lute the air and make noise, and the market in and of itself takes no account of this. As a result, if aircraft noise and pollution go untaxed or uncontrolled, too much air service will be produced for economic efficiency. However, as is well-known, these environmental aspects of air transportation are regulated, and no one proposing deregulation is referring to these aspects of regulation, which are, in any event, not practiced by the CAB. Another sort of externality is what one might call "location" externalities connected with the provision of scheduled transportation. It is akin to the location problem of, say drugstores: since some houses are closer to some drugstores than to others, and since traveling to shop has a cost, some drugstores will have a market advantage over others, at least for some customers. It has been shown some time ago that this will result in too many drugstores, operating with excess capacity at "too high" a cost.104 The situation with airlines is totally analogous, except that the competition is in time rather than space: airlines will all tend to cluster their departures around the same times (usually the most popular ones) rather than spreading them out as would be more socially optimal. The theory behind this for airlines and other transportation companies has been developed by Douglas (1972).105 However, Douglas's argument depends on the assumption of scale economics of plane size, i.e., lower operating costs (or a given length of haul) as the plane size gets larger. Once one gets past the capacity of a 727-200 (150-160 passengers) such economies would appear to exist more on engineers' drawing boards than in reality. Thus, for a given length of haul, Douglas and Miller get a higher cost per seat-mile for a Douglas DC-10 than for a Boeing 727-200.1 106 It is probably true that this sort of competition will cause a modest amount of market inefficiency here, especially on low-density routes. But to claim that regulation is needed to solve this problem is equivalent to claiming that retail trade should be regulated because of the similar problem there. 107 Most economists and most of society as a whole would seem to believe that the cost of this market failure in retail trade is too small to merit regulation there. Analogously, it is impossible to find any evidence that market failure here is great enough to merit regulation on this count in the case of airlines. Indeed, CAB regulation does nothing to solve this problem, because it relates to plane size and the spacing of flights over the time of day-something the CAB has scrupulously avoided regulating.108 104 "Too high a cost" here occurs because of a firm size too small to minimize costs. See Edward Chamberlin. The Theory of Monopolistic Competition (Cambridge, Harvard University Press, 1950). 105 George Douglas. "Price Regulation and Optimal Service Standards." Journal of Transport Economics and Policy 20 (May 1972), pp. 116-127. Also "Equilibrium in a Deregulated Air Transport Model." presented at Seminar on Problems of Regulation and Public Utilities. Dartmouth College, August 1972. 108 See Douglas and Miller, p. 24. 107 In retail trade, regulation to take account of this effect would involve forcing stores to spread out. If anything, the existing location regulation for retail trade does the opposite it encourages clustering of trade activities through zoning. Presumably the unpleasant "neighborhood effects" of having commercial activity on every block (or spread out in some such way) outweighs the effect discussed in the text as regards regulatory policy. 108 Basically, to control for this problem, a regulatory agency would attempt to coordinate scheduled departures of the carriers, spreading them out, and it would encourage the use of aircraft on a given route somewhat larger than the market would generate. There is another sort of market failure which might occur in the airline industry. The theory, of competitive markets assumes that consumers have perfect information about the quality of the product they are buying, or that they can learn by trial and error. But in the case of an airline, "learning" whether it is safe can be so expensive as to cost the passenger his life. Furthermore, there is an externality: if one airline has unsafe procedures or aircraft, it can harm passengers or other airlines by midair collisions and the like; and crashes can, of course, cause damage and injury to those not flying. Thus, there is ample reason to favor continued safety regulation by the Federal Aviation Administration. But this has nothing to do with fare regulation by the CAB, and indeed, the evidence provided by the intrastate carriers would indicate that they haxe excellent safety records, even in relation to CAB-certificated carriers.109 Further evidence on the safety of non-CAB-certificated carriers from the U.S. supplemental (i.e., charter) carriers. On the basis of fatalities per billion passenger-miles, the supplementals have, in fact, been safer than the trunk and local service carriers for nearly every year of their existence except for 1966 and 1970.110 Overall, then, there is no evidence that deregulation of fares and entry is likely to lead to less safe operation, given continued safety regulation by the Federal Aviation Administration. Entry Barriers As is evident from the discussion so far, entry, or the threat of it, by new firms is extremely important to the functioning of competitive markets. Without it, there is no assurance that prices will be driven down to costs whenever excess profits are earned. If for some reason it is difficult for new firms to enter an industry, this may cause market failure, i.e., prices well above costs, and excess profits on the part of firms in the industry. In determining the viability of competitive markets in the airline industry, it is therefore important to consider what barriers to entry by new firms may exist, assuming that the current barrier of CAB regulation is lifted. Two types of entry are relevant here: entry by an existing scheduled airline firm into a new market (i.e., a new citypair route) and entry into a given market by a firm not previously providing air transportation. We consider the case of a totally new firm first. Entry by New Firms into the Airline Industry Following the earlier work of Bain and Caves,111 we consider three possible entry barriers to new firms in the airline industry: minimum capital requirements for efficient operations, absolute cost disadvantages to new firms, and product differentiation. Minimum capital requirements in an industry may occur because scale economies require a threshold investment to achieve efficient operations. If this investment level is high enough, it can make it difficult for new firms to raise the capital needed to begin efficient operation. 100 See footnote 55. 110 Wennedy Report, p. 73. 11 Joe S. Bain, Barriers to New Competition (Cambridge, Harvard University Press, 1956); also Caves, op. cit., chapter 4. In the case of the airline industry, we have already shown that scale economies are likely to be unimportant once a firm is as large as a trunk carrier. Still, Figures 1 and 2 indicate that for firms smaller than the trunk carriers, costs may be higher. The matter which concerns us here is just how large an investment is needed to achieve the minimum efficient airline size. The intrastate carriers in California and Texas provide some evidence here: we have already presented evidence that they have managed to charge fares considerably lower than the trunks on equivalent routes, and that their costs (controlling for such things as length of haul and load factor) are no higher than those of the trunks, and they may be lower. Consider first the case of PSA. In the early 1960's, it managed to undercut trunk fares and earn a return on equity in excess of 20 percent (1960-64), using a fleet of only four to six Lockheed Electra aircraft.112 More recently, Southwest Airlines instituted similar low-cost service in Texas, also undercutting trunk fares as previously described, starting with only three Boeing 737-200 aircraft. In 1974, Southwest's total net physical assets under $16 million in value.113 This investment level represents an extremely low barrier to entry relative to many unregulated industries in manufacturing, such as steel, where efficient, integrated plants cost in the billions of dollars.114 Capital requirements for new firms in the airline industry, then, are very low relative to those of many manufacturing industries which society has decided are sufficiently competitive not to merit regulation. The second possible disadvantage to new firms in the airline industry is an absolute cost disadvantage for a new firm: the idea is that existing firms may have "learned to produce their services at lower costs than newcomers could achieve, the result being that newcomers are at a cost disadvantage. If this were the case in airlines, it would obviously discourage entry. But again, the evidence from the intrastate carriers gives no indication of any such cost disadvantages. It is true that for their first two years or so of operation, both Air California and Southwest Airlines did lose money, as they got their services established.115 But initial losses were quite transitory, and, as previously stated, they were quickly supplanted by profit levels for both carriers significantly higher than those for the trunk carriers.116 The third possible disadvantage to a new firm in the airline industry stems from product differentiation. That is, if existing firms can create the impression in the minds of the traveling public that their services are superior to those of potential new firms, this will create an entry barrier to those potential newcomers. Most certainly, airlines attempt to differentiate their products from those of other carriers, through the luxury of their service, the quality of their meals, the attractiveness of their stewardesses, or other considerations. The question is not, however, whether airlines attempt to differentiate their products, but rather how differentiable the product inherently is. To put the question another way, how easy is it for one airline to copy an 112 Jordan, p. 193. 113 Simat, Helliesen, and Eichner, vol. II. Appendix S. p. 2. 114 See Bain, op. cit., and Leonard W. Weiss, Case Studies in American Industry (New York: John Wiley, 1971), pp. 147-151. 115 See Simat, Helliesen, and Eichner, vol. II, part II and III. 116 See the first part of this section. other's selling innovation? A priori, it is difficult to see anything (service-wise) which one airline can do that another one cannot. Among different airlines, the aircraft are the same, the safety standards are the same, the flight crew training standards are the same, and the ground service (i.e., reservations and baggage) technologies are the same. On the basis of available evidence, then, we have every reason to concur with the conclusion of Caves regarding the airline industry: "we find almost no characteristics in the product to lead us to expect that it would prove readily differentiable." 117 Entry by Existing Airlines on to New Routes On the basis of the evidence presented above, the airline industry would be one of very low entry barriers relative to many manufacturing industries, even if all entry had to be by firms totally new to aviation. In fact, however, that is not the only way in which new entry can occur. It is possible that airlines already possessing scheduled routes can enter new routes, and it is possible for carriers now providing only charter or freight service to enter into scheduled passenger service. As a result of this, entry barriers into any one airline market are even lower than the immediately-preceding discussion would imply. More specifically, the costs for a carrier to add a route to its network are low indeed: if a new city is served, it need only rent space in the airport, and hire appropriate ground support personnel. It might also initially advertise its new schedules intensively. But if the airline is already serving at least one of the cities of the new route, its "brand reputation," to the extent that such a thing exists, is already established on at least part of the route, so it will have an even easier time getting established than a totally new firm (this, however, is not very important if, in fact, the product is not very differentiable in the first place). Overall, then, there is every reason to believe that entry barriers in the airline industry are low enough to allow it to function competitively in the absence of regulation. The issue of regulatory policy regarding airline entry will be discussed further in the concluding section of this chapter. Competition and Product Quality If the evidence presented so far is correct, any efficiency arguments in favor of continued CAB regulation are weak ones indeed. However, one very important aspect of the problem has not yet been covered. The classical argument that competitive markets will generate an economically-efficient optimum goes as follows: if price is greater than the extra cost of producing a good, firms will have an incentive to produce more of the good, for they can continue to make money for each good made. Competition will drive the price down to cost, including a "normal" return, defined to be just enough to continue to induce investment in the industry. This argument, however, deals with a single, homogeneous product. We know that this is not the kind of product provided in the airline industry. Rather, there is a whole continuum of different product qualities, and these qualities vary in several dimensions as well (seat size, meal service, and, most importantly, schedule delay time). 117 Caves, p. 54. The question, then, is the following: will competition in price and product quality together result in an optimal outcome, an optimal combination of price and product quality? Until recently, this issue had not been worked out theoretically for the most important aspect of airline product quality, namely schedule delay. However, Gary J. Dorman, in a recent doctoral dissertation under the direction of the present writer, has solved this problem, and shown that in the absence of any sort of scale economies or externalities, competition in the two dimensions of price and scheduling will indeed generate an optimum.118 The proof of this result is too elaborate to go into here, but the gist of the argument is simple: so long as a market is not providing an optimal combination of fare and service quality, a new airline can enter the market and make money by approximating that combination more closely. Problems arise, however, if the amount at which different passengers value service quality differs considerably; then there is a conflict among passengers as regards desired service quality, and unless there are many flights, this conflict will be difficult to resolve. But if there is a conflict as regards value of service quality to customers, then competition will generate a superior solution in all likelihood, howregulation can do no better than competition; the problem is inherent; ever, because it will probably enable a wider variety of prices and service qualities to suit varied tastes.119 From the evidence presented here, both theoretical and empirical, then, the upshot is straightforward: a loosening of trunk airline regulation in the United States, with a greater reliance on market forces, would promote a greater degree of economic efficiency in the form of lower fares, and a service quality closer to what people are willing to pay for, than existing regulatory policies. Just how great the overall potential benefits of regulatory reform to domestic US air travelers is considered in the next subsection. THE ECONOMIC EFFECTS OF CAB REGULATION ON CONSUMERS Any estimate of the welfare loss or gain from a given policy is by necessity a rough one, because a number of simplifying assumptions are always necessary to make them. Nevertheless, as long as these estimates are interpreted and used with some care, they are considerably better than knowing nothing at all. The present section considers the welfare effects of CAB regulation for consumers, while the following section looks at those effects for producers. To estimate the economic effects of CAB regulation, we work in two steps: we first consider the likely impact of deregulation on fares, and second on service quality as measured by schedule delay. In calculating this loss, we restrict our analysis of coach and economy passengers. This is not a major shortcoming, since these classes of passengers now account for no less than ninety per cent of all scheduled domestic trunk passenger-miles.120 We shall, however, consider qualitatively the impact of CAB regulation for first-class passengers, as well. We shall also restrict our analysis, as said in the beginning, to scheduled flights. 118 Airline Competition: A Theoretical and Empirical Analysis (Ph. D. dissertation, Berkeley, 1976), chapter 3. 119 On low-density routes, this problem can be acute. However, because low-density routes tend to be short in haul, surface alternatives tend to allow some other price-quality alternatives here. 120 U.S. Civil Aeronautics Board, Air Carrier Traffic Statistics (December 1975), p. 6. 83-944-78-9 |