Market Structure and Competition in Airline Markets

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Abstract
We provide an econometric framework for estimating a game of simultaneous entry and pricing decisions in oligopolistic markets while allowing for correlations between unobserved fixed costs, marginal costs, and demand shocks. Firms' decisions to enter a market are based on whether they will realize positive profits from entry. We use our framework to quantitatively account for this selection problem in the pricing stage. We estimate this model using cross-sectional data from the US airline industry. We find that not accounting for endogenous entry leads to overestimation of demand elasticities. This, in turn, leads to biased markups, which has implications for the policy evaluation of market power. Our methodology allows us to study how firms optimally decide entry/exit decision in response to a change in policy. We simulate a merger between American and US Airways and we find: i) the price effects of a merger can be strong in concentrated markets, but post-merger entry mitigates these effects; ii) the merged firm has a strong incentive to enter new markets; iii) the merged firm faces a stronger threat of entry from rival legacy carriers, as opposed to low cost carriers.