The tacit collusion case to be discussed involves the illegal collusion and setting of fuel surcharges to commercial and cargo transatlantic fares between British Airways (BA) and Virgin Atlantic Airways (Virgin). The factors which contributed to its success will be discussed, as well as why, and its implications, of becoming public. To begin with, it would be beneficial to define both collusive behaviour and the nature of the competition involved in the aviation industry. Collusion is the act of a number of firms within an industry agreeing to set a certain price, output or another parameter and is almost always against the law.
This is as they all compete in the given industry, with the setting of prices or outputs done in favour of the companies, and is therefore anti-competitive behaviour, as this moves the outcome away from the market equilibrium. The generated inefficiency is considered illegal by The Office of Fair Trading (OFT) within the UK, who’s mission is to protect consumer welfare whilst ensuring businesses remain competitive and fair (OFT, 2011). A brief overview of the UK aviation industry will help in explaining and justifying certain factors which led to the successful collusion.
Aviation is key not only for transportation purposes but for commercial flights, employing around 234, 000 staff and contributing ? 18. 4 billion to Gross National Product (GNP). The industry is not only essential for global business and trade, but 75% of all visitors to the UK travel by air and adds a further ? 14 billion towards GNP (BATA, 2011). The USA and the European Union have signed an ‘ open skies agreement’ allowing full access to all routes between the two continents, although is more restrictive to EU airlines (IACA, 2007).
In the specific case of BA and Virgin, oil price rises based on the price of barrel oil as shown in ‘ Appendix 1’, created rising fuel costs and uncertainty over future profit levels. Several airlines in the UK and global aviation industry brought in flexible fuel surcharges for passengers and cargo planes. The tacit collusion case of Virgin and BA showed that throughcommunication, and agreeing to certain price rises at a given date, the negative impacts on production costs can be in part offset direct to the consumer. Through the formation of such an agreement, a ‘ prisoner’s dilemma’ game scenario is formed.
This game revolves around joint outcomes based on individual actions, and the payoffs which are created from this. The choice to co-operate in decision making proves to be more beneficial than the absence of any collusive behaviour, although there is always the threat of deviation to add even more uncertainty to the question. Carlton and Perloff (2003) describes how in such a game, both firms must consider each rival’s actions when making their own, and relate the combination of actions to determine best policy. Airline Market – Transatlantic flights | | | | Virgin Atlantic| | | | High surcharge| Low surcharge|
British| Higher surcharge| 25, 25| 15, 30| Airways| Lower surcharge| 30, 15| 10, 10| | | | | | | Profit from Cooperation = 25 + Profit from deviation= 30 + Note: ? D > ? C if r > 1 will prove that deviation from collusion unlikely This constructed game holds several assumptions which may be of use to explain the relative success of the collusive agreement. To begin with, it involves the firms meeting and setting prices more than once, in a repeated game, as fuel surcharges are relatively flexible prices which were changed to relate to the price of fuel, which was extremely volatile as shown in Appendix A.
Following on from this repeated game, it is also for an undefined period. As the price rises came very suddenly, it created an uncertain future with no foreseeable end. Carlton and Perloff (2003) agree with the theory that in a multi-period game, deviation becomes much more costly, and through signalling can lead to successful collusion to benefit both parties. Edgeworth (1897) touches upon capacity constraints which are relative here in the theoretical success of this collusion, when based around the residual demand faced by both firms when looking at its pricing strategy (Carlton and Perloff, 2003).
As the nature of the good is a seat on a plane, clearly capacity constraints are present in the form of the limited seating on aircraft, as well as the inability to in the short run increase output beyond full capacity. During the setting of price, clear communication will most likely result in a non-static equilibrium. As well as this, the symmetry in terms of the market and cost structures has played a part in creating a successful cartel. Each firm produces a relatively homogenous good in terms of economy, business or first class, with a limited amount of features it can differentiate itself from its competitors.
As well as this, using Figure 1, which will be discussed later on, demonstrates that the main costs to an airline are those which cannot be easily reduced or offset, most notably the cost of fuel and aircraft maintenance. Therefore both firms have near perfect knowledge of the cost structure and revenue through observing prices, and will aid in choosing a certain pricing strategy. What follows will be a detailed discussion of the specific market conditions which lead to the successful collusion between BA and Virgin.
The UK Transatlantic Flight market as a whole can be said to hold many key factors which have led to successful collusion. The first is due to the high levels of barriers to entry; the level of costs specific to new entrants in the market. Barriers to entry show that new entrants find it extremely difficult to raise the financial capital needed to establish themselves as long term competitors. The nature of these costs also plays a part, with a high amount resulting in ‘ sunk costs’ which are not transferable to any other industry such as an aeroplane and machinery specific to air travel.
Emphasis also has to be placed on barriers to entry which do not take a physical form, with the restricted capacity of many major airports and regulation within the aviation industry significantly limits the ability to expand operations. An airline company needs to purchase several assets in order to offer the product of a transatlantic flight to a HUB in the USA. The first begins with the licence to operate in an airport and the parking/docking bay such as Manchester or Gatwick. With limited capacity at many leading airports both in the UK and the USA, they become extremely costly.
With Heathrow being used as the main airport for comparison, due to the fact both BA and Virgin primarily operate there, Appendix B shows the extensive capacity constraints for all slots throughout each day. The purchase and maintenance of aircraft is clearly an essential fixed cost, and with strict litigation procedures meaning that there is little opportunity to save costs. The last main fixed cost is in the form of landing fees and en route charges, which each airline needs to pay. Figure 1 (British Airways, 2010)
Figure 1 attempts to demonstrate these barriers to entry, which prevents new firms from entering the market after the monopoly pricing of fuel surcharges sends a signal to potential competitors for the opportunity of supernormal profits. The largest growth in the cost structure for British Airways has been in the sections discussed which pose the biggest barriers to entry; fuel and oil costs at 44. 5%, landing fees at 14. 2% and engineering and other aircraft costs at 13. 1%, placing ever more emphasis on the difficulty for new firms to compete in this market (British Airways, 2010).
Another key factor which contributed to the successful collusion was the weak buyer power in the demand for air travel, and in this specific case for transatlantic flights. The nature of the good is long distance travel, both for leisure and business with no other direct substitute in terms of time and comfort of travel. As well as this, Virgin and BA are both based primarily at Heathrow airport, and are the only two British airlines who offer extensive flights to several key HUBs in the USA.
Along with three U. S airlines they make up the total flights offered to the USA from the busiest airport in the world in terms of international passengers (ACI, 2011). The two combined impact upon the price elasticity of demand, a key concept which may help illustrate why the collusion was a success. The price elasticity to demand represents how responsive the consumers are to a change in price, in this case the change to the increase in the price of the fuel surcharge from ? 5 to ? 0 between the period August 2004 – January 2006 (OFT, 2007). The nature of the good is relatively price inelastic as no low cost airline or competitor can offer the same flight schedule to the important airports in the US, such as New York (JFK). Going hand in hand, this type of travel cannot simply be postponed or chosen differently, especially for business people who have little power over the price they will pay but quite significantly have less financial constraints than those travelling for leisure.
There have been many cases of tacit collusion which have been broken down within the UK, through the act of the Competition Commission (CC) and the OFT investigating what it deems could be found to be collusive, illegal behaviour. The case of BA and Virgin is a unique one as to how it was broken down. The agreement ended directly through Virgin Atlantic Airways admitting to the collusive behaviour directly to the Office of Fair Trade. There may be both relevant theoretical and practical explanations as to why Virgin deviated from co-operation, which will be outlined briefly.
Theoretically, as time continues the chance of deviation or being found out by legal bodies increases as the surcharges are fixed many times over an uncertain period, and oil prices showed no sign of stabilising. With no foreseeable end to the game leaving both firms with an area of uncertainty, and the threat of punishment playing an ever more important role, certain strategies in the game may have been altered. However, practically it may prove to offer a more credible reason as to why Virgin ended the collusive agreement by going to the relevant authorities.
With the fine by the OFT standing at ? 121. 5 million, and the Department of Justice fining BA ? 148 million as the case was co-ordinated between both countries, the cost of colluding was severe (OFT, 2007 BBC, 2007). As well as this, the timeline constructed in Appendix C highlights the previous hostile relationship of the two parties. Even though Virgin cannot compete financially or in number of flights/routes, a fierce rivalry and competitive relationship has always existed with Virgin Atlantic being the only British non-flag carrier to survive the transatlantic flight market.
This collusive agreement then goes exactly to the contrary of what has just been set out, so it may lead to one believing Virgin set out with this goal from the start, or once it became clear a court case would mean the parties involved would financially suffer, Virgin used the immunity clause to allow the collusion became public knowledge. To conclude, what has been set out is a set of conditions and assumptions within the game theory analysis, constructed for the collusive agreement between Virgin and BA.
It aided in discussing the collusion itself, and the nature of which resulted in its success. Following on, the most significant market structural conditions were discussed relating to how they facilitated the successful collusion between the two parties. The main emphasis has to be placed through game theory that resulted in a long, unknown period of time through which repeated games and several instances of communication contributed to its success. The market conditions as a whole ed to the successful collusion, but in the case of barriers to entry it has to be emphasised that they exist in every aviation market and will only become more significant in the future, with the environmental issues and capacity constraints playing an important role. The weak buyer power of consumers contributed hugely, to not only the surcharge actually being introduced, but following on to at least 6 occasions of joint price increases. The amount BA was fined is a clear signal to all other firms that collusive behaviour will be punished severely, and therefore promotes its own punishment strategy.
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