Market Power and the Northwest-Republic Airline Merger: A Residual Demand Approach

Abstract

After the Airline Deregulation Act of 1978, airline mergers helped create hub-and-spoke route systems. These systems allow flights to be fed into a single city, increase the number of seats filled on each flight and, therefore, increase an airline's efficiency. On the other hand, the hub may allow an airline to dominate its home airport and, in so doing, increase its ability to raise fares above competitive levels. A positive relation between fares and concentration is well known, yet concentration alone is not the relevant issue. Rather, it is the potential increase in carrier market power, beyond pre-merger levels, that determines whether mergers pose a threat to social welfare. It is unknown whether mergers that create dominant hubs cause such increases in a carrier's market power. To this end, we provide a direct econometric procedure for estimating this change in market power and, therefore, for examining whether any given merger should be approved. We (1) refine Baker and Bresnahan's [3] market power test to examine the airline industry and control for firm self-selection;' and (2) use pre-merger data to predict the change in market power, if any, that results from the merger of Northwest and Republic at their hub Minneapolis-St. Paul airport. We obtain three main results: First, by itself, Northwest possesses a large degree of market power at its Minneapolis-St. Paul hub; but, a merger with Republic will slightly reduce its ability to raise fares above competitive levels. Second, we find Republic, by itself, cannot control price; but merged with Northwest's complementary route system, it obtains substantial market power. Third, the merger is predicted to increase Republic's market power whether or not overlap service is provided by Northwest. In all, any increase in market power from this merger derives principally from its impact on Republic.