FRBSF Economic Letter
2002-01; January 18, 2002
Competition and Regulation in the Airline Industry
The events of September 11 have had some of their worst economic effects
on the airline industry, leading to a dramatic fall-off in passenger demand
and substantially higher costs. But even before that day, the industry
was facing bad times, with few airlines anticipating profitable performances
in 2001. Some have argued that deregulation has contributed to the industry's
problems, and, furthermore, to problems for passengers.
This Economic Letter analyzes this issue by summarizing the history
of airline deregulation, by illustrating how it has affected the nature
of competition in the industry, and by discussing how potential policy
changes could affect competition in the future.
Regulations and deregulation
Before deregulation of the airline industry began in 1979, the Civil
Aeronautics Board controlled both the routes airlines flew and the ticket
prices they charged, with the goal of serving the public interest. With
deregulation, any domestically owned airline that was deemed "fit,
willing, and able" by the Department of Transportation (DOT) could
fly on any domestic route. The primary regulatory role of the DOT changed
from approving whether an airline was operating in the public interest
to deciding whether an airline was operating in accordance with safety
standards and other operating procedures.
While route schedules and pricing for the airline industry have been
largely deregulated for over 20 years, many other aspects of the industry
are still highly regulated. Perhaps the most important regulation comes
from local governments, which own and manage the airports in their region
and therefore control key bottlenecks to airport services: access to boarding
gates and runways. Most local airport commissions allocate gates without
a formal market mechanism, such as a bidding process; often they require
proof that the airline would operate in the best interest of the public.
In addition, international routes have been deregulated only gradually,
through negotiated bilateral open-skies agreements, which generally allow
airline companies from the two countries in question to fly between those
countries without restrictions. These open-skies agreements do not create
a fully competitive market as they do not allow foreign carriers to transport
passengers within the United States or vice versa.
Finally, certain federal regulations pertain to specific airports. For
instance, airports in Chicago, New York, and Washington, D.C., are subject
to federal "slot" regulations, where airlines must obtain a
slot in order for their aircraft to land or take off. These regulations,
which were designed to avoid congestion at the nation's busiest airports,
have lagged behind market realities. For instance, the nation's busiest
airport, Atlanta's Hartsfield International, is not even covered by slot
regulations. Service to some small isolated markets also is subsidized
and regulated by the federal government.
In summary, even though the end-consumer for airline tickets faces a
market-driven menu of prices and services, key inputs into the industry
are allocated using non-market mechanisms. Thus, 22 years after airline
deregulation, the airline market is still partly regulated.
Nature of airline competition
Since the start of deregulation in 1979, the U.S. airline industry has
grown tremendously. Figure 1 shows the number of domestic U.S. airline
passengers and, for comparison purposes, the same figures for Canada,
both over the past 25 years.
The U.S. experienced a 225% growth over this period, while Canada, which
deregulated its airline industry later and has always had much less competition
than the United States, saw a much smaller growth rate of 80%. Thus, it
appears that deregulation, particularly in combination with competition,
can spur growth in the airline industry.
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Figure 2 shows the average price in constant 1983 dollars for a domestic
airline ticket over the same period for both the U.S. and Canada. Again,
average prices have fallen consistently in the U.S. but have remained
constant in Canada, suggesting a large benefit to consumers from U.S.
practices. Although average U.S. fares have fallen, unrestricted fares
often paid by business travelers are generally thought to have risen steadily.
This has led some observers to argue that airline competition has not
benefited all consumers. But a counterargument is that business travelers
paying full fare also get a superior product, in terms of flexibility
and service. Moreover, the increased demand for air travel suggests that
there are additional new passengers who clearly find air travel their
preferred option and therefore are better off as a result of deregulation.
Thus, even if competition in the U.S. has not benefited every consumer,
it has succeeded in increasing the volume of travel and lowering average
prices, which has almost certainly been beneficial on average.
Deregulation spurred changes in the structure of airlines. Following
deregulation, most of the largest airlines began to operate on a "hub-and-spoke"
system; for example, United's hubs include Chicago's O'Hare, Denver, and
Washington's Dulles, where travelers from a "spoke" city typically
will make connections. The hub-and-spoke system has allowed for efficient
connections for passengers from small- and mid-sized cities, but it also
has increased airline concentration at hubs. The net effect has been to
increase the choice of carriers at non-hub cities and to increase the
frequency of service but also to increase the market concentration at
hub cities.
Over the last 20 years, many of the nation's biggest airlines have shut
down or been acquired by other airlines. The list includes Eastern, Pan
Am, TWA, Republic, Piedmont, Ozark, and Texas Air. Because of the huge
amount of exit, some observers argue that the airline industry is inherently
unstable and requires government intervention. It is true that profits
in the airline industry can fluctuate wildly, precipitating exit. For
instance, while United reported a record net loss of $542 million in the
third quarter of 2001, they reported earnings of $425 million and $359
million in the corresponding quarters of 1998 and 1999, respectively.
The reason for these fluctuations is that an airline's costs are largely
driven by labor and fuel, which are fixed in the short run. Hence, moderate
fluctuations in demand, such as those caused by the events of September
11, can hugely affect profits. The robust earnings of most airlines in
1998 and 1999 can be traced both to the booming economy that spurred demand,
particularly for high-fare business travelers, and to low fuel prices.
While profits are volatile, many industries with volatile profits—ranging
from oil exploration to computer software—operate without substantial
government regulation. Moreover, free markets generally work well for
industries with large fluctuations, because the fluctuations provide incentives
for firms to innovate in response to changes in demand and costs. A good
example in the airline industry is Southwest, one of the fastest growing
airlines in recent years. Southwest operates very differently from many
other airlines: it does not use a hub-and spoke system, its fares are
generally lower and much more uniform, its fleet is homogeneous, its turnaround
time is shorter, and it does not offer meal service. In spite of the recent
downturn in demand for airlines, Southwest has not eliminated any of its
routes, and it reported a third quarter 2001 net profit of $82.8 million.
While it remains an open question as to which of these innovations made
Southwest relatively successful, free markets provide incentives for innovations
to spread, thereby increasing efficiency.
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Moreover, there is little evidence that the airline industry is a "natural
monopoly," i.e., an industry where only one firm is likely to survive
in a competitive environment. Figure 3 plots the Herfindahl index for
a representative long route (San Diego-Boston) as well as for the U.S.
as an aggregate over the 1990s. The Herfindahl is a measure of industry
concentration; a value of 1 corresponds to a monopoly; 0.5 corresponds
to an industry with two equal-sized firms, 0.33 to an industry with three
equal-sized firms, etc. The Herfindahl indices have been very stable over
time, with the industry nationally having the equivalent of 10 equal-sized
firms and the San Diego-Boston route having the equivalent of four to
five equal-sized firms. In spite of the exit, the level of competition
has remained roughly constant over the last several years.
Impact of policies on competition
Because the airline industry is a complex mix of a competitive and regulated
industry, several policy choices could affect its level of competition.
A central policy choice is the mechanism for allocating airport boarding
gates and facilities. Many airport commissions rely on non-market mechanisms
to allocate these scarce resources. Changes in policies by these commissions
to allow for competitive bidding for boarding gates and landing rights
might encourage competition among airlines, and it also might encourage
airport authorities to increase supply when bid values are higher than
costs.
Antitrust policy also may affect the level of competition. A little over
a year ago, United announced plans to acquire US Airways. These plans
were later abandoned after the government decided to challenge the merger.
Most observers anticipate that future merger attempts are likely. There
is significant statistical evidence that airfares increase as market concentration
increases, thereby harming consumers. However, concentrated markets also
benefit some consumers by creating bigger networks with more frequent
and convenient flights. Moreover, mergers also provide incentives for
efficient managerial skills and business practices to dominate. In that
mergers lead to concentrated markets, antitrust policies must balance
these conflicting needs when deciding whether to approve a merger.
A third significant policy dimension involves restrictions on substantial
foreign ownership of airlines and on domestic flights by foreign-owned
airlines. Allowing foreign ownership of airlines could increase the level
of competition for both international and domestic flights. As foreign
airlines already fly to the United States, they are subject to U.S. safety
and security regulations. However, while the current open-skies agreement
between Canada and the United States allows Canadian carriers to pick
up passengers in the United States, it does not allow Canadian carriers
to pick up passengers in Portland and drop them off in Seattle; rather,
they can only pick up passengers in Portland and drop them off in Vancouver.
This limits the ability of a Canadian carrier to gain the hub-and-spoke
economies of scale that might improve its competitive edge on the Portland
to Vancouver market or the Seattle to Vancouver market, and also potentially
on the Portland to Seattle market.
Conclusion
The airline industry today operates in an environment where firms set
prices and domestic routes given market conditions, but where access to
some key inputs, such as airport boarding gates, are determined by non-market
mechanisms. While profits have fluctuated a great deal, the industry in
the U.S. has been characterized by steady growth, falling prices, and
moderate concentration, suggesting a positive impact of deregulation.
Policies to allocate some key inputs on a market basis may yield even
more efficient outcomes.
Gautam Gowrisankaran
Economist
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