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
7
Continent (ii)
G2
R2
8
6
5
Continent (iii)
Continent (i)
9
10
4
1
G1
R3
3
R1
11
2
G3
3
12
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:
C = (GCD + 722) * (S +104) * $0.019
Long Haul:
C = (GCD + 2200) * (S +211) * $0.0115
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
Vt
value of time in
dollars
Lija
# legs from i to j
Decision Variables
Pija 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
Some
merge,
some not
Disaggregate
airlines
Choose
international
gates
Set
airfares
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
demand
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
G
C
D
4-airline game
Airline 1: ORD & LAX
Airline 2: EWR & ORD
CDG
LHR
Airline e: LHR
Airline f: FRA
FRA
EUROPE
USA
ORD
EWR
LAX
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