Market Structure and Competition in Airline Markets

We provide an econometric framework for estimating a game of simultaneous entry and pricing decisions in oligopolistic markets while allowing for correlations between unobserved fixed costs, marginal costs, and demand shocks. Firms’ decisions to enter a market are based on whether they will realize positive profits from entry. We use our framework to quantitatively account for this selection problem in the pricing stage. We estimate this model using crosssectional data from the US airline industry. We find that not accounting for endogenous entry leads to overestimation of demand elasticities. This, in turn, leads to biased markups, which has implications for the policy evaluation of market power. Our methodology allows us to study how firms optimally decide entry/exit decision in response to a change in policy. We simulate a merger between American and US Airways and we find: i) the price effects of a merger can be strong in concentrated markets, but post-merger entry mitigates these effects; ii) the merged firm has a strong incentive to enter new markets; iii) the merged firm faces a stronger threat of entry from rival legacy carriers, as opposed to low cost carriers. ∗We thank Timothy Bresnahan, Ambarish Chandra, Paul Grieco, John Panzar, Wei Tan, Randal Watson, and Jon Williams for insightful suggestions. We also thank participants at the Southern Economic Meetings in Washington (2005 and 2008), the 4th Annual CAPCP Conference at Penn State University, 2009, the Journal of Applied Econometrics Conference at Yale in 2011, and the DC Industrial Organization Conference in 2014, where early drafts of this paper were presented. Seminars participants at other institutions provided useful comments. Finally, we want to especially thank Ed Hall and the University of Virginia Alliance for Computational Science and Engineering, who have given us essential advice and guidance in solving many computational issues. We also acknowledge generous support of computational resources from XSEDE through the Campus Champions program (NSF-Xsede Grant SES150002). †Department of Economics, University of Virginia, [email protected]. Federico Ciliberto thanks the CSIO at Northwestern University for sponsoring his visit at Northwestern University. Research support from the Bankard Fund for Political Economy at the University of Virginia and from the Quantitative Collaborative of the College of Arts and Science at the University of Virginia is gratefully acknowledged. ‡Department of Economics, Penn State, [email protected]. §Department of Economics, Harvard University, [email protected]