Resources: Lecture 27 Wednesday, Nov. 8, Discussion sections. Midterm Monday Covers: Externalities Costs and Supply Monopoly Oligopoly

Transcription

1 Lecture 27 Wednesday, Nov. 8, 2006 Midterm Monday Covers: Externalities Costs and Supply Monopoly Oligopoly Know HW3 and HW4! Like Midterm 1 except there will be a short essay. (Hint: mentioned this during Lecture 19.) Resources: Discussion sections Midterm Prep Q&A session o Thursday o 4:30-7:00 Blegen 5 (basement near coffee shop) Regular office hours o Thur, 8:30-10:00 Today: Guest Lecturer is Jaroslaw Grygolec Will speak on oligopoly in airline industry in Europe.

2 Why airline industry is interesting? Increasing Competition in Airline Industry - Legacy Carriers vs. Entrants American and European Experiences Jarek Grygolec jg@econ.umn.edu Website: Flying is on the rise Airlines in the US: 620 million passengers Employ directly 1 million workers Pay $18 billion in taxes Essential social, leisure and business link Aircraft maker Boeing is the biggest American exporter Era of Regulation New Era of Deregulation Potential race to the bottom motivated regulation of airline industry Heavily restricted entry by regulators Airfares subject to approval by regulators Approval needed also for new routes Regulatory capture inevitable In 70s unregulated intrastate airfares in CA were 40% cheaper than on regulated Eastern interstate routes Deregulation of US market in 1978 I have more faith in greed than in regulation Alfred Kahn, Chairman of Civil Aeronautics Board, 1980 Free entry subject to safety rules

3 Survival of the Fittest? Using Game Theory More than 60 new interstate carriers by 1983, i.e. New York Air, Republic, Piedmont, Ozark Airlines Most of them went bankrupt, were acquired or merged with the incumbents What happened? What was motivation of entrants to enter? Why did they fail? Fathers of modern game theory: John von Neumann Oskar Morgenstern Everything is a game! Players interdependent decisions Big question: What rational players do? Answer: Equilibrium concept 1994 Nobel to Game Theorists Rules of the Game The small entrant - Puppy Dog moves first decides to Enter or Not Enter a single route The incumbent: operates many routes observes entrant s choice moves second John F. Nash Jr. Nash Equilibrium Reinhard Selten Perfect Equilibrium John C. Harsanyi Bayesian Equilibrium decides to Accommodate or Fight entrant

4 Playing the Game Top Dog and Puppy Dogs Enter Small Entrant Not Enter A Fat Cat incumbent accommodates Then it will face entry by many Puppy Dogs entrants to its other routes Fight Entrant: -$1m Incumbent: $7m Incumbent Accommodate Entrant: $1m Incumbent $9m Entrant: $0 Incumbent: $10m Potential Puppy Dogs Observing From Sidelines The incumbent just turns Top Dog: Fight any Puppy Dog Send a message: Don t mess up with us It is cheap to fight few Puppy Dogs What Happened in Europe? New Entrants in Europe! Again? In the past markets dominated by national carriers, often state owned and heavily subsidized by governments Compare two routes in mid 90s: Washington-New York: 216 miles London-Paris: 211 miles European airfare 30% more expensive European Union deregulated airline industry in Flood of new entrants Didn t they learn on the mistakes of American entrants in the early 80s??? As usual, some did (Ryanair, Easyjet), others did NOT (i.e. Volare)

5 Survival of the Fittest: Episode 2 Flood of new entrants in Europe Ryanair Virgin Express EasyJet Debonair GO Buzz bmibaby Year Easy Jet LEAN and HUNGRY Losing the Game? Change the rules Easy Jet is LEAN!!! No thrills, only web tickets Two types of plane to cut service cost Plane is to fly not to stay in the hangar Enter Lean and Hungry Entrant Not Enter Easy Jet is HUNGRY!!! 2002: Firm order of 120 Airbus A319 aircrafts in 5 years with option for 120 in next 5 years Plane not full? Sell tickets for 10 Euro Fight Entrant: $1m Incumbent: $-5m Incumbent Accommodate Entrant: $10m Incumbent $5m Entrant: $0 Incumbent: $10m

6 Incumbents throw in the towel Successful Entrants in Europe Some incumbents founded low-cost airlines to fight new entrants: KLM, the Dutch national carrier, set up airline Buzz British Airways, started up airline GO KLM and British Airways gave up fighting Symbolic deals: KLM sold Buzz to Ryanair British Airways divested GO, which was eventually acquired by Easy Jet Major entrants: Easy Jet and Ryanair earn profits consistently Key to entrants success: Lean and Hungry Look Why? Very costly to fight entrants with Lean and Hungry look in airline industry. Low-cost airlines in the US Legacy Carriers Must Change Southwest and Jetblue Lean and hungry look Rapid expansion Consistent profitability Low cost business class-only carriers EOS Airlines and MaxJet Airways fly on NYC-London route NetJets, Inc. plans to fly on NYC-LA route "The harsh reality is that our world has permanently changed, and we must change with it." Gerald A. Grinstein CEO of Delta, September 2004.

7 Legacy carriers in trouble Summary Europe: Swissair and Sabena went bankrupt in Europe US: Delta and Northwest restructure under bankruptcy protection Cut costs Refocus operations on still heavily regulated international flights Strategy makes a difference: Lean and Hungry Look proves to be a winning strategy for entrants into airline industry Is Puppy Dog strategy always losing? No, it may be successful in other industries Industry shakeout: Low cost airlines to dominate industry Incumbents will have to change or exit Deregulation benefits consumers at last Stelios Ioannou, the founder of EasyJet, seems to know how to enter any industry