Essays on Strategic Behavior in the U.S. Airline Industry Dissertation Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Kerria Measkhan Tan, B.A., M.A. Graduate Program in Economics The Ohio State University 2012 Dissertation Committee: Matthew Lewis, Advisor James Peck Huanxing Yang c Copyright by Kerria Measkhan Tan 2012 Abstract In my first dissertation essay, \Incumbent Response to Entry by Low-Cost Carri- ers in the U.S. Airline Industry," I analyze the price response of incumbents to entry by low-cost carriers in the U.S. airline industry. Previous theoretical papers suggest that airlines might respond to entry by lowering prices to compete harder for existing customers or they might increase prices to exploit their brand-loyal customers. This paper tests which effect is more prominent in the airline industry. I find that when one of four low-cost carriers enters a particular route, legacy carrier incumbents respond differently than low-cost carrier incumbents to new low-cost carrier entry. Legacy carriers decrease their mean airfare, 10th percentile airfare, and 90th percentile air- fare before and after entry by a low-cost carrier. However, low-cost carriers do not significantly alter their pricing strategy. The differing incumbent responses can be attributed to the finding that low-cost carrier entrants tend to match the price set by rival low-cost carriers in the quarter of entry and tend to enter with a lower price than that of legacy carrier incumbents. The results also suggest that entry does not affect price dispersion by incumbent carriers. Legacy carriers have increasingly outsourced the operation of certain routes to regional airlines over the past decade. My second dissertation essay, \The Influence of Low-Cost Carriers on the Use of Regional Airlines," investigates how low-cost carriers influence where legacy carriers decide to use regional airlines. I find evidence ii that legacy carriers are more inclined to switch to regional airlines on routes where a low-cost carrier exists. Moreover, legacy carriers tend to not only decrease average airfares once they start outsourcing but also price match competing low-cost carriers. However, I do not find evidence that low-cost carriers are effectively deterred from entering routes where a regional airline is present. The results refute the notion that regional airlines can serve as an effective barrier to entry, while suggesting that legacy carriers exploit the more cost-efficient regional airlines in order to lower price and therefore better compete with low-cost carriers. My third and final dissertation essay, \The Effect of De-Hubbing on Airfares," studies the price effect of de-hubbing, which occurs when an airline ceases hub op- erations at an airport. Legacy carriers dramatically decrease both the frequency of flights and the number of seats offered once it de-hubs an airport, whereas their competitors generally respond by maintaining their capacity level at the airport. As a result, prices could potentially decrease as the market becomes less concentrated or increase because the de-hubbing airline's capacity reduction diminishes the avail- ability of substitutes. I perform an event study using four cases of de-hubbing at domestic airports between 2001 and 2006 to test which price effect dominates. Not only do average airfares increase after a legacy carrier de-hubs an airport but also the de-hubbing airline and its competitors at that airport tend to increase their prices by a similar percentage. The results suggest that de-hubbing ultimately leads to softer competition between airlines at the de-hubbed airport. iii This is dedicated to my parents, who taught me to work hard and dream big. iv Acknowledgments It seems like only yesterday that Steven Chen, Jason Yau, and I would meet up in the study rooms at Geisel Library on the University of California, San Diego campus in order to study for the math classes that we took together. I remember a particular instance in which I was working through a linear algebra problem using dry erase markers that we \borrowed" from classrooms on campus while taking advantage of the study rooms' one-way windows. They both stopped me and told me that I have a particular knack for teaching. It was at this moment that I realized that I truly enjoyed these study sessions and that teaching was something that I wanted to pursue for a living. Fast forward about ten years and now I am on the verge of obtaining my Ph.D. in Economics and starting my new job as an Assistant Professor at Loyola University Maryland. Surely, there have been others along the way that have helped me achieve my academic goals. This serves as an inadequate, yet sincere thank you to the people who have particularly influenced my life. One of the biggest reasons why I came to Ohio State was the opportunity to work with my advisor, Matt Lewis. I remember meeting him during my recruitment trip and discussing my senior honors thesis on the Southwest Effect. I cannot imagine having a better advisor than Matt. He gives me the freedom and encouragement to pursue the topics that I am interested in, but is not afraid to let me know if he thinks I am not being as productive as I should be. I feel like I can brainstorm openly in v front of him without the fear that he will belittle me if I am incorrect or start to stray towards the wrong path. He is always available when I need to talk and has given me such great advice on research, presentations, and other things. I have the utmost respect for him and will always be greatly indebted to him for the help he has given me over these past six years. Jim Peck and Huanxing Yang serve as the other two members of my dissertation committee. I learned greatly from them when I took their second year microeconomic theory courses and wanted their help to ensure that the empirical results in my research are rooted in theoretical foundations. Jim, in particular, helped boost my confidence when I was about to go on fly-outs while on the job market. I will miss discussing the English Premier League with Huanxing, especially when it comes to the rivalry between our two beloved teams, Liverpool and Manchester United. Other faculty members at Ohio State have also been very influential. Belton Fleisher became a close confidant and someone that I could always turn to for advice. I always knew that Hajime Miyazaki had my best interests in mind whenever he gave me his opinions regardless of whether they were solicited or not. Bruce Weinberg always believed in my teaching potential and nominated me for several teaching awards. He also served as a teaching reference when I was on the job market. I got to know Don Haurin well when we formed arguably the best battery in the history of the Ohio State summer softball league. Similarly, Bill Dupor and I built up a rapport during Saturday morning pick-up basketball games and was gracious enough to serve as the fourth member of my candidacy committee. Finally, Lucia Dunn vastly improved my interviewing skills, especially when it came to the five minute talk on my job market paper. I also have a much firmer hand shake grip thanks to her. vi I also would not have been able to get through my graduate studies without a great core of friends. I developed a close friendship with Michael Sinkey after all the time we spent watching and playing sports, as well as working at various coffee shops in and around the Columbus area. Jeff Baird and Neil Dalvi ensured that I struck the right balance between work and play. Saif Mekhari was never shy to give me his advice on how to best excel in the program based on his experiences. I would not have been as confident and prepared for job market interviews had I not spent endless hours practicing with Matt Jones and Brandon Restrepo. Matt Dicker and Dan Gallardo were always a phone call or Google Chat message away whenever I needed to talk to the friends that knew me best. Last but surely not least, Cassandra Lissey has become my best friend and someone I will love and trust for the rest of my life. As wonderful as the aforementioned people have been, they cannot compare to the impact that my family has had in my life. Sophia is the best little sister that I could ever ask for. My grandparents on both sides of my family have always spoiled me with love and attention. However, my parents have had the biggest influence in my life. I would not have been as fascinated with the airline industry if it were not for my dad, who worked for Korean Air for well over twenty years. He gave me the confidence to chase after my dreams and to learn from my mistakes along the way. He has taught me to always \turn poison into medicine." My mom is the most selfless person I know and is such a great inspiration to me. She has taught me to work hard and to never give up on my goals. I surely would not have been able to accomplish any of this without her love and support. In the end, I just hope that I have made my family proud. vii Vita September 30, 1984 . .Born - Northridge, California. 2006 . .B.A. Economics, University of California, San Diego. 2007 . .M.A.