When should alliances and mergers be permitted? The case of applied game theory

1. When should alliances and mergers be permitted?The case of applied game theory Dr. Nicole Adler

2. Outline • present basic game theoretic framework for analyzing alliances & mergers • discuss small example • draw basic conclusions

3. assume that airlines want to merge e.g. Royal Jordanian joining Oneworld Alliance

4. Will the alliance or merger be beneficial and to whom? • Airlines want to increase/improve profitability and survivability • Passengers want cheap travel at a time most convenient to their needs • Governmental ministries ought to consider social welfare, namely producer and consumer surplus

5. The Model • Government sets rules of market • Airlines attempt to maximize profit • Travelers choose with whom to travel • Airport capacity constrains frequency

6. Assumptions of Model • Airlines maximise profits through: • choice of network (hubs) • choice of alliance partner • frequency • tariffs • Hubs: • 2 hub types: international gateways and regional hubs, all fully connected • International gateway is choice amongst existing hubs alone

7. Assumptions of Model • Airline cost structure; • (1) only variable, based on number of seats and distance traveled (Swan & Adler (2005)) • (2) costs are separable between (i,j) • The discrete choice model describes travelers behavior • McFadden, 2000 Nobel prize winner

8. Cost Function:DEPENDENT ON SEATS AND DISTANCE Short Haul: C = (GCD + 722) * (S +104) * $0.019 Long Haul: C = (GCD + 2200) * (S +211) * $0.0115

9. Market Share Model • Standard disutility function, based on airfares and number of connections Data a, A index and set of airlines δ weight on price variable Vtvalue of time in dollars Lija# legs from i to j with a res reservation value Decision Variables Pijaairfare fromi to j on a;

10. Steps of the Game 0) Know all airlines and their networks • Decide with whom to merge, if at all • Choose international gateways from current hubs • Set airfares • given other airlines’ networks and prices

11. Complete mergers Choose international gates Set airfares Some merge, some not Disaggregate airlines Solution Tree

12. Example • 4 airline game • 6 nodes / airports • each European airline has a single hub and 1 route overseas • each U.S. airline has 2 hubs (one regional and one international gateway) and 2 routes overseas • analyse a complementary alliance with an airline on the other continent

13. LHR CDG FRA ORD LAX EWR LHR 0 346 870 8781 11929 7463 CDG 118 0 610 9018 12155 7691 FRA 100 59 0 9625 12765 8300 ORD 69 30 29 0 3173 1349 LAX 93 43 31 148 0 4467 EWR 54 41 21 144 154 0 GCD demand Illustration: 6 Nodes, Great Circle Distance and Normalised Demand over FRA-LHR for 2001

14. 4-airline game

15. Solution to Base Run-contribution to fixed costs & profits in $000’s per day-

16. Fully merged game with 2 resulting airlines

17. Sub-game Equilibrium Solutions – merger question

18. What can we learn? • Unlikely that all airlines will merge into 2-airline equilibrium solution • Airlines enjoy strong incentives to merge/ally • Merger/Alliance affects international gateway choice • Differences in airfares, before and after mergers/alliances • Differences in ‘frequency’ before and after merger/alliances

19. Conclusions • Model evaluates whether it is worthwhile to merge and if so, with whom • Model solves how-to merger questions; namely how to mesh two networks through international gates • Model computes profitability of networks given competitors

20. Conclusions • Can answer questions such as: • Effect of merger on social welfare • Effect of merger on prices • Effect of merger on competition/concentration • But so can standard economic analyses such as Borenstein (1990) and Richard (2003) • These models can ALSO answer specific questions: • Which mergers will survive in equilibrium • Optimal network design (depending on viewpoint) • Complete effect of merger spatially, considering network-wide effects