Question

United Airlines and Continental Airlines announced a \(\$ 3\) billion merger to create the world's biggest airline. The new airline will be able to better compete with low-cost domestic and foreign airlines. Travelers could face higher fares, although the merged airline has no such plans. But one rationale for any merger is to cut capacity. Source: The New York Times, June 7, 2010 a. Explain how this airline merger might (i) increase air travel prices or (ii) lower air travel production costs. b. Explain how cost savings arising from a cut in capacity might be passed on to travelers or boost producers' profits. Which might happen from this airline merger and why?

Short answer

(i) Prices might increase due to reduced competition. (ii) Production costs could decrease due to operational efficiencies. Savings could go to consumers or boost profits, depending on market strategy.

Step-by-step solution

Title - Understanding Mergers

When two companies merge, they often do so to gain a larger market share, reduce competition, and achieve economies of scale. This means the merged company can operate more efficiently and potentially reduce costs.

Title - Impact on Air Travel Prices

(i) Increase in air travel prices: With the merger, the combined airline may have more control over the market, reducing competition. This increased market power could lead to higher prices for consumers as the company might have less pressure to keep fares low.

Title - Impact on Production Costs

(ii) Lower air travel production costs: The merger could lead to operational efficiencies such as optimized routes, reduced overlapping services, and better utilization of resources like planes and staff. These improvements can lower the overall production costs for the company.

Title - Cost Savings from Capacity Cuts

Cutting capacity means reducing the number of available seats or flights. This can lead to cost savings by requiring fewer planes, less fuel, and lower maintenance costs. These savings can either be passed on to consumers in the form of lower prices or retained by the company to boost profits.

Title - Examining Cost Savings Distribution

Cost savings might be passed on to travelers if the airline chooses to lower prices to attract more customers or remain competitive with other airlines. However, the merged airline might also choose to keep the savings as profits, especially if they have significant market share and lack significant competition.

Title - Likely Outcome of the Merger

Given the merger aims to create the world's biggest airline, it's likely they will have substantial market power. Therefore, it's plausible the airline will retain a portion of the cost savings as profit but might also pass some savings to the consumers to maintain goodwill and market presence.

Key concepts

market share

When United Airlines and Continental Airlines merge, their combined market presence increases significantly. Market share refers to the percentage of an industry's sales that a particular company controls. By merging, they create a larger entity that captures a bigger slice of the aviation market.

This increase in market share means:

• Less competition: With fewer competitors, the merged airline can influence market dynamics more effectively.
• Pricing power: A larger airline can set fares with less pressure to match or undercut smaller competitors.
• Geographic reach: The new entity can serve more destinations and optimize their network.

In summary, a larger market share enables the merged airline to dominate in terms of reach, resources, and influence, potentially leading to higher fares due to reduced competition.

economies of scale

Economies of scale occur when a company reduces per-unit costs as it increases production. The merger of United Airlines and Continental Airlines helps achieve this efficiency.

Here's how they benefit:

• Bulk purchasing: The merged airline can buy fuel and other supplies in larger quantities, securing discounts.
• Streamlined operations: Combining maintenance facilities, staff, and administrative functions reduces redundancy.
• Better asset utilization: Aircraft and crews can be deployed more efficiently across a more extensive network.

By maximizing resources and minimizing waste, economies of scale enable the merged airline to lower overall costs.

operational efficiencies

Operational efficiencies mean improving processes to save time, resources, and money. This merger provides several ways to optimize operations.

Examples include:

• Route optimization: Eliminating overlapping routes can save fuel and reduce flight times.
• Resource sharing: Shared maintenance facilities and crew pools streamline operations.
• Technology integration: Using the best systems from each airline can improve customer service and operational management.

These efficiencies help the airline run more smoothly, cut costs, and offer better service to customers.

cost savings

Cost savings result from reducing expenses without compromising on quality or service. The merger aims to cut costs through various strategies.

Some initiatives include:

• Reducing fleet size: Fewer planes save on maintenance, fuel, and crew costs.
• Consolidating administrative functions: One headquarters instead of two reduces overhead.
• Improving fuel efficiency: More direct routes and newer, more efficient jets cut down fuel consumption.

These cost savings can either result in lower fares for consumers or higher profits for the airline.

market power

Market power refers to a company's ability to influence market conditions, like prices and supply. The merger of United Airlines and Continental Airlines consolidates market power.

Consequences of increased market power include:

• Price-setting capability: With less competition, the merged airline can set prices more freely.
• Barriers to entry: Higher influence makes it difficult for new airlines to compete.
• Customer loyalty: A more extensive network and frequent flyer benefits can retain more passengers.

While this power can lead to higher prices, it can also improve service levels and network reach.