The Cost of Competition

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Executive Summary

To identify an appropriate strategy for a given industry one must look into the external and internal factors influencing the company. This Schnell Air report has been conceived with a triple objective in mind: to provide the Schnell Air Board with (i) a brief and compelling synthesis of Schnell Air’s competitive market environment overview since it entered the Innsbruck – Turin route in January 1997 as compared to prior to its entry, (ii) analyse the available data to establish the extent of predatory pricing strategies being plotted by the two existing duopolies – Air Turin and Innsbruck Air and (iii) by using a Game Theoretic approach model and highlight the affect of a 4th daily service on the same route given the declared intentions by the incumbent Airlines. The market structure and the subsequent change of the three airlines before (Jan’97) and after (Jan’97-Sep’ 97) entry is provided below.

Market Situation Prior to January 1997

The market environment before January 1997 was a duopoly between two large carriers Air Turin & Innsbruck Air. Based on the assumption that both airlines exhibited rational behaviour, it was in their advantage to collude and set the price and their individual outputs at levels that would maximize their joint profits. This situation (illustrated in Appendix, 1.1), shows the demand curve, given by DD, as the individual firm's share of the market demand under circumstances where the two firms are identical with respect to size and costs of production. To understand this behaviour of the collusive duopolies, a mathematical tool called ‘Game Theory’ is used. The classic example for the duopoly analysis here is the ‘Prisoner's-dilemma game’ (shown in Appendix, 1.2). Within this game structure, a payoff matrix has been plotted, which shows the outcomes (each carrier’s profits) for all four combinations of collusion. By understanding the various ‘payoffs’ (referring to the profits or losses that will result from a particular economic decision made by itself and its competitors) a rational, profit-maximizing (or loss minimizing) decision was arrived at between Air Turin and Innsbruck Air to operate in a tacit cooperative equilibrium. Owing to the lack of competition the two duopolies kept the fares high resulting in maximum profit, although they may have suffered large x-inefficiencies (production levels below market demand). This form of collusion is usually against public interest and poses restrictive barriers to trade and competition since it offers little incentive to control costs and keep the price levels down.

Market Situation Post January 1997

Post January 1997, due to the introduction of the ‘Third Package’ of aviation liberalisation measures in the EU, the game changed with the entry of Schnell Air in the market environment. Schnell Air being a smaller carrier, but with a service distinguishable from that of the existing carriers, entered the market with a dominant aggressive strategy in order to maximise load and hence maximise profits. The carrier not only fills a service frequency gap (introduction of an evening service and increase in weekend services), but also provides a far superior quality service w.r.t. price value.

The consequent change in the market environment resulted in an average of 85% load factor and high profits for Schnell Air. Air Turin observed a decrease in average load factor from 65% to 46% and hence a significant decrease in total profits from 116,000 schillings to 1,206 schillings. Innsbruck Air on the other hand reported a very large loss of 140,045 schillings, due to very high total cost/flight (refer Appendix,1.3). This strategic conflict can be observed through a ‘Game ofChicken’ (shown in Appendix 1.4). The Chicken game is an anti-coordination game, played by two rivals, both vying for the same resource. Thus, the firm playing the dominant strategy obtains the market share and hence reaps profit. In this situation Schnell...
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