Two Bus Operators and a Proposed Merger
A regional town of 180,000 people has three bus operators. Redline carries 60% of passenger trips, Bluebird 30%, and a fringe of small operators 10%. Redline and Bluebird propose a merger, arguing that combining depots, ticketing systems and maintenance would save $2.4 million a year. The regulator estimates that the merged firm would have a 90% share. Pre-merger figures show total annual passenger trips of 6 million, an average fare of $2.20, and marginal cost of $0.80. The regulator's demand estimate implies a price elasticity of demand of -0.8 in the relevant range. Entry requires a municipal licence, a depot site and compliance with minimum service requirements; the last new entrant took four years to begin operating. The companies also compete on frequency, route coverage and peak-hour capacity. Consumer groups say fares would rise; the companies reply that without the merger, cross-subsidy of low-density routes would end.
1. Calculate the pre- and post-merger HHI. What does the change suggest about market concentration, and what caveats apply?
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Pre-merger HHI = 60^2 + 30^2 + 10^2 = 3,600 + 900 + 100 = 4,600. Post-merger HHI = 90^2 + 10^2 = 8,100 + 100 = 8,200. The change is +3,600 points, which is very large. On its own, this suggests the merger turns a concentrated oligopoly into a near-monopoly in the town. Caveats: the shares are passenger trips, not revenue or routes; the relevant market may be wider than the town; the 10% fringe may be more competitive on some routes; and HHI ignores entry barriers and buyer power. The regulator should not decide on HHI alone, but the burden shifts to the merging firms to show that cost savings and service benefits are real and will be passed on.
2. Using the elasticity of -0.8 and the claimed $2.4m saving, assess whether the merger is likely to raise fares. Show the reasoning behind your calculation.
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With 6 million trips at $2.20, revenue is $13.2 million. A 10% fare rise to $2.42, with elasticity -0.8, would reduce quantity by about 8% to 5.52 million trips. Revenue becomes 5.52m x $2.42 = $13.36m, slightly higher. Variable cost at $0.80 per trip falls from $4.8m to $4.416m, a saving of $0.384m; adding the claimed $2.4m fixed saving gives a large profit increase. Because demand is inelastic, the merged firm has an incentive to raise fares: the revenue gain and cost saving outweigh the lost trips. The cost saving could, in principle, fund lower fares, but a near-monopoly has little competitive pressure to pass it through. The consumer loss is not just the extra fare; it includes lost trips and reduced service frequency. Judgement: the merger is likely to raise fares unless the regulator imposes a fare cap, route/service conditions or divestment. The claimed saving is not a sufficient reason to approve it unconditionally.
3. How does contestability affect the regulator's decision? Is potential entry a substitute for actual competition here?
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Contestability depends on entry and exit costs. Here entry needs a licence, a depot and minimum service obligations, and the last entrant took four years. Those are barriers, so the threat of entry is weak. Potential competition is not a close substitute for actual competition when sunk costs are high and the incumbent controls depots and ticketing. Non-price competition on frequency and coverage may benefit passengers, but it can also raise rivals' costs and is not a reliable check on fares. The regulator should consider conditions: require the merged firm to divest some depots or routes, cap fares for a period, preserve low-density routes, and publish service performance. If those conditions are enforceable, the cost savings might be shared; if not, blocking the merger is defensible.