Pros and Cons of Airline Deregulation

Deregulation has brought charges that safety has been reduced in the transportation industries. Although theory suggests that safety might be lower in a competitive market than in a regulated one, experimental evidence shows that safety has not declined since the transportation industries were deregulated but has actually continued to improve. Even though deregulation and partial deregulation have brought great benefits to the economy and to the consumer, some interests have been adversely affected. In the airline industry, organized labor has been the principal loser.

To this day, the major airlines are attempting to bring down their inflated labor costs. A number of airlines have established dual pay schemes where new employees are paid less. The deregulation process received a great boost in 1977 when President Jimmy Carter appointed Alfred Kahn to chair the CAB. This quintessential policy entrepreneur took charge at the perfect time. With a powerful intellect, a dedication to microeconomic efficiency, and a quick and infectious humor, Kahn set about reorganizing the CAB.

Under Kahn, the board decided several landmark cases that tested open entry and unrestricted price competition (Civil Aeronautic Board 1978). The policy options, now, were narrowing. Early in 1978, both houses of Congress passed bills to liberalize regulation. Airline executives, such as American’s Crandall, faced with the prospect of a policy “that would leave the airlines half free and half fettered,” now shifted gears and called for the total elimination of economic regulation. In October, 1978, Congress passed the Airline Deregulation Act. President Carter signed it ten days later.

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The act then place maximum reliance on competitive market forces. The Civil Aeronautics Board would automatically certify entry, unless doing so damaged the public interest. Fares would be flexible within a wide zone of reasonableness, and mergers would be readily approved. If all went well, the Civil Aeronautics Board would cease to exist by 1985 (Crandall 1978). The first year of airline deregulation was one of the most difficult years of the history, commented Bob Crandall. As an industry, Airline Company seemed bent on giving away the store. And 1980 proved worse still.

All but two of the major carriers lost money, with American Airlines’ first half losses the worst in the industry. Passenger traffic slumped because of the recession, and the price of jet fuel had doubled again. Intense competition for key routes, with wild fares discounting, caught the industry and its regulators by surprise. The major carriers were not at all prepared for the suddenness of competition. Although the deregulation act had proposed an orderly phase-out of regulation, reallocation of routes and fare competition swept past the board’s half-hearted attempts at stabilization.

By the spring of 1980, carriers were virtually free to determine the routes they served and the prices they charged (Office of Economic Analysis 1982). In May, 1979, World Airways, a former charter, offered a one-way fare of $108 between New York and Los Angeles and New York and San Francisco. This touched off the “transcontinental wars” among the major carriers, under-cutting revenues of more than $750 million, just for those two routes. TWA expanded the war to the semi-transcontinental market, matched by all of the other majors.

Pricing madness went from bad to worse when Eastern tried to enter, with an unrestricted transcontinental fare of $99. World went to $88, the others matched, and the price war spread to “peripheral transcontinental markets of Boston, Washington, and Philadelphia (Praskell 1981). Hastily, the majors began dropping unprofitable routes and entering the potentially profitable markets of their competitors. Braniff challenged American in the Southwest, while Delta attacked American’s hub at Dallas from the East.

Eastern expanded out of LaGuardia toward the west, and United contested more of the major city-pair markets connected to its hub in Chicago. Such unrestricted competition forced a dilution of yields, pushing break-even load factors higher. Accelerated hubbing was the clearest short-term strategic response by the major carriers. This practice, of concentrating connecting flights at a particular airport, had been Intense competition for key routes, with wild fares discounting, caught the industry and its regulators by surprise.

The major carriers were not at all prepared for the abruptness of competition. Although the deregulation act had proposed an orderly phase-out of regulation, reallocation of routes and fare competition swept past the board’s half-hearted attempts at stabilization. By the spring of 1980, carriers were virtually free to determine the routes they served and the prices they charged (Office of Economic Analysis 1982). Used to a limited extent since the 1960s, both Delta and Eastern had developed a significant hub at Atlanta; United at Chicago; American at Dallas, and Allegheny (now US Air) at Pittsburgh.

But hitherto, regulation had severely constrained the use of the hub-and-spoke route structure as an operating strategy. Only after receiving route flexibility could the majors contemplate the potential economies of scale and scope that the hub-and-spoke system had to offer. In terms of strategy, organizational structure, and performance, American Airlines’ adjustments to deregulation, starting as the second-largest, but least efficient of incumbent domestic carriers, was the most thoroughgoing and successful.

As such, it provides the sharpest contrasts for examining the effects of regulatory change on business practice. Conversely, its size and revealed market power show how effective strategy, like regulation, can shape market structure to create sustainable rents. American Airlines was not prepared for deregulation. Its break-even load factor was the industry’s highest. Its labor costs were higher than the industry average and its productivity growth lower. Its fleet was the least fuel efficient, and its route structure the industry’s most fragmented.

During the period in which regulation broke down (1968-1974), American’s management had made several serious errors: overexpansion into hotel properties, acquisition of too many wide-bodied aircraft, cutbacks in the development of computerized reservation systems, a failed merger attempt, and, finally, a managerial crisis. In September, 1973, George Spater, American’s chairman, admitted to making an illegal contribution to the Nixon campaign.

He resigned, leaving American with operating losses, major organizational problems, and ruined morale (Serling 1985). C. R. Smith, American’s colorful chief executive from 1934 to 1968, came out of retirement just long enough to choose a new chairman – an outsider named Albert Casey, president of the Times Mirror Company. Casey, a rough-and-tumble Boston Irishman with a self-deprecating sense of humor, specialized in finance, liked a lot of people, but knew nothing about airlines. His immediate challenge was to restore confidence and eventually, to prepare the organization for the demands of deregulation. The effects of deregulation on market structure and performance were just as dramatic as on industry structure, but not quite so clear.

Several exogenous events, including the second oil shock, the air traffic controllers (PATCO) strike in 1981, and the 1982-1983 recession, also shaped the patterns of adjustment. With this qualification in mind, we can observe significant changes in the following market characteristics: first, entry and exit conditions, second, price level and pricing mechanisms, third, segmentation, fourth, distribution channels, fifth, cost structure, sixth operations, seventh, demand eight, service levels (and safety), and nineth, industry profitability.

Entry into the industry and into individual city-pair markets clearly opened up as soon as the CAB lowered its barriers. Relatively low minimum-efficient scale and capital costs made this possible, but few of these entrants survived to 1988. Despite the hopes of economists, particularly those associated with contestability theory, the airline industry did not turn out to be frictionless (Panzar and Willig 1982).

By building economies of scale and scope, by segmenting markets with strategic pricing, and by developing control of distribution channels, the incumbent firms responded strategically to create competitive advantages and eventually foreclose entry. As the data came in, economists revised their views of the industry’s contestability. At best, it appeared to be a transitional condition. Deregulation prompted an immediate reduction of prices and a continuing fragmentation of pricing structure. Here too, the early pricing responses seemed to support the logic of contestability.

Even monopolists lowered their fares. Eventually though, prices stabilized in the least competitive markets and then increased. Price structure, meanwhile, fragmented into a wide range of special packages, discounts, and incentive deals. By 1987, the proportion of passengers using some sort of discount fare had risen from 37 percent (1977) to 91 percent (Airline Deregulation 1988). Sophisticated customer and competitor analyses, drawing on computerized data bases, was performed daily to optimize revenue by adjusting schedules, fares, and seat allocations among discount categories.

This development should not have been surprising, in view of airline economics and a history of similar, although constrained, pricing practices. Commodity like, price wars at the outset of deregulation were partly the result of the market’s desegmentation. Carriers only gradually implemented strategies to resegment the market by price, service, brand image, and loyalty. Among the most striking features of airlines deregulation was the development and newfound strategic importance of distribution channels (methods of selling tickets). Under regulation, distribution channels were unimportant and unsophisticated.

But with the transition to competition, customer access and control suddenly became critical for sellers, while the fluidity of adjusting markets caused extreme informational problems for buyers. Computerized reservation systems, with a relatively small incremental cost of adding a travel agency and huge economies of scale and scope, quickly became a competitive bottleneck that first movers took a tremendous advantage of. By 1988, American (SABRE) and United (APOLLO) controlled 70 percent of the travel agency channel, leaving competing systems (TWA, Delta and Eastern) with too small a base and other carriers in abject dependency.

Accordingly, Frontier and ten other carriers brought a civil antitrust suit, seeking damages and divestiture of SABRE and APOLLO. The case was based on the essential facility doctrine – the same concept that the government had used successfully to attack the Bell System. Although civil charges were dismissed late in 1988, the Department of Transportation continued to review proposals for divesting the airlines of their reservation systems. Cost reduction was a predictable result of deregulation. The most dramatic and politicized aspect of this process was the deco sting of labor.

Elimination of work rules, increases in hard hours for flight crews, and wage givebacks all contributed to lower costs. Continental, by reducing labor costs to 1. 33 cents per available seat mile, set a competitive baseline for the others. Delta, even with its traditionally nonunion work force, remained at the high end with costs of 3. 54 cents per average seat mile. Like American, every major carrier eventually moved to reduce costs across the entire range of operations, fuel, overhead, fleet and route structure, as well as labor.

In all, the cost per passenger-mile traveled declined by about 30 percent 1981 and 1987. On the other hand, since November 1974 airfare increases have outpaced the rate of inflation, President Jimmy Carter (D, 1977-1981) shared Senator Kennedy’s views on this issue. In 1975, he endorsed legislation to provide airlines with greater flexibility to reduce airfares, ease Civil Aeronautics Board’s regulations on trunk entry, and made it easier, with some protections for small communities for airlines to eliminate nonprofit able routes.

The airline industry strongly opposed the relaxation or elimination of national government rules concerning entry and exit of air routes and passenger ticket prices. During congressional hearings, they testified that head to head competition might cause ticket prices to fall, but it would also bankrupt many smaller airlines, leading to the concentration of airline service into just a few large carriers that could conceivably, control the marketplace and impose even higher fares on passengers than before deregulation took place.

For example, Robert Six, chairman of the board and chief executive officer of Continental Airlines, Inc. estified before the U. S senate Commerce Committee that deregulation will not lead to a more competitive situation. Rather, it is liable to result in a period of initial chaos and ultimately in a situation in which most of the air transportation system will be in the control of a few industry giants. The aviation industry also argued that deregulation would cause service reductions and in some instances complete elimination of service along many less profitable air routes, particularly those serving rural states and small-population cities.

They also worried that deregulation would frighten investors making it more difficult for them to finance badly needed equipment facilities. They also warned that deregulation would adversely affect air safety because price competition would force airlines to defer maintenance and keep airplanes in service as long as possible. The industry’s labor unions also opposed deregulation. They feared that increased price competition might make it more difficult for them to win wage and salary concessions at the bargaining table.

While Congress debated deregulation’s pros and cons, Alfred Kahn, President Carter’s choice to head the Civil Aeronautics Board, was sworn into office on June 10, 1977. He systematically altered the Civil Aeronautics Board’s regulatory behavior to allow airlines to fly as many routes as possible and at the lowest fares that they could afford. As airfares fell across the nation, Kahn received extensive and very positive media coverage.

Although Congress was probably going to deregulate airlines regardless of Khan’s actions, the favorable publicity concerning Khan’s effort signaled to many on Capitol Hill hat it would be political suicide to fight airline deregulation. Sensing an opportunity to destroy its new competition, the larger airlines systematically reduced passenger airfares on routes also flown by the new start-ups. The practice was called predator pricing. The idea was to outlast the new start-ups and later recoup losses by raising passenger airfares after the start-ups were driven out of business.

The strategy worked for Northwest Airlines. Its discount pricing forced People Express to abandon its Newark to the Twin Cities route. Northwest Airlines’ hub was at the Twin Cities Airport. However, in most instances, predator pricing resulted in economic losses for all airlines. Eastern Airlines, for example, lost to much money trying to kill off World Airline coast-to-cost routes that it was forced to withdraw from transcontinental service altogether. Also, United Airlines nearly went bankrupt trying to kill off People’s Express.

By the late 1980s, predator pricing and other factors forced many start-ups into bankruptcy and many others to merge with other airlines. Overall, deregulation increased the number of air carriers but American, Delta, and United continued their dominance over the U. S market. Deregulation changed the basic nature of air service in the United States. Before deregulation most airlines exchanged passengers freely at major airports, a practice called interlining. After deregulation, airlines tried to keep their passengers to themselves.

They discovered that it was more profitable to provide nonstop passenger air service between several major hubs instead of offering point to point, nonstop air service to numerous communities across the nation. Conclusion The airline industry appears to be evolving towards the segmented structure that existed prior to deregulation a small number of large trunk carriers offering long haul domestic and international services, regional carriers offering short and medium haul services within geographic areas and commuter carriers offering very short haul services to small communities.

In aviation’s formative years, this structure was developed and controlled by government regulators. However, today’s evolution toward the segment marketplace is being driven and controlled by market forces with low entry barriers. Regulation has been a long-standing and indeed necessary feature of the airport transport industry the world over. Many countries, however, are now questioning the effectiveness, and indeed the relevance, of such regulations.

More generally, questions are being asked about the appropriate balance between public and private sectors in the industry, whether existing regulations and operating structures are compatible with the introduction of new technology and more intense international competition, and many nations have sought to evaluate more systematically the overall contribution, an costs, of their ports to both domestic economic growth and inter-modal transport systems.

In short, the world’s ports have reached a critical historical juncture. To date, however, airport reform in many countries has simply equated with labour reform, or more precisely a derogation of employment and working conditions. The propriety of such reform programmed must be questioned and, on the basis of the evidence presented in this paper. In developing countries in particular, where social protection for redundant workers is often more notable by its absence, the adverse effects of deregulation are indefensible.

Furthermore, the experience of many countries suggests that deregulation by no means guarantees any improvement in airport performance. In fact, the long-term result may be the opposite. In contrast, there are several countries/ports where significant improvements in airport performance have been achieved while basic standards of employment have been at least maintained, if not improved. Thus, in several cases, productive efficiency continues to be founded on equity and efficiency in the labour market.