Evidence of Changing Contestability in Commercial Airline Markets During the 1980s

Both economists and policymakers championed the deregulation of the commercial airline industry during the late 1970s. Proponents of deregulation argued that competition would be enhanced and as a result, consumers would pay lower fares in a deregulated airline market. Now, a little more than a decade after it began, some of these same economists and policymakers are tempering their enthusiasm for airline deregulation. From the onset, declines in in-flight service, baggage handling, on-time arrival performance, and safety (e.g., near-misses between airplanes) were cited as indicators of the negative effects of airline deregulation (Dempsey 1990; Moore 1986; Trapani and Olson 1982). More recently, reports of growing market concentration, both within various market segments and across the airline industry as a whole, have been used as indicators of deregulation-induced troubles (McGinley 1989; Mead 1989). Some policymakers, alarmed at the rising concentration figures, are even going so far as to propose that regulatory measures be reintroduced into the airline market (McGinley 1989; Nomani and Barrett 1990). Yet observing a change in market concentration should not automatically lead to the conclusion that airline deregulation is failing. A decline in the number of carriers nationally may not translate into a decline in the number of carriers competing for a specific route. If competition on specific routes remains higher than in the regulatory era, then it may be incorrect to conclude that deregulation is not working. Furthermore, even if route-specific competition drops off, one must examine how this decline affects the fares charged and the demand for air travel. If an airline market is contestable, that is, if credible threats of entry discipline pricing in a market, then a decline in the number of competitors will not translate into an increase in airfares above the competitive level. And to the extent that fares do increase, their impact on consumer welfare will depend on the price elasticity of demand in that market. In this paper, commercial airline markets in the United States are examined at three different points in time. For each time period market systems are estimated that include different concentration measures among the regressors. The significance and sign of these concentration measures are viewed to indicate contestability in the commercial airline market. Implications of changes in the significance of the concentration measures are evaluated in the context of changing consumer demand for commercial airline travel. The first set of estimates is based on data from the third quarter of 1983, a time when many new carriers were entering the interstate airline market. Data from the third quarter of 1987 are used for the second set of estimates. By this time an increase in overall market concentration had become evident. Indeed, by 1987, nine of the 17 post-deregulation market entrants had failed and four of the remaining eight had been acquired by other airlines (Congressional Budget Office 1988). This decline in the number of carriers nationally continued between 1987 and 1990. Data from the third quarter of 1990 are the basis for the final set of estimates. The estimates from these three years are used to gain insights regarding the extent to which contestability may have changed in the commercial airline industry. LITERATURE REVIEW Some scholars (Baumol, Panzar, and Willig 1982; Kahn 1988) argue that although the airline market is not (and has never been) characterized by a large number of firms, competitive fares may prevail because the market is generally contestable. A contestable market is one in which "entry is absolutely free, and exit is absolutely costless" (Baumol 1982, 3). As a result, there is the potential for competitors to enter the market at any time. It has been suggested that this threat of entry leads firms to set fares at a competitive level, even if the actual number of carriers in a market is quite small. …