Airlines and Oligopoly Theory
In an oligopolistic market the industry is
concentrated in the hands of a few firms, and the actions of each firm is
interdependent. This means that should one firm decrease prices, it is likely
that they would increase sales at the expense of other firms. Unlike in a
perfectly competitive market, the product is likely to be differentiated, and not
homogenous. Moreover, it is likely that there are high barriers to entry in the
market. This is because, if there were lower barriers to entry, then other
firms would enter the industry, attracted by the abnormal profits, and so would
reduce the market share for the dominating firms. There is strong debate as to whether the airline industry is an oligopolistic market- indeed, it does appear that it is.
High barriers in the airline industry include
the need to book landing slots and to advertise heavily. Low-cost airlines such
as easyJet and RyanAir have increase competition in the airline industry and
have overcome the high entry barriers. However, they have only managed to do so
by differentiating their service substantially from well-established firms like
British Airways, who have a large market share. For example, RyanAir does not
offer ‘free’ inflight meals; it offers fewer cabin crew and less legroom,
meaning that tickets are substantially cheaper. This has resulted in many
customers flying who previously did not when the ticket prices were more
expensive. This has allowed RyanAir and
easyJet to increase their market share. Moreover, this competition also
resulted in British Airways reducing their ticket prices slightly, in order to
ensure that as many customers remain with, and choose, them over the low-cost
airlines. A further evidence of increased competition is seen by the fact that
British Airways introduced its own low-cost service ‘Go’, in order to try to
maintain market share- however, this was eventually sold to easyJet through a management
buyout.
Another barrier to entry in the airline
industry is that the government may not grant rights to certain airlines to
land in their airports. Governments may not grant rights because their domestic
airlines may be generating abnormal profits and so the introduction of a new
airline may drive these profits down through increased competition. Indeed,
such practices were evident in both Romania and Bulgaria up until 2008, when EU
law stated that an airline did not need to seek a licence from the domestic
government for landing rights, if it had an EU carrier licence. Prior to the
new law, British Airways was the main operator on the routw from London to Bucharest,
with tickets priced at €240. However, after the implementation of the law,
prices fell because low cost airlines, such as WizzAir and easyJet, provided a
low cost service, increasing competition on the route and thus forcing British
Airways to decrease their prices slightly. The price decrease was only slight
because WizzAir is a ‘no frills’ airline whereas British Airways also provides
meals, more stewards and stewardesses, leg room and the like, thus meaning that
potential passengers were willing to pay more for a British Airlines ticket
than an WizzAir ticket, (although not as much as prior to the law).
 |
| Figure 2: A kinked demand curve model |
The neo-classical kinked demand curve model,
developed in the 1930s by Hall and Hitch, can be used to illustrate the effect
of price increases and decreases in the market for airlines.
Let’s assume that British Airways increases
the price of its tickets from Heathrow to Rome, say to OA. Monarch and easyJet
are likely to leave their prices at the same level, as they hope to increase
their market share by capturing customers from British Airways.
Conversely, if British Airways cuts its fare
from Heathrow to Rome, to OB, it is likely that easyJet, or even Monarch, would
do the same, fearing that they would lose market share otherwise. Therefore,
the demand curve when prices are cut is relatively price inelastic.
Looking at the kinked demand curve model we
can observe that prices in an oligopolistic market, such as the airline
industry, are likely to be relatively ‘sticky’. If marginal costs increase from
MC1 to MC2 the price is likely to stay the same. British Airways is likely to
absorb the costs and reduce its profit.
In order to lower costs, many airlines are
sharing facilities, in order to benefit from economies of scale. Such programs
include sharing training and cooking facilities.
There is evidence to suggest that such alliances have helped to lower costs for
passengers, thus increasing consumer surplus. However, there are fears that
such practices could encourage cartels to form thus forcing a high prices to be
fixed, decreasing consumers’ welfare.
Indeed, the airline industry seems to be an oligopolistic market. However, the EU is trying to implement reforms, as described above, to ensure an 'open skies' policy and increase competition, thus decreasing costs for passengers.
