Price dispersion in the airline industry: the effect of industry elasticity and cross-price elasticity

This dissertation analyzes the sources of price dispersion due to the pricediscrimination in the U.S. airline industry. Using the multi-stage budgeting approachwith the almost ideal demand system (AIDS) specification, we estimate demand for airtravel at the airline level, and empirically decompose an airline’s own price elasticityinto cross-price elasticity vis-à-vis other airlines and an industry elasticity. Conceptually,cross-price elasticity measures the responsiveness of quantity demanded of airlineservice offered by an airline to a unilateral change in the firm’s own price with totalexpenditures given, whereas the industry elasticity measures the responsiveness of totalquantity of airline travel demanded to a change in the overall price of air travel. Then,we investigate the determinants of price dispersion induced by discriminatory pricingacross airline routes. Our results show that cross-price elasticity of demand for air travel,reflecting competitive-type discrimination, is the key factor affecting price dispersion inthe airline industry. This result is consistent with the earlier findings of Borenstein andRose (1994), but is based on a direct test of the underlying theory of Holmes (1989).