Friday, December 5, 2008

Price formation and the airline industry

The following is an excerpt from an analysis of airline troubles (emphasis mine):
... former American Airlines C.E.O. Bob Crandall gave a speech to a group of airline executives in New York City in June that sounded a little like heresy: Crandall essentially called for reregulating the sector. “We have failed to confront the reality that unfettered competition just doesn’t work very well in certain industries,” he said.

... Crandall ran American Airlines from 1980 to 1998, and he’s a bit of an iconoclast. He has long hated the intense competition in the business and the resulting fare wars and turf battles. He once said that in commercial aviation, prices are set not by a company’s costs but by its “dumbest competitor.” Crandall was also known for ruthlessly cutting costs to keep American profitable; in the mid-1980s, he ordered olives removed from the salads served in-flight, a move that saved the company about $100,000 a year.

... on the subject of reregulation, Crandall may be right. “Airlines work with a very distorted supply-demand equation,” he said, and right now that’s manifesting itself in the form of too many flights, too much traffic, and fares that don’t come close to covering an airline’s costs. Worse, the infrastructure—planes, fuel, gates—is extremely expensive and too inflexible to quickly adapt to changes. So any market corrections involve a lot of pain for consumers and a lot of destroyed capital for airlines.

As pointed out by Yet Another Sheep, economists really do not know how prices are formed. My thoughts are:
1. Gee, if airline companies keep following the dumbest competitor, no wonder they are constantly going bankrupt. Which led to - gee - barrier to entries must be really low if airlines keep pricing below cost to contest the market or deter entry.
2. If airline companies play a pricing game is the Nash Equilibrium the same as the equilibrium in a tatonement process? Or when does Debrey's proof equilibrium in competitive markets break down? Or maybe the airline industry is not a competitive market in the Arrow-Debreu sense.

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