Financial Flexibility and Product Prices: Evidence from a Natural Experiment in the Airline Industry

This paper studies the effects of corporate cash holdings on firm pricing strategy. Focusing on the airline industry to identify markets and rivalry, and utilizing the Aviation Investment and Reform Act of the 21 Century (AIR-21) as a quasi-natural experiment to identify exogenous increases in market-level competition, I test the effect of ex-ante relative-to-rival cash holdings on ex-post changes in firm pricing strategies. I find that firms with more cash respond to competition shocks by pricing more aggressively, but only when there is less concern of retaliation from rivals. Consistent with the competitive impact of AIR-21 being driven by airport gate reallocations toward low-cost carriers (LCCs), LCCs respond by unconditionally reducing prices, whereas shocks manifest only through the cash effect for legacy airlines. Both the responses of LCCs and legacy airlines are dampened by greater concerns of potential rival retaliation. Consistent with AIR-21 forcing airports to reshuffle gates away from dominant airlines, results are strong for ex-ante market dominators, but non-existent for market laggards. Results using alternative proxies for financial strength and market performance outcomes further support the role of cash as a valuable source of financial flexibility. Finally, I argue that competition is likely a determinant of firm cash holding decisions. ∗ I am grateful to René Stulz (Chair), Kewei Hou, and Berk Sensoy for their invaluable advice and guidance. I also thank Hang Bai, Brian Baugh, Itzhak Ben-David, Andrei Goncalves, Yoon Kang Lee, Bernadette Minton, Hoonsuk Park, and Michael Weisbach for helpful comments. † Finance PhD Candidate. 810 Fisher Hall, 2100 Neil Ave, Columbus OH 43210. E-mail: [email protected]. ‡ Preliminary draft. Please do not circulate or quote without permission from the author.