Airlines and competition
Posted September 21, 2007on:
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?