The Functioning of Inter-Modal Competition in the Transportation Market : Evidence from the Entry of Low-Cost Airlines in Germany

We investigate the entry of low-cost airlines (LCAs) in the German passenger transportation market. Using market research data and unique turnover and pricing information, we document that substitution rates between LCA and the incumbent rail operator Deutsche Bahn (DB) are substantial. As the competitive pressure of LCAs is surprisingly effective, both air and rail transport networks are forced to reconsider their pricing strategy. We document the price reactions of the two network providers. Lufthansa reacted by a drastic cut of all prices for all intra-German origin and destinations (O&Ds). We argue that the physical conditions of railroads make it harder for them to react. As railroads are an open system, changing the price system on one O&D has substantial opportunity costs on other O&Ds in the same network. This imposes constraints on price strategies which neither LCA nor the incumbent air network provider have to satisfy to the same extent. While this reduces the capability to react for a rail network provider, reactions can nonetheless be swift and efficient, as we document for some O&Ds. Our case shows the relevance of modern industrial organization and incentive theory in better understanding the interaction of different modes on the same market. It also has interesting implications for regulation of the European long-haul passenger market