The Meaning of Size: Output? Scope? Capacity? The Case of Airline Hubs

Abstract

The "size" of a production facility has different specific meanings depending on the nature of the business decision at issue. We present a general theoretical model illustrating the profit-maximizing firm's interrelated choice of plant size in long-run, medium-run and short-run contexts. The model is then estimated for U.S. airline hubs. The results suggest that competition operates primarily via the capacity (long-run) size decision. A game-theoretic simulation based upon the results is consistent with the argument that the smaller of two hubs sharing an airport is at a significant competitive disadvantage. The "size" of a plant seems a simple concept. Yet, depending on the reason for ask- ing "how big" the plant is, several different definitions are evoked by economists to answer that question. Examples include the current volume of output, the short-run capacity of the plant, and minimum efficient scale. Looking in another dimension, a measure of scope ("How many distinct products does the firm produce at this plant?") is sometimes needed. And, finally, for some purposes it is relative size (measured, e.g., by market share) that is most relevant. The standard textbook discussion of size speaks of these matters at a high level of abstraction. Typically the choice of plant size is portrayed as a long-run decision; it is the combination of fixed inputs that minimizes the cost of producing the desired long-run output. In the short run, firms are said to choose the mix of variable inputs that maximizes profits given the set of fixed inputs already in place. Within that plant, firms may vary output and capacity utilization (within limits). The mission of this paper is twofold. First, we aim to provide a deeper under- standing of the hierarchical relationship which underlies the output, scope and capacity choices of a firm. We do this by modeling explicitly the profit-maximizing calculus of the firm as it makes long-run and short-run decisions affecting its size. Though the model arises from the specific context of the airline industry, in which a hub serves the function of the plant in the generic textbook discussion, it is in fact a quite general discussion of these interrelated choices. Second, we use this model to illuminate some significant aspects of airline competition.