Sunday, May 10, 2009

If investors are rational, why are they willing to buy airline stock?

On Thursday and Friday of last week, I went back to Washington to take care of a last bit of GW business: two of my students, Leigh Ann Coates and Theresa Diventi, successfully defended their Ph.D. dissertations.

I flew on United Airlines, and the plane was stuffed in both directions. Clearly United (as well as others) have done a good job of reducing capacity such that they fly very few empty seats.

Yet even while flying full airplanes, the airlines are losing money. This is perhaps because the airline business is essentially impossible: the fixed costs of running an airline are high, while marginal costs (particularly for the last seat on the plane) are low. The airline business has something pretty close to free entry, and so prices get driven down to marginal cost, which is below average cost, which means airlines on average over time lose money.

When asked how one became a millionaire, Richard Branson famously answered, "be a billionaire and start an airline." So why do people invest in them? It is hard to square this behavior with rational expectations.


Anonymous said...

Massive government subsidy.

UBMW said...

Tax write-offs and kickbacks?

Austin Kelly said...

Finally let Theresa out of the corral!

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