Duopoly Airlines on a Domestic Route

Represent payoffs as (SkyHigh, AeroOne). If both keep $180, each earns $300m. If SkyHigh cuts and AeroOne does not, SkyHigh earns $420m and AeroOne $120m; the reverse is symmetric. If both cut, each earns $180m. Cutting is a dominant strategy for each: if the rival keeps $180, cutting yields $420m > $300m; if the rival cuts, cutting yields $180m > $120m. The Nash equilibrium is therefore both cut, even though both would be better off at $300m each. This is a prisoner's dilemma. The $180 fare is unstable because each airline has a unilateral incentive to cheat, and price cuts are easy to observe and match. In a repeated game, tit-for-tat or tacit collusion might sustain high fares, but that is fragile and may violate competition law. The high fixed costs and frequent-flyer schemes raise the cost of a price war, which can lengthen the punishment phase, but they do not remove the incentive to defect. Hence without collusion, the high-fare outcome is unlikely to persist.

The merger would save $150m a year, but a single airline on the route would face little competitive pressure. The regulator must compare the cost saving with the loss of consumer surplus from higher fares. Before the merger, the Nash equilibrium is already $140, each earning $180m. A monopolist could raise the fare toward the monopoly level; if the fare rises from $140 to $180, passengers pay $40 more, and with 2m passengers the transfer is $80m a year before any quantity reduction. That is less than the $150m saving, so a simple static calculation could show a net gain. But a monopolist may raise the fare further, reduce frequency, and cut quality, and the deadweight loss from fewer passengers must be added. The cost saving is also not guaranteed to be passed through. My judgement: the merger could improve welfare only with a price cap or slot divestiture that preserves entry, otherwise market power is likely to dominate.

Contestability requires hit-and-run entry with no sunk costs. Here entry is costly: airport slots are scarce, aircraft leases are long-term, and frequent-flyer programmes create switching costs. A new entrant cannot quickly replicate the 12-month booking system or the business-traveller network. Therefore the route is not contestable, even if there are only two incumbents. The threat of entry is weak, so the duopolists' pricing is not constrained by potential competition. This strengthens the case for regulation or for merger remedies such as slot divestiture, which would lower entry barriers. It also explains why the $180 fare could persist if tacit collusion were sustained. Contestability analysis therefore shifts the judgement away from relying on market forces and towards active competition policy.