Stephen Batholomeusz at Locked-BS has an interesting take on Qantas versus Virgin today:
Virgin Australia’s $118 million first half pre-tax loss closes the worst calendar for the domestic aviation industry’s profitability in more than two decades. There is no guarantee that 2014 won’t be worse.
With Virgin’s John Borghetti being cagey about his plans for capacity growth this year, there is no signal as to whether the destructive trend of capacity growth out-stripping demand growth — the factor that decimated domestic profits in the December half — will be reversed in the near term. Qantas said yesterday it expected its domestic capacity to rise by three or four per cent.
There is a lot of finger pointing and conflicting data being presented as to who’s to blame for the capacity increases. Borghetti points to Qantas’ capacity growth last financial year to argue that Qantas has added three times his capacity, while Qantas uses data over two years to show that Virgin has added more capacity, in absolute terms, over that period. However, the bottom line is that between them, they have turned a profitable duopoly into a loss-making sector.
This is really odd commercial behaviour. Duopoly businesses are a classic example of a Nash Equilibrium. In game theory, if two players know what each other know then there is no benefit in either changing his strategy because the other immediately counters. If the only product differentiation is price – and it is in airlines – then that leads inevitably to losses as the two simply outbid one another below marginal cost.
A lot of flack has been thrown at Alan Joyce for defending his market share at the cost of profits. But is it he that’s irrational for doing so or is it Virgin that’s breaking the equilibrium?
As the smaller player, Virgin might appear to have an incentive to chase market share. But, given its competitor is partly government controlled and packing some pretty heavy moral hazard baggage, it is surely even more likely to respond in the way that the Nash equilibrium describes, countering every move despite the hit to profits. Why then would Virgin chase market share below marginal cost and at the expense of its own profits? It should be seeking product differentiation instead.
The only way it makes any sense is if Virgin is not a commercial entity. If the parent firms have calculated that they are better off seeing the value of the subsidiary plunge because of a larger offset in the greater traffic that that channels to themselves in international routes then they might be condidered rational. But there is nothing locking domestic passengers into that kind of choice and the international routes will still have to compete with Qantas.
I’m not at all sure that it isn’t Virgin that is acting irrationally, as Alan Joyce has pointed out. They would probably counter that they’re here to compete, and fair enough too, were this a real market, but in a duopoly, at what price? Is there something personal here between Joyce and his former protege, John Borghetti?
