Essays on bundling and low cost air carrier pricing

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Date

2009-05

Authors

Aydemir, Resul

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Abstract

In Chapter 1, I analyze a setting where a pair of retailers which sell unrelated products at the same location (e.g., a strip mall) compete with other retailers located at a different strip mall across town by jointly introducing a bundling discount while independently setting their respective stand-alone prices. Customers who shop from multiple strip malls rather than only one incur additional exogenous shopping costs. I first show that if each retailer chooses a bundling discount non-cooperatively, then the equilibrium bundling discounts will be zero. In contrast, pairs of firms located at the same strip mall always find it profitable to jointly offer positive bundling discounts in order to encourage customer loyalty. Moreover, I demonstrate as a comparative static that as the shopping costs increase, pairs of firms have less incentive to make joint bundling arrangements in equilibrium. If only one pair can introduce a bundling discount, in equilibrium while total industry profit rises, consumer surplus and welfare fall with the increase in shopping costs. When both pairs offer the bundling discounts, all consumers buy a bundle in equilibrium. Thus, the presence of a positive shopping cost does not affect any industry variables in equilibrium except stand-alone equilibrium prices which decrease with the shopping costs so that the standard Hotelling result extends to this case. In Chapter 2, I investigate the effects of shopping costs on the merger incentives of these unrelated retailers in the context of bundling. I demonstrate that contrary to one’s initial conjecture, pairs of firms do not merge to internalize the externalities created by shopping costs and bundling discounts. While consumers are better off with the merger outcome, consumer and total welfare fall significantly when firms stay independent in equilibrium. In Chapter 3, I analyze how legacy carriers and Southwest Airlines respond to the threat of AirTran Airways entry. My estimation results suggest that equilibrium prices of legacy carriers are on average lower in response to the threat of entry by AirTran as expected, whereas those of Southwest are on average higher. This robust result on AirTran and Southwest competition echoes the pricing behavior in the pharmaceutical industry where brand-name prices increase before and after generic entry. The incumbent low cost carrier Southwest, especially with the incapability to further lower its prices significantly, may still find it profitable to capitalize on its loyal price-inelastic (i.e., high-end) customers. Anticipating a definite price cut from AirTran, however, the high-end customers of legacy carriers may be more sensitive to price differentials offered by AirTran relative to the high-end customers of Southwest because of the size of the offer. Hence, legacy carriers, in contrast, simply reduce their prices in response to threat of AirTran entry to keep these valuable customers.

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