RAND Journal of Economics Vol. 33, No. 2, Summer 2002 pp. 298–318

Firm financial condition and airline price wars
Meghan Busse∗

A firm that knows that cutting price may trigger a price war must weigh present versus future gains and losses when considering such a move. The firm’s financial situation can affect how it values such tradeoffs. Using data on 14 major airlines between 1985 and 1992, I test the hypothesis that firms in worse financial condition are more likely to start price wars. Empirical results suggest that this is true, particularly for highly leveraged firms. The article also explores which firms join existing price wars and finds that a firm is more likely to enter a price war the greater the share of its traffic on routes served by the price-war leader.

1. Introduction
Economists’ explanations for price wars differ from those of other observers of the airline industry. Most economic models of price wars, which apply more generally than to the airline industry alone, have emphasized the role of fluctuations in demand. Changes in demand alter the expected profitability of undercutting a tacitly collusive equilibrium; depending on the assumptions made, the models predict that price wars occur either when demand booms or when it slumps. Industry insiders, meanwhile, identify the financial troubles of an individual carrier as an important motivation in initiating the fare cuts that trigger price wars. For example:
[Mark Daugherty, airline industry analyst for Dean Witter] said weaker airlines are willing to risk losses with low ticket prices in order to raise badly needed cash. “That is what is driving a lot of these companies,” said Daugherty. (Los Angeles Times, February 13, 1991, p. 4.)

This comment and others like it suggest that firms’ financial situations might play an important but neglected role in determining price wars. In light of these