Friday, October 24, 2014

Is The Airline Industry An Oligopoly?

See US Airlines Hike Base Fares Despite Falling Fuel Prices; Consumers Unhappy. Excerpt:
"Such fare hikes indicate that airlines don’t plan to pass on the savings on jet fuel from recent oil price drops, Rick Seaney, CEO of travel search site, wrote. Fuel is the largest expense most airlines face, and oil prices have decreased by as much as 25 percent since early summer."
 As I show below, lower costs for firms but not a lower price for the buyers is a possibility in oligopoly. See also Airlines Profits Soaring.

We recently covered market structure in my microeconomics class. Usually four market structures are covered: perfect competition, monopoly, oligopoly, and monopolistic competition. Oligopoly is an industry with a relatively small number of firms which is not easy to break into. The auto industry is often given as an example.

One theory of oligopoly is that each firm (an oligopolist) might face a "kinked demand" curve. All firms choose Q so that MR = MC. Once Q is found that allows us to get the price. But if MC falls (due to things like lower fuel costs) and we stay in the gap in MR, Q does not change and neither does price.

I show later that even a monopoly will lower their price when costs fall.

It is possible that the airline industry is competitive (it is unconcentrated according to Justice Department merger guidelines as I show below). In that case, we might just be seeing an increase in demand outweigh the increase in supply caused by the lower fuel costs, as in the next graph

The Justice Department takes the market share of all firms in an industry, squares them and then adds them up. Here is the airline industry

Firm %Share Squared
American 21 441
Delta 16.6 275.56
Southwest 16.3 265.69
United 15.4 237.16
JetBlue 5.1 26.01
Alaska 4.2 17.64
ExpressJet 2.5 6.25
SkyWest 2.3 5.29
Spirit 2 4
SUM 85.4 1278.6

The 1278.6 is the Herfindahl-Hirschman Index (“HHI”) of market concentration. Now there is still 14.6% of the market going to other firms but they will all be very small. Since HHI is less than 1500, the Justice Department considers the airline industry an "Unconcentrated Market." See Horizontal Merger Guidelines. Mergers are not usually a concern. So maybe it is not an oligopoly. I am not sure.

Here is that monopoly graph mentioned earlier. Price falls with lower costs.


Anonymous said...

i wanted to see if i could get some clarity about your MC curve. when price falls quantity usually increases, which is understood. on you MC curves, you dropped MC2 by an arbritrary amount. how did you know where exactly to put MC following the price drop?

Cyril Morong said...

I am not sure which graph you are referring to. But in either oligopoly or monopoly, the firm has some power over price.

The firm picks Q where MC = MR. If MC falls, by whatever amount, then, for example, in the monopoly graph (the last one), Q will increase and this will cause P to fall.

Yes, I did move MC by an arbitrary amount. That is okay as long as whatever I do afterwards is consistent with that change

Anonymous said...

thanks for the explanation. sorry I was referring to your kinked demand curve and/or oligopoly graph when I posed the question. Thanks for clearing up that it was arbitrary. since the firm has some power over prices when it is oligopoly or monopoly....why would they ever reduce the price? just to sell more units?

Cyril Morong said...

In the oligopoly graph, if MC fell far enough, it would intersect MR at a higher Q and so they would lower price. Once you know Q, you go up to demand, then go left to find P.

Firms are not trying to maximize sales but profits. If MC falls, then it makes sense to increase Q. In fact, in the monopoly graph, if they did not lower P, their Q would be too low and MR would not = MC, which is the condition for maximizing profit.