Jan 2011 Economics Unit 3

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BA and Iberia (Jan 2011)

1)
Merger between BA and Iberia tend to be horizontal integration. Horizontal integration occurs when a firm is being taken over by, or merged with, another firm which is in the same industry and in the same stage of production as the merged firm, e.g.BA and Iberia. In this case both the companies are in the same stage of production and also in the same industry (i.e. airlines industry). The goal of horizontal integration is to consolidate like companies and monopolize an industry. Besides, they can also gain Economic of Scale when doing such strategies. Put another way, they can reduce average cost of production in the long run. For example, according to extract 1, they may also have more buying power when it comes to negotiations to buy new planes from Boeing and Airbus.

2)
Reasons why Iberia made a loss during ‘the usually profitable summer months can be either rising cost and fall in demand.

Firstly, a rise in production cost, which is a significant factor of production, has a huge impact on the amount of profit Iberia can make. Fuel costs is a typical example. Put another way, when there is a rise in cost of fuel, it will eventually push up the price as well, which leads to a significant reduction in demand. As a result, we expect to see a loss . Also, there can be other costs that affect the amount of profit, including wages, taxes and so on.

Secondly, falling demand is another problem. Apart from higher price, a fall in demand can be due to financial crisis, reduction in consumer confidence or because of recession. In these situations, consumers have no incentive to spend for airplanes tickets while they are not sure about their financial status, especially during a recession. Therefore, revenue of Iberia will fall and they can make a loss even during “ the usually profitable summer months”

However, Iberia is not the only company that suffer from this loss. Others airlines have experienced similar problems. From extract 1, BA said that it
had lost £292m in the first half of the year, which includes the summer period.

Due to the fact that Iberia is a national firm, there will be government intervention when Iberia made such losses. For example, government can subsidize for Iberia to reduce cost of production. Therefore, it can contribute to their loss.

Last but not least, this situation will not last for too long. In the future, when the economy has recovered from recession, Iberia will no longer making loss but profit instead.

3)

Contestability means that a market has freedom of entry and exit. In other words, new firms can enter and leave easily; this creates a permanent threat of competition. Contestability requires low sunk costs (costs that are non recoverable). If an industry has high sunk costs, it creates a cost to leave and deters entry.

After merger between Iberia and BA, we expect to see a reduction in contestability. Firstly, by agreeing to merge, the two firms get bigger, which allow them to benefit from economy of scale. Put another way, this has become a mean to make substantial cost savings in order to compete with other low-cost airlines. For example, they can benefit from bulk purchasing of fuel or having more buying power when it comes to negotiation to buy new planes from Boeing and Airbus. As a result, it will push up the barrier to entry where incumbent firms already benefit from decreased long run average cost.

Secondly, The airline industry will be relatively high concentrated through gaining more market share by merger between Iberia and BA. As a result, the new big firm now enjoys more monopoly power that allow them to build brand loyalty. This will also higher the barrier to entry and exit as new firms have to spend heavily on advertising when they enter the airlines industry.

Thirdly, the two companies estimate that within five years the new group will save some £429m a year by cutting overlapping...
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