One of the most objectionable features of present CAB regulation is the approval of capacity reduction agreements in our domestic markets. At present, under section 412 of the Federal Aviation Act, if the Board finds capacity, pooling and other anticompetitive agreements not adverse to the public interest, it may approve them; in so doing, it immunizes them from action under the antitrust statutes.

Capacity agreements were originally justified because of immediate, short-term, severe financial distress. The Board has since permitted use of capacity agreements to resolve problems of unused capacity, fuel allocation, and low profits in certain markets. By apportioning capacity, such agreements effectively determine market share. As a result of Board actions, capacity limitation agreements have proliferated to the point where about 29 percent of the revenue passenger miles of the three largest carriers are now covered. One economic effect is that, given the level of service provided, fares in covered markets are excessive. One can scarcely imagine agreements more anticompetitive in their effect. Such problems are far better resolved through market forces operating in a competitive environment.

DOT opposed the capacity agreements before the Board and has joined with the Antitrust Division of the Justice Department to oppose approval of the agreements before the District of Columbia Court of Appeals.

In contrast, some agreements arguably subject to challenge under antitrust laws do serve valid transportation objectives. These include interline agreements, airline scheduling committee agreements at congested airports, equipment leases, fuel supply agreements, reservations and ticketing arrangements, and technical agreements with foreign air carriers.

We distinguish between the two types of agreements, the one anticompetitive in a way which contributes to economic inefficiency, the other which meets necessary transportation objectives. The administration believes that anticompetive agreements such as those for capacity limitation should be restricted or eliminated but that agreements which serve efficient transportation needs should be continued.

Section 408 of the Act authorizes the Board to approve mergers. Mergers may be permitted unless the Board finds that they will be inconsistent with the public interest, would create a monopoly and thereby restrain competition, or would jeopardize another nonparty carrier. In our view, the standard used by the Board in determining whether mergers or consolidations are approved should be changed to require that competitive principles be weighed against transportation needs. In DOT's filings to date, we have encouraged the CAB to find less anticompetitive solutions to many of the problems I have discussed. It is now clear that more decisive reform is necessary. In times of inflation, recession and energy difficulties, the Nation can ill afford the extravagances created by the present air regulatory system. The administration proposal will get to the heart of the difficulties in each of the areas discussed by changing the regulatory structure which helped produce them. The air regulatory reform bill which we will present will address each of these issues in detail and will implement the basic policy objectives which I have outlined in my testimony.

We look forward to working with the subcommittee to explore each of these areas in more detail. We share the desire to modernize our regulatory structure and let the fresh air of competition make our transportation industry operate more efficiently at lower cost to the consumers we serve.

Senator KENNEDY. Our second witness, Mr. Engman, since February 1973. has served as chairman of the Federal Trade Commission. He has directed particular attention to the agency's responsibilities in the area of antitrust law enforcement. He is outspoken on regulatory reform, and we are anxious to have his views on CAB regulation.

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STATEMENT OF LEWIS ENGMAN, CHAIRMAN,
FEDERAL TRADE COMMISSION

Thank you, Mr. Chairman.

Last year in November when I was asked to present the Federal Trade Commission's views on governmental restraints in the market

place, I expressed concern that, like so many fashionable topics, it would be the subject of much discussion but little action. It is gratifying, therefore, to know that concern with this vital subject has continued into the 94th Congress, and I commend this committee for its role in continuing the inquiry.

At a time when rising prices threaten the welfare of every American, it would be folly indeed, if we were to fail to address this one area where such large efficiencies appear to be available to us without offsetting economic costs.

I am, therefore, pleased to be here, Mr. Chairman, and to have this opportunity to offer my views on Federal regulations affecting the airline industry.

Senator KENNEDY. You have an extensive statement here, and I want you to proceed in whatever way you feel comfortable, but if you want. to highlight it or summarize it, I think, that will be helpful.

Mr. ENGMAN. I normally do that, Mr. Chairman, and I think this will not take long.

Lest someone else feel compelled to say it for me, I must state at the outset that I am no expert on the technical aspects of the airline. industry. I suggest, however, that one need be no expert to perceive that something is amiss with the way the Government currently construes its responsibility toward the American consumer of air transportation.

As spokesman for an agency broadly charged with insuring that the consumer receives the best that the marketplace can provide for him, I find this situation disturbing.

The Federal Trade Commission is committed to the principle that | people are best served by the effective operation of a free and competitive open market.

Today, those conditions are conspicuously absent in our airline industry. They are absent because, over 35 years ago, the Congress, after examining the needs of a then infant industry struggling to raise capital, decided that the public welfare demanded an exception to the principle of competition-demanded that the airline industry be given partial immunity from the antitrust laws and from the rigors of price competition. The arguments mustered in support of that decision were essentially two: That it was necessary to insure the industry against cutthroat competition, and that it was necessary to provide service to localities which would not otherwise receive it.

I was not around at that time. I did not hear the arguments made for and against what was done. But whatever arguments were made at that time and whatever industry conditions they reflected as you indicated, should be of little consequence to us today. For the relevant question now is, where has it all brought us?

There can be little doubt that much of what was intended has been achieved. Whether it is because of, or in spite of, regulation, I do not know, but today we have beyond question the most comprehensive air transportation network in the world. Moreover, despite the current depleted condition of several of our major carriers, the industry over the years has been characterized by extraordinary stability.

SERVICE COMPETITION AND EXCESS FLIGHTS

But these objectives have been achieved at a very high cost. Our system, which severely inhibits price competition and restricts entry,

has led to a fare structure on many routes which economists agree is far higher than that which would prevail if the industry were characterized by price competition and free entry. Several conditions flow from this fact.

The absence of any real price competition coupled with higher than competitive rates leads to large amounts of nonprice competition. One important type of nonprice competition is in terms of frequency of flights. This in turn leads to large amounts of excess capacity. It is not unusual today for several planes to fly almost identical schedules each with a small fraction of its seats filled on some flights.

Senator KENNEDY. That makes two of us. I have done a lot of flying. I just found that out last Thursday evening when I was flying to San Francisco. There were two major flights within 5 minutes of each other, both going nonstop to San Francisco from Dulles Airport. Noticing that we had these particular hearings. I looked at both of them, and the first class in both were full and the rest about one-third full, and they landed within 5 minutes of each other. I have a staff assistant who is consultant for our Health Committee, who makes the trip once a month, and he has been doing a little informal review of this as well, and has found the exact same thing. He finds it going both ways. The point is well made.

Mr. ENGMAN. I have noticed the same situation. It is also true with other pairs of markets; Chicago, for instance.

In short, what we have is economic waste-the classic cost-plus syndrome. The air passenger who finds himself next to an empty seat may be pleased with this state of affairs. He is able to spread out a little. But I wonder how pleased he would be if he were aware that he had paid not only for the seat he was sitting in, but for the seat his briefcase was sitting in, too.

In addition, fixed rates have created a sort of phony war, a war in which airlines compete for business, not on the basis of price, but on the basis of scheduling and comfort. All of us today have standing invitation to fly Cheryl or Karen or Trixie or even Bruce. Those invitations are no more or less than confessions on the part of the airlines that our decision as to which to fly pretty much boils down to whether Cheryl is more attractive than Bruce.

This bogus competition along with creature comforts and the pressure to raise the number of flights can be explained by the simple economics of the airline industry. We start with an increase in fares. In the absence of price competition, each airline tends to compete away the "profits" from the fare increase by engaging in various forms of increased nonprice competition.

More frills are added. Witness the great free-drink battles of recent times or the lounge wars of some time back. Often flight frequencies are also increased. Unfortunately, this tends to reduce overall load factors on all the planes. Rates of return go down, and soon we are told a new fare increase is "required" to maintain the existing rates of return. The whole nonproductive cycle starts all over again.

ANALOGY TO SECURITIES INDUSTRY

The situation is analogous to that which existed in the securities industry a few years ago when it was operating on fixed rates across the board. Since brokerage houses could not offer the customer lower rates,

they offered frills-counseling services and the like. The brokerage houses argued that these frills were worth the extra money, but the institutional investors knew better, and they made the brokers give them the equivalent of rebates under the table. The American consumer of air transportation does not have that power. I wonder how he would act if he did.

Comfort and scheduling are undoubtedly worth something to consumers. But are they worth the price he must pay for them? Obviously, they are worth nothing to those who cannot afford to fly because of the high prices. There is evidence which suggests also that they are not worth it even to those who can and do fly. If it were true, given the choice, some people would choose to pay the higher rates for deluxe or frequent service, why does the industry and the Government shy away from giving them that choice? For surely that has been the pattern in recent years.

RESTRICTIONS ON CHARTERS

Our current system of regulation has prevented the entry of new carriers willing to fly for less. And it has frustrated charter operations willing to lay on "barebone" service at a fraction of the going rates.

It is argued that these limitations are necessary to prevent socalled undue diversion from the scheduled carriers. We can recognize that argument for what it is. "Diversion" would not occur if people thought frequent flights and frills were worth the price.

Do not misunderstand me. I have nothing against Cadillacs. But I question the equity of a system that forbids the sale of Pintos. And I also wonder about a system which permits producers of a "big ticket" item like air transportation to avoid the issue of price except when it is to tell the consumer that a special rate awaits him if he is leaving on a Wednesday morning, plans to remain at his destination for precisely 53 days, is carrying no luggage, and is a charter member of the Flat Earth Society.

COST OF REGULATION

It may be impossible to get a precise measure of how much our system of regulation actually costs the airline customer and the American public. But we can get a rough idea from examining prices in those few markets where regulated carriers face competition from intrastate carriers not subject to Federal regulation. Two such markets currently exist in California and Texas, as the acting Secretary indicated, and you have doubtless already heard and read much about them. Suffice it to say that the unregulated intrastate carrier entered the market with substantially lower fares in each instance. In the case of Texas, the price differential remains today with the result that consumers are offered a lower cost alternative-offered it, I might add, by a financially successful airline, Southwest Airlines. In the case of California, the low-cost competition offered by Pacific Southwest Airlines forced the interstate carriers to appeal for and finally to get from the Government permission to lower their rates to the level of the competition. But you need only step across the State line to appreciate the local character of this consumer benefit. It still costs much more to fly the 226 miles from Los Angeles to Las Vegas than it does to fly the 347 miles from Los Angeles to San Francisco.

The cost to the consumer of continued regulation is suggested also by a 1972 economic study in which the costs of airline operations were compared with fares for flights between 30 different pairs of cities. These comparisons showed that, in markets where there was no competition from an unregulated carrier, fares exceeded costs, costs being defined to include a 7.5 percent return on investment, from 47 percent to 84 percent. Since, with competition, fares could be expected roughly to parallel costs, this wide variation would seem to suggest that the experiences in Texas and California do not reflect unique circumstances.

These then are at least some of the costs that have been imposed on the public in stressing stability and comprehensive service. Whether one has been worth the other is a policy question which Congress should consider.

But any weighing of costs and benefits surely should be preceded by a close examination of their relationship. For it can be argued that many of the costs incurred were not necessary to the attainment of the benefits intended.

SMALL TOWN SERVICE (CROSS-SUBSIDY)

Consider first the benefit of comprehensive service-that is, service to parts of the country where traffic is too light to support a scheduled airline. It is often argued that high fares on heavily traveled routes are needed to subsidize losses on sparser runs which the regulated carriers are required to fly. I frankly have to tell you I do not know how much of this "cross-subsidization" actually occurs, but assuming that there is some, it has the effect of putting the entire industry on a de facto cost-plus system of return, a system which experience has indicated is a very poor check on inefficiency. Also, requiring one air passenger to subsidize the flight of another raises a serious question of equity. If it is a desirable thing to have air service between two small towns, why should only one class of citizens be asked to bear the cost of it?

Finally, the system raises the question of resource allocation, for there can be no question that a subsidy paid from high fares on heavily traveled routes causes misallocation of resources.

Higher fares on denser routes inhibit travel on those routes. The "right" amount of air travel on those routes would be the amount which people would buy at a price which just covered all costs of providing the service. Higher prices will cause them to buy less than that amount. And the resulting loss to society is the same as it would be had the higher price been the result of private price fixing or monopoly.

I express no view on the question of whether some flights should be directly subsidized. I suggest simply that if we are to have a system under which some people subsidize service to others, we should, at the very least, be able to identify its costs so that we can intelligently examine alternate forms of subsidy and so that we can periodically reassure ourselves that the benefits are worth the costs.

DESTRUCTIVE COMPETITION

The other pillar-in addition to comprehensive service-on which our current regulatory system stands is the need to prevent "cut