Socially Optimal Capacity and Capital Structure in Oligopoly

This paper investigates the relationship between air carrier’s debt and capacity. It is shown that the capacity chosen by a profit-maximising carrier will be larger than the cost-minimising capacity due to the effect of passengers’ schedule delay. The paper also shows that in oligopolistic markets, the chosen capacity does not minimise 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. The results of an empirical examination of ten major US carriers suggest that the excessive debt load of the carriers appears to have led to excess capacity as compared with the social optimum.