The Cost of Competition Essay Sample

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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 Air is the dominant player while Air Turin and Innsbruck Air are the weaker players. Moreover, after Schnell Air announced plans to introduce a fourth daily service, Air Turin and Innsbruck Air announced their respective strategies. Assuming that low price was the factor for change, Air Turin decides to drastically reduce their price in line with that of Schnell Air with no change to the quality of service. In contrast Innsbruck Air assumes that quality and frequency is the changing factor and hence decides to up their quality of service with further increase to their marginal cost and also increase frequency in line with that of Schnell Air.

Predatory Pricing & Advice as regards Schnell Air’s Additional Flight

Considering, the above conditions, the need to analyse the concept of ‘Predatory Pricing’ being played by the two competing airlines as a strategy to deter or even drive away Schnell Air from the market is essential. ‘Predatory Pricing’ is a key strategy that can be employed by an incumbent firm either to protect or to extend its market share against competitive attacks by smaller scale competitors and potential entrants or is used to drive out smaller rivals. These strategies have in common the intention of reducing the expected level of profits that actual and potential rivals can expect to earn in the present and future. After rivals exit, the predator firm presumably will raise prices to levels consistent with its market power. The predatory firm loses substantially more than its rival does; the incumbent must accommodate all demand, while its rival is free to cut output to cut its losses. Presumably, the predatory firm expects to more than offset this loss after re-establishing its monopoly position. One problem for this model is that boosting prices after rivals are driven from the market may be self-defeating because new entry would again be stimulated.

In order to analyse the extent to which Air Turin and Innsbruck Air can be accused of predatory strategies, we need to analyse a ‘What If’ situation where Air Turin and Innsbruck Air actually go ahead with their respective strategies.

 First let us consider that Air Turin’s and Innsbruck Air’s strategy is to attract back customers from Schnell Air, i.e. to cause a decrease in the average load capacity of Schnell Air: Assuming that customers behave rationally and hence the real reason for Schnell Air’s success is its quality service at low prices; we can safely say that they are price sensitive and quality conscious. If we split the total passenger/week of Schnell Air into – ‘Price & Quality sensitive’, ‘Only price sensitive’ and ‘Non price sensitive’, assume a ratio of 60:20:20, and assume that the 60% will stick with Schnell Air, the 20% ‘Only price sensitive’ is attracted to Air Turin and the remaining 20% of ‘Non price sensitive’ to Innsbruck Air.

It will be observed that the profit margin of Air Turin is very marginal with an increased load capacity to 60% and Innsbruck Air will report greater loss than it presently incurs with a load capacity of 23%. The average load capacity of Schnell Air also reduces to 51% with a significant decrease in revenues and profits, resulting in a market share of 30%. Thus, we can assume that being a larger carrier with deep pockets Air Turin is subsidising its reduced revenues and profits from its other routes and is hence playing a predatory strategy game to a large extent. In contrast Innsbruck Air is in a loss with no significant profit from its increased frequency and hence is not involved in predatory pricing. The only way Innsbruck Air can actually compete is by decreasing its price.

Conclusion: Considering such a scenario introducing a fourth daily service would prove to be very detrimental, since the marginal cost of Schnell Air will be extremely larger compared to its revenues.

 Secondly is we consider that Air Turin’s and Innsbruck Air’s strategy is to attract back customers from the overall customer capacity on the route: Again assuming that customers are price sensitive and quality conscious, we split the overall total passenger/week into – ‘Price & Quality sensitive’, ‘Only price sensitive’ and ‘Non price sensitive’. Here we assume a ratio of 35:30:35, and assume that the 35% ‘price and quality sensitive’ customers will continue with Schnell Air, the 30% ‘Only price sensitive’ will be split between Air Turin and Schnell Air and the remaining 35% of ‘Non price sensitive’ will be split three ways between the carriers. In accordance with the calculations, we notice that the situation of Air Turin and Innsbruck Air is largely the same with insignificant changes in load. On the contrary, there will be an increase in the load capacity to Schnell Air (which is manageable with its current services) with a market share of 57%. However an addition of another service will result in an increase in marginal costs and finally a decrease in overall profit.

Conclusion: Schnell Air should refrain from adding another service under such circumstances. Schnell Air should at the same time constantly analyze the increase in demand if Air Turin reduces its fare and only based on a significant increase in demand should opt for an additional service.

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