Airline Deregulation

Network industries, which are critical to a modern economy, include air travel, railroads, electrical power, and telecommunications. The air travel sector is an example of a network industry involving both flows and a grid. The flows are the mobile system elements: the airplanes, the trains, the power, the messages, and so on. The grid is the infrastructure over which these flows move: the airports and air traffic control system, the tracks and stations, the wires and cables, the electromagnetic spectrum, and so on. Network efficiency depends critically on the close coordination of grid and flow operating and investment decisions.

Under CAB regulation, investment and operating decisions were highly constrained. CAB rules limiting routes and entry and controlling prices meant that airlines were limited to competing only on food, cabin crew quality, and frequency. As a result, both prices and frequency were high, and load factors—the percentage of the seats that were filled—were low. Indeed, in the early 1970s load factors were only about 50 percent. The air transport market today is remarkably different. Because airlines compete on price, fares are much lower. Many more people fly, allowing high frequency today also, but with much higher load factors—74 percent in 2003, for example.

Airline deregulation was a monumental event. Its effects are still being felt today, as low-cost carriers (LCCs) challenge the “legacy” airlines that were in existence before deregulation (American, United, Continental, Northwest, US Air, and Delta). Indeed, the airline industry is experiencing a paradigm shift that reflects the ongoing effects of deregulation. Although deregulation affected the flows of air travel, the infrastructure grid remains subject to government control and economic distortions. Thus, airlines were only partially deregulated.

Even the partial freeing of the air travel sector has had overwhelmingly positive results. Air travel has dramatically increased and prices have fallen. After deregulation, airlines reconfigured their routes and equipment, making possible improvements in capacity utilization. These efficiency effects democratized air travel, making it more accessible to the general public.

Airfares, when adjusted for inflation, have fallen 25 percent since 1991, and, according to Clifford Winston and Steven Morrison of the Brookings Institution, are 22 percent lower than they would have been had regulation continued (Morrison and Winston 2000). Since passenger deregulation in 1978, airline prices have fallen 44.9 percent in real terms according to the Air Transport Association. Robert Crandall and Jerry Ellig (1997) estimated that when figures are adjusted for changes in quality and amenities, passengers save $19.4 billion dollars per year from airline deregulation. These savings have been passed on to 80 percent of passengers accounting for 85 percent of passenger miles. The real benefits of airline deregulation are being felt today as never before, with LCCs increasingly gaining market share.

The dollar savings are a direct result of allowing airlines the freedom to innovate in routes and pricing. After deregulation, the airlines quickly moved to a hub-and-spoke system, whereby an airline selected some airport (the hub) as the destination point for flights from a number of origination cities (the spokes). Because the size of the planes used varied according to the travel on that spoke, and since hubs allowed passenger travel to be consolidated in “transfer stations,” capacity utilization (“load factors”) increased, allowing fare reduction. The hub-and-spoke model survives among the legacy carriers, but the LCCs—now 30 percent of the market—typically fly point to point. The network hubs model offers consumers more convenience for routes, but point-to-point routes have proven less costly for airlines to implement. Over time, the legacy carriers and the LCCs will likely use some combination of point-to-point and network hubs to capture both economies of scope and pricing advantages.

The rigid fares of the regulatory era have given way to today’s competitive price market. After deregulation, the airlines created highly complex pricing models that include the service quality/price sensitivity of various air travelers and offer differential fare/service quality packages designed for each. The new LCCs, however, have far simpler price structures—the product of consumers’ (especially business travelers’) demand for low prices, increased price transparency from online Web sites, and decreased reliance on travel agencies.

As prices have decreased, air travel has exploded. The total number of passengers that fly annually has more than doubled since 1978. Travelers now have more convenient travel options with greater flight frequency and more nonstop flights. Fewer passengers must change airlines to make a connection, resulting in better travel coordination and higher customer satisfaction.

Although the gains of economic liberalization have been substantial, fundamental problems plague the industry. Some of these problems are transitional, the massive adjustments required by the end of a half century of strict regulation. The regulated airline monopolies received returns on capital that were supposed to be “reasonable” (comparable to what a company might expect to receive in a competitive market), but these returns factored in high costs that often would not exist in a competitive market. For example, the airlines’ unionized workforce, established and strengthened under regulation and held in place by the Railway Labor Act, gained generous salaries and inefficient work rules compared with what would be expected in a competitive market. Problems remain in today’s market, especially with the legacy airlines.

The airlines have not found it easy to maintain profitability. The industry as a whole was profitable through most of the economic boom of the 1990s. As the national economy slowed in 2000, so did profitability for the legacy airlines. Consumers became more price-sensitive and gravitated toward the lower-cost carriers. High labor costs and the network hub business model hurt legacy airlines’ competitiveness. Hub-and-spoke systems decreased unit costs but created high fixed costs that required larger terminals, investments in information technology systems, and intricate revenue management systems. The LCCs have thus far successfully competed on price due to lower hourly employee wages, higher productivity, and no pension deficits. It remains to be seen whether the LCC cost and labor structures will change over time.

The Air Transport Association reports that the U.S. airline industry experienced net losses of $23.2 billion from 2001 through 2003, though the LCCs largely remained profitable. While the September 11, 2001, terrorist attack and its aftermath are a major factor in the industry’s hardships, they only accelerated an already developing trend within the industry. The industry was experiencing net operating losses for many reasons, including the mild recession, severe acute respiratory syndrome (SARS), and the increase in LCC services and the decline in business fares relied on by legacy carriers. Higher fuel prices, residual labor union problems, fears of terrorism, and the intrusive measures that government now uses to clear travelers through security checkpoints are further drags on the industry.

As a form of regulation, antitrust laws inhibit post-deregulation restructuring efforts, making it harder to bring salaries and work rules into line with the realities of a competitive marketplace. The antitrust regulatory laws inhibit the restructuring of corporations and block needed consolidation; the antitrust authorities view with suspicion efforts to retain higher prices. Historically, the CAB had antitrust jurisdiction over airline mergers. When Congress disbanded the CAB in 1985, it temporarily transferred merger review authority to the Department of Transportation (DOT). In 1989, the Justice Department assumed merger review jurisdiction from the DOT that, when combined with its antitrust authority under the Sherman Act, makes it the primary antitrust regulator of the airline industry.

The Justice Department has contested past merger proposals, including Northwest’s attempt to gain a controlling interest in Continental and the merger of United Airlines and US Airways. Antitrust law also applies to international alliances, arrangements that attempt to ameliorate restrictive foreign ownership and competition laws. While labor contracts, airport asset management, and other business practices are themselves high barriers to restructuring, these difficulties are magnified by antitrust regulatory hurdles. Cabotage restrictions, discussed below, also limit competition.

During the regulatory era, rates were determined politically and changed infrequently. The CAB had to approve every fare, limiting the airlines’ ability to react to demand changes and to experiment with discount fares. After deregulation, airlines were free to set prices and to change them frequently. That was possible only because the airlines had earlier created computer reservation systems (CRSs) capable of keeping track of the massive inventory of seats on flights over a several-month period.

The early CRSs allowed the travel agent to designate an origin-destination pair and call up all available flights. The computer screen could show only a limited number of flights at one time, of course; thus, some rule was essential to rank-order the flights shown. CRSs were available only to travel agents and, beginning in 1984, were highly regulated to ensure open access to airlines that had not developed their own CRS system. The DOT regulations restricted private agreements for guaranteeing access. However, the growth of Internet travel sites and direct access to airline Web sites created new forms of competition to the airline reservation systems. Therefore, the DOT allowed the CRS regulations to expire in 2004.

A network can be efficient only if the flows and the grid interact smoothly. The massive expansion of air travel should have resulted in comparable expansions—either in the physical infrastructure or in more sophisticated grid management. Government management of the air travel grid has resulted in political compromises that cause friction with the smooth flow across the grid. Flight delays are increasing due to a lack of aviation infrastructure and the failure to allocate air capacity efficiently. The Air Transport Association estimates that delays cost airlines and passengers more than five billion dollars per year due to the increased costs for aircraft operation and ground personnel and loss of passengers’ time. The FAA predicts that the number of passengers will increase by 60 percent and that cargo volume will double by 2010.

Airport construction and expansion face almost insurmountable political and regulatory hurdles. The number of federal requirements associated with airport finances has grown considerably in recent years and is tied to the awarding of grants from the federal Airport Improvement Program (AIP). Since 1978, only one major airport has been constructed (in Denver), and only a few runways have been added at congested airports. Airport construction faces significant nonpolitical barriers, such as vocal “not in my back yard” (NIMBY) opposition and environmental noise and emissions considerations. Federal law restricts the fees airports charge air carriers to amounts that are “fair and reasonable.” These fee restrictions, although promoted as a way to provide nondiscriminatory access to all aircraft, limit an airport’s ability to recover costs for air carriers’ use of airfield and terminal facilities. Allowing airports more flexibility to price takeoffs and landings based on supply and demand would also help ease congestion at overburdened airports.

Air traffic control involves the allocation of capacity and has a complex history of government management. Unfortunately, the Federal Aviation Administration (FAA), which manages air traffic control, made bad upgrading decisions. The advanced system funded by the FAA was more than a decade late and never performed as hoped. The result was that the airline expansion was not met by an expanded grid, and congestion occurred.

Better technology for air traffic control will help efficient navigation and routings. Global Positioning System (GPS) navigation technology holds great promise for more precise flight paths, allowing for increased airplane traffic. Ultimately, however, a privately managed system that allows for better coordination of airline investment and operation decisions will be necessary to ease congestion. Air traffic control operation is a business function distinct from the regulation of air traffic safety. Using pricing mechanisms to allocate the scarce resource of air traffic capacity would reduce congestion and more efficiently allocate resources.

Implementing cost-based structures by privatizing air traffic control is a controversial and politically daunting issue in the United States, but twenty-nine nations—including Canada—have already separated their traffic systems from their regulating agency. Air traffic control privatization will likely be driven by the decreasing ability of the Airport and Airways Trust Fund to deliver the necessary financial support.

Currently, the FAA rations flights by delay on a first-come, first-served basis—a system that creates overcrowding during peak hours. A system based on pricing at rates determined by voluntary contractual arrangements of market participants, not government regulators, would reduce this overcrowding. One of the results would be the use of “congestion pricing,” such as rush hour surcharges or early bird discounts.

FAA rules that limit the number of hourly takeoffs and landings—called “slot” controls—were adopted in 1968 as a temporary measure to deal with congestion and delays at major airports. These artificial capacity limitations—known as the high density rule—still exist at JFK, LaGuardia, and Reagan National. However, limiting supply through governmental fiat is a crude form of demand management. Allowing increased capacity and congestion pricing, and allowing major airports to use their slots to favor larger aircraft, would lead to better results.

“Open Skies” agreements are bilateral agreements between the United States and other countries to open the aviation market to foreign access and remove barriers to competition. They give airlines the right to operate air services from any point in the United States to any point in the other country, as well as to and from third countries. The United States has Open Skies agreements with more than sixty countries, including fifteen of the twenty-five European Union nations. Open Skies agreements have been successful at removing many of the barriers to competition and allowing airlines to have foreign partners, access to international routes to and from their home countries, and freedom from many traditional forms of economic regulation. A global industry would work better with a globally minded set of rules that would allow airlines from one country (or investors of any sort) to establish airlines in another country (the right of establishment) and to operate domestic services in the territory of another country (cabotage). However, these agreements still fail to approximate the freedoms that most industries have when competing in other global markets.

National ownership laws are an archaic barrier to a more competitive air travel sector. These rules seem to reflect a concern for national security, even though many industries as strategic as the airline industry do not have such restrictions.

Federal law restricts the percentage of foreign ownership in air transportation. Only U.S.-registered aircraft can transport passengers and freight domestically. Airline citizenship registration is limited to U.S. citizens or permanent residents, partnerships in which all partners are U.S. citizens, or corporations registered in the United States in which the chief executive officer and two-thirds of the directors are U.S. citizens and where U.S. citizens hold or control 75 percent of the capital stock. Only U.S. citizens are able to obtain a certificate of public convenience and necessity, a prerequisite for operation as a domestic carrier.

After 9/11, safety and security regulation responsibilities were given to the new Transportation Security Administration (TSA) within the Department of Homeland Security. Created just months after 9/11, the TSA is an outgrowth of the belief that only the government can be entrusted to perform certain duties, especially those related to security. No one has clearly established that a government whose employees are difficult to fire, even for incompetence, will do better than a private employer who can more easily fire incompetent workers.

In September 2001, Congress passed the Air Transportation Safety and System Stabilization Act, which authorized payments of up to five billion dollars in assistance to reimburse airlines for the postattack four-day shutdown of air traffic and attributable losses through the end of 2001. It also created and authorized the Air Transportation Stabilization Board (ATSB) to provide up to ten billion dollars in loan guarantees for airlines in need of emergency capital. While the ATSB risked the kind of mission creep that is inevitable in an industry subsidy program, the deadline for applications to the ATSB has passed. Of the ten billion dollars authorized by Congress for these loan guarantees, the board actually committed less than two billion.

Air travel is a network industry, but only its flow element— the airlines—is economically liberalized. The industry is still structurally adjusting to a more competitive situation and remains subject to a large number of regulations. The capital, work rules, and compensation practices of the airline industry still reflect almost fifty years of political protection and control.

We are finally seeing the kinds of internal restructuring among airlines that was expected from deregulation. Yet, government still has much to do to ensure that the airline market will thrive in the future. The FAA is a command-and-control government agency ill-suited to providing air traffic control services to a dynamic industry. Land slots and airport space should be allocated using market prices instead of through administrative fiat. International competition will increase, and rules regarding national ownership need to change accordingly.

If the government deregulates the grid and transitions toward a market solution, the benefits of flow deregulation will increase, and costs for air travelers will fall even more.