Industry and Firm Studies

Victor J. Tremblay, Carol Horton Tremblay

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317468011
• Edition: 4
• Topic: Business
• Subtopic: Business General
• Index: Business

The fourth edition of this acclaimed text is a rich resource for undergraduate and graduate courses in industrial organization, applied game theory, and management strategy. It incorporates game theory into industry analysis by studying the behavior of successful and failing firms as well as the structure-conduct-performance of particular industries. Chapters address a wide variety of issues concerning industry structure, policy towards business, and the strategic innovations and blunders of individual firms. New coverage of professional sports, soft drinks, distilled spirits, and cigarettes complements revised and updated chapters on airline services, retail and commercial banking, health insurance, motion pictures, and brewing. The book includes firm case studies of General Motors, Microsoft, Schlitz, and TiVo.

I

Industry Studies

1

Airline Service

The Evolution of Competition Since Deregulation

Steven A. Morrison

After forty years of tight regulation by the federal government, the airline industry was deregulated in 1978. Such a dramatic change in an industry’s economic environment is bound to have significant effects, and the airline industry is no exception. Airlines provide an interesting example of how an industry evolves when freed from government regulation. After nearly three decades of deregulation, this evolution is still not complete, although the form to which the industry is evolving is becoming clear.

This evolution has not been without controversy. Each zig and zag of the industry renews the debate about the wisdom of deregulation and the future of the industry. The industry has this high profile because many people are fascinated with aviation. Others devote attention to airlines because airline deregulation was the first of many regulatory reforms (e.g., railroads, trucking, telecommunications, banking) in the late 1970s and 1980s. As the oldest deregulated industry, airlines give analysts insight into other industries. Although the airline industry is a complex one, it is amenable to study because of the wealth of data—a legacy of regulation—the government continues to collect.

This study chronicles and explains the evolution of the domestic passenger airline industry since it was deregulated in 1978.¹ The next two sections provide a brief history of the government’s involvement in the industry and the deregulation movement. The succeeding section describes the technology of the industry and introduces some terminology that will be useful. After a discussion of the demand for air transportation, there is a discussion of what airline deregulation was supposed to accomplish and what it has accomplished. Finally, current trouble spots and policy options are identified.

History of the Industry

The aviation age began in 1903 at Kitty Hawk, North Carolina, when Wilbur and Orville Wright performed the first power-driven, heavier-than-air, controlled flight. It was just eleven years later, in 1914, that scheduled commercial passenger service began. For $5.00 the St. Petersburg–Tampa Airboat Line carried passengers eighteen miles between Tampa and St. Petersburg, Florida. Significant growth in the industry would wait until after World War I, and then it was mail rather than passenger transportation that developed.

The first regular airmail service began in 1918, operated by the Post Office. By 1927, the Post Office had contracted out all airmail service to private carriers. Private carriage was feasible because the federal government undertook the expense of constructing the air infrastructure (e.g., lighted civil airways and beacons for navigation).

Carriers were paid for carrying mail on the basis of its weight and the distance traveled (pound-miles). At one point, after several changes in postage rates and in payments to carriers, carriers received more for carrying mail than the cost of the postage. This posed financial problems for the Post Office and was exacerbated by the incentives carriers had to mail heavy packages to themselves. In 1930, partly in response to such problems, Congress passed legislation to base compensation on capacity and distance (space-miles) instead of pound-miles. Although this ended the problems with the pound-mile system, the space-mile system gave carriers an incentive to use larger aircraft and to use the extra space to carry passengers. Because passenger transportation was not financially feasible without a mail contract, the Postmaster General effectively controlled entry into the industry. Thus subsidized passenger service began, with the Postmaster General as the regulator of commercial air transport.

Aviation continued to develop during the early 1930s, despite the Depression, because of significant technical advances in aircraft design and manufacturing. Reacting to new problems, in 1934 Congress passed an act that divided control of air transportation among three agencies. This also proved unworkable because carriers submitted ridiculously low bids to one agency (zero in at least one case) to win a mail contract, knowing that another agency had the power to raise rates that were too low. Finally, in 1938 Congress passed the Civil Aeronautics Act, which remained basically unchanged until deregulation in 1978. The Act, patterned after the Interstate Commerce Act of 1887 and the Motor Carrier Act of 1935, subjected the industry to public utility-type rate-of-return regulation. To implement the regulations, the Act created what was to become the Civil Aeronautics Board (CAB). This legislation, enacted during the Great Depression, reflected the widespread distrust of market forces that prevailed then and the belief that government regulation could improve the market outcome.

The Civil Aeronautics Act required carriers to have a certificate of public convenience and necessity issued by the Board. The sixteen carriers operating when the Act was passed received “grandfather” rights and were granted certificates for the routes they served. Other applicants had to show that they were “fit, willing, and able” to perform the proposed service and that the service was “required by the public convenience and necessity.”

The Act allowed the entry of new carriers, but the CAB never granted a major (trunk) route award to a new entrant. However, the Board did allow entry into other categories: “local service” carriers providing feeder service for the trunks (1943); air taxi and commuter airlines operating small aircraft, usually with fewer than twenty seats (1952); and supplemental charter carriers (1962). Nonetheless, from the beginning of CAB regulation in 1938 until one year before deregulation in 1978, the Board did not permit entry on any route that already had two or more carriers.²

Initially, the CAB set airfares equal to prevailing first-class rail fares. Ultimately the Board set fares as a function of distance so the industry would earn a 12 percent return on its rate base, assuming a 55 percent load factor (percentage of seats filled). The fare formula included a fixed terminal charge and a fixed amount per mile for each of several mileage segments. Because the Board felt that cross-subsidization of short-haul routes by long-haul routes would foster the development of aviation, the formula was designed so fares for long routes were greater than costs and fares for short routes were less than cost. The Board then allowed carriers to file for the fares called for by the formula.

Because fares were based on industry-wide costs, they differed substantially from costs in many markets, even for the same distance. Although airlines effectively were prohibited from engaging in price competition, they were allowed to compete with service quality, especially equipment and flight frequency, which were explicitly not under the Board’s control. Carriers added equipment and flights in the lucrative long-haul markets and reduced flights (to the extent allowed) in unprofitable short-haul markets.

There was also an interesting link between the Board’s entry policy and its fare policy. Because of the fare formula, an airline’s profits depended to a large extent on its route configuration. The Board was aware of this and awarded new routes to balance the advantages and disadvantages that its prior route awards and pricing rule had created.³

Besides regulating entry, the Board also regulated exit. To exit a route, a carrier had to obtain CAB approval. Because the Board’s restrictive entry policy gave value to a carrier’s right to serve a route, firms did not exit the industry through bankruptcy. Instead, they “exited” through mergers, which provided a convenient way for a healthy carrier to acquire route authority.

The Deregulation Movement

Economists began criticizing CAB regulation as early as the 1950s. Gradually, more and more analysts accepted the position that the airline industry did not have characteristics that made economic regulation necessary. The critics argued that airline regulation had led to higher fares than would prevail in an unregulated market, yet the industry was not earning excess profits.

Since the Civil Aeronautics Act regulated “interstate air transportation,” airlines operating only within one state were not subject to federal regulation. This aspect of the law set up an interesting “controlled” experiment of sorts: by comparing unregulated intrastate fares with fares on similar interstate routes, a measure of the effects of regulation could be obtained. One particularly influential study pointed out that in 1965 the fare charged by the intrastate carrier Pacific Southwest Airlines (PSA) between San Francisco and Los Angeles (338 miles) was $11.43, while the fare charged by CAB-certificated carriers between Boston and Washington, D.C., (400 miles) was $24.65.⁴

Going beyond the compelling case for deregulation provided by academic studies, a series of events during the 1970s set the stage for deregulation. First, the introduction of wide-body jets in 1970 coincided with a recession and led to excess capacity in the industry. The CAB responded by imposing a moratorium on new route awards and by allowing carriers to agree to capacity limitations on major routes. Both actions were widely criticized.⁵ Next, in 1973 fuel prices soared in the wake of the Arab oil embargo. Regulatory reform was seen as a means of fighting inflation and eliminating government red tape.⁶ Furthermore, a change in public attitude toward competition and regulation occurred during the decades since the CAB was created. By the 1970s, people viewed government regulation with the same suspicion with which competition had been viewed during the 1930s.⁷

In 1975, the Ford administration sought deregulation of the airlines. Shortly thereafter, during 1976 and 1977, the CAB began to loosen regulatory control by interpreting the existing statute more liberally, a trend that increased dramatically when economist Alfred Kahn was appointed chairman of the CAB in 1977. The resulting liberalizations, such as the Board approval of American Airlines’ proposed “Supersaver” fares in 1977, gave legislators an inkling of how a deregulated marketplace would function. Although Congress was won over, airlines themselves—and airline labor groups—remained largely unconvinced of the wisdom of deregulation: Most airlines and unions opposed deregulation.

Finally, in 1978, Congress passed and Pr...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Tables and Figures
• Preface
• I. Industry Studies
• II. Firm Studies
• About the Editors and Contributors
• Index