45

the PUC authorized service by Air California, Holiday Airlines and California Sierra Airlines (subsequently replaced by Sierra Pacific Airlines). From the viewpoint of this Subcommittee, the relevant fact is that in recent years the absence of CAB regulation has resulted in four additional airlines providing scheduled service with large aircraft within California. Thus, there is appreciably more airline rivalry in California today than there would have been under CAB regulation. This is obviously undesirable to the CAB-regulated airlines, but it has demonstrably benefited many California residents and visitors, and it has certainly not resulted in "a single carrier monopolizing all of the California markets," neither in 1965 nor in 1975.

REGULATORY PROTECTION

46

Mr. Mitchell is right when he says that the PUC "has given great protection to the regulated (intrastate) carriers," but his further statement that "[n]o competitive authority has been authorized" is incorrect. Between 1968 and 1974 the PUC-authorized rival service between Air California and PSA in the following seven city-pairs: Burbank-San Jose/Oakland, San Diego-San Jose/Oakland, Sacramento-Ontario/San Diego, and short-haul San Jose-Oakland." Furthermore, in 1973 the PUC authorized Holiday Airlines to carry local passengers in the San Diego-Los Angeles, Los Angeles-Burbank and Los Angeles/BurbankSan Jose/Oakland city pairs on flights also serving Lake Tahoe." This provided limited rivalry to PSA's unrestricted services between those cities.

There is no question but what both the PUC and the CAB have given route security to the airlines under their respective jurisdictions. There is also no question but what the adoption of regulation was supported by the trunk carriers in 1938 and by PSA in 1965. Indeed, this support of regulation by the concerned carriers is extremely relevant evidence about their perceptions of who benefits from government regulation. There is considerable question, however, about Mr. Mitchell's statement that PSA's management believed it could not obtain the necesary financing to buy Boeing 727 aircraft "without the security of a certificate," ,"49 and there is also some question that "there was a public outcry for an end to the uncertainty and chaos resulting from the free entry and exit of the intrastate air carriers." 50

51

Several pieces of information are relevant to the matter of buying new Boeing 727's. First, PSA was able to finance and purchase six new Electras between 1959 and 1963 without the benefit of regulated route security. Second, during the six years from 1959 through 1964, PSA accumulated profits after taxes of $7.3 million on total operating revenues of 76.0 million-hardly a record that would discourage investors, especially in light of the low profits of the CAB-regulated airlines during the early 1960s.52 Third, note 1 of PSA's 1964 annual report contains a full description of PSA's financing for its first six Boeing 727's and, as can be seen by reading appendix A of this testimony, there is no indication in that note of any undue financial difficulties. This, even though the arrangements were completed in February 1965, several months before the enactment of assembly bill 413 gave the PUC the power to grant route security to PSA.53

Whether or not there was actually a "public outcry" for regulation is more difficult to determine. The first attempt to extend substantial PUC regulation over intrastate airlines occurred back in early 1949. If there was a public outcry for such regulation it was unsuccessful, for Senate bill 1624 was not enacted.54 Appendix B of this testimony gives two editorials from that period which opposed or questioned the purpose of that bill, so it is clear than any possible outcry was not unanimous.

45 William A. Jordan, supra, note 2, at 7. Mr. Mitchell mentions Air California and Holiday Airlines on pp. 12 and 13 of his statement, but he overlooks Sierra Pacific Airlines. 46 James L. Mitchell, supra, note 1, at 12.

47 PUC decisions 74248 (June 11, 1968), 76110 (Sept. 3, 1969), 79085 (Aug. 24, 1971), and 83476 (Sept. 17, 1974). PSA's successful effort to eliminate Air California from the Burbank-San Jose/Oakland city-pairs is described in William A. Jordan, "Some Predatory Practices Under Government Regulation?" 10-22 (University of Toronto-York University Joint Program in Transportation, Research report 26, January 1975).

48 PUC decision 81893 (Sept. 14, 1973).

49 James L. Mitchell, supra, rote 1, at 12.

50 Id. at 11-12.

William A. Jordan, supra, note 4, at 42-43. Also, PSA Annual Report, 1 (1973). 52 Id. at 336-38. Also, CAB, supra, note 27, at 74

3 Id. at 2.

onate bill 1624, introduced Apr. 26, 1949.

51-146 O 76 pt. 1 - 40

56

My own intensive study of the California intrastate carriers began in January 1965,5 yet I was unaware of the State Legislature's plan to increase the PLC's jurisdiction over intrastate passenger airlines until my first visit to the PUC's offices in early March 1965. At that time a PUC official advised me that assembly bill 413 was being considered and, when I asked why this was happening after so many years of unregulated service, his reply was to the effect that this time PSA supported the legislation. If there were a public outcry favoring regulation one would expect it to be reflected in newspaper articles of that period. In the course of my research I went through the clipping files of the Los Angeles Times and the San Diego Tribune looking for information concerning intrastate carriers. Nowhere in those files did I come across an article containing statements from passengers (or others) complaining about intrastate-carrier service and asking for airline regulation. Mr. Mitchell may be able to supply contrary evidence, but until he does my experiences lead me to believe that assembly bill 413 was enacted with little publicity, let alone "public outcry.”

57

EFFICIENCY AND LONG-RUN PROBLEMS

Unfortunately, Mr. Mitchell failed to focus on that part of my testimony concerning the effect CAB regulation has had in substantially decreasing airline efficiency. The evidence that regulation greatly decreases efficiency (and increases costs) should be particularly disquieting to the regulated airlines because it indicates that there is a fundamental economic weakness in their position even if they are successful in maintaining the regulatory status quo. The history of the regulated airlines has been one of recurrent financial problems despite an overall secular growth rate since World War II of 12.7 percent per year, compared with a growth in constant-dollar GNP of 3.5 percent.5 Thus, there is reason to predict even more problems will occur under existing regulation should the airlines enter a period of small growth or, eventually, secular decline.

The conclusion of my testimony mentions two legislative alternatives to the status quo which would serve to increase airline efficiency. One alternative is to "perfect" CAB regulation by placing every significant aspect of airline operations under the control of the Board. The second alternative is to deregulate by abolishing the CAB's control of entry and exit and to allow any airline to lower its fares without regulatory constraint.59 Furthermore, under this second alternative the airlines would be subject to existing antitrust laws.

60

The CAB has been moving in the direction of the first alternative over the past six years by authorizing an increasing number of capacity agreements and by discouraging other aspects of service-quality rivalry such as lounges and liquor "wars." The perfection of CAB regulation may have considerable appeal to many airline executives and investors since it should do much to solve the current financial problems of some of the airlines. At the same time, however, this move would be detrimental to airline suppliers such as aircraft and engine manufacturers, would decrease the quality of service offered passengers without compensating decreases in fares, and would allow unions and other monopolistic suppliers of inputs to increase the prices of their inputs or to establish work rules

55 On pages 2 and 3 of his statement, Mr. Mitchell reports that most of the research for my dissertation was done while I worked at Western Air Lines from 1960 to 1964. I wish that had been the case, both because it would have resulted in the dissertation being completed in 1966, rather than 1968, and because I much prefer being paid to do research. Unfortunately, as reported in the preface to my book, while my work at Western made me keenly aware of the intrastate carrier "problem," and thus was necessary for the conception and design of the dissertation, the actual research was undertaken primarily between January 1965 and August 1967 while I was a doctoral student at UCLA and an acting assistant professor at Stanford University. During this time, however, my friends and former associates at Western very generously allowed me to use Western's library of CAB publications, tariffs, Official Airline Guides and files concerning Western Air Lines of California. These were very important contributions to the study.

56 Conversation with Mr. John L. Pearson, California Public Utilities Commission (Mar. 8, 1965).

57 William A. Jordan, supra, note 2, at 29-43.

58 Total certificated route air carriers produced 791 million revenue ton-miles in 1946 and 22,425 RTM in 1974. Gross national product in 1958 dollars increased from $312.6 billion in 1946 to $821.1 billion in 1974. CAB, supra, note 27, at 12, and Air Carrier Traffic Statistics 1 (December 1974). Also, Economic Report of the President, 250 (February 1975).

59 William A. Jordan, supra, note 2, at 46–47.

60 William A. Jordan, "Airline Capacity Agreements: Correcting a Regulatory Imperfection," 39 Journal of Air Law and Commerce, 184-93 and 202-5 (spring 1973).

whereby less input is received for a given price. This latter point is very important because it implies that while short-run efficiency is possible through increased regulation, the long-term picture is not encouraging.

In addition to the long-run efficiency problem, unless those administering this "perfect" CAB regulation prove to be remarkably perceptive and responsive to the development of substitutes for airline services and to this and other sources of changes in the demand for airline services, the perfection of regulation has the added drawback of introducing rigidities and economic excesses that will hasten the decline of the airline industry. A Penn Central type problem is much more likely under the extensive regulation of a few large airlines than under the deregulation alternative. Deregulation would result in services being provided by many smaller airlines. Not only would these airlines have to be responsive to economic changes in order to survive, but the failure of any one or several of them would cause little dislocation in the economy. The recent proposal to merge Pan American and TWA is only one indication of how merger, a frequent regulatory solution to airline problems, could result in the development of an airline that was so large that its demise would yield a crisis for the nation.61

Since increased regulation promises immediate solutions to problems, and since short-run solutions are often given priority over long-run solutions, the alternative of "perfecting" CAB regulation is one that will have considerable appeal. Some specific suggestions on how CAB regulation can be improved are presented in one of my recent papers which the Subcommittee may find useful.62 Mr. Mitchell, however, chose to emphasize possible problems resulting from deregulation, so the following sections of this testimony will respond to some of his analyses and predictions concerning deregulation.

SERVICE TO DENSE MARKETS ONLY?

A frequent prediction by airline executives is that without CAB regulation scheduled airline service would be available only over the densest routes connecting the largest cities in the country. Mr. Mitchell makes one of the milder statements in this vein when he says "[a]t most, a few carriers will survive and they will tend to limit their activities to the densest markets.'

1 63

There are several things wrong with this prediction. First, it is inconsistent with the California intrastate experience. Second, it ignores the long-standing policy of, initially, the regulated trunk carriers and, now, the local-service carriers to drop small cities from their routes. Third, it is inconsistent with the law of diminishing marginal returns.

Evidence on the California experience is presented in my book." Actually, as discussed above, the efforts of the intrastate carriers to serve small city-pairs are quite remarkable given the prior coverage of the subsidized CAB-regulated airlines in California.

The relative coverage of small cities by various classes of airlines is also instructive. As of May 1, 1973, the trunk carriers provided service to only 183 communities in the 48 contiguous states, compared with 401 for the subsidized local service carriers and 333 for the unregulated and unsubsidized commuter carriers. Of the 244 unduplicated communities with 1970 populations of 25,000 or less having scheduled airline service, the trunk carriers provided service to only 17 (at ten they provided the only service), while the local service carriers operated at 129 such communities, and the communter carriers at 132 (102 of which received their sole service from a commuter carrier). When it comes to unsubsidized service, small communities clearly received much more service from the unregulated commuter carriers than from the regulated trunk carriers. If deregulation meant the termination of trunk-carrier service at such small communities, the loss would be negligible and would quickly be taken up by commuter or local service carriers.

66

The law of diminishing marginal returns says, simply, that if you hold one physical input constant and increase the use of another input, eventually the

61 Charles E. Schneider, "Banks Asked to Support Pan American," 101 Aviation Week and Space Technology, 31-32 (Sept. 23, 1974).

62 William A. Jordan, "If We're Going to Regulate the Airlines, Let's do it Right," James C. Miller III, ed., Perspectives on Federal Transportation Policy (1975).

63 James L. Mitchell, supra, note 1, at 13.

64 William A. Jordan, supra, note 4, at 17-24, 115-33 and 258-59.

65 CAB, A Profile of Airline Service in the 48 Contiguous States, May 1, 1973, table 1 (December 1974).

66 Id. at tables 3, 4, 5 and 9.

marginal output from using more of the second input reaches a peak and begins to decrease. A common classroom example is adding fertilizer to an acre of land to grow wheat, but an analogy for the airlines would be adding airplanes to a single major route, such as New York-Chicago-Los Angeles, to produce airline service. The results of operating over 2,000 aircraft eight hours a day on this single route are obvious and ludicrous." Somewhat less obvious, but equally ludicrous, would be the operation of more than 2,000 aircraft over routes connecting just the top 100 city-pairs. The law of diminishing returns predicts, and quite reflection supports, that aircraft fleets would be dispersed over the entire U.S., covering high, medium- and low-density routes until the cost (including the market rate of return on investment) of producing the last flight with a suitable aircraft on each route would roughly equal the revenues obtained from that flight. This doesn't mean that scheduling would be error free. Scheduling mistakes are made under regulation and they would occur without regulation. The difference is that without regulation open entry would quickly discipline those who make frequent mistakes, while the discipline of the market works more slowly under regulation.

SERVICE QUALITY AND FARES WITHOUT REGULATION

1968

The California intrastate experience leads Mr. Mitchell to believe that "over the long term, fares would be higher and service would be inferior to that existing under a properly regulated system." Unfortunately, it is impossible to make a precise evaluation of this statement because the characteristics of "a properly regulated system" are not specified. However, assuming such a system would have many of the properties of historical CAB regulation, the California experience does demonstate that service quality without regulation would indeed be inferior to that existing under CAB regulation. Without regulation coach service would be even more dominant than it is today and there would be little first-class service; aircraft design would emphasize low operating costs relatively more than the traditional emphasis on service quality; and passenger load factors in excess of 70 percent would be the norm rather than the present-day 50to 55-percent average.9 But, in contrast to Mr. Mitchell's prediction, the California evidence is clear that without regulation fares would be as Lauch as 50 percent lower than the coach fares authorized by the CAB. The great acceptance of intrastate-carrier service in California indicates that a majority of passengers prefer this tradeoff of somewhat inferior service quality for much lower fares."

DISTORTIONS FROM PROTECTED INTERNATIONAL OPERATIONS

Mr. Mitchell raises the interesting possibility that, with open entry domestically, carriers having governmental protection in their international operations would enjoy "a substantial competitive advantage" over carriers limited to domestic operations." If this were truly an important advantage, TWA should now be the dominant transcontinental carrier (which it is not), and American should have fought to retain its North Atlantic routes in 1950 and its South Pacific routes in 1974 (which it did not).

Actually, the California experience provides relevant evidence regarding this matter. As far as airline regulation is concerned, California can be considered to have been a "country" with entry open to any carrier on its domestic routes, but with controlled entry into "international" routes to all other countries, including those 47 "sovereign states" located to the north and east of it. Despite the limited geographic size of the "country" of California and the resulting relatively small demand for "domestic" airline services, its unprotected "domestic" carriers set the basic service-quality and fare levels wherever they provided service, and were able to force the protected "international" airlines to offer low-fare coach services in those city pairs. True, the citizens of California were greatly benefited by their airlines, and only the most efficient of the California carriers were able to survive, but those few carriers that did survive were also benefited by their government allowing them the opportunity to enter and

67 The system fleets of all trunk carriers (minus Pan American) and local service carriers totaled 2,164 aircraft as of Dec. 31, 1972. CAB, supra, note 27, at 1-2.

68 James L. Mitchell, supra, note 1, at 4.

69 William A. Jordan, supra, note 4, at 34-56 and 200-209.

70 William A. Jordan, supra, 1 ote 2, at 7-29

71 James L. Mitchell, supra, note 1, at 14.

test their mettle against the protected "international" airlines. To use Mr. Mitchell's word, the results may have been "distorted" from what would have occurred had entry been open in the much larger market provided by the 47 adjacent "countries," but many consider the results to have been preferable to the other distortion that would have occurred had entry never been open so that California would have had to depend on "international" airlines for all of its airline services.

Mr. Mitchell points out a major problem faced by airlines with "international" routes when he says "the markets these stronger (international) carriers would tend to serve would have little to do with domestic air transportation needs of the public. The markets served would be those best suited to international travel, and the services would be so geared." " This may explain why the certificated trunk carries were unable to maintain their dominant positions in California city pairs large enough to support two or more carriers. The specialized California intrastate carriers geared their services to the air transportation preferences of the California public, and the majority of these passengers responded by utilizing those more convenient services. The same would occur were all U.S. city-pairs open to any carrier meeting FAA operating standards. To the extent carriers with international routes geared their services to international demand they would be at a disadvantage in domestic U.S. routes.

Mr. Mitchell also states that "carriers with strong international routes would have a substantial competitive advantage which could and undoubtedly would be used to improve their economic position to the detriment of carriers without such protected routes." " I assume he means that profits from international routes would support predatory pricing/practices by these carriers. Since 1958, there have been a number of studies of alleged predatory pricing in unregulated industries, and all have found predation to be relatively costly and, therefore, rare. I have recently completed a study of three alleged cases of predatory practices among airlines operating under government regulation, and my findings are generally consistent with the earlier studies." Predation appears to be a favorite spectre to be raised by suppliers who fear the "chaos" of open entry. It happens, however, that predation occurs much more frequently in speeches and tradejournal articles than it actually occurs in the economy. It may be that the CABregulated airlines practiced predation against the California intrastate carriers from 1949 to 1965. If so, they are certainly in a position to provide clear evidence to support allegations that carriers with international routes will have a predatory advantage over domestic carriers operating under open entry. But this evidence should be forthcoming before any great weight is given to such allegations.

DISTORTIONS FROM PROTECTED INTRASTATE OPERATIONS

"At the other end of the spectrum, the air transportation system would be distorted by protective action by state aeronautic boards and public utility commission." ."75 This is another interesting idea and it has antecedents in the railroad industry through 1920. The problem for the railroads was largely resolved by the Supreme Court and Congress in favor of the primacy of interstate commerce. .70 Similar decisions for the airlines would be even more effective since the comparative advantage of the airlines is in long-haul transportation, making interstate traffic much more important in airline than in railroad operations. If nothing else, the relative size of interstate traffic is evidenced by the fact that there are only a few states in which intrastate airlines have appeared.

Appendix B of my original testimony shows that intrastate city-pairs provided 21 out of the top 100 origin-destination city-pairs in 1972 in terms of passengers (but not RPM)." However, 14 of these 21 city-pairs were located in California and two were in Texas, leaving only five more large intrastate city-pairs in the remaining 47 states (excluding Hawaii). Also, there is no evidence to date that state regulation in California and Texas has been detrimental to passengers. Furthermore, even assuming full carrier protection, it is difficult to imagine many

72 Id. at 15.

73 Id. at 14

74 William A. Jordan, supra, note 47. Several of the earlier studies are noted in this

paper.

75 James L. Mitchell, supra, note 1, at 15.

76 Gabriel Kolko, Railroads and Regulation, 1877-1916, 164-69 and 217-30 (1965). 77 William A. Jordan, supra, note 2, at 50-52. The state of Hawaii is excluded since flights over international waters make all intrastate service subject to CAB regulation