Nonprice competition, cost shocks, and profitability in the airline industry

Abstract

The paper uses stock market data to assess the profit elasticity of nonprice competition and to compare the effects of oil shocks across regulatory regimes in the airline industry. We use the natural experiment provided by the oil shocks of the 1970s to provide market-based estimates of the effect of capacity competition on profits. The 1973 OPEC oil embargo led to oil price increases that resulted in negotiated reductions in scheduled capacity. We show that these negotiated reductions, which essentially amounted to rights to collude on service competition, increased the value of air carriers by insulating the rents created by rate of return regulation from the effects of service competition. The findings include the following. First, the paper provides an empirical estimate of the effect of service competition on profits. We find that a 7% scheduled capacity reduction increases airline expected profits by 16.1%, suggesting that airline profits are very sensitive to nonprice competition. Second, the effects of the oil shocks are negative and similar across regulatory regimes. This result obtains after disentangling the oil price and capacity reduction effects. Failure to distinguish these effects leads to the erroneous conclusion that, under regulation, airlines were sheltered from the oil price shock of 1973. Third, the adverse effects of the 1978–1980 crisis are smaller, the greater the ability of airlines to reorganize their operations to compete in a deregulated environment. In particular, the more involved is the carrier in “hubbing,” the lower the profit effect of the oil shock. At a time when the financial health and competitiveness of the airline industry are being scrutinized and politicians are considering re-regulating the industry, the results suggest that price re-regulation is an ineffective means of promoting financial health since airlines are likely to substitute scheduled capacity for price competition.