The Illusion of Perfect Markets

As any regular follower of my blog will know, I love Economics, and feel that an understanding of the subject can help business owners make better decisions. The Macro environment is very important in considering even what appear to be small business decisions.

However, a tweet (you can follow me on @permjotvalia) I read suggested that the very difficult pricing model of airlines could be solved by more competition. I disagreed with that and would hope to use this blog to demonstrate how in many cases, more competition can leave consumers worse off.

If anything, airlines are one of the best examples of learning from economic principles. They are great at explaining the issue of marginal revenue. (Even if ALL costs are not covered, it is always worth doing something providing marginal cost + $1 is earned). So even if a flight is making a loss, it is worth flying providing the costs of actually flying (petrol, food etc) are covered. That is because the fixed costs are going to be huge; that is wages (fixed), landing fees (fixed) and aircraft costs (fixed).

Travel is also one of the few markets that allows producers to practice perfect price discrimination. They are able to price each seat differently depending on how much the traveller needs that ticket. So if you buy a ticket for tomorrow that will be more expensive than in a months time. Just before Christmas will be more expensive than January. And my pet hate, if you do not stay over on a Saturday night, the return flight can be very expensive (as they can use this to discriminate between business travellers and leisure travellers).

But the airline industry is also very odd in that it is very heavy regulated. You would have to get rid of some these regulations to ensure that there could be more competition. One of the reasons Ryanair prefers pilots to hold Irish licences rather than UK ones is that they can fly an extra couple of hours a week because of that. How would we as consumers feel if the UK upped the limit from around 32 hours a week to say 60? It may lead to lower prices but is that what we would want.

And what about the fixed landing slots regime. In a truly competitive market each and every slot could be up for negotiation. If it got to the stage where all the fixed costs were made flexible, flights could literally decide 24 hours before they were due to take off if it was worth making the flight or not. Although its opaque pricing structure is very annoying, it is also the best guarantee we have that these flights will indeed take place.
So, more competition and flexibility is not always the answer.

Another great example is Premier League Football. Until recently, Sky had a monopoly on live matches. Because of EU intervention, other operators have had to have matches offered to them. This sounds great, but the consumer is a lot worse off as they now have to subscribe to multiple pay for view TV operators.

25
Aug 2011
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POSTED IN Economics General Commentary
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  • http://twitter.com/chrispadfield Chris Padfield

    A few thoughts on this. My original question was to ask whether there is something unique about the “travel industry” that lead to opaque pricing.

    I don't agree on the anaylsis here regarding competition. If the airline industry was trully competitive (as in the perfect competition economic model); airlines would not be able to price discrminate because they would only be able to charge marginal cost. The moment any airline tried to charge more money they would loose their custom to another airline. Of course airlines could never exist in such a model because of the extremley high capital costs (and thus an average cost significantly higher than the marginal cost so pricing at MC would mean the airline would go bust) and because airports are local natural monopoloies. There is therfore an open question as too how much competition is good for the airline industry – something the regulators continually grapple with (most recently in the BA/Iberia merger and BA/American alliance).

    The thing is it's not just airlines that have opaque pricing models – but hotels as well. Hotels exist in a much more competitive market because they cost a lot less to build and there are no local monopolies. There is also a much more elastic supply curve. So clearly compeition here is not helping making pricing more transparent – it's just as hard to work out if you are getting a fair price on a hotel as it is for a flight.

    I think it's more likely there is something unique about the psychology of travel purchasing that is different to say the way people shop for a fridge that leads to travel companies having opaque pricing models.

    —

    Also have to diagree on the point of sky tv. The trully competitive situation here (a perfect competitive market) would be for say 30 companies to have 1 match for each team of the season. These companies would not be able to sell these packages to consumers for very much money at all because they would not provide much value to any footbal fan; so the cost would be very low; and the aggregate cost of purchasing all 30 subscriptions would be a lot less than the cost of Sky TV because the moment any seller put their prices up to anything beyond a trivial amount the fan would just miss one match or watch it in the pub.

    Sky are able to extract a higher value beccause they force an “all or nothing” supply so get closer to extracting the full value that the aggergate of consumers put on tv (i.e. they are not pricing a P=MC). This is obviously great for Sky but the other major benefactor are the footplayers and the clubs themselves.

    The situation where Sentanta had a few matches was not a good example of competition. Sky still controlled the majority of matches so did not need to change their prices – so the Sentanta matces just became an additional cost. If the packages of matches where split into 5 or 10 packages the situation would be very different and the total cost to subscribe to them all would be less than the current pricing from a monopoly supplier.

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