The Effect of Short-term Liquidity and Capacity Constraints on Industry Cooperation

A central theme in industrial organization is product market cooperation and price collusion, yet there is little empirical work in the area. In our paper, The Effect of Short-term Liquidity and Capacity Constraints on Industry Cooperation, which was recently made publicly available on SSRN, we attempt to bridge this gap. Using a novel dataset on aggregate airfare rate increases, we are the first to provide empirical evidence on the peculiar dynamics of how firms in the airline industry cooperate. More importantly, this unique setting allows us to examine the determinants of the cooperation decision from both the initiator’s and the follower’s perspective. A recent $1.7 billion anti-trust settlement has thrust airline price fixing into the media spotlight. While no major United States air carriers have been accused of any wrongdoing, recent events raise suspicion regarding the legality of recent pricing trends for domestic airfare. Although we cannot rule out collusion, the pricing behavior in our data is most similar to that described by the cooperative model of Salop and Stiglitz (1977). The authors show that in an industry with search costs, the perfectly competitive price will not be an equilibrium since each firm has an incentive to raise price by a small amount. Extending this argument leads to a cycle of price increases since the benefits to search are based only on relative prices. This allows for any number of cooperative pricing outcomes.

Theories such as Salop and Stiglitz (1977) rationalize the pricing behavior in our data, but they do not explain the drivers behind the decision to seek additional cooperation. To the best of our knowledge, we are the first to empirically investigate the effect of short-term liquidity and capacity constraints on the cooperation decisions. We find that firms with low levels of short-term liquidity and firms with low levels of idle capacity are more likely both to seek cooperation and to follow a competitors bid for additional cooperation. Recent anecdotal evidence corroborates our finding that short-term liquidity affects the costs and benefits of cooperation and collusion. This finding can be reconciled with standard economic theory if the airline’s financial condition has deteriorated to the point of restricting investment opportunities, reducing the probability of the firm existing for the foreseeable future, or significantly increasing expected transaction costs (see, e.g., Jensen and Meckling, 1976). For example, as short-term liquidity deteriorates, firms are more willing to trade long-term reputation and increased future litigation risk for a chance at additional cooperation today.

On the surface our findings are at odds with the recent work on financial condition and airline pricing. Using data from 1985-1992, Borenstein and Rose (1995) and Busse (2002) provide evidence that financially distressed airlines are more likely to start price wars. The authors argue that this pricing change is motivated by distressed airlines attempting to raise cash to cover their short-term obligations. This price change works through two mechanisms. First, the airline initiating the price war benefits from any elasticity in demand in the short run if the price war is not immediately matched. Second, the price war allows the industry to borrow from future demand. When connecting the results from Busse (2002) with our findings it is important to recognize that the intuition for the results in Busse (2002) builds on the theoretical argument that price wars are likely to start in industries with idle capacity. However, idle capacity in the airline industry has decreased by more than 50% in the past two decades. The increased relevance of capacity in today’s airline industry motivates our two primary hypotheses. In addition to reevaluating the findings in Busse (2002) in a setting with significantly more binding capacity constraints, we hypothesize that idle capacity will be negatively related to a firm’s decision to cooperate.

We directly integrate our hypothesis with Busse (2002) by plotting how the marginal effect of short-term liquidity on the propensity to initiate cooperative actions changes as idle capacity changes. In support of our hypothesis we find that the liquidity constraints are a significantly positive predictor of initiating cooperative actions when average idle capacity is less than 20%. In addition, through extrapolation, we find that the same liquidity constraints become a significantly negative predictor of cooperative actions when idle capacity is between 35% and 45%. This provides support for Busse (2002) in exactly the capacity environment present during her sample period. While we acknowledge the difference between a reduced probability of performing a rate hike and an increased probability of initiating a price war, at the very least these findings show that liquidity constrained firms act significantly differently in the presence of restrictive capacity constraints. Our study extends the recent work of Phillips and Sertsios (2010). The authors provide empirical support for the argument that financially distressed airlines are more likely to have lower prices and lower product quality than their financially stronger industry peers. Our study extends Phillips and Sertsios (2010) by showing how short-term liquidity considerations affect a firm’s incentives to alter the cooperative equilibrium, independent of relative industry prices.

In order for an aggregate rate hike to stick, all non-low-cost air carriers must match the rate hike. Otherwise the cooperative attempt fails and prices return to pre-hike levels. Thus, we are able to augment our study by investigating the cooperation decision from the competitor’s perspective. Specifically, we study the determinants of matching a competitor’s rate hike. Following similar logic as in the case of a price hike we hypothesize and find that airlines with lower capacity and/or better financial health are less likely to cooperate with the initiating firm. Finally, we show that the probability of a rate hike being successful is increasing in the idle capacity and the short-term liquidity of the least constrained competitors.

The full paper is available for download here.