^ ^ ;£} THE SHIFTING OF REGULATION IN A DEREGULATED ENVIRONMENTi PROSPECTS FOR A MISLABELED MARKET Paper for the fulfillment of requirements for the program of Mathematical Methods in the Social Sciences Glen Sarvady May 29, 1984 "...The encouragement, development, and maintenance of an air transportation system relying on actual and potential competition to provide efficiency, innovation, and low prices, and to determine the variety, quality, and price of air transportation services,,," -stated aims of the 1978 Civil Aeronautics Act "•••(avoidance of) The uneconomic, destructive competition and wasteful duplication of services,,,the air carriers and the traveling public are protected against unreasonable and discriminatory passenger express rates, unfair trade praetiffieB_.and monopolies in restraint of competition,,," -stated aims of the 1938 Civil Aeronautics Act IOTRODUCTION/ABSTRACT The Civil Aeronautics Act of 1938 was a farsighted piece of legislation intended to assist a fledgling airline industry blossom into an efficient and thorough transcontinental transportation network. The Act was so successful in anticipating future conditions and necessary actions that it remained on the books, virtually unaltered, for forty years. Many argue, with a fair amount of justification, that the 1938 Act had reached obsolescence and merited replacement long before its expiration in 1978. During its tenure, the airline industry had reached maturity and enjoyed great prosperity, albeit achieved through a highly regulated environment. By the 1960s, the industry had grown to a point where the current legislation was no longer relevant or effective at steering the airline network in the path desired by the Civil Aeronautics Board. In 1978, attempts to revise the existing laws resulted in a swing to the opposite extreme. After forty years of price controls, route allocation, and other strict jurisdiction at the hands of the CAB, Congress decided to pursue a course of deregulation in the airline industry. The bulk of the CAB's powers had been eradicated by I983, and subsequent revisions in the 1978 Act went as far as to dismantle the CAB entirely by 1985. A glut of articles and reports, both predictive and analytical in nature, have resulted from the new state of affairs, as academians and bureaucrats alike strive to evaluate the success and ramifications of the new system. The literature includes purely speculative prose, highly abstract models, projections made from the waning years of regulation, and statistical analyses based on what little data has been amassed since 1978. However, one common thread can be found linking these diverse works. The vast majority appear to be written from extreme positions of pro-deregulation bias. In fact, many seem to begin with an attitude of 'deregulation is a godsend' and proceed to delve for any and all evidence supporting their devotion, in the process squelching any hopes for an objective presentation. This paper purports to dispel several fallacies surrounding the new legislation, first of all, the term 'deregulation' is a severe misnomer most likely attached to the current market for reasons of political efficacy, A relaxation of regulation has occurred for the major airlines, and all carriers enjoy a newfound freedom in fare determination. However, the 19?8 Act and its effect on the industry as a whole can most accurately be termed a shifting of regulation. The CAB, or any agency assuming residual duties upon its demise, how has a hand in the direction of carriers over which it did not previously hold power. The 1938 Act contained a series of objectives, many of which proved to be mutually exclusive. The deregulated environment (I shall continue to refer to it as such despite my objections, since the term has been coined and accepted) has alleviated some of these problems, yet contradictions still exist. The i9?8 Act pledges "to rely on competitive 1 market forces to determine the nature of air service," a promise not yet realized. It is not clear that if such a system were actually installed, the resultant air service network would be at all consistent with the CAB's 1938 vision or any idyllic contemporary wishes. Nor is it certain that such an industry, serving as a basis and support system for numerous private and public functions, should in fact be dictated solely by market forces. I hope to provide new interpretations of documented facts and present data in such a manner as to shed light on the current state and direction of the deregulated airline industry. I shall also present original equations describing carrier exit and entry from small and perimeter markets, illuminating the changes in the amount and complexion of air service since 1978. It is my intention that an unbiased evaluation of the effects of the 1978 Civil Aeronautics Act will result. The Civil Aeronautics Act, drawn in 1938% laid the groundwork upon which federal control of commercial aviation would be based for the next forty years. The Act created the Civil Aeronautics Board, an agency entrusted with the control of firm entry, route structures, fare levels, subsidy allocations, and safety measures for the airline industry. (A list of the official objectives of the CAB is included on the following page.) Scheduled air service had begun in the mid 1920's, operating mainly to ship mail, with the federal government virtually serving as the carriers' sole client. Passengers began to fly in addition to cargo, and the scope of service changed as a result. From its inception, the CAB adopted as its primary function the development ©f a far reaching nationwide airline system requiring a minimum of government subsidization. Since the main competition for passenger transportation in 1938 was the railroad, one of the CAB's first moves was to set airfares to the going first class rail rate. This strategy catalyzed a situation which remains as one of the prime areas of debate regarding the viability of deregulation. Unlike the rail system, air travel operating costs exhibit considerable economies of scale. Airline costs per seat per mile significantly decrease as the distance travelled increases, mainly owing to matters of fuel efficiency. Consequently, from the start long haul routes have been more profitable than short haul jaunts. The CAB exploited this fact, balancing the route portfolios of each carrier between short and long haul routes. In this way, excess profits earned on long hauls could be used to internally subsidize the short haul runs. This system was very politically attractive in the early stages, Self Professed Goals of the 1938 Civil Aeronautics Act In the exercise and performance of its powers and duties under this Act, the Board shall consider the following, among other things, as being in the public interest, and in accordance with the public convenience and necessity: The encouragement and development of an air transportation system properly adapted to the present and future needs of the foreign and domestic commerce of the United States, of the Postal Service, and the national defense. The regulation of air transportation in such a menner as to recognize and preserve the inherent advantages of, assure the highest degree of safety in, and foster sound economic conditions in such transportation, and to improve the relations between, and coordinate transportation by, air carriers; The Promotion of adequate, economical, and efficient service by air carriers at reasonable charges, without unjust discriminations, undue preferences, or unfair or destructive competitive practices; Competition to the extent necessary to assure the sound development of an air-transportation system properly adapted to the needs of the foreign and domestic commerce of the United States, of the Postal Service, and the national defense. The promotion of safety in air commerce, and, The promotion, encouragement, and development of Civil Aeronautics. Source; Civil Aeronautics Act of I938. t as the network was strengthened with a minimum of subsidy infusion from the government. However, economic theory dictates that such cross subsidization is inefficient and will be doomed when exposed to free market forces. An airline would prefer to keep excess profits earned on the long hauls rather than squander them on other routes. Furthermore, an airline without the short haul runs to support could conceivably enter only the long haul markets and cut fares below industry standards while still receiving the same amount of overall profits. In economic terms, this is a result of artificially setting marginal cost curves too high for the long haul and too low for the short haul. If 'true' marginal cost and revenue curves were allowed to infiltrate the marketplace, the system would inevitably break down. No such collapses were to befall the industry for several years, due to the trade's infant status and barriers constructed by the GAB. The 1938 Act aimed to prevent "...the uneconomic, destructive competition, and wasteful duplication of services..." accomplishing this by decreeing "...that no person nor company may engage in air transportation without 2 first receiving a certificate of Public Convenience and Necessity." In other words, no carrier was allowed to enter and compete without a certificate, and certificates were virtually unattainable. The sixteen carriers existing at the time of the 1938 Act were awarded such certificates; they comprise what are known as the trunkline carriers. The number of trunks has shrunk to ten, but not a single carrier