by Peter
J. Ferrara
One of the greatest successes
of President Jimmy Carter, from which this nation is still benefiting,
was airline deregulation. Adopted with broad bipartisan support 20
years ago, airline deregulation has produced sharply reduced prices,
increased service, greater safety and more competition.
Yet, President Clinton’s
Department of Transportation (DOT) is now proposing to start reversing
this highly successful Carter era policy. Under proposed new regulations,
the Department would begin to reregulate airline ticket prices. Moreover,
it proposes to do so in a most perverse way – by restricting
major airlines from reducing air fares and expanding
the availability of low-cost, discount seats.
The rationale for this upside-down
policy is to prevent supposed "predatory pricing", under
which a company will cut prices below costs until it drives out all
competitors, then raise prices to monopoly levels. But this is a solution
in search of a problem. Airfares are sharply down, not up. So predatory
pricing does not seem to be working to increase fares. Moreover, even
though predatory pricing has always been illegal under the antitrust
laws, there has not been one proven case of predatory pricing in the
entire history of the domestic air line industry. Finally, competition
since deregulation has increased, not declined. So "predatory
pricing" does not seem to be preventing competent new competitors
from succeeding.
What seems to be at work
here is another classic special interest abuse of government. Potential
or failing new entrants are running to the government to get protection
from competition from established airlines. They are seeking to use
the government to prevent these airlines from reducing prices to meet
the competition from the new entrants. Clearly, the unjustifiable,
specious, special interest regulations proposed by DOT should be withdrawn.
This report will discuss
these issues in more detail. First, it will discuss the success of
airline deregulation. Secondly, it will discuss the new regulations
proposed by DOT and their rationale – to counter predatory pricing.
Thirdly, it will discuss why DOT in fact does not appear to even have
the legal authority to issue these new regulations. Fourthly, it will
discuss alternative policies to enhance competition in the airline
industry and improve its performance.
The Success of Airline
Reregulation
Before the Airline Deregulation
Act of 1978, the Civil Aeronautics Board regulated every detail of
the airline industry. Most importantly, it determined what routes
each airline could fly and what air fares each could charge. It even
determined whether a new airline could enter the industry. It also
regulated levels of service, employment policies, finances, business
structure, cargo and other factors.
But under the 1978 Act and
the subsequent Civil Aeronautics Board Sunset Act of 1984, all this
regulatory power was eliminated and the CAB was phased out. The Federal
Aviation Administration (FAA) retained authority to regulate air safety.
The overwhelmingly beneficial results of this deregulation surprised
even the most ardent advocates of reform.
Prices Down
Airline ticket prices today
are almost 40 percent lower, after inflation, than before deregulation.
This price reduction saves consumers about $20 billion per year, according
to Robert Crandall, senior fellow in Economic Studies at the Brookings
Institution, and Jerry Ellig, senior research fellow at the Center
for Market Processes at George Mason University.1
Moreover, airline ticket
prices have fallen substantially in virtually all markets, small,
medium and large. Steven Morrison, professor of economics at Northeastern
University, and Clifford Winston, a senior fellow at the Brookings
Institution, report that prices in small hub markets have fallen almost
60 percent as much as in large hub markets, and 90 percent of this
difference in pricing is due to higher costs of serving the smaller
markets.2
Similarly, an April 1996
U.S. General Accounting Office study found that "the average
fare per passenger-mile, adjusted for inflation, has fallen since
deregulation about as much at airports serving small and medium-sized
communities as it has at airports serving large communities."3
The primary reason for these
reduced prices is that after deregulation airlines were allowed to
compete on price. Moreover, new airlines were allowed to enter the
industry, and their competition further reduced prices. All this price
competition also forced airlines to cut costs and reduce expenses,
allowing even lower prices. In addition, some new airlines specialized
in low cost, discount prices for basic, no frills, discount service,
reducing prices even more. Southwest Airlines has been the most successful
of these new discount airlines, and it is now the sixth largest domestic
air carrier.
Service Up
Deregulation has resulted
in more available flights for more consumers. The overall number of
airline flights increased from just over 5 million in 1978 when the
airlines were deregulated to 8.2 million in 1997 – a 63 percent
increase. Airlines flew 5.7 billion passenger miles in 1997, more
than twice as many as in 1978, when they flew 2.5 billion passenger
miles. In 1997, airlines carried about 600 million passengers, up
about two-and-a-half times from 250 million in 1978.
Moreover, increased flights
have resulted for markets of all sizes. The 1996 GAO study found that
in 1995, small community airports as a group had 50 percent more scheduled
commercial departures than in 1978; medium-sized community airports
had 57 percent more departures; and large community airports had 68
percent more departures.
The primary reason for this
increased service is that under deregulation airlines were freed to
expand service, and new airlines were freed to enter the market, at
will. But the key development particularly for expanded service to
smaller markets was the innovation of hub-and-spoke operations. This
system replaced the old approach of flying from City A to City B and
back again. Under the new approach, all flights over large regions
fly to the hub and from there to the final destination, then back
to the hub and home again.
This method of operation
greatly increases the available flights and destinations for passengers
at any city on an airline’s system. For example, take an airline
under the old approach with 25 planes flying each day from one city
to another and back again. The airline offers customers at the various
cities it serves 25 flights and destinations going out each day, and
25 flights and destinations going back each day, for a total of 50
flights and destinations. But with a hub-and-spoke operation, each
of the 25 flights going to the hub offers its passengers another 25
flights and destinations going out again to the spokes on the other
side of the hub, and the same when the planes come back to the hub.
So with the same 25 planes, this airline now offers its customers
at the various cities it serves a total of 625 flights and routes
going to the hub and out to the spokes on the other side, and another
625 flights and routes coming back to the hub and out again to the
original 25 cities, for a total of 1,250 flights and routes each day.
Consequently, any small
city on a spoke in such a system can be connected to 25 other cities
with just one flight leaving the original small city each day. Additional
flights going to the hub later in the day offer access to those 25
cities at different times each day. Morrison and Winston report in
their 1986 book for the Brookings Institution, The Economic Effects
of Airline Regulation, that feasible flight alternatives had increased
as much as 20 percent to 30 percent for passengers from small cities
under deregulation, primarily due to new hub-and-spoke operations.
Moreover, airlines are now
bringing into service smaller jet aircraft designed to provide service
economically to smaller cities. These aircraft will lead to even more
available flights and destinations for these cities.
Safety Up
Despite all the competition
and cost pressure under deregulation, safety has nevertheless improved
dramatically as well. Between 1939 and 1978, fatal airplane accidents
averaged six per year. After deregulation, from 1978 to 1997, the
average was only 3.5 per year, a decline of almost 50 percent.
Moreover, fatal accidents
per million miles flown have only been 7 percent as large since deregulation
as before deregulation. During the 20 years since deregulation, fatal
accidents have averaged only 0.0009 persons per million miles flown,
compared to 0;.0135 before deregulation.
The 1996 GAO study found
no statistically significant difference in safety improvements for
airports serving small, medium and large communities.
Competition Up
Finally, overall competition
has increased under deregulation as well. The number of airlines competing
for passengers has increased 144 percent since deregulation, from
39 in 1978 to 95 in 1997. Moreover, from 1977 to 1997 the number of
effective competitors per route increased by 30 percent. In 1996,
about 18 percent of passenger miles were flown by airlines that did
not exist before deregulation, the highest proportion since the beginning
of deregulation in 1978.
Moreover, economists Morrison
and Winston report that such competition has increased in markets
of all sizes – small, medium and large, though it has increased
less in the smaller markets.
DOT’s Reregulation
Folly
On April 6th
, 1998, DOT released its proposed new regulations in its "Proposed
Statement of Enforcement Policy on Unfair Exclusionary Conduct by
Airlines." The statement was published in the Federal Register
for public comment.
The statement indicates
that DOT’s concern is what it considers to be excessively high
air fares. But it proposes to address that concern in an odd way -
by restrictng the freedom of major airlines to reduce prices and expand
low cost, discount seating. The new regulations include guidelines
that would sharply restrict such reduced pricing strategies to meet
new competition. If an airline violated the guidelines, it would be
subject to a trial before newly established DOT administrators law
judges. If the airline’s actions hurt a small competitor or new
entrant or drove them from the market, then DOT would impose regulatory
sanctions.
DOT’s regulatory statement
also discusses concerns over whether major carriers are excluding
competitors through their control over slots and gates at major airports,
particularly major hubs. Recently, DOT began to adopt new policies
concerning available flight slots at the four major airports where
such slots are sharply restricted due to traffic congestion. These
are Chicago O’ Hare, New York LaGuardia, New York Kennedy, and
Reagan National in Washington. DOT has begun to use its authority
to grant for new carriers at these airports. But it requires the new
slots to be devoted in perpetuity to specific routes. This is a major
departure from current policy, where airlines are free to devote flight
slots to the routes they think best, ultimately allowing the market
to decide. DOT’s new policy begins to move the Federal government
back into regulating routes as well as prices.
The rationale behind the
pricing restrictions is to counter the supposed practice of "predatory
pricing". This term is used for a supposed business strategy
of reducing prices below costs until financially weaker competitors,
in this case primarily small airlines or new entrants, are driven
out of business by the losses from attempting to match these below
cost prices. With this competition removed, the predatory company
or companies can then raise their prices above market levels and earn
monopoly profits.
But as a practical matter,
this business strategy is unworkable, as is widely recognized in both
business and academic quarters. First, at below cost prices, the supposedly
much larger predatory company would be losing far more on its much
larger volume than the smaller companies would on their much smaller
volume. For this strategy to even begin to succeed, the larger company
would have to be able to weather far larger losses in absolute dollars
than the smaller predatory target companies. And even if the larger
predatory company did succeed in outlasting the competitors, it would
then be stuck with enormous losses to make up.
Secondly, if the larger,
predatory company did succeed in driving out competitors, when it
tried to recoup its losses by raising prices to above market levels,
it would attract new competitors to this now high profit market. These
new competitors would drive prices back down to market levels, and
the large, predatory company would never be able to recover its earlier
predatory pricing losses, let alone win above market monopoly prices.
This is especially a problem in the airline industry, where the central
asset in the business – jet aircraft – are the most mobile
assets in history. These aircraft can be redeployed to enter new markets
almost instantly.
For precisely these reasons,
the Supreme Court stated in Matsushita Electric Industrial Co.
v. Zenith Radio Corp., 475 U.S. 574, 589 (1986), "predatory
pricing schemes are rarely tried, and even more rarely successful."
Similarly, the former Civil Aeronautics Board explained,
Most today recognize
that predation is an irrational – and therefore unlikely
– strategy in situations where the predator cannot reasonably
expect to reap monopoly profits for a sustained period after driving
the target company from the market, because of the high costs
of predation.
There is no reason to
conclude that entry or exit is so difficult in this market that
a predator could charge supracompetitive fares for the sustained
period necessary to recoup losses incurred during the period of
predation.
Air Florida, Inc. v.
Eastern Air Lines, Inc., CAB Order 80-3-194, 85 C.A.B. 2063, 2065
(March 28, 1980).
In a later related order
in that case, the CAB quoted from the Congressional Record in the
debate over airline deregulation, saying,
Predatory pricing would
also be impossible under airline reform. Such pricing tactics
by the larger airlines are sensible if a competitor, once driven
out of a market, cannot reenter it. Only then can the predator
raise his prices (and his profits) after the competition is gone.
This cannot be the case in the deregulated environment because
carriers could always enter new markets at will aided by the most
mobile capital investment in history today – the modern jet
aircraft.
Air Florida, Inc. v.
Eastern Air Lines, Inc., CAB Order 81-1-1012 (Jan. 21, 1981).
Experience bears out this
analysis. Even though predatory pricing has always been illegal under
the antitrust laws, not one case of predatory pricing has been proven
in the entire history of the domestic airline industry, whether through
government enforcement actions, available civil suits by competitors,
or complaints to regulatory bodies. In fact, since deregulation, neither
DOT nor the former CAB found any example of predatory pricing in the
25 cases before those agencies where the issue was raised. In addition,
as discussed above, since deregulation competition has increased markedly.
So so-called predatory pricing does not seem to be preventing new
competition.
The problem is that in imposing
regulation to stop non-existent predatory pricing, DOT will discourage
and prevent the very price reductions and discount seating availability
that would benefit consumers. As the Supreme Court said in Cargill,
Inc. v. Monfort of Colorado, Inc., 479 U.S. 104, 122n.17 (1986),
[T]he mechanism by which
a firm engages in predatory pricing – lowering prices—is
the same mechanism by which a firm stimulates competition; because
cutting prices in order to increase business often is the very
essence of competition…[;] mistaken inferences…are especially
costly, because they chill the very conduct the antitrust laws
are designed to protect.
Similarly, two of the leading
authorities in antitrust law have stated in regard to predatory pricing,
"Ill-conceived or ill-defined rules impose heavy social costs
by deterring legitimate pricing and by both increasing and complicating
litigation." P. Areeda and H. Hovenkamp, Antitrust Law
226 (1996).
Or as James Gattuso, Vice
President of the Competitive Enterprise Institute, states,
[R]ules against below-cost
pricing are likely to cause more harm than good. They are every weak
competitors dream. If your rival is underpricing you, drag him into
court. The prospect of years of litigation would certainly make anyone
think twice about lowering prices to beat, or even meet, the competition.4
Similarly, Adam Thierer
of the Heritage Foundation states that DOT’s proposed regulations
" will have a chilling effect on industry competition by discouraging
fare wars that offer consumers significant savings."5
For these reasons, DOT should
withdraw its confused and unnecessary proposed new regulations regarding
low cost airline pricing. These regulations are analagous to the Vietnam
war policy of destroying a village in order to save it. DOT should
leave enforcement of the antitrust prohibition on predatory pricing
to the Justice Dept..
As for policies regarding
slots at congested or hub airports, DOT’s recent regulatory actions
are just the wrong answer for dealing with the issue. Instead of reregulation
of air routes, the Federal Government should adopt policies to remove
government barriers to increased airline competition. Such new policies
would help on the pricing issue as well, and just about every other
air transportation concern. These policies are discussed later in
this report.
DOT’s Lack of Authority
DOT’s new proposed
airline regulations are not only unwise, as described above. DOT also
lacks any legal authority to issue them.
Prior to the 1978 Deregulation
Act, Congress had granted the CAB authority to regulate predatory
pricing only for international air transportation and air cargo service.
But in the Deregulation Act, since airlines were now allowed to set
their own domestic air fares, Congress gave the CAB authority to regulate
predatory pricing for these domestic air fares as well. However, in
the CAB Sunset Act of 1984, Congress abolished this provision. Moreover,
the main point of these 1978 and 1984 acts was to end CAB regulation
of domestic air fares overall.
Consequently, as the CAB
was phased out and DOT succeeded to its remaining authority, DOT gained
no authority to regulate domestic air fares or domestic predatory
pricing. To this day, the word " predatory" in the governing
law can be found only in regard foreign air travel, granting DOT authority
to regulate supposed predatory pricing only in that area.
As a result, DOT has no
legal, statutory authority for its proposed new regulations on domestic
air fare and possible domestic predatory pricing. Congress has explicitly
abolished any such authority. Authority over domestic airline predatory
pricing remains only in the antitrust laws, which continue to prohibit
the practice.
DOT cites as its authority
for the regulations Section 411 of the Federal Aviation Act, enacted
in 1958. That provision continues in force to grant DOT remaining
authority to regulate "an unfair or deceptive practice or an
unfair method of competition in air transportation the sale of air
transportation." But if this was meant to cover predatory pricing,
why did Congress enact a provision in 1978 to give the CAB authority
over domestic predatory pricing? And why did Congress repeal the explicit
authority for regulation of predatory pricing in 1984, but leave Section
411 untouched? These actions clearly show that Congress did not consider
Section 411 to cover predatory pricing. Section 411 cannot be read
to grant such authority when Congress has expressly acted to end CAB
and DOT regulation of domestic air fares and predatory pricing.
DOT regulation of the routes
that may be served with new slots at the restricted congested airports
is also not legally authorized. DOT has statutory authority only to
grant new slots at these airports to new entrants, but nowhere is
it given authority to dictate what routes may be served by these slots.
Alternative Policies
to Improve Airline Competition
Instead of returning to
tried and failed policies of regulating airline fares and routes,
Federal, state, and local authorities should adopt policies to improve
airline competition by removing government barriers to such competition.
These policies would include the following.
