operate large aircraft, particularly the big supplementals. They operate as safely as any other carrier.

Mr. BAKER. I would like to amplify on that, from a sort of legal standpoint; and that is, I do not think anyone contemplates that the carriers are going to operate on what you might call a complete freefor-all basis. You do not have to have detailed economic regulation in order to impose upon a carrier various common carriage operations, if that is what you want. In other words, you can say, you have got to have tariffs, you have got to have schedules, you have got to fly people based on those tariffs, you have got to fly your schedules even if only one person shows up. And that, basically, would say that any consistent failure to perform common carriage types of obligations would be grounds for not allowing you to fly at all; and the notion that you have to tie together common carrier obligations to serve everyone in equal and nondiscriminatory terms with economic entry is just a mistake.

Mr. BREYER. All right.

I have nothing more, and I think we will ask for the last witness. to come to the table, and then I think we will recess for a few minutes. Mr. James Gagnon, of the Airport Operators Council?

We will stand in recess for 5 minutes.

[A brief recess was taken.]

[The prepared statements submitted by Mr. Baker and Mr. Kutzke follow. A followup letter from DOT pertaining primarily to this day's hearing is also included.]

PREPARED STATEMENT OF DONALD I. BAKER

I am pleased to present the views of the Department of Justice on the nature and effects of regulation of routes and entry in the airline industry, and to offer some tentative proposals for reform.

Two weeks ago, Assistant Attorney General Kauper gave this subcommittee a broad overview of the problems associated with Federal economic regulation of the air transportation industry. He pointed out that route regulation actually has had a detrimental effect on the public by denying the American people the type and price of transportation services they could purchase in a free marketplace. My testimony will expand upon those observations as they relate to routes and entry.

At the outset, however, I want to make clear that these questions are inseparably intertwined with the question of airline pricing rules to be discussed next week. In other words, if the present fixed price system were liberalized, to allow carriers to raise or lower their prices, the threat of new entry would be an important factor in determining whether in fact those prices were lower rather than higher. Conversely, if entry were liberalized (as we believe it should be), but nothing were done about pricing, the traveling public would gain little in the way of greater benefits: having more competitors does not insure better competition for the public, if regulators (or statutes) prevent those competitors from competing. Thus, as we review the history of procompetitive policy in California and Texas we should firmly have in mind the fact that pricing flexibility has been combined with essentially open entry policy. The history of CAB entry regulation is familiar, but quite different.

The existing statutory standard has not required the Board to operate the way it has in fact operated. The Board must consider competition, among other things, and it has done so always with an eye to the existing industry. The statutory standards should be revised to deal with this issue. Not only must the Board be required to give greater weight to the competitive process, but this will only prove meaningful if combined with measures that deprive the Board of authority to turn down a route and entry proposal on protectionist grounds. Stated another way, the problem has not been with the Board's authority, but

with its exercise of discretion. Any reform has got to look toward switching discretion from the Board to the managements of air carriers and new entrants. Nobody contemplates that all entry regulation would be eliminated. We and the Administration recognize that it is important that those who fly do so in safe planes, and that they be flown by qualified crews. However, these particular factors are capable of being quite objective, so that entry can be tied to the necessary Federal Aviation Administration certificates. Beyond that, entry into common carrier fields must be tied to ability and willingness to meet common carrier obligations. In other words, a common carrier would be obliged to have published tariffs and schedules and to fly in accordance with them. Any sustained pattern of failure to comply would provide a basis for a finding that the carrier was in fact unfit.

We intend, whatever form our proposals ultimately take, to insure that air service will continue to be a highly dependable means of travel. Liberalized entry need not-and indeed is not likely to lead to "fly by night" operators coming into the business. In this connection, it is worth realizing that the whole "common carrier" legal concept arose at common law in what was very often an "open entry" environment for such operations as stage coaching and innkeeping.

I. ADVERSE CONSEQUENCES OF ECONOMIC REGULATION

In enacting the Civil Aviation Act, predecessor to today's Federal Aviation Act, Congress in 1938 believe it was dealing with two problems. The first was the need to bring stability to the government-subsidized system of air mail carriers which had originated in the late twenties and had been regulated on a piecemeal basis since that time. The second was to encourage the development of the infant scheduled air transport industry in the chaotic economic conditions that characterized the Depression. Today, mail revenue has become a very small proportion of total airline revenues, and the major trunk carriers no longer receive subsidy. The airline industry has matured and attained a level of technological sophistication and size unimaginable at the time economic regulation was established. Today the short run economic prospects that confront the nation are not bright, but conditions are nowhere near the "chaotic and destructive" conditions that were perceived as threatening the very existence of commercial aviation in 1938.

Although the conditions that led to the institution of the economic regulation of airlines are now history, the regulatory system spawned by the Depression still is very much with us. Consequently, the discussion of the current need for regulation must center on an evaluation of what would happen to the aviation industry if regulation were substantially reduced.

The economic evidence accumulated over the past several years convincingly demonstrates that under regulation passengers have been compelled to pay higher air fares and suffer unresponsive service, and scarce capital, energy and other resources have been wasted by the airline industry through overinvestment in aircraft and excessive service competition.1

In exercising the regulatory authority over routes granted to it by Congress, the CAB has restricted the number of carriers permitted to perform scheduled air service, and also has restricted the ability of those few authorized carriers to enter new markets. Today, the number of certificated trunklines is half as many as the 19 which existed in 1938, though the number of revenue passenger miles flown has increased 238 times since that year, and over 70 percent of the revenue passenger miles flown by the trunk carriers in 1972 were flown in markets in which only one or two carriers were certificated. Carriers who already have route certificates can expect that additional entry into their markets will be restricted. It is not surprising, then, that there has been a lack of pricing competition in the airline industry, and several studies have demonstrated that these noncompetitive prices are higher than they would be in the absence of competition. Of course, the lack of price competition is aided and abetted by the CAB's regulation of prices, and the anticompetitive incentives built into the tariff mechanism. Regulatory protection from the threat of entry by carriers who could do a better job at a lower price is surely a major factor in the maintainance of high prices.

1 For a more extensive discussion of the following points and the evidence related to them, see testimony of Assistant Attorney General Thomas E. Kauper before this subcommittee, Feb. 6, 1975.

2 The Domestic Route System, CAB 1974, appendix A, table 10.

Perverse as it may seem, the existence of route regulation actually increases the incentive for airlines to engage in predatory pricing or other anticompetitive measures. An airline knows that if it manages to drive a competitor out of a market with regulated entry, it may obtain increased profits to cover earlier losses.

This observation leads to an important point: contrary to charges made by proponents of continued route regulation, it is not competition that leads to waste in the airline industry. Rather, waste results from the attempts of businessmen to fulfill their normal desire to compete in a regulatory environment which precludes meaningful entry and price competition. Consequently, airlines engage in capacity competition, give away alcoholic beverages, and offer other "frills" which probably would not be provided if free entry and price competition were permitted. Thus, regulation has not led to high industry profits; it has led to higher costs which dissipate the excess revenue generated by the industry's noncompetitive prices.

Excess capacity which may exist in markets where there is more than one carrier, result not from the existence of increased carrier entry and the resultant competition, but from the fact that the regulatory structure prevents carriers from competing in price and forces them to compete through the provision of services which might not be as important to passengers as a price cut. Intrastate carriers in California and Texas operating on a competitive, unregulated environment, have offered higher load factors and lower prices than routeregulated carriers.3

3

Supporters of the current regulatory scheme make the charge that without regulation of entry, service would be undependable. Experience, however, does not demonstrate that this would be the case. First, without regulation, the profit motive would return to its normal governing role: Businessmen would recognize that if they fail to provide dependable service, they soon lose their customers. Second, in the CAB's own New England service investigation, the Administrative Law Judge found that while individual air taxis which are not regulated by the Board might enter and leave particular markets, service continued to be provided by new operators, and the turnover on identity of firms providing that service did not inconvenience the public, as opposed to the carriers themselves.

It is not really all that surprising that private businesses not subject to economic regulation of entry and exit can provide a dependable, widespread service network. For instance, there is no Federal Hotel and Motel Administration, but the large chains do provide nationwide reservations so a traveler may arrange for lodging in a distant city and expect to find the hotel in business and his room awaiting him upon his arrival. But you can be assured, had a Motel Administration been established in the thirties, any attempt to abolish it today would be met by widely publicized fears of the collapse of the American economy due to the inability of business travelers to make dependable hotel and motel reservations.

Proponents of existing route regulation contend that without government regulation of entry and exit, our present air route system would severely contract, leaving numerous small communities without the air service they now enjoy under regulation. Whether this is likely or not is a highly complex issue, but it is a crucial one which must be resolved, because passengers on less heavily traveled routes should neither suffer unnecessarily in order to reform the system, nor receive hidden and quite expensive subsidies without an explicit and convincing justification.

This country's domestic air route system is a complicated, extensive network served by trunk air carriers, local service air carriers, intrastate air carriers, small carriers exempt from regulation under part 298 of the Board's regulation,* supplemental carriers, and several other small specialist carriers regulated by the Board. There are approximately 817 airports in the United States which provide service by certificated airlines.5 Simple arithmetic indicates that there are thus over a half million domestic city-pairs in which airline travel is theoretically

3 Testimony of William A. Jordan before this subcommittee, Feb. 14, 1975, p. 33. The intrastate carriers also have experienced markedly lower costs. Id. 414 CFR pt. 298.

5 Civil Aviation Research and Development Policy Study, Department of Transportation/ National Aeronautics and Space Administration, 1971, supporting papers, p. 4-34. A city-pair is a routing between two cities. It is more precise, though not as conventional, to refer to individual routings as airport pairs, thus reflecting actual passenger routings when more than one airport serves one city or one airport serves more than one city. Because traffic information is not usually available for airport pairs, the term citypair is used in this testimony.

possible. But alternative transportation is available in many city-pairs, convenient air service is not available in many of them, and many of them simply do not have any passengers who wish to fly them. As a result, most air travel actually takes place over a very small percentage of these theoretical city-pair routings. As the Air Transport Association has stated earlier in these hearings, 30 percent of domestic traffic is produced in the 70 largest city-pairs, 40 percent in the 840 next largest, and another 30 percent in the remaining city-pairs.

Apart from basic supply and demand considerations, there are primarily three influences on the number of city-pairs which receive service: subsidy, cross-subsidy, and the advantages of an integrated route system. In order to examine the influence of regulation on the pattern of service, it is necessary to look at each of these factors.

Section 406 of the Federal Aviation Act empowers the Board to grant subsidy to air carriers, and 9 local service carriers and several Alaskan carriers presently receive subsidy of approximately $70 million per year. This statutory provision would allow the Board to insure the provision of air service to remote communities even if there were no economic regulation of air carriers at all. There is considerable agreement that the present method of awarding subsidy is backward and inefficient, but the history of the airline subsidy program shows that the Congress can insure service to remote points if it wants to pay the price. The present low level of subsidy compared to the total air transportation system indicates that subsidy, though expensive, is not a staggering problem.

Some defenders of the status quo argue that if the government does not limit entry and exit, it will be unable to require air carriers to serve the bad markets with the good. Without government regulation, the argument goes, airlines would all serve exclusively the largest markets, and small markets would go unserved. In order to deal with these arguments, it is necessary to distinguish between the next two quite different factors which lead carriers to serve "bad" markets with the "good" ones: cross-subsidization and route system integration.

Each of these two factors allows an air carrier which serves more than a single city-pair to serve as part of that system city-pair which would not be served in isolation. System integration may allow this for a number of reasons: the small city-pairs may be one segment in a larger city pair, as when service from A to B is not economically viable, but service from A to B to C is viable. The smaller market may simply be "entry mileage" on the way to one larger market from another, or from a maintenance base. Or the incremental cost of adding a small city-pair to a given aircraft routing may be low because there is otherwise unusable aircraft time which can be used in that city-pair. This latter factor is important, because many city-pairs do not have enough traffic potential by themselves to use all the capacity generated by a modern aircraft used full time in that city-pair.8

These efficiencies from more extensive operations are offset by the increased costs of managing a complex and far-flung route network with diverse operational characteristics, so that above a very small minimum size, air carriers do not experience any substantial economies of scale." But where potential route system economies exist, they can result in increased service and lower cost to consumers, and the regulatory system should encourage operations which capitalize on them. It seems clear, however, that route regulation is not necessary for the full exploitation of the advantages of route system integration. Without regulation, carriers have an incentive to be efficient and expand their business operations, and they can be expected to do so. Indeed, route certification decreases an air carrier's ability to adapt and expand its route system in response to changing conditions, and this inflexibility undoubtedly explains a substantial portion of the higher costs and prices which are associated with regulated air carriers.

The absence of economies of scale in the airline industry also indicates that addition of another city-pair to a carrier's route system does not always mean increased efficiency or lower costs. Costs can actually be increased by route systems which are unduly complex, do not allow efficient gathering of traffic, or require the operation of too many different aircraft types. Under regulation,

See, Service to Small Communities. CAB staff study, 1972; Eads: The Local Service Airline Experiment, 1972. The Board itself requested introduction of legislation in the 93d Congress which would have authorized it to conduct a limited experiment in procuring subsidized service on a competitive bidding contract basis. 8 See, Testimony of William A. Jordan, supra.

9 Testimony of Thomas Kauper, supra, pp. 15-17.

a carrier has incentives to keep inefficient routes on its system because if it drops them, the route authority might be hard to get back from the government, and another carrier might obtain a certificate for the route, making reentry even more difficult or impossible. The increased costs of retention of uneconomic routes because of regulation increases the overall level of air carrier costs, which may well decrease their ability to offer profitable service in smaller markets. Thus, the result of route regulation is to introduce costly rigidity which decreases, rather than increases, the air carriers' ability to exploit the economic efficiencies of an integrated route system.

Government regulation of market exit is often advocated as a means of preventing disruptive service terminations to small communities. There appears to be no evidence that free exit, subject to notice provisions, would create any serious inconvenience to the public. But more importantly, regulation of exit, rather than increasing the amount of service to small markets, probably decreases it. When air carriers are not free to leave markets which prove to be unprofitable, they will be more conservative in entering doubtful markets, and fewer of those markets will actually receive service.

In contrast to actual efficiencies from route system integration, cross-subsidy is an expensive, inequitable, and unreliable means of including service in lightly traveled city-pairs. Regulation of entry to extract monopoly profits from passengers on some routes so that those profits can theoretically be used to subsidize service to passengers on other routes is a sub rosa tax which Congress probably would not explicitly allow.

Finally, leaving aside the extreme undesirability of cross-subsidization through route regulation, there is considerable economic evidence that it simply does not work in the regulated airline system.10 Increased revenues resulting from restrictions on entry in highly traveled markets are utilized to support excessive service competition rather than to subsidize otherwise unprofitable markets. The inflated level of service and attendant costs thus make it more difficult for carriers to serve lightly traveled markets at all.

In summary, there is little to indicate that regulation brings air service to small communities which otherwise would not have service. Cross-subsidization is theoretically possible under route regulation, but it doesn't work and should not be attempted. Route system efficiencies, which are a real source of otherwise unavailable service, are more available without route regulation. Accordingly, we question the need for continuation of the present close regulation of individual routes.

While it is true that a liberalized entry policy may cause replacement of carriers serving particular markets, such an occurrence need not be detrimental to the public, or adversely affect the level of service to smaller communities which is now rendered by certificated carriers. For instance, Executive Airlines entered the Boston-Bar Harbor market in the summer of 1968 and provided substitute service for Northeast Airlines during the 4-month summer season. In 1970, Executive was ousted from the market by Bar Harbor Airways, another commuter carrier, after Bar Harbor had begun to offer year-round non-stop service between Boston and Bar Harbor. As a result, Bar Harbor received a level of service to Boston for in excess of that which it had been receiving. While Executive may have left the market because it was operating at a loss, the public was benefited by the substitution of a carrier willing to offer year round service responsive to the needs of that community. Hence, the basic reason for Executive's ouster was the superior service offered by Bar Harbor Airways, and not "destructive competition" resulting from free entry. If a CAB route proceeding were necessary, I suspect that Bar Harbor Airways would be still trying (or have long since given up trying) to get on the route; and Bar Harbor passengers would still be waiting for year-round non-stop service to Boston.

Improved and more responsive service is not the only public benefit from restoring the airline industry to the relatively "free entry" conditions it experiences when there is no extensive economic regulation. For years, studies have been noting that when entry into intrastate air transportation in California and Texas was relatively free of regulatory barriers to entry, intrastate air

10 Statement of Gary L. Seevers, and James C. Miller III, Council of Economic Advisers, Feb. 6, 1975; Statement of William Jordan, supra; G. Douglas and J. Miller, Regulation of Domestic Air Transport, pp. 97-103, 162, 174.