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March 9, 1984
Airline Deregulation
deregulation. First, downward pressure on
fares increased as airlines began to engage
in price competition. Despite a sharp rise in
fuel prices in 1979, fare revenues rose much
less rapidly than costs (see Chart 1).
After four decades of regulation, domestic
air transportation was largely deregulated
upon passage of the Airline Deregulation
Act ( AD A) in 1978. Critics of deregu lation
policy point out that, since 1978, there have
been major bankruptcies in the industry,
unstable fares, labor contract disruptions
and loss of service to small communities.
Other critics fear a gradual monopolization
of the industry and the ultimate onset of
higher fares and inferior service. These
concerns together motivated recent Congressional proposals to "reregu late" the
airline industry. This Weekly Letter is a
critique of the rationale for reregulation.
Second, airlines reduced the underuse of
service capacity induced by regu lation.
Load factors (the percentage of seats sold
compared to total seats available) rose
sharply after deregulation from about 56
percent to 64 percent for carriers on major
routes. Nonstop service was reduced and
new "hub and spoke" service configurations were initiated to such cities as Kansas
City, St. Louis and Denver. Although
configurations are less convenient for the
traveler, they permit an increase in service
efficiency and lower fares. The fact that air
travel rose after deregulation despite weak
overall economic conditions indicates that
the public clearly prefers the combination of
lower fares and more spartan service.
Economic regulation
Prior to 1978, the domestic operations of
U.S. airlines were subjectto economic regulation by the Civil Aeronautics Board (CAB).
The CAB regulated the level and structure of
fares, drawing on historical operating cost
information to make its determinations. The
C AB also restricted entry of new carriers into
the industry or into individual markets
(routes). In fact, in the forty years of regulation, essentially no new entry occurred in
scheduled service on major routes.
New, aggressive entry also occurred with
deregulation as twenty-five new carriers
entered trunk and regional service between
1978 and 1982. The attractiveness of the
industry to entrepreneurs is reflected in the
trend of prices for versatile, medium-haul,
used aircraft, (e.g., Boeing 727-200). Their
prices appear to have risen sharply after
deregulation even after accounting for the
effects of general inflation (see Chart 2).
Overall, these events contributed to a continued increase in employment in the airline
industry of about 40,000 in the first two
years after the deregu lation compared with
growth of only 20,000 in the prior two years.
Economists argued that the lack of the threat
of competitive entry dampened incentives
for efficient airline operations. In addition,
restrictions on price competition caused airlines to vie for market share in the non-price
dimensions of service, such as schedule
frequency, provision of non-stop service,
and in-flight and airport amenities. The end
result, they argued, was that airlines charged
fares that were too high, offered inefficient
service levels, and paid too little attention to
controll ing labor and other operating costs.
Price wars?
Air fares have fallen particularly sharply on
the long, intercoastal routes. Indeed, it is not
unusual for a San Francisco to New York fare
to be lower than that on a route half the
length. Critics of deregulation see such
aggressive price-cutting behavior as evi-
Deregulation
Viewed from this perspective, most of the
events that have followed the passage of the
Airline Deregulation Act of 1978 were
expected and desirable consequences of
1
Opinions cxprl''jsed in this rwwsleller donol
necessarilv re'fleet the vip\\,s of the management
of the Federal f<eserve Bank of San Fral1ci--co,
or of the Board of Covertlor<; of ih,.' Federal
f\l:'seI've Svstem.
In the airline industry, such barriers are
usually low because the firms' airline capital
is uniquely mobile: an airplane can be redeployed on a new route relatively easily. It is
not "fixed" to a physical location as in the
case of a plant in the manufacturing industry. Even monopoly suppliers of service on a
route always face the potential of entry by
carriers from other parts of the industry, and
their behavior will be constrained accordingly. This notion of "contestability" of
monopolized markets was examined by
economist Gerald Kaplan in a study of the
fares on individual routes after deregu lation.
Kaplan found that actual and potential entry
protected the market from the exercise of
monopoly power on thinly served routes.
dence of the in herent instabi I ity of the ai rIi ne
industry under deregu lation. In an ideally
competitive market, episodic price "warring" should not be expected to occur.
However, an inherently unstable market
structure is probably not the most likely
explanation for the current pricing behavior
of airlines. One alternative explanation for
the discount fare "wars" on the intercoastal
routes relates to the composition of airline
fleets. Airl ines had purchased large numbers
of wide-bodied aircraft intending them for
use on a variety of high density routes. In
1979, however, the large increase in fuel
prices made these aircraft uneconomical to
operate on al I but the longest routes. In
essence, the industry may have found itself
with excess "long-haul" capacity, and has
tried to increase its passenger loads through
aggressive fare cutting. I f this explanation is
correct, the intercoastal fare "wars" should
abate as the carriers recompose their fleets.
Nor is there evidence that concentration
in air transportation is increasing for the
industry as a whole or on individual routes.
In 1982, the share of traffic,:provided by the
largest five carriers was only 67 percent,
versus 69 percent prior to deregulation. In
addition, in a study of 300 individual airline
markets, economists Graham, Kaplan and
Silby found that, in general, market concentration had either decreased or remained
unchanged since deregulation.
Headed for monopoly?
Much depends, of course, on the ultimate
structure of the industry. In spite of the large
number of new carriers that started operation after deregulation, critics point to the
high rates of bankruptcies in the airline
industry and are concerned thatthe industry
may end up dominated by a few very large
firms with little competition on individual
routes. Indeed, even before deregulation,
most domestic non-stop routes were served
by only one carrier. However, there is little
theoretical or empirical evidence to support
this fear.
Smallcommunity
service
Free entry and exit under deregulation
raised a different concern in small communities. Such communities feared the total loss
of service once CAB service requirements
were abandoned. Economists had argued
that although the type of service (i.e., aircraft
and schedule frequency) and fares might
change, entrepreneurs still would find
means of serving these markets. Nevertheless, the Airline Deregulation Act contained
a provision for transitory subsidies to carriers
serving small markets.
On low and moderate traffic routes, economies of scale probably do dictate that only
one carrier will be ableto serve the route
efficiently. However, as a number of economists, including Keeler and PanzaI' have
pointed out, the provision of service by a
monopolist does not necessariIy mean that
he will be able to exploit monopoly power if
there is a realistic threat of competitive entry.
Competitive entry, in turn, will be more
likely if there are relatively low barriers to
such entry.
In most cases, the fear of wholesale abandonment of small community service has
proved to be exaggerated. In those cases in
which there was significant loss of service
(such as in the Bakersfield, California
market) the loss was due to peculiar
2
new low-cost entrants would erode the
market share of the existing carriers, thereby
blunting the incentives to cut costs by the
regu lated carriers.
manifestations of the transition from a
regulated to a deregulated environment,
such as the bankruptcy of a major carrier.
Even in these cases, new entry usually
provided replacement service.
Deregu lation wou Id be expected therefore
not only to increase operating efficiency, but
also to put downward pressure on the prices
of labor and other inputs. During the transition period, the advantages··of lower input
prices are available largely to new entrants, .
since older carriers may be bound by carie
tractual agreements. As a result, a new carrier in the Northeastern U.s., for example, can
operate at approximately one half the cost
per seat mile of its established counterparts.
In many cases, the increased post-deregulation competition has actually improved the
quality of service to these communities. For
example, a recent survey of 72 communities
where major carriers had terminated service
showed that flight frequencies increased by
30 percent between 1 978 and 1981 due to
an increase in commuter carrier service.
labor wrangles and bankruptcy
The recent bankruptcies and labor disputes
also are more likely to be characteristics of
the transition to deregulation than indicators
of the inherent instability of the industry . .
Under regulation, restrictions on the entry
and exit of firms amplified the bargaining
power of airline labor. An airline could not
leave the industry without losing its operating authority; itthus could not use the threat
of declaring bankruptcy to reorganize in the
subsequent bargaining process. The restrictions on entry under regulation also protected the negotiating position of airline labor.
Entry restrictions removed the threat that
Facing such low-cost rivalry, it is not surprising therefore that major carriers have sought
to find ways of renegotiating their wage bill.
In one case, this was accomplished by a
recent 18 percent negotiated wage reduction; in another, wage reductions were
sought as part of a total financial reorganization. This process is likely to continue until
all producers face a similar cost environment, at which point new entry will
probably slow and the labor market will
likely become more stable.
Randall Pozdena
Chari 1
Index of Expense/Revenue Ratio
for Major Carriers
Chart 2
Used Aircraft Price Trends
MlIllllns lit Ollllars
8.5
8.0
7.5
7.0
197Z",100
112
110
Deregulation ..
108
Deregulation.
6.5
104
6.0
5.5
5.0
102
4.5
100
4.0
3.5
106
1972
98 ':;;;-. L-±-l.-;;:':::-'--:=--'-...,;!;,,-L-:;!. 1982
1972
1974
1976
1978
1980
1974
1976
1978
FRB analysis of Boeing Corp. data,
3
1980
1982
S S"' O .LSl:Il:I
U018U!
YSE'M.
lj1nn • uo8()JO • epellaN • 0ljl?PI
!!l?ME'H.•
e!UJOj!le)
BANKING DATA-TWELFTH FEDERAL
RESERVE
DISTRICT
Commercial and Industrial
Realestate
Loans to Individuals
leases
2
U.S.Treasury AgencySecurities
and
2
Other Securities
Total Deposits
DemandDeposits
Demand Deposits Adjusted 3
4
Other Transaction
Balances
Total Non-Transaction Balances
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other liabilities for Borrowed MoneyS
Amount
Outstanding
2/22/84
175,497
155,132
45,813
59.163
26,824
5,003
12,225
8,139
183,973
42,411
27,492
11,930
129,630
2/15/84
40,278
177
38,016
20,915
Change from
year ago
DoIIar
Percen
Change
214
336
from
110
153
333
5
91
7
- 55
12
-1 ,300
-1,637
-2,317
- 80
416
-
-
528
222
150
264
174
59
281
23
7,023
6,825
3,838
844
645
-
Weekended
2/15/84
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed(-)
NA
NA
NA
NA
NA
NA
148
2,090
Weekended
2/22/84
3
4
5
6
-
-
1.7
0.8
1.8
2.5
3.6
6.5
- 12.5
- 1.6
- 20.3
- 76.7
- 67.8
- 36.5
2.8
681
WeeklyAverages
of Daily Figures
Reserve
Position,All ReportingBanks
1
2
p>jselV
:{)
'ill@\IlJll:{)JJ\'II<W@@ JJ
\\[!;j) \'II@\';i@(Q[
(Dollar amounts in millions)
Loans,leasesand Investments'2
loans and leases! 5
PUOZ!J\I •
(\j) 2l1I
'me) lO:>SpUeA:I
ues
lS4 'ON
OI\1d39\11 S0d 's'n
1l\lW SS\IlJ lSHU
031HOS3Hd
SelectedAssetsand liabilities
LargeCommercialBanks
•
9.5
-
2.2
- 50.3
Comparable
year-ago period
.
NA
NA
NA
Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes U.S. government and depository institution deposits and cash items
ATS, N OW, Super N OW and savings accounts with telephone transfers
Includes borrowing via F RB, TI&l notes, Fed Funds, RPsand other sources
Includes items not shown separately
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