “responsible” nonaggressive behaviours; the most effective profit-maximisation rule under oligopoly is to “get ahead by getting along.”

Nevertheless, the level of oligopolistic interdependence and collusion varies from situation to situation. It depends on such factors as whether the oligopoly is tightly knit (small number of firms) or loosely knit (a larger number);whether it is homogeneous or heterogeneous; whether it is symmetrical (having firms of roughly equal size) or asymmetrical (with one firm disproportionately larger); whether or not the industry is mature (having had time to develop its internal arrangements and institutions to promote cooperation); whether the industry is populated by “reasonable” managers or by a few mavericks.

In the US domestic market, the advent of the Internet has increased the efficient of signaling or collusion. Carriers can see what the competition is doing immediately by going to the Internet that allow them to react quickly by adjusting their own prices. This is a far cry from the days when price books were set in type and could not be changed for months. Now most prices can be adjusted several times a day, if needed. Apparently, this is a game that the airlines are particularly adept at. As consumers have more transparent access to real-time flight pricing through online services like Orbitz, so the airlines are almost obligated to adjust to each other. This is particularly apparent on routes where there is no rogue player, like Southwest Airlines or JetBlue as they are (within limits) free to adjust prices upward. As long as the members of the oligopoly with real selling power tacitly agree that a major price war is not in their interest, chances are that prices can quickly readjust themselves, keeping in mind the balance of costs and optimal prices for maintaining profitable sales levels.

Nevertheless, the combined market share of the “Big Five” network airlines (Delta, United, American, US Airways, and Northwest ) that peaked in 1992 has been declining since deregulation [ *]. Furthermore, with the influx of several low-cost carriers, tacit collusion is becoming difficult to organize, conceal and enforce even though oligopolistic rationality and its collusive consequences are inevitable concomitants of oligopoly industry structure.

Pricing

Pricing is important for the carriers. If prices are too low or too high, it can drag down profits. Thus, it is important for the carriers to derive profitable airfares and discourages unprofitable one.

To maximise profits, the carriers should set prices so that marginal revenue just equals marginal cost. In other words, it should use profit-maximising prices as the starting point.

The economic model of pricing ****show diagram****,

which is called marginal cost pricing, clearly identifies a pricing strategy that will maximise profits. This pricing strategy also identifies the information needed to set prices, thus simplifying the process. In other words, the profit-maximising price is where the incremental margin percentage equals the reciprocal of the absolute value of the price elasticity demand [1] [ **] Based on pricing rule, the carriers should adjust its price where there are changes in the price elasticity of demand or marginal cost since the carriers compete under oligopoly landscapes with homogeneous services.

Airfares have dropped significantly over the years [***] since deregulation which helped to simulate competition resulting in the entrance of several low-cost carriers. This could partially due to regulator and oligopolies increase efficiencies, putting direct or indirect price pressure on their suppliers as well as putting pressure on the wages and benefits of their employees Hence there is growing belief is that oligopolies can be price-neutral as opposed to manipulating prices.

The strategic variable for airline carrier is price in the short run. Generally without product and service differentiation, the basic service offered by the carriers would be homogeneous. Under the Bertrand model, the carriers which produce at constant marginal cost and compete aggressively on price in order to gain a bigger share of the market. Under such condition, the market equilibrium is perfectly competitive pricing.

However, in a loosely knit oligopoly structure, the individual carrier has incentive to offer heterogeneous services. Through heterogeneous services, it can charge personalised pricing or group pricing based on passenger willing-to-pay to achieve higher profits. For example, if carrier X sells its airfares at a single, it loses in two ways. Firstly, some passenger would be willing to pay more than $100 for a ticket during the last hour of the flight. Secondly the carrier does not sell to passengers who are willing to pay more than $50 but less than $60. This is illustrated in the graphic below, where P=price and Q=quantity.

By charging such passengers at different price, the carrier could profitably sell to a much larger passenger base.

Furthermore, with differentiated services, should one carrier cut its price below other carriers’ price; it would take away only part of the other carriers’ entire demand. Thus, carriers should have strong incentive to differentiate its offering in order to raise their equilibrium prices. However, there is a risk of loosing the market if the services are not on par with its pricing and demand. The carriers must balance their desire for market share at the same time avoid head-to-head price competition since the less differentiation in their services, the more direct will be in price competition among them and the lower would be incremental margins.