QUESTION 2 [40 points]

JetBlue and Delta are the only two major airlines with regularly scheduled service between New York and Nantucket. There are 900 potential passengers every week, each of whom is willing to pay up to $400 for a ticket. Since the two airlines provide an essentially identical (bad) service, customers simply prefer to buy from the cheaper one. (If they charge the same price, then they will split the market equally.)

Each airline can transport at most 1200 passengers each week. You can safely assume that each airline spends literal peanuts (i.e., zero) serving passengers; however, each passenger displaces air cargo that is worth $160 in profits to the carriers. Suppose that each airline takes a short-run perspective and only wants to maximize each week's profits, and that neither one would consider shutting down the route in the foreseeable future.

(a)[3 points] What is the appropriate economic model to study price competition in this market?

(b)[7 points] If you use Nash equilibrium to make a prediction, what price is each airline going to charge? Explain your reasoning.

(c)[4 points] Give two possible practical means by which the airlines could earn more than predicted in (b).

(d)[8 points] If construction-related traffic congestion at LaGuardia airport makes Delta's cargo business less attractive to shippers while JetBlue's JFK-based operations remain unaffected, how will your prediction in (b) change? Explain.

From now on, focus on the baseline setting where both airlines face the same tradeoff between passengers and cargo: each passenger displaces cargo worth $160 in profits. However, suppose that the market size has doubled and there are now 1800 potential customers, but each airline's capacity of 1200 passengers remains unchanged. As a result, neither Delta nor JetBlue can serve the whole market alone.

(e)[5 points] Is it a Nash equilibrium for each airline to charge a price of $160 per passenger? Justify your answer.

(f)[5 points] Is it a Nash equilibrium for each airline to charge a price of $400 per passenger? Justify your answer.

Another carrier, American Airlines, also begins serving the New York to Nantucket route. Because their fleet has suffered from the grounding of the 737MAX, it can only carry 800 passengers on this route each week. Of course, as we established in class, domestic air carriers in the US are all equally bad, so passengers still prefer to buy the cheapest ticket possible (splitting the market equally between any airlines charging the same price), and American's cargo business is no more or less profitable than Delta's or JetBlue's.

(g)[8 points] What is the Nash equilibrium of the pricing game among these airlines. Explain.