An Analysis of the Impact of Open Entry on Price and the Quality of Service in the Airline Industry

Abstract

D URING the past three years there has been a gradual transition toward deregulation of the airline industry by the Civil Aeronautics Board (CAB) as originally proposed in the Federal Aviation Act of 1975 and finally enacted in the Airline Deregulation Act of 1978. This move is intended to allow for competitive pricing and freedom of entry and exit in the domestic airline markets during 1981. So far, the price competition has been restricted by the CAB to the offering of discount and standby fares. The impact on price has been a reduction in revenue per passenger mile from 8.24? in 1977 to 8.02? in June of 1979.1 Over this same period the quality of service has declined as measured by an increase in the load factor from 56.1% to 63.6%. This result is consistent with most predictions regarding the impact of price competition in this industry.2 Alfred Kahn (1978) has argued that price competition by itself would (and should) result in a variety of services for consumers but that it could reduce the average quality of service via higher load factors. Price competition is, however, only one dimension of a fully competitive airline market. While price competition will certainly tend to increase load factors, the effect of entry should be to lower them as firms compete through scheduling frequency. The interaction between these forms of competition produces a technical tradeoff between lower prices and higher quality of service and thus raises the question of what a truly competitive airline market will provide the consumer of airline services. This paper examines this intrinsic tradeoff between price and quality in the provision of airline service and analyzes the implications for a competitive airline industry. The presence of this tradeoff has been suggested in the theoretical models of Douglas and Miller (1974b) and DeVany (1975). In both models there is purported to be an inverse relation between the load-factor and the number of firms in a market due to scheduling competition and an inverse relation between the load-factor and the fare level due to profit-maximizing supply responses of firms serving the market.3 It is these theoretical propositions that produce a tradeoff between fare level and the quality of service and make the effects of competition in the typical airline market difficult to predict. Using these theoretical models as a basis, this paper develops an empirical analysis of the relation between fare level, open entry and the quality of service and its implications for a competitive airline market. This involves, first, estimating the equilibrium price and load factor which results from competition in a market with a fixed number of firms. Then, the independent effect of open entry on the competitive market outcome is identified by varying the number of firms and examining the capacity response due to scheduling competition. This analysis yields the zero-profit price and load factor for varying degrees of market concentration. JThe profitmaximizing and output-maximizing price-quality combinations are also generated for the same market conditions. A comparison of these alternative market solutions provides the basis for analyzing the inherent price-quality tradeoff in the provision of airline service and some insight into the nature of a fully competitive airline market. Crucial to the analysis proposed above is an empirical estimate of the supply response of firms serving a city-pair market to changes in Received for publication April 23, 1980. Revision accepted for publication April 15, 1981. University of Texas at Arlington and Southern University of New Orleans, respectively. I These figures are computed using data on domestic trunk carriers in all U.S. markets. They are taken from Air Transport (1979). 2 This prediction follows from the generally accepted theoretical model as developed by DeVany (1975) and Douglas and Miller (1974b). I Douglas and Miller (1974a,b) provide some empirical evidence of the inverse relation between the average load factor and the number of firms serving the market using a crosssection sample of city-pair markets operating in the United States. Similarly, DeVany (1975) provides some preliminary empirical tests of his model and finds the results to be generally consistent with these theoretical propositions.