The Cost Of Competition

The costs of competition

1. Introduction

In 1997 Schnell Air entered into the Innsbruck-Turin air market which at that time existed as a duopoly market (Innsbruck Air and Turin Air). Both Innsbruck Air and Turin Air have adapted to Schnell Air's entry by either changing price or service. This paper will discuss:

 The strategic situation prior to Schnell Air entering the market (January 1997)

 Whether there is predatory pricing by Innsbruck Air and Turin Air as a reaction to Schnell Air entering the market

 A proposed strategic response by Schnell Air to the adaptations made by Innsbruck Air and Turin.

2. Assumptions made for the analysis

Fare structure: I assume that there is an uneven distribution of the different ticket classes used on each flight. More advance fare tickets are sold than full fare tickets. This distribution was assumed for all travel days (no distinction between weekdays and weekend days). For the situation prior to and immediately after Schnell Air entering the market see Appendix 2, for the distribution after the reaction of Turin Air and Innsbruck Air's reaction to the market entry of Schnell Air see Appendix 11. This assumption is, of course, flawed, since the ability of Schnell Air do adjust fare structure according to sales cannot be estimated and was not taken into account here.

Revenue estimates: The revenue projections (Appendices 5, 12 and 15) were based on the fare structure distribution shown above.

Cost estimates: For Innsbruck Air's' reaction after Schnell Air's entry into the market I assumed tripling of indirect weekly costs due to increase in flight numbers/week and to heavy advertising. For the cost estimates of Schnell Air see 5. below.

3. Strategic situation prior to Schell Air entering the market

The strategic situation in 1996 was that of a collaborative duopoly which probably was established in the era of the bilateral air services agreements (one airline per country is the designated carrier for the international route in the case of the route Innsbruck - Turin it is Turin Air and Innsbruck Air). The cooperative nature of the agreement becomes evident through the fact that both carriers share weekend service - Innsbruck operates on Sundays and Turin Air on Saturdays (see Appendix 1). The fee structure and fare for both airlines are similar as well (see Appendix 2) as is the yearly profit (see Appendix 5, last column, Appendix 4 for cost estimates). In terms of game theory, both airlines are playing dove (= they cooperate rather than fight). Appendix 7 shows a theoretical schematic assuming the market size (=revenue/year is 640 million Schillings). Both airlines are close to obtaining Ð... of this market - 348 Million Schillings for Turin Air and 292 Million Schillings for Innsbruck Air (see Appendix 3 for market share and Appendix 5 for revenue).

4. Did Innsbruck Air and Turin Air use predatory pricing as a reaction to Schnell Air entering the market?

Predatory pricing is defined as setting a price below cost. Turin Air and Innsbruck Air have used different strategies to counter Schnell Air's entry into the market. Turin Air has decreased prices and has maintained their original flight schedule; Innsbruck Air has maintained pricing and has increased frequency and quality of service (Appendices 9 and 11). However, both airlines have had a decrease in passenger load to 47% (see Appendix 8). The break-even load factor for the airline industry is around 66% (1999 estimate, see reference 1). Prior to their reaction to Schnell Air's entry, both Turin Air and Innsbruck Air were close to this value, with 65% and 68% load, respectively. Taken together, the decreased load, decreased pricing (Appendix 11) and maintenance of cost structure has led Turin Air from a profit of 46% to a loss of 66%. For Innsbruck Air, the increase in cost due to the higher frequency and increased service of flights together with the decrease in passenger load has turned a 53% profit into a 26% loss. For adjusted total cost estimates please see Appendix 10. From the cost estimates shown in the appendices it seems that both Turin Air and Innsbruck Air operate under cost and therefore exhibit anti-competitive behavior. There are many assumptions made in this analysis that are not supported by hard data, however (cost and revenue calculations for example). However, according to Article 82 (formerly Article 86) of the Treaty of Rome, requires a firm to have a dominant market position at the time that predatory pricing occurs (see reference 2, p. 615, 1st paragraph). At the time that Turin Air and Innsbruck Air reacted to Schnell Air's entry to the market, they had lost their dominant market positions (with market share down to 32 and 22 percent, respectively). Another unanswered question is whether there is recoupment of revenue as a result of the strategies employed by Turin Air and Innsbruck Air. One could postulate that, if Turin Air and Innsbruck Air are successful in driving Schnell Air out of the market (with Schnell Air playing dove to the incumbents' hawk) they could minimally re-establish their pre-Schnell Air loading factors and potentially capture the 30% increase of total passengers resulting from the entry of Schnell Air. For Turin air, a 15% increase in passenger numbers would lead to a loading factor of 75%. Taking into account the new price structure applied by Turin Air after Schnell Air's entry, the airline would be at the break-even point (-1% loss, see Appendix 13). Recoupment would therefore only be possible with an increase in fare structure while maintaining passenger load. Recoupement is at present only taken into account in US competition policy.

I conclude that both Turin Air and Innsbruck Air do not use predatory pricing as a reaction to Schnell entering the market.

5. A proposed strategic response by Schnell Air to the adaptations made by Innsbruck Air and Turin Air

In terms of game theory the responses of Turin Air and Innsbruck Air have clearly turned them from doves into hawks - they are aggressively fighting to counteract Schnell Air's entry into the market. Unfortunately, it is not known how the market reacts to Turin Air and Innsbruck Air's strategy (e.g. will they take away customers from Schnell Air as a result) and therefore this cannot be