6 Hybrid Market Structure and the

Aviation Industry

DOI: 10.4324/9781003388135-6

While the previous chapter introduced the two extremes of the market structure
continuum (Table 6.1), this chapter analyzes the two middle hybrid market
structures: monopolistic competition and oligopoly. In contrast to perfect
competition, which rarely exists in actuality, both oligopoly and monopolistic
competition are prevalent in modern industry, with the airline industry heavily
influenced by the characteristics of oligopolies. Air transportation serves as a
highly concentrated industry where a small handful of firms—airlines, aircraft
manufacturers, airports, and engine manufacturers—dominate the whole industry.
Moreover, with the recent mergers of US Airways–American Airlines,
Southwest–AirTran, and Alaska Airlines–Virgin America, the number of players
in the United States industry is decreasing even further. Analogous trends toward
airline industry concentration are evident in other liberalized markets, such as the
North Atlantic and the European Union. Even more tightly concentrated is the
aircraft manufacturing industry, which is dominated by two mega manufacturers,
Boeing and Airbus. Similarly, among the leading four engine manufactures are
CFM International, International Aero Engines (IAE),1 General Electric, and
Rolls-Royse. The combined grip of these firms hold more than 90% of the market
share. This chapter explores both monopolistic competition and oligopoly, as well
as demonstrates how each hybrid market structure impacts a company’s
productivity and profitability. The chapter is outlined as follows:

Monopolistic Competition
Price–Output Decision
Oligopolies
Characteristic and Condition
Differing Views of Oligopoly
Examples of Oligopoly
 Contestability Theory
Kinked Demand Curve Theory
Cournot Theory
Profitability Issues
Competition and Antitrust Issues
Industry Consolidation
Beyond Market Concentration Considerations
Summary
Discussion Questions

Monopolistic Competition
Monopolistic competition stands out perhaps as the most common market
structure of the four types in the market continuum in Table 6.1. This
configuration represents yet another form of market structure in which the firms
produce similar, but not identical products. Therefore, each firm produces a small
fraction of industry output. In other words, there exists limited market
consolidation. Like perfect competition, it is relatively easy to enter the market,
albeit not without associated entry costs. The key difference is that the ease of
obtaining capital is considerably less in a monopolistically competitive market
compared to an oligopoly market. Other barriers to entry may include customer
loyalty or regulatory restrictions. A monopolistically competitive industry has the
following characteristics:

Table 6.1 Market Continuum

Monopolistic
Perfect Competition Oligop
Competition
Number Large Many Few
of sellers
Type of Homogenous Unique Homogenous
product differentiated
Control None Very little Strong
over
price
 Monopolistic
Perfect Competition Oligop
Competition
Entry Very easy Easy Difficult
condition
Example Agriculture Retail Airlines

Monopolistic competition serves as a market situation in which many

independent sellers produce differentiated products. In this market, each seller
provides goods or services with some degree of product differentiation and
some monopoly power.

A large number of sellers

Full dissemination of information
Low barriers to entry
Product differentiation

The key difference between perfect competition and monopolistic competition is

that in perfect competition, companies mainly sell homogeneous products, while
monopolistically competitive firms sell heterogenous products, facing numerous
proximate substitutes. Firms in a monopolistic competitive environment sell
products that are the same but not identical, and they have some power to set their
own prices. The strategic use of product differentiation aims to encourage
consumers to choose one brand more than another in a competitive market.
Products are differentiated when customers perceive a sense of uniqueness, which
leads them to pay more, despite the existence of close substitutes. That explains
why customers pay about $30 for a bottle of Berg drinking water, while a bottle
of Evian costs only $2 bottle.2
From a firm’s point of view, this is a more desirable situation, since the more a
product can be differentiated, the more control a firm has over its price. Since all
the firms have the same profit incentive, there is still a good deal of price
competition in monopolistically competitive markets. Companies in a
monopolistic competition make economic profits in the short run, but in the long
run, a result of the freedom of entry and exit in the industry, they make zero
economic profit.
 Given the plethora of companies involved, each player keeps a small market
share and is unable to influence the price. Monopolistic competition is extremely
common in today’s business environment. Examples include:

Accounting firms
Books
Convenience stores
Hairdressers
Grocery stores
Garment producers
Hotels
Jewelry shops
Law firms
Private music lessons
Radio stations
Restaurants

Hotels and restaurants stand as prime examples of monopolistic competition since

they provide somewhat unique services, are fairly common in most markets, and
exist in a market with relative ease of entry.

Price–Output Decision
 In perfectly competitive markets, the demand curve for a firm’s product is
essentially horizontal, as the firm is a price taker and has virtually no power to set
prices. In this situation, demand is perfectly elastic. With the gradual escalation of
product differentiation, the elasticity of demand decreases, which shifts the firm
away from a perfectly competitive market and toward a more monopolistically
competitive or oligopolistic market. As mentioned above, this increase in product
differentiation creates the potential for a firm to have more control over the price
that it charges. This situation is depicted in Figure 6.1.

Figure 6.1 Short-Run Equilibrium: Monopolistic Competitive Market.

The demand curve for a firm shifts from a horizontal line to a downward
sloping line. As the firm progresses through the market structure continuum, the
slope of the demand curve will become steeper until it eventually reaches a point
where it encompasses the entire market, making a firm’s transformation into a
monopoly. In a manner analogous to a monopoly, in a monopolistically
competitive environment, firms produce the quantity (Q) where marginal cost
(MC) equals marginal revenue (MR). MR measures the change in the revenue
when one additional unit of a product is sold, while the MC refers to the
additional cost to produce each additional unit. In monopolistic market, firms
charge the highest price (P) that sells that quantity:
 MR − MC
P > MR

The price the firm charges would be on the demand curve. As elucidated by the
figure, the more elastic the demand curve facing the firm, the less control the
individual firm has over its price. Figure 6.2 illustrates the typical demand curves
across the various market structures. Oligopoly is an especially complex case in
which the nature of demand can vary significantly given the dynamics of each
industry. For instance, airlines often appear to have no more control over price
than the typical monopolistic competitor does.
 Figure 6.2 Progression of Demand Curve: Perfect Competition to
Monopoly.

Example
Jet services operated in a monopolistic competitive industry with the following
demand and cost functions:

P = 100 − 0.25 × Q
AC = MC = 20

Find:

a. Optimal output
b. Market price
c. Economic profit or loss
d. Optimal markup

Solution:

a. To find the optimal output, a monopolistic competitive firm sets MC = MR

TR = P × Q
TR = 100Q − 0.25Q2
MR = 100 − 0.50Q
MR = MC
100 − 0.50Q = 20
Q = 160 units
b. To find market price, substitute the value of output.
P = 100 − 0.25 × Q
P = 100 − 0.25 × Q
P = 100 − 0.25 × 160
P = $60
c. To find economic profit,
Profit = total revenue – total cost
TR = P × Q = $60 × 160 = $9,600
d. To find optimal markup,
 We substitute P = $60 and Q = 160 in the point elasticity formula:

Since it is relatively easy to enter a monopolistically competitive market, it can be

expected that any above-normal profits that might be earned in the short run
would ultimately erode in the longer term through the entry of new firms into the
industry. Figure 6.3 exhibits the longer-term equilibrium in a monopolistic
competitive industry where a typical firm earns zero economic profit.

Figure 6.3 Long-Run Equilibrium: Monopolistic Competitive Market.

Oligopolies

An oligopoly is a market structure in which two or more firms dominate the

market. In this market environment, oligopolists can effectively influence the
 price. The markets for aircraft, airports, airlines, jet engine manufactures, etc.
are examples of oligopolistic markets.

The next step along the market continuum from monopolistic competition is
oligopoly, which is characterized by the market dominance of a few firms.
Oligopoly is the most relevant market structure with regard to aviation and is thus
the focus of this chapter. Despite the large number of airlines that operate
globally, individual routes are typically served by one or two dominant carriers
and a handful of lesser competitors. Renowned airlines like Singapore Airlines,
Cathay Pacific, British Airways, Air France, and United Airlines operate their
routes with only a few close competitors, but they are also influenced by
competition from smaller low-cost airlines. Similarly, the aircraft manufacturing
industry is dominated by a handful of manufacturers (Boeing, Airbus, Embraer,
Bombardier, and Sukhoi Superjet3). In July 2018, Airbus acquired a 50.01% stake
in the CSeries (rebranded as the A220) and acquired an additional 25% in 2020
with an option to acquire the remaining interest by 2024. In addition, the CRJ
program was sold to Mitsubishi Heavy Industries (MHI) in 2020.

Characteristic and Condition

In general terms, oligopolies are characterized by the following:

A few firms dominating the market

Heterogenous or differentiated products
Restricted or asymmetric information
Substantial barriers to entry or exit
 Unlike perfect competition or monopolistic competition, the actions of one
firm in an oligopoly substantially affect the market and often the actions of
competitors. This creates a complex interdependence among the firms; that is,
each firm’s decisions will be conditioned on how they believe the competition
will react. For example, an airline might be more likely to reduce fares if it
thought competitors would maintain their pricing, but it would prefer fares to
remain constant if it believed competitors would instantly match price cuts. Thus,
each airline’s pricing strategy is rooted, to some extent, on what it believes its
competitors’ actions and reactions will be. Clearly, this is a complex problem and
one that often presents no clear, optimal strategy.
Therefore, almost any short-run outcome is theoretically possible in oligopoly.
In one conceivable scenario, a firm might adopt “tacit collusion” where it keeps
prices relatively high. Put another way, it “goes along to get along” by avoiding
any aggressive competitive act that would lead to a price war. On the other hand,
oligopoly can, as frequently witnesses in the airline industry, produce aggressive
“cut-throat” competition where the average firm is routinely operating in the red.
While monopolistic competition inherently leads to normal long-run profits, it
is theoretically possible for long-run profits to be above normal in oligopoly if
there is a sufficiently high barrier to entry. Numerous oligopolies, including such
former paragons as General Motors, struggle just to earn normal long-run profits.
In fact, majority of well-established airlines have consistently reported below-
normal long-run profits. The barriers to entry in oligopoly markets keep the
number of competitors relatively small and prevent new firms from coming into
the market. These barriers include high startup fixed costs, the existence of
sizeable economies of scale, control over scarce resources, and exclusive
patent/legal rights.
Oligopoly is often viewed as inherently undesirable, better than monopoly but
not nearly as desirable as perfect competition. While most economists would
probably agree that there is a certain amount of truth to this perspective, there are
some complications. In several instances, a few large firms can often enjoy
economies of scale and produce at far lower costs and sell at far lower prices than
could an industry composed of smaller, more numerous firms. It is far cheaper for
Boeing or Airbus to develop and produce 1,000 aircraft than it would be for 100
small manufacturers to develop and produce ten comparable aircraft each. Boeing
or Airbus can spread research and development costs over more units and
ultimately price them lower. They can then benefit from the experience gained,
becoming increasingly efficient with each additional aircraft produced. There is
no doubt that airlines and air travelers are better served by having two
manufacturers of large aircraft rather than having 200. The presence of economies
of scale, scope, and density is also important in the airline industry, and therefore,
it might be better to have an airline oligopoly than any feasible alternative.
However, this does not necessarily mean that a movement to fewer, larger
firms is automatically more efficient and better for consumers. Such industry
consolidation might be beneficial for efficiency, but it might also artificially
suppress competition. So, how can we decide, say, if two competing airlines
should be allowed to merge? Let us sketch two different views.

Differing Views of Oligopoly

One common perspective presumes that any substantial increase in market
concentration is generally undesirable, and therefore, oligopolistic competitors
should generally not be allowed to merge. Within the airline industry, the
assumption is that airfares will increase as competition on routes is eliminated
through industry consolidation. We will come back to this theory later in the
chapter. A key exception is the situation where denying a merger cannot prevent
increased market concentration because the weaker firm will simply liquidate if
the merger is not approved. This was the rationale when Boeing acquired
McDonnell Douglas in 1996. Rooted in this staunch anti-merger view is the
perception that efficiency gains from economies of scale are likely to be less
significant than the increased danger of oligopoly abuse through increased pricing
power and artificially high profits.
An important foundation for this view is the high barriers to entry. The
staunchest proponents of this view would even contend that elements such as
advertising and brand name recognition are potentially enough in themselves to
seriously impede new entry and, thereby, allow oligopolies to enjoy high profits
even in the long run (see Galbraith, 1979). An alternative view called the market
process view is that very few, if any, barriers to entry (other than legal barriers
established by government) are significant. According to this theory, it is best to
let the market evolve in whatever way firms choose. This approach is likely to
yield efficiency gains, and it will likely be impossible for government regulators
to estimate and predict, so it is best for them to merely stand aside and let the
market process work. High profits, as in the perfect competition model, will
always be short lived. New firms will enter and existing firms will increase
capacity, thus driving down prices and profits. Government can improve
efficiency only by getting its own house in order—eliminating international trade
barriers and other government policies that seriously limit competition and harm
the economy.

Capital Intensive
A capital-intensive industry is one whose greatest costs result from investments in
infrastructure (land, buildings), intellectual properties, equipment, machinery, or
other expensive capital assets. Many airlines choose to own aircraft or large
computer systems, while other airlines choose to obtain the use of such assets
through operating leases. Instances of capital-intensive industries include aircraft
manufactures, airlines, major hub airports, jet engine manufactures, and
automobiles. One advantage (for shareholders, but possibly not for consumers),
inherent in capital-intensive industry, is less competition in light of the large
capital necessity and on the negative side they have a high risk due to the large
investment.
Let us compare and contrast these differing views by considering the
difficulties posed by the capital-intensive and very complex technology
requirements for a new entrant. To illustrate this, consider the field of aircraft
manufacturing. Any entrepreneur intending to start a company that would
compete with Boeing and Airbus would face quite a challenge. Most likely, the
firm would need billions of dollars’ worth of specialized capital equipment to
begin production. Such funding would not be easy. According to the traditional
view, this constitutes a serious barrier to entry.
The reality is that only a limited number of firms or countries have the
resources to design and manufacture commercial aircraft, and this is the primary
reason for the industry to become something of a global enterprise. Aircraft
production stands as one of the most technologically complex and highly capital-
intensive endeavors. For example, Boeing’s 787 Dreamliner required
development costs between $8 and $10 billion, and the company utilized partners
from multiple countries, namely Japan (Kotha et al., 2005). The latest edition of
the twin-engine, long-range, wide-body jetliners from Boeing Commercial
Airplanes is the 777-X. They are known as the 777-9 and a larger version of the
777 wide-body jet. The 777-9 first flew on January 25, 2020; however, its
development has also been interrupted with prolonged delays. The latest
production delay has pushed its entry into service to 2025. Consequently, delivery
of the first jet is scheduled for 2025, five years later than Boeing had planned
when the jet was launched in 2013. In 2020, Boeing took a massive $6.5 billion
charge for the previous delay on the 777X, with entry into service then pushed
out to 2025.4 Similarly, Beijing Daxing International Airport was completed on
June 30, 2019, after almost five years of construction, with a massive cost of
almost $11.4 billion.
However, the market process proponents would point out that modern capital
markets have many trillions of dollars’ worth of assets; billions can be readily
mobilized by presenting persuasive business plan to investors. The example set
by numerous Internet start-ups of the 1990s demonstrated just how easy it can be
to quickly raise billions of dollars if investors are excited about your prospects.
Presently, it seems that two producers, Airbus and Boeing, are enough. However,
in the event that the industry grows sufficiently or Airbus and Boeing somehow
otherwise manage to enjoy high prices and profits, then Lockheed Martin or some
other firm will enter their market. In fact, on July 13, 2008, Bombardier
Aerospace announced the launch of the CSeries, a family of narrow-body, twin-
engine, medium-range jet airliners. The inaugural flight of the CS 100 transpired
in 2013 and entered into service in July 2016. Later that year, Air Baltic took
delivery of the larger version in the CSeries family, the CS300. The carrier
announced that operational performance exceeded expectations, and it anticipates
to put the CS300 on 10 more routes by June 2017.5 The advent of CSeries was
expected to bring more competition for Boeing and Airbus in the narrow-body
market. The CSeries is a clean-sheet design purpose-built for the 100–150 seat
market.
On October 16, 2017, Airbus and Bombardier announced that Airbus would
acquire a 50.01% majority stake in the CSeries partnership. The Bombardier C
Series was a great aircraft, but it encountered challenges in terms of sales. Sales
increased significantly once Airbus took over the program.6 Leveraging
composite materials in A220 with a range of up to 3,450 nm, the A220 offers an
exceptional ability to fly both short and longer ranges with one single aircraft
type. The use of composites materials in the A220 contributes to reducing the fuel
burn and overall maintenance costs. On February 14, 2020, Bombardier unloaded
its remaining stake in the A220 program to Airbus, by getting out of the
commercial aviation business to pay its massive debt.

High Exit Barriers

Another potentially serious entry barrier is high exit barriers. Therefore, investors
must consider worst-case scenarios: what happens to their investment in a
company that performs so poorly that it must be liquidated? Should our
hypothetical aircraft manufacturer be forced into liquidation, it will face the
problem of very limited resale market. Much of its equipment might have only
two possible buyers (Airbus and Boeing). If neither is interested, the equipment
will likely be sold as scrap metal. Thus, any major investment in illiquid assets
faces unusually high risk. Theoretically, this risk might inhibit new entry and
thereby allow Boeing and Airbus to enjoy higher than normal returns.
However, market process proponents argue based on the standard principle of
finance: riskier investments must offer higher expected profits. In other words, if
Boeing ever does earn unusually high long-run profits, it could be reasonably
argued that such profits reflect merely the greater risk. In essence, the risk-
adjusted rate of return would still be a normal rate of return. After all, their
investors also face the risk of illiquid resale markets should Boeing ever fail. In a
broader perspective, since economies of scale are so important in this industry
and since the physical capital may be so specialized, it makes sense in terms of
social welfare to be cautious before capital is plunged into aircraft production. In
other words, because it is so hard to exit that industry, it is perfectly appropriate,
in this view, to hesitate before plunging in. In terms of society’s welfare, returns
should be quite high before a new entry occurs.

Examples of Oligopoly
Oligopolies are very common in modern economies. For instance, when you rent
a car in the United States, you find that almost all of the cars are provided by a
relatively small number of rental companies: Alamo, Avis, Budget, and a few
other smaller firms. This significant level of concentration means relatively high
barriers to entry. Common examples of oligopolistic industries are:

Aircraft manufacturers
Airline industry
Airports
Automobiles industry
Breakfast cereal
 Cable television companies
Cigarettes
Fixed-base operator (FBO)7
Jet engine manufacturers
Long-distance telephone service
Soft drinks
Supermarket chains

Oligopolistic markets are of particular interest, since most major aviation-related

industries are oligopolies. The following sections will take a closer examination
into three major forms of oligopolies that make up the greater part of the aviation
industry: airlines, aircraft manufacturers, and jet engine manufacturers.

Airlines
The airline industry undoubtedly operates in an oligopolistic market structure, as
it only has a few firms participating in a typical city-pair or route. The US airline
industry is dominated by four mega carriers: Delta Air Lines, American Airlines,
United Airlines, and Southwest Airlines. Collectively, these four airlines
command about 70% market share.
While oligopoly market theory suggests that firms should compete by
enhancing services, price cuts can be readily matched. As such, the US domestic
airline industry has totally reversed this trend, as airlines have reduced costs and
service amenities. This phenomenon is partially attributed to the fact that many
non-price competitive aspects can be easily copied by competing airlines, such as
frequent flier programs. Nonetheless, price remains a key driver of consumer
behavior.
Airlines might prefer less price competition, but customer preferences demand
the opposite. However, even an airline like Southwest Airlines, which has
traditionally had a price leadership strategy, is also known for its friendly service
and frequent flight schedule. Southwest’s awareness of service quality is one of
the reasons it has been successful. Similarly airlines, such as Emirates and
Singapore, that pride themselves on their service quality have also been very
successful by adopting this strategy.

Commercial Aircraft Manufacturing

A duopoly is a market structure in which two producers are competing for the
same product.
 Boeing and Airbus are the only two producers of commercial jet with about
99% of global large plane demand. Commercial Aircraft Corporation of China
(COMAC) is planning to make waves in the aviation manufacturing industry,
but not in the near future.

The commercial aircraft manufacturing industry is largely a duopoly (an

oligopoly with two firms). Airbus and Boeing compete in the 100-seat plus
aircraft category, and Bombardier and Embraer compete in the regional aircraft
market. This market is typically divided into two product categories: narrow-body
and wide-body aircraft. Narrow-body aircraft are single aisle, short-range aircraft
that typically carry between 100 and 200 passengers. Wide-body aircraft are
double aisle, medium- to long-range aircraft that can carry between 200 and 450
passengers. A phase of consolidation transpired in aircraft manufacturing with the
acquisition of McDonnell Douglas by Boeing and the exit of Lockheed from
commercial aircraft manufacturing. Given the commercial aircraft manufacturing
is extremely capital intensive, it is unlikely that another manufacturer will enter
the market.

Figure 6.4 Market Share of the Top American Airlines, 1977–2022.

Source: Bureau of Transportation Statistics
 China plans to end the duopoly of Boeing and Airbus. China ranks second in
the world, after the United States, for air passenger traffic and has the fastest-
growing air passenger market. In 2007, however, China announced its intention to
start making large commercial aircraft by 2020. The nation is expected to
purchase 2,230 new aircraft before 2025. Indeed, the demand exists, but the
technology proved to be a major barrier (AP, 2007). In an attempt to overcome
this barrier, China reached an agreement with Airbus to open an A320 final
assembly line (AP, 2007). The goal of this venture was to gain technical
knowledge that would translate into success for China’s own large aircraft
program. The proof of this technological skill transfer was the launch and first
flight of passenger jet, ARJ 21, in June 2016. This 90-seat jet was built entirely by
the Commercial Aircraft Corporation of China (COMAC). A further development
in the Chinese aircraft manufacturing sector came after the announcement of the
larger COMAC C919, a narrow-body aircraft capable of carrying up to 268
passengers. This model is touted as competition to both the A320 and the B737.
By January 2023, COMAC claimed it had more than 1,200 orders, mostly from
Chinese carriers but also from GE Capital Aviation Services.
In both aircraft manufacturing duopolies, the manufacturers offer similar
products (i.e., 737 vs. A320 and CRJ vs. ERJ) at comparable price points. The
only major difference has been Airbus’s insistence on a super-jumbo aircraft
(A380), while Boeing has concentrated efforts on its 787 Dreamliner. The B-787
aircraft is fuel-efficient, has a cruising speed of Mach 0.85, carries roughly 280
passengers, and has a range of up to 8,500 nautical miles. Moreover, it has
smaller stature than the A380 and can access regional airports more easily. Given
the near-identical pricing strategies adopted by both manufacturers, the
competition lies in additional services such as financing agreements or buyback
of older aircraft. The competition between aircraft manufacturers is also
characterized by a nearly even market share for recent aircraft deliveries, as
shown in Table 6.2.

Table 6.2 Aircraft Manufacturers’ Market Share (Deliveries)

Large Aircraft Manufacturers Regional Aircraft Manufactur
Year 2018 2019 2020 2021 Year 2018 2019 202
Boeing 806 380 157 340 Embraer- 90 89 43
commercial
onlya
 Large Aircraft Manufacturers Regional Aircraft Manufactur
Year 2018 2019 2020 2021 Year 2018 2019 202
Market 50% 31% 22% 36% Market 62% 66% 44%
share share
Airbus 813 863 566 611 Bombardier 20 26 16
–
commercial
Market 50% 69% 78% 64% Market 14% 23%
share share
Others 35 19 39
Market 24% 14% 40%
share

Source: Compiled by the authors using delivery reports from Boeing, Airbus,
Embraer, and Bombardier.

Jet Engine Manufacturing

Oligopolistic market characteristics also apply to the commercial aircraft jet
engine manufacturing industry. The products of the industries are not only highly
related, but also exhibit similar barriers to entry: high capital requirements,
economies of scale, and advanced technological expertise and competencies.
While commercial aircraft manufacturing comprises four major firms competing
in two distinct market segments, engine manufacturing is an oligopoly of the “Big
Four”:

CFM International
Pratt & Whitney (P&W)
General Electric Aircraft Engines (GEAE)
Rolls-Royce

CFM International stands as the leading commercial aircraft engine manufacturer,

with 39% of the engine market worldwide in 2020. In 2021, the global aircraft
engine MRO market is expected to be worth 29.5 billion US dollars. Notably,
General Electric has also partnered with Pratt & Whitney (a subsidiary of
Raytheon Technologies) to form the Engine Alliance. This collaboration has
given rise to the GP7000 engine for the A380.8 They hold a near 100% market
share of the commercial aircraft sector. In 2020, Pratt & Whitney came second
with 35% of market share. The company is an American aerospace manufacturer
and a subsidiary of Raytheon Technologies.
General Electric Aviation occupies the third largest manufacturer of jet engine,
with 14% of the North American market.
Additionally, two consortiums were formed to add more players to the engine
market. CFM International (CFMI) was a partnership between GE and Snecma,
the French state-owned engine manufacturer. CFM manufactures the CFM56 and
LEAP engines, which can be found extensively on the A320 and 737 families of
aircraft. Likewise, IAE was formed in 1983 between P&W, Rolls-Royce,
Daimler-Benz, Fiat, and Japan Aero Engines. These consortiums pooled
technological knowledge, reduced risk, and lowered production and development
costs for individual manufacturers. This created an interesting situation where
manufacturers could be both partners and competitors concurrently. In addition to
the two consortiums, P&W formed an alliance with GE for the development of
the GP7200 platform, an engine designed for very large commercial aircraft such
as the A380 (Bowen and Purrington, 2006).
Figure 6.4 displays the worldwide market share for commercial jet engines in
terms of deliveries over the past 45 years. P&W was the dominant jet engine
manufacturer up until the early 1980s, at which point P&W made a strategic
decision that shaped the market for many years. Notably, P&W, a principal
McDonnell Douglas supplier, made the decision to focus on supplying engines
for Boeing’s new 757 instead of the 737, believing that the 757 was going to be
the aircraft of the future (Bowen and Purrington, 2006). This choice led to a
scenario in which CFMI became the sole jet supplier for 737s, while P&W and
Rolls-Royce split orders for the 757s. Despite the commendable sale performance
of the 757s, the 737s became the most successful commercial aircraft in history.
P&W lost even more market share with the demise of McDonnell Douglas.
GE has been the main benefactor of P&W’s declining market share. GE, a
long-time military engine manufacturer, entered the commercial market with the
backing of its large parent company, which encompasses aircraft leasing via
GECAS. GE strengthened its position in commercial engine manufacturing with
its CFMI joint venture with Snecma. In 2020, CFMI held a 39% market share,
while Pratt & Whitney held 35%. The first is the Engine Alliance with GE that
manufactures products for the Airbus A380. The second is the IAE Company of
Rolls-Royce, MTU Aero Engines, and the Japanese Aero Engines Corporation
that manufacture engines for the Airbus A320 and the McDonnell Douglas MD-
90.
Figure 6.5 provides another comparison between the major commercial engine
manufacturers in terms of in-service engines. Notably, Figure 6.5 is lagged, by
roughly an engine’s life, from Figure 6.4. This temporal offset serves as the major
reason why P&W remains a market leader, as many of its older products are still
being used on the Boeing 727 and MD-80 (Bowen and Purrington, 2006).
Therefore, P&W can still turn substantial revenues through maintenance
agreements and selling of spare part inventories. However, as the older aircraft
are retired, P&W’s market share has declined, while GE and CFMI have gained.

Figure 6.5 Commercial Jet Engine Manufacturing Market Share by

Engine Deliveries.
Source: Compiled by the authors using the Airline Monitor (2015)

Engine manufacturers also compete in service categories by creating the most

fuel-efficient engines and by providing the most attractive “power-by-the-hour”
contracts. Within the framework of a power-by-the-hour arrangement, the engine
manufacturers provide fixed-cost maintenance based on the number of hours
flown each year. The airlines provide a fixed level of funding and expect to
receive a given level of support by the engine manufacturers. The contractor
expects to be provided a fixed level of funding, paving the way for a long-term
support arrangement. Similar situations occur for avionics, aircraft interiors, and
in-flight entertainment systems.
The substantial technological knowledge and skills required in the commercial
aircraft engine manufacturing industry are major barriers to entry. Moreover, this
knowledge requirement is a primary motivator for the number of alliances and
agreements generated in the industry, as resources and risk are spread across
multiple firms. An alliance, in this context, is an arrangement between two or
more firms agreeing to cooperate on a substantial level.

Figure 6.6 Commercial Jet Engine Manufacturing Market Share by In-

Service Engines.

Contestability Theory
Recalling the perfect competition model presented in the previous chapter, it is
not the large number of competitors that reliably drives profits to normal levels,
but rather, it’s the expansion of output and entry of new firms. Profits can
temporarily be quite high regardless of how many competitors are in the market.
Likewise, a market marked by just a few competitors does not guarantee any
prospect of high profits. If new competitors can readily enter a market, then even
a single firm may be driven to behave in a competitive manner, earning only
normal profits on average in order to discourage new entry.
The pure concept of “contestability theory” takes this idea one step further and
posits that in the absence of significant entry barriers, the number of firms in an
industry is completely irrelevant. The key element of contestability theory resides
in the stipulation that the feasibility and profitability of entering the market must
prevail, as pointed out in the given quotation.
 Before deregulation, many economists speculated that pure contestability
theory might well apply to the airline industry. Due to the inherent mobility of
aircraft, the thinking was that they could, under certain conditions, readily be
reallocated to whatever routes were commanding higher prices, thus driving those
prices down. Since each airline knew this, they refrained from significantly
raising prices. In other words, potential competition would have the same effect
as actual competition. However, several studies examined the airline industry and
found a positive relationship between airfares and the levels of market
concentration. In essence, the fewer the airlines in a given market, the higher the
fares on average, suggesting that airline markets are not perfectly contestable.
One possible explanation is that economists underestimated the cost associated
with entering a new market. Suppose, for example, that an airline had service to
airport A and airport B but no nonstop service connecting A and B. It might
appear that an aircraft could fly out of one market and be reassigned to a new A–
B route almost instantly in pursuit of the greatest profit. But in reality, a new
route must be planned and announced to consumers well ahead of time, normally
at least three months. Moreover, there might be a need for dedicated advertising
expenditures. These are not massive costs but perhaps create enough friction to
the entry process to prevent pure contestability results.
One of the key elements of contestability theory is that entry and exit from
markets must be free and easy (Bailey, 1981). The complete absence of barriers of
entry would satisfy pure contestability theory. However, within the context of
airline industry, there can be sizeable barriers to entry into a given airport. This is
certainly the case at slot-controlled airports such as London Heathrow.
Nevertheless, the existence of competing airports makes contestability theory
apply to a certain extent even in this market. Ultimately, in oligopoly markets
where there are low barriers to entry, the market power of any one carrier will
considerably be much less compared to markets where there are high barriers to
entry.
However, there is considerable doubt that these slight entry costs can fully
explain observed price variances. Within the realm of intense competition, the
influence of network effects may offer a better explanation. An airline network is
more than the sum of its separate routes, particularly for the legacy carriers that
aspire to offer seamless travel to “almost anywhere.” Suppose, for instance, that
such a carrier found it necessary to operate a nonstop route to Las Vegas because
it is such a popular vacation destination. Additionally, a noteworthy portion of the
airline’s key customers preferred to redeem their frequent flier awards for a Las
Vegas trip. In this case, the value of the Vegas route might far exceed the actual
revenue garnered from paying customers on that particular flight. Thus, the
airline would sensibly keep that route rather than reallocating the aircraft to
another route, such as a nonstop to Minneapolis that would produce more direct
revenue but less total value and revenue for the network as a whole. Thus, the
price of a flight to Minneapolis could remain higher than the price to Las Vegas
even if the market were purely contestable. The same thing happens in grocery
stores when a particular item, a “loss leader,” is sold at an especially low price in
order to draw customers into the store to hopefully buy other items with higher
markups.
To properly judge the contestability of the airline industry, it is imperative to
examine the overall profits of the entire airline rather than at the prices of
particular city pairs. Considering the extremely low long-run profits and return
rates, it may well be that the industry is contestable in this broader sense. We will
cover this in more detail later.
Naturally, it is possible to drown in a deep spot within a pond where average
depth is only knee deep. Likewise, substantial discomfort can persist within
particular cities and city pairs that face relatively high prices, even with the
system-wide average fare being a consumer bargain, actually below the cost
associated with a normal profit.
Fortunately, for consumers residing in those high-end markets, low-cost
carriers (LCCs) with simpler point-to-point networks are entering with increasing
frequency. Numerous instances abound wherein carriers abuse their market power
and generate competition from other carriers. LCCs AirTran and Frontier created
their own hubs in Atlanta and Denver, both of which were formerly dominated by
oligopolistic legacy carriers. Meanwhile, Virgin Atlantic evolved to provide
British Airways with legitimate competition on long-haul flights. While these
examples provide an application of contestability theory on a widespread scale,
the theory is arguably more relevant in small markets with only one or two
airlines. In these situations, airfares typically remain somewhat high, but not high
enough to encourage competition to enter that market.
Figure 6.6 displays a hypothetical demand curve for a firm in an oligopoly
market. According to contestability theory, there are two components to the firm’s
demand curve. The initial aspect surfaces when the firm wants to increase the
price. In a non-contestable market (dashed line above P), the firm can increase
prices and not lose a substantial amount of demand, thus suggesting a gain in total
revenue. However, in the presence of contestability (solid line above P), this
increase in price will result in an even larger decrease in quantity demanded.9
Here, the demand manifests relatively elastic since new competitors may enter
and match the price increase.10 The second component of the contestable demand
curve is when a firm is pondering a price decrease, aiming to simulate a surge in
the quantity demanded and thus increasing total revenue. This holds true in a non-
contestable market, as demonstrated by the dashed demand curve below P.
Alternatively, in a contestable market, new competitors may also see the benefit
from a price decrease. They could strategically venture into the market by
matching the price decrease, but the increase in the firm’s quantity demanded
from the decrease in price is unlikely to be as large as the firm had hoped. In this
scenario, the demand is relatively inelastic since the potential competition is
willing to follow the price decrease. This is demonstrated by the solid demand
curve below P.

Kinked Demand Curve Theory

The theory of the kinked demand curve predicts price stability in oligopolistic
markets. The theory states that in this type of market, there exists a band of price
stability. This band is the kinked portion of the demand curve.
Consider a duopoly with two firms having slightly different demand curves for
their product. Illustrated in Figure 6.7 are these two demand curves for firms, D1
and D2. These two curves intersect at point A as shown in Figure 6.7; this point
lies at price (P) and demand (Q). Both companies want to operate at a point
where marginal revenue equals marginal cost. This particular point serves as the
basis for determining the optimum price, traceable along the corresponding point
along the demand curve. In a duopoly market, the firm with the lowest price sets
the market price, which the other firm must then match in order to remain
competitive.
 Figure 6.7 Price Competition and Market Reaction for Oligopoly.

Based on this information, we can outline the construction of the market

demand curve. Up until point A in Figure 6.7, D1’s demand curve is less than that
of D2. Therefore, based on simple supply and demand, the first firm would charge
a lower price than the second firm. However, the situation is reversed after point
A where firm D2’s demand curve is significantly less than that of D1. Therefore,
the market demand curve will be from point E to point A and from point A to
point G.
In order to construct the market’s marginal revenue curve, firm D1’s marginal
revenue curve should be used up to a demand level of Q units and firm D2’s
marginal revenue curve should be used thereafter. This configuration yields a
situation where the market marginal revenue curve contains a vertical portion,
line B–C. Since the intersection of the marginal revenue and marginal cost curve
will yield the optimum price for the industry, when the marginal cost curve
intersects between points B and C, the market clearing price would be roughly
Price (P) or the price at point A. Therefore, if the marginal cost curve’s
intersection shifts anywhere in between points B and C, the market clearing price
remains the same. At the market price, none of the individual oligopolistic firms
would make any change in the prevailing price, even when there might be some
slight changes in their production costs.
This creates a situation of long-run price stability in the market since there is a
relatively wide range over which marginal cost can undergo alteration (B to C in
Figure 6.8) without changing the profit-maximizing price (A in Figure 6.8).
 Figure 6.8 Kinked Demand Curve.

The airline industry at times seems to provide some indication that this might
be occurring. Notably, major shifts in the demand curves will create significant
fluctuations in the market’s marginal revenue curves, thus changing the market
clearing price. A major shift occurred shortly after the terrorist attacks of
September 11, 2001 which led to a downshift in demand and altered previously
stable equilibriums.

Cournot Theory
The Cournot theory helps explain competition and market equilibrium based on
firms competing through output decisions. This theory assumes that products are
homogenous, market entry is difficult, firms have market power, and cost
structures are similar. Furthermore, each firm assumes that its counterpart will
remain unresponsive to changes. For instance, Boeing believes that Airbus will
not respond to any changes in price and output initiated by Boeing. Likewise,
Airbus assumes Boeing will be equally unresponsive. While this assumption is
probably unrealistic, the model still offers some insight and, given that neither
Airbus nor Boeing can definitely predict the response, the theory may at times
approximate reality.
Consider a duopoly market where the firm’s marginal costs are zero. The
demand curve for the entire market is displayed in Figure 6.9, along with the total
output in the industry being Q. We also observe the marginal revenue curve of the
initial firm, which is exactly half the demand curve, since the demand curve is
linear.

Figure 6.9 Initial Output Decision for the Dominant Firm.

The optimal output decision for the first firm occurs where marginal revenue
equals marginal cost. Since marginal costs are assumed to be zero, the firm would
want to produce at the point where the marginal revenue curve intersects x-axis.
This point is exactly half of the total demand, denoted as point Q/2. The
corresponding price for this level of output from the demand curve is P1. Since
the first firm takes half of the market for itself, the second firm’s maximum
demand would be Q/2. Therefore, the demand curve for the second firm is shifted
to the left and intersects the x-axis at point Q/2. This is displayed in Figure 6.10.
Employing this calibrated new demand curve, the second firm’s optimal output
level is the point where the marginal revenue curve intersects the x-axis. This
occurs exactly at Q/4, and the corresponding price point is P2. Consequently,
based on this, the first firm would take half the market and the second firm would
take a quarter of the market (3/4Q).

Figure 6.10 First-Round Cournot Theory.

Remember that these firms are yet to achieve equilibrium, since the second
firm’s price is far below that of the first firm. With this disparity, most consumers
would opt for the second firm’s product, since the products are homogenous, and
the price is significantly lower. The firms will ultimately readjust their output in
an effort to obtain equilibrium. Moreover, as shown in Table 6.3, these
readjustments will occur over various rounds rather than transpiring all at once.

Table 6.3 Cournot Market Share Theory

Round 1 Round 2 Round 3 Round 4
Firm 1 1/2 Q 3/8 Q 11/32 Q 1/3 Q
Firm 2 1/4 Q 5/16 Q 21/64 Q 1/3 Q
Total Market 3/4 Q 11/16 Q 43/64 Q 2/3 Q
 The Cournot solution is where both firms are in equilibrium with the same
price and output levels. Within a duopoly context, the Cournot solution would
have each firm obtaining 1/3Q for a total market share of 2/3Q. It is worth noting
that total market share declines as firms readjust to equilibrium; in this case, Firm
1’s market share decreased, while Firm 2’s market share increased. The Cournot
theory predicts that firms will continue to readjust the level of output until they
have achieved market equilibrium at the same price level.

Example
Consider two Cournot competitors faced with the following inverse demand
function:

P = 1,000 – 10Q

where P is the industry price and Q = q1 + q2 is the industry output. Both

companies have constant marginal and average cost AC = MC = 50.

a. Determine the Profit Maximization Output.

P = 1,000 – 10 (q1 + q2)
P = 1,000 – 10 q1 − 10 q2
MR1 = 1,000 – 20q1 − 10q2
MR2 = 1,000 – 10q1 − 20q2
b. Now set MR = MC,
MR1 = 1,000 – 20q1 – 10q2 = 50
MR2 = 1,000 – 10q1 − 20q2 = 50
20q1 + 10q2 = 950
10q1 + 20q2 = 950
c. Solve the functions simultaneously.
20q1 + 10q2 = 950
−20q1 − 40q2 = −1,900
−30q2 = 950 => q2 = 31.67

Thus, the profit-maximizing output for both the firms is equal to 31.67 units. This
equilibrium value signifies that each firm has one-third of the market (Round 4 in
Cournot duopoly). The remaining one-third of the market is 31.67 units. Thus, the
whole market encompasses 95 units (31.67 × 3), which, when applied to the
market demand function, will result in the profit being zero (1,000 – 10 × 95 – 50
= 0).
Consider how the manufacturing industry resembles the characteristics of the
Cournot theory. Although Boeing’s and Airbus’s products are not identical, they
are fairly close in terms of technical performance and requirements. Likewise,
cost structures are similar but not identical. Furthermore, barriers to entry are
high, and each firm has tremendous market power and equal market share.
However, the readjusting progression has been evident in the past, as Boeing’s
market share has slowly declined, while Airbus’s market share has increased
(although Boeing did regain share in 2006). Despite large similarities, disparities
exist in cost structure and products, accounting for various outputs.
Conversely, achieving the Cournot solution is rarity within the airline industry.
This is because airlines are better able to differentiate their product, mainly
through route structure and flight frequency. Every airline has a different cost
structure, and each individual carrier has little market power. Due to this, it is
rarely seen that market share distributed evenly among multiple carriers. In fact,
the development of the hub system has led to situations where one airline tends to
dominate particular markets.

Price–Output Determination under Hybrid Market Structure

In order to understand the mathematics involved with determining the optimal
price–output level for a firm within a hybrid market, let’s examine a scenario of
luxury airline DirectJet. The management at DirectJet has asked its financial
managers to study short-run pricing and production policy. DirectJet’s financial
managers were able to determine the airline’s price, fixed cost (FC), and variable
cost functions to be:

P = 10,000 – 8Q
FC = $200,000
VC = 2,200Q + 5Q2

With the ultimate goal of pinpointing the optimal price–output decision for
DirectJet, we need to find the marginal revenue and marginal cost curves. On the
revenue side, the total revenue function (TR = P × Q) can be found simply by
multiplying the price function by quantity (Q). This yields the expression:

TR = 10,000Q – 8Q2
The first-order derivative of the total revenue function will produce the marginal
revenue function of:

MR = 10,000 – 16Q

On the cost side, the two cost components (fixed and variable) must be combined
to create the total cost function:

TC = 200,000 + 2,200Q + 5Q2

From this, the first-order derivative of the total cost function will yield the
marginal cost function:

MC = 2,200 + 10Q

The final step in determining the optimal price–output combination for DirectJet
is to set the marginal revenue and marginal cost curves equal to each other in
order to determine the optimal quantity. This computation is demonstrated below
and also displayed graphically in Figure 6.11.
 Figure 6.11 Marginal Revenue and Marginal Cost Curves.

MR = MC
10,000 – 16Q = 2,200 + 10Q
7,800 = 26Q
→ Q = 300

Based on this calculation, DirectJet’s optimal output is 300 seats per day. At this
level, average ticket price and the airline’s total revenue are as follows:

P = 10,000 – 8Q
P = 10,000 – 8(300)
P = $7,600
TR = 10,000Q – 8Q2
TR = 10,000(300) – 8(300)2
TR = $2,280,000
 or:
TR = P×Q → $7,600 × 300 = $2,280,000

While total revenue is not maximized at this point, total firm profit is maximized
at this value. In order to determine total profit at the optimal level, the total cost at
the optimal output is:

TC = 200,000 + 2,200Q + 5Q2

TC = 200,000 + 2,200(300) + 5(300)2
TC = $1,310,000

Thus, total profit at the optimal output level is

TP = TR – TC
TP = $2,280,000 – $1,310,000
TP = $970,000

No other combination of price and output, based on the cost functions provided
by DirectJet’s financial analysts, will yield the airline with a greater profit. This is
displayed graphically in Figure 6.12, which shows the total revenue, total cost,
and total profit functions. Since the total cost curve is an upward U-shape, the
output level of 300 is the maximum for profit.
 Figure 6.12 Total Revenue, Cost, and Profit.

While the above scenario applies in the short term, it is much different in the
long run. Similar to perfectly competitive markets, any super normal profits
earned by monopolistic competitive firms in the short run will attract new firms
to the market. These new firms will offer similar competing products, but with the
increase in new firms and products entering the market, the degree of
differentiation between products diminishes. As a result, the elasticity of the
firm’s demand decreases, inducing a progressive flattening in the firm’s demand
curve. This creates a situation similar to perfectly competitive markets, as
monopolistic competitive firms tend to become price takers in the long run. This
causes the super normal profits to diminish, and zero economic profits are earned.
In essence, monopolistic competition acts like perfect competition in the long
term. Hence, the principal differentiating characteristic between the two is the
length of the short-run period where super normal profits are realized.

Profitability Issues
The existence of normal long-run profit levels might be explained by the industry
being contestable in the manner already discussed. However, the mere attribute of
contestability itself should not produce the below-normal returns observed in the
airline industry. Rather, the explanation may relate to the industry’s oligopolistic
nature combined with very high fixed costs and very low marginal costs. Recall
that an airline’s schedule is usually set three months in advance and that most
costs are essentially fixed for that period. The marginal cost of placing a
passenger in an otherwise empty seat on an aircraft is extremely low—consisting
mainly of the cost of ticket processing or travel agent commission. Thus, each
individual airline finds itself in a position where even a very low price is better
than nothing for an otherwise empty seat. As discussed in Chapter 11 on revenue
management, each airline strives to make this low fare available only to those
passengers who would not have chosen to fly at a higher price on their own
airline. However, each airline is content to entice passengers away from a
competitor. Suppose, for example, that Joe would have paid $200 to fly airline A,
but is lured into flying airline B for $150. Likewise, Jane would have flown
airline B for $200, but is lured over to airline A for $150. Each airline acts
independently, but the collective result is that each receives $50 less, perhaps
incurring a loss rather than making a profit.
If each could refrain from stealing the other’s customers, they might both
enjoy a normal profit rather than risk bankruptcy. This is a classic “prisoner’s
dilemma.”11 Regrettably, neither airline can trust the other enough to refrain from
this cut-throat pricing, even though both would prefer to cooperate. In essence, if
only one airline stops offering the $150 deal, that airline will lose both Jane and
Joe to the competing carrier. Of course, any attempt to cooperate is complicated
by the fact that government antitrust policy typically prohibits arranging such
cooperation via a formal contract. Furthermore, another complication is that other
airlines will tend to enter the market with aggressive price cuts even if the two
airlines do somehow manage to cooperate. US airlines also argue that the
bankruptcy laws exacerbate the problem by providing a subsidy12 that keeps
failed airlines from actually leaving the market. Thus, even in the long run, it is
difficult for the industry to decrease capacity enough to keep prices high enough
to support a normal profit.13
At first glance, the misery experienced by airline investors from pricing below
costs appears to be a joyous gain for air travelers—as if most carriers were
perpetually selling at “going out of business” bargain rates, and this might indeed
be the prevailing scenario. Conventionally, most economists have viewed
excessively low long-run returns as a problem that will eventually take care of
itself as needed. In this regard, if many investors and lenders don’t think it is
worth investing in the airlines, then they can stop financing them until capacity
decreases enough to raise prices, normalize profits, and thus warrant future
investment. On the other hand, the strong performance by airlines like Ryanair
and Southwest suggests that the business can be profitable if it is “done right.”
Therefore, a majority of economists are probably content to let the industry
evolve as it will, even with rampant bankruptcies, until or unless there is clear
evidence of a problem for consumers.
However, proponents of the “empty core” theory suggest there may already be
a serious problem.14 It is possible for the aforementioned cut-throat competition
to be so severe that it actually does harm consumers by preventing airlines from
offering some higher-priced products that consumers prefer. For example,
suppose there is no available nonstop service on a given route and that two
competing airlines offer service through their respective hubs for a price of $200.
Suppose that the consumer demand is such that one airline could offer nonstop
service on this route for $280 and, if the other carrier maintained its $200 service,
both airlines would be financially viable in the market. In other words, the market
possesses the capacity of supporting both airlines but only one with a nonstop
flight. However, if competition leads either to duplicate such service and/or
significantly cut their price, then the nonstop service becomes financially
impossible to maintain. So, it is possible to offer consumers a chance to pay a
premium and obtain the more desirable nonstop service only if there is no strong
competitive response.
 Consider a scenario in which every time one airline adds nonstop service, and
the other either duplicates that service or substantially slashes prices on its stop
and transfer service so that the nonstop service becomes a financial loser and is
abandoned.15 Moreover, since the two airlines compete in numerous markets,
they each learn of this tendency and, therefore, choose never to start such nonstop
service in similar markets. This problem might explain why airline customers
complain so much about declining quality while at the same time making choices
that drive airlines to reduce quality.16 There is no practical way for an airline to
contract with customers to get them to keep flying the new nonstop route after
competitors respond, even though customers might be willing to do so if they
understood that booking a bargain today would eventually result in poorer
service/higher prices in the future. To illustrate, consider a situation where many
customers’ first choice is $150 with a stop and transfer. The second choice is
nonstop service for $280, and the third choice is $200 with a stop and transfer.
Suppose, airline a starts the nonstop $280 service, but then airline B offers the
$150 service in response. This renders the nonstop service infeasible and it is
abandoned, the market returns to $200 service by both airlines, and customers are
left with their least preferred option. In such a case, consumers would be better
served if the two airlines could freely negotiate a solution. This might involve one
airline induced to not respond by receiving a small side payment, or the two
airlines might take turns adding nonstop service in more marginal markets.
Additionally, a counter-intuitive situation is prevalent where consumers might
actually be better served by an alliance that seems to closely resemble a cartel.
However, this phenomenon is not actually as unique as it may appear. For appear,
for example, in the realm of manufacturing, for firms that are normally
competitors to occasionally team up on particular projects. Similarly, one airline
will conduct maintenance or baggage handling for a competitor. One reason for
this is that economies of scale for certain products may be such that only a single
producer can be efficient enough to viably deliver the product to market. This
relates to the fact mentioned earlier that reducing the number of competitors may
sometimes increase efficiency and increase consumer well-being. If the airlines
were permitted to collaborate, it is easy to perceive, for example, how two large
aircraft with 95% load factors in a particular market might be more cost effective
than three smaller aircraft with 75% load factors operated by separate airlines.
Similar to how aircraft prices might be lower with two producers rather than three
or four, reducing competition on some routes may benefit consumers in some
cases.
It is probably reasonable to assert that most economists in the traditional vein
would view airline cooperation as too radical of a step, primarily due to the
contention that the risk of price collusion conspiracy would outweigh any
potential gain. Conversely, there are those who contend that, given the financial
plight of legacy carriers, the risk of them colluding to make “too much profit” is
not significant. Also, strong proponents of market process would argue that new
entry, and perhaps potential new entry (contestability), could effectively restrain
any harmful anticompetitive impulses. In other words, price conspiracies are
unlikely and, even if the airlines in a given market attempted collusion, a new
entrant would undercut them; that is, the market is contestable, at least in a basic,
practical sense.
Ironically, in this situation, staunch antitrust regulation may ultimately
decrease the number of competitors. Since current regulation may prevent airlines
from cooperating to improve efficiency in particular markets, the eventual
outcome might be more airline failures and eventual liquidation and/or
desperation mergers that antitrust enthusiasts have no choice but to accept.
Although speculative, it is possible, for instance, that Lockheed or McDonnell
Douglas might have remained as competitors to Boeing and Airbus had they been
allowed to cooperate on some projects.
When regulatory preferences conflict with the economic reality of substantial
economies of scale, scope, or density, economic reality will ultimately win. If
more cooperative efforts between airlines are needed, they will eventually
emerge, if not through approved alliances, then through bankruptcy, liquidation,
or mergers that reduce the number of independent airlines. As regulators could
not forestall the transformation of the aircraft manufacturing market into a
duopoly, with each firm able to enjoy considerable economies of scale, it may be
that a similar process is unfolding for airlines. Naturally, tremendous uncertainty
persists in all of this. Nevertheless, given the financial disarray of many legacy
carriers, major industry changes of some sort do seem likely.

Competition and Antitrust Issues

Antitrust policy has a basic and fundamental objective. The objective is to protect
the process of competition for the benefit of consumers, ensuring strong
motivations exist for businesses to operate efficiently, keep prices down, and
maintain high quality. The Sherman Act (1890), the Federal Trade Commission
Act (1914), and the Clayton Act (1914) are the three pivotal laws in the history of
antitrust regulation in the United States. Similar legislation exists in Europe and
many other jurisdictions. The ambit of antitrust policy restricts cartels and
monopolies, thus eliminating price fixing and discrimination, and pricing
practices. The Department of Justice’s (DOJ) Antitrust Division is responsible for
enforcing the federal antitrust laws in the United States and has the authority to
review mergers to determine if they may lessen competition.
Antitrust regulation has evolved into a significant controversy. Some
economists perceive problems with at least some aspect of antitrust regulation,
and some even argue that such regulations should be completely abolished on the
grounds that costs far exceed any benefit.17
One challenge is that the most problematic anticompetitive behaviors are
completely exempt from antitrust oversight. Economists would generally be
thrilled if it were possible, for instance, to address issues like international trade
barriers under antitrust law, but all government policies are exempt from these
laws. Since, as mentioned, there is also a question about the real power of any
barrier to entry outside of government, there emerges a debate as to whether there
is enough of a private monopoly problem to justify a government regulatory
program. Even if there are some imperfections in market competition, as most
economists would probably agree, it is not easy for regulators to make things
better for consumers by imposing fines and escalating legal costs on firms. After
all, such expenses typically get transferred to consumers in the form of higher
prices. Also likely is substantial bias on the part of regulators.
Antitrust regulations are intended to prevent individual corporations from
assuming too much market power such that they can limit their output and raise
prices without concern for any significant competitive reaction. On September 21,
2021, the DOJ filed a civil antitrust suit against American Airlines and JetBlue,
and the suit alleges a violation of the Sherman Act and seeks to enjoin an alliance
formed between the two airlines.18 Back in July 2020, American and JetBlue
formed the Northeast Alliance. According to the DOJ’s complaint, within this
alliance the two rival airlines agreed to “share their revenues and coordinate
which routes to fly, when to fly them, who will fly them, and what size planes to
use for flights to and from four major airports.”

Predatory Pricing

Predatory pricing is a strategy of selling a product below cost to force the

competitions out of business. Predatory pricing is illegal under antitrust laws.

Predatory pricing, theoretically, occurs when a firm:

1. Slashes price below cost in order to drive competitors out of the market; then
2. Raises prices to a monopoly level once competition is gone. It is important
to note that aggressive price cuts, even if they drive competitors out of
 business, are not in themselves predatory. Airlines often find themselves
losing money, fighting over a market that isn’t big enough to sustain all
existing firms. In this case, they may fight it out until some firms leave the
market and raise prices high enough to support normal profits. Therefore,
aggressive price cuts and less-efficient firms going out of business are the
routine results of healthy competition. The label ‘predatory’ solely applies if
prices escalate to monopolistic heights. In many countries, including the
United States, predatory pricing is considered an anticompetitive practice
and is illegal under antitrust laws.

Also, question is raised as to whether predatory pricing is likely to occur at all.

Undoubtedly, it is a high-risk strategy that would likely fail in many cases, even
in the absence of any regulation. Assuming a firm survives Stage 1, that its
competitors go bankrupt before it does, it is likely to face new entrants once price
is increased at Stage 2. These potential newcomers would know that the predator
could not easily afford another round of predatory cuts after already enduring
losses in driving out the first group of competitors. If the predator did
successfully repeat his/her predation, then a third round of new entrants would
likely be drawn in by the knowledge that the predator would struggle to survive a
third confrontation and so on. In other words, a successful predator must be so
fierce that he/she completely frightens off the rest of the world. This is a possible,
albeit uncommon, barrier to entry. A popular example of a failed alleged
predatory pricing strategy comes from Delta and ValuJet. ValuJet began service
hubbed out of Atlanta in 1994. By December 1994, Delta had matched ValuJet’s
cut-rate fares—as low as $29 one way—on flights between Atlanta and the 11
cities that both carriers served. On January 7, 1997, ValuJet suspended its low-
fare service between Mobile and Atlanta. The next day, Delta raised its lowest
fare for the route from $58 to $404—an increase of about 600%.
However, normal price competition is often mistaken for predatory behavior.
If, for example, a competitor enters a market with a close substitute offered at a
lower price, then clearly the incumbent firm must either match that price cut, at
least approximately, or leave the market altogether. Airline A can’t charge a price
much above Airline B if B offers essentially the same product. If A was
previously charging a much higher price before it matches the much lower price
of B, then A will also likely increase output. Essentially, the presence of low-cost
competitor B forces A to abandon its higher-price/lower-volume strategy and
embrace a low-price/high-volume strategy. The only alternative for A is to
abandon the market completely. In this scenario where B eventually pulls out of
the market, A may find it optimal to return to the high-price/low-volume strategy.
The standard business procedure of matching a competitor’s price cuts when
necessary is indistinguishable from predatory pricing. Does it truly make any
sense to forbid legacy carriers from matching the lower prices of low-cost
entrants?
US courts considering predatory pricing charges in recent decades have
focused not on the price cuts but on the feasibility of a “predator” raising prices to
monopoly levels. For example, in the case of Frontier Airlines vs. American
Airlines, the judge summarily dismissed the case because, he maintained, the
government really had no case at all; that is, no credible evidence of predation.
American Airlines merely matched the prices of Frontier but, in the court’s view,
had no hope of gaining any monopoly power even if it destroyed Frontier, since
there were numerous other competitors in the market. The fact that American, like
all legacy airlines, struggled to earn even normal profits over the long run is
supportive of the court’s decision. Although some economists may disagree with
this approach, the courts’ deep skepticism combined with the fact that the legacy
carriers have been, in recent years, struggling just to survive, seems to have
dampened regulators’ enthusiasm for bringing predatory pricing charges.
In 2000, Spirit Airlines initiated a lawsuit alleging that Northwest Airlines
engaged in predatory pricing and other predatory tactics in the leisure passenger
airline markets for the Detroit–Boston and Detroit–Philadelphia routes beginning
in 1996. During this pricing competition, Spirit claimed that Northwest’s fares
were so low that these prices would force Spirit to exit the markets and
consequently, Northwest would raise fares to monopoly levels and consumers
would be harmed. Northwest responded by stating that the low fares in these two
markets reflected head-to-head competition between the airlines. The district
court awarded summary judgment to Northwest, but a panel of the Sixth Circuit
unanimously reversed the district court’s decision.19

Cartels and Collusion

A cartel is another form of market structure created from a formal (or tacit)
agreement between a group of producers to reduce the production and increase
prices.

A cartel is another form of market structure created from a formal (or tacit)
agreement between a group of producers to reduce the production and manipulate
prices. This collusion enables the cartel to exert monopoly-like power in their
pricing policies. While cartels and collusion are generally illegal in the United
States, they are allowed in many foreign markets. In the United States under the
Sherman Antitrust Act of 1890, the Clayton Antitrust Act of 1914, and the Federal
Trade Commission Act of 1914, such collusive agreements are illegal.
Nonetheless, there are several examples, particularly in the sports professions.
The National Football League, Inc. (NFL), Major League Baseball, Inc. (MLB),
the National Basketball Association (NBA), and the National Collegiate Athletic
Association (NCAA) are often cited as examples of cartels.20 Around the world,
there have been famous cartels in oil and diamonds. Arguably, the most famous
and most important cartel in the world economy is the Organization of the
Petroleum Exporting Countries (OPEC).

While OPEC cannot directly set the price of a barrel of oil, its control over
much of the supply enables the cartel to dramatically impact the price by either
increasing or decreasing output. According to US Energy Information
Administration data, in 2022, OPEC members produce around 40% of the world’s
crude oil. However, OPEC members export about 60% of the total globally traded
petroleum by volume.
Considering the international nature of and often extreme competition in air
travel, there is strong potential for collusion in the airline industry. A notable
instance of this occurred in 2006 when the British Airways became involved in a
price-fixing scandal involving fuel surcharges on long-haul flights (Simpkins,
2006). Investigations by both British and American authorities uncovered the fact
that calls were made to Virgin Atlantic concerning the timing and level of
increases in fuel surcharges. British Airways admitted fixing cargo surcharges
from 2002 to 2006 and passenger fuel surcharges from 2004 to 2006 (typical
surcharges rose from £5 to £60 per ticket). In August 2007, the British Airways
was charged $300 million by the Office of Fair Trading (OFT) and US Justice
Department, but Virgin Atlantic was not fined as it was given immunity after
reporting British Airways’ actions.
An inherent problem arises when analyzing cartel and collusion issues in the
airline industry— the fact that the prevalence of information in the industry
makes it fairly simple for airlines to match the prices and output of competitors.
This gives rise to the term “tacit collusion.” Tacit collusion refers to coordination
without express communication. A common example is price signaling. For
instance, one airline raises its prices with the hope that the other airlines interpret
this move as an invitation to collude and respond by matching the price increase.
However, the fact that two airlines have price fluctuations that match exactly does
not mean they are in collusion, but more likely that they are competing fiercely.
Airline alliances create interesting issues related to airline collusion.
Ultimately, these airlines coordinate schedules and prices of flights. In order for
alliances to be allowed, they must receive regulatory approval from the necessary
bodies. However, limits may be placed on their coordination. For instance,
American Airlines and British Airways have several stringent restrictions placed
on them, while the KLM/Northwest relationship was given extensive antitrust
immunity by US regulators. Antitrust immunity is given to potential alliances
based on a variety of factors, including the level of consolidation that would exist
in the industry.
Again, however, there is fierce debate as to whether government antitrust
actions against alleged collusion have been appropriate and beneficial to society.
The abysmal rate of return for legacy airline investment, perhaps the lowest for
all industries, implies that competition is far from lacking. Even if collusion were
attempted, it is difficult to orchestrate high prices for any length of time. For one
thing, such high prices invite new competitors to enter the market and undercut
the cartel. Even before new entry, there is always strong incentive for an
individual firm to violate the collusive agreement as one can potentially earn far
greater profits by slightly undercutting one’s partners.
In fact, the behavior of US airlines in the age of regulation illustrates the
strong tendency to break a cartel agreement. Historically, regulators have severely
limited price cuts, much as a conventional cartel would do, and even prevented
any new entry for nearly four decades. However, airlines struggled to earn even
normal profits. They competed by improving quality—improving the food, giving
away liquor, utilizing larger aircraft, providing roomier seating, and so on. Even
though this quasi, government-aided cartel failed to suppress competition, it
illustrates how difficult it is for firms to secretly suppress competition on their
own.
Employing regulation to prevent price fixing is problematic because, as seen in
the cases of alleged predatory pricing, there is often no clear way to distinguish
innocent behavior from illegal collusion. For example, two airlines may
constantly raise and lower their fares in tandem. This alignment might not result
from collusion but because of logical, independent reactions to market conditions.
One airline’s product is normally a very close substitute for another’s—in the
leisure market, it may approach being a perfect substitute. Inherently, it is not
possible for the prices of two close substitutes to vary greatly; most consumers
would flock to the one that is substantially cheaper. Consequently, it is necessary
to generally match any price cut by a competitor. The widespread availability of
online information in the industry also makes it particularly easy for airlines to
monitor and quickly match the prices and output of competitors. Likewise, any
airline attempting to increase price because of, say, higher fuel costs, will retreat
from the price increase unless competitors follow suit. This dynamic typically
results in either a general increase in airline prices or no lasting price increase at
all.
In the 1990s, US regulators took note of the fact that airlines seemed to be
constantly signaling each other to raise prices. For instance, an airline would
normally announce its intention to raise prices several weeks in advance. If,
following the announcement but before the scheduled price increase, the
competition eventually announced that they too would increase fares by similar
amounts, then the announced price hikes would in fact materialize. On the other
hand, if competitors left prices unchanged, then the airline would cancel the
previously announced fare increase.
In their defense, airlines highlighted that the most announced increases were in
fact canceled, that the overall long-run trend in inflation-adjusted fares was
downward, and that the lack of industry profitability indicated that prices were
not fixed but rather broken. Moreover, as already explained, it is understandable
that prices for close substitutes will naturally either move in tandem or not move
at all. It is also understandable that firms sustaining significant losses would make
every effort to raise prices.
Nevertheless, antitrust regulators insisted on changes and, among other things,
forced airlines to agree to no longer announce fare increases in advance.
Numerous travel agents and consumer groups complained about the change since
it seemed to make fare increases harder to predict and plan for. Airlines responded
to the regulatory constraint by implementing fare increases on Saturdays, a time
when relatively few people book flights. Thus, if competitors refused to join in
the price increase, then the new prices could be canceled by the following
Monday before they had significant impact.
Critics of antitrust regulation argued that the whole episode seemed absurd and
that it was particularly ironic for regulators to force firms to actually raise prices
as opposed to just announcing an intention to eventually raise prices. Still, it does
seem at least theoretically possible that preventing airlines from signaling a desire
to increase prices might ultimately benefit consumers. Regulators claimed that
their actions and general vigilance would keep airline profits and prices from
increasing too much.

Industry Consolidation
The level of concentration in the industry helps determine the market’s structure.
Industries that are highly concentrated may be more prone to exhibit
characteristics of monopolies and oligopolies, while industries with multiple
players may tend to exhibit characteristics of monopolistic competition. Table 6.4
presents the market share of US car rental companies over the past few years.
Despite the relatively large number of players, the rental car industry is highly
consolidated with the top three companies holding a combined 94.87% market
share in 2016. Interestingly, this trend somewhat resembles the consolidation
observed among the airlines. Although mergers within the car rental industry are
less apparent to consumers, but according to Bloomberg, the industry is still in
transition. Similar to the post-merger airlines, there could be potentially future
increases in the stock prices for Enterprise, Hertz, and Avis.

Table 6.4 Market Share of Car Rental Companies, 2022

Car in Number of Market
Rental Companies
Service Locations Share
Enterprise Holdings 1,100,000 6,000 56.69%
Hertz 430,000 3,800 22.16%
Avis Budget Group 350,000 3,200 18.04%
Sixt 18,500 100 0.95%
Fox Rent A Car 18,200 21 0.94%
ACE Rent A Car 9,000 60 0.46%
 Car in Number of Market
Rental Companies
Service Locations Share
NP Auto Group 7,500 100 0.39%
U-save Auto Rental 5,500 124 0.28%
System
Rent-A-Wreck of 1,750 71 0.09%
America

Source: Compiled by the authors from Auto Rental News Fact Book
[Link]
united-states/
There are two widely used methods for evaluating industry consolidation: the
four-firm concentration ratio and the Herfindahl index.

Four-Firm Concentration Ratio

The concentration ratio is a measure of the total market share held by a certain
number of firms in the industry. The formula for the concentration can be
described as:

where n is the number of firms measured and Q is the output.

The concentration ratio is simply the summed output of n airlinecompanies
divided by the total industry output. The most commonly used concentration ratio
is the four-firm concentration ratio, which measures the output of the four largest
firms in the industry. Consequently, the market can then be classified according to
a continuum of the percentage share of the top four.
In this example, American, Delta, Southwest, and United would be grouped
together as indicated using 2020 data from Figure 6.5. To calculate the four-firm
concentration ratio of the US domestic airline industry in 2020, the four largest
airlines in terms of output need to be grouped together and compared to the
industry total. The combined output is 448,683 million available seat miles
(ASMs). When this figure is divided by the total industry output, it produces a
four-firm concentration ratio of 75.3%. The four largest airlines produce 75% of
the industry’s total output (Table 6.5).
Table 6.5 Total US Airline Industry Output by Domestic ASM (Millions)
Airlines 2014 2015 2016 2017 2018 20
American 157,598 200,373 241,732 243,824 248,574 248,
Delta 212,235 220,437 225,276 228,416 238,588 251,
United 214,061 219,956 224,653 234,547 244,771 253,2
Southwest 122,753 140,671 148,658 153,966 159,920 157,2
JetBlue 45,028 49,347 53,705 56,039 60,412 63,83
Alaska 32,434 35,917 38,721 41,468 55,367 59,7
Hawaiian 17,078 17,701 18,351 18,978 20,147 20,56
Allegiant 8,806 10,365 12,125 13,310 14,581 15,86
Frontier 12,539 15,495 18,359 21,895 24,444 28,10
Spirit 16,401 21,351 25,641 29,585 36,270 41,8
Industry 838,934 933,630 981,580 1,012,444 1,066,803 1,09

Source: Compiled by the authors from US DOT Form 41

Markets are separated into categories along the market continuum based on the
four-firm concentration ratio:

Perfect Competition: less than 20%

Monopolistic competition: between 20% and 50%
Oligopoly: between 50% and 80%
Monopoly: above 80% four-firm measurement

Airlines 2017 2018 2019 2020

American 24,37,08,802 24,84,79,803 24,87,79,882 11,95,29,867
Delta 22,65,87,630 23,70,61,948 24,96,94,906 11,96,26,551
United 23,36,67,254 24,44,17,122 25,28,16,292 10,43,13,705
 Airlines 2017 2018 2019 2020
Southwest 15,38,14,165 15,97,98,408 15,72,58,128 10,34,61,328
JetBlue 5,60,30,468 60.407,120 6,38,28,029 3,26,90,655

Source: [Link]
As established earlier in this chapter, the airline industry is an example of an
oligopoly market, and it appears that the four-firm concentration ratio that was
calculated above does in fact support this claim with a 75.3% four-firm
concentration ratio in 2021. In the context of the airline industry, the four-firm
concentration ratios should be calculated on an airport or a city-pair basis, which
better reflects the relevant market. This reality remains for the majority of
airports, merely a handful of major carriers, and this produces an oligopolistic
market. Since consumers are ultimately impacted on an individual market basis,
assessing the four-firm concentration ratio on an airport-by-airport basis provides
a more realistic picture of the air transport industry.
Table 6.6 provides a synopsis of the four-firm concentration ratios when
calculated on an airport-by-airport basis for six major airports in the United
States. While the industry’s concentration ratio was 75.3%, most of the airports
analyzed had concentration ratios substantially above that. In the cases of Atlanta
and Dallas, one dominant hub carrier receives near-monopoly power as it
effectively controls the market. Chicago O’Hare, serving as a hub for both United
and American, is essentially a duopoly. In similar vein, Los Angeles and Las
Vegas both exhibit strong oligopolistic market tendencies with their four-firm
concentration ratios equaling roughly 70%. Similar statistics would be found if
the analysis were applied to other airports.

Table 6.6 Four-Firm Concentration Ratio

Airport 2022
Atlanta (ATL) 91.46%
Baltimore (BWI) 91.47%
Chicago (ORD) 73.37%
Dallas (DFW) 86.97%
 Airport 2022
New York (JFK) 88.09%
Los Angeles (LAX) 67.53%
Las Vegas (LAS) 70.10%
Phoenix (PHX) 82.70%
Seattle/Tacoma International (SEA) 81.67%
Washington (DCA) 57.83%

Source: Compiled using the Bureau of Transportation Statistics.

Using an airport-by-airport analysis of the domestic aviation market, it is clear
that the industry resembles a strong oligopoly. While every market maintains its
uniqueness, with varying levels of concentration, it is unlikely that any one
airport would have a low four-firm concentration value. While the four-firm
concentration ratio enables the analyst to get a quick look at the amount of
concentration in the industry, it usually requires a more in-depth analysis to fully
understand the specific market situation.

Herfindahl-Hirschman Index
Another method used to analyze the amount of concentration in an industry is the
Herfindahl index (also known as the Herfindahl–Hirschman index, HHI).21 This
is a widely used measure, previously utilized in the first chapter to analyze the
amount of consolidation that exists in the industry. HHI is obtained by squaring
the market share of each of the players, and then adding up those squares:

where:

S is the m-firms’ market share

n is the number of firms

The Herfindahl–Hirschman index (HHI) is a frequently accepted measure of

market concentration. The HHI approaches zero when a market is highly
 competitive with a large number of firms. The index approaches its maximum
of 10,000 points when a market is controlled by a single firm.

The measure is simply the cumulative squared value of the market share for
every firm in the industry. Therefore, the higher the index, the more the
concentration (within limits), indicating a less competitive market. By squaring
the market share values, firms with a large market share receive more weight in
the calculation than do firms with a smaller market share. The US Department of
Justice considers a market with a result of less than 1,500 to be a competitive
marketplace. A result of 1,500–2,500 is a moderately concentrated marketplace,
and a result of 2,500 or greater is a highly concentrated marketplace. It should
also be noted that market share can be calculated in terms of different products;
therefore, unique HHIs could potentially be created for the same market.
In a duopoly market for example, if each of the two firms has a market share
of 50%, the HHI would be:

HHI = (50)2 + (50)2 = 2,500 + 2,500 = 5,000

Alternatively, if the two firms held 80% and 20%, respectively, then:

HHI = (80)2 + (20)2 = 6,800

Utilizing data sourced from Form 41, the industry HHI for the domestic US
airline industry was calculated for the past several years. The respective market
share for each airline was based on the number of passengers enplaned. Until
2010, the general trend in the US airline industry was de-concentration, as the
HHI value had dropped over 200 points since 1998. In 2010, the HHI returned to
its pre-1998 levels, a further indication of the cyclicality of the aviation industry.
The current HHI value of around 1,782 is fairly typical of an oligopolistic market,
as values greater than 2,500 generally indicate a high degree of concentration in
the market. However, just as in the four-firm concentration ratio, a much higher
degree of concentration exists at individual airports. The HHI for the top ten US
airlines is presented in Table 6.7.

Table 6.7 US Domestic Airlines

Herfindahl Indexa
Year Index Year Index
 Year Index Year Index
1995 1352 2009 1129
1996 1345 2010 1319
1997 1354 2011 1305
1998 1328 2012 1429
1999 1298 2013 1432
2000 1268 2014 1482
2001 1231 2015 1620
2002 1235 2016 1735
2003 1189 2017 1703
2004 1168 2018 1679
2005 1154 2019 1664
2006 1131 2020 1770
2007 1107 2021 1783
2008 1127 2022 1760

Source: Compiled by the authors using US DOT Form 41 via BTS, Schedule T1.
a
Based on enplaned passengers.
The HHI is frequently used by the Department of Justice to determine whether
or not a proposed merger is acceptable for antitrust reasons. Table 6.8 presents the
pre-merger market share for the major carriers, while Table 6.9 provides the post-
merger market share as well as the industry HHI.

Table 6.8 US Airlines, Pre-Merger

Market Share
Carrier Market Share
Delta 12.7%
Northwest 7.7%
 Carrier Market Share
American 16.0%
United 10.5%
Continental 8.2%
US Airways 9.5%
JetBlue 4.2%
AirTran 4.5%
Southwest 18.9%
Frontier 1.8%
Virgin America 0.7%
Alaska 2.9%
Hawaiian 1.6%
Allegiant 1.0%
HHI 1,154

Source: Compiled by the authors from Form 41.

Table 6.9 US Airlines, Post-

Merger Market Sharea
Airline Market Share
American 19.00%
Southwest 18.30%
Delta 16.80%
United 14.50%
JetBlue 5.50%
Alaska 4.60%
 Airline Market Share
Spirit 3.00%
SkyWest 2.40%
Frontier 2.30%
Hawaiian 1.70%
Other 11.90%
HHI 1,546

Source: Compiled by the authors from Form 41.

Tables 9.8 and 9.9 merely provide an overview of the major carriers’ market
share.
a
HHI values included data from carriers not listed in the tables.
Projected from the proposed mergers, the HHI would increase by nearly 300
points. The Department of Justice usually does not like mergers that raise the
industry HHI above 1,000, as any point above that is deemed too monopolistic. In
addition to these industry-wide HHI measures, certain markets, particularly in the
Northeast, would experience far greater increases in the HHI. Given that the HHI
is only one of many factors employed by the Department of Justice when
evaluating mergers, mergers are often approved on other grounds. Markets are
categorized based on their HHI22:

Less than 1,500: competitive markets

Between 1,500 and 2,500: moderately concentrated markets
Higher than 2,500: concentrated markets

Beyond Market Concentration Considerations

Although the above calculations of market concentration lend a certain aura of
rigor, it remains a very arbitrary decision criterion, partly because it completely
ignores how mergers may increase efficiency and/or reduce prices through
positive impacts of economies of scale, scope, and density. Of course, it is not
possible for anyone, including the merging airlines themselves, to know with
exact certainty how efficient the newly combined airline will be. The mix of
corporate cultures, merging of separate labor unions, and/or other factors creates
uncertainties that become clear, but long after the merger actually occurs.
Proponents of strong anti-merger regulation argue that with no guaranteed gains
in efficiency, it makes sense to keep the number of competitors as high as
possible for as long as possible.
On the other hand, opponents of such vigorous regulation maintain that the
dismal rate of return for the airline industry shows that there is more than enough
competition, implying that firms should generally be free to combine as they
choose. The struggling industry should be allowed to repair itself. For instance,
Ben-Yosef (2005, 265–266) suggests that, had government regulators allowed
them to merge, it is quite possible that United Airlines and US Airways might
have avoided bankruptcy and been in a better position to keep fares low enough
to profitably compete with the low-cost airlines. Thus, rather than focusing on
concentration ratios, regulators might better serve the public interest by generally
allowing troubled firms to merge as they see fit, and allowing the industry to
evolve, as it will as long as there is no indication of higher than normal long-run
profits being generated.
Up to this point, regulators have allowed such free choice in mergers only if it
becomes obvious that one firm is on its way to shutting down anyway. However,
airline alliances, which might be viewed as a sort of partial merger, have often
been allowed considerably more freedom. For instance, the KLM/Northwest
alliance is quite extensive, having received antitrust immunity from US
regulators. At times, governments severely restrict the action of alliance partners,
such as in the case of American Airlines and British Airways, but at least some
cooperation is allowed. The greater degree of freedom allowed in alliances seems
to represent some compromise; regulators may be implicitly admitting that rigid
focus on concentration ratios is not appropriate in an industry largely floundering
in bankruptcy. At the same time, from a pro-regulatory viewpoint, if alliances
should prove to be anticompetitive, they can more readily be altered or even
completely undone.

Antitrust, Market Evolution, and Cooperation

Antitrust law facilitates governmental agencies to restrict company behavior that
creates monopolies or otherwise interferes with competitive markets.23 As
mentioned earlier, the US airline oligopoly is dominated by four firms: American,
United, Delta, and Southwest, which together make up about 75% of the market.
The US DOJ’s antitrust jurisdiction originates from two industrialization-era
rulings, namely, the Sherman Act and the Clayton Act.24 The Sherman Act
contains two main sections that provide a broad outline of antitrust law:

Section 1 prohibits anticompetitive agreements and mergers.

 Section 2 prohibits anticompetitive behavior by a single company.

The Clayton Act provides mechanisms for enforcing the Sherman Act, including
provisions for treble damages, prohibitions on stock acquisition, and regulatory
review of mergers.
On September 21, 2021, the US Department of Justice sued to block an
unprecedented series of agreements between American Airlines and JetBlue.
These agreements entail the consolidation of their operations in Boston and New
York City.
In 1965, the German and French governments started a framework about
forming a consortium to build a European short-haul airliner. The outcome was
Airbus Industrie, formed in 1970 as a Grouping of Mutual Economic Interest.
The rivalry between Airbus and Boeing may also illustrate how some
cooperation can benefit consumers. Consider, for example, the problematic
production of the jumbo aircraft, the A380. Suppose Boeing had decided to make
its own version of the A380 and had then begun to encounter problems similar to
those of Airbus. There was a possibility that both companies would have decided
to simply abandon production. With each having to share demand with the other,
the costs might have been prohibitive. Of course, it never came to this because
Boeing chose not to enter the A380 market. Whether intentional or not, there was
a sort of implicit cooperation when Boeing stepped aside to make the project
viable for Airbus. Governments may unwittingly facilitate such cooperation
through patent laws, which can have the effect of segmenting the market for
different producers.
Implicit cooperation is less likely to take place, though, where the number of
firms is greater. The airline industry may need explicit contracts to coordinate an
efficient allocation of resources for consumers. Airlines might be able to offer
more nonstop service or move to larger, more efficient, and comfortable jets on
more routes if they were able to explicitly cooperate. Certain aspects of this might
be arranged through mergers and some through more limited alliances that might
sometimes resemble cartels but could be aimed at arranging efficient production
rather than suppressing competition. The elimination of the restrictions on
cabotage and international mergers would facilitate this and would also reduce
entry barriers to help reduce the possibility of the cooperation taking an
anticompetitive turn. The five years before COVID-19 hit, the industry saw US
airlines generating significant above-normal profits and that does seem to have
attracted new entrants into the US domestic market, with the launch of Avelo and
Breeze Airways in 2021.
Naturally, current regulators and many economists would oppose such a move
to allow cooperation. It’s conceivable, for instance, that the lack of industry
profitability reflects simple overcapacity rather than the need for complex
cooperation. Eventually, bankruptcy, capacity cuts, and liquidation may decrease
supply, increase price, and return the industry to normal profitability. In any case,
many economists argue that airline consolidation in some form, both in Europe
and in the United States, is inevitable. According to this view, the record shows
that the industry cannot be profitable in its present state, either because there is
simply too much capacity from too many airlines or due to a more complex lack
of coordination. Since investors will ultimately require a reasonable rate of return
to keep capital in the industry, some capital will be withdrawn. Consequently, the
number of large airlines is probably bound to decline somewhat. While regulators
might slow this decline in numbers but cannot prevent it and may, as outlined
above, cause the adjustment to be less orderly and more severe than it would be
had they simply gotten out of the way. Only time will offer definite insights.

Summary
As presented earlier, market structure refers to the number of firms involved in a
market, typically a city-pair for airlines, and the degree of competition among
them. The four types of market structures include perfect competition,
monopolistic competition, oligopoly market, and monopoly. Some of the factors
that determine a market structure include the extent of economies of scale,
barriers of entering and exiting the market, the number of buyers and sellers, and
the degree of product differentiation. Numerous industries contend with notable
barriers to entry, such as high startup costs (as seen in the jet engine and aircraft
manufacturing industries) or strict government regulations which limit the ability
of firms to enter and exit such industries.
This chapter delves into the models of monopolistic competition and
oligopoly, the so-called hybrid markets. A monopolistic competitive industry
involves many firms producing differentiated products, and each firm has some
degree of market power. An oligopoly market structure is characterized by a small
number of large firms dominating the market. In an oligopoly market, the pricing
decision by one firm can have a significant impact on the behavior of the other
firms in the market (mutual independence). Most aviation industries fit the
oligopoly model, but there are different views of what this implies. Some
economists see oligopoly as inherently problematic, while others point to the lack
of high profits in many oligopolies, particularly the airlines, and conclude that
entry barriers are not so significant after all. This chapter then provided an
overview of various theories of oligopoly, including contestability, kinked
demand curve, and Cournot models. Empirical evidence indicates that the airline
industry may be contestable, but only when viewed as a network. From this
viewpoint, it may even be that increased concentration and cooperation through
more alliances can benefit consumers, primarily through economies of density,
and potentially restore the airline industry to reasonable long-run profitability.
Finally, this chapter introduced various indices used to measure the amount of
concentration in the industry.

Discussion Questions
1 What are the best examples of monopolistic competition in the real world?
2 How is price established in a pure competition?
3 How is price established in an oligopoly market?
4 The antitrust laws do not allow firms in the same industry to agree on what
prices they will charge. Is that correct for the airline industry?
5 How is price established in a monopolistic competitive market?
6 If monopolies are socially undesirable, why do governments actually support
having some?
7 Provide examples illustrating how markets change from one structure to another
when technology or other market conditions change.
8 What are the implications for the regulatory authorities of the existence of
contestable markets?
9 You are the manager for DirectJet and unable to determine whether any given
passenger is a business or leisure traveler. Can you think of a self-correction
mechanism that would permit you to identify business or leisure customers?
10 Graphically depict a shut-down case for a monopolistic competitive firm.
When should any firm shut down in the short run?
11 Focus on the airline industry: why is the upper portion of the kinked demand
curve elastic and the lower portion inelastic?
12 What are four distinguishing characteristics of monopolistic competition?
13 South Charleroi Airport is a regional airport serving the leisure travel market.
The inverse demand curve for this airport is P = 150 – Q. Assume that there
are only two airlines serving this airport, each with the identical marginal cost
(MC) of $30.
a. Supposing they perform as Cournot oligopolists, determine the price and
total firm productivity.
b. Compare this with the result under pure monopoly and perfect
competition.
14 Suppose that a typical monopolistically competitive firm faces the following
demand and total cost equations for its product:
Q = 50 – P
 TC = 375 – 25Q + 1.5Q2
where P is the price of the product and Q is the number of units produced.
a. What is the firm’s profit-maximizing price and output level?
b. What is the relationship between P and average total cost (ATC) at the
profit-maximizing output level?
c. Is this firm earning an economic profit? Is this firm in short-run or long-
run monopolistically competitive equilibrium? Will new firms enter
into or exit from this industry?
15 Calculate the change in the HHI for the period of 2006–2017:
a. For the US airline industry
b. For US major airports
c. Have these industries become more or less concentrated over time?
16 Some students may think that university sweatshirts have a relatively high
price when sold at the bookstore. Other than quality, can you think of a reason
for the higher price of the sweatshirts in the bookstore?
17 There are a number of gas stations that are located near the lots of rental car
companies around Orlando International Airport. These gas stations invariably
charge a higher price than other gas stations that are located further away.
Rental cars are normally rented with the proviso that the car be returned with a
full tank of gas. Use these two facts to explain this phenomenon.
18 Suppose there are only two airlines that serve a certain route. Now suppose
that one of the airlines institutes a sale on this route. What will be the effect on
the other airline and what actions will the other airline take?
19 In the preceding example, suppose that one of the airlines opts out of the
market entirely.
20 Will the other airline immediately adopt a monopoly pricing strategy? Why or
why not?
21 Occasionally, an airline will ask passengers what the purpose of the trip is.
Usually, the stated reason is to provide better service for the customer. In
addition to this reason, what other information do you think the airline is trying
to obtain with this type of questionnaire and why?
22 Suppose that two airlines, DirectJet and MyJet, with identical cost functions
are serving a regional airport with following information:
Market demand: P = 1000 – 10Q
Cost functions: AC = MC= $50
a. Calculate the equilibrium output and price for each airline, assuming that
each airline chooses the output level that maximizes profits taking its
rival’s output as given.
 b. Calculate the profit level for each airline at equilibrium level.
c. Suppose that DirectJet’s costs increased to AC = MC = 100 and MyJet’s
costs remained at the same level. Work out the equilibrium quantity and
price for each airline.

Notes
1. IAE is a joint venture between Pratt & Whitney, Rolls-Royce, Aero Engine
Corporation of Japan, and MTU Aero Engines of Germany.
2. Both drinking waters include two atoms of hydrogen (H) and one atom of
oxygen (O).
3. The Sukhoi objective is to compete effectively with its Embraer and
Bombardier counterparts by offering substantially lower operating costs.
4. The Seattle Times, April 27, 2022.
5. Website: [Link] press release, January 12, 2017.
6. Simple Flying, April 20, 2021.
7. An FBO is a company that has a permission to operate on airport grounds in
order to provide services to the airports and the airlines. These services may
include fueling services, hangar services for aircraft, and repair and
maintenance services and facilities.
8. Simple Flying, June 22, 2022.
9. In October 2006, United raised fares in several markets, but when it became
clear that airlines such as JetBlue and Northwest Airlines would not raise
their fares, United rescinded fare increases.
10. Other airlines may not follow a price increase by one airline; therefore,
demand will remain relatively elastic. Furthermore, an increase in price
would not lead to an increase in the total revenue of the airline.
11. The term follows from the idea that two criminals might both go free if each
lies to protect the other. But, under separate police questioning, each knows
that he/she will face a very stiff sentence for lying should the other partner
tell the truth. Unless each can somehow be certain that the other will also lie,
they have an incentive to implicate each other in exchange for a lighter
sentence.
12. For example, many airlines have effectively “dumped” the cost of their
pension programs onto taxpayers via government assumption of these
pension obligations, though with some cuts for wealthier pensioners.
13. Although this may be changing as of late, the much higher cost structure of
the legacy carriers also leads to increased capacity from LCCs. Moreover,
unusually powerful unions are also often cited as contributing to the legacy
airlines’ ongoing struggles.
14. See Raghavan and Raghavan (2005) for a discussion of an “empty core
problem.”
15. This situation explains, incidentally, the puzzling fact that an A–B–C flight
is sometimes cheaper than an A–B flight.
16. Of course, it is also very possible that consumers really do just want lower
prices and may enjoy complaining about quality because they unrealistically
want extremely low prices and high quality!
17. See, for example, Crandall and Winston (2003) and Armentano (1986).
18. Complaint at 2, United States v. American Airlines Group Inc. & JetBlue
Airways Corp. (filed September 21, 2021).
[Link]
19. Spirit Airlines, Inc. v. Northwest Airlines, Inc., 431 F.3d 917 (6th Cir. 2005),
cert. denied, 166 L. Ed. 12 (US 2006).
20. However, it might also be argued that these sports leagues are not really
cartels at all since their product, entertainment, faces many substitutes.
Cooperation among sports franchises might be of the same sort that exists
among different franchises of a given restaurant chain.
21. Herfindahl-Hirschman Index, United Stated Department of Justice, July 29,
2015.
22. US Department of Justice and the Federal Trade Commission, Merger
Guidelines § 1.51.
23. See Einer Elhauge, UNITED STATES ANTITRUST LAW AND
ECONOMICS 1–4 (3d ed. 2018).
24. Federal Trade Commission. “The Antitrust Laws.”
[Link]
laws/antitrust-laws. Accessed September 2, 2022.

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Crandall, R. and Winston, C. (2003). Does Antitrust Policy Improve
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