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Refer to Example 13.3 - 'Competition and Collusion in the Airline Industry' What does this example show us about the failed attempt at 'collusive pricing arrangement' due to prisoners' dilemma in the US airline industry, over the given period?

Refer to Example 13.3 - 'Competition and Collusion in the Airline Industry' What does this example show us about the failed attempt at 'collusive pricing arrangement' due to prisoners' dilemma in the US airline industry, over the given period?

ENGR.ECONOMIC ANALYSIS
ENGR.ECONOMIC ANALYSIS
14th Edition
ISBN:9780190931919
Author:NEWNAN
Publisher:NEWNAN
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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Refer to Example 13.3 - 'Competition and Collusion in the Airline Industry'

What does this example show us about the failed attempt at 'collusive pricing arrangement' due to prisoners' dilemma in the US airline industry, over the given period?

Why did American propose this plan, and what made it so attractive to the other airlines? Was it really to "help reduce fare confusion"? No, the aim was to reduce price competition and achieve a collusive pricing arrangement. Prices had been driven down by competitive undercutting, as airlines competed for market share. And as Robert Crandall had learned less than a year earlier, fixing prices over the telephone is illegal. Instead, the companies would implicitly fix prices by agreeing to use the same fare- setting formula. The plan failed, a victim of the prisoners' dilemma. Only two weeks after the plan was announced and adopted by most airlines, Pan Am, which was dissatisfied with its small share of the U.S. market, dropped its fares. American, United, and TWA, afraid of losing their own shares of the market, quickly dropped their fares to match Pan Am. The price- cutting continued, and fortunately for consumers, the plan was soon dead. American Airlines introduced another simplified, four-tier fare structure in April 1992, which was quickly adopted by most major carriers. But it, too, soon fell victim to competitive discounts. In May 1992, Northwest Airlines announced a "kids fly free" program, and American responded with a summer half-price sale, which other carriers matched. As a result, the airline industry lost billions. Why was airline pricing so intensively competitive? Airlines plan route capacities two or more years into the future, but they make pricing decisions over short horizons-month by month or even week by week. In the short run, the marginal cost of adding passengers to a flight is very low-essentially the cost of a soft drink and a bag of peanuts. Each airline, therefore, has an incentive to lower fares in order to capture passengers from its competitors. In addition, the demand for air travel often fluctuates unpredictably. Such factors as these stand in the way of implicit price cooperation. Thus, aggressive price competition continued to be the rule in the airline industry, especially as "discount" airlines such as Southwest and JetBlue attracted millions of price-conscious consumers, and Internet services such as Expedia and Orbitz facilitated "fare shopping." But recall from Example 9.3 that the industry began to change starting around 2005, as mergers reduced the number of major airlines in the U.S. to just five (American, United, Delta, JetBlue, and Southwest), and airlines filled many more seats, reducing the intensity of price competition.
Transcribed Image Text:Why did American propose this plan, and what made it so attractive to the other airlines? Was it really to "help reduce fare confusion"? No, the aim was to reduce price competition and achieve a collusive pricing arrangement. Prices had been driven down by competitive undercutting, as airlines competed for market share. And as Robert Crandall had learned less than a year earlier, fixing prices over the telephone is illegal. Instead, the companies would implicitly fix prices by agreeing to use the same fare- setting formula. The plan failed, a victim of the prisoners' dilemma. Only two weeks after the plan was announced and adopted by most airlines, Pan Am, which was dissatisfied with its small share of the U.S. market, dropped its fares. American, United, and TWA, afraid of losing their own shares of the market, quickly dropped their fares to match Pan Am. The price- cutting continued, and fortunately for consumers, the plan was soon dead. American Airlines introduced another simplified, four-tier fare structure in April 1992, which was quickly adopted by most major carriers. But it, too, soon fell victim to competitive discounts. In May 1992, Northwest Airlines announced a "kids fly free" program, and American responded with a summer half-price sale, which other carriers matched. As a result, the airline industry lost billions. Why was airline pricing so intensively competitive? Airlines plan route capacities two or more years into the future, but they make pricing decisions over short horizons-month by month or even week by week. In the short run, the marginal cost of adding passengers to a flight is very low-essentially the cost of a soft drink and a bag of peanuts. Each airline, therefore, has an incentive to lower fares in order to capture passengers from its competitors. In addition, the demand for air travel often fluctuates unpredictably. Such factors as these stand in the way of implicit price cooperation. Thus, aggressive price competition continued to be the rule in the airline industry, especially as "discount" airlines such as Southwest and JetBlue attracted millions of price-conscious consumers, and Internet services such as Expedia and Orbitz facilitated "fare shopping." But recall from Example 9.3 that the industry began to change starting around 2005, as mergers reduced the number of major airlines in the U.S. to just five (American, United, Delta, JetBlue, and Southwest), and airlines filled many more seats, reducing the intensity of price competition.
Example 13.3 Competition and Collusion in the Airline Industry In March 1983, American Airlines proposed that all airlines adopt a uniform fare schedule based on mileage. The rate per mile would depend on the length of the trip, with the lowest rate of 15 cents per mile for trips over 2500 miles, higher rates for shorter trips, and the highest rate, 53 cents per mile, for trips under 250 miles. For example, a one-way coach ticket from Boston to Chicago, a distance of 932 miles, would cost $233 (based on a rate of 25 cents per mile for trips between 751 and 1000 miles). This proposal would have done away with the many different fares (some heavily discounted) then available. The cost of a ticket from one city to another would depend only on the number of miles between those cities. As a senior vice-president of American Airlines said, "The new streamlined fare structure will help reduce fare confusion." Most other major airlines reacted favorably to the plan and began to adopt it. A vice-president of TWA said, "It's a good move. It's very businesslike." United Airlines quickly announced that it would adopt the plan on routes where it competes with American, which included most of its system, and TWA and Continental said that they would adopt it for all their routes.11
Transcribed Image Text:Example 13.3 Competition and Collusion in the Airline Industry In March 1983, American Airlines proposed that all airlines adopt a uniform fare schedule based on mileage. The rate per mile would depend on the length of the trip, with the lowest rate of 15 cents per mile for trips over 2500 miles, higher rates for shorter trips, and the highest rate, 53 cents per mile, for trips under 250 miles. For example, a one-way coach ticket from Boston to Chicago, a distance of 932 miles, would cost $233 (based on a rate of 25 cents per mile for trips between 751 and 1000 miles). This proposal would have done away with the many different fares (some heavily discounted) then available. The cost of a ticket from one city to another would depend only on the number of miles between those cities. As a senior vice-president of American Airlines said, "The new streamlined fare structure will help reduce fare confusion." Most other major airlines reacted favorably to the plan and began to adopt it. A vice-president of TWA said, "It's a good move. It's very businesslike." United Airlines quickly announced that it would adopt the plan on routes where it competes with American, which included most of its system, and TWA and Continental said that they would adopt it for all their routes.11
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