There will be doomsayers who will forecast the direct consequences of deregulating rates and entry. Typically they will be based on the reductio ad absurdum case in which at 12:47 on a Wednesday afternoon we shift from total regulation to open competition. It needn't occur that way. If the Congress were to determine that a move in the direction of the free market were warranted, it could easily enough be accomplished in stages. There is ample precedent. Several years ago the SEC was looking at an analogous situation in the securities industry. Brokers then operating on a fixed rate basis argued bitterly that negotiated rates would be a disaster. The SEC rejected that argument and decided to move ahead, not all at once, but on a staged basis. Beginning with purchases of over $500,000, rates were left to the forces of the market. Though this occurred against the background of a bear market and falling volume, there were no disasters. So the cutoff level for negotiated rates was lowered, not just once but again and again at periodic intervals until the fixed rate system was abolished altogether.

It may not be a perfect analogy, but it seems to me that a similar approach could be taken toward the airlines. I suggest a scheduled return to the free market over 2 years or 4 years or whatever period Congress deems appropriate. This would put the fundamental arguments in support of regulation on trial. And it could be done in a manner that would allow the decision as to how far to go to be based on fact and proven results rather than on theory.

My own guess is that we would make it all the way back to "regulation" by the free market and that we would all be better off for it.

Senator KENNEDY. Our next witness is the Assistant Attorney General for the Antitrust Division, the Department of Justice, Mr. Kauper. He formerly served in the Office of Legal Counsel. He was a law professor at the University of Michigan. We welcome him here this morning.

A great deal of attention has been focussed on the Antitrust Division. I am sure you know how important your own work is. I want you to know that we in the Congress think so, too.

You have very extensive testimony here. I am just wondering how you want to proceed. I want to give you a fair chance to present it.

STATEMENT OF THOMAS E. KAUPER, ASSISTANT ATTORNEY GENERAL, ANTITRUST DIVISION, DEPARTMENT OF JUSTICE, ACCOMPANIED BY DONALD BAKER AND KEITH CLEARWATERS, DEPUTY ASSISTANT ATTORNEYS GENERAL

Mr. KAUPER. Mr. Chairman, at your staff's request I have been sitting out there marking out portions of it.

So, I think, what I will try to do is to go through it, but omitting very substantial parts.

Senator KENNEDY. We will obviously include it in the record.

Mr. KAUPER. I am accompanied by Deputy Assistant Attorney General Donald Baker on my right, and on my left Deputy Assistant Attorney General Keith Clearwaters, who will be taking part in these hearings.

Mr. Chairman, I am happy to be here today to present the views of the Department of Justice and to report on the work that the administration is doing on economic regulation of domestic air transportation.

Airline costs affect us all as citizens, taxpayers, and consumers. They affect us when we buy products, when we carry out our jobs, and when we travel for pleasure. Airline costs are in turn directly affected by airline regulation-for it is regulation which tells carriers on which routes they can compete and what means of competition they can use. Basically, it keeps entry tight, while allowing carriers to compete in terms of service but not price. The result is, as you would expect, a sys

tem which sets both price and service at levels above what they would be in a competitive market-in other words, there are more planes, with more empty seats, and the customer pays more than he would under a regime of open competition.

For years nobody much worried about CAB price and entry policies, because we were in a continuing trend of improving equipment, declining cost, declining prices, and rapidly growing traffic. The airline traveler's world was getting better, even though CAB rate and entry regulation was probably slowing down at least the rate at which fares declined, and encouraging excess capacity.

Now, however, the situation has changed. Due to sharply higher fuel and labor costs, airlines have been requesting, and the Board has approved, a whole series of fare increases, which have come at a time when the public at large was, if anything, less able to pay these fares. At the same time, the Board has actively sought to cut back on lowprice air travel, through limitations on promotional fares and restrictions on charter activity. The result of all this has been to raise fares considerably for everyone and to raise them enormously for certain classes of users. The overall effect has been to produce an almost unprecedented substantial reduction in air travel-more empty seats on scheduled flights and fewer charter flights. The reduction in demand has tended to push up the airlines' unit costs, since they have had to spread out their fixed costs over fewer passengers. This in turn has provided the impetus for renewed fare increases, a situation likely to further reduce air travel and hence again increase unit costs. The resulting spiral of increasing fares and costs means that the smaller proportion of the public which can afford to fly gets reduced service at increased prices.

REGULATION OF FARES AND ROUTE ENTRY

We in the administration have been studying for some time how to break out of this upward spiral of prices and costs. We have concluded that the most hopeful avenue is a substantial relaxation of existing price and entry regulation, which forces carriers to offer excessive amounts of unused seats at excessively high fares. That system of regulation has in addition prevented innovative newcomers from coming into the business of interstate air transportation, in the interest of protecting the established carriers against new competition. We believe that more open competitive pricing, if given a chance, would broaden the carriers' entrepreneurial opportunities by giving them a chance to compete with lower fares as well as with extra seats. We believe that it would tend to bring interstate air transportation more into line with what we saw in California and Texas. An environment of lower fares and fuller planes. If this occurs-and both actual experience and economic theory suggest that it will-we have found a basis for breaking the cycle of rising costs and declining service. Lower prices are likely to come quite quickly and lower prices are likely to encourage new traffic quite quickly. By the same token, liberalized entry rules-an environment with less emphasis on route protectionare likely to get onto the routes those carriers who are most efficient at serving them. In a competitive environment, such efficiencies can in turn be passed on to the traveler in the form of lower fares.

The Department's perspective on airline regulatory problems is based of course on our experience in enforcing the antitrust laws in a great variety of industries having a diversity of cost and capital characteristics. It is based on our extensive participation before the CAB in a variety of proceedings. And it is based on our experience in antitrust enforcement in other regulated industries, some of which have economic characteristics similar to those of air transportation. Our experience tells us that regulated firms rarely welcome freer entry rules and more flexible pricing. They generally want to be protected from outsiders and protected from each other by a benevolent regulator. In the airline field, regulated firms generally have opposed pricing flexibility and offered capacity cartel agreements instead. Yet our experience also tells us that in fact competition works in regulated environments much more efficiently than the regulated firms generally believe; and we find increasing use of competition in place of direct regulation as a tool to promote efficiency in a number of regulated environments ranging from wholesale electric power to securities markets.

The Department is currently working with the Department of Transportation, the Council of Economic Advisers, the Council on Wage and Price Stability and the Office of Management and Budget to develop detailed administration proposals which respond to this reality in the transportation sector. We hope to have detailed proposals for air transport regulation reform for presentation to the Congress in the near future. At this point, these agencies have arrived at a broad consensus in principle, which we will discuss today.

We all agree that regulation of rates and routes has been excessive and has inflated present cost and fare levels.

We believe the Government should regulate the airlines where necessary to insure the safety and reliability of air transportation—but this clearly does not require direct Government regulation of airline pricing and entry to the current extent. We believe the focus of Government regulation of the airlines should be on these essentially noneconomic goals, with clear standards and procedures which insure that regulatory powers are not used to unnecessarily limit competition. Even if full rate regulation is deemed necessary to deal with certain problems— for instance, the prevention of monopoly pricing in certain marketssuch regulation should be carefully crafted to limit and clarify goals, standards and procedures.

Reform only of procedural-rather than substantive-provisions of the act cannot correct the fundamental problem of its ambiguous and sometimes conflicting stated objectives. Procedural reform of the act might well be desirable, but it is not likely to be successful without a narrowing and clarification of the standards the Board may apply in making economic decisions, and of the scope of airline activities subject to those decisions. Such a redefinition of the act's economic goals and standards would be a substantial improvement. And in our view, such a redefinition would call into question the continued usefulness of much of present economic regulation.

CAB AUTHORITY TO GRANT ANTITRUST IMMUNITY

The administration group also agrees that the CAB should not be given broad authority to immunize from the antitrust laws all the

private agreements and mergers it approves. Accordingly, our proposals will provide for a much narrower area of antitrust exemption, and for a merger approval approach generally modeled on the Bank Merger Act of 1966.

To explain the basis for these rather broad conclusions, I will sketch briefly the circumstances which led to the imposition of Federal economic regulation of the airlines, describe what I believe to be the lessons of major CAB economic regulatory proceedings, and attempt to outline some preliminary conclusions.

HISTORY OF CAB REGULATION

Federal regulation of air transportation has developed primarily along two paths: one set of statutes which regulate safety, airport and airway affairs, and another specifically directed toward the regulation of the economics of air transportation. The first category of statutes has been the responsibility of the Department of Transportation and the National Transporation Safety Board for several years. The economic regulatory system which the Civil Aeronautics Board administers is now embodied by the Federal Aviation Act of 1958, as amended. The origins of airline economic regulation are usually traced to the Civil Aeronautics Act of 1938, which generally followed the outline of the Interstate Commerce Act in setting up most of the major regulatory features of today's Federal Aviation Act. There had been partial economic regulation of air carriers prior to 1938, however. After experimenting with several different means of administering a system of subsidized air transport of mail, the Congress determined in 1930 to grant the Postmaster General broad powers over the routes, rates, and practices of carriers carrying airmail under contract with the Government. In 1935, the Congress broadened this regulation to prohibit carriers with airmail contracts from engaging in any service on routes other than their airmail routes if such service would compete with another carrier having an airmail contract on that route. The predominance of mail over passenger service was rapidly diminishing throughout this period, however, and by 1937 air carrier income from passenger service was twice as great as mail income. Unregulated carriers without airmail contracts began to compete with airmail carriers, who naturally complained about their unregulated competitors' greater economic freedom. The Interstate Commerce Commission, which obtained economic regulatory powers over motor carriers in 1935, pressed for the extension of economic regulation over all air carriers, under the general theory that it is unfair and "chaotic" for unregulated firms to be allowed to compete with regulated firms.

The protection of a subsidized airmail system was a vital objective of the drafters of the 1938 act. Even today, a very high percentage of the provisions of that act, as amended, still are concerned with the carriage of mail. Today, although the mail system is of crucial importance, it is a small percentage of the air transportation business. There certainly would be no logical basis today for designing the entire air transportation system around the mail system, because the needs of the Postal Service can be met with relatively small and specific modifications to the larger air system.

Just as the "chaotic" conditions generated by the efforts to develop an airmail system have disappeared today, we no longer experience

other very important factors which led to the creation of airline economic regulation in 1938. The Great Depression had shaken our society's confidence in the free market system, and led to a number of laws which substituted direct Government economic regulation of business organizations for the maintenance of free competition. Also, air transportation in the 1930's was thought to suffer from undue division of governmental regulatory authority among the Commerce Department, the Post Office Department, and the Interstate Commerce Commission, and it was considered a very important function of the 1938 act to combine and coordinate all of these functions within one agency.

The drafters of the act, however, vehemently denied any intention to allow the Board to restrain competition or create monopolies. The act itself directed the Board to maintain "competition to the extent necessary" to pursue other rather inclusive goals, and explicitly directed the Board to observe conventional antitrust principles in deciding merger and interlocking control cases.

The act's reliance upon competition among air carriers shows that the Congress clearly did not regard air transportation operations as having "natural monopoly" characteristics which required Government control in the place of the discipline of competition. Instead of detailed control of the rate base, regulation was extended to fares, entry and exit from specific routes, and agreements and mergers.

MERGERS REASONS FOR

The first category of major CAB economic cases are those in which the basic structure of the airline industry itself was at issue. In the last 15 years, the Department of Justice has opposed three major trunk air carrier merger proposals, which had they been approved, would have substantially redrawn the route map of the U.S. domestic system, and considerably increased the already very great concentration of the airline industry in the hands of a very few large trunk air carriers.

Since 1962, we have opposed before the Board the proposed mergers of American with Eastern, Western with American, and National with Northwest.

In the last few years, the Department also has studied several other major airline merger proposals which were never filed and litigated at the CAB.

As a result of studying, testing, and arguing the evidence in these cases, we have come to the conclusion that in the absence of economic regulation, the air transportation industry probably would have a reasonably flexible, competitive structure which would serve the public better than the present Government-controlled structure. Experience under economic regulation, and in unregulated air transportation where available, indicates that the industry tends to have a "competitive" structure, rather than being a "natural monopoly❞ which must be regulated in the interests of the public.

Evidence is quite abundant that there are no important economies of scale in air transportation; that is, larger firms are not more efficient or less costly simply because of their size. In fact, other things being equal, the largest air carriers tend to have a higher level of unit costs.