ESSAYS ON ECONOMICS OF AIRLINE ALLIANCES by XIN XIE B.A., Wuhan University of Technology, 2006 M.B.A., Pittsburg State University, 2008 AN ABSTRACT OF A DISSERTATION submitted in partial fulfillment of the requirements for the degree DOCTOR OF PHILOSOPHY Department of Economics College of Arts and Sciences KANSAS STATE UNIVERSITY Manhattan, Kansas 2014 Abstract This dissertation constitutes two essays in the field of industrial organization. Specifically, the research focuses on empirically assessing the market effects of airline alliances. The first essay examines how codesharing, a form of strategic alliances, by airlines affects market entry decisions of potential competitors. Researchers have written extensively on the impact that strategic alliances between airlines have on airfare, but little is known of the market entry deterrent impact of strategic alliances. Using a structural econometric model, this essay examines the market entry deterrent impact of codesharing between incumbent carriers in U.S. domestic air travel markets. We find that a specific type of codesharing between market incumbents has a market entry deterrent effect to Southwest Airlines, but not other potential entrants. Furthermore, we quantify the extent to which market incumbents’ codesharing influences market entry cost of potential entrants. The second essay examines the effects of granting Antitrust Immunity (ATI) to a group of airlines. Airline alliance partners often want to extend cooperation to revenue sharing, which effectively implies joint pricing of their products (explicit price collusion). To explicitly collude on price, airlines must apply to the relevant government authorities for ATI (U.S. Department of Justice and Department of Transportation in the case of air travel markets that have a U.S. airport as an endpoint), which effectively means an exemption from prosecution under the relevant antitrust laws. Whether consumers, on net, benefit from a grant of ATI to partner airlines has caused much public debate. This essay specifically investigates the impact of granting ATI to oneworld alliance members on their price, markup, and various measures of cost. The evidence suggests that the grant of ATI facilitated a decrease in partner carriers’ marginal cost, and increased (decreased) their markup in markets where their service do (do not) overlap. Furthermore, member carriers’ price did not change (decreased) in markets where their services do (do not) overlap, implying that consumers, on net, benefit in terms of price changes. ESSAYS ON ECONOMICS OF AIRLINE ALLIANCES by XIN XIE B.A., Wuhan University of Technology, 2006 M.B.A., Pittsburg State University, 2008 A DISSERTATION submitted in partial fulfillment of the requirements for the degree DOCTOR OF PHILOSOPHY Department of Economics College of Arts and Sciences KANSAS STATE UNIVERSITY Manhattan, Kansas 2014 Approved by: Major Professor Philip G. Gayle Copyright XIN XIE 2014 Abstract This dissertation constitutes two essays in the field of industrial organization. Specifically, the research focuses on empirically assessing the market effects of airline alliances. The first essay examines how codesharing, a form of strategic alliances, by airlines affects market entry decisions of potential competitors. Researchers have written extensively on the impact that strategic alliances between airlines have on airfare, but little is known of the market entry deterrent impact of strategic alliances. Using a structural econometric model, this essay examines the market entry deterrent impact of codesharing between incumbent carriers in U.S. domestic air travel markets. We find that a specific type of codesharing between market incumbents has a market entry deterrent effect to Southwest Airlines, but not other potential entrants. Furthermore, we quantify the extent to which market incumbents’ codesharing influences market entry cost of potential entrants. The second essay examines the effects of granting Antitrust Immunity (ATI) to a group of airlines. Airline alliance partners often want to extend cooperation to revenue sharing, which effectively implies joint pricing of their products (explicit price collusion). To explicitly collude on price, airlines must apply to the relevant government authorities for ATI (U.S. Department of Justice and Department of Transportation in the case of air travel markets that have a U.S. airport as an endpoint), which effectively means an exemption from prosecution under the relevant antitrust laws. Whether consumers, on net, benefit from a grant of ATI to partner airlines has caused much public debate. This essay specifically investigates the impact of granting ATI to oneworld alliance members on their price, markup, and various measures of cost. The evidence suggests that the grant of ATI facilitated a decrease in partner carriers’ marginal cost, and increased (decreased) their markup in markets where their service do (do not) overlap. Furthermore, member carriers’ price did not change (decreased) in markets where their services do (do not) overlap, implying that consumers, on net, benefit in terms of price changes. Table of Contents List of Tables ............................................................................................................................... viii Acknowledgements ........................................................................................................................ ix Chapter 1 - Entry Deterrence and Strategic Alliances .................................................................... 1 1. Introduction ............................................................................................................................. 1 2. Definitions and Data ............................................................................................................... 6 2.1 Definitions ......................................................................................................................... 6 2.2 Data ................................................................................................................................... 7 3. Model .................................................................................................................................... 15 3.1 Demand ........................................................................................................................... 15 3.2 Supply ............................................................................................................................. 16 3.3 Dynamic Entry/Exit Game .............................................................................................. 19 Reducing the dimensionality of the dynamic game .......................................................... 23 Value Function and Bellman Equation ............................................................................. 24 4. Estimation and Results .......................................................................................................... 24 4.1 Estimation of demand ..................................................................................................... 24 Instruments for endogenous variables in demand equation .............................................. 25 4.2 Results from demand estimation ..................................................................................... 26 4.3 Estimation of Dynamic Model ........................................................................................ 30 Results from first-stage estimation of parameter vectors and .................................... 32 4.4 Results from the dynamic model .................................................................................... 33 Summary of key findings and discussion ......................................................................... 37 5. Concluding Remarks ............................................................................................................. 38 Appendix A - Transition Rules for State Variables ...................................................................... 43 Appendix B - Representation of Markov Perfect Equilibrium (MPE) using Conditional Choice Probabilities (CCPs) .............................................................................................................. 44 Appendix C - Implementing the Nested Pseudo Likelihood (NPL) Estimator ............................ 46 Chapter 2 - Firms’ Markup, Cost, and Price Changes when Policymakers Permit Collusion: Does Anti-trust Immunity Matter? .................................................................................................. 47 1. Introduction ........................................................................................................................... 47 vi 2. Background Information on oneworld Alliance and Antitrust Immunity ............................ 51 3. Definitions and Data ............................................................................................................. 54 3.1 Definitions ....................................................................................................................... 54 3.2 Data ................................................................................................................................. 56 4. Model .................................................................................................................................... 62 4.1 Demand ..........................................................................................................................