Deregulation and the Significance of Competition

f you were a traveler in the year 2000, 22 years after the airlines were deregulated, you would have been unable to fly nonstop between Springfield, Illinois and Washington, D. C. No airline in the country offered this service. Instead, you would be required to go through either Chicago or St. Louis. Your airfare would be about the same, $470 in that year, whether you went through O’Hare using United Airlines or through St. Louis using American. But say that for personal reasons you wanted to drive to your first stop of Chicago or St. Louis, and then take the same flight from that airport on to Washington. Your airfare from either Chi­cago or St. Louis to Washington would then be about $1,200, between two to three times as much, even though the distance to Washington is shorter by 178 miles through Chicago and by 86 miles through St. Louis. The reason is summed up in three words: Lack of Competition.

United competes with American for the Springfield traffic to Washington. Springfield passengers had a choice of almost equal pro­portions, in distance, convenience, and service. And the price is about the same for our Spring­field traveler whether he goes through Chicago or St. Louis. At Chicago, however, United has little competition for the Chicago to Washington
traffic. United has what is known as a “fortress hub” in Chicago. The same situation exists in St. Louis with American. The fares are, therefore, much higher, even though the distance traveled is less.

■ A Look Back at the Arguments for Deregulation

It is clear that many of the arguments made in support of deregulation were theoretical only; there was no practical or empirical basis in the airline industry for them. Airline markets since deregulation have not performed as expected. What happened?

First, predictions made before deregulation did not foresee the evolution of the hub and spoke system, a system that was adopted by every incumbent carrier. Point-to-point service as a primary marketing or operations strategy was maintained by only one major carrier, Southwest Airlines. The hub and spoke system has created major barriers to entry for the startup airlines.

Second, expectations that a simplified fare structure would be adopted, based on the assumption that startups with low operating costs would prevent the development or prolifera­tion of complex fare structures, were not borne

out. The computer reservation systems of the incumbent airlines, coupled with the captured market produced by the hub and spoke system, allowed the proliferation of yield management principles first introduced by American Airlines in the 1970s. The application of these principles had a significant impact on rate structures. The widening of the gap between the price of unre­stricted full-fare tickets (purchased by the time- constrained or business passenger) and the price of the restricted low fares (purchased by the price-constrained, leisure class of passenger) has been due in large part to the workings of comput­erized yield management.

Third, it was predicted that there would be no “economies of scale” in a deregulated airline market. This expectation assumed that incumbent carriers would be unable to bring their size, their experience, their computer reservations systems, their borrowing power, their ownership of slots and gates, or the benefits of the unanticipated hub and spoke systems to create an advantage over smaller, startup airlines. The contrary, in fact, had been assumed, that the incumbent airlines would have difficulty in competing with the more effi­cient low-cost carriers that would emerge after deregulation. The lack of economies of scale argument had focused on the cost side of the equation, not on the revenue side. Experience has shown that there truly are few economies of scale on the cost side (e. g., costs of operation are not reduced because of economies of scale), but there are substantial economies of scale on the revenue side (e. g., the enhancement of revenues) due to the factors enumerated above. As a result, most of the startups that came into the market imme­diately after deregulation, not possessing these attributes, have vanished. With the exception of Southwest, most of the major airlines in opera­tion after deregulation were the very same large airlines that existed before deregulation. More recently, certain low-cost carriers like JetBlue and AirTran have shown staying power utilizing the business model pioneered by Southwest Airlines.

The fact that the incumbent airlines were able to survive, and to expand, in spite of the lower costs of the smaller and more efficient startups, leads to the conclusion that there are economies of scale. Further, competitive responses of the incumbents to the entry of the startups in competing markets suggest the exis­tence of anticompetitive practices by the incum­bent lines, again possible because of the size and presence of the incumbent carriers. This leads to the next argument made for deregulation.

Fourth, it was said that airline markets were “contestable,” that is, in a market where there are only relatively few participants to vie for and share the available market, low-cost car­riers with low fares would necessarily cause the competing carriers to lower their fares. In actual practice, the market contestability theory has not proven out in the airline industry. Free entry into the market has been depressed by slot and gate scarcity. There has been an inequality of management acumen and operating experi­ence. Costs associated with the beginning of operations are substantial, and they normally are not recovered in the short run. Predatory practices by the incumbent airlines are routine, resulting in fares being lowered on the incum­bent airlines to match those charged by startups. These practices include increasing capacity on the routes flown by the new entrant and by the inauguration of new routes to compete with the new entrant. Marketing strategies, such as fre­quent flyer programs that grant advantages to the large, incumbent airlines, have also proven to be effective.

Deregulation was supposed to foster com­petition. Competition is what gives to the con­sumer the best possible deal in price and quality. Until recently, competition has been primarily the result of new airlines entering the market, as well as established airlines entering new mar­kets. Freedom to compete since the industry was deregulated, however, has not been uniform, and competition has been stifled in many ways. We will now take a further look at how the promise of deregulation has been compromised.