India’s airlines are faced with a winter of discontent because, thanks to fare increases, passengers are deciding to take their holidays at home. Airlines increased fares now because a scant three months ago they were cutting them to the bone. In July and August full-service carriers cut fares to levels that were, absurdly, only a whisker more than the fares of low cost carriers (LCCs). So the average fare on the Delhi-Mumbai sector was Rs 5,800 to Rs 6,000 which was 30% lower than in the same month last year – and this at a time when the rupee had depreciated sharply.
This episode raises some interesting questions about how competition in capital-intensive industries should be regulated, especially in those that operate in markets where demand is highly elastic. The aviation industry has characteristics long studied by economists: a fixed number of firms produce a homogeneous product; they compete fiercely; their output decisions alter market prices; and they all seek to maximise profits.
Economic theory can tell regulators whether they should compete on price or quantity. Currently in the aviation industry, the quantities (the number of seats) being fixed in the short run (say, three months), the airlines compete on price. This leads to problems every now and then, which can be avoided if the right model of competition were to be adopted. There are three other models of competition – due to Augustin Cournot, Joseph Bertrand and Heinrich von Stackelberg, respectively – that merit serious scrutiny. In the first, firms compete on quantity. In the second, they set prices simultaneously. In the third, they follow the market leader but compete on quantity.
Although all three models have similar assumptions, they have very different implications for market regulation.
Read the full report here, Business Standard