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 otherairlines? Was it really to "help reduce fare confusion"? No, the aim was to reduce pricecompetition and achieve a collusive pricing arrangement. Prices had been driven downby competitive undercutting, as airlines competed for market share. And as RobertCrandall 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 wasannounced and adopted by most airlines, Pan Am, which was dissatisfied with its smallshare of the U.S. market, dropped its fares. American, United, and TWA, afraid of losingtheir 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 tocompetitive discounts. In May 1992, Northwest Airlines announced a "kids fly free"program, and American responded with a summer half-price sale, which other carriersmatched. As a result, the airline industry lost billions.Why was airline pricing so intensively competitive? Airlines plan route capacities two ormore years into the future, but they make pricing decisions over short horizons-monthby month or even week by week. In the short run, the marginal cost of addingpassengers to a flight is very low-essentially the cost of a soft drink and a bag ofpeanuts. Each airline, therefore, has an incentive to lower fares in order to capturepassengers from its competitors. In addition, the demand for air travel often fluctuatesunpredictably. 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 ofprice-conscious consumers, and Internet services such as Expedia and Orbitzfacilitated "fare shopping." But recall from Example 9.3 that the industry began tochange starting around 2005, as mergers reduced the number of major airlines in theU.S. to just five (American, United, Delta, JetBlue, and Southwest), and airlines filledmany more seats, reducing the intensity of price competition. Example 13.3Competition and Collusion in the Airline IndustryIn March 1983, American Airlines proposed that all airlines adopt a uniform fareschedule 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 forshorter trips, and the highest rate, 53 cents per mile, for trips under 250 miles. Forexample, 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 1000miles).This proposal would have done away with the many different fares (some heavilydiscounted) then available. The cost of a ticket from one city to another would dependonly on the number of miles between those cities. As a senior vice-president ofAmerican Airlines said, "The new streamlined fare structure will help reduce fareconfusion." Most other major airlines reacted favorably to the plan and began to adoptit. A vice-president of TWA said, "It's a good move. It's very businesslike." United Airlinesquickly announced that it would adopt the plan on routes where it competes withAmerican, which included most of its system, and TWA and Continental said that theywould adopt it for all their routes.11

In economics, collusion refers to an agreement or understanding between independent entities, such…

Answered: Refer to Example 13.3 - 'Competition…

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Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC