Slide 1

Capacity Planning and Pricing Against a Low-Cost Competitor

Appendix 13A

• Piedmont Airlines and People Express present a case study of the reaction to entry of a low-cost firm.

• Deregulation in 1979 permitted new entry

• People Express was the first to enter the highly competitive airline industry.

• Choice of 30-seat or 120-seat planes.

2005 South-Western Publishing

Slide 2

Airline Strategy• People Express tried a strategy of a uniform low-price in the

mid-Atlantic states in 1981.

• They cut costs by adding seats and eliminating all 'frills'. Low cost flying would compete with driving.

• People Express could enter with large or small scale planes

• Should they use large scale or small scale, measured number of seats per planes?

• Their decision would be based on what People Express thought would be the reaction of rival firms, particularly Piedmont Airline.

Slide 3

Choices as a Decision Tree• Piedmont Airline could make would be either match the low price of People Express, or to accommodate them, keeping only the customers who like the 'frills' of full service.

• This strategy game can be written as a decision tree.

• The best final outcome (or subgame) being if People Express entered at large scale and Piedmont accommodated.

Slide 4

Game Tree – A First LookLook at an expansion of the game, where the payoffs are given first for the People Express and second for Piedmont {People Express, Piedmont} per flight..

Choice of Piedmont is: Profit per flight{$4,236, $969} accommodate

SMALL JET or to match price {$4,765, $969}

People Express decision accommodate {$8,225, $3,877}

BIG JET or to match price {$5,368, $2,068}

With this diagram, the end game for People Express is best whenthey enter with a big jet, whether or not Piedmont accommodateswith a profit of $5,368 to $8,225 per flight.

Figure 13A.1

Slide 5

Game Tree – With Random Rationing

When Piedmont matched prices for some flights, the incumbent firm tends to keep its customers. This changed the payoffs to the following ones.

Choice of Piedmont is: Profit per flight{$6,979, $1,061} accommodate SMALL JET or to match price {$6,330, $0}

People Express decision accommodate {$3,178. $4,244}

BIG JET or to match price {$6,330, $0}

With this new diagram, the end game for People Express is best whenthey enter with a small jet, whether or not Piedmont accommodates.Unfortunately for People Express, they didn’t see the random discountingstrategy that Piedmont actually took.

Figure 13A.2

Slide 6

Large Scale Entry Deterrence of a Low-Cost Competitor

• As Piedmont was faced with more routes likely to compete with People Express, their decision tree became more complex.

• People Express entered with large scale (120 seat planes). Piedmont matched their low price for some of their flights. But Piedmont, as the incumbent firm, tended to get most of the travelers to select Piedmont.

• People Express did not see that passengers would tend to select the known firm, Piemont, when their prices were identical.

• A price war ensued, and ultimately People Express lost too much money to continue operations.