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view, a single industry-wide fare formula cannot avoid these problems. However, rather than have the Board attempt to set fares on a market-by-market basis, or examine individually the numerous cost-justified deviations from formula-determined fares, the Department believes the Board should give the carriers broad flexibility to adjust fares to costs on a market-by-market basis. In this way, the Board would be spared the necessity of passing on the reasonableness of numerous individual fare filings, and carriers could avoid regulatory lag in changing or modifying fares to track with movements in the level and structure of costs. Finally, DOT advocates fare flexibility as a means of enabling carriers to determine the optimal price/quality relationship in each market. In the Department's view, there are considerable variations in desirable service quality between markets of similar distance.157 Use of an industry-wide fare formula, however, produces the same quality of service in markets of similar distance regardless of the inherent differences in the market's service needs.

American supports fare flexibility because it believes that a fare structure based vpon approximations of industry average costs is inadequate for determining the <ppropriate fare in particular markets. American, like DOT, contends that since costs vary considerably from market to market, equitable treatment for passengers and carriers requires that carriers be given meaningful pricing flexibility in order that these cost variations may be reflected in the fare structure. 158 American also argues that far, flexibility will permit carriers to test fares in the marketplace and thereby determine their effect on traffic. 159

Continental supports fare flexibility as a means of enabling carriers more easily to adjust fares in individual markets to reflect marketing considerations, and to encourage price competition. Continental believes that price elasticity varies from market to market, and that carriers need increased pricing discretion to react to marketing realities.160 Continental argues that under the statute fares are supposed to reflect not only costs, but value of service principles as well. Strict adherence to a uniform fare formula, however, inhibits managements' ability to reflect value of service considerations in the fare structure. Continental supports increased opportunities for price competition so carriers will not have to come to the Board every time they want to introduce a fare reduction.

Delta supports fare flexibility limited to plus or minus 5 percent of formula fares because it believes that such a range more nearly corresponds to costs than does a single formula-determined fare. Delta argues that, in view of the numerous judgmental factors involved in mileage block costing, the best that can be expected with reasonable assurance of accuracy is development of a cost band or profile. Delta believes that after an initial stabilizing period,161 carriers should be free to adjust fares within this band without the fares being subject to suspension on reasonableness grounds.

157 DOT-T-3. The variations are the result of difference in passenger density and type of traffic. The Department believes that in dense markets passengers would prefer lowerthan-average fares and higher load factors, and the converse in less-dense markets. Likewise, the Department believes business passengers would be willing to pay higher fares for more frequent service, and vacation travelers would accept higher* load factors in return for a lower fare.

168 American's contention is that the Bureau's costing methodology produces only esti. mates of average trunkline costs, which, like all averages, tend to mask the wide cost variations that exist between markets. American concedes that the inherent limitations of the regulatory process make it unrealistic to attempt to determine the cost of domestic air transportation on a market-by-market basis. However, rather than ignore the cost variation, as American alleges an industry-wide fare formula does, the carrier contends that the practical way to reflect cost variations in the fare structure is by giving carriers sufficient flexibility to adjust fares to perceived costs on a market-by-market basis.

159 In conjunction with this expectation, American refers to the oft-repeated argument in this proceeding that short-haul fares cannot be raised to the level of short-haul costs without adversely affecting traffic in those markets. American contends that this generalization is deceptive and without convincing support in the record. American believes instead that elasticity varies from market to market, and supports fare flexibility as a means of permitting carriers to increase fares in those short-haul markets where to do so would not significantly affect traffic.

180 For example, Continental points out that in some markets carriers compete against ground transportation. In such markets, Continental believes carriers would utilize fare flexibility to lower fares to attract more traffic. Likewise, flexibility would permit fare decreases in vacation-oriented markets in order to attract added traffic. On the other hand, in business markets, carriers could increase fares to compensate for the lower fares in more price-sensitive markets.

101 Delta proposes that formula-determined coach fares and other basic fares based upon percentage relationships to the coach fare remain in effect without change for a period of 6 months following the final order in this investigation.

In general, the parties which oppose fare flexibility argue that the proposals in effect constitute a deregulation of air transportation and are inconsistent with the policies of the Act. Some express concern that the adoption of such a proposal could result in discrimination between passengers traveling in different markets. Finally, the carriers opposing flexibility argue that it could result in economically destructive competition. They are concerned that in competitive markets fares will necessarily fall to the bottom of the zone resulting in inade quate earnings for the industry.

Upon consideration of the foregoing, the Board has determined to affirm Judge Johnson's rejection of the various zone proposals.

In general, the proposals rest on an erroneous understanding of the Board's past practices with respect to fare policy, and on unrealistic assumptions as to how the industry would respond to a policy of partial deregulation of fures. In our opinion, adoption of any of these propsals would be tantamount to abdicating our statutory responsibility to protect the public interest in reasonable fares. Moreover, we believe that the proposals would inevitably lead to an irrational and inequitable fare structure and to an unwarranted escalation of the fare level.

As previously noted, DOJ's position rests on its contention that the historic absence of price competition in the domestic air transportation industry is largely the result of a uniform Board-established and enforced fare structure. Eliminate the Board-enforced rigidity, says DOJ, and the carriers will engage in price competition rather than costly service competition. However, the facts do not fit the theory. The facts are that until this proceeding, the Board had never prescribed a general domestic passenger-fare level, or minimum or maximum levels. Under section 1002 (d) of the Act, although the Board is empowered to establish reasonable fares, it may do so only after finding the existing fare level unlawful. While the Board has adjudicated the reasonableness of numerous individual fare proposals, prior to the issuance of the opinion and order in Phase 7 of this DPF1,16 it had never before found the existing general passenger-fare level unlawful.163 Consequently, until this proceeding, it has never had occasion to prescribe a general domestic passenger-fare level or structure.

Thus, for over thirty years the carriers have been free to file tariffs proposing changes in their normal fares, either upward or downward, subject to the Board's power to suspend and investigate. The history of carrier-initiated fares under this regime inspires little confidence in the likely end-results of the zone proposals. For, aside from the patchwork fare structure which evolved, the fact is that, for all practical purposes, the only proposals to adjust normal fares during this entire period involved increases. 164 Price competition in normal fares has been virtually nonexistent.185

Indeed, even in Phase 7 of this proceeding, when the Board for the first time established a general constraint on future domestic fare filings, we imposed a maximum fare level only, in an effort to afford managerial discretion in implementing fare changes. The carriers' response to this pricing discretion, however, was to raise virtually all basic fares to the maximum level permitted, and to continue their intensive nonprice competition, as well as price competition in the form of discount fares.

It is clear, therefore, that the general absence of price competition in normal fares is not, as alleged, the result of a Board-imposed fare structure. Rather, it is directly attributable to the economic structure of the industry. Carriers have demonstrated little inclination to engage in such price competition because they normally can expect no significant advantage from such action. Competitors are always free to match any fare reduction, and as a result, a carrier cannot

166

182 Order 71-4-60 dated April 9, 1971.

163 In the Suspended Passenger-Fare Increase case, 25 CAB 511 (1957), the Board, while not finding the existing fare level unlawful, did find that tariffs proposing increases in substantially all domestic fare levels were uniust and unreasonable. The decision did not result in a Board prescription of fares for future application, but only in the cancellation of the proposed increases.

164 Exceptions to the rule are three across-the-board fare decreases implemented during World War II. These reductions were not, however, the result of intercarrier price competition, but were in response to orders to show cause why passenger fares should not be reduced. See e.g., order 2164, adopted February 27, 1943. Also, it should be emphasized that the above discussion is concerned with standard-class fares, and does not consider carrier proposals for introduction of new lower-cost forms of service at fare levels below existing fares, e.g., the introduction of coach service by Capitol Airlines in 1948 at a level approximately 2 cents below first-class passenger-mile rates.

165 In recent years, the carriers have, however, engaged in extensive discount fare competition which was the subject of our exhaustive opinion in Phase 5 of this investigation, and is not further considered herein.

108 Orders 71-4-59 and -60, p. 80.

expect a fare decrease to improve its market share and consequently its competitive position. As a consequence, reductions in normal fares can only lead to a reduced passenger-mile yield and, unless traffic expands substantially, to reductions in carrier earnings. And, as the evidence in Phase 7 indicates, normal-fare traffic appears to be relatively inelastic with the result that general fare reductions do not generate sufficient additional traffic to offset the decline in overall yield.

Also of significance in explaining the absence of normal-fare price competition between air carriers, and a fact with which the proponents of fare flexibility not come to grips, is the character of the industry. Congress has subjected to regulation and control both entry into the industry and entry into individual markets, with the result that the number of competitors over individual routes is necessarily limited. The Congressional purpose was to enable the Board to prevent excessive competition which, because it is uneconomic, would inevitably drive up fares. As a consequence, effective competition on all but a few individual city-pair markets is confined to a relatively limited number of carriers-and many markets are served by only one carrier.107 Under these circumstances, to expect pricing behavior representative of a truly competitive market structure is ingenuous at best, and it is therefore not surprising that competition in basic fares has been virtually nonexistent.

The second failing of the zone proposals is that they are premised on unrealistic assumptions as to how carrier managements are likely to respond. In general, two different types of pricing responses are predicted by the zones proponents. First, they expect that the deregulation of fares within a zone of plus or minus 15 percent of the formula fares will encourage price competition; and second, they support fare flexibility as a means of permitting carriers to adjust fares to the level of costs on a market basis.

Although the proponents of fare flexibility anticipate it will encourage price competition, for the reasons outlined above, we believe instead that carrier managements will react to this form of pricing flexibility in the same manner they have always reacted to the extensive flexibility which they have historically been afforded, and that is to compete on the basis of service rather than price. on the other hand, a policy which automatically permits carriers to adjust fares to levels 15 percent above the formula will enable the carriers to increase fares to levels far in excess of cost plus a fair return. There is no reason to believe that the carriers will not avail themselves of this opportunity, the resultant excessive earnings inevitably being used to finance additional service competition.

In any event, insofar as the different price-service levels predicted to result from increased price competition merely represent introduction of lower cost forms of service—such as with more densely configured aircraft-nothing prevents carriers from introducing such services at appropriate fares. The fare structure we are adopting herein is applicable only to existing forms of service. However, to the extent the price-service differentials envisioned by DOJ and DOT contemplate carriers competing over the same routes on the basis of highload factor/low-price service versus low-load factor/high-price service, there is no evidence that such competition would take place. Without further belaboring the point, it may again be noted that for over thirty years the carriers have been free to offer prices different from those of their competitors, but with insignificant exceptions, airline fares have always been uniform. Again, this phenomenon is hardly surprising. Assuming that a particular carrier were to reduce its fares predicated on achieving a higher-load factor, other competing carriers would be compelled to reduce their fares, the result being that all carriers would have to achieve a higher load factor if earnings were not to be adversely affected. Thus, the public would not have a choice of different prices, but would be forced to pay for whatever level of service could be economically provided at the established fare. We are at a loss to perceive how this result squares with our obligation under section 1002 (e) (2) to take into account "the need in the public interest of adequate and efficient transportation of persons and property * * * at the lowest cost consistent with the furnishing of such service."

American, on the other hand, indicates that it would not expect price competition to result in carriers competing in the same market by offering different fares. Rather, American anticipates that price competition, while producing uniform fares, will result in a greater emphasis on efficiency. However, why a carrier would reduce its fares, and concurrently its yield per passenger-mile, when to do so would not increase its market share, is not all clear, since the result of such action would be that the carrier earns less money than it did prior to the fare decrease. American concedes this point, but fails to adequately explain why a carrier would still act in a manner likely to decrease its revenues.

187 See exhibit TW-9-T-B.

Nor is there any likelihood that under fare flexibility carriers will adjust fares to the level of actual costs on a market-by-market basis, that fare reductions would be made in those markets in which actual costs are below industry average cost for the stage length involved, or that fares would be raised only in markets where costs or other justification exists. Managements' basic incentive is the maximization of revenues, and not adjusting fares to costs. Accordingly, in markets where the value of service exceeds the formula fare, carriers would seek to raise fares to the maximum amount permitted resulting in fares based upon whatever the traffic will bear, irrespective of the cost of service.

In sum, we are forced to conclude that the zone proposals essentially constitute thinly-veiled efforts to eliminate meaningful regulation of passenger fares. The proposals themselves contain no safeguards to prevent unreasonable increases in the overall fare level. Moreover, adoption of a fare zone would nullify our laborious efforts to achieve a rational, equitable and cost-oriented fare structure.

Finally, much of the concern of the proponents of a zone concept of regulation is related to the fear that a detailed Board prescription of the specific fares to be charged in the future would create intolerable rigidities. Such an order woulu, until amended, preclude the filing of fare changes, and amendments could, in many instances, necessitate evidentiary hearings. A fare prescription order which permitted deviations within a zone would permit a degree of carrier-initiated fare change without procedural impediments. However, as detailed elsewhere in this opinion, our order, for the most part, will not contain a prescription of specific fares to be charged for an indefinite future period. Instead, we have determined not to restrict the carriers' freedom to file tariffs proposing fare level changes, or to propose structural changes that have the effect of bringing the fare curve closer to the cost curve at all distances. We will, however, restrict the carriers' discretion to propose structural changes which have the effect of moving the fare curve farther from the cost line at any distance than the fare curve we have adopted herein. Throughout the various phases of this investigation, one of the Board's overriding concerns has been the development of a fare structure as closely cost-based as possible. For this reason, we believe it essential that the Board prescribe the parameters of the fare structure if our efforts are not to prove an exercise in futility. Within these limited constraints, carriers will remain free to initiate fare changes by filing tariffs subject to our powers to suspend and investigate.

In sum, a denial of fare flexibility as here proposed will not prevent carriers from establishing changed fare levels consistent with the provisions of the Act. Nor does our decision in any manner prevent carriers from offering new types of service at fares commensurate with costs. Thus, fare flexibility is already possible whenever factors justifying its existence are present. However, considering the pricing history of this industry and the true economic incentives associated with increases or decreases in fares, we continue to believe that a close monitoring of proposals for fare changes is necessary if the public is to be protected from unreasonable fares and the economic viability of the industry maintained.

[APPENDIX 3]

Before the Civil Aeronautics Board, Washington, D.C.

[Docket 8008 et al.]

(E-16068)

GENERAL PASSENGER FARE INVESTIGATION

(32 CAB 291, 328–31)

Decided November 25, 1960

RATE LEVEL

As noted earlier, the unreliability of the expense and revenue forecasts in the record makes it impossible to determine the proper fare level in this proceeding. We have therefore confined ourselves in this opinion to the fixing of the standards which will be employed in regulating future fare levels. There remains for consideration the question of the method of employing these standards in future cases.

Essentially, the major problems of application of the standards fall into two categories : a) the extent to which the fare level should be based upon results to be anticipated over an extended period, and b) the extent to which fares should be regulated on an industrywide basis.

a) No party has suggested that we attempt to regulate fares so as to produce a particular rate of return for every 12-month period. It is manifest that in an industry in which costs and revenue factors tend to fluctuate and are difficult to forecast precisely for any short-term period, any attempt to maintain a constant rate of return would be futile. There is thus general agreement among the parties that the fare levels must be regulated to produce a reasonable return over an extended period of time.

This is not to say that short-term considerations need always be ignored. For example, if fare relief is necessary to prevent financial ruin to the bulk of the industry, we would clearly not be justified in refusing such relief on the ground that the adverse factors responsible for the industry's condition were merely of a temporary nature. Thus, the extent to which short-term factors would be influential in affecting the fare level must depend on the length of time those factors are expected to remain operative and the magnitude of their impact on the carriers' operating results.

From the foregoing it is apparent that the problem of determining when and for what periods fare adjustments should be made cannot be relegated for solution to any mechanical device. For this reason we do not believe that the 5-year moving average formula proposed in the initial decision is practicable.21 Rather, the determination of when to permit fare adjustments and the length of the future period which should be considered in making these adjustments can be resolved only on a case-by-case basis, applying informed judgment to the task of balancing the relevant factors.

(b) The second major problem in the application of standards relates to the so-called unit of ratemaking. Section 1002 (e) (5) sets forth, as one of the factors to be considered in ratemaking, “the need of each air carrier for revenue sufficient to enable such air carrier under honest, economical, and efficient management, to provide adequate and efficient air service." While we are thus enjoined to take into consideration "each” carrier's need, we are also faced with the facts that a large part of the domestic route structure is served by two or more carriers in competition, and that fares must be uniform as between them, notwithstanding that one carrier's revenue need may be less than another's. In short, we must reckon with the vexing problem of how to reconcile the statutory mandate to consider the need of "each” carrier with the hard fact that fares cannot be regulated on an individual basis. Specifically, shall fares be fixed to meet the needs of the carriers as a group, of the smaller trunks, of the poorest situated carrier or possibly even of the most favorably situated ?

The initial decision concluded that fares should be set at levels which would meet the average of the costs, including return, of the bulk of the industry. In effect, the entire domestic trunkline industry would be treated as a single unit and would be regulated so as to produce an overall rate of return to the industry equal to 10.6 percent, the weighted average of the returns which were found reasonable in the initial decision for the “Big Four” and “Medium Eight” carriers, respectively. The parties disagree among themselves as to the propriety of this "bulkline" approach. Some of the carriers and bureau counsel agree that the nature of the industry requires that fare levels be set on the basis of the industry as a whole, whereas other carriers and the GSA argue that the initial decision method violates the requirement of section 1002 (e) (5) that we consider the need of "each” carrier. We agree in general with the result, although we reach that result by somewhat different means and would subject it to some qualifications.

21 The initial decision found that rates should be set by a formula under which average earnings would be fair and reasonable over a reasonably extended period, yearly and 5-year averages being given special consideration. Under this formula, yearly and 5-year earnings of the industry would be allowed to fluctuate between an average of 10 and 12 percent on investment. Carriers would be allowed fairly high rates in an individual year if the 5-year average is low, and consideration would be given to raising the fare level if the earnings for a particular year fall below 10 percent, and to lowering the fare level if the 5-year average rate is above 12 percent.

We note that the formula would have the effect, at least partially, of adiusting future rates to compensate for past earnings deficiencies or excesses, a result which appears at war with the doctrine of T.W.A. V. Civil Aeronautics Board, 336 U.S. 601 (D.C. Cir.

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