The Contestability of Airline Markets during the Transition to Deregulation

Abstract

The theory of contestable markets has been developed to analyze the equilibrium properties of markets that may have economies of scale but that are characterized by perfectly free and easy entry and exit. In a recent series of papers, Panzar and Willig,1 Baumol, Bailey, and Willig,2 and Baumol and Willig3 have shown that contestable markets, even if actually served by only one firm, exhibit many of the desirable properties of competitive markets in the sense that a weak version of Adam Smith's invisible hand holds sway. In this article we argue that this theory is particularly relevant to city-pair airline markets. Many thin city-pair markets have natural monopoly characteristics, and even those that do not have become readily contested with the demise of restrictive licensing. For most markets, carriers exist with appropriately-sized aircraft and with facilities at one or both end points who could enter. Pricing evidence that accumulated since deregulation is consistent with the premise that medium and long-haul routes served by local service carriers were nearly perfectly contestable in late 1979 and early 1980. In these markets, potential competition by trunk carriers has effectively policed the pricing behavior of the local carriers. The city-pair markets that are primarily served by trunk carriers have been readily contested in the sense that new entry has abounded. However, these markets have not been perfectly contestable since actual competition has brought price changes.