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FEDERAL

RESERVE
CLEVELAND

RANK

I W

E C O N O M I C
1 9 8 6

Disinflation, Equity Valuation,
and Investor Rationality.

Some observers have suggested that the
Great Bull Market of the 1980s is due solely
to lower inflation. The effect of inflation on
stock prices, however, is not quite so direct.
Economists Jerome S. Fons and W illiam P.
Osterberg examine theories of the relation
between inflation and equity prices in light
of recent experience.

R E V I E W

Q U A R T E R

Economic Review

An exhaustible resource model, com bined
with risks stemming from large government
stocks, explains rising gold prices from 1968
to 1981. This paper posits that demand misestimation accounts for the extended decline
in gold prices after 1981.

is published quar

terly by the Research Department of
the Federal Reserve Bank of Cleve
land. Copies of the issues listed
here are available through our Public
Information Department,
216/579-2047.

Editor: William G. Murmann.
Design: Michael Galka.
Typesetting: Liz Hanna.

Opinions stated in

The Collapse in Gold Prices:
A New Perspective.

Economic Review

are those of the authors and not
necessarily those of the Federal
Reserve Bank of Cleveland or of the
Board of Governors of the Federal
Reserve System .

Material m ay be reprinted provided
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"1 ™7 “Don’t Panic”: A Primer
J. / on Airline Deregulation.
The effects of airline deregulation are current
ly a much-debated topic. Recent empirical
work on this issue is summarized and collated
here for the layman. The conclusion is that
deregulation has led to substantial aggregate
benefits to society, but that the industry has
yet to fully adapt to its new environment.

IS S N 0013-0281

Disinflation, Equity
Valuation, and Investor
Rationality
by Jerome S. Fons
and William P. Osterberg

Jerom e S. Fons and William P.
Osterberg are economists at the
Federal Reserve Bank of Cleveland.
Tbe authors would like to thank
Jam es Balazsy for research assist
ance, and William T. Gavin, K .J .
Kowalewski, Richard Kopcke and
Richard Cohn for their helpful
comments.

Introduction
Until the early 1960s, economists largely ignored
the effect of inflation on the prices of corporate
equities. Since revenues and costs were thought to
be proportionately affected by changes in the price
level, profits would expand so as to keep pace
with inflation. As residual claims to the earnings of
corporations, equities were seen as partial, if not
complete, hedges against the effects of inflation.
In the late 1960s and early 1970s,
this notion was shattered. Despite a 95.2 percent
rise in the consumer price index (CPI) from the
end of 1966 to the end of 1977, the Standard &
Poor’s Stock Index rose only 2.4 percent. The 52.5
percent decline in the real value of equities over
this period led to the development of many the
ories to explain the relationship between equity
prices and inflation.
Among the most widely received
theories was one offered by Franco Modigliani and
Richard Cohn (1979). They claimed that investors
make valuation errors by ignoring the gains debt
ors experience from inflation and therefore use
the wrong measure of profits in pricing equities.
Since inflation implies that the principal of the
loan will be paid back in “cheaper” dollars, lend
ers require an inflation premium in the coupon
on the loan. This suggests that a part of the firm’s
debt service is used to maintain the real value of
the firm’s debt and should not be treated as an
expense. Traditional accounting measures, how
ever, treat the entire debt service as an expense.
Modigliani and Cohn claimed that the measure of
“true profits” consistent with rational valuation

would equal accounting profits, plus the portion
of the interest expense attributable to inflation.
They reasoned that a more serious
investor error involves the comparison of the dis
count rate for a pure equity stream with nominal,
rather than real, interest rates. In figure 1 we pre
sent a time-series plot of the nominal interest rate
on Aaa-rated corporate bonds and the earnings/
price ratio of stocks in the Standard & Poor’s
Stock Index. At least since I960, these two series
track one another well. Because long-term nom i
nal interest rates are thought to be largely deter
mined by inflation expectations, this comparison
by investors further erodes the level of stock
prices in an inflationary environment.
Modigliani and Cohn showed that,
in the absence of market imperfections, the real
value of the firm should remain unaffected by
inflation. Using a statistical model,
they found that investors had indeed committed
one or both forms of valuation error.
In this paper, we review the model
introduced by Modigliani and Cohn and the
alternative analyses of other investigators. We
then evaluate those analyses by examining the
behavior of the rate of return required on equi
ties from 1953 to 1985. Surprisingly, we find little
evidence of valuation errors. In particular, we
note that when reported earnings are adjusted in
the manner prescribed by Modigliani and Cohn,
capitalization rates for equities appear to follow
real interest rates, though they may also respond
to factors related to aggregate risk.

anticipated

I. A Fundamental Valuation Model
Fundamental equity valuation models assume
that the goal of the firm’s management is to max
imize stockholders’ wealth. Projects are accepted
only if they increase the market value of the
equity, that is, if the present discounted values of
the expected net cash flows from new projects
are positive. The market value of the firm’s equity
is found by discounting the cash flows distributed
to stockholders at the rate stockholders could
earn on alternative investment flows of equivalent
risk.1 The distribution to stockholders, or divi
dend, equals profits (revenue, less operating
expenses and investment expenditures) minus
interest payments on the firm’s debt.
Following Modigliani and Miller
(1958), we make assumptions sufficient to derive
an expression for the value of the firm’s equity:
a) capital markets are frictionless, that is, partici
pants can borrow or lend at the riskless rate of
interest and there are no taxes; b) the social costs
of bankruptcy are zero; c) all firms are in the
same risk class; and d) equity and default-free
debt are the only types of claims on firms.

EARNINGS/PRICE RATIO FOR THE S&P STOCK INDEX ANO
MOODY’S Aaa-CORPORATE RATE

V “(t)

(1)

X/p

Note that if the adjusted profits of the firm are
expected to grow continually at a rate g, the
firm’s value can be represented as:

V “(t) = X/(p-g)

(2)

Given the above assumptions, Modigliani and
Miller go on to show that a firm’s value is inde
pendent of its capital structure. That is, rational
investors will ignore the effects of the firm’s bor
rowing and base their valuation on the firm’s cash
flow from operations. The levered firm’s total
market value,
is defined as the sum of the
market values of equity,
and debt,

Vl(t),

Vl( t) = S(t)

(3)

S(t),

D(t) :

D (t)

The adjusted profits available for distribution to
the stockholders of a levered firm differ from an
unlevered firm’s adjusted profits at date
by
the firm’s interest expense,
The expected
rate of return to the levered firm’s stockholders,
is simply:

t, X(t),

rD(t).

i = [X(t) - rD (t)\/S(t)

(4)

Combining equations (1) and (3), Modigliani
and Miller’s Proposition 1 states that:

Xft)

(5)

p[Vl(t)J = p[S(t)

D(t)\

Substituting (5) into (4) and allowing for earn
ings growth at rate gives:

(6)

/ =

p-r)d - g,

D(t)/S(t),

where
=
is the firm’s debt-equity
ratio. The value of the equity of a levered firm
can then be found by discounting the income
stream available to stockholders at the appro
priate rate (given by equation [6]). That is:

FI GURE 1

The value of an unlevered (all
equity) firm at date
with expected
adjusted profits is found by discounting the
firm’s expected available net cash flow at the rate
that is appropriate for the firm’s risk class
(p ).2 Viewing the firm as an ongoing concern
with a perpetual income stream
its value is
given by:

S(t) = [X(t) - rD(t)]/[p + (p-r)d - g]

(7)

S O U R C E : Moody's Investors Service; and Standard & Poor’s Corp.

t, Vu(t),

Following Modigliani and Cohn, suppose that at
time
0 there is no inflation and that imme
diately thereafter fully anticipated inflation begins
at the rate p and continues forever. Adjusted prof-

‘Adjusted profits’ refer to after-tax reported profits adjusted for the
effects of inflation on inventory valuation and the value of actual

depreciation deductions. In the N IP A these adjustments are referred to
as ‘IV A ’ and ‘C Cadj,’ respectively. They are based on corporate tax
records and assumptions about asset lives and replacement costs. For a
discussion of the N IP A adjustment, see Grimm (1982). A problem with

This should be distinguished from the so-called book value of

applying this adjustment to the S & P reported earnings index is that the

equity, found by subtracting the book value of liabilities from the

N IP A profits measure is based on “book" profits which vary somewhat

book value of assets.

from reported earnings, especially after 1981.

its will rise continuously at the rate of inflation so

t,
X (0 )epl.

X(t)

that at any date the unlevered firm’s profits,
w ill equal
From equation (1), the value
of the unlevered firm at date
equals
In other words, the
value of the
unlevered firm will not be affected by fully antici
pated inflation. Rationally priced equity claims on
such a firm are complete inflation hedges.

t, Vu(t),
real

Vu(0)ept.

Conventional accounting measures
of a levered firm’s profits are distorted by infla
tion. Accounting profits equal operating income,
minus nominal debt expense. Assume that the
nominal interest rate ( ) is approximately equal
to the sum of the real interest rate ( r) and the
expected inflation rate
and that the firm’s
debt remains fixed in real terms
equals
D[0]
Also assume that the firm’s debt is
structured so that it always pays the current rate
of interest. The levered firm’s accounting profits,
II, can then be written as:

(p)

(D[t]

epf).}

n (0 =
(8)
4

= [ X (0 -

X(t) - RD (t )
(r+p)D(t)}

= [X(0) - rZ)(0)]

ex-ante,

ex-post

ept - pD (0)ept

The firm’s accounting profits have been
expressed in this form to illustrate the following
essential points. 1) The portion of reported inter
est expense attributable to inflation,
should be added back to accounting profits to
yield “true” profits. 2) At high enough inflation
rates, accounting profits may become negative.4
True profits, II*, w ill therefore in
crease at the fully anticipated inflation rate. That is:

pD (0)ep!,

(9)

Equation (13) shows that, although the real value
of a firm’s equity should be unaffected by infla
tion, accounting earnings must be adjusted for
inflation’s effect.
Modigliani and Cohn hypothesized
that investors failed to incorporate inflation in
their valuations of equities. They tested this
hypothesis by regressing a measure of stock prices
on variables that enter either the numerator or
the denominator on the right-hand side of
expression (13). Their estimate of the coefficient
on inflation im plied systematic misvaluation. In
our attempts to replicate the results of Modigliani
and Cohn, however, we found that the results
were sensitive to assumptions regarding lag dis
tributions used to construct proxies for
or expected, values of key variables. In addition,
our attempts to replicate the results of Modigliani
and Cohn yielded a coefficient on inflation that
differed from their estimate (see Appendix).
Rather than update their empirical work, we take
a different approach to evaluating the perfor
mance of Modigliani and Cohn’s model.5

n*(0 = n(0 +pD (o)ept

We utilize observable,
observations on each of the relevant variables to
simulate the model, calculating im plied values
for p, the required real rate of return of a pure
equity stream. To the extent that our measures of
reflect expectations, our estimate of p is an
required rate of return on a pure equity
stream. Consequently, p is analogous to a real
interest rate, adjusted for the risk in equity and
the fact that the security is a perpetuity.
By focusing on the time-series
values of p, im plied by the model rather than the
predicted equity values, we avoid much of the con
troversy surrounding equity valuation having to

g
ante

ex-

= [X(0) - rD(0)]e**
Substituting the levered firm’s true profit stream
n*, into equation (7), we have:
(10)

5 (0 =

n*(0/[p

If, as finance theory suggests, investors are concerned with after
tax real rates of return, then one could replace

fhr+p

with

fl*=fl(1-r)=r+p, where r is the marginal tax rate on interest income.

(p r)d - g]

Clearly, fixing

implies that the change in

R* due

to a change in p is not

1 for 1. This relates to Hendershott's (19 8 1) argument discussed below.

real

Equation (10) therefore indicates that the
value of a firm’s equity is unaffected by inflation.
Now substituting for accounting profits and rear
ranging, equation (10) becomes:
(11)

[11(f) +

p D (t)\/S (t)

p-r)d - g

A n additional factor that is thought to offset the inflation-induced
gain from debt service,

pD(0)ep[

is the possible increase in the

firm’s pension obligations. This argument requires that inflation be unan
ticipated and is relevant only for defined-benefit pension plans (currently
comprising roughly 75 percent of all pension assets). A defined-benefit
pension is one in which contributions are determined by the benefits
they will eventually yield. The obligation of the firm to restore under
funded pensions, however, rests in part on the nature of the firm’s con

This expression reduces to:

tract with labor. Feldstein and Morck (1983) find that the stock market

(1 2 )

n (r)/S (r) = p + (p-r)d -

pd - g,

appears to react favorably to firms with overfunded pensions and nega
tively to underfunded pensions. They note, however, that most large,
well-managed firms have traditionally had overfunded pensions.

or,
(13)

S (t )

= II

(t)/[p

p-r)d - pd - g]

A n empirical update of Modigliani and Cohn is presented by
Townsend (1986).

do with the appropriate form of the discount rate.6
The advantage of this approach is that we are
able to see how p varies over time and, in partic
ular, if it is correlated with inflation or real inter
est rates. This does not contradict the assumption
that at any point in time, all variables in the
denominator of (13) are expected to remain con
stant forever. W hile Modigliani and Cohn
assumed that p is not affected by inflation, the
theories discussed below allow p to be related to
many factors, including the rate of inflation.
In order to isolate p we can re
write equation (13) as:

(14)

P =

n (t)
s(t)

r+p)d + g
1 +d

Using the definition of the nominal interest rate,

K, we have:

n(Q
(15)

p =

S(t)

Rd + g
1 +d
+

Equation (15) shows the relation between the
required real rate of return on a pure equity
stream in a given risk class and mostly observable
variables. The only unobservable variable is the
expected growth rate of reported profits. The var
iable p may be viewed as a modified earnings/
price ratio, adjusted for inflation, leverage, and
earnings growth.

II. The Determinants of p
Below we discuss three theories of the determi
nation of the cost of a pure equity stream. Two of
the explanations given for the behavior of p focus
on a risk premium, while the third considers the
relation between p and the real rate of return on
bonds.
In trying to explain the behavior of
the stock market in the mid-1970s, Burton Malkiel
(1979) adjusted corporate profits for inflation’s
effect on corporate debt and found them to be
steady in low- and high-inflation periods. He
argued that the decline in real stock prices was
caused by an increase in the risk premium
embodied in the rate of return required by
stockholders. The increased risk premium was
due to economic developments of the early
1970s that led to a departure from the relative

stability of the 1960s. He reasoned that investors
thought policymakers could no longer “fine tune
away” economic fluctuations and that long-run
planning involved greater uncertainty. Although
profits rose with the price level, their dispersion
across industries also rose, in turn raising busi
ness risk. The rising use of debt financing was
another source of increased risk for the financial
system. Finally, rising government regulation may
have been perceived as reducing profitability.
As evidence supporting the per
ception of increased risk, Malkiel cites the rise in
the “risk spread” between anticipated returns on
equities and long-term government bonds, as
well as between the yields on Baa-rated corporate
bonds and government bonds. These widening
spreads throughout the 1970s may suggest that
investors believed the credit quality of firms was
falling. According to Malkiel’s findings, we would
expect to see a path for p that starts out low in
the ‘50s and ‘60s and then turns higher in the
mid-to-late 1970s.
A related theory of the behavior of
p involves the possibility of a disinflationary dis
tress premium: real required rates of return on
pure equity streams rise in a climate of disinfla
tion. Firms may be under greater strain in a disin
flationary environment as they are often unable to
match declines in revenue with declines in
expenses.7 This is particularly evident following a
period of prolonged high inflation. Extreme
examples of the upheaval associated with disin
flation can be found in the oil and steel indus
tries. Further, corporate defaults have generally
been higher in disinflationary periods than in
inflationary periods.8 This hypothesis implies that
stockholders will require a premium whenever
there are large reductions in inflation in order to
compensate them for the increased credit risk. By
this hypothesis, p should fall with increases in
inflation and rise with disinflation.
Hendershott (1981) attributes the
valuation error noted by Modigliani and Cohn
solely to investors’ comparisons of the expected
real yield on equities, p, with the nominal yield
on bonds. He claims that Modigliani and Cohn’s

This m ay be due to the existence of fixed labor and supply con
tracts. A simple model introduced by Wadhwani (1986), on the

other hand, suggests that the inflation premium in a levered firm’s debt
service causes nominal debt expense to increase proportionately more
than nominal revenue during inflation, forcing the firm to report lower

accounting profits. Conversely, this expense will decrease more than
proportionately during disinflation, resulting in higher reported, or account
ing, profits.

The emphasis on

is also justified by the implications of work

done by Shiller (1981) and others on the volatility of dividends

and stock prices. The literature on stock volatility suggests that profits
have much lower variances than stock prices. Thus, variation in p and

Fons (1986) investigates the correlation between "unanticipated”
changes in the consumer price index and a measure of expected

corporate default rates embodied in yield spreads. Though not statisti

other factors influencing the rate at which profits are discounted could

cally significant, the relationship between inflation surprises and an

be expected to account for much of the variation in stock prices.

implied default premium on low-rated corporate debt is negative.

model implies that the after tax real bond yield
falls as a result of inflation, while nominal yields
remain constant. Since bonds and equities are
substitute assets, the fall in the after-tax real yield
on debt would lower the rate of return required
by stockholders. The decline in the required
yield on equity offsets the overpayment of taxes
resulting from the inflation-induced understate
ment of depreciation and inventory costs (see
discussion ofFeldstein [1980] below), or
increased risk premia noted by Malkiel, leaving
the nominal value of stocks essentially
unchanged. Hendershott claimed that there were
other factors responsible for the decline in the
real value of equities. First, there was a decline in
savings due to lower real after-tax yields. Second,
there was a decrease in the productivity of new
capital due to higher regulatory costs and higher
energy prices. In addition, Hendershott felt that
an increase in the realized rates of return on non
corporate assets, such as residential housing, may
have induced investors to reduce their holdings
of debt and equity.
By Hendershott’s reasoning, p
should decline in inflationary periods and rise
with disinflation. Declines in productivity, how
ever, would be reflected in a lower expected
growth rate of earnings (g).

& Poor’s Index. The price index, based on as
many as 500 different equities mostly traded on
the New York Stock Exchange, is constructed in
such a way that, when divided into the associated
earnings index, the unwanted weighting factor can
cels. The eamings-per-share index is constructed
from the reported earnings over the past four quar
ters of the firms in the corresponding stock index.
We adjust for inflation-caused inventory valuation
and depreciation errors by multiplying the earn
ings index by the ratio of adjusted-to-reported
after tax profits found in the National Income and
Product Accounts (NIPA) (see footnote 2).
The interest rate on corporate bor
rowings is measured as Moody’s cross-sectional
average yield on single A-rated bonds. This rating
corresponded to the average quality rating (in
terms of par value) of all publicly traded corpo
rate debt as of December 1985. As was previously
discussed, the nominal interest rate embodies
inflation expectations. In using this measure, we
avoid the problems encountered by Modigliani
and Cohn in constructing an econometric proxy
for expected inflation.
The debt-equity ratio for nonfinancial corporations, was constructed from two
sources. Data covering 1953 to 1961 was taken
from Von Furstenberg (1977), in which the
market value of debt is inferred from a present
value relation. The 1961 to 1985 series for the
market values of corporate debt and equity were
constructed by the Board of Governors of the
Federal Reserve System. In this case, the market
value of debt is found by pricing all mortgages
and long-term bonds at the average price of
bonds traded on the New York Stock Exchange,
ignoring such nontraded items as deferred taxes,
leases, and pension obligations. An attempt was
made in the estimation of the market value of
equity (the listed values on all exchanges, times
the number of corresponding shares outstanding)
to avoid the double counting of firm ownership
through stock holdings.
The computation of p involves
assumptions about the process generating the
parameter One extreme is to let assume its
realized value equal to the annualized growth
rate of four-quarter reported earnings for each
period. The volatile behavior of and p when gis
measured this way can be seen in figure 2. We
feel that such erratic movement in is unreason
able since, in theory, is the expected perpetual
growth rate of earnings. Presumably this pre
cludes from being negative.
An alternative way to measure is
to utilize a time-series model to construct an insample one-period-ahead forecast of earnings
growth. We modeled the quarterly growth of
four-quarter earnings as following an ARMA(1,1)
process. Using the forecast for at each date in

1950

1955

1960

1965

1970

1975

1980

1985

S O U R C E : Figures 2 , 3 . and 4 author's calculations.

FI GURE 2

III. Data & Methodology.
Quarterly observations for the period covering
1953 through 1985 on each of the following data
series were used to construct estimates of p: ad
justed earnings per share, stock prices, nominal
corporate interest rates, aggregate debt-equity
ratios, and earnings growth. The values for stock
prices and earnings were taken from the Standard

the calculation of p yields the time-series plot of
p presented in figure 3 This series is only slightly
less volatile than the series constructed from
actual growth rates.

COMPUTED p SERIES WITH ARMA(1,1) EARNING GROWTH

A time-series plot of p constructed
with fixed at its average value is presented in
figure 4. The required real rate of return ranged
between 10 and 13 percent from 1952 through
1974, with moderate deviation. At the start of
1975, however, p began to rise slowly and then
sharply in 1981. It peaked at the end of 1981 and
again at the beginning of 1984. For comparison’s
sake, setting equal to zero over the entire sam
ple period produces values for p ranging
between 4.5 and 7.5 percent from 1952 through
1976, topping out at 14.2 percent in mid-1984.

FI GURE 3

A third alternative is to fix the
growth rate of earnings at its average value over
the entire sample period, 6.4176 percent.9 This
procedure may be justified on the grounds that
investors somehow possess perfect foresight of
earnings growth and that they ignore short-run
fluctuations. The infinite-horizon nature of the
estimated model requires an unbiased estimate
of perpetual earnings growth. It is possible, with
the S&P data, to construct an estimate based on
earnings growth as far back as 1926. The inclu
sion of a persistent recession and a major war,
however, would likely result in a less satisfactory
estimate of expected earnings.

COMPUTED p SERIES WITH FIXED EARNINGS GROWTH

IV. Analysis of Computed p Series
In this section, we analyze the behavior of p,
computed with expected earnings growth fixed at
its actual mean value. Our goal is to shed light on
this component of equity valuation. By their
nature, however, it is not possible to completely
separate the implications of the various hypo
theses discussed above.
The computed value of p appears
to support Malkiel’s hypothesis that p begins to
rise in the mid-1970s due to the risk factors cited
earlier. In addition, the rapid rise in 1981 could
be explained by Bodie, Kane, and McDonald
(1986), who concluded that there was a dramatic
increase in the risk premium required in long
term bonds in the early 1980s. They attribute this
to the switch in operating procedures by the
Federal Reserve in late 1979The disinflation hypothesis pre
sented earlier suggests that p should vary inverse
ly with the level of inflation. In figure 5, we pre
sent plots of p and the rate of inflation. Note that
the major upturns in p appear to coincide with
the inflationary peaks occurring in 1974 and again
in 1981. Smaller, previous inflation spikes do not,
however, seem to be accompanied by any signifi
cant movement in p.
The same figure can be used to
examine Hendershott’s claims. Conspicuously
absent is the hypothesized decline in p as infla
tion rises. The lack of noticeable downward
movement in p during rising inflation eliminates
much of the support for his arguments. His main
conclusion, however, that p is tied to the real rate
of return on debt, can now be addressed.

The average annual growth rate of adjusted earnings over the
sample period w as 17.0 1 percent. The growth rate of this series

since mid-1983 has been so great as to completely dominate this figure.
It w as felt that the effects of this adjustment could not have been rea
sonably foreseen over much of the sample period and, in fact, should
''wash1' over the long run. W e therefore chose to use the average annual
growth rate of unadjusted earnings in the computation of p.

COMPUTED p WITH FIXED EARNINGS GROWTH AND INFLATION

0.20 ___________________________________

0 02 ---------- 1
---------- '---------- 1--------- 1
---------- 1--------- '---------- u
1950

1955

1960

1965

1970

1975

1980

1985

S O U R C E : Author's calculations; and U .S . Department of Commerce, Bureau of Labor
Statistics.

FI GURE 5
REAL Aaa-CORPORATE BOND YIELD

S O U R C E : Moody's Investors Service.

ex-post

A plot of
real long-term cor
porate bond rates is shown in figure 6. This figure
was constructed by simply subtracting 1 from the
ratio of the gross yield on Aaa-rated corporate
bonds to the previous year’s gross inflation rate at
each date. Note that real required rates of return
on fixed income securities reached unprece
dented levels in 1981, the same year in which p
significantly departs from its postwar behavior.
Hendershott’s hypothesis, therefore, appears to
explain the sharp rise in p that occurred in 1981.
However, it does not shed light on the moderate
increase beginning in 1975, but it does help
explain the slight decline in p that occurs
between the end of 1971 and the end of 1974.
Though separate from the riskrelated hypotheses, Benjamin Friedman (1986)

claimed that an increase in the government
deficit, such as that beginning in early 1981,
would drive down the realized rate of return on
equity relative to either short- or long-term debt,
thereby increasing the required rate of return on
a pure equity stream. This theory then suggests
that the rise in p is a function of deficits, thus
explaining the sharp rise in 1981.
Had we found no rational explana
tion for the behavior of p, we would have
searched for evidence of measurement errors
related to corporate earnings. For instance, Feldstein (1980) claimed that biases in the tax system,
rather than inflation-induced valuation errors,
could explain the poor performance of the stock
market. In particular, Feldstein emphasized that
corporate capital depreciation deductions are
based on historical, rather than current, costs. In
inflationary periods, with a rising price of invest
ment goods, this implies that the real value of
depreciation deductions declines. This, in turn,
implies that taxable profits (net of depreciation
deductions) rise, causing real after-tax profits to
fall. Feldstein also pointed out that nominal
rather than real capital gains are subject to capital
gains taxes. This implies that even if the nominal
value of equities increased at the inflation rate,
the real after tax yield on equities would decline.
In contrast to Modigliani and Cohn, Feldstein
viewed the stock market decline as a rational
response to inflation.
Modigliani and Cohn, in response
to the criticism of Feldstein, discussed the possi
bility of tax biases due to inflation. They noted
that other analyses of the interaction of inflation
and taxes have ignored the fact that firms are not
taxed on the portion of returns used to depre
ciate debt. They argue that this offsets the decline
in real after tax profits that results from the
decline in real depreciation deductions. They
support this by noting that the share of corporate
income paid as taxes has remained relatively con
stant in inflationary periods. In their empirical
work, as well as in our construction of p, an
adjustment factor constructed from the National
Income and Product Accounts was used that
attempts to correct reported earnings for depreci
ation and inventory distortions caused by infla
tion. The NIPA adjustment, however, may mis
state the lagged response of tax shelters to
inflation. In addition, the analysis is complicated
further by the fact that much corporate debt is
fixed-rate and thus debt yields do not adjust
instantly to inflation expectations.
In figure 7 we present both unad
justed and adjusted reported four-quarter earn
ings per share using the NIPA data. For the early
part of the sample period the two series are virtu
ally identical. They begin to diverge at the end of

ADJUSTED AND UNADJUSTED EARNINGS PER SHARE

S O U R C E : Standard & Poor’ s Corp.; and U .S . Department of Commerce.

1972, with adjusted earnings falling somewhat
below unadjusted earnings. The situation reverses
dramatically, however, in 1983- At this point, ad
justed earnings clim b far above unadjusted earn
ings. Further study may shed light on the sensitiv
ity of our results to the adjustment of earnings,
especially for the period following 1981.

V. Conclusion
We conclude that equity prices respond rationally
to such factors as real interest rates and risk.
When we use the model of Modigliani and Cohn
to compute the discount factor applied to a pure
equity stream of a levered firm, we find no evi
dence of inflation-induced valuation errors. The
evidence presented, however, is consistent with
the hypothesis that disinflation influences the risk
premium applied to pure equity streams.

FI GURE 7

REFERENCES
Bodie, Zvi, Alex Kane and Robert McDonald,
“Risk and Required Returns on Debt and
Equity,” in Benjamin M. Friedman, ed.,
Chi
cago: University of Chicago Press, 1986.

Financing Corporate Capital Formation,

Feldstein, Martin, and Randall Morck. “Pension
Funding Decisions, Interest Rate Assumptions,
and Share Prices,” in Zvi Bodie and John
Shoven, eds.,
Chicago: University of
Chicago Press, 1983.

Financial Aspects of the United
States Pension System.

Feldstein, Martin. “Inflation and the Stock
Market,”
vol. 70,
no. 5 (December 1980), pp. 839-47.

American Economic Review,

Fons, Jerome S. “The Default Premium and Cor
porate Bond Experience,”
Federal Reserve Bank of Cleveland,
June 1986.

Working Paper

#8604,

Friedman, Benjamin M. “Implications of
Government Deficits for Interest Rates, Equity
Returns, and Corporate Financing,” in Ben
jamin M. Friedman, ed.,
Chicago: University of Chi
cago Press, 1986.

Capital Formation.

Financing Corporate

Grimm, Bruce T. “Domestic Nonfinancial Corpo
rate Profits,”
U.S.
Department of Commerce, Bureau of Eco
nomic Analysis, vol. 62, no. 1 (January 1982)
pp. 30-42.

Survey>of Current Business,

Hendershott, Patric H. “The Decline in Aggregate
Share Values: Taxation, Valuation Errors, Risk,
and Profitability,”
vol. 71, no. 5 (December 1981), pp. 909-22.

American Economic Review,

Malkiel, Burton G., “The Capital Formation Prob
lem in the United
vol. 34, no. 2 (May 1979), pp. 291-306.

States," Journal of Finance,

Modigliani, Franco, and Richard Cohn, “Inflation,
Rational Valuation and the Market,”
vol. 3, no. 2 (March-April
1979), pp. 24-44.

Analysts Journal,

Financial

_________ and Merton Miller. “The Cost of Capi
tal, Corporation Finance, and the Theory of
Investment,”
vol.
1958, no. 3 (June 1958), pp. 261-97.

American Economic Review,

Shiller, Robert J. “Do Stock Prices Move Too
Much to be Justified by Subsequent Changes
in Dividends?,”
vol. 71, no. 3 ( J u n e 1981), pp. 421-36.

American Economic Review,

Townsend, Henry. “Another Look at the
Modigliani-Cohn Equation,”
vol. 42, no. 5 (SeptemberOctober 1986), pp. 63-66.

Financial Ana

lystsJournal,

Von Furstenberg, George M. “Corporate Invest
ment: Does Market Valuation Matter in the
Aggregate?,”
No. 2: 1977, pp. 347-408.

Activity,

Brookings Papers on Economic

Wadhwani, Sushil B. “Inflation, Bankruptcy,
Default Premia and the Stock Market,”
vol. 96, no. 381 (March 1986),
pp. 120-38.

nomic Journal,

Eco

APPENDIX
Reestimation of Modigliani and Cohn’s Model
In this section, we describe our attempts to repli
cate the results of Modigliani and Cohn and then
to reestimate their model, extending the sample
period through 1984.
Modigliani and Cohn estimated the following
regression, which is im plied by expression (13),
after taking the log of both sides:

= a 0 = w l(L )U (t) + w 2(L)D IV(t )
a3 w3(L)[LF/E](t ) + a4D V F(t)
- /1w 4(L)R (t ) + yw 5 (L )P (t) + u (t)
s (t )

The variable is the lag operator and the
parameters
through
represent coefficients
on the lagged terms of the five forecasted vari
ables. The distributed lag,
embodies
the assumption that expected, or
profits
equal a one-sided distributed lag of past profits.
Profits were measured as described in the text
and in Modigliani and Cohn. Although it is not
unusual to view expected dividends as influenc
ing stock prices, Modigliani and Cohn include a
distributed lag of dividends,
on the
grounds that dividends provide information
about future profits. They then restrict the coeffi
cients of the distributed lag on dividends, so that
a change in dividends has no permanent effect
on firm value, given the history of profits. Divi
dends were measured as dividends per share for
the issues in the S&P 500, adjusted as described
by Modigliani and Cohn.
a distributed
lag of the ratio of the labor force to employment,
is included to provide a cyclical adjustment to the
ability of past profits to predict future profits. The
term
is included as a measure of the risk
premium entering the formulation of p. M odigli
ani and Cohn measured
as the 15-year
moving-average deviation of the unemployment
rate from 4 percent. We chose instead to use a
12-quaner moving-average. The distributed lag on
the nominal interest rate,
and the dis
tributed lag on inflation,
are included
to measure the real rate,
also a component

wl(L)U(t),
ex-ante,

w2(L)DIV{ t),

u5(L)LF/E,

DVF(t)

DVF

u4(L)Rit),
u^(L)P{t),
tit),

R( t)

of p.
is measured as the new issue yield on
AA corporate bonds.
is measured as the
annual percent change in the CPIU.
We used the current value and seven lagged
values in each distributed lag. This choice of lag
length differed from that of Modigliani and Cohn,
but seemed only equally arbitrary. We maintained
the following restrictions regarding the form of the
distributed lags: a) the coefficients on profits sum
to one, b) the coefficients on dividends sum to
is quadratic,
zero, c) the distributed lag on
d ) the distributed lag on dividends is linear, e) the
distributed lag on the nominal rate is quadratic,
and f) the distributed lag on inflation is quadratic
with the endpoints constrained to equal zero.
The parameters to be estimated are «0,
and the parameters in the distributed lags.
The theoretical model of Modigliani and Cohn
implies that the coefficient on the distributed lag
of inflation,
should equal
where
the
debt-equity ratio and is the capitalization rate.
Their estimate of
-0.08, differs from a com
puted value of
0.05. Thus, an increase in
expected inflation reduced market values,
although this should not have been the case if
investors had been rational. In feet, Modigliani
and Cohn calculated that a one percent increase
in inflation would reduce the market value of
equities by 13 percent. Thus, the market had
been drastically undervalued due to inflationinduced valuation errors.
When we attempted to replicate the results of
Modigliani and Cohn, over the same sample
period, we estimated to be .015. When the
sample period was extended through 1984, how
ever, the estimate of was -0.025. If the misvaluation of equities was being eliminated, the esti
mate of over the longer period would have
been closer to the theoretically predicted value
than for the shorter period. Since our
results not only differed from those of Modigliani
and Cohn, but indicated worsening misvaluation,
we chose to consider a different approach.

P( t)

LF/E

a3, aA,

Pi y,

y,
d/K,

(d/K)

d/K,

d is

The Collapse in Gold Prices:
A New Perspective
by Eric Kades

“If all men were rational, all politicians honest and we had a world central
bank issuing a single currency that was universally acceptable, then gold
would drop to $20 an ounce— and be overvalued at that.”
— Andre Sharon, gold analyst, quoted in Newsweek, Dec. 1 6 ,1 9 7 4 ; as
quoted by George Seldes in Quotable Quotations.

Eric Kades is an analyst in the

Brian Gendreau of Morgan Guaran

Financial Strategies Group at Gold

tee Trust Com pany, Stephen Salant

man, Sachs, & Co. Fie is a former

of the Rand Corporation, and Mark

analyst at the Federal Reserve Bank

Sniderman of the Federal Reserve

of Cleveland. The author thanks

Bank of Cleveland for helpful com
ments and corrections.

Introduction
The daily summaries and analyses of the gold
market that appear in most newspapers support
Mr. Sharon’s assertion. The press invariably attrib
utes gold price movements to political uncer
tainty, gyrating monetary policies, inflation hedg
ing, and international liquidity concerns. This
view implies that the demand for gold is highly
volatile, subject to coups, sudden shifts in central
bank behavior, oil flow interruptions, and other
jolts to the world economy.

GOLD PRICE AND INTEREST RATE TRENDS
Real value of assets, in 1970 dollars

If Mr. Sharon and the press were
right, then economists would have little to con
tribute to an analysis of even long-term move
ments of gold prices, or to forecasts of price
trends. These activities would be better left to
political experts, to central bank analysts, and to
other savvy observers in areas that are likely to
generate surprises affecting gold prices. There
would be no point in statistically estimating a
demand function for gold, since demand for gold
would be always be fluctuating randomly, not
moving systematically.
This conventional explanation of
gold price movements is essentially a superficial
one. W hile unexpected political and economic
events undoubtedly influence daily gold prices,
such events cannot explain long-run trends in
gold prices. Before the Bretton Woods interna
tional monetary system began to crumble in
1968, the price of gold was fixed at about $35 an
ounce. The real price of gold, that is the nominal,
or observed price divided by a price index, has
followed two distinct trends since 1968 (see
curve A in figure l) .1
From 1969 to 1981, the real price of
gold rose rapidly, except for a few brief, but sharp,
price dips, and for one extended slide. From
1981, until this year, the real price of gold fell —

S O U R C E : London P .M . Gold Fixing; Consumer Price Index: U .S . Department of
Labor. Bureau of Labor Statistics; and Board of Governors of the Federal Reserve System.

FIGURE 1

The price index in this case is the C PIU. W e study the real price to
correct for changes in the purchasing power of the dollar.

rapidly at first, then more gradually. This year has
witnessed renewed strength in gold prices.
As confusing as these long-run
trends might seem, economists can offer an
explanation that draws from previous studies and
that is rooted in the unique characteristics of the
gold market and of gold itself. In this study, we
explain gold price movements in terms of a
model for exhaustible resources, describing the
qualities of gold that account for its spectacular
price rise from 1968 to 1980. We show why m od
els offered in previous studies must be modified
to explain the
in gold prices since 1981.
The recent rise in gold prices can be interpreted
as supporting the perspective we present.

decline

I. The Conventional Supply and
Demand Analysis
If viewed as any other good, gold price move
ments would be analyzed in terms of conven
tional supply and demand. The key factor in
supply would be the marginal cost of extracting
additional ore from the earth (or the cost of recy
cling gold). These costs would follow predictable
patterns and might be estimated effectively. More
analytical difficulty could be expected to arise
from unstable demand. W hile the demand for
gold by industries and jewelers is stable, other
buyers (inflation hedgers and liquidity seekers)
have erratic gold-buying habits.
This demand/supply view of the
gold market turns on gold’s historical role as a
defense against inflation and posits that a predic
table relationship between inflation and real gold

price movements overwhelms any random influ
ences from other types of gold buyers. Interna
tional liquidity measures (money supplies and
related stocks) and exchange rates also enter
conventional gold-pricing models, but these may
be thought of as leading and coincident indica
tors of inflation among nations. But the contem
poraneous correlation between inflation and gold
prices is weak (see figure 2) and formal statistics
show no strong relationship between gold prices
and past inflation.
There are more fundamental arbi
trage arguments against a
and reliable
relationship between gold prices and inflation. If
the real rate of return to gold were
lower than riskless assets during deflationary
times, no rational investor would include gold in
his portfolio while prices fell. Since someone
must hold existing stocks of gold, the rate of re
turn (i.e., price changes over tim e) would be bid
up to induce agents to hold existing stocks. Sim
ilarly, if gold has an extraordinary rate of return
during inflations (with little or no risk) then this
return would be bid down by investors. Thus, gold
cannot yield
more/less than riskless
government bonds during inflations/deflations.
Such a regime would not be in equilibrium since
people will want to increase/decrease gold hold
ings and thereby shift the price of gold. Gold may
well serve as an effective
against inflation
by
purchasing power, but this factor
cannot explain the long-term trends observed in
the high real return to gold.

systematic

systematically

hedge

preserving

II. Gold: An Exhaustible Resource
Gold is literally an
resource. Thomas
Wolfe, a former director of Treasury precious
metals operations, noted, “ [g] old is among the
few minerals that could reach a critical supply
situation within this century, taking account of
available reserves above and below ground.”2
World stocks have declined sharply, on net, since
1968 (see figure 3). Thus, gold’s very scarcity
requires a unique method of determining its price.
Economists do have a valid technique, which has
existed since the 1930s, for analyzing prices of
exhaustible resources.3 An ingenious modification

exhaustible

GOLD PRICES AND IN FLATIO N: A WEAK CORRELATION
% Change, quarter-quarter, in gold prices

% Change, quarter-quarter, in C P IU

S O U R C E : London P .M . Gold Fixing; and U .S . Department of Labo r. Bureau of
Labor Statistics.

FIGURE 2

See Stephen Salant and Dale Henderson, “ Market Anticipations of
Government Policies and the Price of Gold,”

Economy,

Journal of Political

vol. 86. no. 4 (August 1978), pp. 627-48.

See Harold Hotelling, “The Economics of Exhaustible Resources,"

Journal of Political Economy,

vol. 39. no. 2 (April 1931) pp. 137-75.

SHRINKING WORLD GOLD STOCKS
Gold mined and used, metric tons

Net change, world gold stocks, metric tons

rate. If the price rose faster, nobody would sell it,
since it would be a superior investment over any
time horizon. This price path could not constitute
an equilibrium, however, since eventually the
constantly rising price would cause all demand
for manna to be choked off, and yet none would
have been consumed. The good’s value would be
too high for it to be liquidated.
On the other hand, if the price of
manna rose more slowly than
agents would
not want it in their portfolios; in the rush to sell
it, the price would fall precipitously. Then the
price would jump from a very low level in the
initial period (as everyone rushed to sell) to
infinity in the next period, because people would
consume the manna, driving the supply toward
zero. However, then an investor who bought at
the low price in the first period and held on to
the manna could charge a very high price in the
second period, earning a rate of return above
Only a path with prices increasing at the rate
leaves people with no incentives to change their
behavior and, thus, is the only equilibrium for
pricing a simple exhaustible resource like manna.
Curve B in figure 1 indicates such a
price path. It shows how the value of a bond
equal in price to an ounce of gold in 1965 would
have appreciated at a constant real interest rate of
4 percent (arbitrarily chosen). It is easy to see
that from 1965 to 1981 gold yielded a higher re
turn. Curve C shows the
real rate of
return— the real value an investor would have
achieved by purchasing U.S. Treasury bills and roll
ing them over quarterly. Gold even more easily
dominated this investment option over the period.

rh,

rb.
rb

S O U R C E : Annual gold reports ( 1 9 7 8 - 8 5 ) , Consolidated Gold Fields, Ltd.

FIGURE 3

of this technique, by Stephen W. Salant and Dale
W. Henderson, explains the major gold price
movements from 1968 to 1981, but does not fully
explain the decline in gold prices from 19811986, which is the period that interests us here.4
We will use a simple allegory to explain how
exhaustible resources should be priced.

III. Pricing a Depletable Resource:
A Simple Model
A finite amount of “manna” is distributed among
some lucky individuals. Once eaten, the manna is
gone forever. What direction should manna prices
take? Think of manna as an asset, just like stocks
and bonds; we are concerned with only the in
vestment characteristics of manna, not with the
final consumers. Each asset in the economy has
an annual rate of return. We expect the rate of
return to be higher for more risky assets. Inves
tors will demand a higher rate of return on risky
“junk” bonds of an indebted corporation, for
example, than they will require to hold the virtu
ally riskless bonds and bills of the U.S. Treasury
bearing a riskless interest rate
With a fixed, known supply and
stable demand, manna is a riskless asset. There
fore it must yield the same rate of return as the
riskless interest rate on government securities,
The only way it can yield such a return (since it
pays no dividends and earns no interest) is for its
price to rise at a rate equal to the riskless interest

rh.

rb.

See “ Market Anticipations of Government Policies and the Price of
Gold?"

ex post

IV. Gold: A Special Case
No resource exactly duplicates the simple price
path illustrated in curve B of figure 1. Unexpected
events will change the supply of or demand for a
good. These jolts, not readily addressed by eco
nomic arguments, affect the price of a good ran
domly, increasing the variance without changing
the long-run path.
Also, every commodity has its own
peculiarities that alter its price trend systemati
cally. Several such factors operate in the gold
market and are often cited as important determi
nants of price trends.
The costs of m ining gold, for exam
ple, rose between 1965 and 1981 and contributed
to at least part of gold’s price increase. However,
it can also be argued that mining costs could not
be responsible for price increases in a market,
like the gold market, where there are speculators.
Rising extraction costs do not pre
vent speculators from buying gold in one period
and selling it in the next. Because speculators do

1 3

not pay extraction costs (and assuming storage
costs are constant), competition among them will
prevent the rate of gold price increases from ex
ceeding the riskless rate of interest.5 The gold mar
ket unquestionably includes many speculators.
Another salient feature of the gold
market is South Africa’s dominant, almost
monopolistic role in gold production. Since the
price of gold began to rise in 1968, the South
African share of production has averaged near 75
percent, although it has fallen moderately in
recent years. Such hegemony can raise prices
above competitive levels, but, like rising produc
tion costs, cannot account for observed rapid
increases in gold prices. Any attempts by South
Africa to raise prices faster than
would create
arbitrage opportunities that would force prices
back down. Speculators would buy gold in one
period and then, being w illing to accept a rate of
return
would undersell the South Africans in
the next period.
Salant and Henderson conclude
that the only valid special factors in the gold
market are the huge stocks governments hold
and, particularly, the perceptions of speculators
about what buying or selling actions governments
will take. This, they argue, causes the price of
gold to move systematically at variance with the
simple exhaustible resource explanation.
To see how this matters, think about
the amount of gold available to satiate demand in
a given period. Production levels w ill be relatively
stable, because construction of large mines takes
a long time. However, governments hold huge
stocks of gold (now about 40 years’ worth of cur
rent industrial, artistic, and jewelry demand; in
1970, governments held 25 percent more). If they
decide to sell a significant amount of gold in a
given period, the price will drop sharply.
The “threat” of government sales
means that
since there is a chance that govern
ment actions will have a severe impact on its
price. Risky assets must give higher yields, on
average, to compensate their owners. Comparing
curve A (actual real gold price) with C (actual
price trend for real return to three-month Trea
sury bills), strikingly illustrates that gold did
indeed command a return higher than the risk
less interest rate from 1968 to 1981.
There were a few exceptions,
when the price dropped precipitously for short
periods of time. These occasional price dips,
however, fit precisely into the scenario that Salant
and Henderson present. They are the announce-

rb,

1 4

gold can no longer be considered a
riskless asset,

Gold that cost more to extract would not be mined until the price
rose sufficiently to justify the expense.

ment dates of government sales or news leaks of
the likelihood of such sales. These events illus
trate the riskiness of holding gold in the presence
of government stocks that can depress prices
temporarily. For example, arrow 1 in figure 1
marks the first announcement of possible Interna
tional Monetary Fund (IMF) nation sales; arrow 2
shows the price decline caused by the first U.S.
Treasury auction of gold since World War II. The
price decline that lasted from 1975 to 1976
occurred while gold’s role in the international
monetary system was being revised. These
changes included provisions for large sales of
IMF gold, permission for member nations to sell
significant quantities of gold on the free market,
and a major de-emphasis of gold’s monetary
function. All these factors held down gold prices
during most of 1975 and 1976. When direct
depressing effects ended, prices rose again, and
gold achieved superior rates of return— much
higher than
Salant and Henderson’s explana
tion for the trends in gold prices is an elegant
and convincing one for the period from 1968
(which marked the end of gold price-fixing) until
1981, but it breaks down after 1981. There has
been a striking change in the behavior of gold
prices since 1981. They fell, first sharply, then
more gradually, with only short-lived reversals. In
1986 they again began to rise sharply. How, if at
all, can these trends be reconciled with the rela
tionship between the price of gold and with sales
of government supplies of gold described above?
The starting price of an exhaustible resource
holds the key to our explanation.

rb.

V. Initial Price and Expectations of Demand
The
price of a depletable resource plays an
important role in its price behavior. The price
must increase at the rate
(a risky asset like
gold, of which governments hold large stocks,
increases at a rate higher than
In a “perfect
world,” the initial price will be set so that the last
ounce of gold is used via transactions completed
up along a unique price path starting at the initial
price and increasing at the set rate.
A low initial price would result in
greater demand at every date along the price path
and the supply of gold would be depleted at a
price that didn’t extinguish demand. Conversely,
a high initial price would mean less demand for
gold in each period; demand would drop toward
zero, and gold stocks remain. Profits for owners in
both cases would be lower than if the equilibrium
price path were to emerge, so market forces tend
to seek this unique initial price and price path.
To calculate the correct initial
price, it is essential to estimate the demand curve

initial

rb.

for gold— that is, what demand will be for all
prices. Incorrect estimation of the demand curve
would lead to incorrect setting of the initial price
and would necessitate later adjustment of the
price to reflect the true demand.

VI. An Unexpected Price Path
Suppose that, in 1968, market participants esti
mated a demand curve for gold, based on past
demand and existing world stocks. In doing so,
they implicitly calculated that if prices began to
rise at a rate equal to
(plus some risk pre
m ium ), the world’s supply of gold would be
exhausted just as the price rose to levels that
would choke off demand.
Market participants had many
opportunities to observe demand in the price
range from $35 to $100 an ounce (in real 1977
dollars) from at least the beginning of the twen
tieth century until 1978. Although we do not have
the data to plot these points precisely, we assume
for this example that they fit a linear demand
curve fairly well, as shown in figure 4. Based on
these observations, gold speculators postulated
that the same solid line that approximated

POSSIBLE MISESTIMATION OF GOLD DEMAND
Price

estimated the demand curve for gold, given that
demand at the very high prices that prevailed in
1980-81 had no precedent. But why has the
decline in the real (as well as the nom inal) price
of gold been so extended? Market participants are
actively revising their estimates of demand at the
prices where they first began to make serious
errors, in the $200 to $400 range. First, the price
fell precipitously as all speculators temporarily
liquidated stocks in the knowledge that prices
would fall. Most speculators were surprised
when, after this initial price drop, demand was
still too weak to support new price increases
(consistent with the exhaustible resource model).
Since 1983, when the price fall
moderated, the market may be said to have been
groping for a price path that would lead to a
depletion of gold just as demand chokes off.
Demand was weaker than expected in the inter
mediate price range, and so the price continued
to edge downward. The recent rise in gold prices
may indicate that the bottom has been found,
and that gold will yield superior returns.
Perhaps a more fundamental ques
tion is: why did people misestimate the demand
for gold in the first place? Certainly there are
many plausible explanations, and this paper does
not attempt to establish one as being more cor
rect than another. However, one possible expla
nation is that their information was inadequate
and inappropriate. People had virtually no basis
for estimating the entire market demand curve,
since the price had been more or less fixed for
over 25 years. People did not even have estimates
of the average expected demand at higher prices,
let alone the variation to be expected about this
average. Their estimate of market demand proved
correct for prices that were not too far from
observed values, but people systematically over
estimated demand at higher prices. O il market
analysts undoubtedly had similar difficulties fore
casting demand after OPEC suddenly tripled prices
in the early 1970s.6

Quantity demanded
S O U R C E : Author.

Salant notes that rising real interest rates, along with incorrect de
mand forecasting, can help explain w hy gold prices dropped after

1980. W e have implicitly assumed a constant real interest rate. Salant

FIGURE 4

demand for prices from $35 to $100 an ounce
would also be valid at higher prices. However, if
true demand were represented by the broken
curve, then it is obvious how this misestimation
could produce an unexpected flagging in
demand that would, in turn, cause the price
decline in gold observed since 1981.
Figure 4 illustrates just one of
many ways that agents could have incorrectly

points out that if, for whatever reason, the real interest rate rises, the price
of gold would initially fall before increasing at a faster rate. W hy is this so?
A higher real interest rate implies that gold prices must rise more rapidly. If
no price decline occurred when real interest rates rose, the new

higher gold

price path would induce lower demand at every date than the original price
path. But the original price path was set such that supply would be deplet
ed just as a sufficiently high price choked off demand. If no price drop
occurred when a higher interest rate prevailed, the stock of gold would not
be exhausted; some owners would be left holding gold when high prices ex
tinguished demand. This is not an equilibrium; such a prospect forces prices
to jump down when the interest rate rises.

Conclusion
Two distinct regimes explain the unique behavior
of gold prices since 1968. Between 1968 and
1981, prices increased according to the Salant and
Henderson analysis; based on prices actually pre
vailing during the 1968 to 1981 period (as high
as $200 an ounce in real 1977 dollars) estimates
of the demand curve for gold were roughly cor
rect. However, incorrect forecasts of gold demand
at higher prices meant that the price had to fall.
The initial precipitous decline reflects the first
reaction to this prediction. The continued m ild
slide indicated that the market was edging down
the demand curve in search of the price that fits
the Salant and Henderson explanation of gold
price determination. The turnaround in gold pri
ces may well be telling participants that demand
has been reestimated with enough confidence to
justify a renewed upward trend in gold prices.

“Don’t Panic”1 A Primer
:
on Airline Deregulation
by Paul W. Bauer

The old dictum says that if the Devil did not exist, the Church
would have had to invent him. Similarly, if the regulator didn’t
exist, the airline industry would have had to invent him—and
did in 1938. A current question is what would happen to the
industry were it totally deregulated. One thesis is that there
would be a rush by existing and new entrants to those routes
thought to be profitable. Other routes would be abandoned.
Price competition would be destructive. With the essential link
between economics and safety there would be an inevitable
major air disaster, possibly involving a prominent Member of
Congress. Public outcry and congressional responses would
lead to the re-establishment of regulation. Since this was the
sequence of events in the mid-30’s, why re-learn that lesson?
This thesis has been challenged, but the lesson of history . . .
cannot be totally ignored.
Secor D. Browne, Chairman
Civil Aeronautics Board
(January 1972)2

Paul W . Bauer is an economist at
the Federal Reserve Bank of
Cleveland.
The author would like to thank
Randall W . Eberts, Jo e A . Stone,
and others who provided useful com
ments on an earlier draft of this
paper.

Introduction
Former Civil Aeronautics Board (CAB) Chairman
Browne’s statement 15 years ago can scarcely be
interpreted as an unqualified endorsement of the
government’s current policy of airline deregula
tion. It does remind us, however, that the issue of
airline regulation has been controversial for quite
some time.
The Civil Aeronautics Act (CAA) of
1938, enacted to counteract the alleged condi
tions of competitive instability of an industry then
in its infancy, began 40 years of pervasive
government regulation by the now-defunct CAB.
With passage of the Airline Deregulation Act
(ADA) of 1978, the federal government com
pleted an about-face in policy and reintroduced
competitive forces into the market.
For eight years now, the airline
industry has been experiencing a great deal of
turmoil, as evidenced by the large number of
entries, mergers, and bankruptcies. Much of this
turmoil, however, is not the result of deregula
tion, but rather of the fuel price increase in 1979,

1
2

Sound general advice from

The Hitchhiker's Guide to the Galaxy by

Douglas Adams.
Foreword to R .E.G . Davies'

Airlines of the United States Since 1914,

Putnam & Company Limited, London (1972).

of the recession in the early 1980s, and of the air
traffic controllers’ strike in August 1981. Even so,
the regulation debate is heating up again as the
events predicted by Mr. Browne seem to be
unfolding—with such examples as the recent
bankruptcy of Frontier Airlines, the financial prob
lems of People Express and Eastern Airlines, and
the crash of the Aeromexico airliner in southern
California in August 1986.
This paper analyzes the conditions
that prevailed under CAB regulation and that led
to the Airline Deregulation Act of 1978. These
conditions are contrasted with the effects of
deregulation observed so far. Finally, an attempt
is made to predict the future evolution and per
formance of the U.S. airline industry under
deregulation.

I. The U.S. Airline Industry
Under CAB Regulation
Between 1938 and 1978, the CAB maintained
stria control over the two most important decisions
airlines had to make: where to fly and how much
to charge. This meant that airlines could only
compete with one another by offering a higher
quality of service (primarily more frequent flights

and other amenities). Studies have shown that
CAB regulation led to more frequent flights and
to lower load factors (the proportion of seats on a
flight that are filled by paying passengers) than
would be normal in a competitive airline industry.3
Since these actions resulted in high
er costs for the airlines, and since the CAB was
charged with maintaining the financial health of
the industry (that is, preventing losses), it follows
that fares were higher. In fact, the interstate carri
ers subject to CAB regulation marked up fares 20
to 95 percent more than the intrastate carriers not
subject to CAB regulation for similar routes.4 The
General Accounting Office (GAO) estimated that
passengers could save up to $2 billion dollars or
more per year with competitive fares.5

II. The Theory Behind Deregulation
Given fare markups of these magnitudes, why
were the airlines’ earnings so mediocre? The an
swer appears to be that regulated industries do
not have sufficient incentives to control costs.
Given the CAB’s mandate to maintain the health
of the industry by raising fares whenever the airlines experienced hard times and the lack of a
threat of competitive entry (the CAB had not al
lowed the formation of a single new trunk airline
from 1938 to 1978), a strong prima facie case
exists for inadequate cost control. Using data
from 1972 to 1978, Bauer (1985) found that, on
average, airline costs during that period were 48
percent over the m inim um cost of providing the
same service.
Another example of the poor in
centive structure can be found by analyzing labor
costs. Providing a service product— transportation
between two points—airlines could not stockpile
their output in anticipation of a strike. Any output
diverted by one carrier (either to other carriers,
or to other transportation modes) as a result of
the strike is a permanent loss to that carrier.
Further, even when the strike is settled, the air
line may lose some of its customers to other car
riers. Regulated airlines could not offer large dis
counts and free flights to lure their customers
back, as United Airlines did after a strike in 1979.
Under CAB regulation, strikes were very costly to
the airlines, but higher labor costs could be

Douglas, George W . and Jam es C. Miller, (1974)

Economic Regula

tion of Domestic Air Transport: Theory and Policy,

Brookings Insti

tution, Washington, D.C .

4
5

T. E. Keeler, "Airlines Regulation and Market Performance,"

Journal of Economics 3 (Autumn

absorbed by CAB fare increases or CAB approval
to enter some profitable new route. Thus, there
was little incentive for airlines to endure strikes.
Given the evidence on fare mark
ups and the suspicions about airline inefficiency,
proponents of deregulation became convinced
that elimination of CAB regulation, and a move
towards more competition in the industry, would
be beneficial to travelers and, ultimately, to the
industry itself. Two basic tenets drive the model
of the industry that proponents of deregulation
had in mind: one, that the m inim um efficient
scale size is reached at a relatively low level of
output and, two, that new entry and the threat of
new entry into the industry would ensure suffi
cient competition to hold fares close to marginal
cost and only allow firms to earn a normal profit.6
Numerous studies performed prior
to deregulation, using various data sets from the
late 1950s forward, found that larger airlines had
no significant unit-cost advantage (measured in
passenger miles) over smaller airlines. This
research im plied that there was plenty of room in
the U.S. airline industry for anywhere from 20 to
100 efficiently sized airlines (see White [1979]),
and that there was little chance of concentration
increasing in the industry if it were deregulated.
The second tenet, that freedom of
entry would severely lim it any market power that
an airline may have, was being strongly sup
ported by the new theory of contestable markets
(see Baumol, Panzar, and W illig [1982]). Simply
stated, this theory predicts that if market entry
and exit involves no irrecoverable costs and can
occur quite rapidly, the threat of entry is sufficient
to ensure that firms in this market earn no more
than a normal profit.
The following illustrates how this
result occurs. Suppose the firms in a contestable
market decided to collude and to raise their
prices. Although the strategy might work in the
very short run, soon new firms not party to this
agreement would recognize the opportunity for
above-normal profits and w ould enter the indus
try, driving prices back down. In a contestable
market, even a monopolist w ould thus earn a
normal profit, because if it tried to take full
advantage of its monopoly power to earn more
than a normal profit, another firm would enter
and charge the lower price, capturing the entire
market for itself.
Clearly, not all industries in the
economy can be considered contestable (the
auto industry, for example, is definitely not).
However, deregulation proponents considered

Bell

1972), pp. 339-434.

General Accounting Office, Report to Congress, Lower Airline Costs
per Passenger Are Possible in the United States and Could Result
in Lower Fares, February 1977, p. 11.

A normal profit is the minimum return required to keep the firm from
shifting resources out of the industry.

the airline industry a good candidate for
contestability— once the artificial barriers to entry
created by the CAB were eliminated.
The following market characteris
tics were considered to promote contestability:
• Inputs used by the airline
industry are all relatively mobile when compared
to most other industries. Labor, energy, and mate
rials can either be employed or let go on fairly
short notice, as in most industries, but capital is
much more mobile than in almost any other
major industry.
• Airlines can quickly shift planes
from one route to another as the need arises.
Further, since there is a ready secondary market
for used aircraft— in fact, many carriers rent a sig
nificant portion of their fleets— planes are fairly
mobile from one carrier to another.
• Ground facilities are usually
rented, making them fairly disposable (acquisition
is another matter, and will be discussed later).
These properties are thought to
make it relatively easy for incumbent airlines to
begin service on new routes, so that if fares are
too high on a given route, other airlines will
enter those markets at lower passenger fares.
These properties are also thought to facilitate the
start-up of new airlines if existing lines are mak
ing more than a normal profit.
Thus, according to the contestable
market view, there was little to fear on the part of
consumers from airline deregulation. Even if the
industry did evolve into a handful of firms, the
contestable market theory predicted that they
could only earn a normal profit and fares would
be as low as possible.
In summary, the proponents of
deregulation predicted sharply lower coach fares,
as fare markups would be bid down and airlines
would strive to reduce their costs in the face of
observed and potential competition. There would
be some deterioration in service quality as flight
frequencies would be reduced. However, this
would in turn lower airline costs (by increasing
load factors), thus further lowering fares, and pas
sengers would receive the fare-service mix that
they prefer. It was felt that there was no need to
worry about increased concentration in the air
line industry, because the m inim um efficient
scale would be small enough to make room for
many carriers. Besides, the threat of entry would
be sufficient to hold fares down and service qual
ity up, even on routes with few carriers.

This divergence of prediction and reality can be
traced to changes in the airlines’ operating strate
gies that were induced by the increased freedom
given to them by the elimination of CAB regula
tion. These changes in strategy7occurred in the
two areas mentioned earlier: where to fly and
how much to charge. Market competition seems
to have induced even more innovation than
industry experts foresaw, leading to predomi
nately beneficial changes in airline behavior.

Fares
As the CAB’s authority over fares was diminished,
the airlines gradually developed a more complex
fare structure to replace the relatively simple firstclass and coach-fare structure that existed under
regulation. W hile an element of price discrimina
tion certainly exists, most of the variation in fares
is based on differences in the cost of serving the
various classes of passengers.7 Fares are lower for
travel outside the periods of peak demand.
Examples include flying on weekends, flying in
the middle of the day or late evening, and flying
to locations that are out of season. A prime
example of fare differences based primarily on
cost is found between those who can book and
pay for tickets in advance and those who cannot.
It is costly for airlines to fly planes with empty
seats, yet they intentionally have some slack in
their systems so that they can accommodate lastminute travelers— for a higher price.
These pricing strategies have
enabled the airlines to increase both traffic and
revenue far more than if a uniform pricing policy
had been followed. The increase in the industry’s
revenue passenger miles (RPM) and average load
factor are plotted over time in figure 1. Both have
increased since deregulation, although the effect
of the recession in the early 1980s is clearly evi
dent. Traffic increased 33 percent just from 1977
to 1979.
As a result of this shift in pricing
strategy, the average fare that passengers actually
paid (adjusted for inflation) has fallen about 20
percent in the last 10 years, even though the
standard coach fare has fallen very little. Though
this is a far cry from the drop that had been
expected given the fare markups and inefficiency
that existed under regulation, it does represent a

For example, whether one stays over a Saturday night on a round
trip has no effect on the airline’s cost of providing the service, yet it

provides a very useful screening device enabling the airlines to charge
higher fares to business travelers (who generally cannot meet this restric

III. The Effects of Airline Deregulation
The actual effects of airline deregulation, while
being generally beneficial to date, have not mate
rialized precisely as the proponents predicted.

tion) and lower fares to pleasure travelers (who usually can). Thus the air
lines can price discriminate between the two classes of consumers, taking
advantage of the business travelers' higher price elasticity of demand (and
the leisure travelers’ lower elasticity of demand) to increase their revenue
and profits.

quency on most routes (as a result of the increase
in traffic) and by the lower fares (for those who
could qualify for the discount fares); and the air
line industry was able to increase its profits over
what they would have been under regulation as
the increase in load factors lowered costs.

Routes

1945

1950

1955

1960

1965

1970

1975

1980

S O U R C E : Data from Bailey, Graham, & Kaplan (1 9 8 5 ).

FIGURE 1

PASSENGER REVENUE PER RPM
(in constant cents)

OPERATING
PROFIT MARGIN (% )

S O U R C E : Data from Bailey, 6raham, & Kaplan (1 9 8 5 ).

FIGURE 2

considerable savings to travelers. A measure of
the average fares paid by travelers, the average
passenger revenue per RPM, is plotted along with
the average operating profit in figure 2.
All parties benefited to some
extent by this new fare structure. The super-low
fares enabled many leisure travelers to take trips
they would not have considered before; business
travelers gained by the increase in flight fre

The other fundamental change in the airlines’ strat
egies concerns the decision of where to fly. Few
people inside or outside the industry foresaw the
shift of the airlines to what is now known as a huband-spoke system. Since deregulation, instead of
serving a hodgepodge of routes as dictated by the
CAB, airlines organized their routes so that most
of their flights now converge on one or two hubs.
These hubs collect traffic from the “rim” cities,
then the passengers change planes at the hub to
go out on other flights to their final destinations.
The potential benefits of this system were dem on
strated to a small extent by Delta Airlines, which
had a hub in Atlanta even under regulation.8
The hub-and-spoke system has
enabled airlines to increase their load factors on
flights both into and out of the hub, thus lower
ing their costs and enabling them to lower their
fares. An important side benefit is that flights can
be scheduled more frequently because of the
higher traffic density. Thus, instead of flight fre
quencies decreasing under deregulation, as was
generally predicted, they actually increased. Pas
sengers are also more likely to be able to com
plete their entire trip on one airline (which is
advantageous to the airlines) and to avoid the
inconvenience of changing planes at busy air
ports (which the passengers like). Another
benefit is that passengers can fly from almost any
city to almost any other city without having to
endure multi-stop flights. Usually a one-stop flight
can be found, and routes with sufficient traffic
density still receive nonstop service.
How much are these innovations
worth to consumers? Morrison and Winston (1986)
estimated the total benefit of deregulation to con
sumers to be $5.7 billion a year. For the average
passenger, the benefits per trip were $11.08 and
came from the following sources: a gain of $4.04
from lower fares, a loss of $0.96 from slightly
increased travel time, and a gain of $8.00 from
increased flight frequency. Morrison and Winston
further estimate that airline profits would have
been $2.5 billion higher than they were under
regulation. Thus, airline earnings would have

The joke then was, “ It does not matter whether you are going to
heaven or hell; you have to go through Atlanta first.”

been even worse than they actually were (as
reported in figure 1) had CAB regulation con
tinued. These are substantial aggregate benefits.

Passenger Concerns
Even so, the gains of deregulation have not been
shared equally by all travelers and, in fact, some
may be worse off. Travelers who do not qualify
for the discount fares and who must pay the full
coach fare are probably worse off, unless the
benefit from the increase in flight frequency is
sufficient to offset this effect. Also, due to the
oversupply of wide-body jets, which are ideally
suited to carrying passengers coast to coast, fares
for flights between 2,000 and 2,999 miles have
fallen much more than other fares, so that travel
ers on these routes have benefited proportion
ately more than travelers on shorter routes. This
is a temporary7benefit, however, and will last only
until the airlines adjust their fleets. Finally, travel
time for most flights involving large hubs has
increased due to the increase in traffic.
One of the early concerns of
opponents and even of some supporters of dereg
ulation centered on the availability of air service
to small communities. Provision was made in the
ADA for subsidies to help support air service to
small communities for a period of up to 10 years,
but many communities were not covered by these
provisions. However, most small communities, far
from losing service, have gained service. In gen
eral, hedgehopping, multi-stop flights have been
eliminated (lowering travel time), and flight fre
quencies have been increased. Travel time for
trips involving nonhubs has fallen from one to six
percent on average.9 While service by trunk air
lines has been replaced with service by commuter
airlines in many cases (which is seen as less desir
able), most of these commuter lines have their
schedules coordinated with a major carrier at the
connecting hub. When there is provision for on
line ticketing, travelers can save approximately 25
percent over the interline fare. The few com m un
ities that have lost all service have not had
enough traffic to support scheduled carrier ser
vice by any class of carrier. In these cases, sendee
could be restored by government subsidies if the
affected taxpayers deemed it desirable to do so.
Beyond the basic issues of where to
fly and how much to charge, there is the issue of
whether the skies have become less safe under de
regulation. Generally, the argument is that compe
tition gives airlines an incentive to cut corners on

maintenance and to force pilots to fly more hours
than is prudent. Under regulation, it was claimed
that this was not a problem because the CAB en
sured that the airlines were financially healthy so
that they would not be as tempted to cut corners.
So far, the safety record of the air
lines is as good as ever, but there is the charge by
some that the country has simply been lucky.
There are two responses to this charge. First, it is
bad for an airline’s business for its aircraft to be in
volved in an accident that is shown to be a result
of its own negligence. Not only is the public likely
to avoid the airline, but the airline would also
have lost a plane worth m illions of dollars and ex
posed itself to even greater claims of liability.1
0
Second, and more important, one sure way of forc
ing the airlines to perform proper maintenance is
to step up inspections by the Federal Aviation Ad
ministration (FAA). There may be a problem in do
ing this, however. The number of airlines and air
craft in service has risen dramatically since 1978,
but the number of FAA inspectors has remained
the same due to federal budget constraints.
A related problem is that the
number and the level of experience of the
nation’s air traffic controllers has declined since
deregulation as a result of the Professional Air
Traffic Controllers’ Organization (PATCO) strike
in the summer of 1981. Thus, if there is a poten
tial safety problem, it is likely to arise from
inadequate attention to inspection and flight con
trol, not from deregulation.

Industry Concerns
As one might have surmised from the earlier dis
cussion of strikes, labor leaders were also con
cerned about the effects of deregulation. In fact,
however, overall employment in the industry is
up and compensation has kept pace with infla
tion. According to data presented by Morrison
and Winston (1986), from 1975 to 1984, pilots’
average real income fell a modest $500, dropping
to $47,720 in 1977 dollars, while that of flight
attendants increased $1800 to $14,428, and that of
mechanics increased about $500 to $19,775.
Industry employment has increased
since the early 1970s. Employment declined from
a 1980 peak until 1983 when it rebounded and
continued the upward trend it followed from
1971 to 1978 (see Morrison and Winston [1986]).
Though the average worker has not suffered

A n airport is classified as a “nonhub" if its total enplaned revenue
passenger miles represents less than 0.05 percent of the total U .S .

market.

-1

It is assumed, of course, that the idea of preserving life also

_L W

enters into the issue.

under deregulation, many union workers have
been forced to take wage- and work-rule conces
sions, and some have had their careers inter
rupted as they have been either laid off or let go
by airlines performing poorly in the new compet
itive environment. Two-tiered labor contracts
have also been introduced. All this and the
growth of the nonunion sector of the industry
among the entering airlines have induced wide,
and sometimes surprising, wage differentials
between workers for different airlines, so that
aggregate data on the welfare of workers is
somewhat misleading.1
1
Finally, some firms may not have
benefited from deregulation. There have been a
number of bankruptcies in the airline industry
since deregulation, most notably Braniff Airlines
and Continental Airlines, which are both still fly
ing after Chapter 11 reorganizations. Another air
line (Frontier) is not flying, but is being acquired
by Texas Air. In addition, there have been numer
ous mergers, particularly in the last year. Cur
rently pending are two large mergers involving
Continental-Eastem-People Express-Frontier (by
Texas Air) and Delta-Western, that would create
the first- and fourth-largest airlines in the U.S.,
respectively. While business failures impose
some costs, such as uncertainty and inconve
nience on the part of consumers, the loss of jobs
on the part of workers, and the financial loss to
creditors and stockholders, failures are a neces
sary force to ensure that firms operate efficiently
in providing the services that consumers desire at
a cost they are willing to pay.

IV. Future Evolution of the Industry
The current merger wave could be regarded as a
natural process leading toward a competitive air
line industry. Travelers prefer to have nonstop or
one-stop flights with one carrier, rather than take
a flight that would require them to endure two or
more stops, or to change airlines at a busy airport.
Providing such service requires a national route
network with several regional hubs. In addition
to the benefits for travelers, there also might be
cost advantages to operating such a large hub
network. Though the cost studies performed dur
ing the regulatory period indicated that there
were no scale economies in the airline industry,
the cost inefficiencies present in the regulatory
era may have distorted these estimates. Bauer
(1985) used an econometric procedure that
allowed for these inefficiencies and found evi
dence of substantial returns to scale (contrary to

For example, unionized Western Airline workers earn less than
Delta’s nonunion workers. Also, United’s unionized pilots earned
40 percent more than their ill-fated Frontier brethren.

the cost studies that did not allow for ineffi
ciency). This issue aside, there are definitely cost
advantages to the extent that large hub-and-spoke
systems lead to higher load factors. Currently,
only United Airlines and American Airlines oper
ate such networks. However, once the current
wave of mergers subsides, there will be anywhere
from six to eight such super-airlines, perhaps
another four to six medium-sized carriers, and
perhaps 10 to 30 regional carriers.
Should the public be concerned
about the potential anti competitive effects of
these airline mergers? If the industry were per
fectly contestable as discussed earlier, then the
answer would be no. Many researchers have
tested whether or not the implications of the the
ory of contestable markets hold exactly; unfortu
nately, no one has found that they have. Bailey,
Graham, and Kaplan (1985), for example, found
that on concentrated routes (routes served by
only one or two carriers) airlines can raise fares
five to 10 percent over what they could charge on
nonconcentrated routes.
There are two reasons why actual
and potential competition have not lived up to
their promise in the airline industry. First,
capital—both physical and human capital— may
not have fully adjusted to the new deregulated
environment. The number of merger proposals re
cently is evidence that the airline industry is not
in a long-run equilibrium with respect to the
number and size distribution of carriers. Given
that it has been eight years since the formal dereg
ulation process started, it appears that the transi
tion from a regulated to a competitive market
equilibrium will take longer than expected.
A second reason for the apparent
lack of competition on some routes is that entry
into some concentrated markets is not as easy as
was first expected. Many airports across the coun
try7have severe problems with traffic congestion
(for example, airports in Denver and Washington,
D.C.); obtaining gates and takeoff and landing
slots at these airports is difficult. Since gates and
landing rights are “grandfathered” to the airline
holding them as long as they are used, the air
lines that have these scarce resources can earn
monopoly returns from them. This creates a
severe barrier to entry for airlines wishing to
begin service on these routes. The importance of
this problem was highlighted in the recent
merger of Continental Airlines with Eastern Air
lines. To get approval for the merger, slots at
LaGuardia airport had to be sold to Pan-Am so
that it could set up a competing shuttle service.
Even at relatively uncongested airports, such as
Cleveland Hopkins, airlines are reluctant to
release unused gate space. Much of the impetus
for the current merger wave is that airlines find it
is easier to buy other airlines to expand (in an

effort to reach the most efficient size) than it is to
grow internally (and be forced to try to obtain
takeoff and landing slots on their ow n).1
2
Given that the contestable market
theory does not seem to apply on all routes,
should consumers worry about the increasing
concentration of the industry? Currently, the
national four-firm concentration ratio (CR), the
sum of the market shares of the largest four firms
in an industry, has remained unchanged at 47
from 1975 to 1986. Depending on how the cur
rent merger proposals are approved, it is likely
that the resulting concentration ratio for the
industry will be anywhere from 57 to 61. While
this is high enough to cause concern, particularly
in light of the fact that some individual city pairs
now have even higher concentration ratios, there
are reasons not to become alarmed just yet.
First, even though the industry has
a fairly small number of firms, and concentration
is relatively high, fare and route competition has
been intense since deregulation. There have
been no accusations that the industry' as a whole
is earning more than a normal profit. Further
more, to the extent that only large airlines can
provide the national route structure and the
potential for nonstop and one-stop service that
consumers prefer at the lowest cost, the level of
concentration is only a reflection of the fact that
there is only room for a limited number of effi
ciently sized airlines in the market.
If the ultimate effect of deregula
tion is a national market with six to eight huge
airlines, there still would be a great deal of com
petition in the industry, even if many of the major
cities are dominated by as few as two carriers. If
one wants to fly from Cleveland to Los Angeles,
for example, there may only be one or two air
lines to choose from that provide nonstop service.
However, one-stop service is a close substitute for
nonstop service and, in that case, one would con
ceivably have six to eight choices depending upon
which hub city he or she prefened to change
planes. On shorter routes, such as Cleveland to
Chicago, the smaller regional carriers would pro
vide additional competition to the major carriers
and thereby put a check on fares.1 O n still short3

-1

A further cause of the increased merger activity now is that

the Department of Transportation (D OT) has authority over air

line mergers for the next two years, at which time the Department of Ju s
tice (D O J) will have that responsibility. The D O T has been much more
lenient than the D O J.
If they cannot obtain space at the major airports on the route
in question, they have the aircraft that can effectively utilize
the smaller regional airports which, in some cases, may be more conve
nient for passengers.

er flights, Cleveland to Columbus for example, sur
face transportation provides some additional com
petition even if the market for air travel between
those points is concentrated. Given the shortcom
ings of the contestable market theory as applied
to the airline industry, however, the disciplining
effect of potential competition may not be enough
to ensure competitive behavior. It may still be
necessary for the Departments of Transportation
and Justice to enforce current antitrust laws.
In summary, at this point, the mar
ket for air travel in the U.S. is not perfectly contes
table and, on some concentrated routes, airlines
are able to charge modest fare markups on the
order of between 5 and 10 percent. This situation
is likely to continue for the foreseeable future,
until steps are taken to alleviate the congestion
problems at certain airports. The next few years
will probably witness an increase in the concen
tration in the industry to the point where six to
eight large airlines dominate the national market
with a host of smaller regional and commuter
lines filling a variety of special niches. There will
be sufficient competition to ensure that travelers
are better off than they were under regulation,
but it remains to be seen how closely the industry will conform to the perfectly contestable ideal
that was envisaged by proponents of deregulation.

V. Conclusion
Deregulation of the airline industry has been a
painful experience for some travelers, workers,
and firms. Large fuel price increases, the air traffic
controllers’ strike, and recessions have made the
process even more difficult. O n the whole, how
ever, deregulation has been favorable. Far more
individuals have benefited than have been hurt.
Consumers are receiving better service for lower
average fares; employment and compensation in
the industry are up; and the airlines are generally
earning higher profits than they would have
under regulation. Yet, even eight years later, the
industry is still adjusting to its new environment,
and the final results of deregulation have yet to
be determined.
There are several steps that can be
taken to ensure that the gains to date are not lost
and that the costs of adjustment to deregulation
are minimized. First, airport expansion is needed
to help reduce one of the few barriers to entry
that remain in the industry. Deregulation, by great
ly increasing air travel through lower fares, made
the congestion worse. The solution, however, is
not to reduce air travel, but to expand the system.
The federal government has a $3 5
billion fund that can be spent only on promoting
air travel. This fund is financed by an 8 percent
tax on air fares, but has become embroiled in the
current federal budget problems. The money

could be spent to expand airport facilities, to
modernize the air traffic control system, and to
hire more FAA inspectors. These expenditures
would enhance the competitiveness of the system
by lessening the incentives for airlines to merge,
as well as by improving their safety and reliability.
Second, the U.S. Departments of
Transportation and Justice should continue to
enforce existing antitrust laws. W hile the compet
itive discipline that free-entry into the industry
offers should not be ignored, it is important that

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Full text of Economic Review (Federal Reserve Bank of Cleveland) : 1986 Quarter 4

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