There is, therefore, a very respectable body of opinion that regulation really has very little effect. This view merges with the other, which I have already characterized, that regulators tend, almost inevitably, to associate their conception of the public interest with that of the companies they are supposed to be regulating, typically protecting them against competition and supplying no alternative effective stimulus. Paradoxically, according to this view, regulation has the greatest effect in areas, like transportation, where competition could otherwise prevail, and there, because of its tendencies to protectionism and cartelization, it tends to do a great deal of harm; and elsewhere, in the presence of monopoly, its effects are not discernible.

For these reasons, where it can be permitted without intolerable loss of efficiency competition can play a very useful supplementary role even in the most tightly regulated industries. In my judgment, for example, while the basic interconnected, national communications network is probably something like a natural monopoly, competition can and should play an important role in the manufacturing industry that supplies equipment for attachment to that network at the subscriber's end. Similarly, I believe that such competition as we have permitted in the passenger airline business has, on balance, improved its performance.

Still, to return to my first major point: because of the inherent conflicts and contradictions between competition on the one hand and regulation on the other, and because of the inherent tendencies of regulation toward conservatism, protectionism, and cartelization, society must periodically reexamine the premises on the basis of which it decided to impose on the public utility status of an industry, and consider whether a return to essentially unregulated competition might not be preferable, as this Committee is doing today. This is especially important in those industries, like transportation, where a competitive structure may well be feasible that is, consistent with the individual suppliers achieving most or all of the available economies of scale. Transportation is not a natural monopoly. It is precisely in such situation that it becomes essential for us periodically to ask whether regulations may not be doing more harm than good. In my own judgment, transportation is the leading example of an area in which a substantial dose of dereguation, and perhaps something close to complete deregulation, is long overdue.

In the rest of these comments, I will suggest to you why I think this kind of reevaluation is particularly necessary in an industry like airline transportation. Before doing so, I should like to emphasize that competition in the real world is also a very imperfect institution. Consumers are rarely adequately informed about the choices available to them, and as a result the competitive advantage often goes to the more effective saleman, or the less scrupulous advertiser, rather than the most efficient producer or the seller who gives the best value for the dollar. The greater the number of independent suppliers, the more likely mistakes are to be made, and capital committed to ventures that should never have been undertaken. Competition is often wasteful, and produces instability and uncertainty. But most of us regard the competitive market in much the same way as we regard democracy-it is a manifestly inefficient system that is better than any available alternative. To the extent competition is imperfect, our preferred remedy is to try to diminish its imperfections, rather than to supplant it with monopoly or socialized enterprise.

But public utility-type regulation in industries that are potentially and structurally competitive tends to produce the worst economic results of all-worse than regulated, franchised single-form monopoly, on the one hand, and worse than unregulated competition, with all its possible wastes and imperfections, on the other. There are so far two major reasons, and both spring from the fact that in industries of this kind, of which transportation is the leading example, regu

lation specifically involves preventing, controlling and limiting competitionrestricting competitive entry, and prohibiting rivalry in price and service in brief, to use the proper term, it involves cartelization.

In principle, a cartel need be no less efficient than a pure monopoly. Singlefirm monopoly has both the incentive and the opportunity to produce at minimum cost, to take fullest possible advantage of economies of scale, to adopt the most efficient technology, to limit capacity to the amount required to supply the market at minimum cost, to concentrate production in the lowest-cost plants, and to operate them at the most efficient rates. In theory a cartel could do all these things, too, producing the cartel-determined output at minimum cost, pooling, the industry's profits, maximized in this fashion, and distributing them according to some formula among the cartel partners.

But no cartel in history, regulated or unregulated, has to my knowledge ever done these things. The typical practice, instead, is to maintain price by imposing output quotas on the several members, efficient and inefficient alike. Indeed, where cartels have been in a position to make distinctions, they have regulated production more often by cutting back the output of the lowest-cost producers than the other way around, in order to leave room in the market for the highercost firms, whom competition would otherwise have driven out of business. The result has been gross inefficiency in production. We have had the abundant examples of this phenomenon among regulated cartels. Parity price supports in agriculture were accompanied by the imposition of acreage limitations across the board. In petroleum prorationing, production allowables were cut back, at their lowest point, to eight days a month for the typically highest-volume and lowestcost wells, while exempted from all such restraints were the highest-cost, lowvolume marginal or stripper wells, and deeper wells were typically granted larger production quotas than shallow wells, precisely because they were higher-cost! And in transportation, the Interstate Commerce Commission has placed limitations on the ability of railroads, by cutting rates, to reach out for traffic that they were in a position to serve at lower incremental costs than competing trucks or barges.

Moreover, cartels have been typically incapable of imposing full controls on investment and entry. By holding prices at non-competitive levels, instead, they have tended to encourage new competitive entry, particularly, in areas outside their control; and where they have succeeded in restricting entry, they have typically been incompletely successful in restricting the making of additional investments by firms already in the market-for example, the drilling of grossly excessive numbers of developmental wells in the oil industry, in quest of additional production quotas. Maintaining prices in the face of these artifically stimulated increases in production capacity has in turn necessitated further cutbacks in output quotas, forcing producers in turn to operate at even more grossly suboptimal levels, with correspondingly higher costs, and further preventing the distribution of the business to the lowest-cost suppliers. In these important ways, cartels foster inefficiencies far more gross than either single-firm monopoly or unregulated competition.

The resulting inefficiencies are in no sense purely theoretical. The wastes in transportation, for example, have been estimated as running to billions of dollars annually; and the wastes of excessive developmental oil well drilling in the late 1950's and early 1960's in this country were estimated by knowledgeable industry sources as running on the order of $2 billion a year.

Second, and for exactly the same reason, cartels promote waste in another way that is particularly pertinent to the airline industry, by encouraging excessive non-price competition or service rivalry.

Perhaps the simplest way of explaining this is to set forth the economics that underlie both of these two tendencies toward inefficiency. I will do so in the form of a series of propositions, but then I will give you enough illustrations to demonstrate that I am talking about the real world. If regulation limits competition, it must be because some competition would otherwise be feasible: the ability and will to compete are therefore present. And if the regulation is effective, it will hold price above the costs of at least some producers or potential producers. I have already described how this sets up persistent temptations for firms already inside the cartel to expand their capacity and output, and for firms outside the market, and possibly outside the boundaries of the cartel, to enter, increasing the aggregate capacity hanging over the market and creating the necessity for

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 tendency 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 truckers; 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 principal 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.

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And so we have had the unedify.ng experience of the CAB and IATA imposing restrictions on the provision of tree dribas, the size anu sumptuossess of Leals, the amount of gace set weet seats, authorizing concerted reductions in the wnedning of fights, and requiring a mitor supplementary charge for in-fight motion pictures,

One particularly troublesome way in which the government-imposed restric tions on price competition have encouraged cost-indation in this industry has been the general refusal of the CAB to permit carriers with older, inferior equipment to set wibstantially lower rates in order to preserve their market shares in the face of the introduction of newer equipment. Since, when the prices are equai, the customer will obviously prefer the faster and more commodious jet to the slower piston aircraft, the refusal of the Board to permit a batantially lower fare for the latter created an irresistible temptation on the part of carriers to scrap 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 scheduling 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 service 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 prevents 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 competi

tion 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 public air transportation system.