Flying Under the Radar: Multimarket Contact and Tacit Collusion in the U.S. Airline Industry A SENIOR THESIS Submitted to the Faculty in the Department of Economics at Miami University in Partial Fulfillment of the Requirements of Departmental Honors By Henry Jameson Shaneyfelt* Miami University Spring 2021 ABSTRACT This paper serves to identify the effects of multimarket contact on tacit collusion through the measures of average price and price dispersion. Implementing methods used in Evans and Kessides (1994) and Ciliberto and Williams (2014), I employ gate-use data to instrument for the average multimarket contact variable and address any potential bias from endogeneity. Additionally, squared gate-use instruments, which are novel to the existing literature, are included in the analysis. When using the novel instruments, a significant positive relationship is found between average multimarket contact and both prices and price dispersion. Advisor: Dr. Charles Moul *I would like to sincerely thank Dr. Moul for all the help he has provided me throughout this process. I would also like to thank the Miami University Economics Department for giving me the opportunity to complete this research project. 1 Introduction The majority of classical microeconomic theory is based in the analysis of market behavior that does not extend beyond the market’s scope. External markets and their effects on firm behavior are typically not studied at length. However, the modern-day economy is seeing an increasing number of firms competing with rival firms in numerous differing markets at a given time. An intriguing attribute of this newly structured economy is the ability for firms to interact with rivals across markets. The competitive pricing of a firm in one market may now result in a rival firm responding in a different, mutually served market. This occurrence, known as multimarket contact, has been a topic of interest for many economists who posit that it substantially increases the probability of collusive behavior. While this may seem difficult to follow at first blush, the intuition behind this theory makes it clear why this outcome is a plausible possibility. The general notion driving this theory is that multimarket contact creates the potential for larger-scale retaliations to firms who may try deviating from collusive outcomes. For the sake of example, imagine there are two firms, A and B, who simultaneously compete in markets 1, 2, and 3. If firm A were to attempt to deviate from a collusive outcome in market 1 by cutting prices, firm B could retaliate by not just dropping prices in market 1 but by also dropping prices in markets 2 and 3. Lest this outcome be realized, firm A will find it optimal to price less aggressively (i.e., collude) in all simultaneously served markets. Such is the essence of tacit collusion, where non-competitive outcomes are not explicitly coordinated but mutually understood and maintained. As the multimarket contact between two firms increases, the potential retaliation does the same. Due to this, firms that experience higher levels of multimarket contact may be less likely to behave competitively. As this probability of tacit collusion rises, theory indicates that monopolistic behavior is more likely to be observed. The specific characteristics of this behavior that I consider are higher prices and more price discrimination. These serve as strong indicators for tacit collusion, as they would be impossible to occur in a competitive setting. Within a market containing competitive firms, the ability for a firm to price discriminate is ultimately eroded by their rivals’ pricing. Having established these indicators, the challenge then becomes finding an industry that exhibits these characteristics. The domestic airline industry is rich with multimarket contact, as there are few routes in which only one carrier serves. In this paper, I measure the effects of increasing multimarket contact on average price and price discrimination. To identify price discrimination, I measure the magnitude of price dispersion in a given market. Initial results replicating Evans and Kessides (1994) yield 2 results that fail to follow theory and intuition. However, I address the potential endogeneity of the multimarket contact variable by instrumenting for it with gate-use data. Ciliberto and Williams (2014) introduced this application of gates, and I add to it by accounting for non-linearity in the relationship between multimarket contact and gate utilization. When employing this technique, I find that increasing multimarket contact increases both average price and price dispersion. The results from this paper ultimately identify the characteristics of tacit collusion occurring at higher levels of multimarket contact, consistent with the prevailing theory. 2 Literature Review 2.1 Theory Bernheim and Whinston (1990) was the first paper to address the potential for increased multimarket contact causing non-competitive outcomes. They provide a mathematical framework to produce an irrelevance result. This irrelevance result proved that multimarket contact would not have an effect on the optimal strategy of the firm given there are identical markets, identical firms, and constant returns to scale in production technology. Building upon this, the authors then prove that removing any of these three criteria results in multimarket contact having nontrivial effects on equilibrium behavior. The authors prove in this paper that the external threat of retaliation across all other simultaneously served markets was enough to alter a firm’s competitive strategy in a single market. Given that in reality, industries typically do not meet these three mentioned criteria simultaneously, this theory has clear applicative power. The task since this paper was published has been finding significant empirical evidence to test this theory. 2.2 Empirical One of the first attempts at such a test was Evans and Kessides (1994). This was the first paper to assert that the airline industry is a strong candidate for measuring the effects of multimarket contact on average prices. The main result of this paper is that multimarket contact does indeed have a positive relationship with average prices. The most notable of this paper’s contributions are the construction of the average multimarket contact variable, which depends on the amount of overlap among airlines’ routes, and the use of city-pair controls in OLS analysis. While Evans and Kessides (1990) found evidence that increased multimarket contact has a positive relationship with average price, their methodology did not address any potential endogeneity 3 issues stemming from the multimarket contact variable itself. The first paper to do this was Ciliberto and Williams (2014). In this paper, the authors claim that the potential endogeneity of multimarket contact may come from the unobservable heterogeneity that effects the decision to either enter or exit a market. To address this, they instrumented for multimarket contact with gate ownership variables, asserting that the long-term leasing of airport gates makes them plausibly exogenous. This implementation led to substantially larger estimated impacts of contact on analysis, and it laid the foundation for the later structural work that related conduct to contact. Along with average price, there is an existing parallel literature looking at price dispersion in the domestic airline industry. Borenstein and Rose (1994) looked at the effects of increased competition on price dispersion by comparing measures of market concentration to a pricing Gini coefficient, a well-known measure of statistical dispersion. The main findings of this paper are that price dispersion cannot be explained by cost variation alone, and increased competition is associated with higher levels of price dispersion. The authors contest that a significant portion of the price dispersion was coming from price discrimination arising in a context of monopolistic competition. Not all results in the literature concerning price dispersion were the same, however. In response to Borenstein and Rose (1994), Gerardi and Shapiro (2009) replicate their study and find contrasting results. Namely, this paper finds that price dispersion actually decreases as competition increases, which is more aligned with standard oligopoly theory. The authors claim that the cause of the different results was primarily that the cross-sectioned data of Borenstein and Rose (1994) omitted distance from their controls. This omission is claimed to have positively biased their results substantially. 2.3 Contemporary Work Kim, Kim, and Tan (2019) attempted a current application of Evans and Kessides (1994) by looking at the effects of multimarket contact on prices and also price dispersion. The authors specifically looked at the effects of Southwest Airlines on collusive outcomes. The paper found that multimarket contact is positively associated with prices but fails to find the same effect with price dispersion. The authors also noted that the presence of Southwest Airlines on a route results in multimarket contact not having a significant association with price dispersion. In another application of Evans and Kessides (1994), Chiang and Liou (2018) tried to measure the effects of multimarket contact on price dispersion in the airline industry. This paper also implemented the Gini coefficient to measure this dispersion. The main finding from this work 4 was that differing market sizes result in differing effects of multimarket