HD28
DO
AIRLINES IN CHAPTER
11
HARM THEIR
RIVALS?:
BANKRUPTCY AND PRICING BEHAVIOR
IN U.S. AIRLINE MARKETS
Severin Borenstein
Nancy
L.
Rose
Massachusetts Institute of Technology
WP#3798
February 1995
Do
Airlines in Chapter 11
Harm
Bankruptcy and Pricing Behavior
Their Rivals?:
in U.S. Airline
Markets
by
Severin Borenstein* axid
Nancy
L.
Rose**
Februajy 1995
Abstract: The behavior of firms
emd policy
much of the
distress,
in financial distress
interest in recent years.
The turmoil
public poUcy discussion, as
has attracted considerable academic
in the U.S. airline industry has triggered
some observers have argued
paxticulaxly those operating under Chapter 11 bankruptcy protection, reduce
prices to the point of
harming themselves and
their competitors. This study investigates
the pricing strategies of bankrupt airlines and their
airUne's prices typically decHne
remain
that airlines in financial
somewhat before
slightly depressed over the
it
rivals.
files
suggest that an
The data
for baxikruptcy protection
subsequent two or three quarters.
We
find
and
no evidence
that competitors of the bankrupt adrline lower their prices, however, nor that they lose
passengers to their bankrupt
harm
rival.
These
restilts indicate that
bankrupt carriers do not
the financial health of their competitors.
OP TECHNOLOGY
M4y 3
1995
l-IBRARIES
We
thank Robert Gertner for helpful comments, and the National Science Foundation,
Alfred P. Sloan Foundation, auad Center for .\dvanced Study in the Behavioral Sciences for
financicd support. A shortened version of this paper is forthcoming in American Economic
Review Papers and Proceedings, May 1995.
*
University of California Energy Institute, 2539 Channing Way, Berkeley,
510-642-5145, U.C. Davis, and NBER. email: sjborenstein@ucdavis.edu.
CA
94720-5180,
** Sloan School of Management and Department of Economics, M.I.T., Cambridge,
02139, 617-253-8956, and NBER. email:nrose@mit.edu.
MA
Modern economics has generated many
condition
that a
may
affect its
conduct
company constrained by
aggressively, a
common
in the
theories of the
ways
product market.
which a firm's financial
in
Though some
of these imply
capital structure or financial distress will
view among business people
is
compete
less
that a firm in financial trouble has
'nothing to lose" and will slash prices to "generate cash." Perhaps nowhere has this view
been repeated more often than in the
as a blue-ribbon
financially
weak
government task
airlines,
and
airline industry.
force
Managers
major
at
carriers, as well
on the industry's financial woes, have argued that
especially those under
Chapter 11 bankruptcy protection,
have cut prices and harmed the financial health of the industry.^
There are a variety of channels through which financiaJ
particular,
might
affect pricing decisions of
bankruptcy protection
may
distress,
such firms and their
directly alter costs or
demand
and bankruptcy
First, fihng for
rivals.
for the
in
bankrupt
carrier.
If
bankrupt carriers are able to lower their marginal costs through abrogation of existing
labor and equipment lease contracts, then filing for bankruptcy
preferred price on a route. Similarly,
if
and consequently reduce
want to lower
its price.
their
airlines
demand
may
for its flights, a
tacmg other
more
airlines.
heavily.
Second, bajikruptcy
may
bankrupt
carrier
may
choose to match these price decreases or
depending on how lower prices of the bankrupt carrier
not,
lower a carrier's
paissengers perceive a bajikrupt carrier to offer lower
quality service
Competing
may
affect the residual
demand
lead an airline to discount future revenues
This could imply either higher current prices
(ais
in
models with consumer
switching costs, where lower current prices can be viewed as an investment in meirket
share that generates higher profits in the future) or lower current prices (as in collusion
models, where increases in discount rates
behavior).
it
to
Third, bankruptcy
may
more aggressive competition
may
lead to deviations from cooperative pricing
alter the strategic position of the firm,
(e.g.,
by inducing a preference
committing
for greater risk) or less
aggressive competition {e.g., by increasing liquidity constraints or otherwise constraining
managerial actions).
Finally,
bankruptcy may
invite predatory behavior
by financicdly
The Report of the National Commission to Ensure a Strong Competitive Airline Industry states that
"The Commission recognizes that the financial problems facing the airline industry have been caused
by a number of factors and that bankrupt carriers have been one of those factors." (p. 15).
healthy rivals because
may Umit
it
the ability of the bankrupt firm to finance a costly
price war.
Despite considerable theoretical work, there have been few empirical tests of financial
This study contributes to the
or capital structure effects on product maxket behavior.^
empirical evidence by reporting the effect of bankruptcy announcements on pricing behavior in the U.S. airhne industry.
by large U.S.
air carriers
We
use data from the seven Chapter 11 bankruptcy fihngs
between 1989 and 1992: Eastern (March 1989), Braniff (Septem-
ber 1989), Continental (December 1990),
America West (June 1991), and
largest of these, as
nental,
TWA
Pan
Am
TWA. We
We
(January 1992).
measured by the number of
America West, and
(January 1991), Midway (March 1991),
focus primarily on the four
affected domestic routes: Eastern, Conti-
find Uttle evidence that
bankruptcy per se
affects
an
airUne's pricing behavior, although financial distress that culminates in a bankruptcy filing
appears to be associated with somewhat lower prices by the distressed
carrier.
Among
the
four major bankruptcies, only one airhne - Eastern - appears to have significantly reduced
its
prices subsequent to filing for
effects of a
contemporaneous
competing with bankrupt
bankruptcy
The
10%
We
first
11,
and
this
change
strike against the airline.
airlines cut their prices
We
may be confounded
find
with the
no evidence that earners
on overlapping routes subsequent
to a
even for the Eastern bankruptcy.
analysis in this
portation's
1993:2.''
filing,
Chapter
paper
is
based on fares recorded in the Department of Trans-
sample (Databank lA)
ticket
detail the pricing behavior of
for the
26 quarters from 1987:1 through
bankrupt
airiines
and
their rivals for each
of the four major bajikruptcy events. Regression ajialysis of price changes for the full set
of bankruptcies follows.
I.
Pricing Behavior
Around Major Bankruptcy Events
Figures l(a-d) present price trends around the four major airhne bemkruptcies. For
^
See Chevalier, 1994, Chevalier and Scharfstein, 1995, and Kovenock and Phillips, 1995, for examples.
*
Details of the dataset construction are available from the authors, and are virtually the same as those
described in Severm Borenstem and Nancy Rose (1994). A routes was included only if there were at
least 90 passengers recorded in each of the quarters analyzed.
each quarter, we compare the airhne's sampled ticket prices to the average price
domestic tickets on routes
"normalized price"
reflects faxes
price for that quarter.
bankrupt
same 100-mile distance
in the
The
quarter in which the bankruptcy
ior,
we note
to its
filing
normalized prices averaged across
marked change
filing.
Prior to
and apparently permanent, although
5%
Hne indicates the
own
pricing behav-
in pricing patterns
less
subsequent
than industry averages. The decline in
to
25% below
effects
with those of
This stands in contrast to the three other ma-
Continental,
TWA
and America West
all
appear to have
reduced fares relative to previous trends about 6 months before their bankruptcy
these returned to trend within 6
Continental
fcires
months
for
TWA, and
filings;
within a year for America West.
continued to decline relative to industry average fares through the end of
our sample period. With the exception of Eastern, these figures provide
permanent price changes induced by the bankruptcy
tress rather
its
industry average fares)
may confoimd bankruptcy
this
a labor strike during the same period.'*
we analyze.
non-
March 1989 bankruptcy amnouncement, Eastern's
its
bankruptcy was large (dropping to 15%
jor bankruptcies
vertical
the effect of a bainkruptcy filing on an airline's
normalized prices were stable at about
prices after
The bold
all
occurred.
that only Eastern exhibits a
bankruptcy
value of zero for this
solid lines in each figure trace the normalized prices for the
bamkrupt competitors present on the same routes.
first at
A
equal to the (distance-adjusted) overall domestic average
carriers; the da.shed lines trace the
Looking
block.
for all
than bankruptcy per ae
may be
fiHng,
little
and suggest that
evidence of
financial dis-
responsible for observed changes in an airline's
price preferences.
The
is
pricing behavior of non-bankrupt carriers on routes served by each bankrupt firm
represented by the dashed lines in figures l(a-d).' These do not support the contention
that bankrupt airlines have forced
down
For
the prices of their competitors.
major bankruptcy events, competitors raised normalized
all
four
prices in the quarter their rival
The Eastern
strike in the second quarter of 1989 virtually shut dovm the airline and created significant
negative press coverage. We cannot distinguish Eastern's change in pricing strategy around the
bankruptcy from the effects of this strike.
All tickets of
non-bankrupt carriers on a route are included in these calculations
10% share of traffic on the route during the quarter.
carrier has at least a
if
the bankrupt
declared bankruptcy; in 3 of the 4
following the bankruptcy
While these
ceises,
competitors' prices increcised further in the quarter
filing.
figures provide a convenient
summary
of relative price trends, they do
not control for changes in the mix of routes over time. Route changes could pose a particular
problem
for this analysis, since the financially distressed airlines tend to exit routes
5%
completely or drop below the
a caxrier
is
We
"active".
route share threshold
fore the
airlines.
The
bankruptcy
to
denote routes on which
therefore next calculate average changes in distance-adjusted
normalized prices for the a matched
bankrupt
we use
first
filing;
set of routes.^
row indicates the
Table
level of
1
reports these results for the
normalized prices two quarters be-
the subsequent rows report changes in prices relative to this
benchmark over the following four
quarters.'
The number
of routes used in each price
caiculation axe bracketed.
The Eastern column,
for
example, shows that on the 744 Eastern routes in the third
quarter of 1988 (1988:3, two quarters before Eastern filed for bankruptcy), Eastern's prices
were 0.9% below industry average, controlling for
1989:1, the quarter
routes on which
bankruptcy
it
filed for
it
was
filing axe
still
distcuice. Eastern's
normalized prices in
bankruptcy protection, had increased by 1.7%
active.
Data on
for the
prices in the quarter immediately following the
not very informative, since Eastern virtually shut
down
in 1989:2 (it
remained active on only 22 routes). By 1989:3, however. Eastern had returned to
operations (with 564 active routes), and
had been a year
bankruptcy
^
filing,
this
The normalization
is
its
is
now
its
prices subsequent to its
not true of the three other major bankruptcies.
relative to prices of
significant
normalized prices were 16.9% lower than they
While Eastern substantially lowered
earlier.
593
non-bankrupt carriers on routes
in the
Continental,
same 100-mile
distance category that have no bankrupt (or soon to be bankrupt) carrier present. This approach still
does not adjust for changes in "traffic mix," such as decreases in average yield for bankrupt carriers
due to a decline in the proportion of higher fare business travelers. For a carrier in bankruptcy, this
effect will lower the average price reported if, as is often suggested, business travelers are the first to
abandon financially distressed airlines. Similarly, this effect could generate increased average prices
for competitors of a bankrupt airline as a result of a "richer" traffic mix.
''
assure that the bankrupt carrier has been a significant competitor in a route, a route is included
bankrupt carrier has at least a 10% route share two quarters before the quarter
in which it declares bankruptcy. We calculate price changes on the route whenever the bankrupt
carrier has at least a 5% route share.
To
in the analysis if the
-0.009
Table 2
Price Changes of Competitors of Chapter 11 Airlines
Airline
+0.021
Relative Price at t-2
-0.009
-0.363
-0.067
[645]
[261]
[403]
[739]
Change
Change
Change
Change
t-2 to
t-2 to
t-2 to
(0.003)
(0.003)
(0.015)
(0.004)
[658]
[633]
[251]
[399]
-0.009
-0.018
(0.004)
(0.005)
(0.009)
(0.008)
[586]
[608]
[228]
[392]
+0.027
t
t+1
(0.023)
(0.007)
[21]
[608]
[222]
TWA)
to the
or higher (for Eastern
bankruptcy
filing.
As
[387]
(0.007)
(0.010)
(0.009)
[602]
[207]
[359]
[561]
Number
(0.007)
+0.005
+0.020
+0.006
(0.005)
and
+0.007
(0.010)
+0.071
Standa.rd error of average in parentheses.
+0.043
+0.057
+0.024
-0.020
t+2
+0.015
-0.129
+0.010
+0.001
t-2 to t-1
TWA
America West
Continentai
Eastern
of markets included in brackets.
and America West) than they were two quarters
prior
in the figures presented eaxUer, the evidence does not support
the claim that bankrupt airhnes have forced competitors to lower their prices.
These ancdyses average the prices across
some popular accounts suggest that
all rivals,
although theoretical models and
price responses might differ.
Models of predatory
behavior, for example, suggest that financially healthy ("deep pocket") carriers are more
Ukely to undertake aggressive pricing against weaker
airlines
ties
have been more outspoken thaji others
on the behavior of financially weak
in
carriers.
rivals.
Similarly, executives at
blaming the
some
indxistry's financial difficul-
Table 3 reproduces the
last
row
of Table 2
individually for each of the six largest U.S. airlines that have not entered Chapter 11 since
deregulation.
American
Airlines, probably the
Chapter 11 protection, has raised
its
critic of airiines
operating under
post-bankruptcy prices relative to industry norms in
3 of the 4 bankruptcies, the 3 cases in
US Air,
most vocal
which American overlapped on the most routes.
the financially weakest of the major airlines that have not sought Chapter 11 pro-
tection, raised its prices in response to all 4 bankruptcies,
although the average increase
is
Table 3
Average Price Changes of Individual Competitors over
Window
[-2, +2]
Bankrupt Airline
Ecistern
Continental
America West
TWA
Competitor
American
+0.090
Delta
(0.014)
[205]
[421]
[119]
[294]
+0.046
(0.021)
(0.012)
[452]
[327]
[98]
[181]
in parentheses.
significant in only 2 of these cases.
more than one
+0.368
-0.018
+0.007
(0.023)
(0.021)
(0.035)
(0.025)
[71]
[114]
[30]
[123]
+0.012
-0.028
+0.045
(0.019)
(0.011)
(0.026)
[68]
[44]
[32]
-0.014
-0.082
-0.039
(0.019)
(0.009)
(0.013)
(0.014)
[48]
[252]
[120]
[184]
+0.112
Standard error of average
+0.011
(0.009)
[if
USAiir
+0.063
(0.005)
-0.438
United
+0.027
(0.012)
+0.105
Southwest
-0.051
(0.009)
+0.068
Northwest
+0.037
(0.015)
+0.072
+0.019
+0.020
+0.035
(0.012)
(0.014)
(0.041)
(0.022)
[89]
[134]
[19]
[88]
Number
of markets included in brackets.
Only United shows a
of the four bankruptcies,
and Delta, one
significant price cut in response to
of the financially strongest czirriers
during this period, exhibits consistently positive price responses. Overall, there appears
to
be no relationship between financial health and price responses to
A
final possibility
we
investigate
is
whether bankrupt
ctirlines
rivals'
harm
bankruptcies.
competitors by
mcreasing market share through lower prices, service improvements, or special non-price
promotions.
We
first
use matched-route analysis similar to the approach used to analyze
fares in the previous tables.^
Table 4 presents these route average market shares from 2
In this case, however, we use a consistent market share cutoff of 10% for inclusion of a route in order
to avoid a selection bias that would result if the inclusion criterion in period t-2 were different from
the inclusion criterion in later periods.
Table 4
Average Market Share Changes of Chapter 11 Airlines
Airline
Average Share at
Change
Change
t-2
t-2 to
0.352
0.409
0.432
0.329
[744]
[679]
[284]
[4191
t
(0.003)
(0.002)
(0.005)
(0.004)
[599]
[626]
[272]
[388]
-0.116
-0.009
-0.011
(0.003)
(0.006)
(0.006)
[438]
[572]
[256]
[381]
-0.289
-0.012
-0.046
-0.017
(0.032)
(0.004)
(0.008)
(0.007)
[12]
[560]
[240]
[339]
(0.004)
Change
Change
t-2 to
t-2 to
t+1
t+2
in parentheses.
10% minimum route share threshold used
-0.003
-0.052
-0.029
(0.004)
(0.008)
(0.007)
[453]
[586]
[231]
[319]
Number
of
markets included
in brackets.
in all periods.
quarters before through 2 quarters after the carrier
averages are weighted by market
+0.016
(0.008)
-0.120
Standard error of average
+0.028
-0.016
+0.019
-0.026
t-2 to t-1
TWA
America West
Continental
Eastern
size,
files
for
Chapter 11 protection. These
but the results are very similar
if
the markets are
equzdly weighted.
In
routes
all
it
four of the major bankruptcies, the filing carrier's average market share on
continues to serve with a
(minimum 10%
in the case of Continental, or decHnes over the
quarters before
its
share) either remains about constant,
bankruptcy period.
For example, two
bankruptcy declaration, Continental was active on 679 routes, carrying
an average of 40.9% of the passengers.
Continental had dropped below a
10%
Two
quarters after
its
bankruptcy declaration,
share on 93 of those routes, and
its
market share
on the remaining 586 decUned by an average of 0.3%. Eastern, America West, and
all
TWA
a higher proportion of their original routes than did Continental and experienced more
substantial declines in market share on routes they continued to serve subsequent to their
bankruptcy
To
new
filings.
investigate whether airUnes declaring bamkruptcy
routes,
we excimine the bankrupt
harm competitors by
carrier's share of trciffic
on
all
entering
"relevant" routes.
0.158
fixed time effects,
movements over
to control for general airline price
The model
of bankruptcy measures described below.
implicitly
time;
and a
set
assumes that exogenous
changes in the remaining variables typically included in cross-sectioned models of airline
price levels - such as airport congestion, market density, network interconnectedness,
airport
dominance - are
We
sufficiently small that they
can be excluded from the specification.
include two sets of indicator variables designed to capture the effects of impending
The
or recently declared Chapter 11 bankruptcy.
bzmkrupt
in price for a
airline;
first set
measures the average change
the second measures the average change in price for non-
bankrupt airhnes on routes with a near-bankrupt or bemkrupt competitor.
We
scale these
variables so that their coefficients reflect price changes over 4 three-month periods:
and 90
to 90 days
to
days before a bankruptcy
days after a bankruptcy
filing. ^^
The sum
months
after the date of
Chapter 11
filing,
to 90 days
and
and 90
180
to 180
of the price changes over these four periods
window beginning
indicates the net change in price dxiring the
6
and
fihng.
None
6
months before and ending
of the airUnes in our sample exit
Chapter 11 during our observation period, although bankrupt
airlines
do
exit routes or
drop below the 10% share threshold used in the regression analysis.
This model
is
estimated by unweighted ordinary least squares using the 1777 routes
which we observed
for
The standard
at leaist
300 passengers during each quarter from 88:1 through 92:4.
errors are adjusted for heteroskedasticity
of residuals across carriers
on the same
observations axe not weighted by the
be
likely to
The
^^
route.
number
and contemporaneous correlation
Unhke the
figtires
and previous
tables,
of passengers in this regression as this would
induce heteroskedasticity.
results in table 6 suggest that airlines that
file
for
bankruptcy protection cut
their
bankruptcy status for the observed carrier. We define BANKas the mean within a quarter of a dummy variable that is zero until 180 days before the
observed carrier declares bankruptcy and one thereafter. Thus, if an airline declared bankruptcy
would
on July 31, one-third of the way through the third quarter of the year,
Similar
quarters.
subsequent
all
1
for
take on the value 2/3 in the first quarter of that year and
variables are defined for the periods 90 days before, 90 days following, and 180 days following the
The
first
set of variables indicate
RUPT-2
BANKRUPT-2
bankruptcy filing. Changes in these four variables from the previous quarter, ABANKRUPTi, i =
-2, -1,1,2, are included m the regression. The second set of variables indicate the bankruptcy status
of other carriers on the observed route. For airlines not in or within two quarters of entering Chapter
11, RTBANKRUPTi measures the presence on a route of another carrier with non-zero values of
BANKRUPTi. The ARTBAN KRUPT,, = -2, -1,1,2, are included in the regression.
i
10
Table 6
Estimated Price Changes of Bankrupt Airlines and Competitors
Dependent Variable:
Number
DLPRICE
PRICEt -
(=ln
of Observations: 63671
In
PRICEt^i)
i?^=0.36
DLPRICE,_i
HERFINDAHLt
HERFINDAHL,-!
Estimated Price Change:
90-180 days before
0-90 days before
0-90 days after
Chap
Chap
90-180 days after
Change over
Chap
Bankr
11
11
11
Chap
11
[-180,-1-180]
days
Huber-adjusted standard errors in parentheses.
Fixed effects for each quarter not reported.
prices 90 to 180 days before filing for
this lower price level over the
little
11,
by an average of 5.6%, and maintain
subsequent nine months. As in the earlier tables, there
no indication of substantial changes
Competitors exhibit
Chapter
in pricing behavior following the
price response to this behavior.
The
(2%) price decUnes by competitors when the to-be-bemkrupt
this
appears to be more than
offset
from
zero.^'^
ccirrier
and
results suggest
catrrier
cuts
fUing.
modest
its prices,
but
by price increases over the subsequent months. The
net change in prices over the year-long
-5.5% for the bankrupt
bankruptcy
is
window around the bankruptcy announcement
is
-1-1.1% for its competitors, each statistically different
Bankruptcy
endogenous, an issue that we have not addressed
in this
This raises questions about the causality of the bankruptcy-pricing correlation
analysis.
we
filing is itself
observe.
The low
prices that appear to precede a
have induced that fihng, or
may be
bankruptcy
filing
may
themselves
a profit-mzLximizing response to some exogenous shock,
omitted from the model, that contributes to financial decline. The possible endogeneity of
bajikruptcy
to a
is
bankrupt
unlikely, however, to chcinge the conclusion that competitors
airline
by lowering
price.
Faihng to model the bzmkruptcy decision seems
most Ukely to bias downward the estimates of competitors' price changes
since low competitors' prices are
more
do not respond
likely to
in
our model,
induce financiad distress than axe high
competitors' prices.
III.
Conclusion
The behavior
of firms in financial distress
public policy makers. In the adrUne industry,
is
of growing interest to both academics and
many participants and observers have
firms under Chapter 11 bankruptcy of pricing in a
as well as to themselves.
bankrupt
Chapter
airlines
11,
Our
manner
accused
destructive to their competitors
analysis indicates that, with the notable exception of Eastern,
have changed
their prices only
modestly axound the time of entering
with an average decline of about 5.5% overall. Such a price cut
may be
neither
destructive nor myopic, but rather a rational business response to the reduced reputation
that
may surround an
airhne in financial distress. This interpretation
is
supported by the
evidence that competitors do not lower their average prices in response to price cutting by
bankrupt airUnes, and that bankrupt
airlines
do not gain market share despite their price
cuts.
estimated to be +5.8% and the net price change of competitors is -0.6%, each statistically different
from zero. We also estimated these effects including carrier fixed effects and fixed effects for each
100-mile haul length within each quarter. Inclusion of these variables had almost no effect on the
parameters of interest.
is
12
REFERENCES
Borenstein, Severin
and Nancy
L. Rose,
"Competition and Price Dispersion
Airiine Industry." Journal of Political
in the U.S.
Economy, August 1994 102(4), pp. 653-683.
Chevalier, Judith, "Capital Structure and Product
Market Competition: An Empirical
Study of Supermarket Pricing," mimeo, University of Chicago, September, 1994.
Chevalier, Judith
cal
and David
Scharfstein, "Capital
Market Imperfections and CountercycU-
Markups: Theory and Evidence," mimeo, University of Chicago, January 1995.
Kovenock, Daniel and Gordon
An Examination
sity,
Phillips, "Capital Structtire
and Product Market
Rivalry:
of Plant Expemsion and Closing Decisions," mimeo, Purdue Univer-
January 1995.
The National Commission
to Ensxire a Strong Competitive Airhne Industry, "Change,
Challenge and Competition:
D.C.: U.S
A
Government Printing
Report to the President and Congress," Washington
Office,
August 1993.
13
90:1
89:1
Figure la: Eastern and Competitor Prices
(Relative to Industry Average)
10%
-10%
-15%"^
87:1
1
1
1
1
1
88:1
Figure lb:
T
r
91:1
1
1
1
92:1
Continental and Competitor Prices
(Relative to Industry Average)
1
1
i
T
93:1
Figure
Ic:
America West and Competitor Prices
(Relative to Industry Average)
15%
10%
-10%
Figure Id:
TWA
and Competitor Prices
(Relative to Industry Average)
JO
Date Due
Lib-26-67
MIT LIBRARIES
3 9080 00927 9362