Transportation’s Airline Re-regulation Folly

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 Clearly, the unjustifiable, specious, special interest regulations proposed by DOT should be withdrawn.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 6^th , 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.

Conclusion

DOT’s proposed new airline regulations should be withdrawn. Deregulation of the airline industry has been a huge success, and DOT’s proposals would only begin to reverse that success. DOT proposes to adopt such reregulation to counter a phantom problem of predatory pricing that does not exist. Along the way, the regulations would perversely restrict the very reduced airline ticket prices and expanded discount seating that would most benefit consumers and that competition is supposed to achieve. As a result, consumers would only be harmed by this reregulation.

Moreover, DOT lacks legal authority to adopt these regulations. Federal, state and local governments should adopt instead policies that would promote airline competition by removing current government barriers to such competition.

 1. Robert Crandall and Jerry Ellig, "Economic Deregulation and Customer Choice: Lessons for the Electric Industry" (Washington, DC: Brookings Institution, 1997).

2. Steven Morrison and Clifford Winston, "The Fare Skies: Air Transportation and Middle America," The Brookings Review, Fall 1997.

3. U.S. General Accounting Office, "Airline Deregulation: Changes in Air Fares, Service and Safety at Small, Medium-Sized and Large Communities," GAO/RLED-96-79, April 1996, p. 3

4. James Gattusso, "Don’t Outlaw Cheap Airfares," Wall Street Journal, April 8, 1998. P. A22.

5. Adam Thierer, "20^th Anniversary of Airline Deregulation: Cause for Celebration, Not Reregulation," Heritage Backgrounder No. 1173, Heritage Foundation, Wash., DC, April 22, 1998, p. 1