Consider the pricing strategy of Delta Airlines for its Detroit-to-Philadelphia

Question

Consider the pricing strategy of Delta Airlines for its Detroit-to-Philadelphia route. Spirit is a potential competitor along this route. Spirit will make competitive profits on less-popular routes if it does not enter the market for this service. The normal form of this game is:

Delta

Price War                        Accommodate Entry

(low fares)                        (maintain high fares)

S = 0                                 S = 5

D = 0                                D = 10 Enter

Spirit

S = 2                                 S = 2 Stay Out

D = 20                              D = 25

(a). Is there a dominant strategy for either of these carriers? Is there a unique Nash equilibrium?

Now suppose that Delta adopts a preemptive strategy and buys several new aircraft to use exclusively for the Detroit-to-Philadelphia routes. Acquiring these planes is costly and results in an erosion of Delta’s profits when it charges high fares. When charging low fares, however, Delta can take advantage of declining average cost associated with the high fixed costs from the purchase of the new planes. At the lower fares, the combination of increased revenue and declining costs helps generate higher profits. This occurs because the demand for Delta’s Detroit-to-Philadelphia service is elastic at these lower prices. The payoff matrix that depicts the new situation is:

Delta

Price War                        Accommodate Entry

(low fares)                        (maintain high fares)

S = 0                                 S = 5

D = 7                                D = 5 Enter

Spirit

S = 2                                 S = 2 Stay Out

D = 25                              D = 15

(b). Is there a dominant strategy for either of these carriers? Is there a unique Nash equilibrium?

(c). Should Delta pursue the preemptive strategy?

Explanation / Answer

Spirit

Enter stay out

Price war (0,0) (20,2)

Delta Accomodates entry (10,5) (25,2)

a) No dominant strategy for Spirit . Dominant strategy for Delta is to accomodate entry.

Nash equilibrium will be Delta chooses accomodate entry and Spirit chooses to enter.

b)

   Spirit

Enter stay out

Price war (7,0) (25,2)

Delta Accomodates entry (5,5) (15,2)

Price war is the dominant strategy for Delta. There is no dominant strategy for Spirit.

In nash equilibrium, delta will play price war and spirit will choose to stay out.

b) Yes, by preemptive strategy delta earns more.

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