New Research Predicts Post-Merger Airline Behavior

Monday, November 7, 2022

In the United States, mergers that are likely to lessen competition are prohibited because they expose consumers to higher prices and/or inferior products and services. In the airline industry, anticompetitive mergers can lead to higher ticket prices and fewer choices for travelers.

This is especially true when the newly joined airlines are the only nonstop carriers along a route. If flying nonstop is a priority for passengers, they are now at the mercy of a carrier that can set its ticket prices above the previous rate.

Antitrust agencies, which are regulatory authorities overseen by the U.S. Department of Justice (DOJ) that protect and promote competition, analyze mergers, and present evidence to make their case in court to block a merger. Once the merging companies and the DOJ have made their arguments, a judge must determine if a merger gives an airline too much market power, which can lead to unreasonably high ticket prices. Market power in this context refers to the ability of a carrier to set ticket prices above marginal cost, resulting in profit.

Now, thanks to Purdue University Assistant Professor of Economics Joe Mazur and his coauthors, mergers between air carriers can be analyzed in a new way. Their new model quantifies “selection,” which is the idea that the distribution of costs and service quality is different for carriers that have chosen to launch transportation services along a route post-merger than those who have chosen to stay out.

In their research paper “Repositioning and Market Power After Airline Mergers,” published in the RAND Journal of Economics, Mazur and his coauthors consider data from domestic flight itineraries and flight records from the second quarter of 2006 to estimate their model. The model effectively predicts what other airlines not involved in a merger will do in response to that merger.

Mazur’s model estimates the rate at which rival airlines launch nonstop service, and he can then determine if this repositioning sufficiently prevents prices from rising. The researchers also examine how service choices (whether competing firms choose to offer nonstop or connecting flights) affect the market power of merging firms.

The paper shows that, if carriers have full information about demand and marginal costs, carriers will often choose the service type in which they are most profitable. When the merging carriers are the only airline that offer nonstop routes, the data indicate that rival carriers will launch nonstop service 18% of the time. This figure is close to the actual rate of 25% for routes that meet the same criteria.

Selection comes into play when evaluating the timeliness, likelihood, and sufficiency of other carriers setting up shop along a route after a merger. These criteria are outlined in the Horizontal Merger Guidelines to ensure that the new entrant will provide services along a route in a reasonable amount of time and that the new carrier is a strong enough competitor to drive down prices.

A merging carrier will argue the potential entry defense: that is, we know prices will initially increase from the market power gained post-merger, but other carriers will soon launch services along the route to combat this. The paper highlights that this is not always the case.

Carriers that already choose to offer services along a route are there because their costs are low enough and their quality of service is high enough to allow them to operate profitably. Airlines that do not offer services along a route have chosen to remain outside that market for a reason. Perhaps their costs would be too high, or their service quality would be too low. Alternatively, maybe an airline is willing to launch service, but they would not be competitive enough to bring ticket prices back down.

The model, according to Mazur, provides antitrust authorities with a tool to evaluate mergers. “Whereas practitioners were ‘thinking about’ these things before but not able to rigorously analyze them, now they have a tool to actually quantify the likelihood and sufficiency of potential entry.”

"Moreover, that tool doesn’t just apply to airline mergers, but to all mergers,” he said. “Once you account for selection, you see that the likelihood and sufficiency of potential entrants in these markets is quite low, which goes a long way toward explaining why prices stay high after airline mergers, instead of falling.”