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progressive cutbacks of output quotas if the price is to be sustained. These temptations cease only when output is so curtailed, and unit costs of production so increased, by the production cutbacks that entry and investment in new capacity are no longer attractive.

For exactly the same reasons, controls over price competition are subject to evasion because of the incentive they provide for accentuated quality and service rivalry, limited only by the ingenuity of businessmen in seeking new methods of enticing customers to them at the attractive, cartel-sustained price levels. Denied the opportunity to compete by reducing price, they are induced instead to compete for business in other ways that increase costs.

The point is that if competition is sufficiently strong potentially to drive price down to cost—and that is the reason for the regulatory restraints being imposed on competition in the first place--it will also ordinarily be sufficiently strong to induce supplers, confronting a price above costs, to seek other, non-price methods of producing additional sales.

Please observe carefully the general principle; it is an important one: If regulation or cartelization prevent price from falling to costs, then, to the extent that competition continues to prevail, it will tend to raise cost to the level of price.

This ndency toward accentuated non-price competition is of course not confined to the regulated or cartelized industries. On the contrary, and for similar reasons, it tends to take place also in non-regulated industries that are sufficiently concentrated to avoid price competition-witness, for example, the practice of frequent and often functionally meaningless but nevertheless cost-inflating model changes in automobiles and appliances, and the heavy expenditures on advertising and other forms of product differentiation across a wide spectrum of oligopolistic industries.

But there are striking examples in the regulated sector. The Interstate Commerce Commission is not permitted, under the Motor Carriers Act, to place limitations on the amount of equipment and facilities or the schedules put into effect by certificated trut kers; but it does restrict the entry of common carriers, and it does control prices. The consequence is a tendency, well-documented in the literature, for regulated trucking companies to compete by offering greater frequency of service, at the cost of lower average utilization of capacity.

Similarly, the maintenance of non-competitive brokerage commission rates by the New York Stock Exchange has encouraged brokers to engage in cost-inflating methods of service competition—the payment of large commissions to salesmen, and the offering of costly customer services in the form of free advice and research, in addition to the basic service, which is the consummation of transactions in securities.

In the airline industry, the requisite cartelization is achieved by the CAB restrictions on competitive entry, the resultant fewness of competing firms along particular routes, and the rather consistent discouragement of competitive rate reductions and special, promotional rates by the Civil Aeronautics Board, domestically, and by the International Air Transport Association. As a result, as anyone can observe, the airline companies compete very strenuously, instead, in adopting the most modern and attractive equipment, in the frequency with which they schedule flights, in advertising, and in providing comfort, attractive hostesses, in-flight entertainment, food and drink.

In turn-reflecting an almost inevitable tendency for regulation to become ever more thorough and pervasive in structurally competitive situations, because of the necessity for controlling whatever new forms of rivalry ingenious competitors and potentail competitors devise—the CAB and the IATA have been forced to try to control this service rivalry as well. Price regulation alone is obviously meaningless, if quality of service goes unregulated. In the more monopolistic, traditional public utility industries, where regulation has had the prin. cipal purpose of holding prices and profits down, commissions have found it essential to regulate quality of service as well as price: the consumer can be just as effectively exploited by deteriorations in the former as by increases in the latter. So, in these more structurally competitive markets, where regulation has been introduced principally to prevent competition from driving price down, commissions have had to recognize that the service competition that pushes costs up can be almost as "destructive” as unrestricted price rivalry-witness. for example, the disastrous impact of competitive scheduling of flights on airline load factors, costs and profits.

51-146 0 - 76 - pt. 1 - 8

And so we have had the onedifying experience of the CAB and IATA imposing restrictions on the provision of free drinks, the size and sumptuousness of meals the amount of space between seats, author.zing concerte reductions in the whedning of lights, and requiring a uniform supplementary charge for in-fight motion pictures,

one particularly troublesome way in which the government-imposed restrietions on price ompetition have encouraged cost-intation

in this industry has bexn the general refusal of the CAB to permit carriers with older, inferior squignent to set substantially lower rates in order to preserve their market shares in the face of the introduction of newer equipment. Since, when the prices are equal, the customer will obviously prefer the faster and more commodious jet to the slower Jáston aircraft, the refusal of the Board to permit a substantially lower fare for the latter created an irresistible temptation on the sart of carriers to wrap the older equipment and introduce the newer as rapidly as possible, as Professor Richard Caves has pointed out. And this has indeed been a conscious policy of the Board, in keeping with its statutory mandate to promote the utilization of airline transportation.

This last example clearly invites the obvious question : what is wrong with service rivalry of this kind? Isn't it desirable to encourage airlines to shift rapidly to newer, faster and more attractive equipment? Doesn't more frequent wheduling, mean better service, because it means a traveler has a correspondingly greater certainty of being able to get a flight at any time that he wants it? What is wrong with having a financially healthy security brokerage business, enabled by the restrictions on price competition to provide investors with the benefits of research and advice, at no extra charge, and providing brokerage service in small and remote localities where it might otherwise be unprofitable? Effective competition surely does require constant efforts at product and service quality improvement.

The only answer an economist can give is that the proper balance between wervice and price rivalry can only be determined, in a market economy, by subjecting the alternatives to a market test. The proper prescription is to give consumers the opportunity to choose between the two alternatives, the faster jet aircraft at a price reflecting the higher cost of its introduction, and the slower but still serviceable piston aircraft, at whatever rates down to operating costs are necessary to keep them utilized as well. This does not mean that old equipment should not at some point be scrapped. But so long as customers will patronize it at rates that exceed the variable costs of operating it, it continues to have economic value as well as physical serviceability; and any policy that preventy dropping that price down toward variable costs, and thereby provides customers no incentive to keep using the old, promotes premature and wasteful scrapping, and correspondingly wastefully rapid introduction of the new.

The only way of testing whether the increment in service quality consequent on more intensive scheduling is worth the higher cost it entails is to offer shippers or travelers the choice between lower rates and less frequent operations, on the one hand, and the high rates required to cover the costs of more frequent scheduling, on the other. The same is true of flights that on the one hand provide minimum leg room, and no food, drink, or entertainment, and sumptuous flights, on the other, and as many quality combinations as feasible between these two extremes, all at prices reflecting the respective costs of providing them.

Similarly for the security brokers: only if investors are offered the choice between the barebones service of consummating security purchases and sales, at a price corresponding to the cost of doing just that, on the one hand, and, on the other, the execution of orders plus salesmanship, plus advice, plus research will the market provide the economically optimum quantity of both. So long as the customer pays the same price for both of these packages, there will be an inherent tendency to wasteful and cost-inflating service rivalry. And that, it clearly appears, is what has happened in the airline industry.

The objection is not necessarily that airlines have been forced by their competition to incur greater costs for denser schedules, more advertising, meals, and in-flight entertainment than they would if they were able to get together and restrict such expenditures. The objection is, rather, that these cost-inflating service improvements have not been subjected to the test of having to compete with lower-cost lower-price alternatives. The defect, in short, has not been the service competition, as such, but the inadequate play of price competition along with it. In point of historical fact, the airline industry—as well as trucking, and the security brokerage business--offers numerous evidences that price competition will, if given a chance, hold service inflation in check. Witness the popularity of the more Spartan non-scheduled passenger service, the desertion of regular security brokers by large investors, and the wholesale desertion by shippers from common carrier to private trucking wherever they had the opportunity to do so.

In these circumstances, the attempts of the regulators to limit service rivalry are entirely logical. But that still has the effect of limiting the range of customer choices. And it inescapably raises the question of whether it would not be preferable simply to abandon economic regulation plus cartelization in favor of the freer play of price competition.

Senator KENNEDY. Our final witness is Dr. George James, senior vice president of economics and finance, Air Transport Association. He has spent much time analyzing economic trends and problems of the association, problems on behavior of the member airlines, and directing the operations of the Economic Finance Council. Dr. James is a member of the Conference of Business and American Economic Association, university guest lecturer and currently serves on the Doctorial Dissertation Association of American University.

We are glad to have you. STATEMENT OF DR. GEORGE W. JAMES, SENIOR VICE PRESIDENT

OF ECONOMICS AND FINANCE, AIR TRANSPORT ASSOCIATION OF AMERICA, ACCOMPANIED BY JAMES LANDRY AND GABRIEL PHILLIPS

Dr. JAMES. Thank you, Mr. Chairman.
I am accompanied by Mr. James Landry and Mr. Gabriel Phillips.

I have submitted a lengthy statement which I will not read, but I do have a summary which I will read but I request the more lengthy testimony be included in the record.

Senator KENNEDY. It will be included in the record.

Dr. JAMES. I find it enlightening to hear the testimony we have just heard from Professor Kahn. I have many smart friends who have been educated under Professor Kahn.

I must say, however, that after listening to what I heard this morning from all of the other witnesses that I have never been exposed to such incorrect economics in the airline industry except 9 years ago when I first came into the business myself. I think it is terribly important to have the exposure to the industry and understanding of it before you can really understand the practical implications of some of the proposals that have been made and to have a more full understanding of why so many of our witnesses are stumbling on questions that you are asking on what the effects of deregulation would be.

Well, as you stated on December 16, Senator Kennedy, the basic objective of airline regulation is adequate service at reasonable prices. We believe airline regulation has met that test. Nevertheless, we believe that consideration by this subcommittee and others of the issue of regulatory reform presents opportunities not only for thorough review of the existing structure and procedures, but more important, for seeking improvements in regulation. These improvements can lead to an even more effective and responsive publie air transportation system. The more extensive statement we have submitted to this subcommittee, under separate cover, deals with the concept of regulated competition in air transportation, with the objectives we understand are sought through regulatory reform investigations, with the achievements of regulated competition in the air transportation industry since 1938, and with the likely adverse impacts of many of the concepts of regulatory reform that are being proposed. Our statement also makes recommendations for some improvements in present air transport regulation.

I would now like to summarize the principal points made in our statement.

ADVANTAGES OF REGULATED COMPETITION

The system of air transportation, since its inception as an effective force in the American economy in 1938, has been founded on the principle of regulated competition. This has been necessary because of the special position of public transportation in the economy. In the spectrum of economic activity, from a natural monopoly to perfect competition, transportation falls in between.

It is unlike specific public utilities in which embedded costs are immense and therefore economies of scale are apparent. But because of the need and value of providing a public service to a vast interlinking network of cities and communities, air transportation cannot be placed in the so-called perfect or workable competitive environment either. Further, it has characteristics that under

deregulation would quickly lead to a high degree of concentration. These characteristics include the complexity of aircraft operations, the increasing expense of individual aircraft, the need for extensive maintenance facilities, and the fact that an inordinately high percentage of the passenger markets are between points of low traffic density.

The present national air transportation system is characterized by stability, speed, reliability, and above all a vast network of the interlocking air routes involving 58,000 city-pairs. Its value to the Nation and to the public is derived from all of these essential features which would be seriously compromised, if not lost, through deregulation.

We believe it is essential that in the deliberations today, and in those which will follow, special care should be taken to ensure that it is the real world of air transportation which is the subject of scrutiny. Hypothetical models alone—based as they are, not on the actual demonstrated needs of the traveling and shipping public, but rather on theories applicable only in an insulated theoretical environment—may be helpful as a guide to thinking. But their application beyond the classroom or the textbook must be carefully considered in the light of existing, real circumstances.

Senator KENNEDY. How do you say that; what is the basis of that statement?

Dr. James. I do not believe anybody was recognizing that we have 58,000 city-pairs, a stable environment in which that system is now operating, that we have met the test of keeping prices down, that we have a system built in through the Civil Aeronautics Board now in which the consumer interests are being represented and the prices that we might seek are being penalized by the fact that we may not be meeting certain of those standards, and many other points that I will bring out in my testimony in answer to your question in a moment.

Senator KENNEDY. Why would not the Department of Transportation understand that?

POTENTIAL ABANDONMENT OF SMALL TOWN SERVICE

(CROSS-SUBSIDY)

Dr. James. The Department of Transportation, through the submissions they made and the Domestic Passenger Fare Investigation, was not taking as what I would consider a practical position regarding load factors, load factor standards, and the realities of service to this 58,000 network that we now serve. The implications contained in many of the submissions they made would have the load factors and load factor standards beginning abnormally high, and the only way to accomplish this would be to cut out service to many of the communities now serviced. thousands of them, as a matter of fact.

Senator KENNEDY. Can you submit a list of which ones that would be?

Dr. JAMES. Of the communities?
Senator KENNEDY. Yes.

Dr. JAMES. We can attempt to do that, Senator. That is a computerized answer that we would have to develop, and would involve millions of calculations. It is a difficult thing to obtain, and we would have to obtain it.

Senator KENNEDY. How can you be sure that you know and the Department of Transportation does not know?

Dr. JAMES. I know the size of the problem and that is what we are attempting to define.

Senator KENNEDY. I have asked you for specific testimony since you have discredited the witnesses, saying they were speaking through their hat. That is a gracious way of putting it. Then, I asked you the basis of it and you say they do not understand this particular problem. I ask you the basis for your information and you say you have not got it. You supply it and I will ask the Department of Transportation to do the same thing. Let the record speak for itself.

Dr. JAMES. Let me put it this way, Senator. What we have is aggregate information, and what you are asking for is detailed information. The aggregate information is that if we were to attempt to get to a 65percent load factor today we would have to cut 25 percent off of these 58,000 city-pairs. I understand your question to be which of the 58,000 would be cut.

Senator KENXEDY. That is right.

Dr. JAMEs. We have nothing that far. We have gone as far as to say. one-fourth of them would be cut. I do not believe the Department of Transportation has thought of it in those terms, sir.

Senator KENNEDY. Well, I will ask them the same question, to submit information, as I am asking you, so if you can supply information on that and be as specific as possible I will ask them the same question.

[In a letter dated February 7, 1975, the chairman of the subcommittee made more explicit his request of Dr. James for a list of routes that would be eliminated under the conditions discussed above. On April 3, 1975, the Air Transport Association submitted its reply which totaled more than 200 pages. The chairman then requested independent eval

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