Academic journal article Economic Inquiry

Airline Pricing Behavior under Limited Inter-Modal Competition

Academic journal article Economic Inquiry

Airline Pricing Behavior under Limited Inter-Modal Competition

Article excerpt

I. INTRODUCTION

There are three sources of competition in the airline market for short-haul flights which jointly affect fares. Airlines compete with other airlines for the same city-pair markets (intra-modal competition). Moreover, airlines compete with other modes of transport (inter-modal competition) such as trains, especially high speed trains, and cars, which have the advantage of allowing travel at any time. Finally, airlines compete with themselves by setting different fares in different time periods prior to departure. This pricing strategy is known as inter-temporal price discrimination (IPD).

Past empirical contributions exploring pricing behavior and competition in air transportation were not able to control for the effect of inter-modal competition which, we can expect, affected the results. This paper differs from existing works as it attempts to study airline pricing for short-haul flights in contexts with no credible threat of inter-modal competition in order to shed light on pricing behavior in response to the pure air-related competition. To this end, we analyze a market, southern Italy, which definitely shows a highly limited degree of inter-modal competition. For the connections considered, in fact, services by alternative modes, including road transport, require, on average, more than seven times the same traveling time as airline connections. Thus, for these peripheral areas, air transport is often the only realistic alternative. We can assume, therefore, that airline pricing strategies are the straight result of air-related competition. The pricing behavior of airline companies also shows high variability of fares per mile that unlikely can be justified by cost differentials. The fare differentials might, instead, be considered as evidence of different degrees of market power with the capacity to determine mark-ups. (1)

In this paper, we address two issues. The first is to measure the extent to which intra-modal competition determines fares. The second is to shed light on the inter-temporal profile of fares in order to verify whether airlines engage in IPD, and whether IPD is of the monopolistic type or the competitive type. As for the former type, market power is required to price discriminate as it enhances the ability of firms to set and maintain higher mark-ups (Tirole 1988). As for the latter type, market power is not required to sustain price discrimination if consumers show heterogeneity of brand preferences (Borenstein 1985 and Holmes 1989) or demand uncertainty about departure time (Dana 1998).

The dataset we use to address the research question is unique. It covers routes that originate in southern Italy and that operated from November 2006 to February 2011. Data on fares were collected from airline websites to replicate consumer behavior when making reservations. Unlike previous contributions, we simulate the purchase of round-trip fares instead of one-way fares. In this way, we effectively replicate the demand side since travelers more often purchase round-trip tickets rather than one-way tickets. In addition, we precisely recreate the supply side as we can clearly see if, for each round-trip flight, a carrier is a feasible alternative for travelers and is an effective competitor.

Our results on short-haul markets with no alternative modes of transport show that when there is less intra-modal competition, airlines set higher fares since they exploit the greater market power arising from a concentrated market structure. Specifically, a 10% increase of the market share allows carriers to post up to 6.4% higher fares. Consistent with the implementation of IPD, we find a non-monotonic profile of fares--which can be roughly approximated by a 7-curve--with a turning point included in the interval of the 43rd to 45th days before departure. We give new interpretations for the non-monotonicity of fares' inter-temporal profile, in addition to the existing ones. …

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