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The Airlines Fare War and The Prisoners Dilemma

SYNOPSIS In April 1982, American Airlines, the nations largest carrier with 20% share of the domestic market, introduced a new, simplified fare structure and lowered its prices for most business and leisure travelers. Other domestic airlines quickly announced similar fare cuts. American and other carriers hoped that the increase in air travel resulting from the fare cuts would more than offset the price reductions and eventually turns the domestic airlines industry losses into profit. However, rather than establishing a price discipline, a further competitive and disastrous price cut is continued. It started with TWA which operated under creditors and badly needed a revenue and began to undercut the fares by 10-20%. And this price cut is followed by matching by other players, and then led to cutting all the fares by 50%. And even these price cuts happened resulted in increased of summer travel, all airlines has incurred losses. And because of having become used to deep discount, the consumers were unwilling to pay for higher pries anymore. And here, the prisoners dillemma happened. In addition, economic recession and and terrorist attack on WTC in September has resulted in further derease of air travel.

PROBLEM IDENTIFICATION American Airlines new fare structure started a process of competitive fare cuts that led to disastrous price war from the summer of 1992 to 2005 and causing losses to all airlines (and even causing bankruptcy to some airlines) The US airlines seemed to be in prisonners dilemma and faced heavy losses because theyre unable to cooperate The attempts to increase air fares failed because: One or more of the carriers did not go along Passengers were unwilling to pay higher fares Economic recession and terrorist attack in 2001 Pressure from low-cost carriers and discount carriers The doubling of jet fuel prices in 2005

ANALYSIS The market structure of US airlines industry is Oligopoly Price Leadership. American Airlines as the nations largest carrier is the price leader that initiate a price change and then the other airlines quickly follow. The price competition of these ologopolistic firms in the presence of the prisonners dilemma can be examined with the payoff matrix for a pricing game as follow (using American Airlines and TWA as example): TWA Low Fare American Airlines (AA) Low Fare High Fare (2,2) (1,5) High Fare (5,1) (3,3)

The payoff matrix shows that the dominant strategy for both frms is charging the low fare. If TWA charged a low fare (e.g. $100), AA would earn a profit of 2 if it also charged the low fare ($100) and 1 if it charged a high fare (e.g. $150). Similarly, if TWA charged a high fare ($150), AA would earn a profit of 5 if it charged a low fare (e.g. $100) and 3 if it charged a high fare (e.g. $150). Thus, AA should use its dominant strategy of charging the low fare. This applies vice versa and also applies to other airlines. Airlines could earn the higher profit of 3 if they cooperated and both charged the high fare. Theyre in the prisonners dilemma: each airlines will charge the low fare and will earn smaller profit because if it charges the high fare, it cannot trust its rival to also charge the high fare. Therefore, each airlines would take its dominant strategy that would be the least harm for themselves: by charging the low fare. However, since all airlines charged the low fare, the airline industry faced heavy losses. To overcome the industrys heavy losses, all airlines should cooperate to charged the high fare. As exemplified in the payoff matrix, if both AA and TWA charged a low fare, each of them could earn a profit of only 2. But if they both they cooperated to charged the high fare, each of them could earn higher profit of 3. Also, by cooperate to charging high fare, airlines can overcome the increse of jet fuel price and the economic recession. High fare can also drive airlines to increase its service quality so the customers (passengers) are not reluctant to pay for the high fare. Furthermore, the high fare-good service quality can also helps the firms to overcome the pressure from low-cost carriers and discount carriers because customers are able to distinguish between the high fare-good service quality and the low fare-average service quality.

CONCLUSION Oligopolistic firms often face a problem called prisoners dilemma, which refer to the situation in which each firm adopts its dominant strategy. Somehow each of they could do better with cooperating with each other. The market structure of US airlines industry is consider Oligopoly Price Leadership. The problem they are facing is pricing since all airlines charged the low fare, thefore many airline industry faced heavy losses. It is better for all airlines should cooperate with each other tocharged higher fare. Also, by cooperate to charging high fare, airlines can overcome the increse of jet fuel price and the economic recession. High fare can be applied to airlines that provide services and also drive airlines to increase its service quality so the customers (passengers) are not reluctant to pay for the high fare.

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