Airline deregulation: Time to complete the job

Airline deregulation: Time to complete the job

Meyer, John R

Deregulation of the airline industry, now more than two decades old, has been a resounding success for consumers. Since 1978, when legislation was passed ending the government’s role in setting prices and capacity in the industry, average fares are down more than 50 percent when adjusted for inflation, daily departures have more than doubled, and the number of people flying has more than tripled.

Yet even as the economy booms and people fly in record numbers, travelers are increasingly heard complaining about widely varying fares, complex booking restrictions, and crammed planes and airports. Among longtime business travelers, these complaints are often followed by fond but fuzzy recollections of the days before deregulation, when airline workers were supposedly more attentive, seating spacious, and flights usually on time and direct. Even leisure travelers, who have been paying record low fares, can be heard grousing about harried service, crowded flights, and missed connections.

High fares in some markets and a growing gap in the prices charged for restricted and unrestricted tickets have not only raised the ire of some travelers but also prompted concern about the overall state of airline industry competition. Although reregulating the airlines remains anathema to most industry analysts and policymakers, there is no shortage of proposals to fine-tune the competitive process in ways that would influence the fare, schedule, and service offerings of airlines.

Unfortunately, the history of aviation policy suggests that attempts by government to orchestrate airline pricing and capacity decisions, however well intended and narrowly applied, run a real risk of an unhealthy drift backward down a regulatory path that has stifled airline efficiency, innovation, and competition. Today, numerous detrimental policies and practices remain in place, even though they have long since outlived their original and often more narrow purposes. These enduring policies and practices-particularly those designed to control airport and airway congestiondeserve priority attention by policymakers seeking to preserve and expand consumer gains from deregulation.

Troubling legacies

The airline industry was originally regulated out of concern that carriers, left to their own devices, would compete so intensely that they would set fares too low to generate the profits needed to reinvest in new equipment and other capital. It was feared that this selfdestructive behavior would, in turn, lead to the degradation of safety and service, ultimately leading to either an erosion of service in some markets or dominance by one or two surviving carriers.

Regulators on the now-defunct Civil Aeronautics Board (CAB) took seriously their mission to avert such duplicative and destructive competition. No new trunk airlines were certified after CAB was formed in 1938, and vigorous competition among the regulated carriers was expressly prohibited. Airlines were assigned specific routes and service areas and given formulas governing the fares they could charge and the profits they could earn. They were even subject to rules prescribing the kinds of aircraft they could fly and their seating configurations.

Established when the propeller-driven DC-3 was king and when air travel was almost exclusively the domain of the affluent and business travelers, CAB was slow to react to the effects of new technology and the changing demands for air travel. The widespread introduction of jet airliners during the 1960s greatly increased travel speed, aircraft seating capacity, and overall operating efficiencies. By flying the faster and more reliable jets, the airlines were able to schedule more flights and use their equipment and labor more intensively. As travel comfort and convenience increased, passenger demand escalated.

Constrained by regulation, the airlines could respond only awkwardly to changing market demands. Meanwhile, the nation’s aviation infrastructure, consisting of the federal air traffic management system and hundreds of local airports, was barely able to keep pace with the changes. Airports in many large cities desperately needed new gates and terminals to handle the larger jets and increased passenger volumes. The air traffic control system, designed and managed by the Federal Aviation Administration (FAA) for a much smaller and less demanding propeller-based industry, suddenly had to handle many more flights by faster jets operating on much tighter schedules.

A fundamental shortcoming, which remains to this day, is that neither the local airports nor the air traffic control system were properly priced: that is, paid for by users in a way that reflects the cost of this use and the value of expanding airport and airway capacity. The air traffic control system has long been financed by revenues generated from federal ticket taxes and levies on jet fuel. Unfortunately, there is little correlation between the size and incidence of these taxes and the cost and benefits of air traffic control services. Likewise, airport landing fees rarely do more than cover the wear and tear on runways. Among other omissions, they are not equated with the costs imposed by users (on others) when taking up valuable runway space during peak periods. Both airport and airway capacity are allocated to users on a first-come, firstserved basis, a simple queuing approach that provides little incentive for low-value users, such as small private aircraft, to shift some of their activity to less congested airports and off-peak travel times. Not only has this approach been accompanied by air traffic congestion and delays, but it has prompted a series of often arbitrary administrative and physical controls on airline and airport operations that have had anticompetitive side effects.

In the regulated airline industry of the 1960s and early 1970s, many shortcomings in the public provision of aviation infrastructure could be addressed by the relevant parties acting cooperatively. For instance, when seeking to curb mounting air traffic congestion, the FAA imposed hourly quotas on commercial operations at several of the nation’s busiest airports, including Washington’s National, New York’s LaGuardia, and Chicago’s O’Hare airports. As a practical matter, this quota system (as opposed to the queuing used elsewhere) could be smoothly implemented only because a small number of airlines were permitted by CAB to operate from these airports and could thus decide among themselves who would use the scarce take-off and landing slots.

Other airport access controls were agreed on by the airlines, the federal government, and the local authorities. Most notably, nonstop flights exceeding prescribed distances were precluded from flying into or out of National and LaGuardia airports. Similarly, aircraft headed to or from points outside of Texas (and later bordering states) were excluded from Dallas’s Love Field. The purpose of these so-called “perimeter” limits was to promote the use of the newer and more spacious Dulles, JFK, and Dallas-Fort Worth airports for long-haul travel. In a highly regulated environment-in which airline prices and service areas could be adjusted by regulators to compensate for the effects of these restrictions-the airlines had little incentive to object vigorously to these proscriptions, many of which were later codified in federal law and rulemakings.

Airlines and airports in the regulated era also cooperated in the funding of airport expansion. Concerned that airport authorities would exploit their local monopoly positions by sharply raising fees on airport users and spending the revenue on lavish facilities, the federal government placed stringent restrictions on the use of federal aid to airports. Most funds could be used only for runway and other airside improvements and were accompanied by regulations limiting the recipient’s ability to raise landing fees. Hence, when it became necessary to modernize and expand gates and other passenger facilities, particularly after the introduction of jets, many large airport authorities turned to their major airline tenants for financing help. In return, the airlines signed long-term leases with airports that often gave them control over a large share of gates and the authority to approve future expansions. The possible anticompetitive effects of these leases generated little, if any, serious attention.

Learning new tricks

Largely unforeseen 20 years ago was the extent to which major carriers, once deregulated, would shift to hub-and-spoke operations. By consolidating passenger traffic and flights from scores of “spoke” cities into hub airports, the major carriers were quickly able to gain a foothold in hundreds of additional city-pair markets. This network capability was especially valuable for attracting business travelers interested in frequent departures to a wide array of destinations. The airlines soon discovered that timesensitive business travelers would pay more for such convenience.

The introduction of frequent flier programs made hub-and-spoke networks even more effective in attracting business fliers. By regularly using the same airline, travelers were rewarded with free upgrades to first class, preferential boarding, access to privileged airport lounges,_ and -free trips.

Hub-and-spoke systems coupled with the frequent flier programs put the startup airlines at a competitive disadvantage. Without access to the slot-controlled airports, the new airlines faced a handicap in competing for the highly lucrative business market. A wholly voluntary process for distributing slots became impossible in a highly competitive environment. Unfortunately for the new airlines, the FAA grandfathered most of these slot assignments to the large incumbents, allowing them to sell or lease the slots as they saw fit.

New entrants were further hindered in their efforts to build desirable route systems by the persistence of perimeter rules at several key airports. Though strongly supported by residents living near these airports as a way to curtail airport traffic and noise, these limits on long-distance flights are a highly arbitrary means of regulating airport access. The switchover to hub-and spoke systems by the incumbents made it much easier for them to operate within the perimeter limits, because a high proportion of their passengers travel on short- and medium-haul flights connecting from hubs located within the perimeter. For new entrants without well-situated hubs-or the ability to effect changes in the perimeter rules, such as the extension of the limit for Washington National to Dallas-Fort Worth, a main hub for both American and Delta Airlines-these limits created another competitive disadvantage.

Many of the incumbents operated hubs from the very same airports where they also held exclusive-use gate leases and longterm facility and service contracts. The new entrants pointed to these arrangements as significant obstacles to gaining access to gates and other airport services essential for effective competition. By the end of the 1980s, these entry barriers, coupled with the business failure of many new entrants and mounting evidence of high fares in hub markets, prompted growing concern about the sufficiency of airline competition.

Predatory pricing?

During the Gulf War and the national economic recession of the early 1990s, the airlines experienced a sharp drop-off in demand and subsequent operating losses. As the industry began to recover, the excess equipment and labor shed by major carriers created conditions that were favorable for a new wave of startup airlines and further expansion of some existing niche carriers. The former Texas intrastate operator Southwest Airlines began flying in most regions of the United States. By the mid-1990s, one in five travelers was flying on Southwest and other smaller, startup airlines.

For the most part, these new entrants sought profitability through the intense use of labor and equipment and high load factors achieved by offering low fares in city-pair markets with high traffic densities or the potential to achieve such densities through lower fares. By challenging incumbent airlines at their hubs, the new carriers hoped to tap into pent-up demand from leisure travelers and even to attract a fair amount of business traffic. Almost uniquely, Southwest chose to focus its growth at secondary airports in or near major metropolitan areas, thus avoiding congested hubs and minimizing head-to-head competition with major carriers. To many observers, this new wave of entry represented a healthy and overdue development that would counter the tendency of major airlines to exploit market concentration in major hub cities such as Atlanta, Denver, and Chicago.

It was therefore a matter of concern when the new entrants complained that they encountered sharp price cutting by major incumbent carriers, particularly when entering concentrated hub markets. The Department of Transportation (DOT) questioned whether incumbents were setting fares well below cost in an effort to divert customers away from the new challengers, seeking their demise in order to raise fares back to much higher, pre-entry levels. There were also reports of incumbents using their long-term leases and other airport contractual arrangements to exclude challengers; for instance, by refusing to sublease idle gates.

Concerned about possible predatory practices in the airline industry, and recognizing the uncertainty and expense involved in trying to prove such conduct through the courts under traditional antitrust law, DOT offered its own criteria for detecting predatory pricing. It proposed an administrative enforcement process to police unfair competition in the airline industry. Sharp price cutting and large increases in seating capacity in a city-pair market by a major airline in response to the entry of a lower-priced competitor would trigger an investigation and possible enforcement proceedings.

DOT’s proposal, made in April 1998, prompted strong reactions. It was lauded by some, including many startup airlines, as a necessary supplement to traditional antitrust enforcement, giving new entrants the opportunity to compete on the merits of their product. Others, including most major airlines, have criticized it as a perilous first step toward reregulation of passenger fares and service and as incompatible with traditional antitrust enforcement. Meanwhile, in May 1999, the Department of Justice (DOJ) filed a civil antitrust action against American Airlines, claiming that it engaged in predatory tactics.

Spurring more competition

Whether pursued by DOJ or DOT, the development and application of an empirical test for predatory pricing that would not inhibit legitimate pricing responses poses significant challenges. As a practical matter, it would require information, gathered retrospectively, about an airline’s cost structure and the array of options it had available to it for using resources and capacity more profitably. More important, it would do little to remove underlying impediments to entry and competition. After all, for predatory pricing to be a profitable strategy, it must be accompanied by other competitive barriers that allow the airline to gain and sustain market power. Competition is critical to making deregulation work. Accordingly, aviation policies aimed at benefiting consumers should first and foremost center on those areas where government practices are hindering competition.

A good place to start would be to correct the many longstanding inefficiencies and inequities in the provision of aviation infrastructure. Aircraft operators should be charged the cost of using and supplying airport and airway capacity. Neither the use nor the supply of airport runways and air traffic control services is determined on the basis of their highest-value uses. A commercial jet with hundreds of passengers, paying thousands of dollars in ticket and jet fuel taxes, is given no more priority in departing and landing than a small private aircraft. Access determined by first-come, firstserved queuing is a guarantee that demand and supply will be chronically mismatched and congestion and delays will ensue, with air travelers suffering as a result. For low-cost airlines that must make intensive use of their aircraft and labor, recurrent congestion and delays are especially troublesome impediments to market entry, and ones that are only likely to get worse as demand for air travel escalates.

Airports still subject to outmoded slot and perimeter controls would make ideal candidates for experimentation with congestionbased landing fees and other market-based methods for financing the supply of airport and airway capacity. Not only would such cost-based pricing offer a way to control airport externalities such as noise and delay, it would do so with far fewer anticompetitive side effects. In addition, it is past time to reassess the competitive effects and incentives of federal aid rules that limit the ability of airports to raise revenues through higher landing fees.

The laggard performance of the public sector in providing and allocating the use of critical aviation infrastructure is a serious deficiency that will become more troublesome as air travel continues to grow. However, crowded airports, flight delays, and discontent over passenger fares and services should not be viewed as shortcomings of deregulation itself, but as clarion calls to complete the deregulation process, instilling more market incentives wherever sensible and feasible.

John R. Meyer is James W. Harpel Professor Emeritus for Capital Formation and Economic Growth at the John F. Kennedy School of Government, Harvard University. He chaired the Transportation Research Board committee that produced the report Entry and Competition in the U.S. Airline Industry: Issues and Opportunities. Thomas R. Menzies served as the committee’s study director.

Copyright Issues in Science and Technology Winter 1999/2000

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