Capacity and Product Market Competition: Measuring Market Power in a 'Fat-Cat' Industry

In this paper we specify and estimate a structural model which accounts for competition in two variables: capacity and prices. The model has a two-stage set-up. 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. In particular, simpler one-stage specifications would result in a bias in the measurement of market power, which can be linked to the taxonomy for two-stage games given in Fudenberg and Tirole (1984). We then estimate this model – demand, cost (short- and long-run), and conduct – for the European airline industry using data for the period 1976–90. We perform a number of specification tests and reject a simple one-stage specification in favour of our two-stage set-up. In particular, we find that empirically the game is consistent with a fat-cat strategy. In other words, European airlines over-invest in capacities in order to be less aggressive. Moreover, we find that some degree of market power in the product market exists. Market power in the two-stage set-up is significantly lower than in the more widely employed one-stage specification, however, which is consistent with the direction of bias in fat-cat games. This illustrates that firms’ market power in the product market is significantly overestimated whenever capacity competition is not accounted for.