Impact of Bankruptcy and Competition on Airlines

This report analyzes the relationship between bankruptcy filings and competition in the airline industry, exploring how financial distress and market pressures influence strategic decisions and outcomes.

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This report delves into the intricate relationship
between product market competition and
corporate financial decisions. It explores how the
intensity of competition within an industry
influences a firm's strategic choices, impacting
everything from financial health to ethical
behaviour. By analysing various research papers,
we will gain insights into the delicate balance
companies must navigate between short-term
pressures and long-term sustainability.
Bankruptcy and Product-Market Competition:
Evidence from The Airline Industry1
Airlines facing financial hardship utilise
bankruptcy to remain afloat during restructuring.
This process, lasting anywhere from 18 days to
over four years, allows them to continue
operations while renegotiating debts and
streamlining operations. Cost-cutting measures
often involve reducing destinations served, flight
frequencies, and seat availability. However, this
financial reorganisation comes at a potential cost
to brand image. The stigma associated with
bankruptcy can lead to a decline in passenger
confidence and ultimately, a decrease in demand
for the airline's services.
Data and Methodology
The study aims to compare route structure, prices,
and capacities before, during, and after a
bankruptcy filing, drawing on data from nine
national carriers operating within the United States
between 1997 and 2007. Six of these carriers filed
for bankruptcy during the study period. Pricing is
analysed using median fares, while capacity is
measured by the number of available seats offered
on a specific route.
To address concerns about pre-bankruptcy changes
in behaviour that might skew results, observations
two quarters prior to filing are excluded. The
analysis further considers unobserved demand
shifts, seasonal effects, and route-specific factors
by incorporating time trends, fixed effects, and
route-carrier controls. To differentiate the impact
of a bankruptcy filing from the mere presence of a
bankrupt airline, a categorical variable is included.
Additionally, the study employs fixed effects to
account for potential sample selection bias and
confirms these methods are robust through
comparisons with random effects models.
Results
In terms of changes to route structure, the study
finds a significant reduction in the number of
markets served by bankrupt carriers, with an
average decrease of 20.8% during bankruptcy and
a steeper 37.5% decrease post-bankruptcy. This is
likely due to network streamlining as a cost-saving
measure. However, it's important to note that this
effect is amplified since changes by smaller

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airlines are weighted equally to larger carriers in
the analysis. Interestingly, competitors of bankrupt
firms significantly expand their market presence
by nearly 30%, suggesting they capitalise on the
opportunity to fill the void left by the bankrupt
carrier. This expansion appears to be permanent,
potentially altering the competitive landscape.
Furthermore, the analysis reveals a 25% reduction
in the number of markets served out of specific
airports by bankrupt airlines, both during and after
bankruptcy, indicating a network contraction at the
individual airport level.
It was found that bankrupt airlines significantly
reduce flight offerings by an average of 21.5%
during bankruptcy and a steeper 32.8% post-
bankruptcy. Potential pre-bankruptcy reductions
are unclear. Interestingly, competitors generally
don't alter their flight frequencies immediately,
suggesting they may not perceive a significant
opportunity to fill the gap immediately.
Bankruptcy also impacts the total number of seats
offered in a route, which is cut by an average of
29.6% during bankruptcy and 34.7% after.
Competitors also reduce capacity, but by a smaller
margin which may be due to competitors
cautiously evaluating the market.
The next section delves into pricing strategies
around airline bankruptcies. While bankrupt
airlines see a modest price reduction (3%) during
the restructuring period, they raise prices by 4.4%
upon recovery. Interestingly, competitors don't
adjust prices significantly in response to a
bankruptcy filing. This suggests that bankrupt
airlines might utilise initial price cuts to maintain
passenger demand, but raise prices later to recoup
losses. Competitors hold prices steady, suggesting
competitors prioritise stability or are unsure of the
future.
Despite bankruptcy filings, airlines don't see
significant reductions in either average cost per
seat mile or lowest ticket fare. In some cases, costs
even increase post-bankruptcy. This suggests that
filing for Chapter 11 may not be a guaranteed path
to lower operating costs for airlines.
Overall, robustness checks confirm the core
findings. Excluding pre-bankruptcy data (as
suggested by Ashenfelter's solution for potential
endogeneity) yields similar results, strengthening
the conclusion that bankruptcy itself, not just pre-
bankruptcy financial stress, drives the observed
reductions in flight frequencies, capacity, and price
cuts. While some limitations exist, such as the
inability to isolate time-specific trends due to local
market variations, the overall evidence suggests
that airline bankruptcies lead to significant
network reductions and temporary pricing
adjustments, without necessarily guaranteeing cost
savings for the bankrupt carrier.

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Airline bankruptcies, while offering a financial
lifeline, significantly reduce travel options for
passengers through network shrinkage and flight
cuts. While competitors may fill the gaps, the
landscape shifts, potentially impacting
convenience, and pricing.
How do Firm Financial Conditions Affect
Product Quality and Pricing2
This research investigates how a firm's financial
health impacts its decisions on product quality and
pricing. Firms facing financial hardship are more
likely to reduce quality in order to generate
immediate cash flow and resort to aggressive
pricing tactics to gain a larger market share.
However, with bankruptcy, the future benefits of
quality, such as customer retention, become more
important. This could lead to an increase in
product quality as the airline prioritises regaining
customer trust. The impact on pricing remains less
clear. The airline might use its newfound financial
flexibility to lower prices to attract customers.
Therefore, airlines prioritise short-term gain over
long-term customer satisfaction when facing
financial distress.
Thus, the study proposes two key hypothesis:
Hypothesis 1: As the likelihood of default
increases (indicating financial distress), firms will
reduce both product quality and price.
Hypothesis 2: When a firm enters bankruptcy,
product quality will increase relative to the period
of financial distress before bankruptcy.
Model, Data and Summary Statistics
With respect to the empirical strategy and the
econometric model, they used a simultaneous
equation approach to account for the interrelated
decisions of pricing, quality, quantity demanded,
and probability of default. Various factors
affecting each of these decisions were considered,
such as fleet age, airport congestion, oil cost,
average flight miles, oil efficiency, and so on.
The research uses a dataset spanning 12 years
(1997-2008) and includes 21 airlines, though the
data for each airline isn't necessarily balanced
across quarters. This is important because the
generalizability of the findings depends on the
representativeness of the airlines and the time
period studied.
A crucial element for this study is gauging the
financial health of the airlines, as the research aims
to understand how it influences their decisions on
quality and pricing. To address this, the researchers
leverage a modified version of the Merton model

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5 developed by Bharath and Shumway (2008)6.
This choice is particularly relevant because it
offers reduced sensitivity to industry-specific
financial trends, such as the growing popularity of
aircraft leasing. By incorporating daily stock
prices and quarterly debt data, the model calculates
a probability of default for each airline at each
quarter. This metric serves as the foundation for
analysing the impact of financial health on airline
decision-making.
To ensure a clear understanding of how an airline's
financial health influences its decisions,
researchers meticulously considered both external
factors affecting demand and those influencing
supply costs.
A critical challenge in this study is finding the
cause-and-effect relationship between an airline's
financial health and its decisions on quality and
pricing. The issue is that financial distress could
also stem from poor quality or high prices. To
address this, the researchers employ two
instruments:
Percentage of Liquidable Assets: This reflects how
much money creditors can recover by selling the
airline's aeroplanes. This is unlikely to directly
impact how the airline operates or its pricing
strategy. Fleet Redeployability: This measures
how easily the airline can move its aeroplanes to
different routes. This depends on the popularity of
the aircraft types, not the airline's control.
Additionally, airlines can't rapidly change their
fleet due to pilot and mechanic training needs.
The study meticulously validates these
instruments to ensure they truly reflect financial
health and aren't influenced by the airline's quality
or pricing decisions. The Sargan-Hansen test
confirms this.
Results
Firstly, the study looks at the impact of financial
distress on price and quality. The paper found that
airlines with a 60% probability of bankruptcy
significantly reduce prices by 32% compared to
financially healthy competitors. Although this may
attract budget-conscious travellers, the adverse
effects of financial distress on quality of service is
also significant. The quality of service suffers as
airlines cut corners in areas like baggage handling,
leading to an increase in mishandled bags from 5.8
to 7.6 per 1,000 passengers. On-time performance
also deteriorates, translating to flights arriving 19
minutes later on average. These findings suggest
that while financial distress might lead to lower
fares, passengers can expect a decline in the
overall travel experience.
The next section studies the impact of bankruptcy
on price and quality. Compared to financial

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distress, airlines in bankruptcy see a substantial
improvement in both mishandled baggage rate
(reduced to 4.6 per 1,000 passengers) and on-time
performance (flights arriving 10 minutes earlier).
While the price reduction continues during
bankruptcy, it's not statistically significant. This
suggests that bankruptcy might allow airlines to
shed financial burdens and prioritise service
improvements, potentially to attract new
customers or retain existing ones. The analysis for
financial distress and bankruptcy uses a three-
stage least squares method.
The final analysis delves into the impact of
financial distress and bankruptcy on on-time
performance at the route level. This analysis used
a two-stage least squares approach in order to
account for endogeneity. The analysis confirms
previous findings. Interestingly, airlines in
bankruptcy experience an improvement in on-time
performance compared to financial distress. This
positive effect is even stronger when considering
the airline's overall performance (firm fixed
effects). This suggests that bankruptcy allows
airlines to make strategic changes beyond
individual routes. While some improvement likely
comes from better management within routes, the
larger impact with firm fixed effects indicates
airlines might also shed underperforming routes
during bankruptcy, leading to a stronger overall
on-time performance boost.
In conclusion, financial distress in airlines
translates to lower fares for customers, but this
comes at the expense of quality. Bankruptcy,
however, provides a chance for airlines to improve
service and potentially regain customer trust in the
long run.
Product Market Threats and Leverage
Adjustments3
Traditional capital structure theories like pecking
order, market timing and trade-off theory focus on
how firms make financial decisions to reach ideal
debt ratios. However, neither of these theories
consider how competition affects leverage
adjustments.
This paper debates the competition's impact on the
adjustment speed (SOA). One viewpoint argues
that competition pressures firms to cut costs and be
more efficient, potentially leading to faster
adjustments (H0). Competition can also act as a
disciplinary force, pushing managers to optimise
firm value. However, an opposing view suggests
competition might hinder SOA. Increased
competition could decrease profitability, reducing
the incentive for cost-cutting efforts. Additionally,
intense competition can raise a firm's default risk,
making it more expensive to borrow money,
thereby slowing down leverage adjustments (H1).

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Data, Summary Statistics, and Research Design
This section focuses on how competition is
measured in the study. The researchers move
beyond traditional metrics like market share and
introduce Fluidity as the core measure. Fluidity,
developed by Hoberg, analyses changes in rivals'
product descriptions. It uses a "cosine similarity"
technique to assess the overlap between a firm's
product vocabulary and the aggregate shift in its
competitors' product terms. A higher Fluidity score
indicates a greater competitive threat. This
approach offers advantages over traditional
methods: Fluidity is forward-looking, capturing
the dynamic nature of competition, and it
considers competition from both public and
potentially private firms, providing a more holistic
view of the competitive landscape.
The study first establishes a model to estimate a
firm's target debt ratio, considering factors like
profitability, market conditions, and a newly
introduced variable for competition. Subsequently,
the analysis focuses on the speed of debt
adjustment towards this target. It differentiates
between passive and active debt. By incorporating
competition as a potential influence, the
researchers develop a model to assess how such
factors might affect the speed at which firms adjust
their debt levels to reach their target capital
structure.
The descriptive statistics confirm several expected
features of the data. Further, the correlation
analysis reveals that firms in more competitive
markets tend to have higher leverage, larger size,
and invest more in research and development. This
suggests that competition may influence a firm's
capital structure and growth strategies.
Additionally, it is also found that firms facing
steeper competition prioritise good corporate
governance practices. These initial findings form
the base for the subsequent analysis, where the
researchers delved into how competition affects
the speed at which firms adjust their debt levels.
Results
In the first analysis, a statistically significant and
positive relationship is observed between
competition and leverage adjustment speed. A one
standard deviation increase in competition leads to
a 4.6% faster adjustment. To strengthen the
validity of these results and ensure the observed
effect is truly due to competition, the study
incorporates various control variables.
In order to solidify the validity of the findings, the
study then employed alternative measures. These
examined market dynamics (competitor activity
and product overlap) and firm power (market
share, pricing flexibility, and concentration).To

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further strengthen the result, the study did a natural
experiment with real world tariff reductions. The
analysis employed a Difference-in-Differences
(DID) methodology to ensure that only the effect
of tariff reductions, not pre-existing trends, is
captured. The results were compelling. Further a
placebo test was done to show that the effect was
not due to random chance.
Prior research suggested firms with higher debt
(over-leveraged) adjust their leverage faster than
those with lower debt (under-leveraged).
However, this study found that competition had a
positive and significant impact on the speed of
leverage adjustment for both under-leveraged and
over-leveraged firms.
The final section delved into firm specific
characteristics which determine the SOA in
relation to competition. In firms with high agency
cost and information asymmetry, competition
incentivises faster adjustments towards optimal
capital structures. Competition particularly
pressures those firms with weak leadership, to
improve efficiency (stronger for less skilled
managers). This suggests strong leadership may
handle competition better, while weaker
leadership benefits from the external pressure to
improve financial discipline. It was also found that
younger firms, that is those less than 10 years and
those in the introduction and growth stages
according to the Dickinson Model are more
responsive to competitive pressure. This is
possibly due to their higher vulnerability. Finally,
faster leverage adjustments due to competition
create the optimal capital structure which result in
better firm performance and value.
In conclusion, competition, beyond traditional
financial metrics, significantly accelerates debt
adjustments. Firms facing competitive pressure,
particularly younger ones or those with weaker
leadership, can utilise this external force to
optimise capital structure faster.
Do Product Market Threats Discipline
Corporate Misconduct?4
The relationship between product market
competition and corporate misconduct is a
complex issue and has two opposing views which
are discussed in this report. On one hand, intense
competition can create a ground for increased
corporate misconduct (H1). The pressure to meet
short-term financial targets might lead managers to
prioritise immediate gains over long-term
sustainability. This could involve falling short on
safety protocols or ethical practices. Additionally,
competition can incentivise unethical behaviours,
such as bribery or other illegal means, to gain an
edge on rivals. On the other hand, market

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competition can even reduce misconduct (H0) as
they face intense scrutiny from customers and
competitors. Customers have more choices and
can easily switch to a competitor if a company is
involved in a scandal. This potential loss of
business creates a strong incentive for firms to
maintain a good reputation and avoid misconduct.
Furthermore, competitors are more likely to
expose unethical behaviour in a highly competitive
environment, further amplifying the reputational
damage.
Data and Descriptive Statistics
The data, spanning nearly two decades (2000-
2018), reveals that the proportion of firms
committing violations had risen significantly.
Violations were documented across various
categories, such as workplace safety and
environment. To assess competition, the study
employs a measure called ‘Fluidity’, which
analyses changes in product descriptions
compared to rivals. This approach captures the
dynamic nature of competition and provides
insights beyond traditional metrics. Finally, a
regression model delved into the relationship
between market competition and corporate
misconduct.
The data found that roughly 12% of firms were
found to have violated regulations at least once.
Firms with a history of misconduct tended to
operate in less competitive markets (lower Fluidity
scores). These companies also displayed
characteristics of larger, more established
organisations, with substantial assets, lower
growth prospects, and higher leverage.
Additionally, the possible negative correlation
between the competition measure and misconduct
suggested that as competition intensifies,
misconduct appears to decrease. These initial
observations pave the way for further investigation
into how competition might influence a firm's
ethical behaviour.
Results
Firms facing stronger competition were found to
have a lower likelihood of violations and penalties,
with a potential decrease in penalties of over 30%
for a one standard deviation increase in
competition. The negative correlation held true
across different competition measures, alternative
misconduct metrics, and even after controlling for
industry trends, data dependencies, and firm
characteristics.
To address endogeneity concerns stemming from
potential reverse causality or unobserved factors,
the study leveraged unexpected large reductions in
import tariffs as a natural experiment. These
reductions act as an exogenous shock, increasing
competition within an industry. Firms affected by
the tariffs exhibited a significant decrease in

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misconduct compared to control groups, further
validating the findings.
Although increased competition acts as a
disciplinary force, reducing managerial shirking,
this effect is not uniform across all firms. The
negative correlation is stronger for geographically
dispersed companies due to monitoring challenges
and in industries historically prone to misconduct,
such as manufacturing. Initially, the expectation
was that strong internal governance and
competition would be substitutes in preventing
misconduct. However, the study revealed a
complementary effect, where both factors working
together provide a more robust defence against
corporate wrongdoing.
The study then explores potential mechanisms
behind the competition-misconduct link. Firms
facing intense competition are more likely to adopt
stakeholder-oriented practices, such as ESG
incentives in compensation and increased
spending on worker safety, which may drive
cultural and policy changes within firms,
ultimately reducing misconduct.
These findings suggest that fostering a competitive
market environment can not only benefit
consumers through innovation and lower prices,
but also result in ethical corporate behaviour.
Considerations
Long-Term Perspective
These papers highlight the complex interplay
between short-term financial pressures and
decisions and long-term outcomes for firms. While
competition can incentivise positive long-term
outcomes like optimal capital structures and
ethical behaviour (papers 3 & 4), financial distress
can often lead to short-term cost-cutting measures
that reduce quality and damage customer trust in
the long run (papers 1 & 2). In the former, short
term decisions favour long-term results, whereas
in the latter they worsen long-term outcomes. This
shows the importance for companies to strike a
balance between immediate needs and future
goals.
The paper shows that (Chapter 11) bankruptcy
allows airlines to shed financial burdens and
prioritise service improvements. However,
declaring bankruptcy often leads to airlines
permanently shrinking their network and flight
offerings. This can hinder their long-term
competitiveness, especially if competitors
maintain their service levels. As evidenced in the
previous study, bankrupt airlines experience a
steeper decline in flight offerings and seat capacity
after bankruptcy, further impacting their ability to
compete. Additionally, airlines operate in an
industry inherently associated with a degree of
psychological risk. Thus, airline bankruptcies

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carry a unique risk for brand image and trust
compared to other industries.
Ethical Considerations
Papers 3 and 4 highlight the positive aspects of
competition, but policymakers need to
acknowledge its potential downsides. Increased
competitive pressure can incentivize firms to cut
costs in ways that compromise quality or ethical
practices (paper 4 focuses on misconduct, but may
not capture all ethical concerns from the view
point of consumers). Regulations may need to be
adaptable to address these potential drawbacks
while fostering a healthy competitive
environment.
Similarly, airlines facing financial distress must
prioritise clear and frequent communication with
passengers. This includes setting realistic
expectations about potential disruptions and
offering fair compensation for any
inconveniences. By being transparent and
prioritising passenger well-being, airlines can
strive to maintain trust and brand loyalty during
difficult times. This transparency is particularly
crucial before filing for Chapter 11 bankruptcy as
the research suggests airlines are in a more
vulnerable position leading up to the declaration.
Airline bankruptcies often lead to employee
hardships as well. Layoffs to cut costs can cause
significant job insecurity, loss and financial strain.
Additionally, wage cuts and the overall uncertainty
of the restructuring process create a stressful work
environment which could also negatively impact
the day-to-day workings of the airline.
Financial distress of airlines can also have
negative impacts on the environment. Delaying
essential maintenance on aircraft can lead to
increased wear and tear, reducing fuel efficiency.
Additionally, airlines seeking to maximise profits
might optimise routes for shorter flight times and
may also increase passenger loads to maximise
revenue per flight. This contributes to higher
overall emissions due to the increased weight
being carried.
Potential Solutions
With respect to papers 1 and 2, striking a balance
requires airlines to find creative solutions. A
potential strategy could be to prioritise cost-cutting
measures that don't directly impact passenger
experience. This could involve renegotiating
contracts with suppliers or streamlining internal
operations to reduce inefficiencies. Additionally,
airlines could explore alternative revenue streams,
such as ancillary fees for checked baggage or seat
selection, to generate income without
compromising on core service quality.

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To mitigate the long term impact of bankruptcy on
airline networks, they can optimise networks by
creating strategic partnerships (codeshares,
alliances) with other carriers, gaining access to
new routes and potentially reaching new
customers.
Future Research
Overall, future research could explore how
external factors like government regulations and
technological shifts affect a company's financial
health, competition, and ultimately, its success in
the market. Additionally, studies incorporating
insights from behavioural finance, like delay
discounting, can provide a more nuanced
understanding of how financial and competitive
pressures influence managerial decision-making.
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Accessed 24 Apr. 2024.