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An Empirical Model of Dynamic Limit Pricing: The Airline Industry

An Empirical Model of Dynamic Limit Pricing: The Airline Industry

An Empirical Model of Dynamic Limit Pricing: The Airline

An Empirical Model of Dynamic Limit Pricing: The AirlineIndustryChris Gedge ∗ James W. Roberts † Andrew Sweeting ‡July 5, 2012AbstractTheoretical models of strategic investment often assume that information is incomplete,creating incentives for firms to signal iinformation to deter entry or encourageexit. However, the very simple one-shot nature of these models has limited the scopefor testing whether these models can quantitatively or even qualitatively fit the data.We develop a fully dynamic model with persistent asymmetric information, where anincumbent has incentives to repeatedly signal information about its costs to a potentialentrant. The model is well-suited for empircal work in that it has a unique PerfectBayesian Equilibrium under a standard form of refinement, with strategies that canbe computed quite easily. We are in the process of using our model to test whetherdynamic limit pricing can explain why a dominant incumbent airline drops its pricewhen Southwest becomes a potential entrant on a route. The current version of thepaper uses some existing tests to show that there is strong evidence of some form ofstrategic pricing behavior on the routes in our sample.∗ Duke University. Contact: cdg20@duke.edu.† Duke University and NBER. Contact: j.roberts@duke.edu.‡ Duke University and NBER. Contact: atsweet@duke.edu.We are grateful to Joe Mazur for a help in preparing the data used in this study. All errors are our own.1

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