Quantity Discounts and Capital Misallocation in Vertical Relationships∗

I study transactions between aircraft manufacturers and airlines as well as airlines’ utilization of their fleet. Aircraft production is characterized by economies of scale via learningby-doing, which creates a trade-off between current profit and future competitive advantage in the aircraft market. The latter consideration makes large buyers more attractive than small buyers and induces quantity discounts. The resulting nonlinear pricing strategy may distort both production and allocation in favor of large buyers. There is a negative correlation between the size of aircraft orders and the per-unit price. There is also a positive correlation between the price paid and the utilization rate of the aircraft model, which suggests that the manufacturers’ price discrimination leads to the misallocation of aircraft. To assess whether there is an inefficient allocation, I model the market and show that price discrimination by upstream firms may lead to an inefficient outcome compared with uniform pricing. Then, I construct and estimate a dynamic model of the aircraft market that includes a model of utilization. Finally, I conduct counterfactual simulations using the estimated parameters. I find that uniform pricing increases aircraft production by 10% and total welfare by 1.6%. ∗I am extremely thankful to Igal Hendel, David Besanko, Aviv Nevo, Rob Porter and seminar participants at Northwestern University for their valuable comments and suggestions. †Northwestern University, Department of Economics. email: [email protected]