Traditional models of market power (Bresnahan, 1999) assume that the degree of market power can accurately be assessed from models where either price or quantity competition are the only endogenous variables. One of the conclusions of this literature is that significant market power, in the sense of price costs margins, exists in some concentrated industries. In this paper a structural model is specified and estimated which accounts for competition in two variables: capacity and prices.
Recently, more emphasis has been placed on the interactions between product market competition and other "input" markets, such as R&D, advertisement, finance, labor, and capacity. By endogenizing such input markets, which is often done by using a two-stage set-up, a number of fundamental issues need to be reconsidered. Of particular interest is the effect of imperfect product market competition on the demand for inputs. Another issue is that of endogenous costs and market structure (Sutton, 1991). A third area is anti-trust, where conventional wisdom of competition policy may not hold, once another strategic variable is introduced (Fershtman and Gandal, 1994).
The scope of this paper is to investigate whether the inferred significant degree of market power at the product market level is sensitive to the introduction of an input variable, namely capacity. In other words, does endogenous capacity effect the conclusions about product market competition? If so, one could attribute the above conclusion that "there is a great deal of market power, in the sense of price cost margins, in some concentrated industries" (Bresnahan, 1999) to the fact that input markets have not been properly endogenized.
To account for competition in input, as well as, output markets, this paper analysis a two-stage setup. In the first stage firms make capacity decisions followed by a product-differentiated, price setting game in the second stage. Since costs are endogenized through the first stage, this has important implications for the measurement of market power in the product market. This model is applied to the European airline industry using data for the period of 1993-2007.
The European airline industry is a particularly good "industry case" where this argument can be tested. Firstly, there likely exists significant market power due to the regulatory aspects of the industry. The reason for this cooperative duopoly structure in most markets has been created by bilateral agreements between member states. In fact, the rationale for the "liberalization" program in the European airline industry is based on the presumption to end monopolies and bring prices down to "more competitive" level. A first and second package of measures introducing new competition rules, relaxing price controls, and opening market, access where introduced in 1997 and 1999 respectively. Over time the pressure resulted in a third package, leading towards an 'in principle' open intra European market by April 1st 1999. Many of the measures contained in these packages will take time to implement. In addition, the question of third country access, i.e. opening up markets for competitors from non-EC countries and vice-versa, is still to be addressed more completely and remains in the public debate. The road to deregulation is still uncertain, but it is rather clear that the potential for significant market power in the European airline industry existed. This paper intends to assess this claim by measuring market power prior to major deregulations.
