Coordinating prices is easier in some industries than in others. Fixed costs in
ID: 1216786 • Letter: C
Question
Coordinating prices is easier in some industries than in others. Fixed costs in the airline industry are very large, and marginal costs are very small. The marginal cost of flying one more passenger from Chicago to New York is no more than a few dollars: the cost of another snack served and a small amount of additional jet fuel. As a result, airlines often engage in last-minute price cutting to fill the remaining empty seats on a flight. Even a low-price ticket will increase marginal revenue more than marginal cost. As with other oligopolies, if all airlines cut prices, industry profits will decline. Therefore, airlines continually adjust their prices while monitoring their rivals’ prices and retaliating against them for either cutting prices or failing to go along with price increases. In recent years, mergers in the airline industry have increased the possibility of implicit collusion by reducing the number of airlines flying between two cities. Often only one or two airlines will fly on a particular route. Southwest Airlines and JetBlue, however, have undertaken an aggressive campaign to enter many airports, thereby increasing competition. For example, before Southwest entered Washington, DC’s Dulles International Airport in October 2006, United and Continental Airlines were the only major airlines serving the airport. But would increasing the number of airlines on a route from two to three have much effect on the ability of the airlines to engage in price collusion? Austan Goolsbee and Chad Syverson of the University of Chicago studied the effects of Southwest’s entering airline markets over an 11-year period. They found that when Southwest begins flying a particular route, ticket prices drop by an average of 29 percent. These price declines indicate that airlines may have been practicing implicit price collusion before Southwest’s entry into the market. Perhaps surprisingly, Goolsbee and Syverson found that more than half of the price decline occurred after it became likely that Southwest would enter a market but before Southwest actually began flying planes on the route. One possibility is that airlines already in the market lowered prices to keep frequent flyers from switching to Southwest.
Question
The following appeared in an article in the Wall Street Journal: “Last week, true to discount roots dating to 1971, Southwest [Airlines] launched a summer fare sale on domestic flights, with one-way prices as low as $49. As in the past, major competitors were forced to follow suit.” Why would other airlines be “forced” to follow Southwest’s fare decrease? What if this fare decrease took place during an economic recession, when incomes and the demand for airline travel were falling?
Explanation / Answer
the other airlines would be forced to follow southwests fare decrease bwcause of competition. when southwest decreases fare the other flight companies also subsequently do so. this is donr to remain in the industry and be a part of the industry. otherwise the other companies would fade out and southwest would adopt a monopoly. the demand for the other company tickets would fall leading them to exit the industry.
if the fare decrease took place during a recession then the demand would increase more than normal.