Airlines face the Prisoner's Dilemma

If companies collude with each other, how can they minimise the damage to themselves once they're caught out?

By: Dr Devendra Kodwani (Department for Accounting and Finance)

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Markets such as the airline industry, where there are a few large players, are known as oligopolies. In such markets, the limited number of players mean there’s an opportunity – and temptation – for firms to formally or informally agree to increase the prices of the services they provide, operating what is known as a cartel. Game theory can help us understand this behaviour, and the choices made.

The Prisoner’s Dilemma is a classic game devised in the late 1940s by John Nash (the subject of the movie A Beautiful Mind) to teach the conflict between group and individual rationality. Consider a crime drama where two partners are arrested. Both are being separately interrogated by a clever inspector who offers them this deal:

  • If one implicates the other, he may get parole while the other will get 20 years in jail
  • If neither implicates the other, both will get two years in jail
  • If both implicate each other, both will get ten years in jail

Given the consequences of the different choices, and to minimise their individual punishment, both partners choose to implicate the other and end up getting ten years in jail.

Prisoner’s Dilemma is applicable to many walks of life. Consider sports. Imagine a contest with two players. Each player’s in a dilemma about whether to take a performance-enhancing drug. Rationally, each player may think like this:

  • If I don’t take it and the other one takes it, this increases my chances of losing
  • If I take it and the other one doesn’t take it, this increases my chances of winning
  • If both of us take it, then at least I’m not disadvantaged

Thinking like this each player ends up taking the drug!

There's an incentive to any player in the game to blow the whistle

However, cartels aren’t a recent phenomenon. Adam Smith, the father of modern economics, warned of such possibilities over three hundred years ago in Wealth of Nations, when he wrote,

"people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices".

Fearing this, many countries have created regulators to curb anti-competitive behaviour. But would Smith have approved of regulatory interventions to prevent anti-competitive practices in a free market? The answer would appear to be no, as he went on to say,

"it is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice".

Now, let’s get back to the recent story about airlines. It is alleged that British Airways (BA) and Virgin conspired to increase the prices of passenger tickets, by making almost parallel increases in fuel surcharges over the last few years. Virgin reported this to the Office of Fair Trading (OFT), a government agency in charge of curbing anti-competitive practices.

Let’s look at this case from the perspective of game theory. The Enterprise Act 2000 provides that any party involved in cartels can become an informer to the OFT and cooperate with the investigating agency for possible ‘immunity from prosecution’. This provides an incentive to any player in the game to blow the whistle on another player.

Whether Virgin and BA cooperated and earned huge profits, or not, won’t be known until the full report of the ongoing enquiry is published. But, by becoming an informer before BA could do so, Virgin has increased its chances of going scot free by playing the game smartly. It appears it's one more smart move from Richard Branson and co!

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