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An Empirical Model of Dynamic Limit Pricing: The Airline Industry

An Empirical Model of Dynamic Limit Pricing: The Airline Industry

variable was divided

variable was divided into five categories (very low, low, medium, high and very high). Severaldifferent boundaries for the categories were used. Column 2 of Table 7 contains theregression results of the equivalent of equation (17) for the ρ coefficients when the cut-offspoints for the boundaries are (in millions) {1.5, 3, 4.5, 6}. The u-shaped pattern remains:incumbent monopolists decrease fares by an average $84 on the medium attractivenessroutes. For routes either side of this the change in fare once Southwest becomes a potentialentrant is not significantly different from zero.Whilst the u-shaped pattern of how firms respond when faced with the threat of Southwest’sentry agrees with the intuition of Ellison and Ellison and provides further evidenceof strategic entry behavior in the airline industry it is important to point out that in thissetting entry deterrence is welfare enhancing: prices are lower than the Nash outcome andsunk entry costs are avoided. The repeated incentive to signal ensures that this auspiciousoutcome materializes in each period thus appeasing concerns of future price spikes onceentry had been deterred.Figure 6: Market Attractiveness and the Effect on FaresEach data point in the graph corresponds to a ˆρ coefficient from equation (17), as reported in Table8. For example ˆρ 1 = −22.19 is the left-most point and ˆρ 6 = −89.93 is the data point correspondingto population decile six.34

5.2 Welfare ImplicationsThe above results are suggestive of firms entering into some form a strategic entry deterrence:on those markets for which entry is more likely to be deterred incumbent firms arereducing fares. For those markets of high or low attractiveness incumbents do not altertheir prices once entry is threatened by Southwest. Whilst this latter observation is consistentwith a static monopolist, who rather than cutting fares prior to entry will insteadwait for entry to occur before altering its price vector, the cutting of prices on marketsof middling attractiveness is not an optimal static outcome. There are two questions thatfollow. First, is this result necessarily the outcome of dynamic limit pricing? Second, whatare the welfare implications of these observed strategies?As noted in the introduction cutting prices prior to the entry of a potential competitorrequires a linkage between pre-entry prices and post-entry competition. The maintainedhypothesis of this paper is that pre-entry prices act to signal the marginal cost of the incumbentand in so doing indicate to a potential entrant the intensity of post-entry competition.Entry is deterred if the sunk entry cost is too high to cover the expected NPV of futureprofits, being when the signaled marginal cost of the incumbent is “too low”. Under certainconditions it was shown that using price to signal cost was a subgame perfect strategy ofthe incumbent and fully informative: low cost types set low prices so as to separate fromhigher cost types. However, a similar pricing profile could be observed if incumbent firms,when faced with the threat of entry, reduce fares so as to increase consumer switchingcosts. This “clientèle” effect shrinks the residual demand curve and thus makes entry lessauspicious to a potential entrant. As with dynamic limit pricing we would expect the pricedecrease to only occur on those markets of middling attractiveness and thus the reducedform results above could be explained by both dynamic limit pricing and firms building aclientèle. In the following section the structural estimation technique will be detailed forhow these two explanations can be distinguished. The insight is that there is informationcontained in how incumbent prices change as the rival first appears as a potential entrantand then again on entry and these profiles differ depending on whether incumbent firms35

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