Diplomarbeit - University of Nebraska Omahacba2.unomaha.edu/faculty/mohara/web/Blechschmidt95airline.pdf · Diplomarbeit Concentration and Contestability in the Deregulated United

Technische Universität Braunschweig Institut für Wirtschaftswissenschaften

Abteilung für Volkswirtschaftslehre Prof. Dr. Franz Peter Lang

Dr. Johannes Laser

University of Nebraska at Omaha College of Business Administration

Department of Economics Prof. Dr. Michael O'Hara

Diplomarbeit

Concentration and Contestability in the Deregulated

United States Airline Industry

Jens Blechschmidt Rehrbrinkstr. 26

30890 Barsinghausen

Diplom-Wirtschaftsingenieurwesen Studienrichtung Elektrotechnik

Matr. Nr. 2338895 SS 1995

Technische Universität Braunschweig University of Nebraska at Omaha institut für Wirtschaftswissenschaften College of Business Administration Abteilung für Volksuvirtschaftslehre Department of Economics Professor Dr. Lang Professor Dr. O'Hara

Diplomarbeit Es wurde mit

Herrn Jens Blechschmidt, Rehrbrinkstr. 26, 30890 Barsinghausen, Wirtschaftsingenieurwesen/Elektrotechnik, Matr.Nr. 2338895

folgendes Thema für eine sechsmonatige Diplomarbeit vereinbart:

Concentration and Contestability in the Deregulated United States Airline Industry

Die Aufgabenstellung umfaßt folgende Teilaufgaben: • Darstellung der historischen Entwicklung des ordnungspolitischen Rahmens des

Luftverkehrs in den Vereinigten Staaten • Darstellung und Analyse der volkswirtschaftlichen Theorien, die der Deregulierung

des Luftverkehrs zugrunde liegen • Analyse der Auswirkungen der Deregulierung, insbesondere auf die

Marktkonzentration im inneramerikanischen Linien-Passagierluftverkehr gberprüfung der Anwendbarkeit der genannten Theorien auf die spezielle Marktstruktur des Luftverkehrs

• Diskussion eventuell notwendiger ordnungspolitischer Eingriffe und Entwicklung eines adäquaten Wettbewerbskonzepts für den Luftverkehr

Die Arbeit wird am Institut für Volkswirtschaftslehre der TU Braunschweig in Kooperation mit dem College of Business Administration der University of Nebraska at Omaha (USA) angefertigt.

Betreuer in Omaha: Professor Dr. Michael O’Hara Betreuer in Braunschweig: Professor Dr. Franz-Peter Lang Beginn der Arbeit: 30, Juni 1995 _____________________ (Prof. Dr. M. O'Hara) Abgabe der Arbeit: ______________ ______________________ (Datum) (Unterschrift)

EIDESSTATTLICHE ERKLÄRUNG Hermit versichere ich, daß ich die vorliegende Arbeit selbständig and ohne fremde Hilfe

angefertigt habe. Außer den angegebenen Quellen wurden keine weiteren Hilfsmlttel

verwendet.

Omaha, den 17. November, 1995

__________________________

(Jens Blechschmidt)

v

TABLE OF CONTENTS List of Figures . ..........................................................................................................................vii List of Tables ............................................................................................................................viii CHAPTER I. OVERVIEW AND PURPOSE OF THE STUDY.............................................. 1 CHAPTER II. PUBLIC POLICY FROM REGULATION TO DEREGULATION IN THE U.S. AIRLINE INDUSTRY .......................................................... 3 A. Theoretical Backgrounds ........................................................................................... 3 1. Main Market Structures . .......................................................................................... 4 2. The Perfect Competition Theory ............................................................................ 4 a) Definition of Perfect Competition . ................................................................... 5 b) Perfect Competition and Economic Efficiency ............................................. 5 3. The Contestable Market Theory ............................................................................ 7 a) Conditions for Perfect Contestability .............................................................. 7 b) Contestability and Industry Equilibrium ......................................................... 9 4. Perfect Contestability Contrasted with Perfect Competition ............................10 5. Reasons for Regulatory Activities ........................................................................11 a) Economies of Scale and Scope and Natural Monopolies ........................11 b) Universal Service ............................................................................................13 c) Destructive Competition .................................................................................13 d) Protection Against Misinformation ................................................................14 e) Abolishment of Entry Barriers .......................................................................14 B. The Regulatory Framework Before 1978 ..................................................................14 1. The History of the U.S. Airline Industry ...............................................................15 2. The Civil Aeronautics Act of 1938 .......................................................................16 a) The Civil Aeronautics Board ..........................................................................16 b) Regulated Market Parameters ......................................................................16 3. The Federal Aviation Act of 1958 . .......................................................................18 C. Rationale for Deregulation .......................................................................................19 1. No Economies of Scale Effects Expected ..........................................................20 2. Ease of Entry and Exit . ..........................................................................................20 3. The Texas and California Experience .................................................................21 D. The Airline Deregulation Act of 1978 ....................................................................21 1. Important Changes in Public Law ........................................................................22 2. Dwindling Authority of the Civil Aeronautics Board ..........................................23 3. The Resulting Open Market ..................................................................................24 CHAPTER Ill. CHANGES IN THE U.S. AIRLINE INDUSTRY ..........................................25 A. Market Developments and Industry Structure ....................................................25 1. Types of Airlines . ....................................................................................................25 2. Branch Specific Parameters .................................................................................28 3. Industry Developments 1945 - 1994 . ..................................................................30

vi

4. Major Acquisitions and Mergers ...........................................................................33 5. Bankruptcies Since Deregulation .........................................................................37 6. Hub-and-Spoke Route Systems . .........................................................................39 B. Concentration ..............................................................................................................44 1. The Herfindahl-Hirschman-Index .........................................................................45 2. Concentration in the Domestic U.S. Airline Industry ........................................47 3. Concentration at Large Hub-Airports ..................................................................50 4. Comparison of Hub- and Industry Concentration ..............................................61 5. Concentration and Air Fares .................................................................................63 C. Conclusion ....................................................................................................................64 1. The Failure of Perfect Competition ......................................................................65 2. The Failure of Contestability .................................................................................66 CHAPTER IV. THE CONTESTABLE MARKET THEORY AS A GUIDE FOR A NEW COMPETITION CONCEPT .............................................................................69 A. Entry Barriers ..............................................................................................................69 1. Frequent Flier Programs (FFP) ............................................................................70 2. Computer Reservation Systems (CRS) ..............................................................71 3. Travel Agent Commission Overrides (TACO) . ..................................................72 4. Code-Sharing ................................................................................................74 5. Facility Constraints .................................................................................................75 6. Landing Slots . .........................................................................................................75 7. Price Matching ........................................................................................................76 B. The Concept..................................................................................................................76 1. Overview of the Concept ...... ................................................................................78 2. A New Independent Transportation Commission .............................................80 3. Policy Options for Regulation ............ .............................................................80 CHAPTER V. SUMMARY AND FUTURE WORK ...............................................................84 APPENDICES ...........................................................................................................................86 Appendix Table I. Traffic Summary 1560 -1994 U.S. Scheduled Airlines ................87 Appendix Table II. Load Factor- U.S. Scheduled Airlines 1945 -1994 ......................88 Appendix Table Ill. HHI of the Domestic U.S. Airline Industry From 1970 - 1983 . .............................................................................................................89 Appendix Table IV. HHI of the Domestic U.S. Airline Industry From 1987 - 1994 ..............................................................................................................94 Appendix Table V. HHI of Twelve Large Hub-Airports in the United States 1972 - 1993 .....................................................................................97 REFERENCES ........................................................................................................................120

vii

LIST OF FIGURES Figure 1. Long-Run Equilibrium of the Competitive Firm and Industry ....................... 6 Figure 2. Price Sustainability for Natural Monopolies ..................................................10 Figure 3. Domestic Market Shares of Major Airlines 1978 vs. 1994...........................28 Figure 4. Developments in the Domestic Airline Industry 1945-1994 .......................31 Figure 5. Major Acquisitions and Mergers Since Deregulation ...................................36 Figure 6. Airline Route Structures ...................................................................................40 Figure 7. Route System Before Deregulation ................................................................43 Figure 8. Hub-and-Spoke Route System After Deregulation ......................................43 Figure 9. Percentages of Domestic and International Traffic of the U.S. Airline Industry in 1978 and in 1994 .......................................................44 Figure 10. Concentration in the Domestic U.S. Airline Industry 1970-94 ....................48 Figure 11. Percentage of International Passengers Enplaned at Selected Hubs by U.S. Carriers in 1989 ...................................................................................52 Figure 12. Geographical Location of Air Traffic Hubs in the United States ................53 Figure 13. Concentration (HHI) for Selected Hubs 1972-1993 .....................................55 Figure 14. Average Change of HHI per Year in 3-Year-Periods at Selected Hubs ....57 Figure 15. Market Shares of the Two Dominant Airlines at Denver-Hub in 1972 and in 1993 .........................................................................................................59 Figure 16. Market Shares of the Two Dominant Airlines at Houston-Hub in 1972 and in 1993 .........................................................................................................59 Figure 17. Market Shares of the Two Dominant Airlines at Atlanta -Hub in 1972 and in 1993..........................................................................................................60 Figure 18. Market Shares of the Two Dominant Airlines at Detroit-Hub in 1972 and in 1993 . .......................................................................................................60 Figure 19. Average Industry HHI Compared to Average Hub HHl ...............................62 Figure 20. U.S. Airline Market Entry Barriers . .................................................................70 Figure 21. A Concept For Increased Contestability in the U.S. Airline Industry..........79

viii

LIST OF TABLES Table 1. Variety of Market Structures ............................................................................... 4 Table 2. Dwindling Authority of the Civil Aeronautics Board.......................................24 Table 3. Major Airlines (Passenger) and Their Domestic Market Share in 1978 and 1994 ...................................................................................................27 Table 4. Major Airline Bankruptcies and Domestic Market Shares in Year of Bankruptcy and in 1978 ..................................................................38 Table 5. Advantages and Disadvantages of Hub-and-Spoke Route Structuring for Both Airlines and Passengers ...................................................................41 Table 6. Interpretation of HHI . ........................................................................................46 Table 7. Examples for HHI for Different Numbers of Firms of Equal Size ...............47 Table 8. Tendencies of Changes in Concentration (HHI) From 1970-1994.............49 Table 9. Concentration (HHI) at Selected Hubs 1972-1993 ......................................54 Table 10. Travel Agent Commissions Paid by U.S. Major and National Carriers .....73

CHAPTER I

OVERVIEW AND PURPOSE OF THE STUDY

Today, the airline industry is radically different from what it was prior to 1978. Before

1978 it resembled a public utility, with a government agency, the Civil Aeronautics

Board (CAB), determining the routes each airline flew and overseeing the prices they

charged. Now, without regulation, the airlines have complete freedom to choose their

own route structure and to fix ticket prices.

Responsible for this abrupt turn was the Airline Deregulation Act, approved by

Congress on October 24, 1978 and signed into law by President Jimmy Carter. The

primary justification for airline deregulation was the expectation by leading economists

(e.g., Elisabeth Bailey, William Baumol and Alfred Kahn) that the airline industry would

be highly competitive or at least would have the characteristics of a "contestable"

market. A perfectly contestable market, referring to the original theory developed by

Baumol, Panzar and Willig in the late 1970s, forces firms (even monopolies) to set the

price equal to cost. Therefore, this theory was supposed to be the adequate concept to

replace inefficient regulation that caused high airfares and excess capacity.

Since the Airline Deregulation Act of 1978 was passed, the industry was shaken

by mergers and bankruptcies and the new situation led to significant changes in the

performance of the airline industry. In the 1980s, several studies analyzed the effects of

deregulation, most of them with the result that the airline industry is not as "contestable"

as predicted. However, none of these studies presented a possible competition concept

based on the Contestable Market Theory.

The purpose of this study is to describe changes, in the airline industry since

deregulation, to analyze why the U.S. airline industry today is neither "competitive" nor

"contestable" and to suggest a possible concept to increase contestability in this market.

The analysis of the concentration of both the entire airline industry and the individual

markets (hub-airports) is crucial for the rejection or acceptance of contestability and

perfect competition, and therefore constitutes an important element in this project.

The project starts with Chapter II, which presents background information about

the Perfect Competition Theory and the Contestable Market Theory, describes the

I. Overview and Purpose of the Study 2

regulatory framework prior to deregulation, and explains why deregulation proponents

voted for the abolishment of any regulatory activity in the U.S. airline industry. This

chapter ends with a brief description of the impact of the Airline Deregulation Act of

1978 on the airline industry.

Chapter III provides an overview of the domestic U.S. passenger airline industry

from 1945-1994, concerning the developments of traffic, capacity and efficiency. Next,

the concentration of the domestic U.S. passenger airline industry and twelve large

hub-airports in the United States from 1972 to 1994 are analyzed. The results of this

analysis and its effects on both the Perfect Competition Theory and the Contestable

Market Theory are discussed in the conclusion.

In Chapter IV, a possible competition concept is suggested that rests on the

belief that the Contestable Market Theory is applicable to the airline industry if entry

barriers, which impede contestability today, are abolished by temporary regulatory

activities. These entry barriers are described in detail in the beginning of this chapter.

The results of this study are summarized in Chapter V. An overall conclusion and

suggestions for further research are presented.

CHAPTER II

PUBLIC POLICY FROM REGULATION TO DEREGULATION OF THE U.S. AIRLINE INDUSTRY

Chapter II describes the change in the public policy from regulation to deregulation

concerning the U.S. airline industry. Section A contains some general theoretical

information about the Perfect Competition Theory and the Contestable Market Theory

and explain the necessity of regulatory activities if the premises of perfect competition or

perfect contestability are not fulfilled by the industry itself. Section B will provide a

retrospective view of the time prior to airline deregulation, including the essential laws ,

institutions and the parameters that have been regulated by government. Section C

deals with the rationale for deregulation as viewed by the Civil Aeronautics Board.1

Section D will provide detailed information of the Airline Deregulation Act of 1978 and

will show the decline of the Civil Aeronautics Board.

A. Theoretical Backgrounds

To fully comprehend this study, it is necessary to have a basic understanding of

the economic theories that are the pillars of regulatory and deregulatory policy

in the United States: The Perfect Competition Theory and the Contestable

Market Theory.

This Section begins with a short overview of the "classical" market structures

applied by academic economists. In the following subsections, the Perfect Competition

Theory and the Contestable Market Theory are described and contrasted. Directly

derived from these theories is the reasoning behind regulatory activities, which is

explained at the end of this section. The theoretical background provided in Section A

does not refer specifically to the airline industry. It also can be applied to any other

industry or market.

1 The Civil Aeronautics Board was the government institution that regulated the airline industry for 40 years, from 1938 to 1978.

II. Public Policy from Regulation to Deregulation 4

1. Main Market Structures

Main market structures and their specific characteristics are distinguished by academic

economists according to (1) how many firms they include, (2) whether the products of

the different firms are identical or somewhat different, and (3) how easy it is for new

firms to enter the market. Table 1 contains an overview of various market structures that

have been identified.

The two extremes are pure monopoly and perfect competition; both are "ideal"

market systems which in reality only can be approximated. The hybrid forms of

monopolistic competition and oligopoly share some of the characteristics of the first two

and are the most commonly found market structures. Although the recently (1982)

developed "Contestable Market Theory" is not a "classical" market theory, it is

comparable to them and plays an important role in the considerations of this study. To

provide a better comparison, it is listed with the classical market structures.

Table 1. Variety of Market Structures

Type of Market Structure

Number of Sellers

Nature of the Product Barriers to Entry

Pure monopoly One Unique product May be

considerable

Oligopoly Few Identical or

differentiated products May be

considerable

Monopolistic competition Many

Somewhat different products (example: restaurant meals)

Minor

Perfect contestability

Many, few or one

All firms produce identical products

None

Perfect competition Many

All firms produce identical products None

Source: Partly from Baumol, W.J./Blinder, A.S., Microeconomics, 1988, p. 173.

2. The Perfect Competition Theory

Two centuries ago, Adam Smith suggested that perfectly competitive firms use

society's scarce resources with maximum efficiency and that only this


condition would provide the optimal welfare for a society and serve customers'

tastes most effectively.2

a) Definition of Perfect Competition

A market is said to operate under perfect competition when the following

four conditions are satisfied:

1. Numerous participants: Each firm is so small, relative to the

market, that it can exert no perceptible influence on price.

2. Homogeneity of product:The product offered by any seller is

identical to that supplied by any other seller.

3. Free mobility of resources: Unhindered free mobility of all

resources, including free entry and exit of firms into and out of the

market.

4. Perfect information: All buyers and sellers in the market

possess complete and perfect knowledge.3

These conditions are essential criteria to verify the grade of approximation of a

given market to perfect competition.

b) Perfect Competition and Economic Efficiency

In this subsection, it will be demonstrated why perfect competition, in theory, was

assumed to be the most efficient market form. To develop this assumption, it is

necessary to consider some economic theorems.

Theorem 1: Profit can be maximized only at an output level at which

marginal revenue is equal to marginal cost.

Theorem 2: Under perfect competition the firm is a price taker and has a

horizontal demand curve. The profit is maximized where

marginal cost is equal to price. 2 Smith, Adam, Wealth, 1930, pp. 43-45; (short citation: "Wealth" is a keyword of the title and refers to the full title in the References on page 131). 3 Baumol, W.J./Blinder, A.S., Microeconomics, 1988, p. 174.


Theorem 3: For the competitive industry the demand curve is downward

sloping because if every firm, in contrast to only one, expands

its output it would make a substantial difference meaning that

customers can be induced to buy the additional quantities

arriving at the market only if the price of goods falls.4

Figure 1 shows the perfectly competitive industry moving to a long-run equilibrium

where firms maximize profits (price = marginal cost). Entry of new firms forces the price

down until it is tangent to the long-run average cost curve. As a result, in long-run

competitive equilibrium (without any regulatory activity) it is always true that price is

equal to marginal cost and to average cost.5

Baumol and Blinder point out that as long as price is higher than long-run average cost

and therefore profits are made in the industry, new companies will find it attractive to

enter the market, and expanded production with competition will force the market price

to fall. Long-run equilibrium is reached when profits are no longer attracting firms to

enter, nor are firms forced to exit the market because of losses. This means that under

4 Baumol, W.J./Blinder, A.S., Microeconomics, 1988, pp. 172-189. 5 Shirrs, J.K./Siegel, J.G. Dictionary of Economics, 1995, p. 266.


perfect competition, in long-run equilibrium, firms work with zero economic profit in the

economic sense. Of course, firms may earn profits in the accounting sense, because

the average cost curve includes the cost of all inputs, including the opportunity cost of

the capital which forces the firm to earn the normal economic-wide rate of profit to make

sure that investors do not exit the business with their invested capital.6

The conclusion is that in long-run equilibrium under perfect competition, every firm

produces at the minimum point on its average cost curve. Thus the outputs of competitive

industries are produced at the lowest possible cost to society and the industry reaches its

maximum efficiency.

3. The Contestable Market Theory

In the late 1970s and early 1980s, William Baumol, John Panzar, and Robert Willig

attempted to formalize the conditions under which natural monopolies could be

expected to reach efficient equilibria without regulation. They argued that optimal

price and output conditions would be achieved in any market having certain

characteristics which made it "perfectly contestable".7 They finally formulated a

general theory of contestability in 1982, four years after Congress promulgated the

Airline Deregulation Act of 1978.

a) Conditions for Perfect Contestability

Essentially, four conditions have to be fulfilled so that a market may be

considered perfectly contestable:

1. Equal Access to Economies of Scale

The first condition is that all firms in a market and potential entrants have equal

access to economies of scale and to the same technology, whether expressed as

access to competitive levels of unit costs or as equivalent access to product 6 Baumol, W.J./Blinder, A.S., Microeconomics, 1988, p. 184-189. 7 Baumol, W.J./Panzar, J.C./Willig, R.D., Markets, 1988.


quality.8 The Contestable Market Theory permits natural monopolies as a

result of economies of scale.

2. Free Entry and Exit

The second condition is that a firm can enter and exit a market without entry and exit

costs, and that "sunk costs" are not present. Sunk costs are costs of resources that

have already been incurred at some point in the past whose total will not be affected by

any decision made in the present or future. For example, advertising costs during

market entry constitute sunk costs . 9 The requirement of free market entry and exit

implies that there are no "entry barriers" erected by governmental regulations or by

other firms in the market.

3. Price Sustainability

The third condition for contestability is that consumers can respond to a price reduction

set by a new firm entering the market more quickly than the incumbent firm's can

respond with a matching price cut.10 If this condition is not fulfilled, the new entrant can

not attract consumers with a lower price and therefore will find it difficult to gain market

share.

4. The "Threat of Potential Entry"

The essential point of the Contestable Market Theory is the "threat of potential entry". It

was assumed by Baumol and Blinder that if a new firm can enter and exit a market

without costs, even a natural monopolist would be forced to price at cost because of this

"threat of potential entry". If the price, of the natural monopolist were to be higher than

costs, the potential entrant would enter and offer lower prices to the consumers, Thus

8 Levine, M.E., Competition, 1987, p. 404. 9 Shim, J.EC./Siegel, J.G. Dictionary of Economics, 1995, p. 321. 10 Dempsey, P.S., Laissez-Faire, 1992, p. 222.


the entrant would make profits before the incumbent could match the price and could go

out of business when the monopolist reacts in pricing downwards.11

b) Contestability and Industry Equilibrium

Industry equilibrium in a perfectly contestable market dominated by a natural monopoly

is only possible if the natural monopolist chooses a price that is sustainable. A

necessary premise for sustainability is "price subadditivity". Subadditivity means that it

is more expensive for two or more firms to produce an output y than it is for a natural

monopoly to produce the same output (the cost of producing the whole is less than the

sum of the costs of producing parts). Figure 2 illustrates how, in theory, a natural

monopoly will be able to find a stationary price that covers its own costs and yet

protects it from entry.

Baumol, Panzar and Willig point out that in the case of a natural monopoly, the

rule MC < p = AC emerges as a necessary condition for equilibrium in perfectly

contestable markets.12 The price nearest MC that yields a non negative profit to the

supplier is p=AC at point E, where the demand curve intersects the average cost curve.

The authors mention that for a single-product firm, this is the rule for second-best

pricing under a zero-profit constraint (the best pricing would be the one under perfect

competition with MC=AC). In Figure 2, the demand curve cuts the average cost curve to

the left of point M, of minimum average cost. In that case, if the monopoly selects the

price p i at which the average cost curve and the demand curve intersect, any entrant

attempting to capture a segment of the market by supplying some smaller output ye

must incur an average cost S that is above the incumbent's price p i.

11 Baumol, W.J./Blinder, A.S., Microeconomics, 1988, p. 244. 12 Baumol, W.J./Panzar, J.C./Willig, R.D., Markets, 1988, p. 28.


Since the entrant cannot hope to sell anything at a price higher than the incumbent's,

any such attempt at entry must result in a loss for the entrant. In addition, no entrant can

cover its costs if it supplies more than the incumbent, because the prices at which

quantities can be sold lie below the associated average costs. Therefore, given the

market conditions depicted in Figure 2, the price p i is sustainable for the incumbent

monopoly.13

4. Perfect Contestability Contrasted with Perfect Competition

Unlike the Perfect Competition Theory, the Theory of Contestable Markets does not

require that a number of firms compete in any given market in order to achieve efficient

performance. The Theory of Market Contestability assumes instead that non-

participating producers can be such perfect potential entrants that they can offer a

13 The entire Theory of the Contestable Markets is developed in: Baumol, W.J./Panzar, J.C. WiIlig, R.C., Markets, 1988.


supply response when monopolists charge higher than competitive prices and produce

lower than competitive output. This supply response would force monopolists to

produce the optimal output and price characteristics of competitive markets.14

The Contestable Market Theory, in contrast to the Perfect Competition Theory

allows for economies of scale and natural monopolies and for only a small number of

firms. Markets which contain a few relatively large firms can be highly contestable,

though they are certainly not perfectly competitive.15 However, both market theories

claim to provide maximum efficiency and maximum welfare to society, if working under

ideal conditions, because firms are forced to price at (average) cost.

5. Reasons for Regulatory Activities

Because the market systems of perfect competition or perfect contestability may not

function ideally, governments frequently intervene in these areas. The main reasons for

regulatory activities based on the Perfect Competition Theory are (a) the

phenomenon of natural monopoly that leads to concentration, (b) the desire for.

universal service, (c) to prevent destructive competition and (d) the protection against

misinformation.16 As mentioned previously, the Contestable Market Theory has been

developed to show that a market can work efficiently without regulation, even if some of

the above phenomena (which would make regulation necessary, according to the

Perfect Competition Theory) are present. However, one reason for regulation based on

the Contestable Market Theory is the abolishment of entry barriers.

a) Economies of Scale and Scope and Natural Monopolies

One of the main reasons to regulate an industry, according to the Perfect

Competition Theory, is the existence of a natural monopoly:

14 Levine, M.E., Competition, 1987, p. 404. 15 Baumol, W.J./Blinder, A.S., Microeconomics, 1988, p. 244. 16 Daneke, G. A./Lemak, D.J., Reform, 1985, pp. 4-10 and Baumol, W.J./Blinder, A.S., Microeconomics, 1988, pp. 292-300.


"A natural monopoly is an industry in which advantages of large-scale production make it possible for a single firm to produce the entire output of the market at lower average cost than a number of firms each producing a smaller quantity."17

The cost advantages of large-scale production basically stern from two effects

that can take place in a market: economies of scale and economies of scope effects.

1. Economies of Scale

Economies of scale are savings that are acquired through increases in quantities

produced. The reasons for these savings are (1) increased specialization and division of

labor and (2) use of more efficient or high-tech machinery and equipment. As the scale

of production grows, the enterprise becomes more efficient and simultaneously, the unit

costs decrease.18

2. Economies of Scope

A concept related to economies of scale is economies of scope. Economies of scope

are savings that are made possible by the simultaneous production of many different

products. The unit cost of producing one more item may be diminished when the scope

of activity broadens. An example of economies of scope in the airline industry is

advertising costs. Advertising costs per unit of serving a particular city-pair market are

lower the more city-pair markets are served, due to quantity discounts in media

purchasing.19

In industries where there are great economies of scale and scope, society will

obviously incur a significant cost penalty if it insists on maintaining a large number of

firms. If a monopoly can provide a less expensive product, it is in the society's best-

interest not to sustain free competition. If the market system is based on the Perfect

17 Baumol, W.J./Blinder, A.S., Microeconomics, 1988, p. 215. 18 Shim, J.K./Siegel, J.G. Dictionary of Economics, 1995, p. 118. 19 Dempsey, P.S., Laissez-Faire, 1992, p.:238.


Competition Theory, then regulation is the adequate means to avoid exploitation by the

monopolistic firm.20

b) Universal Service

Another reason for regulation is the desire for universal service, which means the

availability of service at reasonable prices even to small communities where the small

scale of operation makes costs extremely high. In such cases, regulation can

encourage a public utility to supply services to consumers at a financial loss, permitting

at the same time higher profits on other sales. This cross-subsidization is possible only

if the firm is protected from price competition and free entry of new competitors in its

more profitable markets.21 If that protection is not provided, many new firms would enter

the business and cause prices to be driven down in those markets, with the effect that

the original supplier can no longer subsidize the unprofitable markets and small

communities would be left abandoned.

c) Destructive Competition

The third reason for regulation under perfect competition is to prevent the market from

destructive price competition in multifirm industries with large capital costs and low

marginal costs. The risk is that price competition drives the firms' prices down toward to

their marginal costs and that average costs are higher than marginal costs. As in most

industries where economies of scale are present, the average cost curve in general is

declining, which indicates that marginal costs are below average costs for one particular

output. If price is lower than average cost, the firm cannot pay its total costs in the long-

run and will go bankrupt. To prevent the firms from going bankrupt, under destructive

competition, regulation is opportune because the price can be set by regulatory

agencies.

Regulators can generally set the price in two ways: (1) they can set the price

equal to marginal cost (marginal cost pricing) or (2) they can set the price equal to

20 Baumol, W,J./Blinder, A.S., Microeconomics, 1988, p. 296. 21 Dempsey, P.S., Laissez-Faire, 19x2, p.:249.


average cost. The latter is not desirable because, as explained in Theorem 1, firms

would not produce at that point where profits are maximized (marginal cost = marginal

revenue) and, even more importantly, the industry would not produce at its most

efficient level. The first method indicates that subsidies (government and/or cross-

subsidizing) have to be paid to the firms to avoid their bankruptcy. 22

d) Protection Against Misinformation

A final reason for regulation is to protect the environment (e.g. consumers, employees,

etc.) from being misinformed or cheated by firms and unscrupulous sellers. This is

especially true in the airline industry concerning overbooking of planes, flight

cancellations because of low passenger demand, and misleading advertising that

promises low fares for only an infinitely small number of seats.

e) Abolishment of Entry Barriers

A criterion where regulatory activities concerning the Contestable Market Theory could

be necessary is the abolishment of entry barriers. Bailey and Baumol point out that

regulators should be aware of entry barriers erected by firms or by government, and

should take steps to discourage the maintenance of those barriers. In case there are

entry barriers that arise out of technological circumstances that require heavy sunk

investments, the government should ensure equal access to the sunk facility and, if the

sunk facility is privately owned, the government should require that all firms seeking to

use the facility are given access to it, so that all users are charged the same price.23

B. Regulatory Framework Before 1978

After having given a brief overview of the reasons for regulatory activities, the regulatory

framework of the U.S. airline industry before deregulation in 1978 will now be explored.

The time before deregulation can be divided into two significant phases: (1) the phases

22 Baumol, W.J./Blinder, A.S., Microeconomics, 1988, p. 302. 23 Bailey, E. E./Baumol, W. J., Deregulation, 1984, pp. 123-125.


without any economic regulation (from the beginning of the air transportation industry in

1918 to 1938), and (2) the phases of strict government regulation (from 1938 to 1978).

1. The History of the U.S. Airline Industry

Following is a short overview of some important acts concerning the airline industry

which were promulgated before 1978:

1918 The history of air transportation in the U.S. started in 1918 when airmail

service was inaugurated by the Army.

1925 The Kelly Act (Air Mail Act of 1925) established air transportation

autonomous from the military by permitting the postmaster general to award

contracts to private airlines for the movement of mail.

1926 The Air Commerce Act of 1926 gave jurisdiction over safety and the

maintenance of airways and navigation facilities to the Secretary of

Commerce.

1930 The McNary-Waters Act of 1930 established a formula for airmail payments

based on the amount of mail transported.

1938 In 1938 the government started the regulation era of the airline industry by

passing the Civil Aeronautics Act of 1938, the predecessor of the

1958 Federal Aviation Act of 1958. The intent of these acts was to prevent the

airline industry from suffering the effects of destructive competition that had

already occurred in the rail and motor carrier industry (the Motor Carrier Act

was passed in 1935 to stop this).24 Actually, the Federal Aviation Act of 1958

did not mean a significant amendment concerning the regulatory era.

1978 The Airline Deregulation Act of 1978 was passed by Congress.

Since the Civil Aeronautics Act of 1938, and the Airline (Deregulation Act of 1978

changed the framework of the airline industry, significantly, these acts are described in

further detail.

24 Dempsey, P.S., Laissez -Faire, 1992, pp. 159-163.


2. The Civil Aeronautics Act of 1938

The Civil Aeronautics Act of 1938, signed into law by President Roosevelt, established

the Civil Aeronautics Authority and the Air Safety Board as independent regulatory

agencies designed to provide regulation over the air transportation industry. Essentially,

these agencies were given the authority to regulate (1) rates, (2) entry, exit, and routes,

(3) antitrust, and (4) safety.

a) The Civil Aeronautics Board

In 1940 the functions of the Air Safety Board were consolidated with the functions of the

Civil Aeronautics Authority and a new agency, the Civil Aeronautics Board , was

constituted.25 This agency regulated the airline industry until the Airline Deregulation Act

of 1978 was promulgated. After 1978 it continued regulating the airline industry with

reduced authority until 1985, when it disappeared completely. Some of its functions

were transferred to the U.S. Department of Transportation and to the Department of

Justice.

b) Regulated Market Parameters

1. Rates:

The Civil Aeronautics Board was given the authority to suspend or establish air fares

and determine whether proposed rates were "just and reasonable".26 The Board's

regulation of fare levels can be divided into four distinct phases:27

1. In the first phase, airfares were conventionally set at the prevailing first-

class rail fare.

25 U.S. Public Law: Reorganization Plan No. IV of 1940, Section 7 (a) and (b). 26 U.S. Public Law: Civil Aeronautics Act of 1938, Sec. 403 (a) to (d) and Sec. 404 (a) to (c). 27 Bailey, E.E./Graham, D.R./Kaplan, D.P., Deregulating, 1985, p. 16.


2. In the second, after the first formal review of fares in 1942, the

Board approved fare increases but without any formal guidance

as to the desired level of earnings for the industry.

3. In the third, fares were set to achieve an average 10.5 percent rate of

return for the industry based on actual industry operating costs.

4. In the fourth, the Board set fares to get a 12 percent return

based on standard industry load factors and seating density and

standardized accounting conventions.28

In all four phases the Board's focus was on overall industry profitability rather

than on the relationship between fares and costs in particular markets.

2. Entry, Exit and Routes:

The Civil Aeronautics Board was authorized to prescribe which routes should be flown,

which communities would receive air service, and to designate the specific carriers

which would be permitted to serve such markets. The Board could grant or deny

certificates of "public convenience or necessity".29

As internal entry criteria of the Civil Aeronautics Board, the following four

questions were to be considered in any application for new service:

1. Will the new service usefully serve the public, and be responsive to the

public need?

2. Can and will this service be served adequately by existing routes or

carriers?

3. Can the new service be served by the applicant without impairing the

operations of existing carriers contrary to the public interest?

4. Will any cost of the proposed service to the government be outweighed by

the benefit that will accrue to the public from the new service?30

In fact, between 1938 and 1978, the Civil Aeronautics Board granted no new

authority to domestic "trunk carriers"31 in the belief that it would reduce the possibility of

28 Dempsey, P.S., Laissez-Faire, 1992, p. 167. 29 U.S. Public Law: Civil Aeronautics Act of 1938, Sec. 401 (a) to (n) and Sec. 402 (a) to (h). 30 Dempsey, P.S., Laissez-Faire, 1992, p. 168.


destructive competition among airlines.32 Exit of firms out of the market was controlled

by the Civil Aeronautics Board, as well. Actually, the Board did not permit a single exit

or bankruptcy among the trunk carriers in the four decades of regulation.

3. Antitrust:

The Civil Aeronautics Board also had the authority to approve or disapprove intercarrier

transactions, such as consolidations, mergers and acquisitions. 33 It permitted, for

example, the mergers of the 16 trunk carriers of 1938 into the 11 that existed in 1978

and the mergers of 19 local-service carriers into the 8 in 1978.34

4. Safety:

After the Civil Aeronautics Authority was consolidated with the Air Safety Board to

become the Civil Aeronautics Board (CAB) in 1940, the CAB was given the authority to

set minimum safety standards and to issue air carrier operating certificates. Its duty was

also to inspect the maintenance of equipment in air transportation.

3. The Federal Aviation Act of 1958

The Federal Aviation Act of 1958 was promulgated for the following purpose:

"To continue the Civil Aeronautics Board as an agency of the United States, to create a Federal Aviation Agency, to provide for the regulation and promotion of civil aviation in such manner as to best foster its development and safety, and to provide for the safe and efficient use of the airspace by both civil and military aircraft, and for other purposes.35 In general, the Federal Aviation Act of 1958 did not mean a change in the

economic regulatory era of the airline industry. The Civil Aeronautics Board continued its

work and another agency, the Federal Aviation Agency, was created to execute the

regulation of the airline industry with special focus on safety concerns. The laws

31 "Trunk carriers" were classified by the Civil Aeronautics Board as the airlines which were granted permanent operating rights between any two cities within the United States. In 1981 they were renamed "major carriers". 32 Wilson, G.S., Airport, 1993, pp. 7-9. 33 U.S. Public Law: Civil Aeronautics Act of 1938: Sec 408. 34 Dempsey, P.S., Laissez-Faire, 1992, p. 174. 35 U.S. Public Law 85-726: The Federal Aviation Act of 1958: August 23.1958: Introduction.


concerning the economic regulation of the airlines remained unchanged, compared to the

Civil Aeronautics Act of 1938.

C. Rationale for Deregulation

This section examines the criticisms of regulation in the airline industry and describes the

rationale of the Civil Aeronautics Board in the late 1970s to deregulate the domestic

aviation industry. Congressional scrutiny of arguments for deregulating the airline industry

began with a series of hearing in 1975 under a Senate subcommittee chaired by Edward

Kennedy. The principal criticism concerning the economic regulation in the airline industry

was that pricing and entry restrictions resulted in:36

• insufficient price competition

• excessive service

• inflated airline costs

• less than adequate profits

• high airfares

• misallocation of resources

• encouraged carrier inefficiencies

• excess capacity

• artificial barriers to entry

The Civil Aeronautics Board, under Alfred Kahn as its Chairman, considered the airline

market performance without regulatory intervention as a market with approximately "perfect

competition".37 The Kennedy Subcommittee concluded:

"The airline industry is potentially highly competitive, but the Board's system of regulation discourages the airlines from competing in price and virtually forecloses new firms from entering the industry. The result does not mean high profits. Instead, the airlines - prevented from competing in price - simply channeled their competitive energies toward costier service: more flights, more planes, more frills. ... "38

36 Wilson, G.S., Airport, 1993, p. 9. 37 Levine, M.E., Competition, 1987, p. 400. 38 S e n a t e Subcommittee on Administrative Practice and Procedure of the-Judiciary Committee, 94th Congress, 1st Session, Civil Aeronautics Board Practices and Procedures, pp. 207-8 (1976) (As cited by: Dempsey, P.S., Laissez -Faire, 1992).


On its way towards, an economically deregulated airline industry, the Civil Aeronautics

Board made several assumptions to justify the application of the Perfect Competition Theory.

These assumptions are described in the following sections.

1. No Economies of Scale Effects Expected

The main assumptions of the economists employed by the Civil Aeronautics Board was

that in the airline industry there were no significant economies of scale. As previously

explained, economies of scale effects would lead to "natural monopolies" and prohibit

perfect competition. The Civil Aeronautics Board argued that in the absence of any cost

advantages of big firms over small, there would be no motive to merge and the Board

denied that the air transport industry was a natural monopoly due to falling unit costs.39

Some deregulation proponents insisted that even if there would be natural

monopoly effects in the airline industry, these characteristics need not be a problem,

because according to the Contestable Market Theory, a natural monopolist would be

forced to price at cost because of the "threat of potential entry".

2. Ease of Entry and Exit

As aircraft are highly mobile inputs of the airline industry, the Civil Aeronautics Board

emphasized the ease of entry and exit of that industry which is an important condition

for the application of the Perfect Competition Theory. It was argued that aircraft could

be acquired for market entry (1) by reassigning them from a less attractive market, (2)

by acquiring them from a firm which was using them less profitably, or (3) by leasing

them. 40 These aircraft could then be operated using public airports and airways, while

airlines organized or rented the necessary ground services. If commercial results would

not justify continued operations by a particular firm in a particular market, aircraft could

be sold or returned to lessors easily. Ground services as well could easily be dismantled

and therefore exit from a market would then occur with a minimum of losses from sunk

costs. 39 Dempsey, P.S., Laissez-Faire, 1992, p. 221. 40 Levine, M.E., Competition, 1987, p 400.


3. The Texas and California Experience

In Texas and California, two states in which entry was not regulated as strictly as in the

other states (in other areas, however, they were regulated as strict as the other states),

"new entrant" operators, such as Southwest Airlines or Pacific Southwest Airlines had

significantly lower air fares and higher load factors. California did not control entry at all

until 1965 and the Texas Aeronautics Commission permitted entry by intrastate airlines

to compete with CAB-certificated airlines. Because of the favorable performance of

these two less-regulated markets and other already deregulated markets, the Civil

Aeronautics Board assumed that under deregulation, the entire airline industry in the

United States would be able to offer lower rates to passengers by reducing their costs

and increasing load factors.41 However, a difference between California and Texas and

the other states In the United States is that these two had a large amount of intrastate

traffic between Houston and Texas and Los Angeles and San Francisco.

All these factors led the Civil Aeronautics Board to predictions that price, output

and, by implication, firm selection behavior in deregulated airline markets, would

generally approximate that of perfect competition. Perfect competition implied (1) cost-

based pricing, (2) survival of low cost producers, and (3) disappearance of service

competition generated by regulated prices fixed at too high of levels. The conditions for

perfect contestability - equal access to economies of scale, few sunk costs and price

sustainability - also were seen to be fulfilled by the airline industry and there were no

doubts that a deregulation of the airline industry would be successful for both airline

companies and customers. In 1978 the Airline Deregulation Act was promulgated.42

D. The Airline Deregulation Act of 1978

In 1978, Congress passed and President Carter signed into law the Airline Deregulation

Act of 1978, which (1) dismantled the regulatory umbrella that had traditionally shielded

the industry from destructive competition, and (2) abolished the Civil Aeronautics Board

41 Dempsey, P.S., Laissez-Faire, 1992 and Levine, M.E., Competition, 1987, pp. 40 42 Levine, M.E., Competition, 1 9 8 7 , p . 4 0 3 .


(as of 1985).43 The underlying theory of this legislation was that liberalized entry and

pricing would force carriers to adhere to the competitive pressures of the marketplace to

provide the range of price and service options desired by the public. The Airline

Deregulation Act of 1978 actually does not constitute a separate body of legislation but

instead amends several pieces of existing legislation, of which the Federal Aviation Act of

1958 (as the amended version of the Civil Aeronautics Act of 1988) is the most

significant.

l. Important Changes in Public Law

The Airline Deregulation Act of 1978 was promulgated for the following purpose:

"To amend the Federal Aviation Act of 1958, to encourage, develop, and attain an air transportation system which relies on competitive market forces to determine the quality, variety, and price of air services, and for other purposes.44

In summary, the most important immediate effects of the Airline Deregulation Act

of 1978 were:

1. Shifted Burden of Proof for Easy Market Entry

The burden of proof in route authority cases was shifted from the need for a positive

showing of the applicant that its entry is required by public convenience and

necessity, to a showing by opponents that entry of the applicant is inconsistent with

public convenience and necessity.

2. Automatic Market Entry Program

To a limited degree, automatic market entry was provided, which required no

Board review of approval. Airlines could enter the market with almost no

restriction.

43 Dempsey, P.S., Laissez -Faire, 1992, p. 193. 44 Public Law 95-504, Airline Deregulation Act of 1978, 92 STAT. 1705.


3. Dormant Route Authority

Carriers were allowed to obtain route authority for routes tha t were not being

flown by the carriers that had been certified to fly them.

4. Fares

A statutory zone of reasonableness for fares was set, which was to be adjusted as

airline costs changed and within which airlines could vary fares without permission

from the Civil Aeronautics Board.

5. Small Community Service.

A ten-year Essential Air Service Program should ensure air service to small

communities, with government subsidies for local services to be phased out within six

years.45

The Airline Deregulation Act of 1978 determined a gradual relaxation of the

CAB's regulation of the industry, with full rate and route authority, although the fare

flexibility provisions, particularly with respect to discount fares, were less broad than

the fare policies the Board had already adopted. In the following years after

deregulation, the Civil Aeronautics Board successively lost its authority completely.

The fading authority of the Civil Aeronautics Board will be shown in the next section.

2. Dwindling Authority off the Civil Aeronautics Board

Table 2 shows the decline of the Civil Aeronautics Board from 1978 to January 1,

1985. During this period, the Board lost its authority over fares, subsidies and routes.

Some of the Boards' functions were transferred to the Department of Transportation

and the Department of Justice.

45 Bailey, E.E./Graham, D.R./Kaplan, D.P., Deregulating,1985, pp. 34ff


Table 2. Dwindling Authority of the Civil Aeronautics Board

Date Event

1978 • Airline Deregulation Act of 1978 was promulgated 1979 • Automatic Market Entry program starts (AME) 1981 • most domestic route authority expires 1983 • domestic fares authority expires

• authority over domestic mergers and intercarrier agreements is transferred to the Department of Justice

1985

• Civil Aeronautics Board ceased operations • remaining tasks of international negotiation and small community

service shifted to the Department of Transportation • subsidy programs transferred to the Department of Transportation

1986 • subsidy program terminates _ Source: Partly from Bailey, E.E./Graham, D.R./Kaplan,D.P., Deregulating, 1985, pp. 32-37.

3. The Resulting Open Market

The Airline Deregulation Act of 1978 rested upon a confidence in the inherent

structural competitiveness of the domestic U.S. airline industry. There was no other

industry in the U.S. that has been deregula ted so sharply. By passing the Airline

Deregulation Act of 1978, governmental regulatory barriers to entry were removed and

the Civil Aeronautics Board could no longer block new carriers from entering the

industry, nor could it conduct lengthy route cases to decide which additional carrier

would be permitted to serve a particular pair of cities. The Airline Deregulation Act of

1978 gave airline management complete freedom in the structuring of their route

networks and provided complete freedom of pricing. Finally, the Airline Deregulation

Act of 1978 aimed to establish an “open market” in a competitive industry that should

follow the market forces of perfect competition and perfect contestability without any

regulatory activity.

The chapter will analyze the changes of the airline industry after

deregulation and will show that the assumptions of a competitive or contestable industry

were incorrect.

CHAPTER III

CHANGES IN THE U.S. AIRLINE INDUSTRY

In Chapter III, changes in the U.S. airline industry since deregulation are analyzed.

Section A examines the developments in the airline industry, seen as one market, and

provides an overview of the changes in the structure of the industry. Section B deals

with the changes in concentration. Industry concentration, as well as the concentration

at twelve selected large hub-airports, are measured by the Herfindahl-Hirschman Index

to analyze tendencies towards higher concentration or monopolization.

A. Market Developments and Industry Structure

This section will focus on the tendencies of the airline industry in the United States

concerning growth, capacity and concentration, which are reflected by parameters such

as revenue passenger miles, available seat miles, and load factor. Merger activities,

acquisitions and bankruptcies in the airline industry led to significant changes in the

industry's structure. These activities, as well as an overview of the different types of

airlines in the United States today, will be regarded in this section.

The Hub-and-Spoke Route System is applied by all major airlines and constitutes

the dominating route structure system today. It has an impact on both passengers and

airline management. Advantages and disadvantages of this route structure system also

are explained briefly in this section.

1. Types of Airlines

Airlines in the United States are distinguished in different categories due to the amount

of their revenue. The different categories are "majors", "nationals" and "regionals".

III. Changes in the U.S. Airline Industry 26

Majors Major airlines are earning revenues of $1 billion46 or more annually in

scheduled service. They used to be called "trunk carriers" before

1981, and they usually provide nationwide and sometimes worldwide

service. All major airlines need two certificates from the federal

government for their operations: a "fitness certificate"47 issued by the

Department of Transportation and an "operating certificate"48 issued

by the Federal Aviation Administration.

Nationals National carriers are scheduled airlines with annual revenues between

$100 million and $1 billion. They serve particular region of the country,

although some of them provide long-haul and

international service. Among the nationals are some of the former

"local service airlines" which, prior to deregulation, operated between

major cities and smaller communities surrounding them.

Regionals Regionals are divided into three sub-groups: large and medium

regionals and commuters. Their annual revenue is $20 million to

$100 million for large regionals, or less than $20 million for medium

regionals and commuters. The regionals usually serve small

communities and they do not require a fitness certificate if they

operate aircraft with a seat capacity of less than 30 seats.

The major carriers always have been the dominating airlines before and also

after deregulation. In 1960, for example, all major carriers together accounted

for 95.67% of the total revenue passenger miles in the domestic market and

in 1994 this percentage fell only slightly to 92.84%. Table 3 compares the

market shares in the domestic passenger market of the eleven trunk carriers

46 1 billion = 1,000,000,000. 47 The fitness certificate basically establishes that the carrier has the financing and the management in place to provide scheduled service with large aircraft (defined as aircraft with 61 or more seats and a payload of more than 18,000 pounds). For detailed information see Public Law 85-726, Statute 72: The Federal Aviation Act of 1958, Section 401. 48 Operating certificates spell out numerous requirements for operating aircraft with 31ormore seats and more than 9,000 pounds payload capacity, e.g. training of flight crews and aircraft maintenance. For detailed information see Public Law 85-726, Statute 72: The Federal Aviation Act of 1958.Section 604.


in 1978, the year of deregulation, to the ones of the nine major airlines in

1994.

Table 3 Major Airlines (Passenger) and Their Domestic Market Share in 1978 and 1994

1978 1994 Trunk Carrier Market Share (%) Major Airline Market Share(%)

American 13.80 American 18.18 Continental 4.60 Continental 9.74 Delta 12.26 Delta 16.48 Northwest 2.68 Northwest 8.78 Trans World 9.65 Trans World 4.55 United 21.57 United 17.40 Braniff* 3.93 Southwest** 5.14 Eastern* 11.36 American West 3.15 Western* 5.17 US Air** 9.40 Pan American* 4.84 National* 2.36 Summation 92.22 92.84

Source: U.S. Department of Transportation: Air Carrier Traffic Statistics and Bailey, E.E./Graham,

D.R./Kaplan, D.P., Deregulation, 1985. ________________________ *These airlines ceased operations or merged into other airlines between 1978 and 1994. Figure 5(p. 42) presents an overview of all important airline mergers since deregulation. **These airlines started their service after 1978.

Figure 3 compares the changes in market shares of the six biggest airlines with

continuing service from the beginning of deregulation in 1978, to the market shams in

1994. Only Trans World and United decreased their market share. Some of the trunk

airlines in 1978 have been replaced by others or they merged into one of the bigger

airlines.49

49 For merger activities see also in Chapter III, Section A. 4.


The fact that some airlines lose market share or exit the market whereas others

increase their market share, leads to the assumption that the industry structure changed

towards more concentration. This assumption will be supported by the measurements of

the HHI regarding the industry concentration (see Section B) and the concentration at

the twelve biggest hub-airports in the United States. A significant increase in

concentration will be shown at the hubs, as well as a moderate increase in the domestic

airline market since deregulation.

2. Branch Specific Parameters

The following parameters are commonly used to show developments of traffic,

capacity and efficiency in the airline industry. These parameters, unique to the airline

industry, are (1) revenue passenger miles, (2) available seat miles and (3) the load

factor.

The amount of traffic in the airline industry is measured in revenue

passenger miles (RPMs): A revenue passenger is a "person receiving air


transportation for an air carrier for which remuneration is received by the carrier."

People who receive reduced air fares are not included in this definition.50

One revenue passenger mile is one revenue passenger transported one mile

in revenue service. Revenue passenger miles are computed by summation of the

products of the revenue aircraft miles flown on each inter-airport hop multiplied by the

number of revenue passengers carried on that hop. The revenue passenger miles are

generally used to measure the amount of traffic in the airline industry and to compare

the industry growth throughout the years. They are used as well to calculate the market

shares of each airline in a particular market. The market shares are concluded as the

percentage revenue passenger miles flown by a specific airline divided by the total

amount of revenue passenger miles in the industry.

Another area of interest is the development of capacity. The standard measure

of capacity used by the Department of Transportation, is the available seat mile.

Available seat miles are "the aircraft miles flown in each inter-airport hop multiplied by

the number of seats available on that hop for revenue passenger use."51 If an airline for

example uses an aircraft with a capacity of 200 seats, available for revenue passengers

for a flight of 500 miles, the available seat miles are 100,000. This parameter gives

information about the capacity of an airline on a particular flight or on a certain route. It

also is used to measure the capacity of the whole airline industry as the aggregation of

all airlines in a market.

The load factor is the ratio of revenue passenger miles to available seat miles. It

represents the average percentage of seats occupied by revenue-producing

passengers. Decreasing load factors indicate that capacity is being utilized less than

before. In that case the airline is carrying fewer passengers relative to available

capacity. 52 The load factor is an important parameter to measure the efficiency of

airlines. A significant low load factor would indicate that an airline (or the entire airline

industry) is utilizing resources in an inefficient way, producing higher costs to society

due to the expenses of the unused, excess capacity.

50 U.S. Department of Transportation: Air Carrier Traffic Statistics, July 1994, p. 203. 51 Ibid. p. 301. 52 Banfe, C.F., Management, 1992, pp. 164-165.


3. Industry Developments 1945 -1994

Figure 4 contains the summation of the revenue passenger miles and the available seat

miles from all scheduled passenger airlines in the domestic market of the United States.

The load factor, which appears in the graphic, is the average load factor for the entire

airline industry. The time period from 1945 until 1994 was chosen to demonstrate the

trends that originated prior to deregulation in 1978.

As shown in Figure 4, the airline industry grow constantly from 1945 to 1994.

Despite the many restrictions of the CAB route and pricing policies, the airline industry

grew rapidly, as the increasing values of revenue passenger miles and available seat

miles indicate.

This growth is due primarily to technological improvements that increased travel

convenience and made reduced fares possible. During the first wave of growth in the

late 1940s and 1950s which was inspired by the introduction of long-haul propeller

aircraft, the CAB encouraged carriers to expand their scheduled service to every city of

appreciable size in the United States. In addition, the CAB authorized competitive

services in most of the denser routes and permitted carriers to offer selective discounts

to expand their customer base to include price sensitive vacation and family travelers.

In the late 1950s and early 1960s, the available passenger miles increased

significantly. Responsible for this dramatic increase was the introduction of jet aircraft

that offered more seat capacity, increased the convenience of air travel, and at the

same time reduced costs. The revenue passenger miles increased as well, but less

spectacularly.53

53 Bailey, E.E./Graham, D.R./Kaplan, D.P., Deregulation, 1985.



While revenue passenger miles and available seat miles increased, load factor

decreased constantly until 1971. This decrease was caused by the nonprice competition

of the airlines in this period. The operating economies of the long-haul propeller aircraft

and jets over the older planes they replaced led to a growing disparity between fares

(fixed by the CAB) and costs. This gave carriers in competitive markets strong

incentives to engage in inefficient nonprice competition, such as offering additional

flights or roomier seating, thus increasing the proportion of unfilled seats per flight (i.e.

reducing the load factor). Through much of the regulation period, declining load factors

offset some of the cost advantages of the new aircraft.54

One of the most important arguments of deregulation proponents who claimed

that under regulation the U.S. domestic airline industry was producing excess capacity

was the fact that available seat miles were almost doubt the revenue passenger miles in

the 1970s. Since deregulation in 1978, the available seat miles continue to exceed the

passenger revenue miles, but the trend is going towards less excess capacity and

increasing load factors as airlines try to cut costs.

It can be concluded that since its inception, the U.S. domestic airline industry has

been a growth industry. The assumption that the Airline Deregulation Act of 1978 is

responsible for the growth in this industry is false, as the historical data shows the same

growth-rate prior to deregulation. The time period from 1971 to 1978, in particular,

demonstrates the same characteristics as the post deregulation period: growing traffic

and increasing capacity, as well as increasing load factors.

Of course, there were effects that are not reflected by the fact that the airline

industry has continuously grown, for example, the effects on pricing. Prices fell radically

after deregulation, producing a positive effect on consumer demand and public welfare.

It should be mentioned that price reductions in the airline industry today are chosen by

the companies. Investigations in recent years gave evidence to the assumption of a

dependence of prices in correlation with an increase of concentration and monopoly

power, e.g. due to hub dominance of airlines at large airports.55

54 Bailey, E.E./Graham, D.R./Kaplan, D.P., Deregulation, 1985, pp. 16-21. 55 Peteraf, M. A./Reed. R., Pricing, 1994, p.196 and Abunassar, W./Koford, K.. Airline Fares, 1994, p. 374.


Another considerable aspect that is not reflected by this statistic is the

development of service-quality. Gaynor and Trapani concluded in their study that

deregulation resulted in a welfare loss due to decreased quality of service. One result of

their study is that from 1971 to 1979, unadjusted consumer surplus 56 increased on the

average of $4.3 million per city-pair market due to deregulation of fares and entry,

whereas quality adjusted consumer surplus increased only $2.07 million.57

4. Major Acquisitions and Mergers

Prior to deregulation, the Federal Aviation Act of 1958 gave the CAB a broad discretion

to approve or disapprove mergers based on a “public interest" test.58 In the first decade

of regulation, from 1938 to 1950, the Board denied all proposed mergers between trunk

carriers. In the mid-1950s it swung to the other extreme and approved mergers on

public interest grounds even when they had anticompetitive effects. From 1956 to 1978

the CAB reverted to its earlier, restrictive posture and approved only four mergers.59

Most often mergers took place to avoid a bankruptcy, which could result in the

discontinuation or reduction of service.60

With the Airline Deregulation Act of 1978, Congress amended Section 408,

concerning mergers, to state that the Board's merger decisions should be governed by

the forces of the market place, not by federal economic regulations.61 Section 408 (b) of

the Airline Deregulation Act of 1978 required the CAB, and later on, the Department of

Transportation, to approve any merger, unless…

“the Board finds that the transaction will not be consistent with the public interest or that the conditions of this section will not be fulfilled.”62

56 Consumer surplus is the extra satisfaction or utility gained by consumers from paying actual prices for goods lower than the consumers would have been prepared to pay. In theory, consumers’ surplus is maximized only in perfect competition. 57 Gaynor, M./Trapani, J.M., Welfare, 1994. 58 Public Law 85-726, Federal Aviation Act of 1958, Section 408 (b). 59 These mergers were: United and Capital Airlines, Northwest and Northeast Airlines, Allegheny and Mohawk Airlines, Delta and Northeast Airlines. See also: Bailey, E.E./Graham, D.R./Kaplan, D.P., Deregulating, 1985, p. 174. 60 Banfe, C.F., Management, 1992, p. 72. 61 Until 1985, the CAB still had the power to approve mergers. After 1985, this function was transferred to the Department of Transportation. 62 Public Law 95-504, Airline Deregulation Act of 1978, Section 408 (b).


Section 408 (b) continues by stating the conditions under which the Board should not

approve a merger:

"...the Board shall not approve such transaction - (A) if it [the merger] would result in a monopoly or would be in furtherance of any combination or conspiracy to monopolize or to attempt to monopolize the business of air transportation in any region of the United States; or (B) the effect of which in any region of the United States may be to substantially lessen competition, or to tend to create a monopoly.…” The following part of the same section determines that the Board, and in

continuation, the Department of Transportation, was even allowed to approve mergers

which cause anticompetitive effects or monopolization:

"...unless the Board finds that the anticompetitive effects of the proposed transaction are outweighed in the public interest...." After the Department of Transportation assumed the CAB's jurisdiction over

mergers, acquisitions, and consolidations on December 31, 1984, it approved every

airline merger submitted to it. In total, there have been 51 mergers and acquisitions in

the first ten years of deregulation.63

The primary motivation for airline mergers is to increase the economic

performance of the combined carriers and to utilize "synergisms". Synergy is said to

exist if the combined firm's value and/or earnings exceed that of the individual firms.

Banfe explains that merger synergisms can emerge from three sources:64

1. Economies of scale (operations and marketing).

2. Financial strength (ability to survive business cycles; lower cost of debt).

3. Market strength (reduced competition; stronger ability to perform in

markets).

There are four different types of mergers that can be distinguished in the airline

industry: 65

63 Dempsey, P.S., Laissez-Faire, 1992, p. 227. 64 Banfe, C.F., Management, 1992, p. 73. 65 Banfe, C.F., Management, 1992, p. 73 ff.


1. Horizontal mergers: Two airlines of the same category merge, e.g. Pan

Am and National in 1979.

2. Vertical mergers: Airline merges with a non-airline firm which is in the

production stream, e.g. a ground service company.

3. Congeneric mergers: A merger with related, but not horizontal or vertical

firms, e.g. hotel chains or car leasing firms.

4. Conglomerates: Unrelated enterprises combine.

This study focuses on horizontal merger activities. Quite often, mergers in the

airline industry have been "take overs". An important take over strategy in the airline

industry was a leveraged buyout (LBO): The purchaser of a firm offers a very high price;

after the purchase takes place, the debt is charged to the purchased firm. The principal

reasons motivating airline LBOs in the 1980s were (1) the availability of capital, due in

part to the renewed interest in airline lending by banks and the current favorable interest

Environment, (2) the realization of premium values for used aircraft and facilities and (3)

the belief that the airline industry will have strong earnings in the future. The criticism of

LBOs centers on the impact of massive amounts of debt and on the weakened ability of

airlines to buy new aircraft or maintain existing aircraft properly. The debt load has been

an essential factor for many bankruptcies and consolidations in the airline industry since

deregulation. Examples for companies that have been target firms for LBOs are

Continental Airlines, Trans World Airlines, US Air and Northwest Airline.66

Figure 5 gives an overview of merger activities since deregulation.

66 Schrader, H.A., Deregulierung, 1992, pp. 44-53 and Dempsey, P.S., Laissez-Faire, 1992, p. 14.



5. Bankruptcies Since Deregulation

Along with acquisitions and mergers go many bankruptcies of both small and major

carriers. Although in deregulation’s inaugural years new airlines appeared, most of them

could not survive. Dempsey mentions that from the 176 airlines to which deregulation

gave birth, only one (America West) was still alive, and that over 150 airlines went

bankrupt in the same period.67

It is worth mentioning that bankruptcy does not automatically mean that an airline

has to cease its operations. Under certain conditions, U.S. law allows for the so-called

"Chapter 11" bankruptcy, under which a company can continue with (reduced)

operations although it is unable to make payments. Under Chapter 11 bankruptcy, a

company has to offer a plan for the payment of secured and unsecured creditors and

has to give plausible suggestions for a successive reorganization.68 A big advantage for

a company undergoing Chapter 11 bankruptcy is that contracts with unions are

avoidable and cuts in wages are possible.

Borenstein and Rose found in their study about bankruptcies and pricing

behavior that airlines on average reduce their prices by 5-6 percent prior to a

bankruptcy filing.69 They recognize four reasons for this behavior:

1. Bankrupt carriers are able to lower marginal costs through abrogation of

existing labor and equipment lease contracts.

2. Low prices during bankruptcies could be seen as an investment in future

market shares.

3. Bankruptcy may alter the strategic position of the firm, committing it to

more aggressive competition.

4. Lower prices can be seen as a rational business response to reduced

demand experienced by an airline known to be in financial distress. Table

4 highlights the major airline bankruptcies since deregulation.

67 Dempsey, P.S., Laissez-Faire, 1982, p. 309. 68 Nebraska State Bar Association, Lincoln, 1889. 69 Borenstein, S./Rose, N.L., Bankruptcy, 1995, pp. 397-402.


Table 4. Major Airline Bankruptcies and Domestic Market Shares in Year of

Bankruptcy and in 1978

Major Airline in Bankruptcy

Date of Bankruptcy

Market Share in Year of Bankruptcy Market Share in 1978

Braniff# 1982 1989

1.64% 1.10%

3.97%

Continental 1983 1990

3.90% 8.28%

4.66%

Eastern 1989 2.90% 11.49% Pan American 1991 1.67% 4.89% America West 1991 3.85% --- Trans World

_L 1992 5.52% 9.76%

Source: Partly from Dempsey, P.S., Laissez-Faire, 1992. Air Carrier Traffic Statistics, Bailey, E.E./Graham, D.R./Kaplan, D.P., Deregulating, 1985,

and Borenstein, S./Rose, N.LL., Bankruptcy, 1995

# Chapter 11 bankruptcy is possible only once every seven years.

The decline in market shares in the year of bankruptcy compared to 1978

occurred because airlines sold equipment and routes to other airlines when they faced

financial problems. As a result, the sale of operating assets to rate cash for short-term

payments caused the above-listed airlines to lose market shares while other airlines

prospered.

One example is Pan American. Due to financial problems, Pan American

consistently sold off some of its assets:

1980 Pan Am sold its Manhattan headquarters building for $400 million

to Metropolitan Life. Insurance Company and its Intercontinental

Hotel Chain to Grand Metropolitan of London for $500 million.

1985 Pan Am sold its transpacific routes and 747 aircraft to United

Airlines for $750 million.

1988 Pan Am sold 16 Airbus A320 aircraft and options for 34 more

aircraft for $115 million.


In the same time period, it also sold its transatlantic routes to London to United

Airlines and the Washington-New York-Boston-Shuttle and remaining European routes

to Delta Airlines.70

In summary, after deregulation was inaugurated in 1978, many airlines faced

financial problems and went into bankruptcy. Filing bankruptcy was not necessarily a

negative ordeal; airlines could rid themselves of union contracts and use the protection

of Chapter 11 bankruptcy in many ways which gave them several advantages over

competitors. Ruppenthal claims that Continental sought voluntary bankruptcy in 1983,

more than likely as a result of the advantages of doing so.71 Congress passed the

Bankruptcy Amendments Act of 1993 to eliminate the opportunity for airlines to take

advantages from filing bankruptcy. The Act placed a one-year limit on the period of

exclusivity for a debtor to submit a plan of reorganization, and limited the period for

soliciting acceptance of the plan by creditors to 425 days after the initial filing.72

6. Hub-and-Spoke Route Systems

Today's airline management distinguishes three different types of route

structures: (1) The Hub-and-Spoke Route System, (2) the In-Line Route System and (3)

the Grid-Network.73 Figure 6 offers a schematic view of these route structures.

70 Dempsey, P.S., Laissez-Faire, 1992, pp.129 and 308-310. 71 Ruppenthal, K.M., Deregulation, 1987, pp. 65-82. 72 Phillips, E.H., Reform, 1994. 73 Banfe, C,F., Management, 1992.pp.24-26.


Under regulation, the CAB generally awarded routes to carriers to divide the

market into systems. Airlines were awarded mixtures of higher- and lower - density

routes to allow for cross-subsidization of the less profitable routes with profits earned

from more profitable markets. Because of the need for beyond-segment passenger flow

to increase load factors on non-stop flights, what emerged were mostly patterns of

predominantly in-line route structures.74

With deregulation, the CAB lost the authority to award routes and the airlines

were allowed to serve any domestic route. Airlines adapted to the new environment by

developing Hub-and-Spoke Route Structures and in the first years after deregulation

there was a sharp increase in "hubbing”.75 Hubbing is defined as a process by which an

airline operates connecting banks of arriving and departing flat selected airports. By

channeling passengers from many points through an intermediate connecting point, or

hub, a carrier can combine passengers with different origins and destinations and

thereby increase the number of city-pairs served, as well as the average number of

passengers per flight. Table 5 compares the advantages and disadvantages of the Hub-

and-Spoke System for airlines and passengers.

74 Dempsey. P.G., Laissez-Faire, 1992, p. 285. 75 Kooper, D.M., Deregulation, 1988, p.30.


McShan and Windle found in their study about the implications of Hub-and-

Spoke routing for airline costs and competitiveness that the extent of Hub-and-Spoke

routing has increased dramatically since deregulation and that this network

reconfiguration results in significant cost savings for the airlines.76 The same authors

calculated an average annual hubbing growth rate of 1.7% for the period 1970-1977

76 McShan, S./Windle, R., Hub-and-Spoke, 1989, pp. 209-230.


and an annual growth rate of 6.9% for the period from 1977-1984 (which represents a

total growth of 81% from 1970-84). These numbers show the significant increase in

hubbing since deregulation. Figure 7 provides an illustration of a typical routing system

before deregulation. Figure 8 shows the Hub-and-Spoke routing strategy after

deregulation.



B. Concentration

This section examines changes in concentration of the domestic U.S. airline industry.

The domestic market of the airline industry in the United States always has been more

active than the international market. Figure 9 shows the percentages of the domestic

traffic compared to the international traffic for all U.S. air carriers in 1978 and in 1994,

measured in revenue passenger miles.

Examining the concentration of firms in a given market, measured by the market

shares of each firm in this market, gives important evidence for monopolization or

tendencies toward monopolization in that market. As the Theory of Contestable Markets

allows for natural monopolies, monopolization, per se, does not necessarily indicate that

the public welfare has to decline with increasing monopolization. This, of course, is only

valid in case a potential entrant exerts a certain "threat of potential entry" to the

monopoly firm in the market, so that the monopolist does not use monopoly power to

charge higher prices than under perfect competition.

For the Theory of Perfect Competition, on the other hand, monopolization does

have a significant impact: perfect competition is not possible with a monopoly in the

market, as one of the conditions of perfect competition is the large variety of small firms

that can exert no perceptible influence on price.


With research of concentration in the airline industry, it is possible to analyze

whether the condition of perfect competition concerning the number and size of firms in

the market is fulfilled or not. If perfect competition is rejected by the market because of

monopolization, the next step in research is to verify the applicability of the theory of

contestable markets, i.e. to analyze the relationship between prices and monopolization.

If prices increase with monopolization, it could be concluded that the market is not

perfectly contestable and that there is no "threat of potential entry".

In this research, two concentrations are measured: (1) the industry concentration

and (2) the concentration of airlines at twelve large hub-airports. The average

concentration for all airports will be calculated and contrasted with the concentration of

the industry. In both cases, concentration is measured by the Herfindahl-Hirschman

Index. This Index is used by the Department of Justice in the analysis of the competitive

effects of mergers, and constitutes the appropriate index for investigation.77

1. The Herfindahl-Hirschman-Index

The Herfindahl-Hirschman Index can be used to measure concentration in a

variety of contexts. In this research, the Herfindahl-Hirschman Index is used to analyze

the effects of horizontal mergers on market concentration in the U.S. airline industry.

In 1992, the Department of Justice published revised formal numerical guidelines

for horizontal mergers based on the Herfindahl-Hirschman Index. These guidelines are

used by the Federal Reserve as the first step in analyzing the effect on competition of

bank mergers. Applied to industries other than banking, the guidelines specify that if a

merger would result:

• in a post-merger Herfindahl-Hirschman Index of less than 1800 or

• in a change in HHI of less than 50.

It is likely that the market structure would not reach a concentration level, or

concentration would not increase enough, such that firms in the market would have the

77 Rhoades, S.A., Herfindahl, 1993, pp. 188-189.


market power to maintain prices above the competitive level for a significant period. The

common interpretation of the HHI is reflected in Table 6.78

Table 6 Interpretation of HHI

Grade of concentration HHI

High concentration 1800 < HHI Moderate concentration 1000 < HHI < 1800

Low concentration 0 < HHI < 1000 Source: Aberle, G., Wettbewerbstheorie, 1992, p. 97, and

U.S. Department of Justice: Horizontal Merger Guidelines, 1992

The HHI accounts for the number of firms in a market, as well as for

concentration, by incorporating the relative size (market share) of all firms in a market. It

is calculated by squaring the market shares of all firms in a market and then summing

all the squares (N= number of firms; S i= market share of each firm):79

∑=

=N

1i

2iSH

As a result of squaring the market shares, the HHI gives much heavier weight to

firms with large market shares than to firms with small shares. This feature of the HHI

corresponds to the theoretical notion in economics that the greater the concentration of

output in a small number of firms (high HHI), the greater the likelihood that, other things

equal, competition in a market will be weak.

The HHI reaches a maximum of 10,000 when a monopoly exists in which one

firm has 100 percent of the market. In a purely competitive market, the HHI theoretically

approaches zero. Table 7 provides a sense of what different values of the HHI imply for

the concentration of a market, assuming that all firms have the same market share.

78 U.S. Department of Justice: Horizontal Merger Guidelines, 1992. 79 Scherer, F. M., Structure, 1980, p. 58.


Table 7 Examples for HHI for Different Numbers of Firms of Equal Size

HHI Number of Firms of Equal Size in the Market

Market Share of Each Firm

1000 10 10% 2000 5 20% 3300 3 33.3% 5000 2 50%

Source: Rhoades, S.A., Herfindahl, 1993, p. 189.

2. Concentration in the Domestic U.S. Airline Industry

The market shares of the different airlines are measured by their percentage of

revenue passenger miles relative to the total amount of revenue passenger miles of the

entire industry. Figure 10, on the next page, provides the HHI values for the years

between 1970 and 1994.



The most remarkable changes in concentration are summarized in Table 8.

Table 8. Tendencies of Changes in Concentration (HHI) from 1970-1994

Time period Tendency Change80

of HHI Reasons

1970-77 moderate, but

continuous decrease

-1.6% • Changes in market shares (MS): American, United and

TWA lose slightly

1977-78 increase 4.7% • United, Eastern and Delta gain market share

1978-79 decrease -8.2% • United loses 3% MS

1979-83 moderate increase 2.3%

• Braniff exits in 1982 • Texas Intl. merges with

Continental in 1981 • United gains 2.6% MS

1983-1987 decrease -3.5%

• Strong merger activities • About 25 new airlines enter

the market (e.g. Southwest, American West, etc.)

1987-92 increase 5.8% • Merger activities • New entrants leave the

market

1992-94 decrease -4.4% • new entrants enter • Big airlines lose MS

Source: U.S. Department of Transportation: Air Carrier Traffic Statistics

It is remarkable that the values of the HHI between 1971 and 1977 show only

very slight changes, whereas, after deregulation„ the changes are much more abrupt.

This reflects very well the "turbulence", i.e., the merger activities and entry or exits in the

airline industry, after-the CAB lost the power to regulate entry and exit.

Regarding the guidelines of the Department of Justice concerning merger

activities, the concentration for the entire time period is far below the critical value of the

HHI of 1800. However, there are some changes in concentration in which the HHI 80 Average change per year in each time period.


increases significantly (HHI increases more than 50) from one year to another: in 1978,

1983, 1988 and in 1991.

In summary, during the period from 1970 -1994, the HHI remains on a moderate

level far beyond the critical value of 1800. Although there has been a slight increase of

the HHI in recent years, as compared to the 1970s, it cannot be seen as a significant

increase that jeopardizes the industry concerning monopolization. Recent statistics

show a downward trend towards less concentration. The airline industry therefore does

not seem to be highly concentrated.

This could lead to a wrong conclusion: in this examination, the entire airline

industry was considered as only one big market, containing different airlines with certain

market shares relative to the total amount of traffic in the industry. In reality, it is

necessary to consider every route between two cities as one market and analyze the

concentration of these particular markets. Dempsey points out that in 1992, nearly two-

thirds of the city-pair markets were unregulated monopolies, where firms could charge

monopoly rates.81

A possibility for airlines to gain monopoly power and influence on certain routes

is inherent in the dominance of particular airports. The next section analyzes the

concentration of twelve large hub-airports in the United States from 1972 to 1993. It will

be shown that the HHI of the airports is significantly higher compared to the HHI at

industry level, and that, in fact, the airline industry offers an extremely high level of

concentration at the airports.

3. Concentration at Large Hub-Airports

This section analyzes the concentration of twelve of the largest hubs in the United

States from 1972 to 1993. The purpose of this investigation is to show that the airline

industry may have a significantly higher concentration (HHI) in individual markets

(airports) than the analysis of industry concentration demonstrates.

81 Dempsey, P.S., Laissez-Faire, 1992, p. 234.


Air traffic hubs are not airports; they are "cities and Standard Metropolitan

Statistical Areas requiring aviation services"82 and can consist of several airports. Hubs

are classified according to their size, measured in the percentage of total enplaned

passengers. Four categories are distinguished: (1) Large hubs, (2) Medium hubs, (3)

Small hubs and (4) Non-hubs. In 1993, the United States had 27 large hubs, 30 medium

hubs, and 68 small hubs; in 1972, there were 25 large, 36 medium, and 92 small hubs.

The selected hubs for this investigation are: San Francisco, Los Angeles, Denver,

Phoenix, Miami, Atlanta, New York, Detroit, Chicago, Houston, Washington D.C., and

Dallas. In 1993, these twelve (hubs together accounted for 43.66% of all the enplaned

revenue passengers with domestic destinations in the United States.83 As Figure 11

shows, the percentages of enplaned passengers with international destinations carried

by U.S. carriers in 1989 is, except for New York and Miami, relatively low. This reflects

the importance of these airports as strategic hubs for the domestic market in the U.S.

airline industry.

1989 is used as the year of investigation, because it is the last year before the

Department of Transportation hired a different company to compile the Airport Activity

Statistics. This change of companies resulted in a change in the way that the number of

enplaned passengers now are accounted for; domestic and international enplaned

passengers are aggregated in one overall "total". The percentages in Figure 11 refer

only to U.S. carriers; passengers choosing other than U.S. carriers are not included. In

New York, for example, from all the passengers who flew with U.S. carriers in 1989,

approximately 19% had international destinations. The following map in Figure 12

shows the geographical location of the 12 hubs in this sample.

82 Department of Transportation: Airport Activity Statistics of 1972. 83 Percentage calculated by using data from: Department of Transportation: Airport Activity Statistics of 1993 and Air Transport Association: Traffic Summary 1960-1994.




At every hub, the top eight airlines, concerning their percentage of enplaned

passengers, are considered in the calculations. The Herfindahl-Hirschman Index is

calculated by summing the squares of the market shares of these eight airlines. The

summation of the market shares of these top eight airlines at the hubs varies between

65% and 100% and the average error in calculating the Herfindahl-Hirschman Index is

only 2.5%, i.e., negligible.

Table 9 and Figure 13 show the HHI for each of the twelve hubs in three-year

periods from 1972 -1993.

Table 9. Concentration (HHI) at Selected Hubs 1972-1993

= HHI > 1800

Hubs 1972 1975 1978 1981 1984 1987 1990 1993 San Francisco 2184 2102 2443 1325 1472 1673 1911 2436 Los Angeles 1579 1505 1468 975 921 988 1074 1288

Denver 2115 2076 1947 1989 2649 3772 3562 3786 Phoenix 1993 1864 1850 1208 830 2376 2687 2641

Miami 2318 2598 2559 2158 2450 2280 1381 2677 Atlanta 3797 3910 4044 4279 4391 4568 4589 7039

New York 1461 1588 1542 1455 1131 1254 1341 1585 Detroit 1766 1573 1506 1465 1333 3889 4782 5903

Chicago 1784 1650 1747 1738 2551 2764 2859 2958 Houston 1581 1524 1508 1241 1571 3287 3564 3856

Washington D.C. 1331 1293 1263 960 864 1029 1304 1746 Dallas /Ft. Worth 2262 2696 2395 2265 3146 3695 4010 3692

Source: See calculations in the appendices .



In 1972, the first year of the investigation, six hubs had HHI values of less than

1800, five had values between 1800 and 2318, and Atlanta offered the highest

concentration of 3796 because of the dominance of Delta and Eastern Airlines, who

together accounted for 86% of market share in terms of enplaned passengers.

According to the interpretation guidelines of the Department of Justice, this 1972

sample would be comprised of moderate concentration hubs and five high concentration

hubs. Atlanta could be regarded as a Delta-Eastern duopoly. In 1993, the final year of

this investigation, only three hubs had HHI values of less than 1800.

Figure 14 illustrates the changes of the Herfindahl-Hirschman Index in an

average percentage per year for the investigated 3-year-periods from 1972 to 1993.

The most remarkable changes are commented on in the graphic.



In the last six years of regulation from 1972-1978, the concentration of all hubs

remained almost constant with no significant changes. In the first three years after

deregulation, the concentration declined at ten of the twelve hubs with percentage

changes up to -18.44%. This development coincides very well with the expectations of

the economists who predicted a lower concentrated airline industry after deregulation.

In the 1981-1984 period, the first moderate changes towards more concentration

occurred, although seven of the twelve hubs still showed only a moderate

concentration.

From 1984-1987, the increase of concentration is enormous, with annual rates of

up to 43 percent. The increase in Phoenix (36.7%), in Detroit (42.86%), and in Houston

(27.91%) is significant, and in 1987, eight of the twelve hubs had an HHI of more than

1800, which indicates a high concentrated market. The periods from 1987-1990 and from

1990-1993 show the same characteristics of increasing concentration. Finally, in 1993,

there were only three hubs (New York, Los Angeles and Washington D.C.) that had a

moderate concentrated market; but they show tendencies as well to reach a high level of

concentration (HHI=1800) very soon. Atlanta and Detroit with HHls of 7039 and 5903 may

already be considered as monopolies: in Atlanta, Delta Airlines accounts for 84% of the

market share, and American Airlines in Detroit for 76%. The following four Figures

illustrate the changes in market shares for the two dominant carriers from 1972 to 1993 at

the four highest concentrated hubs in 1993.



The graphics show the increase in market share and the tendencies towards

monopolization at these hubs. It is also important to note that the next closest

competitor has a very small market share compared to the incumbent. For example, in

Atlanta, Delta has 84% whereas the next "largest" only has a market share of

approximately 4%.


The result of the investigation in this section is that concentration at nine of these

twelve hubs increased significantly since the 1983-1987 period. Obviously, there is a

strong tendency towards monopolization at these hubs. A recent study from Wilson

showed the same tendencies for airports in Boston, Las Vegas, Indianapolis and

Cleveland.84

4. Comparison of Hub- and Industry Concentration

Figure 19 compares the average industry HHI to the average hub HHI. The average

HHI at the hubs is calculated by weighting the HHI with their percentages of market

share.

84 Wilson, G.S., Airport, 1993.



Industry concentration increased moderately from 1987 to 1993 and reached its

maximum of 1295 in the year 1993. As this value is far below the critical value of 1800,

the airline industry, when viewed as one large market, cannot be considered to be

highly concentrated.

The developments at the hub-airports are radically different. The first year of the

investigation in 1972 showed a high concentrated average of HHI=1835. From 1975 to

1981, the concentration fell to HHI=1615 and therefore fulfilled the predictions of the

deregulation proponents that the airline industry would be less concentrated after

deregulation. This tendency changed dramatically after 1981, when mergers and

acquisitions led to significant changes in the structure of the airline industry. The

average HHI at the hubs reached 2933 in 1993 and hubs in 1995 must be considered

as highly concentrated, with a tendency towards monopolization.

5. Concentration and Air Fares

Several studies conducted over the last few years examine the relationship

between concentration and air fares in the airline industry. The important question to be

answered is whether there is a "threat of potential entry" preventing firms from charging

higher prices than at cost level in concentrated airline markets (individual markets, as

well as the national market).

Dempsey mentions that passengers who live in a hub city and begin their flight at

this location sometimes pay more than 50 percent above the industry norm. He refers to

a study conducted by the General Accounting Office (1988) which compared fares at 15

high concentration hub-airports with fares at 38 low concentration hub-airports. The

study found average fares to be 27 percent higher at the hubs.85

Borenstein discovered in his research about fares and concentration in 1988 that

a 10 percent increase in the average endpoint enplanement share of an airline would

lead to a 4.3 percent increase in average fare.86

Bailey, Graham and Kaplan reported in their study in 1985 that fares in more

concentrated markets are about 5 to 10 percent higher than in non-concentrated 85 Dempsey, P.S., Laissez-Faire, 1992, pp. 230-31. 86 Borenstein, S., Hubs, 1988.


markets, although they claimed that carrier pricing is constrained by the threat of entry. 87

In a recent examination of airline fares and concentration from 1994.

Abunassar and Koford concluded that concentration increases prices and that

the contestability model as applied to the airline industry is weak.88

Another recent study from 1994 by Peteraf and Reed found that airport share at

large airports increases yields on monopoly routes and the number and concentration of

potential entrants have only little effect on pricing.89

Sawers concluded that "airlines which control a large share of departures from

any airport seem to be able to charge higher fares than airlines with a small share of the

departures." 90

Each of the above mentioned investigations found a dependence of air fares on

concentration. Therefore, It can be assumed, that the threat of potential entry does not

work in the airline industry as predicted. The reason for this are entry barriers, that are

erected by incumbent airlines.91

C. Conclusion

A summation of the findings of this chapter are as follows:

1. The airline industry has always been a growing industry, even before

deregulation, i.e., deregulation did not mean a significant change

concerning traffic growth and increasing load factors.

2. After deregulation, mergers, acquisitions and bankruptcies changed the

industry structure significantly.

3. Average industry concentration increased after deregulation, but always

remained on a moderate level.

87 Bailey, E.E./Graham, D.R./Kaplan, D.P., Deregulating,1985, p. 199. 88 Abunassar, W./ Koford, K., Airline Fares, 1994, p. 374. 89 Peteraf, M. A./Reed, Randal, Pricing, 1994, p. 196. 90 Sawers, D., Competition, 1987, p.27. 91 Entry barriers in the U.S. airline industry are explained in detail in Chapter IV, Section A.


4. Concentration at airports increased significantly. Some airports today may

be already considered as monopolies (e.g., Atlanta and Detroit) or

duopolies (e.g., Denver and Houston).

5. As a response to being given the authority to determine their own routes,

the dominating route structure chosen by the airlines is the Hub-and-.

Spoke Route System.

The reason for increasing concentration at the airports can be seen in the

competitive benefits of concentration for the airlines. These benefits result from the

increased ability of a dominant carrier to establish barriers to entry into a market, e.g., in

occupying gatespace at airports. Wilson found that the effective utilization of airport

concentration as a competitive strategy enables the incumbent carrier to substantially

lessen the amount of competition it must face.92

While the Airline Deregulation Act of 1978 removed barriers to entry through the

elimination of fare and route restrictions, it did not ensure access to individual markets,

such as airports. The conclusion is that, if left unrestricted, the incumbent airlines could

eventually eliminate all competition in certain markets and begin to earn monopoly

rents.

1. The Failure of Perfect Competition

Perfect competition is only possible if (1) there are numerous participants in a market,

(2) the offered products are identical, (3) free entry and exit is possible, and (4) all

buyers and sellers have perfect information. In the airline industry only the second

condition is currently being fulfilled.

As the analysis in this project shows, the criterion of numerous participants

seems to be fulfilled at the industry level, but not at the level of the airports, where high

concentration characterizes the market structure. In these individual markets, in some

cases one airline dominates the market as a monopolist. This fact has an impact on the

entire industry, for example on prices.93 Free entry and exit generally is possible since

the Airline Deregulation Act of 1978 was been passed, but entry barriers, erected by the 92 Wilson, G.S., Airport, 1993, pp. xxii-xxiii. 93 See Chapter III, Section B. 2..


airlines that are already in the market, effectively impede the establishment of new firms

in the market. Finally, the criterion of perfect information is not fulfilled. Computer-

reservation-systems of some particular airlines offer possibilities for these airlines to

manipulate information and to use this marketing tool to reach competitive advantages.

It must be concluded that, contrary to the predictions of Alfred Kahn and other

economists, perfect competition does not exist in the deregulated U.S. airline industry.

This fact, however, does not mean that contestability is not possible at the same time.

The following section evaluates whether airline markets in 1995 can be considered

"contestable", referring to the original theory of Baumol, Panzar and Willig.

2. The Failure of Contestability

In Section B.5. of this chapter it was shown, that air fares depend on the grade of

concentration. The consequence of this fact is that the Contestable Market Theory is not

valid in the airline industry, since an essential criterion of this theory is that prices do not

depend on concentration. The reason why the Contestable Market Theory does not

work in the airline industry is, essentially, the missing "threat of potential entry" due to

entry barriers erected by incumbent firms. These entry barriers led to a highly

concentrated industry where entry is no longer possible.

The effect of entry barriers on the airline industry is that new firms find it difficult

to enter the market and therefore do not exert a significant "threat of potential entry" to

incumbent airlines to prevent them from charging monopoly prices. Airlines that are

already in the market actually do charge higher prices if they have monopoly power,

regardless of potential entrants.

In contrast to "potential" entry, "actual" entry does have an effect. Bailey and

Baumol point out that in many cases, incumbent airlines respond immediately to meet a

competitor's lower fares. This is possible because of new technologies like computer-

reservation-systems which allow changes of ticket prices on an hourly basis. As

explained in Chapter I, an important premise for contestability is "price sustainability",

which means that an incumbent firm cannot react immediately with a matching price to

the low price offer of a new entrant. Bailey and Baumol say clearly that "the condition of


contestability theory that incumbents' prices must be relatively 'sticky' is not met in

aviation".94 As a result, new entrants are losing market shares, or are unable to attract

passengers at all and sooner or later will go bankrupt. In fact, only a few airlines were

able to achieve major carrier status after deregulation; of them, by 1995, US Air is trying

to merge with United or American Airlines because of financial problems, and America

West is in bankruptcy.

Although the emergence of the potential entry criterion in the late 1970s that

preceded the Contestable Market Theory provided sufficient intellectual justification for

deregulation, the actual experience of the airline industry since deregulation has proven

the industry to be more complex and less predictable than anticipated. According to

Dempsey, whose results are supported by the results of other research that is cited in

this study, it can be concluded that (1) in the airline industry there is currently insufficient

threat of potential entry disciplining incumbent airlines and (2) as a result, the premises

for contestability, in the sense required for the original theory to apply, are currently not

fulfilled. As one commentator noted:

"entry into the industry by new carriers seems remote, and entry onto new routes is far more difficult than many envisioned it would be under deregulation. Many industry observers thought that the deregulation of pricing and entry would make airline markets "contestable". That is, airlines could engage in 'hit and run' entry into each others' market in response to profit opportunities - simply by shifting a plane from one route to another. Instead, the evidence compiled in the US Air-Piedmont record as well as a large body of solid research by economic and legal scholars in the past three years, demonstrates that the incumbent airlines are able to charge higher prices on routes where other carriers face barriers to entry".95 Although the U.S. airline industry obviously is not perfectly contestable, some

economists point out that the airline industry at least could be considered as "imperfect"

contestable.96 Imperfect contestability in this case means that actual market entrants do

exert influence on price whereas potential market entrants do not, or not significantly.

94 Bailey, E. E./Baumol, W. J., Deregulation, 1984, p.129. 95 Guerin/Calvert, Hubs, 1987. 96 Morrison, S./Winston, C., Contestability, 1985 (as cited by: Schwartz, M., Contestability, 1986, pp. 37ff.).


Morrison and Winston found in their study that the number of actual entrants has a four

times higher impact on market performance than the number of potential entrants. They

interpret this as indicating that the airline industry is not perfectly contestable, but

imperfectly contestable. Although this theory helps to classify markets, a regulatory

concept can only be based on perfect contestability, since only perfect contestability

assures a threat of potential entry (if entry barriers are not present) that avoids

monopoly pricing.

CHAPTER IV

CONTESTABILITY AS A GUIDE FOR A NEW

COMPETITION CONCEPT The previous analysis showed a significant increase of concentration in the airline

industry, especially at hub-airports. Important findings were that neither the Perfect

Competition Theory nor the Contestable Market Theory work as was predicted. In this

chapter, considerations will be made about how to increase competition and

contestability. First, the entry barriers which impede contestability are presented. In a

second step, a competition-concept is provided that rests upon the belief that the

Contestable Market Theory actually is applicable to the airline industry if entry barriers

can be abolished by temporary regulatory activities.

A. Entry Barriers

The Airline Deregulation Act of 1978 removed existing formal barriers which enabled

new airlines to enter the airline market in the United States. The entry barriers that are

now present in the airline industry have not been established by the government;

instead, they have been established by the companies that are already in the market.

The Department of Transportation determines that an entry barrier exists "if there is a

socially undesirable limitation on the entry of new capacity into an industry or market. In

particular, a barrier exists if a new entrant either cannot enter at all or must incur higher

costs of production than those borne by firms already in the industry or market.97 Figure

20 illustrates the main entry barriers for a market entry of a new airline: (1) frequent flier

programs (FFP), (2) computer reservation systems (CRS), (3) travel agent commission

overrides (TACO), (4) code sharing agreements, (5) facility constraints, (6) landing slots

and (7) the immediate price matching of incumbent firms.

97Department of Transportation, Pricing, 1990 (as cited by: Wilson, G.S., Airport, 1993, p. 44).

IV. Contestability as a Guide for a New Competition Concept 70

The following sections describe these barriers to market entry in the U.S. airline industry

in more detail.

1. Frequent Flier Programs (FFP)

Frequent flier programs were established to encourage brand loyalty by offering benefit

to repeat travelers. These programs provide incentives for travelers to continually use

only one airline. While these programs have benefitted consumers, they also can make

it more difficult for a new entrant to attract passengers.98 Business travelers, for

example, who have already decided on a particular frequent tier program of a carrier

and have some investment in accumulated mileage, often prefer the same carrier over

its rivals even when the rivals' flights are cheaper. This brand loyalty makes it very

difficult for a potential entrant to find a niche in the market, especially because 98 Wilson, G.S., Airport, 1993, p. 64.


incumbent airlines with a well developed route system can offer more interesting

destinations for "free flight tickets" to their customers than a new entrant with fewer

routes.99

2. Computer Reservation Systems (CRS)

Several airlines have developed systems that automate the travel agents, ticketing,

reservations, and accounting system. In 1993, 95 percent of travel agents in the United

States used one of the airline -owned ticket reservation systems.100 From a travel agent's

perspective, CRSs three major functions are:

1. Allowing agents to make reservations and issue tickets.

2. Providing the agency with a source of current information such as total

sales and commissions earned.

3. Offering the travel agency various forms of office automation.

For the airlines, computer reservation systems are far more useful than for travel

agents. The main advantages for the airlines are as follows:

1. Only CRSs offer the possibility to change schedules and fares quickly.

2. Airlines can meet the demand of passengers by managing available seats

to different segments of the market.

3. The number of seats for which discount fares are offered can be adjusted

on an hourly basis.

4. Airlines can track the purchase habits of their customers.

5. An airline which controls the system on which travel agents make

bookings on itself and is competitors gains market intelligence because A

receives information about market preferences and the success of

marketing initiatives.

6. A CRS owner can use this information to distort market signals to its

rivals, leading them to incorrect decisions.101

99 Dempsey, F! S., Laissez-faire, 1992, p. 235. 100 Wilson, G.S., Airport, 1993, p. 62. 101 Levine, M.E., Competition, 1987, p. 461.


The two largest CRSs are "Sabre" (owned by American Airlines) and "Apollo"

(owned by United Airlines) which in 1988 controlled 75 percent of the market. Smaller

airlines which cannot establish their own CRS may participate in a carrier-owned

reservation system by paying fees for being listed on a particular CRS. Theoretically, a

listed airline could pay fees for every listing, booking, and cancellation transaction

without receiving any revenue.102 Another disadvantage for carriers who only participate

on other CRSs is that competitive considerations of the sponsoring carrier could result

in manipulations (e.g., excluding certain flights or presenting them only after listing their

own flights).103

The Department of Transportation concluded in 1988 that CRSs represent a

significant barrier to entrance since they reinforce the carriers dominant position and

reduce competition in the air passenger market by artificially raising the cost of

participating airlines.104

3. Travel Agency Commission Overrides (TACO)

Domestic U.S. airlines typically pay travel agencies a base commission of 10% of a net

ticket price for booking flights. Wilson, 1993, points out that many airlines pay additional

monetary incentives of one to five percent to travel agencies in the form of market share

override commissions. Generally, the TACO is based on the monthly ticket dollar

volume of the agency and the percentage of the total business done with the sponsoring

airline. For example, an airline may pay a travel agency a 10% commission on all sales

up to $100,000 per month and a 3% additional commission for sales between $100,000

and $200,000. The goal of a TACO is to increase travel agencies' bookings on the

sponsoring airline. There are no restrictions on TACOs and any airline has the

opportunity to pay commissions to travel agencies.105

The commissions paid by the dominant or hubbing carrier could potentially

represent the largest commissions and revenues for a travel agent since TACOs are

102 Wilson, G.S., Airport, 1993, p. 82. 103 Bailey, E.E./Graham, D.R./Kaplan, D.P., Deregulating, 1985, p. 187-88. 104 Department of Transportation, Airfares, 1988 (cited from: Wilson, G.S., Airport, 1993, p.63). 105 Wilson, G.S., Airport, 1993, pp. 65-67.


based on total sales volume. Thus, TACOs make it difficult and more costly for new

carriers to enter the market. In order to remain competitive, a new entrant either has to

pay much larger override commissions to the travel agency or has to offer override

commissions on a greater share of the bookings.

The following table shows travel agent commissions paid by U.S. major and

national carriers from 1990-1993. Agent commissions reached a 1993 high of $7.49

billion and are the third highest operating costs for U.S. carriers, behind wages and fuel

costs.

Table 10 Travel Agent commissions Paid by U.S. Major and National Carriers

1990 1991 1992 1993

Commission (in millions)

6388 6811 7136 7494

Rates in % 12.96* 14.08 14.31 14.36 Source: Aviation Week & Space

Technology, January 23, 1995. *Rate includes overrides

The most recent innovation of airlines to save expenses for travel agent

commissions is "ticketless" travel. Ticketless travel means that consumers make their

reservations from their personal computers directly with the airline, without using travel

agencies. ValuJet was the first airline that inaugurated ticketless travel in 1993.

Southwest Airlines planned to cease issuing tickets at the end of January 1995, and

United Airlines is about to establish a ticketless domestic network during this year.106

If all airlines would establish ticketless travel, then, of course, TACOs will lose

their importance as an entry barrier. But it seems unlikely that the airline industry could

do entirely without the distribution channel of the travel agencies since it can not be

assumed that ticketless travel will be supported by the majority of the customers in the

near future.

106 Ott, J., Ticket, 1995, pp. 40-41.


4. Code-Sharing

Since deregulation code-sharing has become a popular marketing practice. Prior to

deregulation a connection at an airport between two flights was possible as an "on-line"

connection with the same carrier, or an "interline" connection if the connecting flight was

provided by a different carrier.

Code-sharing is an agreement where an airline agrees with another to share its

computer reservation system (CRS) code. If both carriers have the same two-letter

code, the CRS will heat them as if connections between them are on-line, even if they

are actually interline. Code-sharing arrangements have become common especially

between major carriers in the U.S. and their commuter airline partners who provide

them with traffic feed. Provisions of such agreements may include repainting the

airplanes in the other partner's colors, relocating gates, and changing flight schedules to

match the larger carrier's operation. A disadvantage for travelers is that they assume a

flight will be on-line with a major carrier and when they arrive at the airport, they

discover that one or more of the sectors will be flow by commuter airlines, perhaps

using a small and uncomfortable turbo-prop aircraft.107 The U.S. Government Accounting

Office sees two negative aspects of code-sharing alliances:

1. Code-sharing discourages the smaller airlines from providing interline service to

any other carrier besides is code sharing partner

2. Research indicates that carriers with code-sharing agreements charge almost

eight percent higher airfares than carriers which did not have similar contracts.108

Dempsey points out that in 1987, ninety percent of the 31.7 million passengers

who flew with regional airlines were carded aboard code-sharing airlines. Code-sharing

constitutes an entry barrier to those routes, where a big airline only serves the market

because of the alliance with a smaller one. If code-sharing did not exist in the airline

industry, the new entrant, for example, could be a competitor to the smaller airline. With

107 Shaw, Steven, Marketing, 1990.pp.204-205. 108 U.S. Government Accounting Office (GAO): Airfares, 1990 (cited from: Wilson, G.S., Airport, 1993.p. 68).


code sharing, it actually is a competitor to the incumbent airline and has to compete with

their pricing policy.109

5. Facility Constraints

A major entry barrier is terminal facilities constraints at airports. Airports often require

long-term bases of 15-30 years or the construction of a terminal by an airline in order to

finance operations and support the sale of revenue bonds. In return, the airline is given

complete control of the terminal space. This includes the authority to sell and sublease

the facilities to other carriers. The control of gate space gives the incumbent carriers the

ability to set prices and conditions of entry for new competitors at a particular airport.

Despite this, research has proven that the larger the shares of the gates leased at an

airport by any particular airline, the higher are the air fares.110

6. Landing Slots

Another barrier to entry and impediment to contestability is the difficulty for a new

entrant to obtain landing slots. Slots are time periods during which airlines have landing

or takeoff rights. Prior to deregulation, the CAB approved agreements allowing carriers

in certain congested airports to form scheduled committees to allocate among

themselves limited slots. The "buying and selling" of slots by carriers was prohibited for

much of the recent past and was not legal before April 1, 1986.

Slots are necessary because at some airports air traffic has increased drastically

and air traffic control could not effectively and safely handle all incoming flights at the

same time. The High Density Rule of the Federal Aviation Administration required four

of the top fifty major airports to allocate aircraft landing slots in 1993.111 There are

estimates that by 1997, more than 33 of the major airports will be experiencing severe

congestion and therefore inaugurate landing slots.112 The shortage of operating capacity

109 Dempsey, P.S., Laissez-Faire, 1992, p. 235. 110 Wilson, G.S., Airport, 1993, p. 58. 111 These four airports are: Chicago O'Hare, J. F. Kennedy and La Guardia in New York, and Dulles Intl. Airport in Washington D.C. 112 Department of Transportation, Pricing, 1990 (as cited by: Wilson, G,S., Airport, 1993, p. 53).


at the airports with high traffic density where landing slots are controlled by airport

authorities not only constitutes a significant obstacle to potential new entrants but

results in higher airfares, as recent studies have discovered.113

7. Price Matching

The last entry barrier to be discussed is price matching of incumbent firms towards new

market entrants. Supposedly, a new entrant is attracted by profits in the airline industry

and thus enters the market. The profits attracting him can be made to disappear

immediately as a result of price cuts and capacity increases of incumbent airlines.

Obviously both firms incur losses which can only be stopped if one of them exits the

market. As the incumbent generally is the larger and better known airline, it can attract

more traffic at any given price level than the new entrant. The result is that the market

entrant experiences a battle of market control, finally is deterred from entry, and the

incumbent earns profits by raising air fares after the new entrant has left the market.114

B. The Concept

The preceding chapters showed that the airline industry currently faces the problems of

increasing concentration and monopolization. The reason for this tendency must be

seen in market entry barriers for new entrants which impede, or at least lessen,

competition. The economists who voted for deregulation essentially made three wrong

assumptions. They predicted that:

1. There were no economies of scale effects in the airline industry.

2. There were no significant barriers to entry, except licensing requirements.

3. Even without a perfectly competitive market, airlines could not charge

monopoly prices because the airline industry was considered to be highly

"contestable".

None of these predictions are fulfilled by the present airline industry. As

economists have shown (e.g., Levine. Dempsey, Bailey), there are significant 113 U.S. Government Accounting Office: Competition, 1990, pp.: 1-6. 114 Levine, M.E.. Competition, 1987, pp, 445-46.


economies of scale and numerous entry barriers; as a result, the missing threat of

potential entry impedes contestability.

Perfect competition is not possible where economies of size lead to concentration

in a market, and therefore does not seem to be an appropriate guide for regulatory

activities in the U.S. airline industry. Economies of size are in an industry and can not

be eliminated. Contestability, in contrast, could be a guide for regulatory activities. The

theory allows for economies of size and for monopolies in a market, as in the airline

industry. The correlation of prices and concentration shows that monopolization without

"threat of potential entry" is not in the public interest.

The assumption made in this study is that contestability might work in the airline

industry if its premises are fulfilled, which means, above all, that entry barriers are no

longer preventing new entrants from exerting a threat to incumbents, The challenge is to

find ways to abolish entry barriers without establishing the same regulatory framework

that was present from 1938-1978 before deregulation took place. Without any

regulation, on the other hand, this goal does not seem to be achievable. Dempsey

mentions four different grades of possible regulatory intervention.

1. Heavy handed regulation (like before deregulation).

2. Regulatory reform ("light-handed" economic regulation).

3. Economic deregulation and antitrust regulation.

4. Laissez-faire.115

As the history of the airline industry in the United States demonstrates, neither

rigid governmental control nor laissez-faire seem to have provided the desired results.

The solution, suggested in this study, is to apply "enlightened" regulation, which would

provide an alternative somewhere between alternative two and three. In this project, an

outline of possible activities is introduced to ensure a higher level of competitiveness

and contestability for the U.S. airline industry.

115 Dempsey, P.S., Laissez-Faire, 1992, p 338.


1. Overview of the Concept

Figure 21 illustrates an overview of a possible regulatory concept. This concept is based

on the belief that the Contestable Market Theory is applicable to the airline industry and

that existing entry barriers can be abolished through regulatory activities. In contrast to

the time of regulation, from 1938-1978, these regulatory activities should not involve just

the airline industry. Instead, it is suggested to take into consideration all modes of

transportation (i.e., railroads, trucks and water carriers) in the United States, to

harmonize transportation as a global matter.

This regulation concept should be considered as a concept used in a transition

period to lead the U.S. airline industry from (now "lighter") regulation to a deregulated

industry where contestability works out well. This condition could be reached by

diminishing the regulatory activities step by step in those fields, where the industry

seems to fulfill the premises of contestability.

The following sections explain the necessity for a new independent "Federal

Transportation Board" and give a more detailed description of the possibilities to take

away market entry barriers through regulatory activities. The suggestions for these

regulatory activities are mainly based on the findings of this study. A complete

discussion of a regulatory concept is beyond the scope of this research.



2. A New Independent Transportation Commission

Once the anticompetitive effects of specific barriers are recognized, it is necessary to

identify an institution that is best suited to address these barriers. A critical point in

finding such an institution is the experience that after the first few decades of existence

of a particular commission, it tends to favor the interests of the industry it regulates.116

To avoid this, and taking into consideration the complexity of the transportation system

of an entire nation, it is necessary to establish an institution that is responsible for all

modes of transportation, i.e., for airlines as well as for rail-, motor-, and water-carriers.

Therefore the suggestion in this study is to combine the tasks of the Interstate

Commerce Commission (rail- and motor carriers) with the ones of the Department of

Transportation (airlines) and the Federal Maritime Commission (water carriers). The

new commission could be called the "Federal Transportation Board". One condition is

that this agency would not be depending on political influences, to assure maximum

neutrality in decision-making which should be based strictly on serving the public

interest.

First of all, the Federal Transportation Board should regulate, the parameters

which cause entry barriers to the airline industry or to the other transportation industries.

Suggestions to achieve this goal in the airline industry are made in the next sections.

Regulation, in the context of this concept, should be understood as a transition period

until the industries (one after another) are "fit" for deregulation. Then, the next step

should be to reduce regulation in favor of a deregulated industry, where well-working

contestability impedes monopoly rents from being charged by natural monopolists.

3. Policy Options for Regulation

Considering the broad variety of possible options for a regulatory policy, the

suggestions made in this project can only provide hints for further discussion. It is

beyond the purpose of this study to develop an entire regulation strategy for the U.S.

airline industry.

116 Dempsey, P.S, Laissez-Faire, 1992, pp. 332-342.


Regulation should begin at the hub-airports. In addition to a need for additional

space at airports, i.e., to expand their capacity, a strategy to make access to airways

and facilities available for all airlines should focus on the sale and lease of slots and

gates at an airport. Wilson points out that antitrust proceedings against airlines are

possible by law if all the following elements are met:117

1. An airport has an HHI greater than 1800.

2. A dominant carrier has denied the use of the facility to a competitor by:

a) refusing to sell or lease limited airport resources (landing slots or

gates) to a competitor in cases where the incumbent does not need the

slot or underutilizes it, or,

b) selling or leasing the facility at exorbitant costs, which reflect the

monopoly or oligopoly power of the lessor seller.

3. The dominant airline intends to monopolize slots and reveals that intent

by:

a) refusing to sell or lease the facility to a competitor even though the

dominant carrier does not need or under utilizes the slot, or

b) leasing or selling at an exorbitant cost, which reflects monopoly or

oligopoly power.118

As Wilson found in his study, many of the above criteria can be found in the US.

airports. The reason why these antitrust proceedings have never been utilized is that

airlines routinely were granted antitrust immunity under provisions of the federal

Aviation Act of 1958. A new regulatory agency, like the suggested Federal

Transportation hoard, would already find the instruments to intervene at the airports, so

that the implementation of freeing facilities and slots should be possible without

immense effort.

After the facilities and slots have been "released", one possible option would be

to lease slot to the airlines for a short-term period rather than allow the carriers to retain

landing rights. The reallocation could be done through a kind of lottery, so that new

carriers also would have the opportunity to gain access to a slot controlled airport. After

117 Wilson, G.S., Airport, 1993. 118 Hardaway, R.M., Regulation, 1991, pp. 214-229 (as cited by: Wilson, G.S., Airport, 1993, p. 296).


a short time period, the carrier would have to furnish proof that it utilizes the slot (or

facility) properly. This solution would (1) generate additional revenue for the federal

government and (2) open airports for additional carriers. The key for success is in the

determination of the individual lease terms. The length of the lease for slots and

facilities needs to be long enough to justify the carrier's investment in service to the

market, on the other hand the agreement must be short enough so the landing rights or

facilities do not become assets of the airlines.119

Another area where regulation is necessary is consumer protection. Consumers

must be protected against unfair practices that result from the manipulation of computer

reservation systems and travel agent commission overrides. Government regulation

currently only addresses overbooking and lost or damaged baggage. The new

regulatory agency should be empowered to intervene for market-inspired flight

cancellations and should establish rules against travel agent commission overrides

which provide incentives for consumer fraud. Marketing practices like misleading

advertising should be forbidden. It is not desirable for customers that an airline

advertises a "super low fare ticket" that applies to a very few seats to attract customers.

If the consumer wants to purchase a ticket of the special fare, he is offered more

expensive fares because the special offer is already sold out. Provisions to avoid these

tactics not only protect consumers, at the same time they help to abolish entry barriers

for new airlines. If advertising were fair and commission overrides were no longer paid,

a new market entry would not find such distorted competition as is currently in

existence.

Frequent flier programs produce competition distortions because of the loyalty of

customers to an airline in the awareness of certain benefits, even if a new entrant could

offer better service for a lower price. Those benefits, especially, should be limited that

arise for the traveler if their employer buys their tickets for them. Requiring travelers to

report bonuses as a taxable benefit in those cases, could be a first step in this direction.

The regulatory agency introduced in this project should be aware of destructive

price wars and "predatory" price responses if new entrants enter the market.

Furthermore, a regulation should be imposed to prohibit the extraction of monopoly or

119 Wilson, G.S., Airport, 1993, pp. 305-308.


oligopoly rents. An industry-wide mileage-based formula, like Dempsey suggests, could

be devised as a benchmark by which to assess reasonableness of rates.120 This formula

should not be seen as a way of establishing the same rate regulation that prevailed

before 1978. It should just ensure to lower those prices which can not be sustained by a

cost justification and at the same time set a minimum, to prohibit predatory pricing and

pricing below fully compensatory levels.

All these provisions and regulatory activities should be introduced while

considering the interactions with other transportation industries like railroads, motor and

water carriers. The goal to be achieved, is to minimize the overall transportation costs of

the United States and, at the same time, try to establish a healthy environment in which

private firms may compete successfully.

120 Dempsey, P. S., Laissez Faire, 1992, pp. 345-47.

CHAPTER V

SUMMARY AND FUTURE WORK

The essential findings of this study are:

1. Deregulation did not change the tendencies of traffic growth, capacity growth or

increasing load factors significantly. The U.S. airline industry always has been a

growth industry since its beginning in 1918.

2. According to the statistics of this research, the Herfindahl-Hirschman-Index (the

official index of the U.S. Department of Justice to measure the concentration of

an industry) of the U.S. airline industry increased from 1166 points in 1978 to

1351 points in 1992 and then fell to 1228 points in 1994. This is far below the

limit of 1800 points where an industry has to be considered highly concentrated.

3. Concentration at large hub-airports increased significantly after deregulation. The

research of twelve huge hub-airports showed a weighted average HHI of 1860

points in 1978, compared to 3299 points in 1993. In 1978, six airports had HHIs

higher than 1800 points and, in 1981, this number decreased to only four

airports. The tendency of decreasing concentration changed after 1981. In 1993,

nine hub-airports out of the twelve in this study were highly concentrated. Most of

them have to be considered monopolies or duopolies.

4. The predictions of Alfred Kahn and other leading economists (e.g., Baumol and

Bailey) that the airline industry would be highly competitive or contestable are not

fulfilled. Economies of scale in the airline industry leads to natural monopolies

and to higher concentration. The criterion of “a large number of sellers", which is

one premise of perfect competition is not fulfilled at many individual markets like

hub-airports or certain routes between hub-airports.

V. Summary and Future Work 84

5. Entry barriers erected by incumbent firms and the missing "threat of potential

entry" prevent contestability. Several studies showed the increase of air fares in

highly concentrated markets (e.g., at monopoly routes) and support the

assumption that the Contestable Market Theory has failed, entry barriers for new

airlines to be considered are: (1) frequent flier programs, (2) computer

reservation systems, (3) travel agent commission overrides, (4) code sharing

agreements, (5) airport facility constraints, (6) landing slots and (7) price,

matching by incumbent firms if a new airline enters the market.

6. In this study, it is suggested to re-regulate the U.S. airline industry using an

"enlightened" regulation policy that is based on the Contestable Market Theory,

The presented concept primarily aims to abolish the entry barriers and, therefore,

to foster contestability and competition. A new "Federal Transportation Board"

should coordinate, for a certain period of time, airlines, railroads and motor and

water carriers, for a global perspective of all transportation in the United States.

The long run goal is not to maintain regulation but to diminish successively the

regulatory activities and to establish a stabilized dereguIated environment that

ensures the needs of the "public interests" are met.

The framework of this study could be utilized for an expansion of the project to

additional airports. Since only twelve hub-airports were included in this project, the

investigation of other airports might add to the significance of the findings in this study.

In particular, a project might be designed to see what impact changes in the airline

industry, since deregulation, have had on small and medium size hub-airports, as well

as on other individual markets i.e., certain routes between hubs.

Additional research also could be done to investigate the access and competitive

issues from a carrier perspective. An examination of the airline side of the entry barriers

could present important information about the motivation for market entry and about the

problems a new entrant has to face. The results could be extremely useful to derive

V. Summary and Future Work 85

regulatory activities to establish a "threat of potential entry" according to the contestable

market theory.

Antitrust laws could be used more effectively. A research should investigate the

possible ways these laws can be applied to the highly concentrated airports today.

Ensuring access to gates and slots for more airlines at congested hub-airports is of

paramount importance for contestability.

Finally, the creation of alternative competition concepts and their verification by a

computer aided scenario-analysis could contribute to manage the complexity of

transportation and to establish, in the long run, a "contestable" airline market in a

deregulated environment.

APPENDICES

Appendix Table I. Traffic Summary 1960-1994 87

Appendix Table II. Load Factor 1945-1994 88

Appendix Table III. HHI of the U.S. Airline Industry 1970-1983 89





Appendix Table IV. HHI of the U.S. Airline Industry 1987-1994 94



Appendix Table V. HHI of Twelve Hub-Airports 1972-1993 97























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Documents

Diplomarbeit - University of Nebraska Omahacba2.unomaha.edu/faculty/mohara/web/Blechschmidt95airline.pdf · Diplomarbeit Concentration and Contestability in the Deregulated United