OPTIMAL FARES AND PRODUCT QUALITY: THE CONTRIBUTIONS OF

DOUGLAS AND MILLER

While the discussion so far has acknowledged that CAB regulation of interstate plane fares has some effect on product quality (flight frequency and load factor), it has taken no explicit, quantitative account of these effects. The first work to analyze these dimensions of air transportation quantitatively was that of Douglas and Miller, published in 1974.75 This work attempts, in a most ingenious way, to quantify the benefits and costs of the quality changes which CAB regulation has brought about. The basic idea behind their methodology is that lower load factors allow more convenient service (in ways described below), but cost the traveler more in fares. Their model trades off the value of this convenience to the traveler against the cost of providing it.

The Douglas-Miller methodology

They assume initially that every traveler has a "most preferred" time of departure. To the extent that he is unable to leave exactly when he would most prefer, he is subject to a "schedule delay" equal to the difference between the time he would prefer to depart and the time he does depart. This schedule delay is made up of two components. First, it is unlikely that any one flight will be scheduled exactly at the desired departure time, even if the traveler can get reservations on that flight. The difference between desired departure time and the departure time of the nearest flight is termed frequency delay. Furthermore, the flight closest to the desired departure time may be booked. The average time incurred waiting because the nearest flight is book is termed stochastic delay. Schedule delay is simply the sum of frequency delay and stochastic delay.

Douglas and Miller not only define the concept of schedule delay, but they also provide estimates of how much schedule delay is likely to occur on a given route per passenger (averaged over the year) as a function of the amount of traffic on the route, the size of aircraft used, and the number of flights (assuming a given seating configuration).

Holding the number of passengers on a route and the capacity of an aircraft constant, their method provides an estimate of expected schedule delay per passenger as a function of load factor. Now, a lower load factor costs more to provide in terms of operating costs, but it provides additional benefits in terms of reduced schedule delay time. The point of Douglas and Miller's analysis is to estimate and weigh these benefits and costs quantitatively.

To do so, it is necessary to evaluate in money terms both the costs of varying load factors and the benefits of varying schedule delay. The costs of offering various load factors and flight frequencies for a given trip, plan type, and seating configuration can most certainly be estimated, and Douglas and Miller do so. However, it is much more difficult to evaluate schedule delay time, that is, to determine the amount which the average passenger would be willing to pay to leave a minute (or hour, or whatever) closer to his preferred departure time. Douglas and Miller assume that the typical passenger would value his schedule delay time at somewhere between $5 and $10 per hour, i.e.,

75 "Economic Regulation of Domestic Air Transport," chapters 5 and 6.

normal level, and to cross-subsidize service on lower-density lines. We shall return to this matter in the next section.

THE DOMESTIC PASSENGER FARE INVESTIGATION-SCOPE AND INTENTION

The CAB has for some time been aware of the service quality competition of the sort noted above, and has attempted to do something about it. More specifically, the Domestic Passenger Fare Investigation of 1971-74 (DPFI) was intended to develop (for the first time) an allaround fare policy, and to deal with the service quality competition problem, and some others, as well. Let us therefore briefly consider the DPFI, the policy changes resulting from it, and the actual changes in fares and service qualities which in turn resulted from these policy changes.

The first change in CAB goals resulting from the DPFI was to up the target rate of return to be built into fares from 10.5 to 12 percent rates of return (in both cases this is the after-tax return on all assets, debt and equity combined). The appropriateness of this change is highly questionable, especially given that the industry has managed to get all too much capital at a much lower (but normal) return of 7.5 percent after taxes.

In addition to a rate of return standard, the DPFI resulted in a loadfactor standard of 55 percent overall, i.e., fares were to be set such that a carrier could earn exactly a 12 percent after-tax return on all assets if 55 percent of the seats were filled. This change, unlike the target rate of return, was based on a new principle. The CAB has previously set target rates of return, but it had not set a target load factor. Previously, if the return was "inadequate," the Board could authorize fare increases; but if additional service competition drove the return back down to an "inadequate level," another fare increase would be needed, and so on. This "rachet effect" could theoretically drive fares ever higher, with no increases in cost at a given load factor.45

In principle, the notion of a 55 percent load factor standard on which to base fares was an improvement, relative to past practice, which was vulnerable to the aforementioned rachet effect. However, there are at least two reasons why the policies resulting from the DPFI may fall well short of what is feasible by way of economic efficiency (note we say "may" here, because a complete discussion of economic efficiency in the airline industry is deferred until the next section).46

First, the assumption of a 55 percent load factor is arbitrary, and there is little, if any, evidence that it represents an optimal trade off between fare and service quality (i.e., the ease of flying when one wants to fly) on a significant number of routes. In fact, evidence presented in the following section indicates that on most routes a higher load factor would be appropriate. Furthermore, it is likely that the optimal load factor will vary from route to route, making a single universal number inappropriate.

44 A more detailed discussion of the DPFI may be found in Douglas and Miller, pp. 150-169.

45 The term "rachet effect," applied to this phenomenon, was first used by Douglas and Miller. See pp. 54-57.

46 For a more detailed critique of the DPFI, see the Kennedy Report, pp. 121-122, and Coleman, pp. 6-13.

Second, we have already presented evidence that a 12 percent rate of return is probably higher than the opportunity cost of capital, and higher than the airline industry has historically generated. On the basis of past evidence, one would expect rates set to generate a 12 percent rate of return at a 55 percent load factor to, in fact, generate a lower post-tax return (say, 7.5 percent), as service quality competition drives the load factor overall below 55 percent. That is, load factors would be driven down until airline profits equaled the opportunity cost of capital.

47

So far, we have been primarily concerned with describing the goals and policies of the Civil Aeronautics Board in its execution of the Civil Aeronautics Act of 1938, with only a hint here and there as to the economic appropriateness of its policies. It is now time to turn to a more systematic economic evaluation of these policies.

THE IMPACT OF CAB REGULATION: AN ECONOMIC ANALYSIS

At the end of the previous section, I described a hypothesis about airline regulation on which most students of the area agree that, although the CAB has set trunk airline fares at high, "cartel" levels, the potential profits from these fares are competed away through frequency and service quality competition on the part of the airlines. As a result, the airlines do not gain profits from the regulation, and the consumer is left paying a fare much higher than he would prefer, with lower load factors and presumably higher service quality than he would prefer.48

This section is concerned with examining the evidence regarding this hypothesis, and with providing an estimate as to the likely welfare loss or gain from CAB regulation. Consideration must be given to costs and benefits to several groups: consumers in high-density markets, consumers in low-density markets (which perhaps currently are cross subsidized), carriers, and suppliers of inputs to carriers. We shall postpone our discussion of the effects of various regulatory policies on broader considerations such as the national defense and the postal service to a later section.

EVIDENCE OF THE IMPACT OF CAB REGULATION ON FARES AND SERVICE

QUALITIES THE INTRASTATE ROUTES

In order to test the hypothesis that CAB regulation has held fares at an unnaturally high level, and load factors at an unnaturally low level, the first place one would be inclined to look would be domestic markets outside the reach of the CAB's powers. Such markets currently exist on intrastate routes in California and Texas.

Markets in both States have enjoyed considerably less regulation, both of fares and of firm entry, than have the intrastate trunk routes controlled by the CAB. Both are regulated to some degree, however, in California by the California Public Utilities Commission, and in Texas by the Texas Aeronautics Commission.

47 At no time in the past 20 years have the airlines earned a return as high as 12 percent overall. If the cost of capital of 12 percent assumed by the CAB were correct, most firms would have gone out of the industry years ago. See Kennedy Report, pp. 121-122.

48 The idea here is that higher service quality comes from higher fares, and there is a limit to what the typical traveler is willing to pay for high service quality. This is discussed at length below.

In California, both fares and firm entry were almost totally unregulated until 1965, except that a new firm had to meet safety standards set by the Federal Aviation Administration, and the PUC could set maximum rates, but not minimum ones. In 1965, the Public Utilities Commission was given the right to control both fares and entry of firms, with the aim of achieving an ". . . orderly, efficient, economical, and healthy intrastate air network . . ." along with stability, low fares, and frequent service.49

The Texas Aeronautics Commission (TAC) has complete control over entry of firms, as does the California PUC, but very limited control over fares. Technically, it has control over an intrastate carrier's fares; but it claims no control over the fares of intrastate operations of interstate carriers, so it has effectively allowed pricing freedom for both carrier types.50 The law requires the TAC to "further the public interest and aeronautical progress by providing for the protection, promotion, and development of aeronautics." 51

TABLE 3. FARES ON INTRASTATE AND COMPARABLE INTERSTATE ROUTES

1 La Guardia to Washington National. See Simat, Helliesen, and Eicher, vol. I, exhibit 7. Source: Official Airline Guide, Feb. 1, 1977.

In both States, the relevant regulatory agencies have been considerably more liberal than the CAB in allowing new firms to enter, and in allowing downward price competition. Thus, before 1965, 16 new carriers entered the California market, and after 1965 two new carriers have been allowed to enter in California. Of these 18 carriers, however, only two important ones, Pacific Southwest Airlines (PSA) and Air California have survived.52 In Texas, one carrier, Southwest Airlines, has entered the market, and then only after lengthy court litigations although the Texas Aeronautics Commission favored entry of Southwest Airlines from the beginning, Texas law allows court

Simat, Helllesen, and Eichner, vol. I. p. 11.

Testimony of Charles A. Murphy. Executive Director. Texas Aeronautics Commission, before U.S. Senate. Committee on the Judiciary, Subcommittee on Administrative Prac tices and Procedure, Hearings on Oversight of Civil Aeronautics Board Practices and Procedures, Feb. 14, 1975, 94th Congress, First Session, vol. II (Washington, U.S. Government Printing Office, 1975), p. 328.

Simat. Helliesen, and Eichner, vol. I. p. 11.

It is worth noting, however, that the carriers which went out of business in California tended to be very small and short-lived (under a year, usually). Thus, this experience does not indicate that a well-established carrier would be likely to go out of business with deregulation. See Jordan, pp. 14-33.

appeal of TAC decisions by interested parties, including carriers already serving the routes proposed for service by Southwest.53

The numbers of intrastate carriers succeeding in each market (one in Texas and two in California) may seem small. But even these small numbers would seem to be enough to instigate vigorous price competition. They cut fares sharply and forced the CAB-regulated carriers to match the cuts for intrastate traffic. As a result, fares on every intrastate route are significantly below fares on routes of equivalent length and traffic density as CAB routes.

Fare differences

To give an idea of these differences, Table 3 presents some current California intrastate fares (and yields per mile) alongside equivalent figures for routes of similar length on CAB-regulated intrastate routes.55 The results are revealing. They indicate that fares on interstate routes are consistently greater than fares on equivalent California routes by 70 to 120 percent. Thus, the fare for the PittsburghCleveland route (105 miles) is $27, or over 120 percent greater than the Los Angeles-San Diego fare of $12.25 (for a trip of 109 miles). Similarly, the fare from New York (La Guardia) to Washington (National), a distance of 215 miles, is $37, or 80 percent greater than the fare for Los Angeles-Fresno of $20 (for a trip of 213 miles). As the reader can verify, the results are more or less the same for comparison of any of the other comparable city-pairs.

Similar fare savings are available in Texas. Between Dallas and Houston, a distance of 222 miles, the current fare is $25 on weekdays before 7 p.m., and $15 for evenings and weekends (both figures include taxes).56 This compares with a fare of $37 (including taxes) for the New York-Washington route, a distance of 215 miles (Table 3).

The low fares provided by the intrastate carriers in California and Texas are not achieved at the cost of safety or modernity of aircraft. The intrastate carriers use aircraft identical to those of interstate carriers on equivalent routes, and their safety records are excellent in comparison with CAB-certificated carriers.57 Furthermore, it is not clear that the service quality provided by the intrastate carriers is overall inferior to that provided in coach service on equivalent routes by interstate carriers. Both generally use coach seats 18 inches wide pitched 34 inches apart. Although the intrastate carriers do not serve meals, the trunk carriers do not generally serve meals or free snacks on the hops of 65 to 350 miles served by the intrastate carriers. As regards flight frequency, the evidence from a number of routes where new low-fare competition has been instituted by an intrastate carrier would suggest that the low fares charged by intrastate carriers will induce sufficient new demand to support more flights than the higher fares previously charged by CAB-certificated carriers. Finally, the in

53 Simat, Helliesen, and Eichner, pp. 17-18.

54 A full discussion of this pricing behavior may be found in Jordan. Chapter 5 for California, and in Simat, Helliesen, and Eichner, vol. II, chapters II and III for California and Texas, respectively.

It was pointed out at the beginning of this chapter that by 1977 the CAB had already embarked on a program of very modest deregulation; this means a 1977 comparison might not show the full effect of deregulation of CAB routes, relative, say, to 1974. However, these comparisons are for regular fares, whereas in early 1977, it was mainly in discount fares that the trunk carriers made reductions.

se Dallas-Houston fares come from the Official Airline Guide, Feb. 1, 1977, p. 451.

57 Testimony of J. Barnum, Hearings on Oversight of Civil Aeronautics Board Practices and Procedures, vol. I, p. 10.