Maritime
Competition under U.S. Cabotage Laws:
Regulated
Bilateral Monopoly
Gary
A. Lombardo
United States Merchant Marine
Academy
Robert F. Mulligan
Western Carolina University
Abstract
This paper
examines maritime conglomerates interacting as a regulated bilateral
monopoly. The strategic management
literature on entrepreneurial innovation is reviewed. The microeconomic theory governing two
competing firms in a market closed to entry of additional competitors is
developed and used to analyze competitors operating under the U.S. Cabotage
Laws. Competing firms jockey for
advantage, and attempt to manoeuvre their competitive partners into
disadvantageous positions. The
prisoners' dilemma framework is applied to analyze the firm’s strategic behaviour
and suggest that cooperative behaviour dominates competition under certain
circumstances.
Keywords:
Cabotage laws, regulated bilateral monopoly,
prisoner's dilemma, innovation, competitive advantage.
INTRODUCTION
Overseas liner shipping embodies a high fixed cost structure and
extensive government regulation as well as asymmetric and, at times, seasonal demand. Companies in this industry respond
strategically in terms of shipping capacity and price decisions. Strategic responses may be either to hold
shipping capacity constant and vary price, hold price constant and vary
shipping capacity, or vary both shipping capacity and price. One rival becomes the initiator, acting first
on its understanding of current and unfolding market conditions. Other rivals respond both to the initiator
and to their own understanding of market conditions. Initiating strategic change may result in
unanticipated outcomes. The rivals'
concerns that they may be disadvantaged as a result of strategic manoeuvring
are at the core of conference agreements, consortia, alliances, and cabotage
laws.
This research applies a microeconomic framework to investigate liner
shipping competition and the core strategic issues of capacity and pricing
within the context of protected competition under the cabotage laws. Maritime conglomerates, like most business
firms, attempt to maximize profit rather than revenue. Thus, two issues assume paramount
importance. One, pricing to generate
revenue results from the tension between sales volume and sales profitability. Two, capacity utilization must be continually
fine-tuned to provide the optimal balance between acquired resources and their
profitable utilization. Further, these
two issues are dynamic in nature, whereby the maritime enterprise strives to
reach the optimal equilibrium point, and then adjusts its entrepreneurial plans
in response to disequilibria created by changing market conditions and the
strategic behaviour of competitors. The
dynamic nature of competition and the rivals' strategic responses lead to the
conceptual adoption of a strategic group of two relatively evenly matched rivals. Rival behaviour is analysed by means of the
prisoner's dilemma paradigm to guide the strategic decisions on the part of
each firm with respect to shipping capacity and price decisions within the
context of a nation's cabotage laws.
Cabotage laws protect the domestic rivals from foreign competition, but
not from each other. Rivals must also
respond to any action initiated by the regulatory authority, which alters the
contours of the market environment.
The strategic implications of regulated bilateral monopoly are discussed
in terms of long-run and short-run incentives.
The initiating firm's strategic attempts to attain short-run advantage
may be counter to its rival's interests as well as the initiator's long-run
interests. This may discourage innovation
and foster a desire to establish a history of cooperative behaviour. If this is the case, government regulation may
be necessary to protect the nation's economic growth and social welfare. The research findings are then applied to the
case of two American-flagged competitors, CSX Lines and Matson, operating in
the protected trade routes between Hawaii and the U.S. West Coast from 1996 to 2001.
The remainder of the paper is organized as follows: a literature review is provided in
"Theoretical Foundations," covering strategic groups, entrepreneurial
innovation, and microeconomic theory; next the historic and behavioural
background of the two firms studied is presented in "Hawaii-U.S. West
Coast Trade;” followed by a discussion
of the various combinations of price and shipping capacity competition within
the framework of the prisoner’s dilemma paradigm is presented and implications
for strategic behaviour are discussed in "Classification of Competitive
Outcomes;" leading finally to the "Conclusion."
THEORETICAL FOUNDATIONS
Bergantino and Veenstra (2002) conducted research to examine liner
shipping competition in terms of network theory. Additional research conducted by Panayides and Cullinane (2002)
investigated competitive advantage and Fusillo (2003)
examined excess capacity and entry deterrence.
Song and Panayides (2002) researched
cooperative game theory and Brooks (2002) analyzed regulation in North America
from a Canadian perspective. This
previous research has been helpful in understanding liner shipping competition
with respect to pricing and shipping capacity.
This section surveys the relevant literature from three research
streams. The management literature on
competition within strategic groups contributes a basic framework in which firms'
strategic behaviours may be discussed.
The literature on innovation and entrepreneurial behaviour in business
firms provides a clarifying analysis highlighting several unusual factors
unique to the maritime industry.
Finally, the basic microeconomics of firm cost structure is reviewed and
applied to maritime conglomerates.
Strategic Group Competition
The strategic group literature can be dated from Hunt’s (1972) research
on the major home appliance industry.
Porter (1980) and Barney and Hoskisson (1990) argue that strategic group
mapping serves as an aid to conduct an industry structural and competitive
analysis. Peteraf and Shanely (1997)
assert that strategic group analysis should be used to investigate competition
of intra-industry firms. This strategic
group assessment is fundamental to understand the industry segment under
investigation. Greve (1998) and Gordon
and Milne (1999) report evidence to suggest that strategic groups are comprised
of organizations which are similar in terms of market position, products and
the use of production technologies.
Reger and Huff (1993) argue that firms within a strategic group pursue
similar strategies; which are different than the strategies of firms found in
the other strategic groups within the industry.
For the purposes of this research project, a strategic group is formed
within the liner shipping industry consisting of two relatively even matched
firms. The relevant strategic dimensions
of the firms in the strategic group under study are the shipping trade lanes
between the port of Honolulu, Hawaii and the ports of Long Beach/Los Angeles,
Oakland, and Seattle on the West Coast of the United States; the environmental
context (U.S. flagged vessels under the Cabotage Laws
(Jones Act)); and the ability to compete on pricing and shipping capacity. The size of the firms in terms of revenues,
although roughly similar, is not a relevant strategic dimension. Rivals have access to the strategic decisions
of each firm by virtue of the requirement that an individual firm’s pricing
becomes public information given the involvement of the U.S. Federal Maritime
Commission.
Each rival within the strategic group must generate its revenues from
the same customer base. Thus pricing
decisions are a critical strategic dimension crucial to each firm’s
success. Correspondingly, each firm is a
capital intensive enterprise that strives to balance its capacity with the
level of demand for its services. This
is accomplished by either adding or removing container vessels from its fleet
for the identified shipping trade lanes.
Each firm also faces asymmetrical cargo movements with the heavier
shipping load being transported to Hawaii resulting in an imbalance of an
increased number of empty container boxes at the Port of Honolulu than at the
West Coast ports. Certainly each rival
operates in an environment where the balance of power favours the shipper, or
buyer of the firm’s services.
Both CSX Lines and Matson are important subsidiaries of complex
corporations. CSX Lines’ parent is a
vertically integrated transportation company.
Matson’s parent is a diversified conglomerate headquartered in Honolulu with
a dedicated focus to serve the Hawaii trade.
Both organizations pursue a common strategy, that
of providing low-cost, integrated ocean transportation services within the
United States Cabotage Laws. As a
result, they compete on a fixed trade route protected from foreign
competition. They benefit from the high
entry barriers that must be overcome by potential domestic entrants who face
enormous capital costs to acquire vessels, and very high human capital costs to
employ individuals knowledgeable about the industry segment. Further, the entry barriers for potential
foreign entrants are virtually prohibitive as they would be required to develop
a United States subsidiary to conform to the Cabotage Laws. Conversely, CSX Lines and Matson face high
exit barriers due to their ownership of high capital assets, e.g., ocean
vessels and port equipment, which can neither be redeployed outside their
industry segment nor sold to recover capital expenditures. Their combined market share dwarfs that of
other competitors.
Entrepreneurial Innovation
A maritime enterprise focuses on a delimited field of competence, most
often by specializing in transport among particular destinations. This paper examines maritime firms competing
in a narrowly defined trade route between Hawaii and the U.S. West Coast. Maritime firms may also specialize in
handling certain kinds of cargo. Piore
and Sabel (1984) suggest market instability promotes competitiveness, and
provides an advantage to small or highly-adaptable firms which can react more
quickly in response to market volatility, high uncertainty, or rapid
technological change. Maritime enterprises
certainly operate in an unstable and highly competitive environment
characterized by low profit margins; however, the maritime industry has long
been dominated by very large firms.
Significant barriers to entry, including high initial costs of investment,
prevent small firms from competing successfully. Thus, the maritime firms which thrive best on
uncertainty are not smaller firms, but more adaptable, flexible, large firms. This feature of the maritime industry is a
significant departure from the established literature on entrepreneurial
innovation.
Coase (1937) identifies transaction costs as the
main reason the division of labour is organized in firms. Transaction costs are especially critical in
the highly capital-intensive maritime transport sector where firms have to live
with the consequences of investment decisions over the long run, merely because
the industry's capital equipment, chiefly ships and port infrastructure, are
both expensive and long-lived.
Researchers have identified the importance of small and medium-sized
firms in driving economic growth (Birch 1979, 1981, 1987; Davidsson et al
1994a, 1994b, 1996), as well as documenting negative relationships between firm
growth and firm size and/or firm age (Evans 1987a, 1987b; Dunne et al
1987). A related line of inquiry has
documented decreasing shares of production and employment by large, old,
well-established firms, being displaced by increasing shares to large numbers
of newer, smaller firms, since about 1970 (Brock and Evans 1986, 1989; Carlsson
1989, 1992; Loveman and Sengenberger 1991; Acs 1996a; OECD 1996). In the maritime industry, however, as
suggested earlier, the more relevant distinction is between more or less
adaptable large firms, than between large and small firms.
Small firms in most other industries act as agents of change (Acs 1992) and tend to be more innovative than large firms,
which often suffer from more bureaucratic organizational structures (Acs and Audretsch 1987a, 1987b, 1988, 1993). The level of bureaucratic inertia a firm
experiences generally increases with age and size (Hannan and Freeman
1984). Because firm age and firm size
are highly correlated, empirical examinations may have difficulty separating
these two as causal factors. The
established management literature on entrepreneurial innovation suggests that
most entrepreneurial firms should have leaner, less bureaucratic management.
Large, established firms, exploiting the comparative advantage that
comes from being large and established, generally deepen existing innovations
the firm may have pioneered (Almeida and Kogut 1997; Almeida 1999). Though large firms have comparative advantage
in extending existing innovations they originally pioneered, eventually
diminishing returns must set in. Johansson
(2001, p. 71) suggests large firms look for innovative processes, trying to
improve what they already do well, whereas small firms look for innovative
products, which are more important for long run growth (Acs et al 1999). In the maritime industry, some firms may tend
to innovate in terms of refining and extending processes in which they already
possess comparative advantage, while more entrepreneurial firms are increasingly
likely to offer innovative services and introduce cost-saving technologies.
As a firm grows or ages, it becomes increasingly difficult to alter the
competence base of its research functions, or of the firm as a whole. Leastadius (2000) suggests large, established
firms only embrace new technology that complements the organization's existing
competence base. New technology which
challenges the organization's competence base, or renders it obsolete, will
typically be resisted. Also, an
established firm may be more interested in protecting existing rents than
creating new profits (Geroski 1995, p. 431).
Small new firms will not have rents to protect. Small firms' less bureaucratic organizational
structure enables them to better exploit new knowledge and information,
compared with large firms (Link and Reese 1990; Link and Bozeman 1991). Since the maritime enterprises in the
research project are both large, they can be classified as innovative or
non-innovative based on how adaptable they prove in responding to changing
market conditions and technology. Large
firms can have different degrees of bureaucracy. A large, leanly organized maritime firm which
is receptive to entrepreneurial innovation automatically has an advantage in
exploiting new information and extracting competitive advantage, over a
similarly large but more bureaucratic organization which attempts to avoid the
challenges of innovation.
Empirical investigations find firm age and size have negative impacts on
firm growth rates, and conversely, firm youth and smallness have positive
impacts (Davidsson et al 1994a, 1994b, 1996; Liu 1999; Heshmati 2001; Johansson
2001). The microeconomic factor of high
firm turnover (firm entry combined with firm exit, which frees up resources for
better uses) has been found to contribute to macroeconomic growth (Davidsson et
al 1994a, 1994b, 1996; Kirchhoff 1994; Reynolds 1994, 1997, 1999; Griliches and
Regev 1995; Dunne et al 1998, 1999; Foster et al 1998; Callejón and Agustí
1999; Johansson 2001). Audretsch (1995)
concludes that gross firm entry and exit are more important for generating
labour employment than net firm entry.
Dynamic resource reallocation occurs primarily through firm entry and
exit (Eliasson 1991a, 1991b; Eliasson and Taymaz 2000; Johansson 2001, p.
119). The maritime transport industry is
characterized by high turnover as firms switch markets fairly frequently. In a highly competitive environment, such as
confronts the maritime shipping industry, learnable information and knowledge
are in rapid flux. Thus maritime
businesses face less incentive to acquire new information and knowledge which
obsolete rapidly and afford limited benefit.
Maritime firms thus tend to retreat into established activities,
lowering economic growth (Eliasson 1983, 1984, 1991b). Overall, the maritime industry is not
particularly innovative and exhibits typical behaviour of caretaking the status
quo. This may result from the industry's
being closely regulated and highly subsidized.
Since all maritime shipping firms are viewed as large, firm age becomes
a more relevant factor in distinguishing innovative from passive maritime
enterprises. In the maritime industry, a
new firm is likely organized specifically to exploit a specific market
opportunity. It would be small wonder if
such a firm could normally grow faster than more established firms which are
comparatively immunized against innovation.
In a sense all maritime firms are also established, though they often
migrate from market to market in search of better profit opportunities. The large accumulation of wealth needed to
create a shipping line presupposes a long-standing commitment to the industry,
but ships being mobile assets, they tend to flow into markets where they earn
the highest profits.
Empirical and theoretical studies of firm turnover include Orr (1974),
Du Rietz (1975), Baldwin and Gorecki (1989), Acs and
Audretsch (1989), and Johansson (2001).
Siegfried and Evans (1994) propose the stylized fact that entry
increases and exit decreases with firm profitability and growth of local
markets. However, Audretsch (1995b)
finds firm survival rates lower in highly-innovative markets than in
less-innovative ones, though surviving firms have higher growth rates, an
outcome also observed by Baldwin (1995).
Somewhat atypically, maritime shipping firms operate at relatively low
profit margins and face high competition, but rarely go bankrupt or enter the
market de novo. More often, a diversified multinational firm will
purchase a shipping component to enter the maritime industry, and sell the unit
to exit. Maritime firms, whether
components of larger corporations or not, exit and enter particular markets,
another uncommon feature of the maritime industry which the literature on
entrepreneurial innovation largely fails to address.
Microeconomic Theory
This section reviews the basic economic theory relevant to understanding
the competitive nature of maritime firm behaviour. Maritime firms maximize profit rather than
volume. It appears most widely
applicable to assume that firms face conventional u-shaped short-run marginal
cost functions determined by either fleet purchase and building decisions, or
alternatively, by fleet leasing decisions.
The size of the fleet a firm operates is fixed in the short run and
determines the volume of shipping at which marginal cost (cost per additional
TEU) will be minimized. Firms attempt to
match fleet size with expected demand to ensure they generally operate at or
near the minimum of their short-run marginal cost curve, but because future
demand is never perfectly known in advance, to a greater or lesser extent,
firms generally operate out of cost-minimizing equilibrium. Firms always desire and
plan for a certain level of excess capacity, affording the opportunity to
profit from unplanned (and usually temporary) increases in demand. Without excess capacity, firms forego profit
opportunities afforded by exceptional demand.
However, it is a well-known feature of maritime business planning that excess
capacity is kept very low due to low profit margins. When firm capacity greatly exceeds current
demand beyond the need for excess capacity, firms have to assess whether the
shortfall in demand is temporary or permanent.
In response to a demand shortfall that is expected to be permanent,
firms could either cancel or reduce planned shipbuilding or ship purchase
programmes, and lease out part of their current fleet to other firms. Because firms can lease their ships to other
firms, they generally have a revenue-generating alternative to maintaining
significant unused excess capacity. In
addition, because a firm can generally lease additional ships, the need for
excess capacity is minimized. Thus, for
simplicity, we assume zero excess capacity.
<<Figure 1 about here.>>
Figure 1 illustrates the cost structure of a typical maritime firm. A
similar approach is presented by Haralambides (2001) to describe pricing of
port services. Short-run marginal cost
curves are based on resource constraints which are binding in the short run but
not in the long run. Fleet size is one
example of such a constraint. In the
short run the firm is constrained by the size of its current fleet, but in the
long run it can adjust fleet size to any desired level, through sales, leases,
or building new ships.
Firms should always operate in the region of output where short-run
marginal cost is upward-sloping, represented by the dotted lines in the figure. In the long run, average cost may be
increasing, decreasing, or flat.
However, long-run average cost, even if it is decreasing, never does so
rapidly enough to offset the steeper increase in short-run marginal costs. Marginal cost necessarily rises faster in the
short run than in the long run because the distinction between long-run and
short-run costs is based on flexibility and reallocation of resources. Some resources are held fixed in the short
run, guaranteeing that short-run marginal costs rise faster than long-run
marginal costs, which result from fewer constraints. Constraints which may be binding in the short
run include fixed-term ship-leasing and labour contracts. Because these are periodically renegotiated,
they are always less binding over the long run.
The long-run average-cost curve is depicted as downward-sloping because
with significantly greater volume the firm can benefit from scale economies,
and because, over the long run technology improves lowering costs.
HAWAII-WEST COAST TRADE
Two maritime business competitors have been identified for the current
study: CSX Lines, a subsidiary of CSX
Corporation, and Matson, a subsidiary of Alexander & Baldwin. These two firms have a history of competing
in the Hawaii/U.S. West Coast trade routes regulated under the U.S. Cabotage
Laws.
CSX History1
CSX Lines
can be traced to its genesis, the announcement by CSX Corporation on April 21,
1986 to acquire Sea-Land approved by the U.S. Interstate Commerce Commission. CSX Lines (as
Sea-Land Service, Inc.) entered the Hawaii and Guam trades in 1987 with the
goal to provide the most reliable and cost-effective containerized ocean
shipping. CSX Lines offered eight linehaul vessels in the Hawaii/Guam service. The company offered multiple weekly sailings
from the U.S. Mainland to Honolulu, Hawaii with continuing regularly scheduled
barge service to the five Neighbour Islands.
During 1996, the U.S. domestic market experienced rate weakness and high
fuel costs, but the firm realized record results and market share increases in
each major trade lane. Fifteen vessels
were enrolled in a U.S. program for which $2.1 million a year for each
participating vessel was expected to be received. Projections called for improvement in the
container-shipping industry with further consolidations and U.S. government
deregulation while anticipating over-capacity to peak in 1997. However, excess capacity and significant rate
deterioration persisted through 1997.
Continued consolidation and increased government deregulation were
forecast.
A major reorganization took place at Sea-Land during March 16, 1999 as
the subsidiary was reformed into three business units; global container
shipping, international terminal operations, and domestic trade under the U.S.
Cabotage Law. A few months later, on
July 22, agreement was reached with A.P. Moller-Maersk Line to purchase the
international liner business of Sea-Land.
The transaction was completed on December 10, 1999.
<<Table 1 about here.>>
During the period 1996 to 2001, as viewed in Table 1, CSX Lines
performance deteriorated and contributed a declining share of operating income
to the CSX Corporation. This resulted in
a sizable loss by CSX Lines in 1999, which was only halted by the sale of the
international component of Sea-Land.
Notably, before the sale, CSX Lines' expenses accounted for
approximately 40-50% of CSX Corporation’s expenses compared to only
approximately a 35-40% contribution to revenues. After the sale CSX Lines' expenses accounted
for approximately 9% of CSX Corporation's revenues as opposed to approximately
8% of revenues.
Matson History2
Matson is a wholly-owned subsidiary
of Alexander & Baldwin, Inc. Matson
enjoys a longer history in the maritime sector than does CSX Lines. Matson's 1996-2000 financial performance is
given in Table 2. Matson traces its origins to 1882, when
Captain William Matson sailed his three-masted schooner Emma Claudina
from San Francisco to Hilo, Hawaii, carrying 300 tons of food, plantation
supplies, and general merchandise.
Matson has maintained its primary interest, as its fleet expanded, to
carry freight between the Pacific Coast and Hawaii.
Among
its many innovations and technological advancements, Matson launched its
freight containerization program, which revolutionized Pacific cargo carrying
during the mid to late 1950s. Matson, continually
striving for efficiency and customer service, expanded its fleet during the
1980s and early 1990s with container and ro-ro vessels. In February 1996, Matson and American
President Lines (APL) inaugurated a 10-year alliance agreement which allowed
both carriers to serve their respective markets in a cost-effective
manner. For Matson, this involved the
domestic trade of Guam and Micronesia and for APL, international ports in the
Far East.
<<Table 2 about here.>>
Matson is the parent company of Matson Intermodal
Systems, Inc. which was established in 1987. Matson Intermodal is
an intermodal marketing company that arranges North American rail and truck
transportation for shippers and carriers, frequently in conjunction with ocean
transportation. Matson Logistics
Solutions, Inc. was formed in 1998 to provide supply and
distribution services to Matson customers, including management of
transportation purchases, inventory and on-time deliveries. This subsidiary
also handles special projects, including moves for unusual cargo, construction
projects and film production units.
Another Matson subsidiary, Matson Terminals, Inc., established in 1921,
provides container stevedoring, terminal and equipment maintenance services for
Matson and other carriers in Honolulu.
Stevedoring Services of America Terminals (SSAT), which is partly owned
by Matson, manages the company's container stevedoring and terminal services in
the West Coast ports of Los Angeles, Oakland and Seattle. The remaining subsidiary, Matson Services
Company, Inc., established in 1969, provides harbour tugboat assistance for
vessels in Kahului, Maui and Hilo, Hawaii.
CLASSIFICATION OF
COMPETITIVE OUTCOMES
The Prisoner's Dilemma
Given the analysis of a strategic
group of two rivals, the prisoner’s dilemma conceptual paradigm can be used to
explain the firms’ strategic decision making with respect to pricing and
shipping capacity factors. Black (1990)
provides an insightful presentation of the prisoner’s dilemma paradigm. The prisoner’s dilemma is readily associated
with the decisions of two suspects who allegedly collaborated to commit a crime
and are being held in separate physical areas unable to communicate with each
other while being interrogated by the police.
Each suspect cannot rely on his collaborator’s assistance to have the
charges dropped. In the classical case,
a suspect’s options are to either to confess or remain silent. If one suspect confesses and his collaborator
does not, the confessor turns state’s evidence and aids in the conviction and
relatively long jail sentence of his collaborator. If both suspects confess they each receive a
relatively short jail sentence. If both
suspects do not confess they may receive a very light jail sentence for a
related offense or, possibly, no jail sentence at all.
In the context of two firms
competing within a strategic group, the prisoner’s dilemma takes on a strategic
competition orientation. Instead of
achieving the objective of limited or no jail time, the firms strive to
increase profitability. Overall consumer
demand for consumers' goods is relatively inelastic in any highly affluent
market where shipping costs are held to a very low percentage of the final
retail cost to the consumer. If overall
customer demand and individual firm expenses are constant, one firm’s increase
in prices will drive its customers to its competitor, resulting in the
competitor’s increased profitability – increased sales volume at constant
expenses. Alternatively, if both firms
raise their prices, and hold costs constant, their profit margins will
increase.
If one firm raises its shipping
capacity to meet increased industry sector demand, it will generate additional
revenues while the competitor, offering constant shipping capacity, must turn
away new business. However, if both
firms each increase shipping capacity to meet increased industry sector demand
the resultant overcapacity will be detrimental to their efforts to increase
profitability, as their cost structure will be higher.
Just as it is apparent that the two
suspects will need to present a united front to the interrogating police to
receive the maximum benefit, so also should the two rivals within the strategic
group act consistently to attain their strategic objectives. However, given the regulatory environment in
the United States and the specific requirements of the antitrust laws, the
rivals are not permitted to cooperate.
Thus, their strategic decisions related to price and shipping capacity
must be made in a self-interested way devoid of the rival’s cooperation. In effect, this research will use the
prisoner’s dilemma conceptual paradigm to frame the initiating decision on the
part of one rival, the responding decision on the part of the second rival, and
the resultant impact on both rivals.
Price Competition with Fixed Capacity
First we consider the case of price competition where capacity is held
fixed. For convenience the market
leader, the firm which initiates each round of change, is called firm A. Once firm A has chosen a strategy, firm B is
free to respond. We examine only
qualitative changes in price, assuming fixed capacity. There are a variety of reasons why capacity
might not change when price is changed.
It might be a conscious strategic decision on the part of the competing
firms. Regulatory authorities might in
the past have required firms to demonstrate increases in capacity to justify
past price increases. Regulators will
not look with favour on firms which later reduce capacity, if they permit such behaviour.
A firm can increase price, maintain price, or lower price, providing a 3
x 3 matrix of nine possible outcomes. We
assume negligible excess capacity and therefore little scope for customer
substitution between the two firms. We
assume total market demand is perfectly inelastic, that is, there is a certain
volume of goods which must be shipped, almost regardless of the price, and this
demand is not very sensitive to the magnitude of price changes. Because capacity is held fixed, there is no
scope for transfer of freight between firms.
Whenever one firm charges less than the other with fixed capacity, it
earns lower profits than its competitor.
Outcomes are summarized in Table 3.
<<Table 3 about here.>>
If A raises price, B may respond by raising, maintaining, or lowering
price. If B raises price in response,
neither firm loses or gains market share, and both
firms gain revenue and profits. Although
neither firm gains strategic advantage, both firms benefit. The only loser would be the customers. If B maintains price in response, A gains strategic advantage.
If B lowers price, A gains an even greater strategic advantage.
If A maintains price, B may respond by raising, maintaining, or lowering
price. If B raises price, B gains
strategic advantage because with the assumption of fixed capacity there is no
scope for transfer of freight from one carrier to the other thus the firm with
the higher price earns higher revenues without facing higher costs or the loss
of its customers. If B maintains price,
neither gain advantage. If B lowers
price, A gains strategic advantage.
If A lowers price, B may respond by raising, maintaining, or lowering
price. If B raises price it would gain
additional revenues while A is losing revenue due to its lower price; thus B
gains strategic advantage. If B maintains
price it would maintain revenue while A is losing revenue; thus B gains
strategic advantage. If
B lowers price, both firms lose
profits.
Competition in Shipping Capacity with Fixed Prices
Next we consider the case of capacity competition where price is held
fixed. Outcomes are presented in Table
4. If A
increases capacity, B may respond by raising, maintaining, or lowering
capacity. If B increases capacity, both
firms lose profits by raising costs.
Although both firms lower minimum SRAC by increasing capacity, thus
moving down the LRAC, they have both imposed the cost of carrying unused
capacity, because the total freight volume in the market is limited. If B maintains capacity, B gains strategic
advantage because its costs are unchanged, but A's rise with its expanded, unused
capacity. If B lowers capacity, this
forces a transfer of demand to A, which benefits from lowered unit costs and
increased freight carriage.
<<Table 4 about here.>>
If A maintains capacity and B increases capacity, A
gains strategic advantage. If B
maintains capacity, neither gains advantage.
If B lowers capacity, A gains strategic advantage, because though A's
profits are unchanged, B imposes higher unit costs on itself, as well as losing
revenue along with volume.
If A reduces capacity and B increases capacity, B gains strategic
advantage due to its increased customer contracts and lower unit costs. If B maintains capacity, B gains strategic
advantage. If B reduces capacity, both
firms lose profits.
Competition when Both Price and Quantity are Allowed
to Vary
Finally, we consider the general case where both competitors are free to
change both price and capacity. A firm
is defined as the preferred or low-price carrier whenever its shipping rates are
lower than those of its competitors.
This occurs whenever a firm lowers its rates if its partner maintains or
raises rates or whenever the competing firm raises rates and the first firm
maintains or lowers rates. Preferred
carriers always gain market share and shipping volume unless shipping capacity
constraints prevent the transfer of share and volume. Share and volume are always transferred to
preferred carriers when the preferred carrier increases capacity. However, a preferred carrier must increase
capacity to gain volume. A preferred
carrier will lose volume if it reduces capacity.
Even in the absence of one of the two competitive partners being the
low-cost or preferred shipper, any firm that increases capacity while its
partner decreases capacity must gain share at the expense of the partner. If a
firm increases capacity and its competitor increases capacity, the firm can
only gain share if it is the preferred or low-cost carrier, and that may result
in lower profits.
If a firm increases capacity and its competitor maintains capacity, it
increases share if and only if it is the preferred carrier. If neither firm is preferred, neither gains
share, but the firm which increases capacity, increases excess capacity,
incurring added costs, without gaining added revenue, thus losing profits, and
then the other firm gains strategic advantage.
If a firm increases capacity and its competitor decreases capacity, it
gains market share regardless of price changes.
When shipping volume shifts between firms because of capacity
constraints, we can say volume is supply constrained. When volume shifts due to price, we can say
volume is demand constrained.
If a firm maintains capacity, and its partner increases capacity, there
is no shift in demand or market share unless the partner becomes the preferred
carrier by lowering price or if the first firm raised price. If both firms maintain capacity, there is no
shift in demand or market share unless one firm is preferred, and then the
transfer is limited by the gaining firm's initial excess capacity. If a firm maintains capacity, and its partner
decreases capacity, demand and market share shift to the first firm regardless
of price changes.
The above considerations are formalized in the following four axioms of
competitive outcomes:
- Axiom
1 (diagonal symmetry): When two competitive partners make matching
decisions with regard to changing or maintaining price and quantity, both
must gain or lose profits together, and neither firm gains strategic
advantage.
- Axiom
2 (off-diagonal symmetry): The firm initiating a strategic decision with
regard to changing or maintaining price and quantity has no special
strategic advantage, thus the same combination of price and quantity
changes leads to the same strategic outcome, without regard to which firm
initiated the decision. As a result
the matrix of outcomes is symmetric about the principal diagonal.
- Axiom
3 (capacity constraint): A firm receives more shipping volume whenever it
increases capacity and its partner decreases capacity, or when it increases capacity and
is the preferred or low-cost carrier.
Conversely, a firm loses shipping volume if it lowers capacity, or
if its partner is the preferred carrier, and its partner increases
capacity.
- Axiom
4 (decreasing LRAC): Firms move to
new short run marginal cost curves whenever they increase shipping capacity,
with lower minima. (This assumes
constantly and perceptibly improving technology, though we also assume
that lowering capacity raises the minimum SRAC). Firms incur higher marginal costs
whenever they have to carry unused excess capacity, which occurs whenever
both firms increase capacity and the competitive partner is the preferred
or low-cost carrier.
<<Table 5 about here.>>
Based on the four axioms, we can determine strategic advantage according
to table 5, which can be thought of as a tree diagram. This schematic is constructed from the
perspective of firm A, but applies equally well to firm B. A gains strategic advantage, the final and
desired outcome, by accomplishing one of the following: increasing its own
profits, or decreasing B's profits. A
can increase its profits by increasing revenue, decreasing cost, or both. A can increase revenue by increasing price,
increasing volume carried, or both. A
can decrease cost only by increasing capacity, and this works only if the added
capacity is fully utilized. A gains
strategic advantage as long as B loses, so A gains advantage if B's profits
diminish. This occurs if B's revenue
falls, or if B's costs rise. B's revenue
falls if B lowers price, or if B loses shipping volume, or both. B's cost rise whenever B carries substantial
unused capacity, which can only occur when A draws volume from B.
<<Table 6 about here.>>
The outcomes arrived at are presented in Table 6, based on application
of the four axioms. Since each firm
chooses from among nine possible actions with regard to price and capacity, the
outcomes constitute a 9x9 matrix with 81 cells.
Seventeen outcomes and cells have already been determined as presented
in tables 3 and 4. One cell is common to
all three tables. In some cases both
firms increase profits, thus both gain absolute advantage, though neither gains
relative advantage. In other cases there
is a clear gainer of strategic advantage as one firm either receives higher
profits, or the other receives lower profits, or both. In several cases (footnote 3 in Tables 3 and
4, footnote 4 in Table 6) both firms clearly lose profits. There are also several instances where one
firm clearly gains strategic advantage over the other, in terms of imposing
higher costs or drawing volume and revenue from the competitor, though both
lose profits - a Pyrrhic victory.
Discussion
In each row of Table 6, there is at least one column in which firm B is
the unambiguous gainer of strategic advantage.
Thus firm A never receives a guaranteed strategic advantage from
initiating change if B selects the appropriate response. Consequently, change should never be
initiated by either firm. It is more
advantageous to wait for the other firm to initiate change, and then respond in
such a way that the responding firm (here arbitrarily designated firm B) gains
strategic advantage.
The only conceivable motive a firm could have to initiate change would
be the hope of engaging in a cooperative game.
From Table 6 it is clear that there are only two outcomes where both
firms benefit -- where A increases price and either
maintains or lowers capacity, and where B makes exactly the same changes. If A looks on making
one of these two moves as the first stage of a cooperative game, and if -- and
only if -- B responds appropriately, that is, by matching A's changes, then
both firms can increase profits. It is
also clear that one of these potentially cooperative outcomes is preferable to
the other -- where both firms raise price and maintain capacity.
Regulators must be vigilant against this kind of cooperative gaming, because
firms face clear incentives to raise price without limit, as long as both firms
cooperate. Economic theory suggests that two firms
competing in a regulated bilateral monopoly face incentives to collude, thus
effectively acting as a single business unit.
The analysis presented here goes beyond the conventional view. Because the regulatory authority protects the
bilateral monopoly firms from competition, it seems more logical to view the
regulator, together with the bilateral monopoly firms it regulates, as a single
business unit. Then it becomes apparent
that the regulatory authority faces inconsistent incentives. The regulatory mission encompasses maximizing
both the consumer surplus, which implies both minimizing profits in the
regulated sector and encouraging entry by new competitors, and simultaneously ensuring
that competing firms remain profitable, which implies the contrasting
conditions of maximizing firm profits and discouraging entry of new firms into
the regulated market.
Implications for Strategic Behaviour
It is not entirely clear that B will cooperate with A, however. B can choose two alternative courses which
would make it gain strategic advantage.
The cost of this short-term gain, is that A
will be unlikely to make future changes which B can profit from. In the short term, B should cooperate as long
as it gains profits equal to or greater than any profits it could gain by
double-crossing A. Regulators have
created a competitive environment which discourages innovation in price-setting
or capacity. Thus, regulators must
assume the responsibility of initiating this kind of narrowly delimited
change. There is no clear disincentive
against technological innovation which lowers costs and thus must always confer
competitive advantage.
In the context of a regulated bilateral monopoly, firms face conflicting
incentives. In the short-term, there is
no incentive to innovate in terms of either price or capacity. A firm will only innovate with long-term
cooperative gains in view. Faced with
innovation, the responding firm faces a short-term incentive to choose the most
favourable outcome for itself. Long-term
incentives present the possibility of cooperative behaviour. Once firms establish a history of cooperative
behaviour, the incentive is to continue the cooperation. In this event, regulatory authorities must
intervene in the public interest.
CONCLUSION
The only conceivable motive a firm could have to initiate change would
be the hope of engaging in a cooperative game.
Table 6 provides a clear indication that the firm initiating a strategic
action is not guaranteed a resultant competitive advantage. It may only gain a competitive advantage if
the responding firm fails to select the appropriate strategic response. This observation confirms the substantial
body of management literature suggesting that large, established firms tend to
be less innovative (Hannan and Freeman, 1984; Geroski, 1995; Almeida and Kogut,
1997; Almeida, 1999; Lombardo and Mulligan, 2003). Consequently, change should rarely be
initiated by either firm. It is more
advantageous to wait for the other firm to initiate change, and then respond in
such a way that the responding firm gains strategic advantage. This condition leads to the temptation of
cooperative behaviour.
This research investigated price and shipping capacity competition by
two firms within a strategic group. The
theoretical approach used in this research analysis can be applied to two
rivals, CSX Lines and Matson, in the maritime industry sector that serves the
United States domestic Hawaii/West Coast trade routes operating under the U.S.
Cabotage Laws. Analysis of strategic behaviour
of cooperative monopolists reveals a strict dichotomy between their short-run
and long-run incentives. A rationale
for, and philosophy supporting, government regulation was developed. Firms function best in this context by
understanding the limitations and opportunities this business environment
affords.
ENDNOTES
[1]CSX Corporation
Annual Reports, 1996-2001 and CSX Corporation Homepage. November 12, 2002, www.csx.com.
2Alexander &
Baldwin Annual Reports, 1996-2001 and Matson Homepage. November 12, 2002, www.matson.com/history.html.
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Figure
1
Maritime
Long-run and Short-run Cost Structure
|
Table 1 |
|||||||||
|
CSX Lines Financial Performance1,2,3 |
|||||||||
|
Year |
CSX Lines Operating Revenue
|
CSX Corp. Operating Revenue |
CSX Lines as Percentage of
CSX Corp. |
CSX Lines Expenses |
CSX Corp. Expenses |
CSX Lines as
Percentage CSX Corp. |
CSX Lines Operating Income |
CSX Corp. Operating Income |
CSX Lines as Percentage of
CSX Corp. |
|
2001 |
$681 |
$8,110 |
8.40% |
$649 |
$7,153 |
9.07% |
$32 |
$957 |
3.34% |
|
2000 |
$666 |
$8,191 |
8.13% |
$666 |
$7,386 |
9.02% |
$0 |
$805 |
- |
|
1999 |
$3,809 |
$10,375 |
36.71% |
$4,020 |
$9,802 |
41.01% |
$(211) |
$573 |
- |
|
1998 |
$3,916 |
$9,490 |
41.26% |
$3,783 |
$8,359 |
45.26% |
$133 |
$1,131 |
11.76% |
|
1997 |
$3,991 |
$10,232 |
39.01% |
$3,713 |
$8,673 |
42.81% |
$278 |
$1,559 |
17.83% |
|
1996 |
$4,051 |
$10,220 |
39.64% |
$3,733 |
$8,715 |
42.83% |
$318 |
$1, 505 |
21.13% |
|
Notes: 1All monetary values stated in millions of dollars. 2Reclassification and presentation of financial data
occurred at time of Sea-Land sale to Maersk on 3 Source:
Prepared by authors. |
|||||||||