Monday, June 8, 2009
Capacity Investments, Exclusionary Behavior, and Welfare: A Dynamic Model of Competition in the Airline Industry
Posted by D. Daniel Sokol
ABSTRACT: This paper applies recently developed methods for estimating dynamic games to a unique data set to study the strategic capacity decisions of firms in the US airline industry during the 1990s. Using an incomplete information variant of the Ericson and Pakes (1995) framework along with the econometric methodology of Bajari, Benkard and Levin (2007), I recover the complete cost structure of firms in the airline industry while accounting for important sources of consumer, firm, and market heterogeity.
I find that the intensity of competition in a particular market depends directly on the characteristics and identity of the incumbent firms. In particular, entry by low-cost carriers (Lccs) tends to trigger dramatic changes in prices and capacity which cannot be explained by standard static models of competition. I find that hub carriers excessively invest in capacity, providing them with a commitment to price aggressively in future periods. In doing so, the hub carrier is able to substantially increase the likelihood of exit by targeted Lccs. Using the estimated structural parameters, I also demonstrate the degree to which both competition and welfare su¿er as a consequence of exclusionary investment in capacity by dominant firms.