Fare War on a Single Route
Two airlines, A and B, are the only carriers on a 200,000-passenger route. Both charge N$4,200 one way and each carries 100,000 passengers a year. Leases and airport slots cost each airline N$200m a year and do not vary with passengers; marginal cost per passenger is N$600. A consultant models a fare cut to N$3,400: if one airline cuts and the other holds its fare, the cutter carries 140,000 passengers and the other 60,000. If both cut, each carries 100,000 at the lower fare. Annual operating profits in N$m are therefore: both hold, 160 each; A cuts alone, 192 for A and 16 for B; both cut, 80 each, with the position symmetric if B cuts alone. The board of airline A meets to decide whether to cut. The regulator cannot block fares but reviews mergers. Consumer groups say fares are too high; the airlines argue that route costs are high and that a fare war would force one carrier out.
1. Using the payoff information, explain the likely outcome of the board's decision and why it has the structure of a prisoner's dilemma.
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Start with airline A's best response. If B holds its fare at N$4,200, A earns 160 by holding and 192 by cutting, so A cuts. If B cuts to N$3,400, A earns 16 by holding and 80 by cutting, so A also cuts. Cutting is therefore A's dominant strategy. B's payoffs are symmetric, so B also cuts. The unique Nash equilibrium is (cut, cut), with 80 each.
Yet both would be better off at (hold, hold), earning 160 each. The equilibrium is Pareto inferior to cooperation, which is the definition of a prisoner's dilemma: each firm's individually rational choice produces a collectively worse result.
The arithmetic shows why the incentive to cheat is strong. A unilateral cut raises A's profit from 160 to 192, a gain of 32, while imposing a loss of 144 on B. Once one firm cuts, the other must match or lose most of its passengers: holding against a cut leaves only 16. The likely outcome is therefore a fare war, even though both boards might publicly prefer stable fares. The outcome is not caused by irrationality but by the structure of the payoffs: the private gain from cutting exceeds the private loss from the rival's response, and no binding agreement exists.
2. Explain how the kinked demand curve model is consistent with the fare being stable for a period before the war.
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The kinked demand curve assumes asymmetric rival responses: a price rise is not matched, so the firm loses many passengers and faces a relatively elastic demand above the current price; a price cut is matched, so the firm gains few passengers and faces relatively inelastic demand below the current price. At N$4,200 the demand curve therefore has a kink, and marginal revenue has a vertical discontinuity at that output.
This explains rigidity. A small change in marginal cost, for example a modest fall in fuel prices, shifts the marginal cost curve within the vertical section of marginal revenue, so profit-maximising price and output do not change. The fare stays at N$4,200 even though costs have moved.
The payoff matrix supplies a game-theoretic foundation for the asymmetry. If B holds, A gains by cutting, so a cut may occur when the incentive becomes large enough. But once A has cut, B's best response is to match, which is exactly the assumption that demand below the kink is less elastic. The kink model is therefore better at explaining why small shocks do not move the fare than at explaining the outbreak of a war; the matrix explains the outbreak, and the kink explains the periods of stability between wars. A large shock, such as a big fall in marginal cost or the arrival of a new entrant, can push marginal cost outside the discontinuity and trigger a price change.
3. Evaluate whether the airlines could sustain collusion and whether the regulator should intervene.
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Collusion would mean both holding the N$4,200 fare and sharing the 320 total profit. It is unstable for several reasons. Each firm has a clear incentive to defect: cutting raises the defector's profit to 192 while the loyal firm drops to 16. A cartel needs monitoring, enforcement and a credible punishment; here the punishment is immediate matching, which restores 80 each, still below the 160 available from cooperation. In a repeated game, tit-for-tat or trigger strategies can sustain cooperation if the firms discount the future lightly and demand is stable. But demand on a single route is cyclical and transparent, and route-level cheating is easy to detect and copy, which may help collusion; multimarket contact across routes can also support tacit coordination.
Legally, price-fixing is prohibited in most jurisdictions, so any agreement would be unenforceable and expose the firms to fines. Without a legal agreement, price leadership or focal pricing may emerge, but it is fragile.
Should the regulator intervene? A fare war benefits consumers in the short run, with fares 19% lower, but if one carrier exits, the survivor may raise fares above the pre-war level. Merger review should block a merger that creates monopoly power on the route. Other options include slot rules that keep the route contestable, transparency requirements, and subsidies for essential routes rather than tariff-style price regulation, which weakens cost control.
Judgement: collusion is unlikely to be sustainable without enforcement, and regulation should focus on contestability and on preventing a monopoly outcome after the war rather than on setting fares directly.