Question
“Predicting Price-Setting Strategies” Please respond to the following:
- Determine the importance of predicting the pricing strategies of rival firms in an industry characterized by mutual interdependence. Examine the common price setting strategies of airlines that use game theory. Predict the potential effects of such pricing strategies on the demand for seats, and conclude the resulting impact on the profitability of the airlines.
Sample paper
Predicting Price-Setting Strategies
Firms in an industry characterized by mutual interdependence should make efforts to predict the pricing strategies of rival firms. Mutual interdependence occurs when the actions of a particular firm has significant impacts on other firms within the industry (Tucker, 2010). Mutual interdependence is a characteristic of firms in the oligopolistic market structures. Oligopoly market structures occur where there are a few large firms dominating the market. If one firm takes a particular action such as increasing the sale of its products (through price reduction), such action may have negative consequences on the operations of other firms, which may experience a drop in demand of their products (Tucker, 2010). Failure to predict the pricing strategies of rival firms may lead the consumers to shift to rival products since they may be cheaper or come with additional benefits.
Airlines that use game theory may apply certain price setting strategies. One of these strategies is to introduce baggage fees separate from the ticket price. Airlines often face a challenging operating environment due to frequent fluctuation in fuel costs. When operational costs increase due to high fuel costs, an airline may see it necessary to hike prices. However, such a decision could lead to passengers opting for rival airlines. In 2010, American Airlines applied game theory in price setting to overcome the dilemma (Alam, Bodda, Pai, & Sandhu, 2010). The airline introduced baggage fee as separate from the ticket price. This way, the ticket price remained the same but customers having baggage would have to pay an additional $15. To prevent customers from cancelling their tickets, the airline also introduced a $100 fine for cancellation (Alam, Bodda, Pai, & Sandhu, 2010). As such, the best decision for the customer is always to pay the baggage fee since cancellation is more expensive.
Southwest Airlines chose a different strategy by introducing a bags-fly-free policy. Southwest Airlines is the only airline that opted for a different strategy, mainly because it was still making profits (Alam, Bodda, Pai, & Sandhu, 2010). Charging baggage fee is the dominant strategy in the industry since it helps the airline earn higher revenues. The equilibrium position is where all airlines charge baggage fees. In this case, passengers would not have any other alternatives. Southwest Airlines opted for a point that is not at equilibrium in setting its prices. The airline opted for a bags-fly-free policy since it was still profitable. The aim was to attract a larger number of passengers from airlines charging baggage fees. The non-equilibrium position is the best for Southwest Airlines.
The pricing strategies have significant effects on the demand for seats. In the case of American Airlines, the pricing strategy holds the potential to improve the demand for seats. By failing to reveal the baggage fees in the ticket price, the customers have no choice but to pay since other alternatives are costly. This will increase profitability since the airline is able to charge higher prices with no significant impact on demand. This is more so if other airlines adopt the same pricing strategy. The pricing strategy for Southwest Airlines is also likely to increase demand in the short run. However, this may not increase the profitability in the long-run. This is because at some point, the number of new customers attracted by lack of baggage fees may decline. Southwest Airlines will thus need to charge baggage fees in the future.
References
Alam, N., Bodda, G., Pai, G., & Sandhu, P. (2010). Airline baggage fees: a game theory perspective. Haas School of Business.
Tucker, I. B. (2010). Microeconomics for today. Mason, OH: South-Western Cengage Learning.
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Long-Term Investment Decisions-Managerial Economics And Globalization
