In work on airline fares, Morrison and Winston (1995) reported the following reg
ID: 3226598 • Letter: I
Question
In work on airline fares, Morrison and Winston (1995) reported the following regression model results for the 3rd quarter of 1993. The sample included carriers providing direct or on-line connecting service for the 1,000 most heavily traveled routes in the U.S. t-statistics are in parentheses.
a.From these results, does actual competition discipline the market? How about potential competition?
b. Are the results consistent with a model of pure contestability?
c. Why would you expect an increase in flight distance not to have a proportional effect upon airfares? Do the results in the above regression bear this out? What impact does a 10% increase in flight distance have upon airfares in 1993?
d. From the reported results, what effect does route density have upon airfares? Is it possible to explain the result on route density in terms of an airline’s load factors?
ln average fare 027 ln (route competitors) -.120 ln airport competitors) (2.1) C12.00 .383 ln (distance) .048 ln (route passengers) (47.9) (9.6) R2 48 observations 35,513Explanation / Answer
ln(average fare) = -0.027 ln(route competitors) – 0.12 ln(airport competitors) + 0.383 ln(distance) – 0.48 ln(route passengers)
a.From these results, does actual competition discipline the market? How about potential competition?
With increase in route and airport competitors, there will be decline in the average fare because the coefficients of route and airport competitors is negative. Increase in airport competitor will have more adverse effect on average fare as compared to route competitors. So the actual competition discipline the market. There is potential competition if there is evidence that a new firm could and would be likely to undertake the necessary additional investments or other necessary switching costs to enter the relevant market in response to a small and permanent increase in prices. From the regression equation, if there is any increase in the value of competitors and the distance and route passengers are constant, the average fare will come down. So there is not potential competition.
b. Are the results consistent with a model of pure contestability?
If a firm in a contestable market raises its prices much beyond the average price level of the market, and thus begins to earn excess profits, potential rivals will enter the market, hoping to exploit the price level for easy profit. When the original incumbent firm(s) respond by returning prices to levels consistent with normal profits, the new firms will exit. So in a contestable market, if the average fares increases the number of airport and route competitors increases to bring down the average fare. The regression equation shows that increase in number of competitors will lower the average fare if the distance and route passengers are constant. So, the results are consistent with the model of pure contestability.
c. Why would you expect an increase in flight distance not to have a proportional effect upon airfares? Do the results in the above regression bear this out? What impact does a 10% increase in flight distance have upon airfares in 1993?
The airfares would not be proportionately related with the distance. That is if the distance is doubled, airfare cannot be doubled. This is because, apart from the fuel costs (related with distance), there are other costs like maintenance cost, employees cost etc which are not proportinately related with distance. This is reflected in the regression equation. If the distance is doubled, keeping other variables constant, the average fare will increase by (0.383 * ln 2) 0.2654 times and not doubled.
If all other variables are constant, 10% increase in flight distance will led to increase in 0.383 ln(1.1 * distance), that is 0.383 ln(1.1) = 0.0365. So, the new average fare would be ln(old fare) + 0.0365 =
ln(old fare + e^0.0365) = ln(old fare + 1.037) = ln(1.037*old fare)
So, 10% increase in flight distance will led to increase 3.7% increase in air fare.
d. From the reported results, what effect does route density have upon airfares? Is it possible to explain the result on route density in terms of an airline’s load factors?
The coefficient of route passengers in negative, so increase in route density will lower the airfare. With increase in route density, there will be increase in airline’s load factors, which increases the company efficiency and the profitability to cost ratio. As the profitability of the company increases, it passes some share of profits to its customers by lowering down the airfares in the competitive market. So with increase in route density the airfare will decrease.