Penn State University

We propose a methodology to empirically study the behavior of firms deciding whether to enter into a market and the prices they charge if they enter. In our multi-agent selection model firms simultaneously play an entry game, and, conditional on entry, set profit maximizing prices. The main complications we analyze are ones that result from the presence of multiplicity in the entry stage and the endogeneity of prices in the demand equations. We use cross-sectional data from the US airline industry and estimate the same model, while allowing for the unobservables to be correlated. We find: i) the markup is larger when we use the new methodology than what we find when run standard GMM, implying that models that do not account for endogenous market structure give bias estimates of price elasticity and therefore market power; ii) LCCs and Southwest have considerably lower marginal costs; iii) Southwest has lower, and LCCs have higher, fixed costs than the legacy carriers. We also run two counterfactual exercises, one where the legacy firms collude, and another where two legacy carriers merge. We find that in both cases prices rise, and in the case of the merger there are heterogeneous responses in entry decisions across firms. ∗We thank T. Bresnahan, John Panzar, Wei Tan, Randall Watson, and Jonathan Williams for insightful suggestions. We also thank participants at the Southern Economic Meetings in Washington (2005 and 2008) and the Journal of Applied Econometrics Conference at Yale in 2011, where early drafts of this paper wer