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

Christopher Gedge, James W. Roberts and Andrew Sweeting

No 20293, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: 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.

JEL-codes: D43 D82 L13 L41 L93 (search for similar items in EconPapers)
Date: 2014-07
New Economics Papers: this item is included in nep-com, nep-cta and nep-tre
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