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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 air mail under contract with the government. In 1935, the Congress broadened this regulation to prohibit carriers with air mail 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 regulator firms.10 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 two 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." Thus, the 'caotic and destructive" conditions which frquently are thought to be the 1938 Act's genesis are now only a matter of history.

As this history indicates, airline regulation must be viewed against the particular background of the circumstances which created it in order to understand its goals. Various parties involved in the drafting and passage of the original 1938 Act made references to their desire to allow regulation of "chaotic" competition among air carriers, and given the above description of the Act's historical context, such as desire seems understandable. 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

352 Stat. 973.

446 Stat. 259 (1930).

549 Stat. 619.

C. S. Rhyne, The Civil Aeronautics Act Annotated (1939), p. 35.

7 Id. 32-33.

8 Motor Carrier Act of 1935, 49 U.S.C. 301 et seq.

Rhyne, supra, 32-33.

10 The ICC advanced similar arguments with respect to competing surface modes. Boies, Experiment in Mercantilism: Minimum Rate Regulation by the ICC. 68 Colum. L.R. 599, 614 15; J. Meyer, M. Peck, J. Stenason, C. Zwich. Economics of Competition in the Transportation Industries 10 (1964); Report of the Attorney General's National Committee to Study the Antitrust Laws 269 (1955); Coordination of Motor Transportation, 183 ICC 263 (1932).

11 As noted above, certain of the noneconomic regulatory functions conferred upon the CAB's predecessor agency were later transferred to other agencies. See note 1, supra. 13 H. Rept. No. 2254, 75th Cong., 3rd Sess., April 28, 1938; 83 Cong. Rec. 5960. 13 S3 Cong. Rec. 6729-32.

14 Section 1, 49 U.S.C. sec. 1301.

directed the Board to observe conventional antitrust principles in deciding merger and interlocking control cases.'

15

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. Unlike the usual statute regulating a "natural monopoly," the Act does not require, but rather prohibits, government control of the regulated firms' investment in equipment or facilities, and of the specific services they provide under their certificates. Instead of detailed control of the rate base, regulation was extended to fares, entry and exit from specific routes, and agreements and mergers.

16

Other characteristics of the original 1938 Act seem to have been included largely because the Interstate Commerce Act was taken as a model. Thus the 1938 Act prohibited discrimination, preference or prejudice among various users of air transportation, required joint fares for connecting traffic, and allowed classification of regulated air carriers into various categories.

II. THE LESSONS OF MAJOR CAB ECONOMIC PROCEEDINGS

With that background on the origins of the present Act, I will now turn to the way it has been administered, and what we have learned in the process. Market structure

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.

In 1962, we opposed the proposed American-Eastern merger before the Board. The hearing examiner ruled in our favor, finding that consummation of the merger would create an airline with more than one-third of the entire domestic airline industry's business, greatly increase existing economic concentration in the airline industry, create a regional monopoly in the northeastern United States, and create numerous city-pair monopolies within that region. The merger proposal was subsequently withdrawn.

Ten years later, the Department opposed the merger of Western Airlines with American on similar grounds, although there was very little actual overlap between the American and Western systems. The hearing examiner recommended disapproval, essentially on nonantitrust grounds, and the merger was withdrawn after the Board issued an order disapproving it.

A merger proposal between National Airlines and Northwest Airlines, which we opposed on the grounds that it would increase concentration in the trunk airline industry and destroy important potential competition between the two merger partners, also was withdrawn after the hearing examiner issued a decision recommending disapproval on antitrust grounds. 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.

These merger proposals have raised very serious questions as to the proper structure of the industry, both as to the need for the proposed merger and as to its likely effect on competition and other important economic processes. 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 governmentcontrolled 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.

15 Section 408(b), 49 U.S.C. sec. 1378.

16 Section 401 (e) (4), 49 U.S.C. sec. 1371.

17 See American-Eastern Merger, Recommended Decision of Hearing Examiner Ralph L. Waser, docket 13355, November 27, 1962; American-Western Merger Case, orders 72-7-91 and 72-7-92, and docket 22916, June 13, 1972; Northwest-National Merger Agreement, Recommended Decision of Associate Chief Examiner Robert L. Park, docket 23852, May 22,

51-146 76 pt. 15

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, and there are some indications that these increased costs are caused by the difficulties of managing an airline of very large size.18

The reasons for this are apparent-the airlines' "right of way" is the air itself, and their "tracks" if any, are the air traffic control guideways maintained by the Federal Government. Well over 80 percent of the airlines' investment is in flight equipment, which is among the most mobile of assets, rather than in fixed assets, as is the case in the classical "natural monopoly." "19 Not only does this make competitive service economically feasible, but it makes duplication of routes far less risky, because competitors can more easily adjust their operations by rescheduling an aircraft from one city-pair to another-assuming that the government does not prevent them from doing so.

In view of this conclusion that air carriers will not become more efficient or more profitable by merging to become larger, why have so many mergers been proposed? Perhaps the most important reasons for mergers among the regulated air carriers have been the effects of regulation itself. Air carriers know that when they hold a certificate, it is the nature of economic regulation that the Board will to a greater or lesser degree protect them from entry by new competitors on that route. Similarly, the air carriers know that they cannot expand onto a new route without obtaining a certificate. Consequently, any certificated air carrier, no matter how poorly run and how debilitated financially an operationally, has one very valuable asset-its route certificate. This asset typically has been sold by merger of weak carriers into stronger carriers. As a result, no large federally certificated air carrier has gone out of business other than through merger with another federally certificated air carrier. Because the Board has allowed virtually no new firms to join the ranks of the certificated air ca.riers, there has been a steady diminution in the number of air carriers with certificates from the Federal Government.

It has been observed that during the period when California intrastate airlines were essentially free from economic regulation, many firms entered and left the market, but none of them left the market through merger. One very careful economic study of this phenomenon, and the contrast between unregulated California airlines and the regulated interstate airlines makes a convincing and apparently unrebutted case that in the absence of economic regulation, there probably would have been many more competing airlines in the United States than the CAB has allowed to exist.20

As long as new certificates are not freely given, one would expect that there would be some transfer of certificates as carriers seek to reorganize their route authorities. However, sale or trade of certificate authority has been fairly rare, although not unprecedented, because until lately the Civil Aeronautics Board did not encourage such "trafficking in certificates." Recently, the Board's willingness to consider transfer of certificate authority has led to a number of "route swap" proposals.

When there is limited entry, we believe that transfers of certificate authority very well may provide a practical means of reorganizing certificated route authority in a form more closely aligned with the economic or operational requirements of the air transportation system. The carriers' objective in a route swap is, of course, to increase profits. In cases where the increase in profits would take place because the route can be served more efficiently as part of the transferee's route system, we believe the transfer of authority may well be in the public interest. The motive for a route transfer, however, may be to eliminate competition, as where two carriers both possess authority on a given route, and one proposes to

18 In the American-Western Merger Case, docket 22916, see exhibits DOT-T-1; CO-RT500, pp. 7, 16-24; CO-R-512-517; CO-R-528-529; RW-120-125; RW-SR-900; BOR-R100. In the National-Northwest Merger Case, docket 23852, see exhibits DOT-T-1, DJ-1, DJ-RT-1, and Transcript pp. 1412-13.

The numerous academic studies in this area apparently all conclude that there are no economies of scale in the airline industry above the size of the very smallest air carriers. See sources cited in G. Douglas and J. Miller, Economic Regulation of Domestic Air Transport (1974), pp. 14-15, and W. Jordan, Airline Regulation in America (1970), pp. 191-194. The Board itself has endorsed in general terms the conclusion that there are constant returns to scale in the industry. Domestic Passenger Fare Investigation, phase 5-Discount Fares, order 72-12-18 (December 5, 1972), p. 48.

19 American-Western Case, supra, exhibit DJ-RT-1, p. 5; see also order 72-12-18, supra, p. 48. 20 Jordan, supra, pp. 14-33.

21

transfer its authority to the other, eliminating competition between the route swap partners on that route. In such cases the public is likely to be injured by the reduction in competition on that route. We have opposed some anticompetitive route exchange proposals, notably the American-Pan American route exchange involving Caribbean and South Pacific routes, and the Pan AmericanTWA agreement,-2 which involves both Atlantic and Pacific routes. Generally speaking, route transfers, including the reciprocal route transfers currently called route exchanges, are merely partial mergers. Consequently, as with mergers, there would be far fewer route transfers, if any, in the absence of entry restrictions.23

We have seen that the "natural monopoly" argument for regulating entry and exit finds no support in the facts of air transportation economics. Other asserted reasons to regulate entry and exit from air transportation markets are that without such regulation, there would be "destructive," or predatory conduct by airline firms, and "chaotic" conditions would constitute a serious public detriment. Let us examine these fears in turn.

In order for predatory conduct to pay off, it is necessary for a firm to go through two processes: First, it must drive competitors from the market by using predatory practices, such as below-cost price cuts; this kind of conduct is costly to the would-be predator. Second, the predator must recoup those costs by using the resulting freedom from competition to behave like a monopolist. This second step will not be possible if the firms which were driven out can reenter the market quickly and easily. As I have explained, entry into air transportation markets generally would not be difficult to accomplish quickly if there were no government restriction. Accordingly, the economists who have written on this matter have concluded that the prospects for profitable predatory conduct are poor in this industry."

Given these economic facts, government regulation of entry actually can cause the predatory conduct it is supposed to prevent. A government prohibition on entry can be the most effective insurance possible for a predator which is trying to recoup the costs of predatory conduct.

Of course, if predatory conduct does take place in the airline industry, it is subject to the antitrust laws just as it is in another industry, if it is not somehow immunized by government action.

In the New England service investigation, where the benefits of entry and exit regulation for small (and presumably relatively less stable) air carriers were directly in issue, the Administrative Law Judge found on the basis of the record that there had been no evidence of predatory behavior.25 The proponents of entry and exit regulation in that case argued, and the Board agreed,26 that there is a public interest in "continuity of service" which requires some entry and exit regulation. We question this re ult, in view of the Administrative Law Judge's uncontroverted finding that although commuter carriers had entered and exited several New England markets, there had been no significant lapses of service to the public because of this turnover." In light of these facts, the "continuity of service" which entry and exit control brings is not an assurance of service to the public, but an assurance of tenure to the carrier. Essential public facilities such as grocery stores and pharmacies do not enjoy this type of protection from competition, and we see no reason why air carriers should.

Pricing

The Department of Justice has been very selective in participating in fare proceedings at the Civil Aeronautics Board, because the economics of the industry change rapidly enough to seriously limit the future applicability of many decisions as to specific fare levels. As a result, participation in complex proceedings on specific fares may produce considerably less important benefits than one would expect from the same expenditure of effort in a structural proceeding. The Department did participate in the Board's recent Domestic Passenger Fare Investigation (DPFI), however, because we believed the Board's decisions in that pro

21 American Airlines, Inc.-Pan American World Airways, Inc. Route Exchange Agreement, docket 26245 (pending).

22 Application of Pan American World Airways, Inc. and Trans World Airlines, Inc. for Approval of an Agreement, docket 27114, et al.

23 See American-Western Merger Case, exhibit DJ-RT-1, supra, pp. 6-10.

24 See sources cited in A. Kahn, The Economics of Regulation, pp. 219-20.

25 Initial Decision of Administrative Law Judge Greer M. Murphy, docket 22973, July 9, 1973. p. 75.

20 Order 74-7-70, July 17, 1974; p. 15.

Initial Decision, New England Service Investigation, supra, p. 75.

ceeding not only would bring important revisions in the level and structure of all domestic airline fares, but would set the rules under which that level and structure would be set for many years to come. Largely on the basis of comprehensive evidence produced by the Department of Transportation, we became convinced that airlines would be more efficient and less likely to engage in wasteful service competition-flying empty seats and piano bars-if the Board encouraged them to compete on the basis of price, instead of preventing them from doing so by fixing one fare which all carriers must charge.

The key point here is that the economic characteristics of the airline industry are such that even when the government eliminates price competition, carriers still have the incentive to compete, and will compete any way they can, if only through "frills" which are less important to passengers than price. Once a flight is scheduled, the cost of carrying additional passengers in the airplane is very low compared to the cost of flying the airplane in the first place. Thus, the marginal passenger on a flight is very profitable-any competitive initiative which diverts passengers onto an airilne's flight may pay off richly.

In scheduled service, it appears that next to price, the variable most important to the passenger on a scheduled airline flight is the ability to find a seat on a flight at or near his preferred departure time. Consequently, when the price is fixed, competitive rivalry is diverted into capacity competition-competing carriers offer large numbers of flights in an attempt to cover as many preferred departure times and attract as many customers as possible. The evidence in the recent capacity agreements case is quite convincing that, even under the present system of uniform fares, carriers do not have the incentive to offer ruinous amounts of capacity simply because of this phenomenon. But it is clear that fare regulation has caused the airlines to offer the consumer large numbers of flights and empty seats instead of cheaper transportation. Stated another way, they have tended to "compete away" the "monopoly profits" generated by excessively high regulated fares.

Allowing price competition by the airlines would give them an incentive to offer consumers a choice as to the combination of fare and load factor they want, and all the evidence is that the result would be that lower fares would be available to the users of scheduled interstate fight. The experience of the intrastate carriers in California and Texas confirms this. Of course, higher load factors also would be involved-but all this tells us is that the public would rather pay considerably less for travel even at the price of being somewhat less certain of getting on their first choice of flight. Accordingly, we were disappointed when the Board rejected the arguments of the Department of Transportation and Justice in favor of allowing air carriers to price freely within a "zone of reasonableness" instead of requiring a rigid adherence to one identical fare for all carriers offering service in a particular market.

We were gratified that the Board decided in phase 6 of the DPFI to base its fare decisions upon load factor and seating configuration standards which excluded from the rate base any service amenity not included in the Board's standard for such service.

Under the Phase 6 policy, the fare is based on the amount of capacity associated with a standard load factor, in a standard aircraft configuration set by the Board, rather than the actual load factor and configuration of a particular carrier or the industry. We believe this approach can allow carriers greater freedom to experiment with different levels of capacity and types of service without being deprived of the motive to keep their services as economical as possible. In Phase 6 and the related coach lounge proceeding," we argued that the Board violated the spirit of its Phase 6 policy by attempting to punish a carrier offering a different type of service by requiring that carrier to charge a different fare, rather than simply requiring that carrier to charge a fare based upon the more economical aircraft configuration which the Board adopted as its standard. This was the first proceeding in recent years in which we carried our disagreement with the Board to the Court of Appeals, and this matter is now pending rehearing en banc on the Board's motion after a decision favorable to our position.

We also have pending in the Court of Appeals a review of the Board's decision to extend rate regulation to the charter field for the first time, despite numerous arguments in opposition.

28 Chicago-Los Angeles Fare Reduction Case, docket 25587, now pending action by the court of appeals as Continental Airlines, Inc. v. Civil Aeronautics Board, D.C. Cir. Nos. 73-1714, 73-1718.

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