Question

You’re working for the DOJ as an economist in the Economic Analysis Group (EAG) group. You’ve been asked by Nancy Rose, the chief economist at the DOJ and airline-industry expert, to review the American Airlines – US Airways merger. Given the recent consolidation in the airline industry prior to this proposed merger, she along with other regulators are very concerned about the approval of further mergers.

1. American and US Air have claimed that there will be substantial variable costs savings when they merge (as is often the case with proposed mergers).   Suppose in a representative market, there are 4 firms: American, US Air, Southwest, and Delta. Further, suppose that demand is of a constant elasticity form, Q=p^-E.
   1. What is a reasonable value for E based on academic or government research?
   2. Suppose further that the marginal costs for American, US Air and Delta equal $5, and marginal costs for Southwest equal $4, while fixed costs are zero. Take your value you suggest for E above, and calculate the Cournot equilibrium before any merger takes place.   What are the equilibrium quantities and market price?
   3. Suppose the proposed merger is permitted, what happens to equilibrium quantities and the market price? Does this seem like a reasonable prediction? Why or why not?
   4. What would costs need to fall to for the merged entity to do no harm to consumers?

Given your modeling efforts, what would you recommend regarding the unconditional approval of the merger? Are there conditions under which you would let the firms merge? Think big in terms of requests to both airlines and airports that would make you comfortable with the merger being ap

Answer 1

Answer (i): Equilibrium in the airline industry haven had been a matter of contention for quite some time now. The airline companies usually enter in to the market with huge capital at hand, but in the gradual phase, due to high pressure to meet the industry standards, the companies need to ensure a certain level of productivity. To meet the standards, these firms often end up being bankrupt or they wisely go for the merger with other larger airline companies. Merger of the company’s highly depend on the elasticity of the demand for the merger. As per many research done, it has been observed that the elasticity of merger demand in the airline market is approx. 2.2.

Answer (ii) : Cournot equilibrium postulates that in a market competition, the price of a firms product or output are often decided on the basis of the price fixed by their competitors. Therefore, If the marginal cost of American, Us Air and Delta airlines equals $5 and that of the Southwest airline equals $4,fixed cost being zero, then the Cournot equilibrium value will be:

       For American, Us Air and Delta airlines        :             

                              Q = P-E

                                  = $5 - $2.2

                                  = 2.8

       & For Southwest airline       :             

                              Q = P-E

                                  = $4 - $2.2

                                  = 1.8

Answer (iii) : If the merger takes place, then there is a huge shift in all the economic variables. After the merger takes place, the merged firm will now have more than the required amount of cash, and therefore will be in a position to incur a higher price rise. Intact the merged firm will now want to set the benchmarks, and therefore will set higher standards. Therefore, for the airline companies, the price will rise. Due to the rise in prices, the equilibrium quantity of the demanded will sharply decrease in the initial stage, but in the longer run, other airline companies will also cope up with the price change and the quantity demanded will become stagnant.

Answer (iv) : In order for the airline companies and for the merged company to not make any harm to the consumers, the cost should be below their revenue generated. It is impediment that the airlines merged firm will focus on higher revenue generation now and a larger share of profit. If the costs are lesser than the revenue, there should not be any harm caused to the consumers.

                             Survival of the fittest is the base of human evolution. A small airline company may lose to survive in the highly competitive airline market. However, a merged big firm has a greater chance of survival and more so for the consumers. From the consumers point of view, the more the number of airlines in the market, the greater is the competition among them, and thereby better for the consumer’s profit. Therefore, this merger should be allowed, owing to ensuring that all other airlines standard necessities and regulations are correctly met.