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Empirical Implications and Tests of the Contestability Hypothesis

Empirical Implications and Tests of the Contestability Hypothesis. Steven Morrison and Clifford Winston. Presented by Ian Fetters. Introduction. Baumol , Panzar , Willig – if there are no sunk costs for entry and exit, incumbent firm has no choice but to price at welfare-maximizing price

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Empirical Implications and Tests of the Contestability Hypothesis

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  1. Empirical Implications and Tests of the Contestability Hypothesis Steven Morrison and Clifford Winston Presented by Ian Fetters

  2. Introduction • Baumol, Panzar, Willig – if there are no sunk costs for entry and exit, incumbent firm has no choice but to price at welfare-maximizing price • Airlines are often called contestable markets – are they perfectly or imperfectly contestable?

  3. Empirical aspects of perfect and imperfect contestability • Does presence of potential competitors generate welfare-maximizing performance? • Look at markets which meet technology, demand conditions for contestable markets, are comparable in all respects but potential competitor

  4. Empirical aspects of perfect and imperfect contestability • If markets with potential competitors have welfare-maximizing performance, then market is perfectly contestable • If effect of potential competitors on welfare is significant, but does not generate maximum welfare, market is imperfectly contestable

  5. Lit • Baumol, Panzar, Willig - “it is highly plausible that air travel provides real example of contestable markets” • Moore, Call, Keeler; Graham, Kaplan, Sibley – measures of efficiency depend on number of actual competitors • Bailey, Panzar – in some cases, number of competitors does not influence efficiency

  6. Methodology and data • Use data from 1983 – greater adjustment to deregulation • Use direct measure of consumer welfare – compensating variation – difference between welfare in deregulated environment, optimal welfare • Caves, Christinsen, Tretheway – constant returns to scale for carriers no matter what size, so there is potential for perfect contestability

  7. Perfect contestability • If perfectly contestable, welfare change is equal to 0 if there is at least one potential competitor • “Potential carrier” – serves at least one of the airports involved, but does not serve route

  8. Perfect contestability • 769 randomly selected routes with at least one potential competitor • Mean welfare change: $0.014 per traveler mile ($4.61 for average traveler, total welfare change of $2.5 billion in 1977) • So perfect contestability is not the case • Explanations

  9. Imperfect contestability • Welfare change measure is influenced by both actual, potential carriers, as well as other factors • “Actual competitor” – airline that offers nonstop service or on-line connecting service

  10. Model • DELTA1W = 2.31NN+1.41NS+2.16NM+2.52NL+1.30SS+2.56SM+3.51SL+ (.37) (.32) (.40) (.50) (.32) (.38) (.48) • 2.62MM+3.12ML+3.42LL+.60SLOTDUM+.06PCTBUS-.44ACTUAL-.15PTT (.43) (.46) (.50) (.19) (.005) (.04) (.02) • NN, NS, NM, NL, SS, SM, SL, MM, ML, LL – hub dummies [non, small, med, large] • SLOTDUM – slot dummy • PCTBUS - % of business travelers on route [inelastic demand] • ACTUAL – number of actual competitors • PTT – number of potential competitors

  11. Imperfect contestability • Additional competitors reduce difference between optimal welfare and actual welfare by $0.0044/mile • Potential competitors reduce difference by $0.0015/mile • Conclusion: airlines are imperfectly contestable

  12. Extensions • Effects on welfare of potential carriers might increase as number of actual carriers falls • Insignificant effect of potential carriers until there are at least four potential carriers – “critical mass” is required

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