Capacity and Product Market Competition: Measuring Market Power in a "Puppy-Dog" Industry

Capacity and Product Market Competition: Measuring Market Power in a 'Puppy-Dog' Industry* In this paper we specify and estimate a structural model which accounts for competition in two variables: capacity and prices. The model has a two-stage setup. In the first stage firms make capacity decisions followed by a product-differentiated, price setting game in the second stage. Since costs are endogenized through the first stage, this has important implications for the measurement of market power in the product market. In particular, simpler one-stage specifications would result in a bias in the measurement of market power, which can be linked to the taxonomy for two-stage games given in Fudenberg and Tirole (1984). We then estimate this model demand, cost (short and long run), and conduct for the European Airline Industry using data for the period of 1976-1990. We perform a number of specification tests and reject a simple one-stage specification in favor of our two-stage set-up. In particular, we find that some degree of market power in the product market exists. However, market power in the two-stage set-up is significantly lower than in the more widely employed one-stage specification, which is consistent with the direction of bias in puppy-dog games. This illustrates that firms market power in the product market is significantly overestimated whenever capacity competition is not accounted for. * We like to thank Robert Marks, Garth Saloner, David Sappington, Andrea Shepard, Lars Sorgard, Zhentang Zhang, and the seminar participants at Stanford Business School, Rice University, Humboldt University, INSEAD, London Business School, and the Norwegian School of Economics and Business Administration for their comments. We acknowledge financial support from the C.V. Starr Center at New York University, INSEAD research grant No. 2024R, and Indiana University.