Freeman

ARTICLE

Re-Regulating Airlines

Deregulation has increased air travel, lowered costs, and increased safety.

JUNE 01, 1993 by PAUL A. CLEVELAND

Paul Cleveland is an assistant professor of finance and economics at Birmingham-Southern College in Birmingham, Alabama.

In 1978, Congress passed legislation which phased out the Civil Aeronautics Board and thus deregulated the airline industry. The bill was passed amid industry speculation that deregulation would endure for only a brief period of time. Trade publications prophesied re-regulation would follow the demise of a number of the large trunk carriers. They predicted that only four or five large carriers would survive in the competitive environment and when this occurred a movement to re-regulate the industry would result.

Fourteen years after deregulation we have seen the financial collapse of several of the large trunk carriers and the merger of others. As a result, just as industry insiders forecasted, the number of large airlines in the nation has shrunk substantially. Additionally, the media are running numerous stories about fluctuations in the airline industry and the loss of stability. Amid these stories there are calls for re-regulation just as industry officials had prognosticated; but no one seems interested in the facts about deregulation.

In the midst of all the clamor about the instability of the industry and the demise of once profitable carriers, no one seems to be asking whether or not deregulation has resulted in anything positive for the consumer. Given the media attention to gloom and doom, the reality might surprise many people. In fact, in the years since deregulation, air travel has increased dramatically and the real price of air travel has fallen. In 1977 domestic air travel accounted for 147.078 billion revenue passenger miles of air transportation service. By 1986 this level in creased to 252.724 billion revenue passenger miles. This is an increase of 71.8 percent or an average annualized growth rate of over 6 percent. To put this growth rate in perspective, we can note that real GNP for the economy grew at an average annualized rate of less than 3 percent for the same period.

In addition, airlines are increasing the percentage of seats actually filled on their flights, thus making more efficient use of their resources. The average load factor during the ten-year period leading up to deregulation was 52.4 percent. This percentage increased to 59.8 percent for the following ten-year period. This increase has been accomplished through the development of hub-and-spoke networks which allow the airlines to clear passengers through central terminals and thus offer much wider varieties of service than could have been offered before. It is granted that network expansion typically requires passengers to make one stop en route to their final destinations, but it is this approach which has made air travel accessible to many more consumers. Furthermore, it is a technique that allows the airlines to control costs and operate their equipment efficiently. This is borne out by the data which indicate that the number of available aircraft for service has risen by 52.2 percent from 1977 to 1986. Given that air passenger service has increased by more than 70 percent for this same period we can see the increased efficiency of the equipment used. That the airlines were forced to control their costs of providing the service is just one more positive result of deregulation. This process weeded out those firms which could not provide service at the competitive rate.

As a final consequence of deregulation, some might be surprised to find out that the number of fatalities per passenger mile of service has actually fallen during deregulation. Air travel is safer today than ever before. During the ten-year period prior to deregulation the industry averaged 253.5 fatalities per year. During the ten-year period following deregulation average yearly fatalities in the industry dropped to 153.8. This reduction even includes those airline deaths that occurred as a result of some type of terrorist activity. Why has this happened? I think it is the result of competition which has streamlined the industry and resulted in the continued operation of only those airlines most qualified to offer a quality service at an attractive price.

Given all these positive results, why then would anyone propose re-regulating the airline industry? We can identify three reasons for those proposals. First, some individuals have a vested interest in a regulated airline industry. Second, many people continue to hold the misconceived notion that industrial competition depends solely on the number of market participants. Finally, there seems to be a rising concern that major airlines are developing monopoly control at their primary hub airports. Let’s examine each of these areas of concern.

Vested Interests

If deregulation taught us anything, it is that industry insiders have a vested interest in being regulated. In the years since deregulation took effect we have seen numerous airlines unable to manage the resources at their disposal well enough to continue in business. As a result, a competitive environment has forced them from the industry. Managers in this industry must have had a much easier life when they were not allowed to compete against one another. Even now, those who have competed successfully must long for the days when life was easier. No doubt they would welcome the re-regulation of the industry.

This is true not only for the managers, but for the other employees as well. When competition is thwarted it is easy to request and obtain pay increases that would never be warranted in a competitive environment. Therefore, it shouldn’t be surprising to see union officials discuss the “disaster” of deregulation. Indeed, competition has been a disaster for the unions because it has undermined their privileged position.

Finally, there are governmental officials. They also have a vested interest in re-regulating the industry. Bureaucrats must have bureaus. Without them they have no position from which to meddle in the affairs of others. Busybodies are generally uninterested in producing something valuable for someone else. Rather, they prefer to intrude upon other people’s businesses.

Understanding the Nature of Competition

Next consider the prominent view of competition. People today have developed a distorted understanding of the meaning of competition. As Israel Kirzner points out in his book Competition and Entrepreneurship, the reason for this confusion rests with economists and their focus on long-run, perfectly competitive equilibrium as a definition of competition. But as Kirzner quite rightly points out, this is not competition at all. Rather, it is the absence of it.

In the context of the airline industry, the current concern with the number of remaining large carriers is unimportant. The process of competition is working. We see the process working as we watch those airlines which are unable to keep up fall by the wayside. Their assets are then reallocated to the remaining firms that have proven their ability to provide a relatively more desirable service to the traveling public. In light of this process, is it any wonder that air travel has expanded so rapidly since deregulation?

Even if it were true that numbers were important, the re-regulationists would still be no better off in their argument for re-regulating the industry. This follows from the fact that it is not the number of airlines that exist which is important in their argument, but rather the number of airlines that provide service for a particular city-pair market. During the regulatory years it was not surprising to be limited to only one carrier which served a specific city-pair market. For more heavily traveled routes, we sometimes found two firms; but it was unusual for more than two air carriers to serve the same route. Therefore, if the result of airline deregulation is the elimination of all but four airlines, and the remaining carriers serve roughly the same markets, on the basis of numbers alone we must conclude that there is more competition.

The “Monopoly Control” Hubbub

This brings us to the final concern. In recent years there has been a great deal of interest about the level of competition at hub airports. In particular, some writers have suggested that airlines are engaged in developing monopoly control over air transportation into and out of their primary hubs. These writers have focused on the percentage of service dominated by one cartier at some airports. For example, Delta accounts for a significant proportion of the traffic through Atlanta, and Northwest accounts for a sizable portion of traffic through Minneapolis. The critics argued that since these airlines control such large portions of the traffic through these hubs, they can therefore charge higher prices for nonstop service originating or ending at these hubs.

In response to this criticism one is left to wonder why this state of affairs is so bad. After all, if price is the primary factor for the customer there are probably numerous one-stop options to and from these airports. Alternatively, if time is of the essence, then the extra price would certainly not be problematic from the consumer’s point of view. Either way, one would be hard pressed to argue that the airlines were not providing a valued service for the price. We have already seen that one result of deregulation has been the development of hub-and-spoke networking which typically requires that passengers be funneled through a central clearinghouse en route to their final destinations. We also saw that this approach makes the most efficient use of resources. Therefore, it is not surprising to find that passengers pay a premium for nonstop service.

There remains, however, one more feature of the airline industry that we should consider with respect to the issue of fortress hubs. Specifically we need to consider the way in which airports are constructed and operated in the United States. Airports have typically been constructed and operated as public enterprises. That is, they are government owned and operated. The funding to construct airports has come from local bond issues and from federal funds. To obtain gates and landing slots the airlines sign use agreements with the public authorities assigned the task of overseeing airport operations.

There are two types of use agreements commonly employed. They are the compensatory agreement and the residual cost agreement. A compensatory agreement is a standard type of contract. The airline agrees to compensate the airport authority for its use of the facilities according to the terms of the agreement. The rates for leasing gates and for landing and take-off slots are spelled out in the agreement. Under this type of contract the financial risk of the airport remains with the airport authority.

A residual cost agreement is somewhat different. Under the terms of this contract the airlines agree to pick up any additional costs of the airport not covered by previous payments for gates, landing and take-off slots, concessions and other ground-related revenues. This contract shifts the financial liability from the airport authority to the airlines. In particular, the airline most at risk is the one with the dominant presence at the airport using such a contract.

Dominant airlines have been unwilling to sign these agreements without the inclusion of a “majority-in-interest clause.” A majority-in-interest clause allows the airline underwriting the burden of the financial risk the power to control future capital decisions. Thus a dominant airline could prevent the expansion of the airport if the proposed construction did not meet its own time frame for expansion. In a very real sense, the airline would be in a position to thwart entry because of the nature of the use agreement.

The problem in this case is not a competitive airline industry. Rather the problem is a socialized system of airports. If the airports were privatized this problem would vanish, for an entrepreneurial airport would seek profitable airport expansions. Someone might try to argue that airlines which currently have the majority positions at airports would end up purchasing the airports so as to continue to limit entry and competition; but this argument is weak. In this case the airline would be pitted against itself. Should it operate its airport at a less than optimal level and take a loss on the airport for the sake of its air passenger service? I think the answer is no. Through the fortress hub situation the competitive airline industry has revealed to us another industry which needs to be competitive.

What will happen to the airline industry in the future? Will it be re-regulated as the industry prognosticators have forecast or will it remain competitive? Will we ever seriously consider privatizing the airports or will we continue to operate them as relics from the past? For now we don’t know the answers to these questions. Let us hope that we will have the common sense to maintain and enjoy not only a competitive airline industry, but a competitive airport industry to match.

ASSOCIATED ISSUE

June 1993

comments powered by Disqus

EMAIL UPDATES

* indicates required

CURRENT ISSUE

November 2014

It's been 40 years since F. A. Hayek received his Nobel Prize. His insights, particularly on the distribution of knowledge and the impossibility of economic planning, remain hugely important today. In this issue, we look back on the influence of his work. Max Borders and Craig Biddle debate whether liberty must be defended from one absolute foundation, further reflections on Scottish secession, and how technology is already changing our world for the better--including how robots, despite the unease they cause, will only accelerate this process.
Download Free PDF

PAST ISSUES

SUBSCRIBE

RENEW YOUR SUBSCRIPTION