Bankruptcy and Product-Market Competition: Evidence from the Airline Industry∗

Classical models of product market competition maintain that firms maximize their profits regardless of their financial condition. Yet over the last two decades a growing theoretical literature has examined whether a firm’s capital structure impacts competition in the market for the firm’s products. In this paper we ask whether a firm operating under bankruptcy protection significantly reshapes competition for the firm’s product in markets where the bankrupt and the non-bankrupt firms are in direct competition, using evidence from the US airline industry. The first part of the paper shows that (1) the median price in markets where a bankrupt carrier operates significantly drops; (2) competitors of a bankrupt firm differ in the way they react to the bankruptcy. In the second part of the paper, we estimate a structural model of demand for air travel and a model of airline pricing behavior. The results show that (1) shifts in the pricing equations of the bankrupt firm and of its competitors explain the observed price changes; (2) there is no evidence that consumers substitute away from a bankrupt airline to its competitors. Finally, we present a counter-factual experiment, to study how prices and consumer welfare would have changed if bankrupt firms had to liquidate their assets and exit the industry, without the possibility of operating under Chapter11 protection. We show that consumers did not benefit significantly from the availability of Chapter 11 to United or USAir; but that consumers benefited substantially from the availability of Chapter 11 to ATA. ∗We thank Ken Ayotte, Leora Friedberg, Rick Green, Vikas Mehrotra, Amalia Miller, Nicholas Rupp, Patrik Sandas, and David C. Smith for comments and suggestions. We also thank seminar participants at the University of Virginia Economics Department, and the Empirical Research in Corporate Finance Conference at the University of Oregon, Eugene, the International Industrial Organization Conference in Boston, the Southern Economic Association Conference in Washington. Lynn LoPucki generously shared his Bankruptcy Research Database. A previous version of this paper was circulated under the title “Financial Decisions, Bankruptcy, and Product-Market Competition in the Airline Industry”. All remaining errors are our own. †Department of Economics, University of Virginia, [email protected], ph: (434) 924-6755. ‡McIntire School of Commerce, University of Virginia, [email protected], ph: (434) 924-4184.