Suppose the airline industry consists of two firms, A and B. These two firms engage in Cournot competition with each other over a certain route for which inverse demand is P(Q) = 1000 − Q with Q = qA + qB. The main component of each airline’s marginal cost is fuel which is assumed to cost 400 per flight (regardless of the number of passengers).
(a) Solve for the Cournot equilibrium price. Suppose the airlines figure out a way to collude with each other and still have the same fuel cost of 400 per flight.
(b) Solve for the market price when the two firms collude Suppose for whatever reason the world price of oil falls (as it has), and fuel costs for the airlines fall with it so that their marginal cost is now 100 per flight.
(c) Solve for the new Cournot equilibrium price assuming the firms are not colluding.
(d) Solve for the new market price assuming the firms are colluding
As of July 1, 2015, the Department of Justice has begun investigating the major U.S. carriers for collusion because they have noted that fuel costs have fallen recently, yet airfares have not.
(e) In the example I have given, what do you note about how fares change when costs fall? As an economist for the Department of Justice, does the direction of the change in fares in response to a change in marginal costs provide any evidence of whether or not the airlines are colluding?
(f) In a single line, give one possible reason for why the fares charged by the airlines may not have changed despite their costs falling.