Market Structure and Competition

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Market Structures

How would you evaluate levels of competition among airlines?

define the relevant market, then look at individual carriers, parent companies or alliences

measures of competition at or over period of time

number of carriers

individual market share

ASK/ATK, RPK/RTK

Flights, seats, passenger etc

market concentration of 3 biggest players C3

Sum of squares of individual market Share = Herfindahl-Hirschmann Index (HHI)

Herfindahl-Hirschmann Indem (HHI)

sum of the squares of the market shares of each individual firm in the relevant market

HHI= s_1^2+s_n^2 etc.

10,000 represents a monopoly

high HHI could lead to regulatory scrutiny in the event of mergers

HHI gives proportionately greater weight to market share of larger firms

Assessment of mergers in the US

Small Change in Concentration

increase of less than 100 points, unlikely to have adverse competitive effects, no further analysis required

unconcentrated markets (HHI below 1.500)

mergers unlikely to have adverse competitive effects, no further analysis required

moderately concentrated markets (HHI between 1500 and 2500)

Mergers that increase the HHI by more than 100 points: potentially competitive concerns, might result in scrutiny

highly concentrated markets (HHI above 2500)

mergers that increase the HHI by 10 and 200 points: potentially competitive concerns, might result in scrutiny

mergers that increase HHI by more than 200 points: increase market power, companies need to provide evidence that merger is unlikely to increase market power

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Characteristics of Perfect Competition

conditions that must be satisfied:

homogeneous identical product

large number of independent buyers and sellers

buyers and sellers have perfect information

easy to enter and exit market

no transaction costs

firms are price takers at the market price

equilibrium price depends on demand and supply

horizontal firm demand vs downward sloping industry curve

firms see P=AR = MR

firms can only influence the quantity they produce

Characteristics of Monopolistic Competition

given lack of influence over price under perfect competition, firms seek to differentiate products where possible

under monopolistic competition, there are still many producers

firms have some ability to set prices even though products are very similar as a result of brand loyalty

branding and advertising are therefore key to differentiate products

demand relatively elastic but firm has some ability to set output and price to maximise profit: MR=MC (P>MR)

large price differential will lead costumers to switch

Characteristics of Monoply

Monopoly occurs when there is a single seller of a particular good in a given market

the firm's demand curve is the market demand curve

the firm is protected by entry barriers

government intervention and regulations

intelectual property

capital investment required

technology

economies of scale

the firm is a price maker, subject to market elasticity

can charge price above MC to maximise profit where MR=MC

supply curve. not relevant for monopolist: output depends on MC

Disadvantages of Monopoly

ability to charge high prices and earn above-normal profits

ability to restrict sales to certain customers

ability to price discriminate

no incentive to develop product

no incentive to improve efficiency and reduce costs

Advantages of Monopoly

economies of scale from large operation

lower competitive risk encourages investment

can spend large amounts on R&D

regulation of public/natural monopolies can ensure customer needs are taken into account

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Entry Barriers

marked economies of scale in aircraft prodcution

government intervention

bilateral air service agreements

ownership estrictions

licensing or franchising

use of patents e.g. aircraft and engine technology

access to infrastructure

US: Airline leases terminal

Europe: Slots - Grandfather rights

access to distribution systems, if airlines own GDS

predatory behaviour

price cuts, capacity or frequency increases, schedule mirroring

access to factors of production

how easy is it to earmark land for new airport?

access to capital markets

track record of existing vs new airlines

access to information

route demand and performance data available to incumbents

brand loyalty

requires big new entrant investment in advertising

switching costs

FFP programmes lock people in

exit costs?

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Oligopoly

Characteristics of Oligopoly

Oligopoly refers to markets with few, large producers

concentration ratio of largest firms is key to measure competition

significant barriers to entry usually present

non-price competition is high with product differentiation - although not always possible e.g. steel vs car industry

price depends on firm's output and on its competitors

firms are price-makers but high degree of interdependence

firms must think through what competitors would do and how they will respond to its actions

difficult to evaluate and there may be no optimal strategy

typical market structure experienced by aircraft and engine manufacturers as well as airlines and airports

Maximising profit in an oligopoly

highly competitive markets tend towards normal levels of profit in the long run based on the lowest cost producer

however monopolists can extract above normal short and long-run profits if they manage costs and know elasticity

in the case of oligopolies, short and long-run profits can be above or below normal levels

outcome depends on entry barriers and competitive dynamic

P= MC in cases of fierce competition

P>> MC where players cooperate implicitly or explicitly

Cooperation vs Competition

Cooperation novels firms reaching agreements with each other for the purpose of limiting competition

agreements can be explicit (collusion) or implicit, resulting in higher prices to consumers and restricted production

significant risk of collusion to alleviate uncertainty as to how competitors will react to enable profit maximisation

anti-trus regulation therefore generally prohibits collusion

collusion (including cartels) outlawed in many countries

however, implicit understandings often arise in stable industries e.g. where firms know from experience how others will respond

Equilibrium price/output in an oligopoly

in an oligopolistic market, each firm will do the best it can given what its competitors are doing

I.e. each firm takes its competitors into account and assumes they are doing likewise

most oligopolies exhibit periods of price stability and profit interspersed with price-changing activity and price wars

some oligopolies are more competitive than others - e.g airlines

Contestability Theory

if new competitors can readily enter a market (no barriers) then the market is contestable

may drive oligpolists to behave as if there was already real competition i.e. lower prices and profits

if an airline increases price, there comes a point where it will encourage new entry and its demand becomes more elastic

ideally the airline should price just below the point at which a new entry is encouraged (P*)

Contestability of airline markets

positive relationship between fares and market concentration -> prices fall when entry occurs

airline markets arguably not perfectly contestable

contradicts expectation of deregulation that markets would be contestable because of asset mobility (aircraft)

however, the industry has been able to establish many barriers to entry that made true contest ability difficult

FFPs, slots and gate access, hub dominance

notwithstanding the above, the industry has struggled to make profit and many successful LCCs have emerged

Kinked Demand Curve Theory

consider an oligopolist with output Q* at price P*

own price increase will have no response from competitors: they will just gain marketshare

own price decrease will be matched by competitors defend market shares

the combined marginal revenue curve is vertical at Q*

this results in price stability even if costs change

Game Theory

in a non-competitive oligopoly, firm behaviour depends on how it thinks its rivals will react but profits lower than under illegal collusion

if you now this, and so does the other firm, then why does implicit coooperation not occur

Game theory: The best strategy a firm can adopt given each assumption about rival's behaviour

the outcome is not necessarily the collusooine one as each firm may be able to make more money by pursuing an alternative strategy, no matter what the competition does

The Prisoners' Dilemma

two parties commit crime, then retained separately, if one confesses it will have a better penalty than without confessing

two airlines with similar cost base competing on the same route who can set pricing low or high

each airline has dominant strategy to charge low fares

they make more money this way no matter what the other does

airlines may eventually reach an understanding they are better off with both charging high fares

attempts to undercut will lead to retaliation and lower profits owverall

if different cost bases; demand stimulation make implicit collusion unlikely

the prisoner's dilemma is a simple game and price rigidity is a natural outcome of equilibrium

firms seek to avoid mutually destructive price competition

real games are more complex, however, and may not have dominant strategies

whether a game is played once or many times will impact on how easily a collusive outcome can be reached

in the absence of collusion, firms may signal price moves e.g. crease in fuel surcharge (price leadership)

in the airline industry, competitive outcomes often prevail despite an oligopolistic structure at route level

Despite oligopolistic attributes, airlines are often unable to extract monopoly profits

airlines would ideally compete on non-price aspects in a "cosy" oligopoly setting, however

price cuts can be easily matched and marginal cost can be very low: the cost of filling another seat very low

non-price aspects can also be easily matched

FFPs, lounges, IFE, seat pitch etc.

some would argue that airline seats are a commmodity

many passengers seem to value price more than other attributes

airlines face different competitors on each route

networks compete against each other: contestability

at city, airport or O&D level there is more competition than on a route level

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Summary

there are four distinct market structures on the continuum form monopoly to perfect competition

monopolists can set prices and earn above-normal profits

under perfect competition, price = marginal cost

the airline industry is essentially oligopolistic but pricing tends to be highly competitive and it can be argued hat the industry is relatively contestable given low profits

implicit cooperation unlikely where LCCs are present

several theories try to explain oligopolistic from behaviour

game theory illustrates well the challenges faced by airlines