NordAir, FjordJet and SkyLynk: Contestability and Predatory Pricing
NordAir and FjordJet operate the only direct service between two capitals. The route carries 1.2 million passengers a year. Both airlines charge $180 one way; each has a marginal cost of $70 per passenger and fixed costs of $60 million a year. A new entrant, SkyLynk, is considering the route. It would need to spend $40 million on airport slots, marketing and staff training before carrying a single passenger; much of that spending could not be recovered if it exited. SkyLynk's marginal cost would also be $70. NordAir's management proposes cutting the fare to $120 for a year if SkyLynk enters, then raising it again. The competition authority is reviewing whether the route is contestable and whether the incumbent's response should be treated as predatory pricing. NordAir argues that the market is naturally a duopoly because fixed costs are high and average costs fall as passenger numbers rise.
1. Calculate NordAir's annual profit at $180 and at $120, assuming it carries 600,000 passengers in each case.
Read the worked answer
At $180: revenue = 600,000 × $180 = $108m. Variable cost = 600,000 × $70 = $42m. Contribution = $108m - $42m = $66m. Fixed cost = $60m. Profit = $66m - $60m = $6m. At $120: revenue = 600,000 × $120 = $72m. Variable cost remains $42m. Contribution = $72m - $42m = $30m. Profit = $30m - $60m = -$30m. So the fare cut turns a $6m profit into a $30m loss on these assumptions. This calculation matters because it shows the cut is not costless for NordAir. A predator must be able to bear losses until the entrant exits. NordAir's $6m normal profit is thin, so a prolonged price war could be risky for the incumbent too. The calculation also shows that the cut is below average cost: average cost at 600,000 passengers is $60m/600,000 + $70 = $100 + $70 = $170, so $120 is well below average cost but above marginal cost. That distinction is central to predatory pricing analysis.
2. Assess whether the route is contestable, using the evidence on sunk costs and market structure.
Read the worked answer
A contestable market is one where entry and exit are cheap, so incumbents are disciplined by potential entrants even without actual entry. Here the route has only two incumbents, which looks oligopolistic. But contestability depends on barriers, not just concentration. SkyLynk must spend $40m on slots, marketing and training before carrying a passenger, and much of that is sunk: it cannot be recovered on exit. Sunk costs are a barrier to entry because they make entry a risky irreversible investment. The incumbents also have established schedules, loyalty programmes and airport slots. On the other hand, marginal cost is $70 for all three firms, so there is no large cost advantage for incumbents. If SkyLynk enters, it can compete on price. The threat of entry may still constrain NordAir, but the $40m sunk cost weakens that threat. The market is therefore only partially contestable. NordAir's argument that high fixed costs make it a natural duopoly is not fully convincing: high fixed costs can create economies of scale, but they do not by themselves prevent entry if the entrant expects enough passengers to cover them.
3. Evaluate whether NordAir's proposed cut to $120 should be treated as predatory pricing.
Read the worked answer
Predatory pricing normally requires a price below cost with a realistic prospect of recouping losses after rivals exit. NordAir's $120 fare is above marginal cost ($70) but well below average cost ($170 at 600,000 passengers). Pricing below average cost is not automatically predatory, because firms may use marginal-cost pricing in a price war or to fill capacity. The key questions are intent and recoupment. The proposal is explicitly temporary: cut to $120 for a year if SkyLynk enters, then raise the fare again. That pattern is consistent with a predatory strategy. But NordAir must be able to survive the loss. At 600,000 passengers it loses $30m a year at $120; if it loses market share to SkyLynk, the loss is larger. Recoupment is also uncertain because SkyLynk's $40m is sunk but not necessarily lost if it stays; and regulators may intervene. A competition authority should look for internal documents, whether the fare is targeted at the entry route, whether output expands, and whether NordAir has a credible route to recoupment. A legitimate competitive response would be a general fare reduction or improved service, not a selective temporary cut designed to signal exit.