Saving Airline Deregulation

 

kenneth button is a professor in the School of Policy, Government and International Affairs at George Mason University, where he teaches economics.

Illustrations by Hugh Syme

Published January 19, 2016. 

 

Sea changes in public policy often originate in surprising places. In 1975, Sen. Ted Kennedy, proud heir to New Deal traditions of big government, nonetheless called for sweeping economic deregulation of America's tightly regulated airline industry. "Regulators all too often encourage or approve unreasonably high prices, inadequate service and anticompetitive behavior," he explained. "The cost of this regulation is always passed on to the consumer. And that cost is astronomical."

The seminal victories, changes to air-cargo regulations in 1977 and the Airline Deregulation Act of 1978, exposed both domestic cargo and passenger service to the bracing winds of competition. Thereafter, presidential administrations from both political parties pursued the Open Skies initiative, which over the next decade or so also largely deregulated routes and fares for international air service to the United States.

Airlines responded with a host of innovations. Among the most important: hub-and-spoke route systems that vastly increased the options for flying to and from midsized cities and yield-management pricing that filled seats that would otherwise have flown empty and kept fares low for travelers who could book in advance.

But lurking beneath the surface of this story of deregulation that has dramatically increased productivity and left consumers far better off is the question of whether the success is sustainable. On one hand, the giant legacy carriers that stumbled through the first decades of deregulation earning little or no return on their vast investment are finally covering at least their operating costs and are apparently better positioned to confront future economic storms. On the other, the consolidation that has made this possible has made it all the harder for new entrants, opening the door to anticompetitive behavior on the part of the incumbents that could undermine consumers' gains.

Indeed, it's possible to glimpse a future in which airlines grow bolder in flexing their muscles (political as well as economic) to inhibit competition. The blocking of upstart discounter Norwegian Air International's application to serve transatlantic routes using Irish registration and the campaign to limit flights to the United States by the hard-charging Persian Gulf airlines (Etihad, Emirates and Qatar) are early warnings that U.S. carriers are increasingly inclined to battle for anticompetitive privilege.

That's where the removal of the last glaring vestige of economic regulation of airlines in America – the denial of so-called cabotage rights to foreign carriers that want to compete directly in the domestic airline market – fits in. But I put the cart before the horse. First, some background on how we got from there to here.

poster las vegas
Klein, David (1918-2005)/Private Collection/Photo © Christie's Images/Bridgeman Images

The Best and Worst of Times

The U.S. domestic airline market is the largest in the world: in 2014, passengers flew almost 600 billion miles – a fivefold increase since 1975. But while the market is still growing, the pace of growth has slowed. Most travelers are largely served by hub-and-spoke networks, with flights feeding from regional airports into hubs, at which point most passengers transfer to other planes to continue on to their final destinations. The payoff: a route like Portland, Ore., to Savannah, Ga., may only serve a handful of travelers a week, but those travelers can depart from Portland on any of a dozen-plus daily flights leaving between 5:30 a.m. and 5 p.m. linking through to their destination via Atlanta, Newark, Washington, Chicago or Dallas.

The current stability of the airline market is new. U.S. carriers were conspicuously unsuccessful in recovering their full costs in the three decades following deregulation. Indeed, since deregulation, the operating margins of U.S. airlines have averaged around zero (yes, zero) percent. The consequences, of course, have been predictable, with many carriers disappearing through bankruptcy or merger.

Some of the tribulations of the industry were clearly self-inflicted, with carriers often focusing on size rather than profitability – a common problem across many transportation sectors, where management often seems focused on growth and technological improvements to the neglect of the bottom line.

Government has been part of the problem, too. Washington has yet to replace the decades-outmoded air-navigation system, which often upsets the delicate dance of hub-and-spoke connections. And it has added to travelers' (and carriers') miseries, with its flat-footed approaches to everything from terrorism prevention to tarmac delays.

But this picture – at least the parts of the picture within the airlines' control – has been changing rapidly in recent years, with U.S. carriers consolidating to reap greater economies of scale without butting heads with rivals. They have also moved to unbundle their services, pricing baggage carriage, food and drink and early boarding separately, and adding semi-premium seating for those willing to pay more than least-common-denominator coach fares but less than stratospheric business-class fares.

Travelers may grumble about this unbundling, waxing nostalgic for the days when two checked bags and a chicken dinner came with every ticket. It does, however, suggest greater appreciation on the part of the carriers of how markets work. By the same token, the carriers' success in filling flights by means of sophisticated yield-management techniques is lamented by passengers – especially those stuck in middle seats. But apart from the fact that it is simply good business practice not to waste capacity, there is the oft-neglected social gain of less pollution and less crowding of inadequate airport and air-traffic infrastructure as the average load factor rose from 51 percent in 1971 to 85 percent in the first half of 2015.

Not surprisingly, the more businesslike behavior of the U.S. carriers has increased profits, and, to a degree, stabilized them. It's hard to quibble with the notion that in the long run, investors must make a competitive market return on capital to keep the industry healthy; somebody, after all, has to pay to replace aging aircraft. And, by one indirect measure of profit adequacy – cash flow over and above current operating expenses, there isn't much of a case to be made that the industry is coining money. Operating margins in 2014 averaged 8.6 percent, less than the 10 to 12 percent that industry analysts argue is adequate to attract capital.

 
Since deregulation, the operating margins of U.S. airlines have averaged around zero (yes, zero) percent. The consequences, of course, have been predictable, with many carriers disappearing through bankruptcy or merger.
 

But reasonably stable profits have come with increasing industry concentration, which raises some red flags. And the case for concern is worth a close look.

The remaining legacy carriers, American, United and Delta, along with Southwest, accounted for 70 percent of the domestic passenger-miles flown in 2014. But on many routes there is clearly a high degree of competition – especially when travelers have options of moving through a hub in addition to direct services, as in our Portland-to-Savannah example. In this sense, it was probably misguided for the Justice Department to have initially blocked the merger of US Airways and American Airlines on the grounds that it would leave only three network carriers in the market, asserting that "competition from Southwest, JetBlue or other airlines would not be sufficient to prevent the anticompetitive consequences of the merger." The department also contended that "Southwest, the only major non-network airline, and the other smaller carriers have... business models that differ significantly from the legacy airlines."

While it is true that Southwest's modus operandi initially differed from those of American, United and Delta, it was certainly competitive with them – the term "the Southwest effect" is not without content. For that matter, Southwest's business model has gradually converged with that of other big carriers. It now includes a frequent-flier program that makes regular patrons think twice before flying another carrier, has de facto different classes of service and routes some 40 percent of its passengers through hubs.

As is so often the case, however, the devil is in the details. One could argue that overall industry concentration is largely beside the point because competition on individual origin-destination city pairs determines the degree of market power confronting individual fliers. In some contexts, the long-term prospects for the level of competition that best serves consumers in the domestic airline market are problematic.

One important outcome of the recent wave of mergers and the general tightening of supply has been a decline in the number of flights offered. The deregulation of the 1970s led to an explosion in service powered both by entry from new carriers and the network magic offered by hub-and-spoke systems. But the forces driving growth in service tailed off and went into reverse in 2007. The largest 29 airports in the United States lost nearly 9 percent of their scheduled flights between 2007 and 2012. More ominously, small and medium-sized airports lost 21 percent and 26 percent, respectively.

This is not to say that most American travelers are now inadequately served. As a cursory glance at one of the online travel search engines makes clear, the hub-and-spoke systems of the carriers still ensure a high level of flight frequency and convenience for large and medium-sized markets. But the decline in flights is associated with a reduction in the number of carriers flying the typical spoke, raising the prospect that individual airlines will be able to exercise market power on more routes. And, while the primary risk for most travelers from the decline in flying frequency is higher fares, passengers to and from smaller markets also risk major inconvenience. That brings us back to the real subject of this article: cabotage.

easyjet
airberlin silo

poster texas
© David Pollack/Corbis

What's in a Word?

Cabotage rights for foreign airlines – allowing foreigners to provide purely domestic service – are hardly ever granted. Indeed, the only big exception is the European Union, which has created an open market of well over 400 million people. Airlines from member countries can establish themselves anywhere in the EU, provide service between any airports they wish and set fares at their own discretion. Thus, Air France can provide service between Munich and Berlin, while Lufthansa can fly from Marseille to Paris. More to the point, cabotage has opened the EU to innovation that has dramatically extended service to smaller markets, even as it lowered fares.

For example, Ryanair (now the world's largest carrier of international passengers) flies between Trieste and Trapani, while easyJet (a British-based carrier) flies from Paris to Toulouse.

But in the United States, the prohibition on foreigners providing domestic service is almost total. Air France is not just barred from operating a flight between Los Angeles and Boston; it cannot sell a ticket between those cities even if the flight continues on to Paris. Nor, for that matter, could Air France buy a U.S. carrier that flies from Los Angeles to Boston.

The law does allow for exceptions to those prohibitions, but don't hold your breath. The Department of Transportation can grant a foreign airline an exemption for up to 30 days, if and only if there is an emergency that can't be managed by domestic carriers. Sky-high fares and airline strikes, by the way, don't count as emergencies.

Airline cabotage prohibitions are sometimes defended on the same grounds as maritime cabotage prohibitions: national security concerns. The reality is more prosaic. Domestic airlines and their unions don't want to compete with foreigners today any more than General Motors and the United Auto Workers did in the 1980s.

Cabotage to the Rescue?

Few economists – or for that matter, anyone else outside the airline industry – think cabotage restrictions promote the interests of consumers. Indeed, the remarkable success of the end of restrictions within Europe in terms of fares and flights – especially in smaller markets – is testament to the cost consumers in the United States bear for the lack of it.

One, of course, might ask why foreign carriers would be willing to fly to places their U.S. counterparts eschew. While it is quite possible that services over shorter, thinner routes could not be justified on economic grounds, there is no solid way of confirming that theory in a market in which foreign carriers are denied access. Indeed, the success of Ryanair, easyJet and a number of other startups in serving European cities avoided by the legacy carriers suggests that the burden of proof ought to be on the opponents of liberalization.

There are a number of ways in which cabotage restrictions could be relaxed and maybe eventually make more radical reform possible. One politically attractive option would be to allow foreign carriers to bid for publicly subsidized services that come under the Essential Air Services and the Small Community Air Service Development Grant programs, on the premise that they are providing "emergency" services or fostering local economic growth.

The Essential Air Services program was created in 1978 as a sop to communities that (sometimes correctly) feared airlines would desert them once regulators could not require carriers to link them to the national transportation network. Under the program, the Department of Transportation offers subsidies in return for providing service to orphaned markets. Critics have long argued, however, that the need is not great – some subsidized airports are less than an hour's drive from unsubsidized ones – or that the subsidy is a giant waste of taxpayers' money because so few people make use of the flights.

The small-communities program, which can also involve financial assistance for marketing programs, additional personnel, studies and aircraft acquisitions as well as flight subsidies, has been criticized for failing to achieve much. A study at MIT, for example, found that of the 115 such grants awarded between 2006 and 2011, less than 40 percent met their primary objectives.

Cabotage to the rescue? The catch here is that opening only routes covered by the two subsidy programs wouldn't have much impact on the market. The air carriers that provide similar services in very small markets in Europe generally have high costs and receive concomitantly high subsidies. Widerøe's Flyveselskap, the main supplier of Norway's "social-service-obligation" flights, has costs per passenger-mile that are over 13 times the average of Ryanair and seven times the average of Southwest.

Ryanair, a possible low-cost entrant, currently uses only Boeing 737-800 aircraft with 189 seats, while easyJet uses Airbus A319s and 320s with 156 and 180 seats, respectively – much larger than the 19-seat maximum requirement of the Essential Air Services program. These fast-on-their-wings carriers might find ways to adapt to small-scale service at reasonable cost, but it would be a stretch and they would need motives to try.

Note, too, that the program's routes don't form networks on their own, but serve as independent links that do not fit any of the linear, hub-and-spoke, or radial route models that create the prospect of commercial success for short-haul operations. Currently, the program's domestic carriers often treat such routes as appendages to other (potentially profitable) parts of their networks – a circumstance that would not apply to foreign airlines if they were not permitted to set up their own hubs.

poster chicago
© David Pollack/Corbis

Small-communities-program financing has, in some cases, been bolstered by the private sector through revenue guarantees, guaranteed minimum ticket purchases and other kinds of support. This may be seen as risk-sharing between the community, the federal government and the airline. But again, it is difficult to see how opening such routes for non-U.S. carriers without added accommodations would catalyze any significant change in the national market for air services.

Very small markets are not the only ones, though, that have been hurt by declining service during market consolidation. One major concern is cities that lost as much as two-thirds of their flights – notably, Cleveland, Memphis, Pittsburgh, St. Louis and Milwaukee – when they were demoted from hubs to airports that must rely solely on the traffic they originate. Clifford Winston of the Brookings Institution suggests that these former hubs be opened to foreign carriers, eliminating cabotage restrictions between the hubs and any other city that has lost some flights in the domestic consolidation. This would not only serve to succor these locations, but may also be seen as an experiment in finding out whether foreign carriers would enter the market and with what consequences.

The difficulty here is that foreign airlines, even if they are more efficient than their U.S. counterparts, would face serious risks in restoring traffic to hubs abandoned by domestic carriers. Foreign carriers could make some use of these hubs as a source of international traffic. But most major foreign carriers already belong to global strategic alliances (Star Alliance, SkyTeam, Oneworld) that funnel traffic from U.S. network carriers.

There is also a more fundamental issue here. A selective end to cabotage restrictions would again give regulators authority to decide who flies where and how often. Besides potentially being the thin end of the wedge toward more extensive re-regulation, managing a partially regulated route structure efficiently would require considerable knowledge of the network economics of the industry. When an airline dehubs an airport, it seldom withdraws all services and, in addition, other domestic carriers often take up some of the slots vacated. Thus the regulator responsible for drawing borders between domains of domestic airlines and potential foreign entrants would have to make judgments concerning which airports fall into each category.

The airline industry is nothing if not dynamic and, judging by pre-1978 experiences, regulatory agencies are not fleet enough to create a reasonable facsimile of an efficient outcome. That's assuming that they would even be motivated to try; political interference would seem inevitable.

A legally separate, but operationally entwined, issue is the matter of foreign investment in U.S. airlines. The general rule since 1938 has been that foreigners may own up to 49.9 percent of the stock in an airline, but their voting shares must be capped at 25 percent. Moreover, the CEO and at least two-thirds of the directors must be U.S. citizens.

The rationale (as with cabotage restrictions) is nominally military: domestic airlines must commit to providing airlift capacity on a few days' notice. But the need to maintain a formal Civil Reserve Air Fleet does not bear scrutiny well. The Government Accountability Office points out that such use has seldom been activated – the first time was in 1990, as part of Desert Storm – and when it was, only a very small part of the available supplementary fleet was drafted. It's uncertain, moreover, whether allowing greater foreign investment in the U.S. commercial fleet would improve or weaken the reserve capacity. It would probably enhance the commercial viability of the U.S. passenger civil-airline industry by opening more sources of finance and allow for more integrated services with foreign alliance partners.

 
norwegian jet
Shock Therapy?

The various paths of gradualism outlined would be difficult to manage and would not contribute much to sustaining competition in the partially protected domestic market for air travel. There are also lessons to be learned from elsewhere about the potential pitfalls of gradualism in liberalizing the market. In particular, one can compare the admittedly destabilizing impact of the 1978 Airline Deregulation Act, which brought benefits for U.S. travelers almost immediately, with the tortuous road to competition (and consumer satisfaction) in Europe that was fought every step of the way by the incumbent flag carriers.

A complete removal of cabotage restrictions (retaining, of course, safety and security regulations) would avoid all the game playing that would inevitably complicate gradualism. The exact effects are impossible to predict. If they weren't, we would not need free markets to achieve efficient resource allocation. My educated guess: most travelers would benefit as more choice was introduced, though the incremental impact would not be as great as the 1978 reforms.

The simplest change, allowing foreign long-haul carriers to feed their international routes with hub-and-spoke systems that could haul domestic traffic as well, would make a difference – but probably not all that much difference. For one thing, much of the potential gain is already being exploited by domestic carriers that feed traffic to their foreign-alliance partners.

One would expect some use of "consecutive cabotage" – as in carrying passengers from, say, Los Angeles to Philadelphia on flights terminating in London – especially by foreign long-haul carriers not allied with U.S. legacy airlines. But even here, long-haul routes require types of aircraft not conducive to shorter-haul operations, and scheduling operations is challenging, given time zone differences. Changing the gauge of aircraft between long-haul and domestic services would require significant investment, with the foreign carrier either setting up a domestic network or acquiring one from an existing operator. In the longer term, however, consecutive cabotage may act as some check on the market power of incumbent U.S. airlines.

The benefits from an end to cabotage restrictions would most likely be greatest in smaller markets from which U.S. carriers have largely withdrawn. This would take time, since new entrants would need to define their strategies. But there is little question that opening the door to well-funded carriers with decades of experience in diverse markets would eventually pay off for consumers.

poster miami
Klein, David (1918-2005)/Private Collection/Bridgeman Images

The Not-Quite-Impossible Dream

Can one imagine circumstances in which Congress would reform cabotage rules and make the changes sufficiently broad to ensure significant market entry? Maybe.

For one thing, the decline in service and rise in fares since consolidation – notably in small markets that can ill afford the loss – have generated anger among the public and unease among policy nerds about the long-term viability of airline competition. It has yet to be mobilized around a specific proposal for change, but cabotage reform could be that catalyst. For another, increasing airline competition is one of the few issues on which the political left and right can agree, especially since it would cost the federal government nothing. Indeed, it could be linked to an end to existing subsidies for small markets.

Domestic airline interests would hardly give in easily. But one could imagine changes that would soften the blow – for example, linking an end to restrictions for EU carriers in the United States to an opening of the internal European market to U.S. carriers. The same could also be said about reciprocal agreements to allow cabotage in both the Canadian and U.S. markets. Moreover, it's worth noting that U.S. carriers, which have worked long and hard to defend consolidation as critical to the health of airline competition, have lost the political and moral high ground in opposing yet more competition.

Cabotage reform still seems like a long shot. But then, deregulation seemed a long shot when, nearly four decades ago, Ted Kennedy reached across the aisle (and into the regulatory agencies) to build a coalition strong enough to break the grip of airline regulation.

flybe silo

main topic: Regulation
related topics: Markets, U.S. Economy, Economy, European Union, Business