Analyzing Default Risk and Liquidity Demand during a Financial Crisis: The Case of Canada

This paper explores the reliability of using prices of credit default swap contracts (CDS) as indicators of default probabilities during the 2007/2008 financial crisis. We use data from the Canadian financial system to show that these publicly available risk measures, while indicative of initial problems of the financial system as a whole, do not seem to correspond to risks implied by the cross-sectional heterogeneity in bank behavior in short-term lending markets. Strategies in, and reliance on the payments system as well as special liquidity-supplying tools provided by the central bank seem to be more important additional indicators of distress of individual banks, or lack thereof than the CDSs. It therefore seems that central banks should utilize high-frequency data on liquidity demand to obtain a better picture of financial health of individual participants of the financial system.Financial Institutions; Financial markets; Payment, clearing, and settlement systems

Dynamic Price Competition: Theory and Evidence from Airline Markets

We introduce a model of oligopoly dynamic pricing where firms with limited capacity face a sales deadline. We establish conditions under which the equilibrium is unique and converges to a system of differential equations. Using unique and comprehensive pricing and bookings data for competing U.S. airlines, we estimate our model and find that dynamic pricing results in higher output but lower welfare than under uniform pricing. Our theoretical and empirical findings run counter to standard results in single-firm settings due to the strategic role of competitor scarcity. Pricing heuristics commonly used by airlines increase welfare relative to estimated equilibrium predictions

On the Empirical Content of Quantal Response Equilibrium

The quantal response equilibrium (QRE) notion of McKelvey and Palfrey (1995) has recently attracted considerable attention, due in part to its widely documented ability to rationalize observed behavior in games played by experimental subjects. However, even with strong a priori restrictions on unobservables, QRE imposes no falsifiable restrictions: it can rationalize any distribution of behavior in any normal form game. After demonstrating this, we discuss several approaches to testing QRE under additional maintained assumptions

Are Consumers Affected by Durable Goods Makers' Financial Distress? The Case of Auto Manufacturers

The financial decisions of durable goods makers can impose spillovers on their consumers. Namely, durable goods provide a consumption stream that frequently depends on services provided by the manufacturer (e.g., warranties, parts, and maintenance). Manufacturer bankruptcy, or even the possibility thereof, threatens this service provision and can substantially reduce the value of its products to their current owners. We test this hypothesis in one of the largest durable goods markets, automobiles, using data on millions of used cars sold at wholesale auctions around the U.S. during 2006-8. We find that an increase in an auto manufacturer’s financial distress results in a contemporaneous drop in the prices of its cars at auction, controlling for a host of other influences on price. The estimated effects are statistically and economically significant. Furthermore, cars with longer expected service lives (those within manufacturer warranty, having lower mileage, or in better condition) see larger price declines than those with shorter remaining lives. These patterns do not seem to be driven solely by reduced demand from auto dealers affiliated with the troubled manufacturers or by contemporaneous declines in new car prices. Our estimates imply a potentially large indirect cost of financial distress on car manufacturers.

Dynamic Price Competition: Theory and Evidence from Airline Markets

We introduce a model of dynamic pricing in perishable goods markets with competition and provide conditions for equilibrium uniqueness. Pricing dynamics are rich because both own and competitor scarcity affect future profits. We identify new competitive forces that can lead to misallocation due to selling units too quickly: the Bertrand scarcity trap. We empirically estimate our model using daily prices and bookings for competing U.S. airlines. We compare competitive equilibrium outcomes to those where firms use pricing heuristics based on observed internal pricing rules at a large airline. We find that pricing heuristics increase revenues (4-5%) and consumer surplus (3%)

Incorporating Search and Sales Information in Demand Estimation

We propose an approach to modeling and estimating discrete choice demand that allows for a large number of zero sale observations, rich unobserved heterogeneity, and endogenous prices. We do so by modeling small market sizes through Poisson arrivals. Each of these arriving consumers then solves a standard discrete choice problem. We present a Bayesian IV estimation approach that addresses sampling error in product shares and scales well to rich data environments. The data requirements are traditional market-level data and measures of consumer search intensity. After presenting simulation studies, we consider an empirical application of air travel demand where product-level sales are sparse. We find considerable variation in demand over time. Periods of peak demand feature both larger market sizes and consumers with higher willingness to pay. This amplifies cyclicality. However, observed frequent price and capacity adjustments offset some of this compounding effect

Organizational Structure and Pricing: Evidence from a Large U.S. Airline

Firms facing complex objectives often decompose the problems they face, delegating different parts of the decision to distinct sub-units. Using comprehen-sive data and internal models from a large U.S. airline, we establish that airline pricing is not well approximated by a model of the firm as a unitary decision-maker. We show that observed prices, however, can be rationalized by account-ing for organizational structure and the decisions by departments that are tasked with supplying inputs to the observed pricing heuristic. Simulating the prices the firm would charge if it were a rational unitary decision-maker results in lower welfare than we estimate under observed practices. Finally, we discuss why counterfactual estimates of welfare and market power may be biased if prices are set through decomposition, but we instead assume that they are set by unitary decision-makers

Incorporating Sales and Arrivals Information in Demand Estimation

We propose a demand estimation method that allows for a large number of zero sale observations, rich unobserved heterogeneity, and endogenous prices. We do so by modeling small market sizes through Poisson arrivals. Each of these arriving con-sumers solves a standard discrete choice problem. We present a Bayesian IV estima-tion approach that addresses sampling error in product shares and scales well to rich data environments. The data requirements are traditional market-level data as well as a measure of market sizes or consumer arrivals. After presenting simulation studies, we demonstrate the method in an empirical application of air travel demand

Organizational Structure and Pricing: Evidence from a Large U.S. Airline

Although typically modeled as a centralized firm decision, pricing often involves multiple organizational teams that have decision rights over specific pricing inputs. We study team input decisions using comprehensive data from a large U.S. airline. We document that pricing at a sophisticated firm is subject to miscoordination across teams, uses persistently biased forecasts, and does not account for cross-price elasticities. With structural demand estimates derived from sales and search data, we find that addressing one team’s biases in isolation has little impact on market outcomes. We show that teams do not optimally account for biases introduced by other teams. We estimate that corrected and coordinated inputs would lead to a significant reallocation of capacity. Leisure consumers would benefit from lower fares, and business customers would face significantly higher fares. Dead-weight loss would increase in the markets studied. Finally, we discuss likely mechanisms for the observed pricing biases