Working Paper: NBER ID: w20293
Authors: Christopher Gedge; James W. Roberts; Andrew Sweeting
Abstract: The one-shot nature of most theoretical models of strategic investment, especially those based on asymmetric information, limits our ability to test whether they can fit the data. We develop a dynamic version of the classic Milgrom and Roberts (1982) model of limit pricing, where a monopolist incumbent has incentives to repeatedly signal information about its costs to a potential entrant by setting prices below monopoly levels. The model has a unique Markov Perfect Bayesian Equilibrium under a standard form of refinement, and equilibrium strategies can be computed easily, making it well suited for empirical work. We provide reduced-form evidence that our model can explain why incumbent airlines cut prices when Southwest becomes a potential entrant into airport-pair route markets, and we also calibrate our model to show that it can generate the large price declines that are observed in the data.
Keywords: Dynamic Limit Pricing; Airline Industry; Entry Deterrence; Asymmetric Information
JEL Codes: D43; D82; L13; L41; L93
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Incumbent airlines cut prices (L93) | Entry by Southwest Airlines (L93) |
| Entry by Southwest Airlines (L93) | Incumbent airlines cut prices (L93) |
| Price cuts by incumbents (D43) | Deterring entry by Southwest Airlines (L93) |
| Market power of incumbents (D43) | Pricing behavior in response to entry threats (L11) |
| Pricing strategies of incumbents (L11) | Threat of entry by Southwest Airlines (L93) |