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Contrived Competition: Airline Regulation and Deregulation, 1925–1988

Published online by Cambridge University Press:  13 December 2011

Richard H. K. Vietor
Richard H. K. Vietor
Affiliation:
Richard H. K. Vietor is professor of business administration at theHarvard Business School.
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Extract

Although many have studied regulatory policy in the United States, few have viewed it as a process, shaping markets and industries and, in turn, being affected by the structures it helped to create. By looking at the forty-year history of airline regulation and then focusing on one company's adaptations to deregulation, this article demonstrates that monocausal explanations fail to capture the complex and dynamic nature of the interaction between regulation and competition in America.

Type
Articles
Information
Business History Review , Volume 64 , Issue 1: Government and Business , Spring 1990 , pp. 61 - 108
Copyright
Copyright © The President and Fellows of Harvard College 1990

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References

1 Among the best studies by economists are Caves, Richard E., Air Transport and its Regulators: An Industry Study (Cambridge, Mass., 1962)Google Scholar; Richmond, Samuel B., Regulation and Competition in Air Transportation (New York, 1961)Google Scholar; and Jordan, William A., Airline Regulation in America: Effects and Imperfections (Baltimore, Md., 1970)Google Scholar; Kahn, Alfred E., The Economics of Regulation (New York, 1971), 2: 209–20Google Scholar.

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9 Quoted in Serling, Robert J., Eagle: The Story of American Airlines (New York, 1985), 65.Google Scholar

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11 Franklin D. Roosevelt, Executive Order No. 6591, 9 Feb. 1934; also, U.S. Congress, Senate, Special Committee, Investigation of Air Mail and Ocean Mail Contracts, 73d Cong., 2d sess., parts 1–9, 1934.

12 Public Law 308, 48 Stat. 933, 39 U.S.C. 463 (1934); Rhyne, Charles, The Civil Aeronautics Act Annotated (Washington, D.C., 1939), 29–31.Google Scholar

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15 The Roosevelt administration preferred that all regulatory responsibilities for transportation be consolidated in a single agency—either the ICC or a new cabinet department. See Franklin D. Roosevelt, “Message of Transmittal,” 31 Jan. 1935, in Federal Aviation Commission, Report, ii–iv; and, U.S. Congress, Senate, Subcommittee on S. 3659, Committee on Interstate Commerce, Civil Aviation and Air Transport, 75th Cong., 3d sess., April 1938, 1–2.

16 The original (1938) act actually combined regulatory and developmental (air traffic control and safety) functions under the same administrative roof. But after just two years, Congress amended the act, restoring air traffic control and safety to the Commerce Department (and changing the name of the Civil Aeronautics Authority to the Civil Aeronautics Board); see Reorganization Act of 1940, 54 Stat. 735; also, U.S. Congress, House, House Report No. 2505, 76th Cong., 3d sess., 1940.

17 Civil Aeronautics Act of 1938, 52 Stat. 973; also, Rhyne, Civil Aeronautics Act Annotated.

18 The board itself drew this distinction in Civil Aeronautics Board, “Acquisition of Marquette by TWA—Supplemental Opinion,” 2 CAB 409 (1940), 411–13.Google Scholar

19 Civil Aeronautics Board, Annual Reports, 1946–1949 (Washington, D.C.).Google Scholar

20 Investigation of Nonscheduled Air Service, 6 CAB (1946), 1049Google Scholar; Large Irregular Carriers, Exemption, 11 CAB (1950), 609Google Scholar; U.S. Congress, Select Committee on Small Business, Future of Irregular Airlines in United States Air Transportation Industry, 83d Cong., 1st sess., 1953, and U.S. Congress, House Judiciary Committee, Report Pursuant to H. Res. 107 on Airlines, 85th Cong., 1st sess., 5 April 1957.

21 Transcontinental and Western Air North-South California, 4 CAB 373 (1943Google Scholar), and Colonial Air et al., Atlantic Seaboard Op., 4 CAB 552, 555 (1943Google Scholar).

22 In a 1947 case, for example, this ambivalence toward city-pair competition (among trunk carriers) was clear, as the examiner sought to distinguish “between the cut-throat, disruptive type of competition where the existing carrier is fighting for financial survival and the constructive kind of competitive service imposed to stimulate traffic, reduce costs, encourage better service, and otherwise promote the development of the industry”; see Civil Aeronautics Board, Docket No. 679, Detroit Washington Service Case, “Report of Examiner,” 17 March 1947, 84.

23 See for example, the President's Air Policy Commission, Survival in the Air Age (Washington, D.C., 1948)Google Scholar; U.S. Congress, Congressional Aviation Policy Board, National Aviation Policy, 80th Cong., 2d sess.; and, Landis, James M., “Air Routes under the Civil Aeronautics Act,” Journal of Air Law and Commerce 15 (Summer 1948): 299.Google Scholar

24 Load factor dropped from 79 to 60 percent in two years; Civil Aeronautics Board, Annual Report, 1948, 3.

25 Cherington, Airline Price Policy, 186–289.

26 Civil Aeronautics Board, Docket No. 1102, Southern Service to the West, “Report of the Hearing Examiner,” 21 June 1959, 99, and 12 CAB 518 (1951), 534.

27 Rizley, Ross, “Some Personal Reflections after Eight Months as Chairman of the Civil Aeronautics Board,” An Address to the Enid Chamber of Commerce, Enid, Okla., 13 Nov. 1955, In Journal of Air Law and Commerce 22 (Autumn 1955): 445–52.Google Scholar

28 Richmond, Regulation and Competition, 112–90.

29 Caves, Air Transport, 307–13. Net investment, as of 1955, was reported as $1,239,305,000, in U.S. Congress, Antitrust Subcommittee, Report on Airlines, 18.

30 Jordan, Airline Regulation in America, 62–65.

31 Redford, Emmette S., The General Passenger Fare Investigation, Inter-University Case Program No. 56 (University, Ala., 1960), 43–44.Google Scholar

32 This rapid turnover of aircraft, however, may not have been an unmixed benefit. Richard Caves pointed long ago to the fact that excessive equipment competition may have precluded some desirable utilization of older aircraft for lower fare service; see Caves, Air Transport and its Regulators, 241, and Kahn, , Economics of Regulation, 2: 213–14.Google Scholar On the re-equipment cycle, see Hector, Louis J., “Problems in Economic Regulation of Civil Aviation in the United States,” an Address before the New York Society of Security Analysts, 28 Nov. 1958, in Journal of Air Law and Commerce 25 (1958): 101–7.Google Scholar

33 Civil Aeronautics Board, Handbook of Airline Statistics, 1972, 464; 1978, 136.

34 Civil Aeronautics Board, Handbook of Airline Statistics, 1974, 134–35.

35 Fruhan, The Fight for Competitive Advantage, 24.

36 Ibid., 126–39.

37 In these markets, load factor improved considerably, to the point where travelers actually complained of difficulties getting tickets. Jordan, William A., “Airline Capacity Agreements Correcting a Regulatory Imperfection,” Journal of Air Law and Commerce 39 (1973): 184–86Google Scholar; U.S. Congress, Senate, Judiciary Committee, Subcommittee on Administrative Practices and Procedure, Civil Aeronautics Board Practices and Procedures—A Report, 94th Cong., 1st sess., Committee Print (Washington, D.C., 1975), 145–46Google Scholar. These capacity agreements were ruled unlawful in Civil Aeronautics Board, Docket No. 22908, Capacity Reduction Agreements Case, “Report of the Examiner,” 18 Nov. 1974.

38 Commissioner G. Joseph Minetti, quoted in U.S. Senate, CAB Practices and Procedure, 84–86.

39 Jordan, “Airline Capacity Agreements,” 203.

40 The CAB's procedure and methodology had been subject to criticism since the late 1950s, when commissioner Louis Hector resigned and sent an open letter to President Eisenhower, criticizing the board's lack of rational criteria, policy flip-flopping through case-by-case, oral decisions, justified after the fact by written opinions; Louis J. Hector, “Problems of the CAB and the Independent Regulatory Agencies,” A Memorandum to the President, 10 Sept. 1959. In the DPFI, the board adopted an elaborate new set of standards, including 1) determination of an industry-wide average cost; 2) a target load factor of 55 percent; 3) a 12 percent rate of return; 4) a rate structure based on mileage; 5) an assumed price elasticity of demand of -0.7 percent; and 6) an automatic quarterly process for reporting costs and calculating fere adjustments. See U.S. Congress, Senate, CAB Practices and Procedure, 109–13.

41 For a detailed analysis of the theoretical literature that pertains to airline deregulation, see Katz, Jonathan L., “The Politics of Deregulation: The Case of the Civil Aeronautics Board” (Ph.D. Diss., Columbia University, 1985)Google Scholar, chaps. 2 and 3.

42 In addition to those previously cited, see Meyer, John R., et al. , The Economics of Competition in the Transportation Industries (Cambridge, Mass., 1959)Google Scholar; Levine, Michael E., “Is Regulation Necessary? California Air Transportation and National Regulatory Policy,” in Yale Law Journal 74 (1965): 1416–47CrossRefGoogle Scholar; Keeler, Theodore E., “Airline Regulation and Market Performance,” Bell Journal of Economics and Management Science 3 (Autumn 1972): 399CrossRefGoogle Scholar, Douglas, George W. and Miller, James C. III, Economic Regulation of Domestic Air Transport: Theory and Policy (Washington, D.C., 1974)Google Scholar, and MacAvoy, Paul and Snow, John W., Regulation of Passenger Fares and Competition among the Airlines (Washington, D.C., 1977)Google Scholar.

43 Derthick and Quirk, The Politics of Deregulation, 29–39.

44 Harrigan, K. and Kasper, D., Senator Kennedy and the CAB (Boston: Harvard Business School, Case No. 9–378–055, 1977)Google Scholar.

45 Breyer, Regulation and Its Reform, 321–22.

46 Economic Report of the President, February 1975 (Washington, D.C., 1975)Google Scholar, chap. 3.

47 CAB Special Staff, Regulatory Reform: Report of the CAB Special Staff (Washington, D.C., 1975); also, 284–91.Google Scholar

48 See U.S. Congress, Senate, Commerce Committee, Subcommittee on Aviation, Regulatory Reform in Air Transport, 94th Cong., 2d sess., April-June 1976, 827; and, U.S. Congress, Senate, Committee on Commerce, Science, and Transport, Subcommittee on Aviation, Regulatory Reform in Air Transportation, 95th Cong., 1st sess., March-April 1977.

49 Regulatory Reform in Air Transportation, March-April 1977, 510.

50 Rush Loving, Jr., “The Pros and Cons of Airline Deregulation,” Fortune, Aug. 1977, 212; Robert Crandall, “Speech in Detroit,” 28 May 1975, in Robert Crandall Papers at American Airlines, Dallas, Texas.

51 McCraw, Prophets of Regulation, chap. 7.

52 See especially, Civil Aeronautics Board, Docket 30277, Chicago-Midway Low Fare Route Proceeding, 12 July 1978; and CAB Order No. 38-7-40, 74.

53 Robert Crandall, “Airline Regulation: Sense and Nonsense,” Remarks before the Rotary Club of Tulsa, 12 July 1978; also, Alfred Kahn, “A Funny Thing Happened on the Way to Cincinnati,” before the American Association of Airport Executives, Cincinnati, Ohio, 22 May 1978.

54 Kahn, Alfred, “The Uneasy Marriage of Regulation and Competition,” Telematics 5 (Sept. 1984): 16Google Scholar. At the time, however, few advocates of deregulation had recognized the need for stricter antitrust enforcement. By the time of this article, though, Kahn would warn that “the prevention of unfair competition is the proper job of the antitrust laws, not economic regulatory commissions.”

55 Certain regulatory functions involving customer services (baggage complaints, bumping, and smoking), interline ticketing, and joint fares would devolve upon the Department of Transportation. U.S. Congress, House, Committee on Public Works, Legislative History of the Airline Deregulation Act of 1978, 96th Cong., 1st sess., 1978.

56 Robert L. Crandall, “Opening Remarks, System Marketing Management Meeting,” 2 April 1980, quoted in Vietor, Richard, American Airlines (A) (Boston: HBS Case Services, Case No. 9–385–182, 1985), 1.Google Scholar

57 Again, difficult macroeconomic conditions coincided with important changes within the industry. The second oil shock drove jet fuel prices from 40 to 90 cents a gallon—or to about 25 percent of operating costs. With inflation at 10.1 percent, wages per employee reached $26,691. As GNP growth turned negative (0.7 percent), airline traffic fell 4 percent. (American's traffic dropped 15 percent from a 1979 level inflated by United's strike.)

58 The economist James McKie used the “tarbaby” metaphor to describe the spread of economic regulation across market segments and functions; McKie, James, “Regulation and the Free Market: The Problems of Boundaries,” Bell Journal of Economics 1 (1970): 6–26.CrossRefGoogle Scholar

59 Office of Economic Analysis, Civil Aeronautics Board, Competition and the Airlines: An Evaluation of Deregulation (Washington, D.C., 1982), 22.Google Scholar

60 Ibid., 108.

61 Thomas Plaskett (vice-president of marketing, American Airlines), “Address to American Airlines Marketing Meeting,” Spring 1981, 31.

62 Salomon Brothers, Industry Analysis, 31 May 1983, 6.

63 Morrison and Winston, Economic Effects of Airline Deregulation, 7; and Levine, “Airline Competition in Deregulated Markets,” 413.

64 CAB, Office of Economic Analysis, Competition and the Airlines, 49.

65 Crandall, Robert L., “Remarks Before the 33rd Annual Conference of Airport Operators Council International,” Mexico City, 30 Sept. 1980, 8Google Scholar.

66 American Airlines, “Market Activity Report, 1980”; and Merrill Lynch, Airline Industry Annual financial Statistics, December 1982.

67 Serling, Eagle: The Story of American Airlines.

68 Albert Casey, retired CEO, American Airlines, interview with author, 1 April 1987.

69 Copeland, Duncan, “Information Technology for First-Mover Advantage: The U.S. Airline Experience” (D.B.A. diss., Harvard Business School, 1990).Google Scholar

70 Copeland, Duncan, “Evolution of Airline Reservation Systems: 1945–1985,” working paper, Harvard Business School, Boston, Mass., 1988).Google Scholar

71 American Airlines, “Profit Improvement Plan” (a slide presentation), 1980.

72 Wesley G. Kaldahl, “Address to a Lenders Meeting,” 4 May 1982.

73 American Airlines, “The Dallas/Ft. Worth Connecting Complex,” 20 Jan. 1982.

74 Wesley G. Kaldahl, “Presentation to Airline Analysts,” 2 July 1985, 7.

75 Thomas G. Plaskett, vice-president, marketing, American Airlines, interview with the author, Aug. 1984; and Plaskett, “American Airlines Marketing Meeting,” 24.

76 Discount pricing across broad categories of passengers, which was sometimes forced by the “no-frills” discount carriers, was devastating to the profitability of high-cost carriers like American. In the spring of 1982, before American's strategy was fully implemented, Braniff suddenly shifted strategies after its rapid expansion as a full-service carrier proved unsustainable. Howard Putnam, who had been the president of Southwest Airlines, tried to save Braniff with a low-fare strategy—especially on routes in the Southwest and Midwest where it competed with American. In a moment of poor judgment, Robert Crandall allegedly telephoned Putnam and urged him to end the price war by raising prices 30 percent. Putnam made a tape recording of the conversation and gave it to the Justice Department. Crandall eventually settled the resulting suit by a consent decree, in which he agreed not to discuss pricing with other airline executives; Business Week, 5 Aug. 1985, 92.

77 United Airlines v. Civil Aeronautics Board, 766 F.2d 1107, 1109 (7th Cir. 1985Google Scholar).

78 Robert L. Crandall, interview with the author, August 1984; and interview with Judith Leff, September 1987; also, C. A Pasciuto, vice-president of employee relations, American Airlines, “Remarks Before Western Railroad Association,” 28 April 1983.

79 The “two-tier pay scale,” as American takes pains to explain, is not a phrase coined by the company. Indeed, management did not initially see the “B” rate as a separate wage system. Rather, it was a front-end adjustment to lower costs of new employees. The same applied to flight attendants; it was a temporary measure, scheduled to reconverge with the “A” scale after several years, and disappear altogether after nine years. With the pilots, American made a commitment to recall more than 500 already on furlough, but at 15 percent less than they were making before, for five years. American's management hoped that these temporary differentials would make American more competitive until its operating costs came down and its low-cost competitors accrued their own seniority and overhead costs. From the union's perspective, this temporary concession was the least unattractive means of protecting oldtimers from the cutbacks and benefit losses that deregulation made inevitable.

80 American Airlines, “The Plan for Achieving Union Productivity Improvements,” early 1982; and, “A Blueprint for the Future …,” American Airlines' Proposal to the Transport Workers Union, 1982.

81 American Airlines, “Fleet and Route Planning Issues,” mid-1984.

82 American Airlines, “American's Planned North/South Hubs,” Presentation to the Board of Directors, 17 July 1985.

83 American did enter Europe in 1987, and it continued to expand as rapidly as it could acquire routes. But the new small hubs did not prove to be useful as gateways; Bridget O'Brian, “American Air Expands into Three Continents, Flexing Its U.S. Muscle,” Wall Strut Journal, 8 June 1990, 1, A4.

84 Bailey and Williams, “Sources of Rent in the Deregulated Airline Industry,” 173–202.

85 US AIR and Piedmont combined, and then acquired Pacific Southwest Air, to form a new national carrier by 1989. Half a dozen other small regional carriers did remain independent, serving small geographic niches in which the national carriers were not interested. These include Air Wisconsin, Alaska Air, Aloha, American West, Jet America, and Midway.

86 Weinberg, M., Continental Airlines (A) (Boston: HBS Case Services No. 9–385–006, 1984)Google Scholar; and, “House of Mirrors,” Wall Stnet Journal, 7 April 1988, 1.

87 Oster, Clinton V. Jr, and Pickrell, Don H., “Marketing Alliances and Competitive Strategy in the Airline Industry,” Logistics and Transportation Review 22 (1986): 371–87Google Scholar; also, “Major U.S. Airlines Rapidly Gain Control Over Regional Lines,” Wall Street Journal, 17 Feb. 1988.

88 “Texas Air's Hard Bargainer,” New York Times, 16 Sept. 1986.

89 Bailey, Elizabeth E. and Panzar, John C., “The Contestability of Airline Markets during the Transition to Deregulation,” Law and Contemporary Problems 44 (Winter 1981): 809–22CrossRefGoogle Scholar; and Baumol, William J., Panzar, John C., and Willig, Robert D., Contesable Markets and the Theory of Industry Structure (New York, 1982).Google Scholar

90 Bailey, Graham, and Kaplan, Deregulating the Airlines; also, for a good review of the revisionist literature, see Sinha, Dipendra, “The Theory of Contestable Markets and U.S. Airline Deregulation: A Survey,” Legistics and Transportation Review 22 (1987): 405–19.Google Scholar

91 Don Carty, quoted in “A pact that will help American become a low-cost airline,” Business Week, 28 Nov. 1983, 41.

92 Meyer and Oster, Jr., Deregulation and the Future of Intercity Passenger Travel, 110.

93 “Assessing the Effects of Airline Deregulation,” New York Times, 20 March 1988.

94 See Cherington, Airline Price Policy, 186–289.

95 By 1985, travel agents accounted for 57 percent of all airline tickets sold; United Airlines v. Aeronautics Board, 766 F.2d 1107, 1109 (7th Cir. 1985Google Scholar); also, Civil Aeronautics Board, Investigation into the Competitive Marketing of Air Transportation, Order 82–12–85 (Washington, D.C., 1984)Google Scholar, and U.S. Congress, Senate, Committee on Commerce, Subcommittee on Aviation, Computer Reservatim Systems, 99th Cong., 1st sess., 19 March 1985.

96 Blumestock, James and Thomchick, Evelyn, “Deregulation and Airline Labor Relations,” Logistics and Transportation Review 22 (1986): 389–403Google Scholar; also, Meyer and Oster, Deregulation and the Future of Intercity Passenger Travel, 83–107. However, a study by Canadian economists indicates that “since deregulation, the growth rate of compensation in the U.S. airline industry exceeds that of the transport/utility sector of the economy and nearly matches that of the U.S. business sector”; Andriuliatis, et al., Deregulation and Airline Employment, 27, 31–32.

97 New York Times, 20 March 1988.

98 Bailey and Williams, “Sources of Rent,” and David K. Massey, “Hub Strategies,” Airline Executive, June 1987, 37–41. In commenting on this point, however, Meyer suggested that the prospect of point-to-point hub overflights with appropriate new aircraft, like 757s, 767s, and 737–300s, may partially undermine hub dominance.

99 Proposed solutions, such as sale or auction of slots, were second-best, since dominant firms had the deepest pockets. Not surprisingly, Robert Crandall was a vocal advocate of a market for peak-hour slots. Phillips, Lawrence T., “Structural Change in the Airline Industry: Carrier Concentration at Large Hub Airports and its Implications for Competitive Behavior,” Transportation Journal 25 (Winter 1985): 18–28Google Scholar; and Robert Crandall, interview, March 1987.

100 Revenue-passenger miles grew 7.6 percent annually between 1968 and 1978, and 8.7 percent from 1978 to 1987; Merrill Lynch, Airline Industry, Nov. 1985, and Department of Transportation, Air Carrier Monthly Traffic Statistics, June 1987.

101 In 1986, the number of federal controllers was down to 22,000, from 27,000 before the PATCO strike in 1981. By 1987, the number of departures handled per controller had risen by 52 percent. While the incidence of near-collisions had increased, most other safety measures had improved because of continuing advances in avionics; see, Federal Trade Commission, Bureau of Economics, The Deregulated Airline Industry: A Review of the Evidence (Washington, D.C., Jan. 1988), 76–77.Google Scholar

102 FTC, The Deregulated Airline Industry, 61–83; also, Morrison and Winston, The Economics of Airline Deregulation, 25–47.

103 Congressional Budget Office, Policies for the Deregulated Airline Industry (Washington, D.C., 1988), 4.Google Scholar

104 Kahn, Alfred, “Airline Deregulation—A Mixed Bag, But a Clear Success Nevertheless,” Transportation Law Journal 16 (1988): 248–49 and footnote 58.Google Scholar

105 For a comparison across several industries, see Vietor, Richard, “Regulation and Competition in America, 1920s–1980s,” in Governments, Industries and Markets, ed. Chick, Martin (London, 1990), 10–35.Google Scholar

106 Williamson, Oliver E., The Economic Institutions of Capitalism (New York, 1985).Google Scholar

107 Lazonick, William, Competitive Advantage on the Shop Floor (Cambridge, Mass., 1990)Google Scholar, and Business Organization and the Myth of the Market Economy (forthcoming).

108 This point is acknowledged, and thoughtfully discussed, in Michael Levine, “Airline Competition,” 393–417.