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 travelled routes are needed to subsidize losses on sparser runs which the regulated carriers are required to fly. 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 travelled routes causes misallocation of resources.

Higher fares on denser routes inhibit travel on those routes. The "right" amount of air travel on these 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. The other pillar—in addition to comprehensive service-on which our current regulatory system stands is the need to prevent "cutthroat" competition which could threaten the industry's stability and perhaps result in a single-firm monopoly.

This has not happened in California, and I see no reason to expect that it would be a general problem.

The number of firms present in any industry depends largely on whether there are large economies of scale relative to market demand. If there are, there will be only a few firms in the industry. In the most extreme cases, there may be only one. But the airline industry does not have large economies of scale. The basic unit of production is the airplane itself. Economic studies indicate that an efficient airline can be run with only a few of them. They can be-and are easily shifted from one route or carrier to another.

Single firm service may emerge on some lightly travelled routes because of the small size of the market. But it is doubtful that such firms could charge monopoly prices because of the constant threat of entry by other firms. The ability to shift planes easily from one market to another makes the threat of entry quite credible in this industry. Much of what I have said you have doubtless heard from others. The question is "what do we do about it?" This is obviously a complex area, and the precise answer to that question is not clear. However, two points are quite clear to me.

First, I believe that no one is going to be able to provide a complete answer until we have a better accounting of the costs and benefits of the current system. At present, neither the Federal Trade Commission, nor the Congress nor the American public has any idea of what the current system of regulation costs or what it produces. My interest in this question as a Federal official is not as important as my interest as an air traveller and a taxpayer since I, along with millions and millions of other Americans, am paying the bills. Congress' need to know is greatest of all. For without the facts on the table, you will have no frame of reference against which to compare alternate approaches.

Second, my experience has led me to conclude that the free enterprise system is the best regulator of all. I can see nothing about the airline industry which would suggest to me that in 1975, Government regulation of the airline industry is providing the consumer with more for his money than the free market would provide. Therefore, I suggest you listen to proponents of regulation with an open mind, as I have done. But I submit, given the conditions that exist today in the industry and in regulated industries in general, that the competitive market should be made the point of departure for the debate and that the burden of proof should rest with those who argue against competition rather than with those who would return to it. The burden should also be on those who, in the name of reform, stop short of this goal.

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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 ČAB 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 protection— are 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 markets— such 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