Does Vertical Integration Affect Firm Performance? Evidence from the Airline Industry

This paper investigates the performance implications of firms’ vertical integration decisions. Our setting is the U.S. airline industry. Major airlines subcontract service on low-density short and medium-haul routes to regional airlines. These regional partners are either owned by the major airline or are independently owned and contract with one or more major airlines. Earlier work (Forbes and Lederman, 2007) has argued that the primary benefit of ownership of a regional is that it mitigates incentive problems that arise when unforeseen schedule disruptions require the major to make changes that involve its regional partner’s operations. We explicitly test this hypothesis by estimating the relationship between a major’s performance on flights that it operates out of a given airport and its extent of vertical integration with the regional partners that operate flights on its behalf out of that airport. Our estimation approach accounts for the endogeneity of airlines’ ownership decisions. In addition to estimating an overall performance effect, we also investigate how this effect changes as the likelihood of schedule disruptions increases. We exploit the fact that while ownership decisions are fixed in the short-run, an important source of unanticipated schedule disruptions – weather changes on a day-to-day basis. Because ownership decisions cannot respond to these daily changes, we are able to observe carriers with both owned and independent regionals in a variety of weather conditions. Our results indicate that majors using owned regionals at an airport experience shorter delays and fewer cancellations than majors at the same airport using independent regionals. Moreover, this performance advantage increases as weather deteriorates. The effects we estimate are both statistically and economically significant. Our results provide one of the first pieces of direct evidence that contracts cannot replicate the incentive alignment achieved through ownership. presented by Silke Forbes FRIDAY, Oct. 5, 2007 1:30 pm – 3:00 pm, Room: HOH-706 USC FBE APPLIED ECONOMICS WORKSHOP