SOCIALLY OPTIMAL CAPACITY AND CAPITAL STRUCTURE IN OLIGOPOLY: THE CASE OF THE AIRLINE INDUSTRY

This paper explores the relationship between an air carrier's debt and its capacity. It is shown that the capacity chosen by a profit-maximizing carrier will be larger than the cost-minimizing capacity due to the effect of passengers' schedule delay. The paper also shows that in oligopolistic markets, the chosen capacity does not minimize the total social costs, which include both the carrier's private costs and passengers' schedule delay costs. Given that the airline industry is among the most highly leveraged industries, and that the heavy use of financial leverage would affect airlines' capacity decisions, this paper attempts to identify the capital structure that would lead to the socially optimal allocation of capacity. Results of an empirical examination of 10 major U.S. carriers suggest that the excessive debt load of the carriers appears to have led to excess capacity as compared with the social optimum.