Again, in these markets the carriers tend to earn neither excess profits nor losses.

So our general conclusion, based on this and additional information, is that there is not much cross-subsidy actually taking place. Senator KENNEDY. Very fine. Thank you very much.

[The prepared statement submitted by Mr. Miller for himself and Mr. Seevers follows:]

PREPARED STATEMENT OF GARY L. SEEVERS, MEMBER, COUNCIL OF ECONOMIC ADVISERS AND JAMES C. MILLER, SENIOR STAFF ECONOMIST

Economic Effects of Regulation of the Domestic Air Carriers by the CAB

Mr. Chairman, members of the Committee: We are pleased to appear before you today to discuss the economic effects of regulation of the domestic air carriers by the U.S. Civil Aeronautics Board.

For a number of years the Council has questioned the efficacy of airline regulation and suggested certain reforms. As a matter of fact, our most recent economic report,* published just two days ago, contains a section which discusses airline regulation and which implies that certain reforms are needed. A copy of that section of the report is attached as an appendix to this testimony.

In the remainder of this testimony we outline what we consider to be the major costs of CAB regulation, we examine the economic performance of a hypothetical deregulated air carrier market, and we indicate the kinds of regulatory reforms the Administration now has under review.

THE COSTS OF AIRLINE REGULATION

As they pertain to the airlines, economic conditions today are very much different from what they were in 1938, when airline regulation was established. At that time, the U.S. Government was attempting to promote an "infant" industry through an inefficient system of airmail subsidy. Basically, the Government granted contracts to air carriers and prevented competition on those routes where contracts were granted. Recognizing the potential for excess profits on passenger services then or in the future, carriers would "buy-in" on these contracts for extremely low rates.' This perfectly rational economic behavior on the part of the air carrier firms was then cited as evidence of "destructive competition" in the airline industry and thus a need for governmental intervention to "rationalize" competition." It was also said that governmental controls were needed to assure safety of operations.

Today, the domestic airline industry is no longer an infant industry in need of promotion; having increased in size since 1938 some 250-fold, by most standards it is now truly "mature". Mail contracts are no longer the vehicle for subsidy, and as a percent of total domestic revenue subsidy has declined from 31.6 percent in 1939 to less than 1 percent today. Except for minor payments to Northeast Airlines in the mid-1960's, the trunk carriers have been completely off subsidy since 1959.3 Air safety, which until 1958 was a primary CAB concern, is now vested with the Federal Aviation Administration of the Department of Transportation (DOT).*

Another important change in the nature of the industry and its regulation is that the principal city-pair markets today are served by two or more airlines.5

Economic Report of the President, Washington, GPO, February 4, 1975.

1 See Richard E. Caves, Air Transport and Its Regulators: An Industry Study, Cambridge, Harvard University Press, 1962, p. 124.

2 Note that the legislative "Declaration of Policy" admonishes the Board to create "Competition [only?] to the extent necessary to assure the sound development of an airtransportation system .. [Original (1938) language now contained as section 102(d) of the Federal Aviation Act of 1958, as amended.]

3 For a discussion of the existing subsidy mechanism and its deficiencies, see George C. Eads, The Local Service Airlines Experiment, Washington, The Brookings Institution, 1972. Responsibility for investigating air accidents was transferred from the CAB to the National Transportation Safety Board in 1966.

5 Note that from 1955 to 1971 the percentage of total revenue passenger miles attributed to markets where 2 or more carriers each accounted for at least 10 percent of the market rose from 55.6 percent to 76.6 percent. Sec, George W. Douglas and James C. Miller III, Economic Regulation of Domestic Air Transport: Theory and Policy, Washington, The Brookings Institution, 1974, p. 114.

Over a fairly wide range of prices, carriers, in equilibrium, will earn normal profits and thus, arguably, the choice of price is not material to them. However, the passenger's cost of service is greatly dependent upon the price and load factor option chosen by the Board. In esssence, the passenger's "full cost" of travel is the ticket price plus the "cost" of delays he, or she, incurs in waiting for a flight. We see in figure 1 the rather obvious proposition that as the average load factor rises the associated break-even fare falls. If this were the only element in the passenger's cost of service, public policy would dictate a fare consistent with load factors of near 100 percent. However, as load factor falls delay cost increases. Passengers find it more difficult to secure accommodations on the desired departure and flights are fewer, with more time in between departures. When translated into money terms this delay cost is as characterized in figure 1. The passenger's full cost of service is thus the sum of these two types of cost, i.e., ticket price plus delay, and, given these two curves, for some average load factor level the "full cost" is at a minimum, i.e., ALF.

13

A recent Brookings publication by Professors Douglas and Miller came to the conclusion that the Board has chosen too low a load factor standard, i.e., 55 percent as opposed to 60-65 percent, and consequently is promulgating fares which are too high. This means that the typical passenger is paying an "excess fare" which exceeds the value of the reduction in delay. This in turn means a higher full cost of service with no offsetting higher profits to carrier. Thus, there is regulation-induced excess capacity which represents a deadweight loss to society." Douglas and Miller estimate that during 1969 air passengers paid excess fares to domestic trunk carriers ranging between $366 million and $538 million, for which they received quality improvements valued at between $118 million and $182 million. This leaves a deadweight welfare loss in trunkline service for 1969 of between $248 million and $356 million.15

Since 1969 the Board has established target load factors of 55 percent as opposed to the then-prevailing levels of approximately 50 percent. However, the recent increases in fuel prices have raised the optimal average load factor to approximately 65-70 percent, so the present configuration of service is still characterized by efficiency costs on the same order of magnitude. Based on total domestic trunk revenues of $9,316 million for the year ending September 1973, this implies a current annual welfare cost for trunk service ranging between $355 million and $509 million.

There are additional costs of airline regulation. First, there is evidence that the relationship between the Board and the industry has resulted in a level, and structure, of fares which maximizes total capacity rather than one which maximizes total passenger traffic.16 This is illustrated in figure 2." Since some costs are "external" to the airlines and their passengers, this behavior has quite likely resulted in excessive investments in airport and airway facilities as well as excessive consumption of fuel.

Second, the Board's policy of protecting existing carriers from competition by preventing the entry of new carriers 18 not only means that the public has been denied lower price-quality options, but that potentially more efficient carriers have not been able to test the efficiency of existing carriers. Whether new carriers would have significantly lower costs is subject to considerable debate, but evidence on relative carrier costs and the evidence from unregulated markets certainly raises this possibility.19 There are two significant problems with this approach, however. First, a regulator is inherently less capable of administering resources "correctly" than is an individual competitive entrepreneur. The regu

13 In the DPFI the Board announced its intention of in effect setting fares at levels which would cover costs (plus a reasonable return on investment) on the basis of an industry-wide average load factor of 55 percent.

14 The analysis only briefly summarized here can be found in Douglas and Miller, ibid., chapter 6.

15 Miller and Douglas, ibid., p. 172.

་

16 See Arthur S. De Vany, "Effects of Price and Entry Regulation on Airline Ontput, Capacity and Efficiency," Bell Journal of Economics and Management Science, (forthcoming Spring 1975; and Douglas and Miller, ibid., pp. 60 and 176-77.

17 Rather than choosing fare level F*, the Board has chosen fare level F**. Figure 2 is adapted from De Vany, ibid.

18 Since regulation was established in 1938. not a single new trunk carrier has entered the market, and not a single trunk has exited the market except through merger.

19 See Robert J. Gordon, "Airline Costs and Managerial Efficiency" in Transportation Economics: A Conference, Columbia University Press for the National Bureau of Economic Research, 1965, pp. 61-94; Theodore E. Keeler, "Airline Regulation and Market Performance,' ," Bell Journal of Economics and Management Science, Autumn 1972, pp. 399-424; William A. Jordan, Airline Regulation in America: Effects and Imperfections, Baltimore, The Johns Hopkins Press, 1970, chapter 11; and Douglas and Miller, ibid., pp. 141-9.

(For illustration purposes only; not drawn to scale.)

lator neither has information as good as that of the entrepreneur nor does he, or she, have the appropriate incentives. Second, in terms of fact versus theory, the performance of the existing regulatory agencies causes one to be extremely skeptical of achieving good industry performance by relying upon regulation.

ECONOMIC EFFICIENCY OF DEREGULATED MARKETS

Costs of regulation such as those described above implicitly assume some alternative, usually and ideally, efficient markets. In real life, critics of regulation must be careful to identify realistic alternatives. Two such alternatives immediately come to mind: (a) “enlightened" regulation, and (b) total deregulation. On the one hand, it is entirely possible that a truly enlightened regulator could eliminate most of the costs described above. For example, in an ideal setting the CAB could adopt target load factors by market characteristic and accordingly, by regulating fares, eliminate the costs of "excess capacity."

20

At the other extreme is the hypothetical, completely deregulated, competitive market. The theoretical argument for the efficiency of deregulated airline markets is extremely powerful. The airline industry appears to conform closely to the necessary conditions for price competition: no significant scale economies," fairly elastic or firm demand, relative difficulty of coordinating pricing and output policies i.e., collusion, and, in the absence of controls, relative ease of entry and exit.

20 For this discussion, by the term "deregulation" and its derivatives we mean the elimination of economic regulation only, not the elimination of sofety regulation.

21 On the question of scale economies see Douglas and Miller, ibid., pp. 13-18 and the sources cited therein.

Finally, there are numerous regulator-imposed constraints on routings and service requirements which serve to raise costs. To our knowledge a precise estimate of all these costs has not been made. In our judgment this figure would be in the neighborhood of $1 billion per year, or around 10 percent of total domestic trunkline revenues.-3

Looking at the question of optimal price and load factor, with fare flexibility, a carrier would have an alternative means of attracting additional passengers: lowering price. The carrier could then judge the most effective way of attracting business: lowering price or providing more service. The result would be the appropriate market combination of price and quality. Moreover, in some markets there may well be a distribution of price and quality combinations that is desired by the public. Free markets provide incentives for this configuration to come about.

24

Under conditions of free entry and free exit, firms would have to stand a more substantive "market test" of their efficiency. More efficient firms would survive, and inefficient firms would be forced to exit. The removal of restrictions on routings would result in lower costs to consumers, and uneconomical markets would be abandoned. There might well be some "market imperfections," but in economic efficiency terms these would probably be fairly minor.

Of course, we would like to rely upon facts concerning deregulated markets as well as upon theory. Unfortunately, we do not have ideal tests of deregulation since the CAB has preempted truly comparable experiments. However, we do have two deregulated markets that are similar in many respects to CAB-regulated markets, except, of course, for differences in the degree of regulation.

First, we have the intrastate markets, which are outside CAB jurisdiction. Prior to 1965, the California Public Utilities Commission regulated maximum prices in intrastate air service, but not entry and exit.20 Professor William A. Jordan has made an extensive study of the history and economic character of this market and has concluded that in virtually all respects the California intrastate airline market is much more efficient than comparable interstate CABregulated markets." Even today, with tighter regulation, fares in California intrastate markets average much less than fares in comparable interstate markets.

A similar result was obtained in the Texas intrastate market, where Southwest Airlines, a carrier licensed by the Texas Aeronautics Commission, is in competition with Braniff Airways, a CAB-regulated trunk carrier, and Texas International Airways, a CAB-regulated local service carrier. Despite having its service introduction postponed nearly four years because of judicial challenges by Braniff and Texas International, the carrier is now serving the "golden triangle" (Dallas, Austin, and Houston) at a profit, charging fares which average some 20 to 50 percent less than comparable CAB-regulated fares.

28

The other major unregulated market is that of commuter airlines, previously known as air taxis. In 1952, faced with doing something about a plethora of illegal interstate air taxi operations, the Board simply exempted from regulation any interstate air carrier which utilized aircraft having no more than 12,500 pounds gross take-off weight.20 At that time it was thought that no operator could provide profitable scheduled operations with such small aircraft. Subsequently, however, technology changed, and equipment of this weight is now capable of carrying up to 19 passengers at reasonable comfort and speed and at relatively low cost. Today there are literally hundreds of such operators which provide regularly-scheduled service to low-density markets-and in some higher-density

22 Some of these have been instituted to assure service to points that the incumbent carrier might not ordinarily serve. To some extent, then, such costs are revealing of the resource costs of pursuing certain social "non-economic" objectives.

23 Note that these losses are not simply transfers from consumers to producers or from consumers to consumers. They represent the economic cost of squandered resources. 24 For example, a low load factor, low-density, high-amenity, high-priced service catering to business travelers, and a low-cost, no-frills service catering to the vacation traveler. At present such specialization is limited-another cost of regulation.

25 These include: (a) collusion over prices and/or service, (b) quasi-monopoly service in marginal markets, and (c) inefficient mixes of aircraft and frequencies. On the latter point, see George W. Douglas, "Equilibrium in a Deregulated Air Transport Market," paper delivered at a seminar on Problems of Regulation and Public Utilities, Dartmouth College, 1972, processed.

26 Since then control over entry and exit has been instituted.

27 Jordan, ibid. Also see Bureau of Accounts and Statistics. "Traffic, Fares, and Competition: Los Angeles-San Francisco Air Travel Corridor", Washington, U.S. Civil Aeronautics Board, 1965.

28 Under section 416(b) of the Federal Aviation Act.

29 That standard was recently changed to a 30-passenger capacity and a net payload of no more than 7,500 pounds.

markets, often in direct competition with trunk and local service carriers. Since with few exceptions these carriers receive no government subsidy, and since they are handicapped in terms of the size of the aircraft they may operate, they tend to serve marginal, or uncertain routes; thus, their turnover is judged by some as being fairly high. However, it is notable that such unregulated carriers serve many markets that CAB-reguiated carriers have chosen to abandon and that their service, given their equipment and the characteristics of their markets, is safe and reliable.

By no means has the brief discussion touched on all the characteristics of deregulated markets. In the space remaining, however, we should like to respond to the more significant criticisms raised by those who oppose less regulation of the domestic air transport system:

1. Without regulation, flights would be unsafe. Critics of deregulation argue that regulation is needed to insulate carriers from market forces; otherwise, the "dog-eat-dog' atmosphere of free competition would lead carriers to skimp on safety, to the public's detriment. There are several answers to this: First, the governmental instrumentality charged with air safety is the FAA, not the CAB. Deregulation, as we have defined it, would leave the FAA's role unaffected. Second, there is little direct evidence that economic regulation has had any effect on air safety. For example, the Board has never withdrawn or suspended the certificate of a trunk operator on grounds that its operations were unsafe, and its constraints on entry have seldom if ever revolved around issues of safety. One variant of the safety hypothesis is that high profits mean safe operations. However, when we tested this naive proposition over the period 1939 to 1953, for which there appeared to be adequate variations in profit rates and fatality rates to make a test feasible, we found the result contrary to what critics of deregulation would have predicted. While the net effect was small and statisically not meaningful, the result actually showed a positive relationship between industry profit rates and industry fatality rates."

30

32

2. Under deregulation there would be wholesale abandonment of markets, leaving only the "top-25" (or top-50 or top-100) markets with adequate service. This prediction is based, in essence, upon the assumption that CAB regulation presently constraints the abandonment of hundred of markets. In particular, it is argued that the present pricing structure enables a considerable amount of crosssubsidy whereby a carrier uses the excess profits from some markets to offset losses in others that presumably would not receive service under deregulated conditions. Miller and Douglas have found that the extent of this cross-subsidy is greatly overstated," and apparently the Board agrees. If this is true then presumably most alleged "losing" markets are in fact self-supporting and would not be abandoned if regulation were terminated. Second, even if one carrier abandons a market, this is not to say that some other carrier could not serve it at a profit. Third, there may be points which would be abandoned if carriers were restrained to the CAB-regulated fare, but free to charge a higher fare if need be, carriers could serve many such markets at a profit. There are numerous cases where trunks or local service carriers have abandoned markets that were later served by commuter carriers at a profit, often a slightly higher price and a more frequent service configuration.

3. Under deregulation, only a handful of carriers would survive. This could happen, but if it did such industry concentration would not be a problem. Since there are no pervasive scale economies, there is little reason to anticipate this outcome any more than one might anticipate the emergence of several hundred operators. However, even if only a handful of carriers did survive, the ease of entry into deregulated markets would act to "police" the market and thus prevent any abuses of monopoly power.

4. Under deregulation, prices and schedules would be unstable. Without doubt deregulation fares would be less stable than at present. After all, regulation has virtually precluded price competition. However, rates would not fluctuate broadly. The reason is that information is a scarce resource and carriers can reduce this expense and thus attract passengers by keeping such rates relatively stable. The

30 The result was as follows: Domestic fatality rate (passenger fatalities per 100 million miles flown) = 1.76+ (.009×domestic industry profit rate). (T-statistic on variable coefficient.25; equation R2.08.) Data sources: U.S. Civil Aeronautics Board. Handbook of Airline Statictics: 1971 Edition, Washington, GPO, 1972, p. 554; and Caves, ibid., p. 392. 31 Miller and Douglas, ibid., chapter 6.

32See CAB Order 74-3-82. March 18. 1974, pp. 66-72. Moreover, the Board has recently enunciated a policy of eliminating any cross-subsidy. (Ibid., p. 68.)

33 Perhaps the replacement carrier is more efficient, or the point is more complementary to its route system.

51-146 76 pt. 16