A Model of Dynamic Limit Pricing with an Application to the Airline Industry

Christopher Gedge, James W. Roberts, Andrew Sweeting

NBER Working Paper No. 20293
Issued in July 2014
NBER Program(s):   IO

The one-shot nature of most theoretical models of strategic investment, especially those based on asymmetric information, limits our ability to test whether they can fit the data. We develop a dynamic version of the classic Milgrom and Roberts (1982) model of limit pricing, where a monopolist incumbent has incentives to repeatedly signal information about its costs to a potential entrant by setting prices below monopoly levels. The model has a unique Markov Perfect Bayesian Equilibrium under a standard form of refinement, and equilibrium strategies can be computed easily, making it well suited for empirical work. We provide reduced-form evidence that our model can explain why incumbent airlines cut prices when Southwest becomes a potential entrant into airport-pair route markets, and we also calibrate our model to show that it can generate the large price declines that are observed in the data.

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Document Object Identifier (DOI): 10.3386/w20293

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