The Costs of Competition

1. Explain how between January and September 1997 the game changed compared to that which had existed prior to January 1997.

Before Jan 1997 there was a collaborative duopolistic market in the airline sector for the route between Innsbruck and Turin. There were only two operators, called Air Turin and Innsbruck Air, who provided all of the commercial flights between these countries. Before 1993, that means before the ‘third package’ was introduced, the airlines had provided their service based upon the traditional bilateral agreement between the countries. With this agreement the two countries had decided on the airlines that would be used to service flights between the cities, but they also decided on issues like the frequency of flights between countries and the amount of capacity that each side could take on. When the ‘third package’ was introduced in January 1993 the airlines were provided with the liberty of choosing their own fares and schedules. Until 1997 the two airlines benefited from being the only two airlines on this route. They collaborated on their flight fares and on flight schedules, which resulted in higher prices for their passengers. For example, Air Turin only flew on Saturdays in the weekend while Innsbruck air only flew on Sundays. Above that, the fares of the flights were very similar for both airlines, as well as the profit they make each year. In Table 1 it is shown that the pricing strategies that were used are very similar. The fare structure also shows that they even use the same price discriminations for their passengers. Both airlines own approximately half of the market share; Air Turin leads with a market share of 58%, while Innsbruck Air has the leftover 42%. Even the average load factors of the flights of Air Turin and Innsbruck air are very similar, with 65% and 68% respectively.

Appendix 1. Fare structure

The game theory of a duopoly analysis can explain this type of cooperative behavior from the operators. The classic example for the duopoly analysis is the Prisoners dilemma (Table 2). In this dilemma, a pay off matrix is pictured that shows the outcomes for the four different types of cooperation of the two parties. A game involves one prisoner/company choosing its optimal strategy on the reasonable expectation that its rival parties will choose their optimal strategy (Table 2). In this case both airlines know each other’s strategy because of the past and the cooperation and not one of both airlines has anything to gain by changing their own strategy. We can say that both airlines are in the Nash equilibrium because they both have chosen a strategy and they won’t benefit from changing it.  As a result they were both able to keep prices up and maintain a complementary schedule. If they would start a price war with each other, it may lead to decreasing profits and revenues. In this Nash equilibrium the companies seek to minimize their maximum possible losses.

Table 2. Prisoners’ Dilemma

This collusive duopoly made it very difficult and costly for other airlines to enter the Innsbruck-Turin route because of their position of dominance in the market. In 1997, the Australian airline Schnell Air entered the market to provide a rival service on the Innsbruck-Turin route. The management of Schnell Air believed that its rivals had taken advantage of the lack of competition to keep fares high and work inefficiently. Schnell Air chose for more competitive prices but still maintained a good quality service. The firm chose for a dominant pricing strategy because they didn’t explicitly take into consideration the prices of their competitors and they tried to maximize their own payoffs. All the consumers that were price sensitive changed from operators to Schnell Air because their strategy was based on the price sensitive and quality-seeking customers. Nine months after entering the market, Schnell Air acquired 47% of the market share, while the market shares of Air Turin and Innsbruck Air had fallen to 32 and 22% respectively. This made Schnell Air become a dominant firm on that route because it accounts for a significant larger market share than its rivals (market share above 40%). The market structure had thereby changed into a dominant firm oligopoly because Schnell Air had competitive advantage over the other firms on this flight route and produced the largest part of output on the route. Furthermore new travellers had been drawn to the Innsbruck-Turin route with an increase of 30%.

1. Provide an explanation of predatory pricing strategy and assess the extent to which Air Turin and Innsbruck Air could be accused of predatory pricing

“Predatory pricing occurs when a company with substantial market share sets its prices at a sufficiently low level with the purpose of damaging or forcing a competitor to withdraw from the market or create barriers to entry for potential new competitors. The predator will suffer losses in the first stage but will earn positive rent during the second stage.” 

By September 1997 Air Turin and Innsbruck Air had realized that the entrant Schnell Air had formed a threat to their place in the market because their load factors had both fallen to 46 % and their market shares tot 32 and 22 % respectively. When Schnell Air announced to introduce a fourth daily flight, both operators knew their share would decrease even more if they were not going to react.