Is airline price dispersion the result of careful planning or competitive forces?

Airlines ; Competition ; Prices

Dynamic Analysis of Oligopolistic Behavior in the U.S. Airline Industry

The recent history of the airline industry has exhibited relentless price wars of national proportion begun by failing airlines desperate to fill their planes. However, price reductions and sporadic discounting are often observed intermittently on scattered routes from time to time. If substantial discounts are offered, these episodes may also be classified as less publicized (or covert) price wars. An arbitrary rule is described that classifies the most traveled routes between the second quarter of 1990 and the third quarter of 1992 as experiencing or not experiencing a price war on the b~sis of distribution of prices. The classification scheme is helpful in characterizing market behavior during price wars and normal periods. The causes and effects of price wars are assessed, and special attention is given to the relationship between price wars and concentration. The analyses are conducted in the context of an economic theory that depicts price wars as a normal reaction to changing market conditions when a specific type of equilibrium characterizes an industry. The most profound result is that price wars do not increase market concentration as successfully as more cautious price reductions taken during normal periods. The recent history of domestic airlines has been marked by mergers, takeovers, failed airlines, volatile ticket prices, and price wars. Whereas the airline industry is among the most studied in the past decade, domestic airline price wars have not been the central focus of economic research. Examination of these price wars during the early 1990s is timely and significant with regard to both the economic literature and the political arena. Past economic studies focused largely on st~tic models aimed at describing airline industry behavior at a point in time. For example, Borenstein (1) links airport dominance and route concentration to high fares and argues that increased concentration of this nature should lead to even higher fares. The General Accounting Office (2) published a similar, more detailed static model seeking to capture the effects of certain barriers to entry, market share, and congestion on airfares. It found that a single variable does not a have a large effect on prices but that in combination the factors studied can significantly increase airfares. That study enjoyed the contribution of a tremendous amount of data, which enriched the explanatory power of the results substantially. A recent study, which was more parsimonious in its use of data, was done by Evans and Kessides (3). They found evidence that airport concentration was a strong determinant of fares on a given route. They further concluded that for the quarter they studied route dominance was relatively unimportant in explaining higher prices. The contrasting results of these studies affirm the need for a dy~ namically based model to explain pricing behavior. In a later section of the paper, reference is made to a Chow test of structural change across time periods. This test confirms that pricing behavior has not been the same across time, which suggests a possible explanation for differing results in previous papers. Department of Economics, Southern Methodist University, Dallas, Tex. 75275-0496. Economic studies focusing on the evolving nature of the airline industry are less numerous than single-period studies. Morrison and Winston ( 4) study entry and exit patterns as affected by hubbing and route fares. They find that airlines tend to shy away from airports where other airlines have hubs because of limited gates. They, like Evans and Kessides, find a strong correlation between airport concentration and high prices. However, they predict that hubbing should eventually decrease fares, since hubs allow increased airline connectedness and contact with competitors so that airlines should be able to compete with each other more effectively. Kim and Singal (5) examined the dynamic nature of prices during the merger wave of the mid-1980s. They identify the price changes on routes affected by specific mergers, compare them with price changes on routes unaffected by those mergers, and find that the elimination of the noncooperative failing airline allows the remaining airlines to collude more successfully. Furthermore, they suggest that multirnarket contact helps airlines maintain a less-than-competitive arrangement and that the competition observed shortly after deregulation is less likely under the evolving market structure. However, since 1988, the airlines seem to have entered a new era of short-term price wars and collusive periods, in contrast to the predictions of Kim and Singal. Why has the stability they predicted broken down? Or does this recent trend actually reflect a different kind of equilibrium that has until now not been considered? The model described here will show that pricing behavior varies not only over time but over routes. The causes and effects of price wars are modeled and evaluated to demonstrate that the airlines reflect both competitive and collusive behavior at various times and on various routes. It is shown that, regardless of hub and route dominance, lagging demand can trigger destructive competition and that certain types of routes will be more prone to prke wars than others. Furthermore, there are clear winners and losers from price wars, and the toughest battles are fought on the routes with the most at stake. PRICE WAR EQUILIBRIUM A growing theoretical literature has been devoted to explaining the dynamic nature of imperfect markets. It has been recognized since Stigler (6) that the static models of collusive cartel, CournotNash equilibrium, or Bertrand competition do not sufficiently explain the behavior of firms existing in such markets. Whereas we know that a cartel is an unstable arrangement at best, empirically we observe that highly concentrated industries are likely to behave like any one of these classic models (including cartel) at some time. In the past decade, game theorists have developed dynamic models to portray more realistically the actions of oligopolist

When Will an Airline Stand Its Ground? An Analysis of Fare Wars

The research presented in this paper focuses on the recent onset of price wars in the airline industry while accommodating multimarket contact, multiple products, and a dispersed price distribution. An important innovation in this study is in developing a price war definition using a rank dominance criterion. A second innovation is the extension of a probit model to a bivariate probit, which assesses the behavior of multimarket firms after a price war occurs. In particular, a carrier may choose to stay and fight when a price war erupts or may simply leave a route. Carriers will engage in fare wars when market shares change, higher elasticity customers patron the route, and load factors drop. Carriers will leave routes after a fare war when offering service to another carrier's hub but will remain steadfast in their own spheres of influence.Price wars; Airline industry studies; Multimarket contact, JEL classifications: LI3, L93,