Savings that hurt: Production rationalization and its effect on prices

• Published date: 01 January 2020
• DOI: http://doi.org/10.1111/jems.12330
• Author: Madhu Viswanathan,Mauricio Varela
• Date: 01 January 2020

J Econ Manage Strat. 2020;29:147–172. wileyonlinelibrary.com/journal/jems © 2019 Wiley Periodicals, Inc.

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147

Received: 1 February 2018

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Revised: 30 May 2019

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Accepted: 28 August 2019

DOI: 10.1111/jems.12330

INVITED REVIEW

Savings that hurt: Production rationalization and its effect

on prices

Mauricio Varela

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Madhu Viswanathan

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1

Department of Economics, University of

Arizona, Tucson, Arizona

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Department of Marketing, Indian School

of Business, Hyderabad, India

Correspondence

Mauricio Varela, Department of

Economics, University of Arizona, 1130 E

Helen St, Tucson, AZ 85721.

Email: mvarela@email.arizona.edu

Abstract

Postmerger scenarios often lead to a reallocation of resources and production

across the merged entity. Production rationalization, the process of reallocating

production across facilities so as to reduce total costs, results in firms equating

marginal costs across markets. This results in marginal costs, and hence prices,

being higher in some markets and lower in others than otherwise would be

without production rationalization. This paper proposes a model of competition

that elicits these effects and the resulting consequences on consumer and producer

surplus. The paper also presents empirical evidence to show that production

rationalization, in the form of fleet reoptimization, affected prices following the US

Airways/American Airlines merger. Prices of the merged firm increased 10% on

routes typically served by US Airways relative to routes typically served by

American Airlines, and by 12% relative to US Airways’rivals’prices. Price‐cost

regressions confirm such price hikes were likely due to fleet reoptimization.

KEYWORDS

American Airlines, cost synergies, merger effects, production rationalization

JEL CLASSIFICATION

D40; L11; L40; L93

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INTRODUCTION

Mergers often lead to large scale reallocation of resources and production across the merged entities. This process,

production rationalization, wherein the merged firm reoptimizes over both its previous and newly acquired resources,

can lead to dramatic changes in both the internal operations of the firm as well as market outcomes. While scholars

have extensively focused on identifying ways to optimally allocate resources and in general, believe that such optimal

reallocation leads to efficiency gains, there is a very little study on the impact of such reallocation on consumers.

To illustrate why consumers may not necessarily gain from these reallocations and subsequent cost efficiencies,

consider our context; the US Airways—American Airlines merger, wherein production rationalization in the form of

fleet reoptimization occurs. Before the merger, US Airways utilized a fleet of fuel‐efficient Airbus aircraft for domestic

operations. In contrast, American Airlines utilized gas‐guzzling McDonnell Douglas MD80s in addition to their fuel‐

efficient Boeing aircraft. If US Airways had some underutilization in the operation of its Airbus aircraft, the merger

would allow American Airlines to tap into US Airways’underused fleet, retiring some MD80s and saving costs for the

merged firm. Given the aggregate scale of the two airlines, it is possible that the number of consumers who could be

served with the more efficient airplanes exceeds the available number of fuel‐efficient airplanes. In other words, it is

entirely possible that the marginal consumer for American Airlines would continue to be served with MD80s while the

marginal consumer for US Airways would now be served with MD80s instead of Airbus aircraft. Thus, the marginal

cost of serving a US Airways customer would have increased, while the marginal cost of serving an American Airlines

customer would have remained the same. Crucially, as prices are determined by the marginal consumer, prices for US

Airways’customers would have risen while prices for American Airlines’customers would have remained flat,

negatively affecting some consumers without benefiting others.

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How does production rationalization affect consumers? This is the question that we seek to answer in this paper. To do

so, our paper develops a stylized model that formalizes the effects of production rationalization on prices and uses this

framework to guide an empirical analysis of production rationalization in the airline industry. In particular, we develop a

stylized model to show how, due to the US Airways—American Airlines merger, production rationalization in the form of

fleet reoptimization could have increased prices for some customers without significantly decreasing prices for others. We

then empirically test the predictions from our stylized model using price and cost data for the US domestic airline industry.

Our empirical strategy consists of two steps. First, we use a difference‐in‐difference estimator to test for price

changes before and after the merger. We find prices of the merged firm (i.e., AA/US) increased 10% more on

predominantly US Airways routes

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than on predominantly American Airlines routes. In addition, merging parties’

prices increased approximately 12% more than rivals’prices on predominantly US Airways routes while prices

increased only 6% more than rivals’on predominantly American Airlines routes. We take this as strong evidence that

the merger resulted in prices increasing for US Airways’customers. Second, to show that such price increases were due

to production rationalization, we correlate prices with the operating costs of McDonnell Douglas MD80s and Airbus

A319s aircraft and find prices of the merging parties on predominantly US Airways routes track the costs of the A319

more closely than those of the MD80 before the merger, and vice‐verse after the merger. In contrast, prices on

predominantly American Airlines routes track the costs of the MD80 more closely than those of the A319 both pre‐and

post‐merger. We take the reversal in the relationship between the operating costs of aircraft and price as strong

evidence that production rationalization, in the form of fleet reoptimization, caused some of the price increases on US

Airways’operations and no price effects on American Airlines’operations.

While we have focused on a merger scenario, production rationalization is not limited to mergers. Firms constantly

reallocate resources, facilities, and technologies in response to changes in supply, demand, regulatory, and

technological conditions. Changes in trade deals, investments in infrastructure, expansions in input markets, all

facilitate production rationalization by making it easier for firms to move inputs across facilities. Identifying the impact

of production rationalization in many of these circumstances is more challenging as reallocations and responses to

changes are more gradual. In contrast, mergers offer an ideal context to assess the impact of production rationalization

due to the magnitude of changes and the relatively short duration these changes take to realize.

Our paper is mostly related to the literature on merger efficiencies and, to a lesser extent, to that on the multimarket

competition. Most literature on merger efficiencies focuses on the type and size of efficiencies that mitigate consumer

welfare loss from reductions in competition. For example, see Farrell and Shapiro (1990) for the size of marginal cost

efficiencies, Werden and Froeb (1998) on how merger efficiencies constrain future entry, and Stennek (2004) on

information transfer as a form of efficiencies. This paper differs from Farrell and Shapiro (1990) and subsequent work

in that it explores how variable cost synergies in and of themselves can be detrimental to consumers, absent any market

power effects. Of course, increased market power would only exacerbate the welfare concerns described in this paper.

The literature on multimarket competition focuses on how cross‐market supply spillovers (e.g., Bulow,

Geanakoplos, & Klemperer, 1985) or conduct spillovers (e.g., Bernheim & Whinston, 1990) affect market outcome,

with empirical work

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focusing mainly on showing how increases in multimarket contact increased collusive behavior

between competitors. Our paper provides an alternate mechanism (production rationalization) to explain increases in

prices that does not rely on competition. In particular, we argue that a merger generates the opportunity for

rationalizing production across markets. Even if there are no reductions in competition, this rationalization has effects

on the marginal cost of production in every market, altering prices, rivals’responses, and consumer welfare.

The paper also adds to the growing empirical literature that evaluates merger effects post facto, and particularly in the

airline industry (Luo, 2014), Goolsbee and Syverson (2008), Kwoka and Schumilkina (2010), Gayle (2008), and Kim and Singal

(1993). Peters (2006) shows how price changes for five different airline mergers were mostly due to changes in unobserved

costs (inferred from pricing decisions), and not so much as changes in market structure. Werden, Joskow, and Johnson (1991)

specifically compare price changes following the Northwest‐Republic and TWA‐Ozark mergers across routes that suffered the

loss of competition relative to those that did not. They find prices increased on select routes that did not suffer loss of

competition. Unfortunately, as the main focus of their paper were routes that did suffer loss of competition, the authors do not

explore further plausible causes for such price increases. Our paper provides one possible explanation for their findings.

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VARELA AND VISWANATHAN