The visible hand in economics

Airlines and competition

Posted on: September 21, 2007

I’ve been thinking about the fact that AirNZ is going to shut down Freedom Air in March 2008. With Freedom Air, Air NZ was able to serve the budget end of the market and the higher quality end by selling a differentiated product. However, the company could have simply offered different services in different compartments of the plane, it seems a touch over the top to create a whole separate brand just to get the advantage of price discrimination (at least in this case).

The true purpose of Freedom air was to prevent competition. By paying a whole lot of money to run a cut price airline, Air NZ was able to make it uneconomical for other potential entrants from coming into the market, as their marginal cost was greater than the price they could set when competing with Freedom. The investment in Freedom air acted as a form of commitment. As the investment in capital, goodwill etc for Freedom air was costly to reverse, Air NZ could credibly commit to fighting a new competitor on the Trans-Tasman route through the low prices Freedom charged, rather than just allowing them entry.

However, Air NZ has dropped Freedom right when Virgin was getting in on the act. I expect this is because the costly commitment to fight the new competitor was not sufficient to prevent the new competitor entering. As a result, Air NZ has decided to dump Freedom Air and just accept that there is a new competitor. I guess this is fair enough, as Virgin has some very deep pockets, and if Air NZ decided to fight them they may well be on the losing end. As a result, Freedom Air was a useful mechanism to reduce small scale competition in the market place, but it was not effective at preventing the arrival of one of the big boys.

In the future, I’m sure the case of Freedom Air will be a useful case study in how an incumbent can use costly commitment to prevent the entry of a new competitor. How do you think the commitment game functions in this case?

5 Responses to "Airlines and competition"

With the utmost respect, I do not concurr.

Airlines were the first major industry in the US to be deregulated in the 1970’s as the wave of ‘contestable’ theory came in. Air travel was identified as particularly prone to ‘contestability’ as there are no (or little) barriers to entry or exit.

Am I contradicting Matt here? Sadly so. Air travel is prone to ‘hit and run’ entry, since when prices are substantially (or at least enough) above marginal cost, a new entrant can swoop in and rent planes on short term leases in the large and liquid plane market, make a profit while it lasts before counter-vailing action can be taken, and then leave and not re-lease their planes, or even sub-lease them.

Likewise, the ‘commitment’ of current incumbents by establishing ‘low cost’ airlines is weak. Ex post entry these firms can leave the market at little cost by ending their leases on their planes. If they cannot do this, they can sub-lease elsewhere. Thuse the incumbent is not ‘committed’ to staying in the market (in the sense that costs are all sunk) in that they can recoup their entry cost (planes) by not continuing to lease, selling, or sub-leasing them.

There is a huge literature on this. In particular, I note Alfred E. Kahn’s “The economics of regulation: principles and institutions”.

Just to stirr things up a bit!

Interesting. Have we observed constant large scale hit and run entrants attacking the Trans Tasman travel market? Furthermore, it is all well and good to call a market contestable, but if the marginal costs are asymmetric then it does not matter as the firm with the lowest marginal cost will close out the market. Note I was not talking about the price for air travel changing, I was just saying that Freedom made it uneconomical for other airlines to enter.

I agree that firms can hire planes and set up a new airline relatively quickly. However, their marginal cost will be above the marginal cost of an established player like Freedom which owns its own planes and have established networks. That was the point of Freedom air, it gave Air NZ a credible way to cut prices and prevent entry.

I think that the commitment value of Freedom air is high in so far as Freedom was set up to be an aggressive cut price airline. Think of it this way, Air NZ and Quantas effectively serve the higher end of the market, while Freedom is provided capital from Air NZ to serve the low end of the market. Given the elasticity of demand for the low end of the market, and no doubt given the way that Air NZ structured its costs, it would react heavily to any entry in the low end of the market. That was the purpose of Freedom and it did its job well. Note: Commitment and sunk costs are different, sunk costs do not influence the decision of a firm, commitment implies that a given investment makes the firm commit to being more aggressive. Irreversibility matters because it makes this commitment credible, and I don’t think that Freedom airs assets are very liquid, so I think there would be a reasonable degree of irreversibility.

I do like the idea of contestability though, and I fully agree that that concept influences the structure of the game and prices. However, I do think that the purpose of Freedom was to provide a credible commitment to wipe any new entrants out of the market.

I would be interested in hearing why you think Freedom air was formed though, I’m sure there are plenty of interesting reasons.

Hmmm, this industrial stuff is all a bit confusing for me. I think Matt’s right about precommitment: it doesn’t rely on sunk costs and it doesn’t rely on barriers to market entry. Precommitment commits the firm to a course of future actions. Here Air NZ could commit to running a low cost airline by setting up Freedom IF it was costly to liquidate the cut-price airline. This is where I start getting confused.

If Dan’s right and airlines have very low fixed costs then there is almost no precommitment power in setting up a cheap airline. It doesn’t precommit you to running the airline in future because it’s easy to liquidate it and change your mind when someone else tries to enter. So either Freedom is substantially different from the airlines Dan’s talking about, or Matt’s wrong about Freedom providing commitment power.

It’s a tough call: Matt has a higher post-count than Dan which makes him the more credible e-source, but Dan randomly threw in the name of a supposedly relevant academic paper which makes him sound intellectual. I’ll let the viewers decide πŸ˜‰

I’m not really an expert here, but I don’t agree with the main thrust of your post either.

You’re arguing (I think, but correct me if wrong!) that Air NZ held onto the Freedom brand to dissuade entrants into AirNZ’s markets, but that since there has been a recent entrant (Virgin) with deep enough pockets not to be deterred by low initial profits, AirNZ has decided to fold the Freedom brand to make cost savings now that the deterrent effect hasn’t worked.

Firstly, aren’t we talking about several quite different markets here? And in the geographical sense, not in the sense of “high end” and “low end”, where the latter is what you think Freedom was set up to prevent entry to.

First there are the large trans-tasman routes, ie Sydney/Bris/Melb/Wgtn/Chch/Auckland. Virgin entered the trans-tasman market a few years back on a couple of the larger routes,.

Freedom Air seemed to serve 2 quite separate markets which Virgin Blue hasn’t touched: the routes to Gold Coast, and the routes to Aussie from Hamilton/Palmy/Dunedin.

And finally the new Virgin NZ domestic is competing only with Air NZ domestic, not on any of the old Freedom routes.

So its difficult to see either a relationship between Virgin entering the transtasman market a few years back and the scrapping of Freedom, or between Virgin’s domestic entry and the scrapping of Freedom.

If you’re suggesting that Freedom’s presence on those regional-city-to-Aussie routes was a disincentive to an entrant on those particular routes, I’d probably agree. But how could the presence of Freedom on those routes have any impact on other trans-tasman routes or on NZ domestic ones?

Freedom’s presence on those little routes also doesn’t necessarily mean they were making losses on those routes (after all, why protect a loss-making route from entry?). Price have been quite high on those routes (equivalent to Melbourne to Wgtn on AirNZ) for a few years now (we could probably check their profits if they file separate financial statements…I’m unsure of whether they do though). And Freedom is not solely a cut-price airline – they even had business class seats.

So I’m not convinced the holding of the Freedom brand, nor the continual flying of the particular routes that Freedom was on, had anything at all to do with dissuading entry to any of the markets Air NZ served. More likely AirNZ maintained Freedom on the routes that Freedom flew because they were profitable. I reckon they’re scrapping the brand now not because it was a loss-making ineffective exercise in trying to deter entry, but because there are small cost savings. After all, the same planes are going to fly the same routes as Freedom did, just with different livery – this doesn’t point to a loss making market.

As to why they maintained the brand this long, that’s an interesting question. Not sure I know the answer…

Interesting website! Cheers

Good points Tim. I agree that geographical separation is important when discussing airlines, as a flight from Auckland to Wellington is a completely different product to a flight from Auckland to the Gold Coast. I am definitely ignorant on the specifics of this market.

The best points against my above argument have come from Tim and Dan (actually those are the only points, but they were good points so I wanted to use the term best πŸ˜‰ ). As far as I can tell these were:

1) Freedom does not give a credible vehicle for commitment as the investment is reversible. (Dan)
2) There are important differences between the market that Freedom and Air NZ served that had nothing to do with price, but more to do with geography. (Tim)

I have already discussed the first point earlier. I feel that there were significant irreversible elements (such as goodwill, and yes even the planes as I think there is a sunk cost from selling them) that make the commitment credible.

The second point removes the idea that Freedom is cut price. However, it replaces this assumption with the idea that Freedom serves a different geographical market. If this is the case, then we still have to ask, why Freedom instead of Air NZ. Surely it is more costly to run two brands! I suspect that Freedom ran on specific routes where Air NZ wanted to prevent competition. The irreversible investment in the Freedom brand gave competitors the feeling that it was optimal for Freedom to act aggressively to competitors where Air NZ would not. In that case the idea still holds, although may representation of it is completely wrong πŸ˜‰ .

If I have mis-represented what you guys said, please correct me.

Ultimately, I still find the idea of Freedom being anti-competitive appealing, especially as there are no alternative to pick from (except price discrimination, however I don’t think that setting up another airline is the cheapest way to get price discrimination going).

Still I would be glad to hear any more comment, especially if you can offer me some exciting alternative that explains why Freedom Air was bumbling around in the first place πŸ˜‰

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