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A Dynamic Oligopoly Game of the Us Airline Industry

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A Dynamic Oligopoly Game of the US Airline Industry: Estimation and Policy Experiments
Victor Aguirregabiria∗ University of Toronto Chun-Yu Ho∗ Boston University

This version: November 19, 2007 PRELIMINARY AND INCOMPLETE VERSION

Abstract This paper estimates the contribution of demand, cost and strategic factors to explain why most companies in the US airline industry operate using a hub-spoke network. We postulate and estimate a dynamic oligopoly model where airline companies decide, every quarter, which routes (directional city-pairs) to operate, the type of product (direct flight vs. stop-flight), and the fare of each route-product. The model incorporates three factors which may contribute to the profitability of hub-spoke networks. First, consumers may value the scale of operation of an airline in the origin and destination airports (e.g., more convenient checking-in and landing facilities). Second, operating costs and entry costs may depend on the airline’s network because economies of density and scale. And third, a hub-spoke network may be an strategy to deter the entry of non hub-spoke carriers in some routes. We estimate our dynamic oligopoly model using panel data from the Airline Origin and Destination Survey with information on quantities, prices, and entry and exit decisions for every airline company over more than two thousand city-pair markets and several years. Demand and variable cost parameters are estimated using demand equations and Nash-Bertrand equilibrium conditions for prices. In a second step, we estimate fixed operating costs and sunk costs from the dynamic entry-exit game. Counterfactual experiments show that hub-size effects on entry costs is, by far, the most important factor to explain hub-spoke networks. Strategic entry deterrence is also significant and more important to explain hub-spoke networks than hub-size effects on demand,…...

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