Aviation policy: past and present. (Association Lecture).

Bailey, Elizabeth E.

1. Introduction

Airline deregulation has been a symbol of the trend toward less expansive government over the past quarter century. The move from economic regulation to deregulation has delivered on its efficiency promises. Although there are only a handful of large carriers remaining after the consolidations of the 1980s and 1990s, there have been enormous benefits to consumers in terms of lower prices and more convenient schedules. However, airline competition remains imperfect, particularly at hub airports. The nature of these imperfections is explained better by models of oligopolistic behavior than by the contestability theory.

Paradoxically for this industry, 19 men and four airplanes brought the drive to shrink government to an abrupt end on September 11, 2001. The resulting tragedy has dramatized the public-good aspects of protection from terrorist attack and the need for information sharing by law enforcement authorities. Emergency legislation sought to provide financial stabilization for the airline industry in the short run. Subsequent legislation addresses the need for stronger aviation security in the long run.

This paper begins with a look at past policy. It describes the nature of aviation regulation and the causes and beneficial consequences of economic deregulation. It then evaluates the nature and extent of competition in the deregulated marketplace. Finally, it examines continued areas of governmental intervention in aviation, including new security and bailout policies.

2. The Regulatory Era: 1938-1978

The Civil Aeronautics Board (CAB) was formed in 1938. Most infrastructure industries (transportation, communications, energy, financial services) had major regulatory initiatives during this period. There was a downturn of faith in a laissez-faire economy emanating from the Great Depression (Vietor 1990).

The Civil Aeronautics Act of 1938 created a five-member independent regulatory agency and gave it authority to (i) control entry into the industry (both interstate and foreign commerce) and control entry of existing carriers into new or existing routes; (ii) control exit by requiring approval before cessation of service to a point or on a route; (iii) regulate fares on the basis of rate-making provisions adopted from the Interstate Commerce Act (which regulated railroads); and (iv) approve mergers, grant antitrust immunity to international rate-making agreements, and engage in other antitrust functions. The original act gave the CAB authority over safety issues as well. Congress separated safety regulation from economic regulation in the Federal Aviation Act of 1958 (Bailey, Graham, and Kaplan 1985).

The CAB designed route authority to ensure that an integrated service network would develop. Route rights were granted to trunk carriers on long-haul parallel routes and to local service carriers within geographic regions. For example, United Airlines was granted the east-west route through Chicago, and TWA was granted the east-west route through St. Louis. Originally, planes flying coast-to-coast had to stop at these interior cities because of the limitations of airplane technology. Competition was not direct, but instead occurred over parallel routes (New York to San Francisco via Chicago or St. Louis). In this way, air travel was similar to rail transport. However, the introduction of jet aircraft in the late 1950s and early 1960s enabled overflights of cities (nonstop service). Competition then became direct.

The local service carriers were granted service in largely nonoverlapping regions, for example, North Central around Minneapolis, Allegheny around Pittsburgh, and Ozark around St. Louis. Because these carriers were intended to serve as gatherers of traffic from small communities, the CAB severely restricted their ability to compete against the long-haul trunk carriers. Throughout the regulatory period, the focus of the CAB was on strengthening existing carriers, not authorizing new carriers. If a carrier was nearing bankruptcy, it would be merged into a financially healthy carrier (Transportation Research Board 1991).

Because of the monopoly, or near monopoly, conferred by CAB route authority, it was necessary to regulate rates so that consumers were protected from prices that were too high. Prior to World War II, airfares were conventionally set at the prevailing first-class rail fare. Gradually, a more formal review process set fares on an industry-wide basis. Fare competition was not precluded by statute, but the CAB's procedures and policies strongly discouraged it. Discount fares were permitted for charter carriers, which were also called "irregular," or unscheduled, carriers. There were no low-fare scheduled carriers. Proposals to change fares substantially were the subject of hearings. Thus, fares could not be changed quickly. There were also provisions to subsidize jet service to small communities (Meyer and Oster 1982).

This type of price and entry regulation contrasts sharply with market competition, in which the status quo is regularly overthrown and in which there is no legal recourse to entry and price changes as long as no antitrust laws are violated. Regulation entailed delays of two to four years for most route entry and industry-wide fare cases.

3. The Deregulatory Era: 1978-Present

By the early 1970s, evidence had begun to accumulate from a number of infrastructure industries that regulation was having unintended consequences, such as harm to efficiency and innovation. Government was viewed as being captured by the industries they were supposed to control and was believed to have become heavy-handed, doing more harm than good. In aviation, three carriers (Eastern, TWA, and Pan American) were near bankruptcy in the early 1970s. Political forces began to marshal, and these forces reached full flower in the aviation hearings held by Senator Edward Kennedy in 1975. Steven Breyer, now a Supreme Court Justice, provided Kennedy staff support for these hearings (Breyer 1982).

There was a lot of drama generated by the way the hearings were staged: Each day produced a dramatic point; for example, on one day, East Coast Boston fares were shown to be twice as high as West Coast San Francisco fares for routes of similar distances and densities. On another day, it was made clear that no new carrier entry had been permitted into the industry in 40 years. The hearings were fact-based. Evidence was brought to bear to address the fears aroused by reform and to convince others of the benefits of reform. One fear was that lower fares would lead to carrier bankruptcy. California and Texas provided the basis for a natural experiment, since their state regulators chose to deregulate fares for flights within their states. Southwest Airlines in Texas and Pacific Southwest Airlines in California offered much lower fares than CAB-regulated airlines and prospered financially (Levine 1965). Their fares were half as high as the CAB fares, due mostly to higher load factors and planes configured with mor e seats. Importantly, trunk carriers were not crippled financially by the coexistence of the low-fare scheduled carriers.

Another influential leading activity concerned Federal Express, which had requested deregulation of airfreight so that it could introduce an innovative new service in the mail area. Overnight package delivery would be offered at prices significantly higher than those for slower postal service delivery. Since no one opposed the idea, cargo deregulation was granted, and the new business proved to be a huge success.

With these early successes and the momentum of the Kennedy hearings, the stage was set for airline passenger deregulation. President Jimmy Carter was behind the reform movement and appointed two deregulators--Alfred Kahn and Elizabeth Bailey--to the Civil Aeronautics Board. A new economic theory called the contestability theory helped to provide a practical template for reform (Baumol, Panzar, and Willig 1982). The idea was to segment an industry into markets and to evaluate the extent of contests for the market that could take place under conditions of free entry and exit. Airlines were viewed as a potentially contestable industry. While most markets were limited by demand to only one or two carriers (an average of 1.5 in 1978), airplanes were viewed as "marginal costs with wings" that could readily be moved from one market to another if pricing became too high (Bailey and Baumol 1984; Kahn 1990). Indeed, deregulation improved route pair competition somewhat, to around 1.9 to 2.0 per route in recent years.

Deregulators at the CAB provided immediate opportunities for downward pricing flexibility by asking carriers to "show cause" why up to 35% of all fares should not be discount fares (to fill empty seats during off-peak periods). If an airport was underserved (e.g., San Jose or Newark at the time), carriers should "show cause" why the CAB should not permit any carrier to enter any route at that airport. In another initiative, it was announced that diversion was no longer to be considered a material fact when considering route entry. By such stratagems, entry was opened into airports, routes, and the industry within a year after passage of the Airline Deregulation Act of 1978. In contrast, upward pricing flexibility was delayed until 1980, after entry had been fully opened (Bailey 1981).

In terms of the entry of low-fare scheduled carriers, Southwest is the archetypal carrier. An important source of the airline's cost savings and efficiency is its avoidance of congested primary airports in large cities. With its low-fare, point-to-point strategy, Southwest has successfully generated high traffic volumes in many secondary airport-pair markets (e.g., Ontario, California, to Oakland, California) and has pressured other airlines to lower their fares not only in the same markets, but also in related airport-pair markets (e.g., Los Angeles to San Francisco). In 160 short-haul (<750 miles) airport pairs that Southwest entered between 1990 and 1998, air passenger traffic increased by more than 174%, and average yields adjusted for inflation fell by 54%. Southwest alone accounts for about 75% of passenger traffic on low-fare airlines (Transportation Research Board 1999). Thus, the existence of this single carrier has had an enormous influence on the price benefits to consumers from airline deregulatio n.

Economists have been surprised by how much of the gains from deregulation have been in the service dimension rather than in the price dimension (Bailey and Liu 1995). Most cities now offer convenient business travel whereby people can travel to their destination in the morning and return that evening. Of the $8.5 billion gain from such improved scheduling, $1.0 billion needs to be netted out to reflect the negative of the extra stop at a hub airport (Morrison and Winston 1986; Winston 1993). In terms of price performance, about half of the $6.5 billion gains are negated by booking restrictions, particularly in terms of mandatory Saturday night stays and advance-purchase requirements. Leisure travelers' benefits from deregulation have been mainly in lower fares, while business benefits have been mainly in frequency improvement. Basically, carriers set frequencies for business needs and then try to induce leisure travelers to fill empty seats.

Innovations following deregulation include the development of complex yield management systems that have evolved to price discriminate among travelers, for example, offering cheap tickets to early bookers and requiring last-minute travelers to pay a lot more. Large airlines, such as American and United, also innovated by developing computer reservation systems for travel agents. The host airlines' flights appear on early screens and give these large carriers a benefit for the high investments they made in these systems. Government eventually weighed in to remove some of the bias toward the monopolistic host airlines (Levine 1987). At the present time, use of the Internet for sales is beginning to bloom. The Web offers airlines significant savings on their marketing and distribution costs.

Overall, airlines have been reasonably profitable over time, but profits are still vulnerable to the business cycle. The industry loses money during recessionary periods, such as the early 1990s, and recoups these losses when the economy improves, as in the late 1990s. The average consumer is paying 27% less than what the regulated prices would have been, and 80% of passengers are paying less than they would have under government-set prices (Morrison and Winston 1989; Winston 1998). Demand for air services has more than doubled from 254 million domestic passengers in 1978 to 582 million in 1999.

In an analysis of the nature of competition following deregulation, the extent of contest-ability has been questioned. There was a natural pricing experiment in the late 1970s, during which local service carriers were permitted to charge higher prices than trunk carriers. During the period of the experiment, prices set by local service carriers were below those allowed in long-haul markets, in which carriers faced actual or potential trunk competition. These long-haul markets looked contestable. However, local service carrier prices were near allowed levels in short-haul markets, in which there was less fear of trunk competition because of trunk fleet composition. Thus, the short-haul markets did not appear to be contestable (Bailey and Panzar 1981).

Other evidence supports an oligopolistic interpretation of postderegulation pricing conduct at hub airports. Concentrated hubs are defined as airports where one carrier accounts for more than 50% of all local traffic or where the sum of two hubbing carriers accounts for more than 75%. Comparisons of average fares in city-pair markets involving 10 concentrated and 5 unconcentrated hubs consistently found higher fares in the concentrated hubs (by about 14-18%), especially in short-haul markets. At such airports, high fares do not seem to induce entry. Instead, the hub networks can be viewed as bringing about oligopolistic rather than contestable behavior (Morrison and Winston 1987; Borenstein 1991; Borenstein and Rose 1994; Hendricks, Piccione, and Tan 1997).

Further evidence comes from industry attempts to gain systemwide price increases. In March 2000, Continental proposed $20 and $40 price increases based on distance. Most carriers engaged in parallel pricing and immediately matched. The fare hike was rescinded when Northwest failed to match. Some time later, Northwest proposed a similar level of systemwide fare hikes, but based on a leisure-versus-business distinction; the action was immediately matched by all of the trunk carriers (Baker 2001).

4. Antitrust Oversight following Deregulation

When there is a reduction in economic regulation, it is important that there be a continuation of antitrust oversight. The Department of Justice (DOJ) has been vigilant in the conduct area. Robert Crandall, CEO of American Airlines, was caught on tape trying to price fix with Howard Putnam, then CEO of Braniff, shortly after deregulation. More recently, the DOJ brought charges of predatory pricing against American Airlines. The government accused American of incurring large short-term losses in the late 1990s to drive three low-cost competitors (Vanguard Airlines, Sun Jet International, and Western Pacific) from the Dallas-Fort Worth Airport, where American is the dominant carrier. All of these competitors except Vanguard have gone out of business. The issue was whether American was simply responding to market forces by lowering prices and increasing flights or whether flooding a market with capacity while matching price constitutes predation (Baker 2001). In April 2001, the court made it even harder to prove monopolization through predatory scheduling by finding against the DOJ. Further, U.S. antitrust law is not designed to prevent bankruptcy or purchase, and thereafter disappearance, of small low-fare carriers.

Deregulation caused a major change in carrier strategy toward route networks. Local service airlines immediately entered longer-haul and denser markets. Their feed into these markets gave them a stable pattern and level of earnings (Bailey and Williams 1988). Trunk carriers moved from the linear system of routes designed by regulators to hub-and-spoke systems under which traffic flowed more efficiently. Since consumers dislike changing carriers, all airlines attempted to provide one-carrier service (Levine 1987). Within a decade following deregulation, trunk carriers strengthened themselves by merging. Some mergers were with local service carriers at their hubs (TWA and Ozark, Northwest and Republic). Other trunk or local carriers merged with each other to achieve their national service goals (Delta and Western, US Airways and Piedmont). Antitrust authorities by and large accepted most of these mergers. Unfortunately, studies of these mergers found that fares paid by hub-originating and hub-terminating passen gers became higher and were only partially offset by the efficiency gains arising from the creation of a larger network (Borenstein 1990; Brueckner, Dyer, and Spiller 1992; Kim and Singal 1993).

For this reason, the DOJ opposed the $4.3 billion bid made by United Airlines in May 2000 to buy US Airways. There was concern that the same carrier would control too many contiguous hub airports in the east, furthering the negative competitive consequences that had been found to arise from hub dominance. The DOJ did, however, approve the takeover of the failing TWA by American in 2001.

In terms of international aviation policy, there has been massive privatization of government-owned airlines abroad, which was driven by the need to match the efficiency of U.S. carriers. There has also been a growing desire to form alliances among international carriers. Antitrust immunity is needed for such alliances. At the most basic level, an airline alliance may be simply a joint marketing deal known as code sharing, in which both airlines put their identification codes on a flight and they both sell it, even though only one operates it. The next step from simple code sharing is block booking on each other's flights, then joint marketing of the two airlines' network routes and sharing of frequent-flyer codes. In the closest alliance, that of KLM and Northwest, the carriers have completely integrated their business.

Some alliances have not received the approval they wished for. Twice, American Airlines and British Airways have sought approval for an alliance. Governmental authorities want British Airways to cede Heathrow airport slots as a condition of approval. The governmental view is that entry needs to be open at Heathrow (open skies) before this alliance is permitted to go forward. The carriers have not been willing to cede sufficient slots at Heathrow to enable the alliance to be approved.

5. Government Ownership of Aviation Facilities

Two types of aviation facilities continue to be owned and operated by the government: airports and air-traffic control facilities. When it became necessary to modernize and expand gates and other passenger facilities over the past two decades, many large airport authorities turned to their major airline tenants for financing help. In return, airports offered long-term leases that often gave air carriers control over a large share of gates and the authority to approve future expansions. Thus, instead of using regulation to open competition, airport policy has locked in monopoly elements.

There has also been a lack of efficient pricing policies at airports. Airport landing fees rarely do more than cover the wear and tear on runways. Fees are not equated with the costs imposed by users (on others) taking up valuable runway space during peak periods. Both airport and airway capacity are allocated to users on a first come, first served 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 also prompted a series of often arbitrary administrative and physical controls on airline and airport operations that have had anticompetitive side effects such as perimeter rules and slot control (Transportation Research Board 1999). Finally, there is provocative research suggesting that carriers also have incentives to overschedule planes at hub airports, leading to furthe r delays (Mayer and Sinai 2002).

The U.S. government runs air traffic control. There have been a number of criticisms of current aviation policy in this area. In the 1980s, air traffic controllers went on strike. The system responded by temporarily limiting airway capacity, basically by stretching out the periods between takeoffs and landings, creating delays. Such delays have continued. In 2000, U.S. air traffic delays were occurring for about one flight in four during peak summer season. Flights are controlled by a ground-based system that obliges pilots to stick rigidly to prescribed routes--often not the shortest ones--dictated by the need to stay close to radio beacons or radar stations. Conventional air traffic control, which relies on radar and wireless communications, has severe limits in today's crowded skies. Radar is accurate to only a few miles and involves exchanging much routine information between the pilot and the controller over the airwaves. There are plans to replace today's radar-based system with one built around satelli tes. Such a system could rely largely on Global Positioning System data, rather than radar, for navigation. If the new technology passes testing over the next several years, it would enable flight plans to follow a variety of more efficient and economical flight paths. However, having the new technology work for large, busy airports and for zero-visibility landings could take another decade or more.

6. Security Interventions

The issues discussed above were the major aviation policy issues facing the industry prior to the tragic event of September 11, 2001. The simultaneous hijacking of four planes and the use of airliners to destroy the Twin Towers of the World Trade Center and to attack the Pentagon has emphasized how vulnerable the industry is to terrorism. The government has been turned to for both immediate financial help and long-term structural change in aviation security.

On September 11, as the terrorists crashed planes into the Twin Towers and the Pentagon, United and American began to ground their airplanes. Within a short time, the Federal Aviation Administration ordered a nationwide shutdown. For three days, the entire U.S. aviation system was shut down for the first time in history. For four days, no international flights were permitted into the United States. Even after flights began again, the negative externalities persisted. Traffic was down 35-40% for the month of September (vs. the previous year) and was still down 20-25% for the month of October. This drop in traffic is much steeper than any that had occurred before. For example, the drop in air traffic during the Gulf War in spring 1991 was 10-11%.

Within weeks after September 11, an airline financial stabilization package was rushed through Congress. There was concern that the unprecedented drop in airline revenues, along with high potential liability, would preclude the industry from obtaining private financing. Emergency airline bailout legislation provided the industry with an immediate $5 billion cash infusion, most of which was used up in the fall of 2001. The legislation also created an Air Transportation Stabilization Board empowered to grant up to $10 billion in loan guarantees for up to nine months (applications through June 2002). Two of the three members of this board are strong market advocates, namely, Alan Greenspan (Chairman of the Federal Reserve) and Paul O'Neill (Secretary of the Treasury). The government also took on an insurance role, setting up a special master at the DOJ to pay the extraordinary costs of liability after insurance coverage. Thus, a strong degree of financial security was offered to keep the industry solvent and abl e to borrow.

Clearly, the traveling public views protection from terrorism as a public good. There is a growing view that federal control of security can help internalize the externality. The European system of government supervision of screeners, as well as the extent of professionalism of the European workforce, is viewed as superior to the U.S. system. In the past, the screeners of baggage and passengers have been paid by airlines and local airports in the United States. There has not been information sharing among various law enforcement officers or between law enforcement officers and screeners. The Anti-Terrorism Bill of October 26, 2001, addresses this need for information sharing among the Immigration and Naturalization Service, the Federal Bureau of Investigation, and those handling airport security.

The Aviation Security Bill of November 19, 2001, federalizes screeners of passengers and baggage, imposes a surcharge on airline tickets, and tightens law enforcement aspects of security. Some flexibility for local airport authority experimentation will be permitted. Efforts to minimize the transaction costs associated with improved security were not addressed.

7. Conclusions

It is ironic that at the beginning of the twenty-first century, there is a new regulatory wave in aviation policy. The role of government is being increased, much as it was in the early decades of the twentieth century. However, there has not been a return to detailed intervention in airline economic decisions. Rather, the new wave reflects a new focus of American society on financial stabilization and on improving its ability to provide security.

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Elizabeth E. Bailey *

* John C. Hower Professor of Business and Public Policy, Wharton School, University of Pennsylvania, 3100 Steinberg Hall-Dietrich Hall, Philadelphia, PA 19104-6372, USA; E-mail baileye@wharton.upenn.edu.

This paper was presented as an invited lecture on "Airline Deregulation: Past and Present" at the Southern Economic Association meetings on November 18, 2001, in Tampa, Florida.