ABSTRACT MULTIMARKET CONTACT ON TACIT COLLUSION: EVIDENCE FROM THE AIRLINE INDUSTRY by Christopher Granquist This paper examines the effect of multimarket contact on tacit collusion using empirical evidence from the airline industry. We replicate a model of multimarket contact applied to price and apply it to price dispersion, and address potential endogeneity in our measure of multimarket contact through fixed effects. We find three early results: (i) Increased concentration in the U.S. airline industry has reduced the effect of multimarket contact on prices, but the effect remains relatively strong and positive; (ii) The effect of multimarket contact on price dispersion may have either a positive or negative effect based on specification; (iii) First-stage regression results suggest that the percentage of gates owned by a carrier or their low-cost competition at the destination airport on a route is a strong instrumental variable for future extension. MULTIMARKET CONTACT ON TACIT COLLUSION: EVIDENCE FROM THE AIRLINE INDUSTRY Thesis Submitted to the Faculty of Miami University in partial fulfillment of the requirements for the degree of Master of Arts in Economics by Christopher Granquist Miami University Oxford, Ohio 2020 Advisor: Dr. Charles Moul Reader: Reader: c 2020 Christopher Granquist ii This thesis titled MULTIMARKET CONTACT ON TACIT COLLUSION: EVIDENCE FROM THE AIRLINE INDUSTRY by Christopher Granquist has been approved for publication by Farmer School of Business and Department of Economics iii Contents 1 Introduction 1 1.1 Introduction . .1 2 Literature Review 2 2.1 Multimarket Contact . .2 2.2 Price Dispersion . .3 2.3 Contemporary Work . .3 2.4 Contribution . .4 3 Data 4 3.1 Data Sources . .4 3.2 Observations . .5 3.3 Dependent Variables . .6 3.4 Control Variables . .7 3.5 Multimarket Contact . .8 3.6 Instrumental Variables . 10 4 Results 11 4.1 Replication . 11 4.2 Price Dispersion Results . 12 5 First-Stage Regression Analysis 14 5.1 Instrumental Variables . 14 5.2 Results . 16 iv List of Figures 1 Summary Statistics Table .......................... 19 2 Contact Between Airline Pairs, Q1 2014 ................. 20 3 Comparison of Average Contact Summary Statistics ......... 20 4 Log Price Regression Results Table .................... 21 5 Comparison of Average Contact Results ................. 22 6 Gini Coefficient Regression Results Table ................ 23 7 Within-Obs Std. Deviation Regression Results Table ......... 24 8 First-Stage Regression Results Table ................... 25 List of Tables v Dedication vi Acknowledgments vii 1 Introduction 1.1 Introduction Unilateral market power is a well-established theoretical and empirical phenomenon. In the absence of unilateral power, however, it is possible for multiple firms to collude as a cartel to increase market power. The purest mechanism of collusion would be legally-binding collusive agreements, but the real world does not favor legal collusion in markets. Instead, firms may engage in tacit collusion by enacting a set of credible strategies that allow firms an avenue of punishment to those who break a tacitly collusive equilibrium. Mechanisms that allow tacit collusion amount to threats such as price wars. The determinants of tacit collusion is a relatively recent chapter in industrial organization literature, especially concerning firms operating in a single market. However, real world firms operate across many markets, and the resulting multimarket contact that arises allows for new avenues of punishment to enable tacit collusion. Generally speaking, market power creates market inefficiencies. The specific effect of multimarket contact creating market power through tacit collusion may create these inef- ficiencies through multiple routes. The literature finds empirical evidence for the effect of multimarket contact in allowing firms the power to raise prices in a market. Instead of statically increasing prices, tacit collusion may also enable firms to engage in price discrimi- nation. If price discrimination does not increase the quantity of goods sold in a market, then it creates market inefficiencies primarily in the terms of decreased welfare in the market, but also induces a shift of existing welfare from consumers to producers. If price discrimination does exist in a market, it would come in the form of price dispersion, which would indicate different prices being charged to different consumers in the market. The airline industry is a favored industry of industrial organization due to publicly avail- able data and well-defined markets. Evidence for the effect of multimarket contact and its role in facilitating collusion begins with Evans and Kessides (1994), who use airline data to find evidence of a positive effect of multimarket contact on prices. At the same time, Borenstein and Rose (1994) use the airline industry to investigate the effects of competi- tion on price dispersion. We believe it is a natural extension to use airline industry data to examine the effect of multimarket contact on price dispersion as a mechanism of tacit collusion, since strong empirical evidence exists connecting the effect of multimarket contact as a specific mechanism of competition on prices as an effect of tacit collusion, and empirical evidence exists connecting the effect of competition within a market on price dispersion as a mechanism of tacit collusion. We replicate models from the literature, and then apply the models to price dispersion as an independent variable. 1 2 Literature Review 2.1 Multimarket Contact The microeconomic theory of multimarket contacted was formalized by Bernheim and Whin- ston (1990). Bernheim and Whinston produce an irrelevance result for multimarket contact; competition across markets would not affect firm strategy under assumptions of identical markets, identical firms, and constant returns to scale. In the absence of these assumptions, competition across markets may have an effect on firm strategies. Evans and Kessides (1994) find that the airline industry is an ideal industry to test for multimarket contact. Since city- pair markets are well-defined in the airline industry, there are no ad-hoc assumptions made by the researcher. The hub system for airlines encourages airport dominance, which differ- entiates production costs across markets. Firms also sort into national, regional, or low-cost carriers, with varying access to capital and production costs across markets. There is also significant discretized returns to scale as the cost to fly a plane faces only marginally increases fuel costs between flying a single passenger or flying at full capacity. Evans and Kessides (1994) then test the hypothesis that prices in the airline industry are affected by multimarket competition using panel data from 1984 to 1988. EK use an OLS regression on log prices on a suite of controls and a constructed variable to measure multimarket contact, controlling for fixed effects. The multimarket contacted variable con- structed in EK (1994), labeled AverageContact, is a monumental construction in future works addressing multimarket contact in the airline industry. The results conclude that empirical evidence upholds the BW theory of multimarket contact and tacit collusion, such that markets whose firms compete in a number of other markets find significantly higher prices overall as compared to markets whose firms face a low amount of multimarket con- tact. Evans and Kessides also find that market fixed-effects have a significant negative effect on the magnitude of multimarket contact. CW (2014) reexamine multimarket contact in the airline industry by revisiting EK (1994). Using updated data from 2004 to 2007 combined with survey data concerning gate leases, CW (2014) explore structural parameters of tacit collusion. The results find that firms with little multimarket contact do not collude and marginal changes in multimarket contact are only significant for firms at low levels of contact, as well as reinforcing the previous results that assuming Bertrand-Nash competition for firms will lead to biased results. Relevant to our paper, they replicate EK (1994) reduced-form analysis and Ciliberto and Williams suggest that the AverageContact variable as constructed by EK is itself endogenous at the beginning of their research. Ciliberto and Williams also explore a wider variety of control specifications as well as using number of gates leased by a firm and their competition at airports in the market as an instrumental variable for the AverageContact regressor. 2 2.2 Price Dispersion Concurrently to Evans and Kessides in 1994, Borenstein and Rose (1994) examine the airline industry. Instead of analyzing mutltimarket contact, however, Borenstein and Rose investi- gate price dispersion in the airline industry. BR (1994) uses the Gini coefficient (defined in Section 3.4) as a measure of price dispersion. The results find that price dispersion cannot be entirely explained by cost variation, and instead that price discrimination is driving a significant effect of price variation. BR further explain possible sources of price dispersion, emphasizing that price discrimination may increase in the face of increasing competition. Borenstein and Rose also use an OLS regression of Gini on a suite of controls as well as several variables to measure competition, and then instrument the competition variable. The result of BR is a finding of a positive association of competition within a market to price dispersion, of which a significant portion of the price dispersion is attributed to price discrimination. GS (2009) revisit Borenstein and