The short and long run effects of entry on U.S. domestic air routes.

There has been much written in the popular and trade press recently about the entry of "low cost" carriers onto domestic air routes and the competitive responses of incumbent carriers. For example, when Southwest Airlines, "the industry's perennial low-price champ,"(1) entered the Washington/Baltimore market in 1993 with flights from Baltimore-Washington International (BWI), the Wall Street Journal reported that fares to be offered would be as much as 86 percent cheaper than existing fares and that incumbents Continental Airlines and USAir would compete with their own low fares.(2) Aviation Week & Space Technology stated that Southwest's chairman, Herbert D. Kelleher, expected total traffic on Southwest's two new BWI routes (to Cleveland and to Chicago) to double or triple within a year.(3)

An important policy question arises from these reports: Are the introductory low prices sustained past the promotional period? If the low introductory prices are not sustained past the promotional period, it may be that they are predatory, designed to drive out competition with little or no long-term benefit to the airline passenger. A recent report prepared by the Office of Aviation Analysis of the U.S. Department of Transportation found evidence that the low fares offered by Southwest may not be sustained. The authors stated:

Without a competitive discipline, over time Southwest's fares will increase to cover cost inefficiencies that will creep in, and to extract monopoly profits. We already see Southwest's prices beginning to increase where it has forced out its competition and its load factors have attained relatively high levels.(4)

In this article we use time series analysis and econometric models to address two questions related to entry on U.S. domestic airline routes:

First, how different is the effect of the low cost carriers' entry onto routes from the entry of other carriers? Although low cost carriers such as Southwest may generate considerable publicity when they enter routes, it may be that established carriers, such as American and United, use a similar low fare entry strategy. Their entry could result in price effects and traffic generation not statistically different from that of the low cost carriers.

Second, are the price and traffic effects of new entrants, both low cost and other carriers, sustained past the initial promotional period or are they merely promotional? In answering this question, we try to address the wider public policy question as to the longer-term consumer benefits from new entry. If competition is driven out of a market by low promotional fares, and if these fares are not maintained, then there is clearly little long-term benefit from route entry.

The rest of the article is structured as follows: The next section reviews the literature on pricing, entry, and competition in the airline industry. Section three presents a time series analysis of entry during the 1991 to 1994 period. Section four presents an econometric model to analyze the effect of carrier presence on price. Finally, section five draws conclusions and discusses the public policy implications of the results.

LITERATURE REVIEW

There has been extensive research concerning the determinants of prices or yields on U.S. domestic air routes, including the presence of new entrants or low cost carriers on a route.(5) Common variables used to explain yields include measures of route concentration and measures of airport presence at the endpoints of a route. The research generally shows that increased concentration on routes as well as increased market share at route endpoints contributes to higher yields. In two of the papers reviewed, the researchers explicitly measured the effect of newly certified low cost carriers on yields using econometric models.(6) Bailey, Graham, and Kaplan,(7) using 1980-1981 data, and Strassmann,(8) using 1980 data, both found that newly certified carders had a negative and significant effect on U.S. domestic yields. Two other papers, without using formal modeling, provided evidence that low cost carriers depress yields. Although the major thrust of the paper by Whinston and Collins(9) was to examine the effect of entry by the low cost carrier, People Express, on stock prices, the authors also provided some evidence that the carrier served to lower airline prices. The authors showed that mean prices fell by 34 percent on the fifteen routes People Express entered during the two-year period 1984-1985. Whinston and Collins also showed, using a small route sample, that prices did not climb back to original levels in the year following entry. Bennett and Craun(10) examined the effect of low cost carrier Southwest on yields and traffic. The authors present graphs that illustrate when Southwest entered certain California markets in 1989 and 1990, there was a dramatic increase in traffic and a major drop in yields. The graphs do not indicate any major increase in fares or drop in traffic in the periods following Southwest's entry, providing evidence that [TABULAR DATA FOR TABLE 1 OMITTED] Southwest's low prices and traffic boosts are sustained past the original promotional period.

In summary, there is some econometric evidence available indicating that low cost carriers depress fares on routes in which they operate and some illustrative examples indicating that fares are not substantially increased in the periods after entry by low cost carriers. In the next section, we describe the effects of entry on prices, market concentration, and passenger traffic during the years 1991 to 1994.

TIME SERIES ANALYSIS

Data were collected on the top 200 U.S. domestic origin and destination pairs as of the second quarter of 1994, for the three-year period from the third quarter of 1991 to the second quarter of 1994. These data were the most recent data available at the time of analysis. A three-year period was thought long enough to generate sufficient time to determine longer-run entry effects on prices and passengers. The data were provided by Database Products, a private company that produces reports based on data originally supplied from the U.S. Department of Transportation's Database 1a, or 10 percent ticket sample. The data included origin and destination passenger traffic, yields, and average length of haul by carrier on each of the 200 routes. Other data collected included population and per capita income for each of the origin and destination cities and stage lengths for each of the city pairs.(11)

Table 1 presents means for the key variables in our analysis. The mean one-way price on a route was $135.84. The average route distance was 816 miles, providing carriers a yield of about seventeen cents per mile. The mean score on the Herfindahl Index was 4,777, which allows for slightly more competition than one would find on a route with two carriers, each with a 50 percent market share.(12) The average number of passengers per quarter, per route, both directions, in our sample was about 139,000. Thirty-seven percent of the routes in the sample had slot controls at one or both of the endpoints. Twenty-three percent of the routes in the sample had slot controls at one or both of the endpoints. Twenty-three percent of the routes were classified as vacation routes (with one endpoint in Florida, Nevada, Hawaii, or Puerto Rico), and 2 percent of the routes were intra-Hawaiian routes.

Table 2 provides a description of entry activity during the three-year period.(13) It can be seen that carriers entered a total of 168 routes during that period, with entry activity peaking during the second quarter of 1993 with twenty-three entries reported. Southwest and Reno Air had [TABULAR DATA FOR TABLE 2 OMITTED] the most entry activity with, respectively, nineteen and eighteen routes entered, while the largest carders had relatively few entries. Delta Airlines, for example, reported only one entry during the three-year period.

As a counterpoint, Table 3 provides statistics on exit from the 200 routes over the three-year time period.(14) As indicated in the table, there were 125 route exits during the period. Although a number of the exits were related to carriers ceasing operations (Enterprise, Midway, Pan Am), the majority of them resulted from business decisions of ongoing carriers. Among the carriers that exited from the most routes were American (14), TWA (12), and United (11).

One of the goals of this article is to examine the impact of entry by different carriers. In order to facilitate this goal, Figures 1 through 3 each contain information on the impact of entry [TABULAR DATA FOR TABLE 3 OMITTED] on four separate sets of air carriers. The solid bold line with squares represents the impact of all air carriers. The dashed line (long dashes) with triangles represents the impact of carriers that were in existence as interstate carriers prior to deregulation and includes American, Continental, Delta, Northwest, TWA, United, USAir, and Pan Am. The dashed line (short dashes) with ovals represents the impact of Southwest Airlines. The solid line with Xs represents the impact of all other carriers in Table 1, except those included in the previous two groups and the intra-Hawaiian carriers. The groupings are intended to show if there are differential effects of entry dependent on the identity of the entrant.

Figure 1 provides an indication as to what happens to market concentration on a route after entry. The figure shows movements in the Herfindahl Index in the four quarters before and after entry. The Herfindahl measures in the figure are indexed to 1 in the quarter before entry. One would expect that concentration on a route would fall after a carrier enters and the figure indicates that this is precisely what happens. Concentration falls, on average, by 15 percent in the quarter following entry. This is offset by a five percentage point rise during the next three quarters. As indicated in Figure 1, the decrease in the Herfindahl Index is largest when Southwest Airlines enters a route. Entry by Southwest results in a 25 percentage point drop in the quarter following entry.