The United Kingdom’s main airport, Heathrow, is proposing to, ‘increase charges for airlines to use the airport’, in order to fund ‘investment including the opening of the new Terminal 2 in 2014 and improved check-in and baggage facilities’. Heathrow believes that this investment will, in the long term, lead to an increase in revenue. Therefore, Heathrow is presuming that the airlines demand to use the airport is inelastic. This is most likely true because the airlines using Heathrow are well established and so they will suffer large costs if they move to another airport. In addition, Heathrow is one of the world’s busiest airports, therefore airlines will be very resistant to potentially suffering a decrease in revenue by moving to other airports, like Gatwick or Stansted.
Therefore, assuming that airlines continue to use Heathrow, they must decide whether they would be able to pass on the costs to consumers and therefore the possible effects the increased costs will have on their profitability. Most of the major routes to and from Heathrow are operated by a few large airlines. Virgin Atlantic and British Airways are particularly concerned about this ‘incredibly steep’ rise in costs that may ‘penalise
customers and airlines.’ It seems likely that
the airlines are operating in an oligopoly
market and may consider entering into an
informal collusive agreement to match ticket
prices as they act interdependently. If the
airlines did not agree informally on ticket
pricing, then, as a non-collusive oligopoly,
they would be resistant to increase the price of
the tickets and so instead they would have to
account for the extra cost and experience a
decrease in profit.
The kinked demand diagram shows that in a non-collusive oligopoly market demand when price increases is elastic, however, when price decreases demand is inelastic. This means that when a firm increases its price other firms will not follow. As a result increasing the price from P to P1 will create a large decrease in quantity demanded, from PBQ0 to P1AQ10. This is because consumers will use another airline instead of paying higher prices.
Therefore, oligopoly firms usually maintain their price at P. As shown in the non-collusive oligopoly diagram, even when there is an increase in marginal cost,
MC to MC1, the price and quantity remain the same.
In contrast, by deciding to make an informal
or tacit collusive agreement, firms come to act
like a monopolist. A monopolist is a single
firm who has complete market power. In such
an agreement, one dominant firm, such as Virgin Atlantic or British Airways, may emerge as the price leader and other firms will follow in their pricing.
By informally colluding successfully, the firms are able to retain their original profits and pass all costs onto the consumers. As shown in the collusive oligopoly diagram, firms naturally come to increase their price together, to P, where all costs are covered so that abnormal profit, PCAB, can still be made.
However, an increase in price, resulting from a collusive oligopoly, relies on the price elasticity of demand being inelastic, so that consumers continue to use the airlines at Heathrow, instead of going to other airports or using another form of transportation. It is likely that demand for tickets with airlines in Heathrow is inelastic because it is the largest airport in the UK, providing consumers with the best connections. In addition, consumers in the UK have few other alternative modes of international transportation, especially for those travelling on business, who are travelling out of necessity. Also business travellers are likely to have more inelastic demand because the company pays, rather than the individual. Therefore, airlines are likely to continue to be able to generate
healthy profits, even with an increase in costs.
Overall, Heathrow’s choice to increase the charges for airlines is particularly controversial, as its
success relies upon a number of factors which are difficult to forecast. This may be the reason for
previous ‘miscalculations [that] had resulted in Heathrow receiving around £650m less money over
the last five years.’ Heathrow also relies on the airlines maintaining enough demand to afford to
continue using the airport. Though the investment may greatly improve Heathrow’s future facilities,
current passengers will not benefit, meaning that the steep price increases may seem unjustifiable.
Additionally, if airlines together develop monopoly power then regulators may become concerned
with the lack of consumer choice. It is most likely that if Heathrow increases the price, airlines will
pass the costs on, so that consumers are most severely affected.
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