A Model of Dynamic Limit Pricing with an Application to the Airline Industry

We develop a dynamic limit pricing model where an incumbent repeatedly signals information relevant to a potential entrant's expected profitability. The model is tractable, with a unique equilibrium under refinement, and dynamics contribute to large equilibrium price changes. We show that the model can explain why incumbent airlines cut prices dramatically on routes threatened with entry by Southwest, presenting new reduced-form evidence and a calibration that predicts a pattern of price changes across markets similar to the one observed in the data. We use our calibrated model to quantify the welfare effects of asymmetric information and subsidies designed to encourage Southwest's entry.