The young lawyers and economists who came to Washington in the late 1970s with Alfred Kahn, the architect of airline deregulation, had an uncommonly heady experience. They created real change. Their blueprint enjoyed bipartisan support and its initial success exceeded their rosiest expectations.
Things look far different today. We who are still willing to defend airline deregulation are a lonely lot, at least outside the small world of government bureaucrats and professional economists who remain true believers. There may be a "silent majority" out there who appreciate their improved access to air travel. If so, they are drowned out by the deafening complaints of passengers who think service has never been worse and fares have never been higher, and from employees who have lost their jobs through mergers and bankruptcy.
At the very least, we have to face up to the sobering realization that the robust competition unleashed back in 1978 may not endure. Long-established airlines continue to go out of business or be absorbed by a few dominant carriers. New entrant airlines, the oxygen of competition, are scarce. Deregulation advocates look around and ask whether the marketplace can work with only a handful of survivors. And if not, what do we do now?
For me, the question is not wholly academic. In 1985, I saw my airline opportunity and took it. With two partners, I sunk everything I had (and a lot I didn't have) to acquire control of a Los Angeles-based company that became an airline -- not a movie or CIA creation -- called Air America. Readers from the West Coast or Detroit may remember Air America's super low fares to Hawaii and Las Vegas. For others, Air America is just another forgotten airline that went bust. I recall the excitement and hope as we entered the airline business in 1984, and later the harsh realization that even our efficient L1011 Tristars could not compete against established carriers armed with sophisticated competitive weapons.
Clearly it is time for introspection and reconsideration. Those like myself, who were so sure we were right about the opportunities for new entrants and the nature of airline markets, should have a little humility. On the other hand, there are better alternatives than acceptance of tight oligopoly and the reregulation of fares and routes -- but as I will suggest they require a degree of governmental intervention aimed at preserving competition. The paradox here is that the pure laissez-faire approach pursued by recent administrations has turned out to be the worst enemy of effective deregulation and consumer choice.
Deregulation's Flight Plan
Of the six intellectual assumptions behind airline deregulation, four have been proven completely false:
- Deregulators believed that airline size was not critical to efficient operations. The marketplace, to the contrary, has ruled that bigger is better.
- Deregulators believed that barriers to entry are low in the airline business. Experience has demonstrated that they are very high.
- Deregulators believed that increased competition would produce low unrestricted fares. In fact, it has generated a bewildering array of discriminatory prices.
- Deregulators believed that travel agencies were obsolete as well as potentially misleading channels of information and distribution. But travel agencies became more powerful than ever.
A fifth assumption, that the antitrust laws would restrain competitive abuses, has been negated by the policy default of two administrations.
Only one idea has proven correct: that bureaucrats in Washington could not figure out what airline consumers want as well as real-world airline managers. But it remains to be seen whether the bureaucrats currently in charge of competition policy -- and their congressional supervisors -- will provide the regulatory framework necessary to allow air travel markets to work efficiently.
Bigger is Better
A "natural monopoly" tends to occur in an industry where a company's average costs keep dropping the bigger it gets. Eventually, only one company can survive because any smaller competitor will have higher costs. Of course, natural monopolies, such as electric utilities, must be controlled if their prices are to be reasonable.
Deregulators believed airlines were not natural monopolies. They did not need to be big to be efficient, and there was presumably room for many airlines of varying sizes and descriptions. As economists say, the industry lacked substantial "economies of scale." Academic studies in the 1960s and 1970s indicated that many smaller airlines, such as regional carriers like Allegheny or Frontier, actually had lower unit costs than the "majors," such as United or American.
We now know that these studies were superficial. Airline size may not be decisive if the issue is who can most cheaply fly a given plane between two cities. For example, World Airways' costs of flying a DC-10 between Newark and Los Angeles were as much as 20 percent lower than those of its far bigger competitors, American and United Airlines. In classic economic theory, the low-cost producer wins. But World Airways is long gone while American and United are rapidly moving to industry dominance. Why? Because big airlines enjoy huge cost savings which flow from unique marketing advantages associated with scale. These include the market power of an integrated national hub-and-spoke system, as well as the ability to price selectively against upstart competitors.
These advantages of bigness had been largely hidden by years of inefficient route and fare regulation. During the forty-year existence of the Civil Aeronautics Board (CAB), airlines primarily operated "linear" route systems, carrying passengers directly from origin to destination, sometimes after one or more stops. The CAB conceived its job as ensuring that there were flights connecting all cities or regions that had consumer demand for service.
But in the now dominant hub-and-spoke system, airlines funnel traffic along multiple "spokes" from various cities to a central "hub," like Chicago. With connections, a carrier can serve thousands of city-pairs inexpensively, with but a few hundred daily flights. As a matter of simple arithmetic, the more spokes, the more city-pairs can be serviced, and at geometrically lower average costs. A single airline generally comes to dominate a hub simply by expanding until its effective costs are lower than everyone else's (other than competitors flying from that city to a different hub). In effect, each hub tends to become a mini-monopoly, disciplined, if at all, by spokes from other hubs.
Prior to deregulation, a few airlines did develop small-scale hubs, notably Delta at Atlanta. No one understood, however, just how powerful large hubs could be, particularly when combined with new competitive tools -- or should we say anti-competitive tools? -- described more fully below, such as frequent flyer programs, aggressive yield management, and computer reservations systems. Furthermore, carriers require more than one hub to be effective competitors, if only because business travelers favor airlines with the broadest geographical coverage and also like to accumulate frequent flyer premiums.
So bigger evidently is better in the airline industry, and all healthy airlines are trying to expand to take advantage of economies of scale. In conventional economic theory, this expansion should lay to rest concerns that oligopolists will restrict output or increase prices. But troubling questions remain. Are there so many advantages to bigness that, five years from now, the industry will be a series of shared monopolies? Can this industry earn reasonable profits and remain competitive at the same time?
Breaking in is Hard to Do
Deregulation theorists recognized that even on busy routes only a few airlines could compete head to head. Competitive success requires a marketing identity built on frequent service. Travelers typically look first to the airline with the most daily flights. Even dense routes like Boston-Washington or New York-Los Angeles have only enough passenger demand to support three or four nonstop carriers. Many less dense routes have enough demand to support only a single carrier, or at most two.
With few direct competitors, how could monopolistic behavior be thwarted? The answer was found in the "theory of contest-ability" -- one of the biggest analytic failures of deregulation. Its allure derived from the perception that an airplane is the most mobile of all business assets. The theory assumed that if Airline X saw that Airline Y was charging exorbitant prices or providing inferior service on a route, it could easily and cheaply enter the market simply by redeploying aircraft. This was particularly true, according to the theory, because Airline X could just as easily exit the market if it was not successful. Thus, Airline Y, if rational, would not raise prices or lower service to monopoly levels lest it lure Airline X into its market.
Unfortunately for the theory, the plane also has to take off and land. At this country's most popular and most profitable airports, landing rights (sometimes called "slots") have been fully apportioned, free of charge, to established carriers. Under FAA's Buy-Sell Rule, enacted in 1985, these airlines are free to sell these slot gifts to each other, or to a new carrier. In order to deter competition, carriers that have slots often bank them. Under current FAA rules, an incumbent carrier need not use its slots more than 55 percent of the time; the FAA has proposed to increase this to 90 percent. It now costs as much as $5 million and up to buy a well-timed takeoff and departure slot at Chicago's O'Hare. Since even minimally competitive service requires several daily round-trips per city market each day, the costs quickly add up to "real money" -- which a new entrant must borrow while its bigger competitors use free slots.
It gets worse. Even if you can take off and land, you have to get passengers from the plane to and from the terminal. This requires jetways and airport "gates." Airport gates are frequently locked up by competing airlines in long-term leases. In some cases, "majority-in-interest" clauses give incumbent airlines veto power over new airport construction, and they can exercise their rights to thwart competitors' expansion plans. The lock-in of both slots and gates are artifacts not of the free market, but of bad regulatory policy.
It is, of course, possible to expand airport and airway capacity. The CAB issued several studies and sounded many unsuccessful alarms in 1978-1981. In the years since, the cost of implementing the National Airspace Plan (NAP) has increased, according to the General Accounting Office, from $14 billion in 1983 to $34 billion. In late 1990, Transportation Secretary Samuel Skinner pushed through Congress legislation intended to finance airport expansion by imposing surcharges on passengers. However, this initiative comes too late to affect the industry's competitive structure. The beneficiaries of new airport facilities will be the few airlines that survive.
Moreover, it turned out that an airline's most important asset is not its airplanes. As Michael Levine, dean of the Yale School of Organization Management, has shown in a seminal article in the Spring 1987 issue of the Yale Journal of Regulation, the key asset is the ability to dispense and manage information. If prospective passengers don't know the plane is there, they won't fly on it. Information about airline schedules and prices is dispensed primarily through sophisticated computer systems marketed to travel agents -- and both the computer systems and the travel agents are effectively manipulated by the big, established carriers. Easy entry by new competitors is a mirage. To be sure, any actual or potential competition is better than none, but the theory of contest-ability was misleading and wishful.
Deregulation strategists assumed that increased competition would bring unrestricted low fares to the general public. In economic theory, price discrimination occurs when different customers are charged a different percentage of the seller's cost of service. Though hardly rare in the economy, price discrimination has historically been viewed as a classic exercise of monopoly power, and pertinent regulatory statutes outlaw "unreasonable" or "undue" price discrimination. Classical economics does recognize some situations where price discrimination is beneficial, but none was thought to apply to airlines.
For several years after deregulation, through at least 1982, many airlines, particularly new entrants, attempted to compete using unrestricted low fares. Most of us still remember the $99 fare war that erupted after World Airways tried to enter the New York-Los Angeles/Oakland market in 1979. These and many other new low fares, both restricted and unrestricted ones, fueled the initial euphoria of deregulation.
Initially, the two-tier SuperSaver discount structure offered one price for so-called nondiscretionary travelers, primarily businessmen, who booked at the last minute, and a lower one for vacationers with flexibility and desire to stay awhile. But this is not necessarily price discrimination. Business travelers demand high-frequency service and plenty of seats available for reservation at the last moment, which is expensive to provide. Discretionary travelers, on the other hand, can be accommodated on just a few flights each day using a widebody, which has lower per-seat costs, or can be steered to fill up empty seats in flights that service primarily business travelers. When airlines impose advance purchase restrictions, their ability to exploit economies of scale through this steering process is enhanced. Minimum stay requirements (such as the familiar Saturday night routine) seem, on the other hand, to be nothing other than market segmentation devices. They do nothing to lower costs or promote consumer welfare and are wholly discriminatory.
The surprise was that unrestricted low fares disappeared altogether and that the fare differentials became so large and complex. An airline's lowest general discount fare, usually involving a Saturday night stay and at least a week's advance purchase, is around 25-35 percent of its regular coach fare. While deregulators expected that price discrimination would decrease over time, these differentials exceed any plausible cost differences. Airlines have, moreover, developed vast computer facilities tracking each seat on every flight, for months into the future, to determine whether the effective selling price should be raised or lowered. Prices constantly fluctuate between the lowest discount fare and the regular coach ("Y") fare, as predictions of demand change. These so-called "yield management" systems are designed to maximize airline revenues by ensuring that the carrier collects the highest possible fare from each passenger.
Yield management is also used with devastating impact to undercut low-fare carriers through selective price cutting, a practice whose mere threat has grown sufficient to deter the would-be low-fare carrier. Large incumbent carriers meet (or even beat) the new entrant's low fare on just enough seats and flights to deny the new entrant a foothold. Faced with the same price from "old reliable" and a new carrier, passengers will generally opt for the established airline. With computerized yield management, the incumbent can keep its losses from reduced fares tolerably low and avoid losing enough passengers to permit the new carrier to become viable. Particularly when coupled with short-term increases in capacity, such selective price cutting is fairly labeled predatory.
This is not to say that yield management is always wrong. There is an argument that "charging what the traffic will bear" may actually be economically efficient. By extracting every penny from customers able to pay higher prices, airlines arguably are better able to offer the lowest possible prices to those who can pay the least. The result may be that more people fly, planes operate nearer capacity, and the system operates more efficiently.
In its most developed form, this type of pricing is called by economists "perfect discrimination." But this "perfection" may be nothing more than the latest, albeit subtle, version of that typical American industrial malady, planning only for the short term. There is a large difference between the short and long-term elasticities of demand for airline travel. Extracting every available penny from consumers in the short term means long-term shrinkage of the market. In the age of the fax, it is getting progressively harder even for Washington lawyers to justify $310 for a one-way ticket to Detroit, just 450 miles away. Thus, however elegant yield management may be from the standpoint of static allocative efficiency, it is likely to be self-defeating over time.
The most discriminatory innovation of the deregulation era was the frequent flyer program ("FFP"). FFPs are the proverbial free lunch. The employee who generally benefits does not pay, and the company that generally pays does not benefit. Taxation of these credits as income is a political nightmare, even though the express language of the Internal Revenue Code should require it. From an airline marketing standpoint, however, FFPs are brilliant. By promoting brand loyalty in an industry whose customers used to believe that all firms produce essentially the same product, FFPs discourage the shopping-around that is necessary to stimulate price competition.
Frequent flyer programs also serve as another serious barrier to entry. A new airline cannot compete with the worldwide coverage offered in the frequent flyer programs of the major carriers, so customers attracted by FFPs are more likely to stick with the majors. Moreover, fares are significantly higher than they would otherwise be, because the price of a ticket must cover not only the costs of the traveler's seat, but also the cost of giving him a free trip in the future. As usual, the free lunch has a catch. In sum, the deregulators' idea that fares would become simplified and that unrestricted low fares would become widely available to the entire population proved incorrect.
Agents of Influence
Travel agencies were regarded in 1978 as dinosaurs -- obsolete and inefficient middlemen who would be tossed aside when airlines were free to use modern mass marketing to reach the public directly. This assumption was soon proved wrong. Deregulation removed the antitrust immunity that had permitted airlines to structure the travel agency system as their sole outside avenue of airline ticket distribution. A few upstart airlines did attempt to circumvent the travel agency system and its traditional 8-percent commission costs, by using methods such as Ticketron (World Airways) or by requiring direct airline ticketing (People Express in its initial stages). But these approaches failed so quickly that no one even tried to develop alternatives.
Bewildered by new and more complex fares, consumers became more dependent than ever on travel agents. Airlines, seeing that travel agencies would remain a key part of ticket distribution, chose to cultivate rather than alienate agents, who now issue over 90 percent of U.S. airline tickets.
The real mischief, however, is not in the survival of travel agents, but in the way airlines compensate them. Hidden bonus commissions, called "overrides," create incentives for agents to steer bookings not to the airline with the cheapest fare but to the one with the biggest commission. Sophisticated travel agencies even use computer software to do the steering. This has both increased ticket prices and retarded the ability of new entrants to compete. New airlines that wish to compete using low fares must, all things being equal, find a way to convince travel agents to accept the reduced commissions those fares generate. Because most business travelers do not pay for their tickets and, to the contrary, receive frequent flyer benefits from their favorite airline, this is a tough sell.
The Antitrust Paradox
No one believed that the airline industry would be without serious competitive problems just because it was deregulated. It was understood that deregulation was a new experience, a veritable laboratory where the unexpected would be commonplace. For this reason, deregulators stressed that antitrust standards generally applicable to unregulated industries would have to be enforced vigorously.
This intention fell victim to a mixture of ideology and bureaucratic lassitude. As everyone knows, the Reagan administration came to town skeptical of antitrust. What particularly galled the administration was that the antitrust laws could be used to attack bigness, per se, as opposed to practices that were economically inefficient. Under Elizabeth Dole, the Department of Transportation, however, went beyond a mere critical approach to antitrust issues to complete laissez faire. The results were disastrous.
In the years 1984-1988, the entire period it had jurisdiction over mergers, the Department of Transportation approved every airline merger brought before it, even over the objections of the Department of Justice. But some mergers were profoundly anticompetitive, such as the union of Northwest Airlines and Republic Airlines, which competed head-to-head at their two main hubs (Minneapolis and Detroit). True, Republic Airlines' long-term future in the airline industry may not have been bright, but it was not a "failing airline" in the antitrust sense. Even if Republic had to merge to survive, it did not follow that Republic had to merge with its arch competitor. It did follow that Northwest Airlines would pay the highest price for Republic, because the resulting transaction would not only provide Northwest with Republic's assets but would also eliminate a competitor. This is precisely the type of transaction the antitrust laws were designed to thwart.
The best and only defense of Reagan administration airline merger policy is that it might not have mattered anyway. Perhaps the forces impelling the industry into fewer and larger carriers are so great that the industry would have become concentrated even with the best antitrust analysis and the most principled decision-making. Unfortunately, we will never know. It is at least plausible that a tighter merger policy would have compelled a more competitive structure today.
A second gross failure of antitrust enforcement relates to airline computer reservation systems (CRS). American's Sabre and United's APOLLO achieved dominance in the early 1980s, a decade after the industry tried and failed to develop a single centralized system for travel agent bookings. CRS introduced enormous efficiencies into the marketplace, and it is widely agreed they are indispensable, given the complexity of post-deregulation fares and service patterns. These systems, however, have great potential for abuse.
In the early deregulation years, the reservation system vendors, led by Sabre and APOLLO, "biased" the displays of competing airline flights. The nonvendor's flights looked less attractive than the vendor's on computer screens. Sometimes, the non-vendor's competing flights would not appear until the tenth screen, even though, from the consumer's standpoint, it was superior to the vendor's flight, which appeared on the first screen. Sometimes, the nonvendor's flights would not appear at all, particularly if connections were involved. It took a very conscientious travel agent to ensure that all competing airlines' flights were fairly presented to the would-be traveler.
If the problem of "bias" was not enough, new entrants were frequently charged five or even ten times the fees imposed on established airlines when travel agents booked on them. If a new entrant wanted to offer a fare of $59 for a competitive flight between New York and Detroit, it could do so. But when the reservation was booked in APOLLO or SABRE, the airline would likely be charged about $3.50 for the computer service (in addition to the agent's commission). In an industry where a 5-percent gross profit margin is considered handsome, $3.50 out of $59 is substantial.
These and other CRS abuses eventually led to enormous protest and considerable civil litigation. Under congressional pressure, a Department of Justice study in 1982-1983 concluded that serious problems existed. The vendors' activity, if judged by rigorous antitrust standards, could have formed the basis for divesting these systems from their airline owners, thus assuring the industry's distribution systems would rest in competitively neutral hands. The Justice Department, however, decided to recommend dealing with CRS abuse via regulation, rather than to require divestiture. The CAB assented and imposed regulations in December 1984. This was a mistake.
At the time, the decision to regulate rather than litigate was deemed reasonable by most observers, including myself. In fact, the regulation did effectively eliminate the gross bias against competitor's flights. However, other competitive problems actually got worse. The regulation that outlawed discriminatory booking fees was used by the major CRS vendors as justification to charge everyone uniformly high booking fees. This acts as a tax on airlines that do not own reservation systems and transfers a significant portion of their profit to the CRS vendors. American and United may well have made up all the profits, or even more, that they lost through the elimination of bias. The Department of Transportation, however, refused to remedy these and other abuses. Subsequently, non-vendor carriers have scrambled to buy a share of a computer reservation system. No major airline that does not own a significant stake in a CRS is today doing well. As Fred Kahn often said, better not to regulate; but if you have to regulate, regulate well. This has not occurred.
Birds of Prey
The final failure of antitrust enforcement was the wishful thinking about the possibility of predation. This attitude did not go so far as that of Judge Robert Bork, who insisted in his book, The Antitrust Paradox, that predatory conduct was almost never profitable in the long run, and therefore regarded charges of predation as a waste of judicial time and as a shield for the inefficient. Deregulators were more influenced by the argument that, whatever the dangers of predation, they were outweighed by the costs of bad diagnoses and imprecise fixes.
We were also influenced by happenstance. The first formal complaint of price predation after passage of the Airline Deregulation Act came in a complaint by United Airlines, no less, against the hapless World Airways' $99 transcontinental fare. Who could take such a complaint seriously? The CAB's short order dismissing the complaint was written with a view to discouraging litigation designed to thwart new, low fares, which were, after all, precisely the objective of public policy at that time.
How the worm has turned! Selective price cutting by high-cost, established airlines has become a barrier to entry. Just as pernicious, but potentially easier to cure, are the numerous predatory tactics deliberately used by airlines to raise their rivals' costs. CRS and airport access (both gates and slots) issues are examples. For at least five years, the trend to greater industry concentration has been palpable and the need for a more activist antitrust policy has been manifest.
The final assumption of the deregulators was that the airline industry was too complex to be regulated from Washington. How could bureaucrats know better than airline executives (in touch every day with their customers) which routes airplanes should fly?
Here the deregulators were right, for even the brightest airline regulators cannot predict the most efficient means of service, or replicate marketplace pricing. The logic of hubs and spokes was not self-evident until the marketplace, once free of regulation, identified it. Indeed, United Airlines' first post-deregulation strategy was to jettison its short-haul and feeder routes, on the theory that linear long-haul routes were the most lucrative.
Despite its flaws, airline deregulation can be considered a long-term success in one key respect -- not because of its impact on prices, which may be transitory, but because it has led to vastly increased service. The industry's rate of growth from 1978 to 1990 has been phenomenal. People use the system, whatever its imperfections. Few passengers in the United States are now more than a single well-timed connection away from the country's major cities. Virtually no points in the continental United States are more than two well-timed connections apart. A few nonstop markets that existed in 1977 no longer exist today, but in the more significant city-pair markets there are literally tens of flights per day between and over the hubs.
In Winds of Change: Domestic Air Transportation Since Deregulation, the most recent, comprehensive, and objective study of the problem, the Transportation Research Board of the National Academy of Sciences found that the rate of growth in passenger trips nearly doubled in the twelve years between 1977 and 1989, in contrast to a slower 50 percent growth in the ten-year period from 1968 to 1977. The study also noted polls indicating that 19 percent of the population traveled by air on pleasure trips in 1977, while 25 percent did so in 1988. While much of this growth reflects the lower average air fares that deregulation has, at least until now, facilitated, it also derives from the significant rationalizing of route systems that deregulation allowed.
The problem is that we can no longer be sure that broader service and lower fares will endure. Because new entry into the airline business is extremely unlikely, the number of national competitors can only diminish, as carriers fall by the wayside or are absorbed by bigger ones. Nor is pricing behavior likely to improve as the number of national competitors is reduced to a handful. To the contrary, every study has shown that, other things being equal, prices will be higher in single-carrier city-pair markets than in more competitive two-carrier markets, and still higher than in three-carrier markets. Only the magnitude of the price premium is debated. Within a decade, we may see only three major carriers left -- American, United, and Delta. (Not coincidentally, they are the largest shareholders in the three dominant computer reservation systems). In many regional markets, there will only be one carrier and no real threat of potential entry.
The airlines' financial cataclysm in the last twelve months falls well outside the parameters of the industry's usual "boom or bust" patterns. It is totally unprecedented for five major airlines (Eastern, Pan Am, Midway, Continental, and America West) to be in bankruptcy and varying stages of liquidation. TWA and the Trump Shuttle are not far behind. While a few major carriers other than the Big Three could survive and remain independent, there is no great likelihood that they will.
Where do we go from here? The prevailing view within the administration remains resolutely laissez faire, coupled with the hope that, somehow, the survivors will be as numerous as five, six, or seven. Unfortunately, there are indications that the laissez-faire gamble is destined to fail. One recent piece of evidence is airline labor costs, where, to the chagrin of organized labor, economists have deemed deregulation quite effective. But lately, despite a soft economy, the major carriers have given their employees surprisingly generous and similar raises -- a sure sign of oligopoly.
It would be tragic if the only choice were between oligopoly and reregulation of routes and fares. There is no shame in making mid-course corrections based, not on ideology, but on what we have learned about airline markets. The conceptual mistake is to assume that deregulation of routes and fares necessarily require deregulation of everything. On the contrary, evidence suggests that a prudent competition policy is the necessary complement. Six steps, taken in combination, would enormously increase the prospects that the airline industry will remain workably competitive.
Step One: Divest Computerized Reservation Systems
Genuine competition requires equal access of airlines to potential customers and vice versa. While admitting there is a problem, the Department of Transportation denies the need for a comprehensive regulatory remedy. If the department is unwilling or unable to regulate reservation systems effectively, the computer systems must be divorced from airline ownership altogether.
Involuntary divestiture of CRS is subject to at least two criticisms. First, outside vendors may not have the incentive to innovate technologically as vigorously as airline owners would. Nor is there any guarantee that booking fees would be lower. But it is time for the Justice Department to do a complete analysis of the costs and benefits of divestiture. Unless the problems are found insuperable, divestiture is the best remedy.
Step Two: Improve Infrastructure and Unlock Slots and Gates
Important as new airports and new facilities are, the primary physical barrier to competitive entry remains the inability to get landing and arrival slots at airports in New York, Washington, and Chicago. An airline cannot be efficiently run without such slots. The buy-sell rule, which allocated the entire "slot" capacity of our most congested airports to existing airlines in the vain hope that they would be freely transferable to competitors, has no procompetitive value. The carriers who hold these slots and who paid nothing for them generally will not sell them to new entrants at any reasonable price. The rule adds hundreds of millions of dollars to the effective net worth of the established carriers, moreover, and simply means that these airlines get richer while newer airlines get poorer.
The buy-sell rule, despite its good intentions, must be repealed. And because likely alternatives to the rule are positively painful, we must reduce the congestion that is the basis of the slots' value. The FAA must provide an efficiently priced air traffic control system that can handle the country's needs. Either way, landing slots at peak hours should carry higher prices, to reflect their true value. Those increased revenues could be spent on enlarged capacity. Failing that, the system should be privatized. The economic costs are immense when valuable traveler time, to say nothing of fuel and capital resources, are wasted waiting to take off or land. Congestion also creates artificial scarcity, which then invites the premium fares and barriers to competitive entry.
Step Three: Eliminate Frequent Flyer Programs
The benefits that FFPs provide are dwarfed by their discriminatory and anticompetitive consequences. There is, in any event, no basis whatsoever to permit their use as the equivalent of after-tax cash compensation. Free vacations for the upper-middle and executive classes do not seem to have any great social benefits and can fairly be seen as travel subsidized by less affluent taxpayers who must pay for their vacations out of after-tax income. No new legislation is required to assure that FFPs are taxed. The Internal Revenue Service could issue enforceable regulations on this subject tomorrow, though bipartisan congressional blessing would be highly desirable to provide political cover.
Step Four. Reinvigorate Antitrust Policy
Eleven years of extreme austerity have markedly reduced the federal government's ability to enforce a competition policy, even where consensus can be found. The field of airline transportation is no exception. The old CAB's cadre of antitrust lawyers and economists was deliberately dismantled, and the Department of Transportation's few competition analysts have had to shuffle from crisis to crisis. The antitrust division of the Department of Justice is, bureaucratically speaking, in better shape and morale may have recovered to some extent from the depths of the Reagan years.
Effective antitrust enforcement, however, depends not only upon adequate resources but on coherent doctrine acceptable to courts, and there is an obvious "chicken-and-egg" relation between the two. I believe that the need for coherent doctrine is the more critical. Most antitrust analysis in this industry has focused on mergers -- an issue that should recede as merger candidates become scarce. As we have seen, the greatest need now is a conceptual framework for analyzing genuinely predatory behavior and its possible remedies. Antitrust policy has not addressed such behavior, though deep selective price cuts are likely to be below marginal costs (and therefore unprofitable even in the short run) if marginal costs reflect the capacity increases that frequently accompany them. On the other hand, selective price cutting that merely matches new entrant prices without flooding the market with capacity is not necessarily predatory. These distinctions go to the heart of airline competition as it has evolved over the last ten years, and need to be carefully analyzed, to form the basis for new rules.
Another priority is the conduct of carriers that dominate hubs, a subject which the Antitrust Division has had under study for some time with no discernible results. In one case in which I was personally involved (on behalf of client Air Canada), United Airlines was permitted to purchase bankrupt Eastern Airlines' gates at O'Hare. United, however, has no plans to use the gates, and it directly competes with the alternative purchaser, Air Canada, which is severely constrained by lack of gates.
If antitrust policy dealt with such situations firmly and efficiently, they might not occur in the first place. Deregulation meant that airlines should not be treated as public utilities, not that they should be uniquely exempt from competition rules.
Step Five: Revise International Route Policy
International air transport remains regulated, and access limited. Whenever applicable treaties require the United States to choose which one or two carriers will fly a given international route, the Transportation Department typically chooses a big established carrier. New entrants have gotten only crumbs. Moreover, big carriers are free to buy and sell routes, and these private deals are routinely rubber stamped. The Transportation Department takes the position that whichever carrier will pay most for a route is the carrier that will be able to do the most with it.
While this view reflects commendable humility on the department's part, it is misleading. Many of these route sales are taking place while the industry as a whole is flat on its back, having lost over $2 billion over the last twelve months. The "marketplace" has therefore only two or at most three buyers. Desperate sellers offer the routes at fire-sale prices, and the buyers receive virtually risk-free investments, for they are buying routes on which, by definition, competition is limited. In overwhelming proportion, the buyers are American, United, and Delta. If these carriers were strong and competitively dominant before the route transfers, they are virtually impregnable now.
These policies are the ingredients of government supervised cartelization, not an efficient marketplace. They reflect an almost Japanese-style collaboration between dominant industry players and a government ministry aimed at increasing market share. If this is to be transportation policy, we need to look at the full costs and benefits.
< font class= headline>Step Six: Liberalize Domestic Service by Foreign Airlines
Defenders of laissez-faire policies frequently compare concern over concentration in the airline industry to allegedly misplaced fears in the 1960s and early 1970s about lack of competition in the U.S. automobile industry. Industry "globalization," it is said, will eventually lead to worldwide airline markets. But, of course, current policy drastically limits the entry of foreign airlines to the U.S. domestic market. The Federal Aviation Act restricts foreign owners to 24.9 percent of an airline's common stock and forbids foreigners from "controlling" U.S. airlines. The Transportation Department, after initial waffling, has relaxed these barriers somewhat, but still insists that airlines be majority owned and controlled by U.S. citizens.
The arguments in favor of this protectionism boil down to two: national security and the need to negotiate reciprocity. National security is a smoke screen. Foreigners who own U.S. airlines can easily be informed that their holdings are subject to seizure in an emergency. Reciprocity has a more reasonable ring to it. If foreign airlines are permitted to participate in the U.S. domestic market, U.S. carriers should be permitted to operate in theirs. But we should be leading this movement to freer worldwide competition. If a world-class carrier like SAS wants to "save" a bankrupt carrier like Continental, or if Swissair wishes to fly between Chicago and Los Angeles, we should let it -- with thanks.
It is a truism in Washington that genuine competition has few advocates. Each of the steps outlined above will surely be assailed by interest groups. Defenders of the status quo will point to the recent unprofitability of the airline industry as evidence that there can be no monopoly power at work -- oblivious to the fact that recent losses arise not only from the triple shocks of recession, Persian Gulf instability, and high jet fuel prices, but from the detritus of once viable carriers exiting the industry precisely because they cannot compete with the dominant players.
Half-measures will not work. The underlying economies of hub-and-spoke systems are a reality. Since hub-and-spoke systems point in the direction of oligopoly, it is vital that any controllable influences toward further concentration be dealt with vigorously. The nation must either substantially reduce those barriers to entry that are subject to alleviation, or it must accept that the U.S. airline marketplace will be dominated by a very few carriers, and not necessarily very profitable ones.
If concentration of the industry continues unabated, the country will be susceptible to calls for regulation by the middle of this decade. There is, to say the least, no assurance that regulation of fares or routes would improve the situation. But the present situation is intolerable. We need a procompetitive regulatory strategy to realize the promise of deregulation. Such is the paradox of the free market.
The Exceptional Survivor
Defenders of laissez faire invariably bring up the success of Southwest Airlines as proof that competitive entry remains open. Southwest has been among the most consistently profitable of U.S. airlines and enjoys the lowest costs in the airline industry. It is a remarkably efficient, well-managed organization (and I don't just say this because they are a client of my law firm). Virtually alone among smaller U.S. carriers, Southwest does not hesitate to enter any airline markets that fit its long-term strategy. It makes no difference who the competitors are and how deep are their pockets.
Southwest's success, however, owes much to its conservative financial strategy and some very unique factors. Southwest has a low-fare and generally nondiscriminatory pricing policy. It prefers to enter major markets only where there is unfettered, uncongested airport capacity to facilitate high-frequency service. These policies, in combination, give Southwest instant market share and tend to ward off predatory selective price cutting by the major carriers. If a larger carrier decides to price-compete with Southwest, it must be prepared to reduce fares for most or all passengers, not just on a few flights. Furthermore, Southwest chooses only relatively short-haul markets, averaging under 500 miles. Such flights are not readily susceptible to competition over hubs because passengers flying relatively short distances are unwilling to make connections. Finally, Southwest itself totally dominates at least one important airport, Dallas's close-in Love Field, from which long-haul flights are prohibited by legislation. This base gives it stability and some protection against the onslaught that has felled other new entrants. Yet, even Southwest knows that it would be suicide to enter traditional international or long-haul markets and take on big carriers on their own terms.
We need more Southwests. We won't get them without abandoning laissez faire.