Pro-Competitive Vertical Integration: The Relationship between Legacy Carriers and Regional Airlines

Transcription

1 Pro-Competitive Vertical Integration: The Relationship between Legacy Carriers and Regional Airlines Kerry M. Tan July 2016 Abstract This paper investigates the competitive effects of legacy carriers vertical integration decision with independent regional airlines. Legacy carriers are more inclined to operate a route using a regional airline partner, as opposed to its own fleet, when a low-cost carrier enters that route. Moreover, legacy carriers airfares are lower on routes operated by an independent regional airline. The results suggest that legacy carriers exploit the more cost-efficient regional airlines in order to lower prices and better compete with low-cost carriers. JEL classifications: L93, L24 Keywords: Vertical Integration, Legacy Carriers, Regional Airlines, Low-Cost Carriers, Airfares I would like to thank the editor, Larry White, and two anonymous referees, as well as Matthew Lewis, James Peck, Huanxing Yang, Stephen J.K. Walters, Nicholas Rupp, and seminar participants at The Ohio State University, East Carolina University, the Southern Economic Association Annual Meeting, and the International Industrial Organization Conference for helpful suggestions and comments. All errors are my own. Department of Economics, Loyola University Maryland, 4501 N Charles St, Baltimore, MD 21210; kmtan@loyola.edu. 1

2 1 Introduction Spengler (1950) provides a seminal paper on antitrust issues associated with vertical integration, arguing that this strategic behavior could intensify competition. More recently, de Fontenay and Gans (2005) theorize that upstream competition incentivizes firms to vertically integrate in order to lower prices. Empirical papers on the market for electricity (Mansur, 2007) and ready-mixed concrete (Hortaçsu and Syverson, 2007) find that vertical integration indeed leads to lower prices. In the airline industry, legacy carriers have recently become more reliant on independent regional airlines to provide service for passengers within their route network. Under these vertical integration arrangements, planes are owned by the regional airlines, but are painted to resemble the legacy carrier s fleet. Flight crews are employed by the regional airline, yet the legacy carrier is responsible for ticketing and operations at the airport. This paper assesses the competitive effect of the vertical integration agreements between legacy carriers and their regional airline partners. One way this paper addresses this issue is by investigating the circumstances under which a legacy carrier decides to have a route served by an independent regional airline instead of its own fleet. The results suggest that legacy carriers tend to allocate the operation of routes entered by low-cost carriers to an independent regional airline. Second, I analyze the legacy carriers pricing behavior associated with this vertical integration decision. On this note, I find that legacy carriers set a lower average airfare, 10th percentile airfare, and 90th percentile airfare on routes operated by an independent regional airline. The papers most closely related to this paper are Forbes and Lederman (2009) and Forbes and Lederman (2010), which both analyze the legacy carriers decision to use either an independent regional airline or a wholly owned regional airline. First, Forbes and Lederman (2009) find that legacy carriers are more likely to operate with a wholly owned regional airline on routes that are more integrated with the legacy carrier s route network and are more susceptible to adverse weather conditions. Moreover, Forbes and Lederman (2010) find that service quality, as measured 2

3 by on-time performance and cancellations, improve when using a wholly owned regional airline as opposed to an independent regional airline. This paper differentiates from the work done by Forbes and Lederman by providing an alternative reason why legacy carriers would want to vertically integrate with regional airlines. In particular, I focus on how upstream competition between legacy carriers and low-cost carriers influence the relationship between legacy carriers and independent regional airlines, which contrasts from the service quality motivations in the existing literature. As such, this paper complements the findings in the existing literature on the relationship between legacy carriers and regional airlines. 2 Data The dataset used in this paper is primarily derived from the Airline Origin and Destination Survey (DB1B), which is published quarterly by the Bureau of Transportation Statistics. It is a ten percent survey of domestic air travel and contains data on the origin, destination, non-stop distance between endpoints, ticketing and operating carrier, 1 market fare, 2 and number of passengers paying a particular market fare. Dates when legacy carriers were protected under Chapter 11 bankruptcy are obtained from public sources. Finally, annual reports published by the Regional Airlines Association, an industry trade group, lists the partnerships between legacy carriers and regional airlines and are summarized in Table 1. 3 The sample time period for this paper is 1998 to The key distinction between the ticketing carrier and the operating carrier is that the ticketing carrier is the airline that the passenger purchased the ticket from, whereas the operating carrier is the airline that is in charge of the aircrew and fleet used on the flight. 2 Market fare is calculated by the Bureau of Transportation Statistics as the itinerary yield multiplied by the number of miles flown. Ancillary fees, such as baggage fees, priority seating fees, and the cost of food and beverage purchased on the flight, are not accounted for in the market fare. 3 Since this paper focuses on the legacy carriers vertical integration decision with its independent regional airline partners, wholly owned regional airlines are omitted from the analysis in this paper and are not reported in Table 1. 3

4 Table 1: Legacy Carrier Partnerships with Independent Regional Airlines Legacy Carrier American Airlines Continental Airlines Delta Air Lines Northwest Airlines United Airlines US Airways Independent Regional Airline Air Wisconsin Chautauqua Airlines Compass Airlines Mesa Airlines SkyWest Airlines Trans States Airlines Chautauqua Airlines Colgan Air Commutair SkyWest Airlines Atlantic Coast Airlines Chautauqua Airlines Compass Airlines Mesaba Airlines Shuttle America SkyWest Airlines Compass Airlines Mesaba Airlines Air Wisconsin Atlantic Coast Airlines Chautauqua Airlines Colgan Air Commutair ExpressJet Airlines GoJet Airlines Great Lakes Airlines Gulfstream International Airlines Mesa Airlines Shuttle America SkyWest Airlines Trans States Airlines Air Midwest Air Wisconsin Colgan Air Chautauqua Airlines Mesa Airlines 4

5 The following steps are undertaken to clean the data. First, I eliminate observations where the distance is equal to zero or the market fare is less than $10. Observations with an unidentified ticketing carrier are also dropped. Only observations related to coach fares on nonstop flights are kept. 4 I then limit the sample to routes within the contiguous United States with a maximum distance of 1,500 miles since regional airlines would not be used on longer routes and restrict the sample to the 2,500 routes with the highest number of passengers from 1998 to I drop routes that are never serviced by a legacy carrier in order to focus on routes where there is the potential for strategic behavior between legacy carriers 5 and low-cost carriers. 6 An observation in the resulting dataset is at the carrier-route-year-quarter level. Legacy carriers have become more attracted to partnering with regional airlines in part because regional airlines benefit from relatively lower costs. For example, Hirsch (2007) found that senior pilots and flight attendants at United Airlines make 80 percent more and 32 percent more, respectively, than their counterparts at regional airlines. Moreover, Brueckner and Pai (2009) analyze how regional airlines have steadily replaced their turboprop aircraft with more cost efficient regional jets, leading to lower operating costs. As a result, the use of regional airlines by legacy carriers has drastically expanded over time as the total number of routes that legacy carriers operated using independent regional airlines increased from 283 in 1998 to 1,547 in Since regional airlines have a more efficient cost structure, then perhaps legacy carriers could consider operating all routes using its regional airline partners. However, scope clauses in labor union contracts between legacy carriers and its labor unions create a constraint on the amount of 4 It can be the case that regional airlines are flying travelers on one leg of a one-stop or multi-stop itinerary. However, the issue with these itineraries is that a legacy carrier can be responsible for a portion of the the one-stop or multi-stop itineraries as well. In other words, I focus on nonstop products in order to avoid the complication with some passengers flying on a legacy carrier plane to get them from a origin airport to a hub airport and then a regional airline from the hub airport to the final destination airport. Thus, focusing on nonstop products lends to a cleaner analysis of the legacy carrier s decision to operate that particular route themselves or with an independent regional airline. 5 The six legacy carriers studied in this paper are American Airlines, Continental Airlines, Delta Air Lines, Northwest Airlines, United Airlines, and US Airways. 6 The four low-cost carriers studied in this paper are AirTran Airways, JetBlue Airways, Southwest Airlines, and Spirit Airlines. 5

6 routes that the legacy carrier can operate using a regional airline. As discussed in Forbes and Lederman (2007), scope clauses typically take on one of two forms: 1) a cap on the total number of operated by a regional airline on behalf of a legacy carrier or 2) the legacy carrier must increase the amount of flights used by its own fleet by a pre-determined ratio for every increase in routes operated by regional airlines. These scope clauses effectively create a trade-off for the legacy carrier when they decide which routes to allocate to its own fleet or to an independent regional airline partner. Figure 1 shows that 117 million and roughly 423,000 passengers flew on flights operated by legacy carriers and independent regional airlines, respectively, in This corresponds to a market share of 69.7% for legacy carriers and 0.3% for regional airlines. While the number of passengers flown by legacy carriers decreased to 79.5 million passengers (47.3% market share) in 2015, 16.3 million passengers (9.7% market share) flew with an independent regional airline operating on behalf of a legacy carrier. 7 Figure 1: Number of Passengers Flown by Operating Carrier The number of passengers is calculated based on whether the operating carrier was an independent regional airline, low-cost carrier, or legacy carrier. As such, the number of passengers is not determined by the ticketing carrier. For example, independent regional airlines would be credited for the number of passengers it flew on behalf of a legacy carrier. Legacy carriers only get credit for passengers who flew on flights that they operated themselves. 7 To be sure, these market share calculations ignores passengers flown by wholly owned regional airlines on behalf of the legacy carrier. When combining independent regional airlines with wholly owned regional airlines, the number of passengers flown by any regional airline increases from 13.3 million (7.4% market share) in 1998 to 63.5 million (35.1% market share) in

7 Since industry deregulation in 1978 made it easier for new airlines to enter the industry, start-up airlines emerged that found ways to lower costs relative to that of legacy carriers. These low-cost carriers decreased the cost of operation by using a point-to-point network and a fleet consisting of the same aircraft. 8 Legacy carriers established low-cost "airline within an airline" in order to counter the influx of new airlines, but they have all since been discontinued because they quickly became a financial burden to the legacy carrier. 9 As with regional airlines, low-cost carriers have experienced a remarkable growth in the number of passengers flown between 1998 and Figure 1 illustrates that the number of passengers flown by low-cost carriers has increased dramatically from 50.5 million (30.1% market share) in 1998 to 104 million (61.9% market share) in During this time period, there have been 1,174 instances of entry 10 by low-cost carriers into routes with a maximum distance of 1,500 miles, with AirTran Airways entering 356 routes, JetBlue Airways entering 156 routes, Southwest Airlines entering 502 routes, and Spirit Airlines entering 160 routes. The expansion of the low-cost carrier s route network largely explains their recent growth and their emergence as a major influence in the U.S. airline industry. This paper studies how the low-cost carriers expanding route network has impacted the growing use of independent regional airlines by legacy carriers. 3 Empirical Analysis Legacy carriers could potentially charge lower prices by exploiting a regional airlines more efficient cost structure. However, the legacy carrier s pricing strategy could be endogenous with its 8 For example, Southwest Airlines operates Boeing aircraft exclusively, comprising of 614 Boeing 737 and 66 Boeing 717. Moreover, JetBlue s fleet of 194 planes include Airbus 320 and 321, as well as Embraer 190. On the other hand, legacy carriers operate a larger variety of planes manufactured by Boeing, Embraer, and Airbus. Low-cost carriers are able to reduce training and maintenance costs since their fleet is more concentrated on a fewer assortment of planes. Source: low-cost-carrier-strategies-maintain html 9 Examples include Continental Lite (Continental Airlines), Song (Delta Air Lines), and Ted (United Airlines). 10 Each instance is defined by entry into a one-way airport pair. For example, when Southwest started operating the route between Detroit Metro Airport and Philadelphia International Airport in 2004, two routes are entered: the route from Philadelphia to Detroit, and the route from Detroit to Philadelphia. 7

8 vertical integration decision to operate a route using its own fleet or outsourcing to an independent regional airline. In order to resolve these inherent endogeneity issues, I implement a fixed effects price regression using instrumental variables. The first stage regression, which is based on Goetz and Shapiro (2012), uses indicator variables for low-cost carrier entry (LCCentry) and threat of entry (LCCthreat) as instruments for independent regional airline service indicator variable (REGservice), which assumes the value of 1 if a legacy carrier operates at least one flight of a route in a year-quarter using an independent regional airline, and 0 otherwise. 11 Goetz and Shapiro (2012) explores how the decision for a legacy carrier to engage in codesharing agreements with other legacy carriers is influenced by both actual entry and the threat of entry by low-cost carriers. Under a codesharing agreement, a legacy carrier serves as the ticketing carrier for an itinerary operated by a rival legacy carrier partner. Similarly, I am interested in estimating the impact of low-cost carrier entry and threats of entry on a legacy carrier s vertical integration decision involving an independent regional airline partner. Entry is identified when a low-cost carrier starts servicing a route and remains on that route for at least two consecutive quarters. In some cases, airlines are seen in the DB1B to operate on a particular route only to drop out for a quarter and reappear in the subsequent quarter. This is not an example of actual entry but represents an issue with the DB1B being a ten percent sample of airline tickets. Nevertheless, this problem was resolved by qualifying entry when the low-cost carrier did not service the route in question for at least four quarters before the identified quarter of entry. The airline must have also flown at least 100 passengers on the entered route in the quarter of entry. Threat of entry is identified when a low-cost carrier services both endpoint airports of a route, but does not operate a nonstop flight on the route itself. For example, Southwest Airlines flew to eight destinations from Houston Intercontinental Airport (IAH) and fourteen destinations from 11 It is possible that a legacy carrier operates some of a route s flights itself and allocates the remaining proportion to a regional airline. Replacing REGservice with the fraction of total route passengers flown by a regional airline partner yields qualitatively similar regression results. 8

9 Indianapolis International Airport (IND) in 2005:Q1. However, Southwest did not fly nonstop on the IAH-IND route. Since Continental was one of the legacy carriers who operated that route at the time, LCCthreat = 1 for the observation pertaining to Continental Airlines servicing the IAH-IND route in 2005:Q1. Gerardi and Shapiro (2009) find that increased competition, measured using the number of airlines servicing a route or the route-level Herfindahl index, decreases airfares along different points of the price distribution. I follow their specification for my second stage regression, using fitted values for independent regional airline service ( REGservice) as my variable for competition. Although I primarily use the legacy carrier s logged average airfare (lnprice) as the dependent variable in the second stage regression, I conduct robustness tests using logged 10th percentile airfare (lnp10) and logged 90th percentile airfare (lnp90) as in Gerardi and Shapiro (2009). Table 2: Summary Statistics Variable Mean S.D. Min Max REGservice Price ,500 P ,500 P ,500 LCCentry W Nentry OtherLCCentry LCCthreat W Nthreat OtherLCCthreat Bankrupt Number of routes 2,267 Number of obs. 415,948 The fixed effects instrumental variables regression specification is as follows: REGservice i jt = β 1 LCCentry jt + β 2 LCCthreat jt + γ i j + γ t + ε i jt (1) lnprice i jt = δ 1 REGservice i jt + δ 2 Bankrupt it + η i j + η t + ν i jt. (2) 9

10 Equation 1 refers to the first stage regression of REGservice i jt, the indicator variable that identifies when legacy carrier i vertically integrates with an independent regional airline on route j in time t, on indicator variables for low-cost carrier entry (LCCentry jt ) and threat of entry (LCCthreat jt ), as well as carrier-route fixed effects (γ i j ) and year-quarter fixed effects (γ t ). Equation 2 refers to the second stage regression of lnprice i jt, the the logged average airfare set by legacy carrier i for route j in time t, 12 on fitted values of REGservice i jt and an indicator variable that identifies if legacy carrier i is bankrupt in time t (Bankrupt it ), as well as carrier-route fixed effects (η i j ) and year-quarter fixed effects (η t ). Standard errors are clustered by carrier-route to account for heteroskedasticity and serial correlation between a carrier-route combination. Summary statistics for the 415,948 observations on 2,267 routes from 1998:Q1 to 2015:Q4 are reported in Table 2. Table 3: Legacy Carrier Price Response to Regional Airline Service (Pooled Regression) First Stage Results Second Stage Results (Dependent variable: REGservice) (Dependent variable: lnprice) LCCentry REGservice (0.005) (1.258) LCCthreat Bankrupt (0.005) (0.124) N 415,948 N 415,948 Note: This table reports the results of the fixed effects instrumental variables regressions outlined in Equations 1 and 2 using REGservice as the dependent variable in the first stage and lnprice in the second stage. Observations are at the carrier-route-year-quarter level. Carrier-route and year-quarter fixed effects suppressed. Standard errors, in parentheses, are clustered by carrier-route to account for correlation between a carrier-route combination over time. * indicates significance at 5% level. ** indicates significance at 1% level. Goetz and Shapiro (2012) find that legacy carriers are more likely to engage in codeshare agreement with rival legacy carrier partners on routes entered by low-cost carriers. They also find these codesharing agreements are more likely to occur where low-cost carriers threaten entry, in which the low-cost carrier services both endpoint airports of a route but not the route itself. Table 12 Regional airlines do not sell tickets independently from legacy carriers and rely exclusively on legacy carriers for passenger traffic. In fact, official websites for regional airlines will merely identify the routes that it services for legacy carriers and sometimes include links to the legacy carrier s official website for ticketing purposes. 10

11 3 presents the main results of this paper, pooling observations for all six legacy carriers. The estimated coefficient for LCCentry (0.019) is positive and statistically significant, implying that legacy carriers are more inclined to vertically integrate by operating the route with an independent regional airline partner on routes that experience entry by low-cost carriers. On the other hand, the estimate for LCCthreat (0.006) is positive, yet statistically insignificant. Thus, the threat of entry by low-cost carriers appears to influence the decision for legacy carriers to use a rival legacy carrier partner as evidenced in Goetz and Shapiro (2012), but not necessarily an independent regional airline partner. The second stage results in Table 3 analyzes the pro-competitive effect of vertical integration on the legacy carriers pricing strategy. The estimated coefficient for the fitted values of REGservice (-3.013) is negative and statistically significant, suggesting that legacy carriers decrease their average airfares on routes operated by an independent regional airline partner. The results also suggest that airfares are lower when a legacy carrier is under Chapter 11 bankruptcy protection since the estimated coefficient for Bankrupt (-0.320) is negative and statistically significant. Two tests are conducted on the instruments outlined in Equation 1. First, the Kleibergen- Paap rank LM test statistic is (p-value = ), which suggests that the two instruments, LCCentry and LCCthreat, are correlated with the endogenous variable, REGservice. Second, an overidentification test of all instruments yields a Hansen J statistic of (p-value = ), implying that the instruments are uncorrelated with the error term in Equation 2. Therefore, the instruments used in the first stage regression are valid. Forbes and Lederman (2009) find that the legacy carriers vertical integration decision is motivated by service quality concerns, whereas Forbes and Lederman (2010) find that vertical integration improves airline performance, as measured by flight delays and cancellations. The results in Table 3 complement their findings by suggesting an alternative motivation behind this vertical integration decision. Namely, legacy carriers could use regional airlines in order to lower its average airfare, allowing them to better compete with low-cost carriers. 11

12 Table 4: Legacy Carrier Price Response to Regional Airline Service (Separate Regressions) Legacy Carrier AA CO DL NW UA US First Stage Results Dependent variable: REGservice LCCentry (0.011) (0.012) (0.009) (0.012) (0.014) (0.010) LCCT hreat (0.005) (0.014) (0.010) (0.014) (0.011) (0.009) N 75,813 29, ,159 32,462 80,868 81,039 Second Stage Results Dependent variable: lnprice REGservice (0.442) (0.286) (0.990) (5.416) (0.749) (0.380) Bankrupt (0.064) (0.146) (0.259) (0.370) (0.032) N 75,813 29, ,159 32,462 80,868 81,039 Note: This table reports the results of the fixed effects instrumental variables regressions outlined in Equations 1 and 2 using REGservice as the dependent variable in the first stage and lnprice in the second stage. Observations are at the carrier-route-year-quarter level. Carrier-route and year-quarter fixed effects suppressed. Standard errors, in parentheses, are clustered by carrier-route to account for correlation between a carrier-route combination over time. * indicates significance at 5% level. ** indicates significance at 1% level. Different legacy carriers could respond differently in their vertical integration decision. Table 4 presents the regression results run separately for each of the six legacy carriers: American Airlines (AA), Continental Airlines (CO), Delta Air Lines (DL), Northwest Airlines (NW), United Airlines (UA), and US Airways (US). In general, the signs of the estimated coefficients are consistent with those presented in Table 3. However, the reduced sample size for each legacy carrier renders several of the estimates to be statistically insignificant. Note that the estimate for Bankrupt associated with the regression for Continental Airlines is blank since it is the only legacy carrier to never file for bankruptcy during the sample time period. Industrial organization economists have been interested in Southwest Airlines as a case study on the effect of low-cost carriers in the airline industry. For example, Boguslaski, Ito, and Lee (2004) identify the market characteristics that influence entry decisions by Southwest Airlines. 12

13 Moreover, Bamberger and Carlton (2006) find that Southwest Airlines has a high survival rate, meaning that Southwest Airlines successfully remains on an entered route for at least a year after entry. Finally, Goolsbee and Syverson (2008) show that Southwest Airlines are more likely to enter a particular route when it already services both endpoint airports. Consequently, it could be the case that the main results from Table 3 are largely influenced by Southwest Airlines. Table 5: Legacy Carrier Price Response to Regional Airline Service (Southwest vs. Other LCC) First Stage Results Second Stage Results (Dependent variable: REGservice) (Dependent variable: lnprice) WNentry REGservice (0.008) (0.493) OtherLCCentry Bankrupt (0.006) (0.049) WNthreat (0.008) OtherLCCthreat (0.005) N 415,948 N 415,948 Note: This table reports the results of the fixed effects instrumental variables regressions outlined in Equations 1 and 2 using REGservice as the dependent variable in the first stage and lnprice in the second stage. Observations are at the carrier-route-year-quarter level. Carrier-route and year-quarter fixed effects suppressed. Standard errors, in parentheses, are clustered by carrier-route to account for correlation between a carrier-route combination over time. * indicates significance at 5% level. ** indicates significance at 1% level. In order to check that legacy carriers respond to entry and the threat of entry by Southwest Airlines and other low-cost carriers in a similar fashion, I replace LCCentry and LCCthreat in Equation 1 with actual entry by Southwest Airlines (W Nentry), actual entry by other low-cost carriers (OtherLCCentry), threat of entry by Southwest Airlines (W Nthreat), and threat of entry by other low-cost carriers (OtherLCCthreat). 13 Table 5 presents the regression results. Although the estimated coefficient for OtherLCCentry is positive and statistically significant in the first stage regression, W Nentry is positive, yet statistically insignificant. This suggests the legacy carriers are more likely to operate using a regional airline partner on routes entered by AirTran Airways, 13 WN is the International Air Transport Association code for Southwest Airlines. 13

14 JetBlue Airways, or Spirit Airlines, but not necessarily when Southwest Airlines is the entrant. Moreover, the second stage regression results are qualitatively similar with those in Table 3, implying that legacy carriers average airfares are lower for routes where they use a regional airline partner and when they are bankrupt. Table 6: Legacy Carrier Price Response to Regional Airline Service (10th Percentile Airfare) First Stage Results Second Stage Results (Dependent variable: REGservice) (Dependent variable: lnp10) LCCentry REGservice (0.005) (0.824) LCCthreat Bankrupt (0.005) (0.081) N 415,948 N 415,948 Note: This table reports the results of the fixed effects instrumental variables regressions outlined in Equations 1 and 2 using REGservice as the dependent variable in the first stage and lnp10 in the second stage. Observations are at the carrier-route-year-quarter level. Carrier-route and year-quarter fixed effects suppressed. Standard errors, in parentheses, are clustered by carrier-route to account for correlation between a carrier-route combination over time. * indicates significance at 5% level. ** indicates significance at 1% level. Table 7: Legacy Carrier Price Response to Regional Airline Service (90th Percentile Airfare) First Stage Results Second Stage Results (Dependent variable: REGservice) (Dependent variable: lnp90) LCCentry REGservice (0.005) (1.734) LCCthreat Bankrupt (0.005) (0.171) N 415,948 N 415,948 Note: This table reports the results of the fixed effects instrumental variables regressions outlined in Equations 1 and 2 using REGservice as the dependent variable in the first stage and lnp90 in the second stage. Observations are at the carrier-route-year-quarter level. Carrier-route and year-quarter fixed effects suppressed. Standard errors, in parentheses, are clustered by carrier-route to account for correlation between a carrier-route combination over time. * indicates significance at 5% level. ** indicates significance at 1% level. Gerardi and Shapiro (2009) find that increased competition puts stronger downward pressure on 90th percentile airfares than on 10th percentile airfares. I conduct a similar test by replacing lnprice in Equation 2 with logged one-way 10th percentile airfare (lnp10) and logged one-way 14

15 90th percentile airfare (lnp90). Tables 6 and 7 presents the regression results using 10th percentile airfares and 90th percentile airfares as the dependent variable in the second stage, respectively. Unsurprisingly, the first stage regression results in Tables 3, 6, and 7 are exactly the same regardless of the dependent variable used in the second stage. Consistent with the results in Gerardi and Shapiro (2009), the results in Tables 6 and 7 show that increased competition, which in this case occurs due to the legacy carrier s vertical integration decision with its regional airline partners, has a stronger effect on 90th percentile airfares than on 10th percentile airfares. Indeed, the estimated coefficient for between the estimate for REGservice in Table 3 (-3.013) is REGservice associated with 10th percentile airfares (-1.908) and 90th percentile airfares (-4.122). All three estimates are statistically significant. Moreover, the effect of bankruptcy follows a similar pattern, affecting airfares on the right tail of the legacy carriers price distribution more than airfares on the left tail. 4 Conclusion This paper investigates the effects of legacy carriers decision to vertically integrate with its independent regional airline partners. I find that legacy carriers tend to operate a route using an independent regional airline when a low-cost carrier enters that route. Moreover, the results suggest that this partnership allows legacy carriers to decrease their airfares along their price distribution. Therefore, I conclude that legacy carriers use regional airlines as a pro-competitive response to competition with low-cost carriers. Although regional airlines provide a more cost-efficient alternative to operating a route themselves, legacy carriers are unable to use regional airlines on all routes. First, regional airlines use smaller aircraft that can only carry between passengers and are limited by a maximum range of 1,500 miles. As such, legacy carriers would not want to use regional airlines if the distance is too far or if the demand for a particular route is too high. In these cases, it would be 15

16 more profitable for a legacy carrier to operate the route with their own fleet and aircrew. Moreover, "scope clauses" in labor agreements with legacy carriers limits the number of routes that can be outsourced to regional airlines. Despite these limitations, regional airlines serve as a means for legacy carriers to better compete with competitors on certain routes. Industrial organization economists have long been interested in pricing phenomenons, particularly in the U.S. airline industry. Previous papers have found evidence that airlines charge higher prices at their hub airport 14 and that competition affects the ability for airlines to price discriminate. 15 This paper analyzes yet another facet of price competition between airlines by investigating how vertical integration in the airline industry allows legacy carriers to set a lower price in order to better compete with low-cost carriers. References Bamberger, G., and D. Carlton (2006). "Predation and the Entry and Exit of Low-Fare Carriers." in Darin Lee (ed.), Advances in Airline Economics I, Elsevier. Boguslaski, C., H. Ito, and D. Lee (2004). "Entry Patterns in the Southwest Airlines Route System." Review of Industrial Organization 25, Borenstein, S (1989). "Hubs and High Fares: Dominance and Market Power in the U.S. Airline Industry." The RAND Journal of Economics 20, Borenstein, S., and N. Rose (1994). "Competition and Price Dispersion in the U.S. Airline Industry." Journal of Political Economy 102(4), Brueckner, J., and V. Pai (2009). "Technological Innovation in the Airline Industry: The Impact of Regional Jets." International Journal of Industrial Organization 27, de Fontenay, C., and J. Gans (2005). "Vertical Integration in the Presence of Upstream Competition." The RAND Journal of Economics 36(3), Forbes, S., and M. Lederman (2007). "The Role of Regional Airlines in the U.S. Airline Industry." 14 See Borenstein (1989), Lederman (2008), and Lee and Luengo-Prado (2005). 15 See Borenstein and Rose (1994), Gerardi and Shapiro (2008), and Savin (2001). 16

17 in Darin Lee (ed.), Advances in Airline Economics II, Elsevier. Forbes, S., and M. Lederman (2009). "Adaptation and Vertical Integration in the Airline Industry." American Economic Review 99(5), Forbes, S., and M. Lederman (2010). "Does Vertical Integration Affect Firm Performance? Evidence from the Airline Industry." The RAND Journal of Economics 41(4), Gerardi, K., and A. Shapiro (2009). Does Competition Reduce Price Dispersion? New Evidence from the Airline Industry." Journal of Political Economy 117(1), Goetz, C., and A. Shapiro (2012). Strategic Alliance as a Response to the Threat of Entry: Evidence from Airline Codesharing." International Journal of Industrial Organization 30, Goolsbee, A., and C. Syverson (2008). "How Do Incumbents Respond to the Threat of Entry? Evidence from the Major Airlines." The Quarterly Journal of Economics 123(4), Hirsch, B. (2007). "Wage Determination in the U.S. Airline Industry: The Role of Unions and Product Market Competition." in Darin Lee (ed.), Advances in Airline Economics II, Elsevier. Hortasçsu, A. and C. Syverson (2007). "Cementing Relationships: Vertical Integration, Foreclosure, Productivity, and Prices." Journal of Political Economy 115(2), Lederman, M. (2008). "Are Frequent-Flyer Programs a Cause of the Hub Premium?" Journal of Economics & Management Strategy 17(1), Lee, D., and M.J. Luengo-Prado (2005). "The Impact of Passenger Mix on Reported Hub Premiums in the U.S. Airline Industry." Southern Economic Journal 72(2), Mansur, E. (2007). "Upstream Competition and Vertical Integration in Electricity Markets." Journal of Law and Economics 50(1), Spengler, J. (1950). "Vertical Integration and Antitrust Policy." Journal of Political Economy 58(4),