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

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

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

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

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

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

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

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

Market Share Model Standard disutility function, based on airfares and number of connections Data a, Aindex and set of airlines δweight on price variable V t value of time in dollars L ija # legs from i to j with a resreservation value Decision Variables P ija airfare from i to j on a;

Steps of the Game 0)Know all airlines and their networks 1)Decide with whom to merge, if at all 2)Choose international gateways from current hubs 3)Set airfares given other airlines’ networks and prices

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

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

Illustration: 6 Nodes, Great Circle Distance and Normalised Demand over FRA-LHR for 2001 LHRCDGFRAORDLAXEWR LHR CDG FRA ORD LAX EWR demand GCDGCD

4-airline game

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

Fully merged game with 2 resulting airlines

Sub-game Equilibrium Solutions – merger question

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

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

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