The Future of the Airline Industry

The Future of the Airline Industry

September 26, 2013  | ENO CENTER FOR TRANSPORTATION

Last month the Department of Justice (DOJ) filed suit to block the proposed merger of American Airlines and US Airways. The lawsuit was something of a surprise to observers of the airline industry primarily because other recent large-scale mergers, such as United-Continental and Delta-Northwest, were approved with little incident. What is it, many in the industry asked, that makes this merger different and a potential threat to competition? Why draw the line here?

The DOJ contends that this merger is different because not only would fares and fees increase, but also that the new airline would hold an effective monopoly on too many of the flights at certain airports. In particular, DOJ singled out Ronald Reagan Washington National Airport as a place where the new carrier would control 69 percent of the slots, thus potentially diminishing competition and increasing fares for Washington, DC area passengers.

While DOJ may very well be correct that this merger will reduce competition and increase fares and fees, the decision about how much competition is sufficient and how low airfares should be, is inherently subjective. At the moment, U.S. airline passengers are still enjoying airfares that are historically low and airlines are still operating on thin profit margins compared to other industries. It is hard to imagine that after this merger, the big four remaining airlines would suddenly be able to raise fares and dramatically increase those profit margins. It is possible that some specific markets could face a lack of competition, but why not deal with those on a case-by-case basis?

Regardless of the merits of of the lawsuit, the DOJ’s action brings an important transportation policy issue to the forefront, namely, what is the appropriate role of the federal government in preserving airline industry competition? To begin to answer this question, it is helpful to understand the history of the airline industry.

Pre-Deregulation

The airline industry has always struggled to make a profit in part because of ruthless competition. The industry began unregulated, primarily used as a means of transporting mail. But as competition for these mail contracts became fierce, the airlines began competing destructively. The epitome may have been when Braniff’s bid of 0.00001907378 cents/mile for an airmail contract was beaten by Eastern’s bid of 0.00 cents/mile. The industry lobbied Congress to create what eventually became the Civil Aeronautics Board (CAB), to regulate industry entry, fares and routes.

Many of the same forces that created this initial intense competition are still in place today. There are high fixed costs. You have to buy or lease planes, hire crew, purchase jet fuel, and secure landing slots and gates before you ever collect a dime in revenue. Once you have made these enormous investments, you are faced with inventory – seats – the value of which vanishes as soon as a plane takes off. This means you will do anything to sell these seats rather than miss out on potential revenue, even if it means selling below marginal cost in the short-term with the hopes of defeating your competitor.

The Regulated Era (1938-1978)

Under the CAB, fares were set based on airlines submitting their costs to CAB and then being provided with a profit margin. The result was that airlines made little effort to control costs, and fares were high relative to today. Meanwhile, you could not enter the market and operate a given interstate route without CAB approval. This served as a tremendous barrier to entry for new carriers, and ensured that existing carriers were insulated from competition both from each other and new entrants. The only exceptions were intrastate carriers, like Southwest Airlines in Texas, which were able to compete within a state without economic regulation.

In the regulated era airlines could not compete on the basis of fares or routes; instead they competed, on a limited basis, with service amenities and sometimes frequency. Air travel remained out of reach of the middle class which hindered innovation and economic activity. Fortunately, the intrastate carriers were providing a real-life demonstration of the power of competition and innovation. This evidence—along with a groundswell of support from academia, and eventually Congress and the Carter Administration—led to the deregulation of the industry in 1978. Economic regulation was slowly removed, the CAB was dissolved in 1985, and the industry returned to its initial competitive state. While at this point it was a very different industry, many of the same pre-deregulation problems began to resurface.

Post-Deregulation

The post-deregulation airline industry made life for air carriers nasty, brutal, and often short. Competition became just as fierce as it had been prior to regulation, and for the same reasons. Only now the industry played a much larger role in the economy due to the advent of ubiquitous passenger (as opposed to freight) travel, jet engines, vastly improved safety, and the decimation of the nation’s passenger rail service. Carriers that had been in service for decades – Braniff, Eastern, Pan Am, National – went out of business when they couldn’t compete. New entrants flooded the market but most failed. Jim Oberstar, former Chair of the Transportation and Infrastructure Committee in the House, was fond of noting that the only remaining major post-deregulation carrier in recent years was America West Airlines (they are now, of course, part of US Airways but some might argue JetBlue is now a major carrier). As a whole the industry, during this period, competed so viciously that every major carrier went bankrupt and only one – Southwest Airlines, which had experience competing in Texas prior to deregulation – managed to consistently turn a profit.

The good news was that consumers benefitted from lower fares, more frequent service, and more choices. But the industry was in turmoil, and could not sustain profits. During the recession of the early 90s, the industry hemorrhaged money and several airlines went bankrupt. During the late 1990s, during boom times, the airlines were profitable but barriers to entry remained low enough that new entrants would keep fares in check. However, competition also forced airlines to dramatically cut costs, including passenger amenities. While there were occasional interventions by DOJ, for the most part market forces effectively protected consumers from high fares.

The Industry Today

Several trends have stabilized the industry in recent years. First, the airlines finally realized that they need to be cautious about adding capacity and the only way to grow without dying is to consolidate. This has kept airlines from expanding too rapidly and touched off the recent wave of mergers. Second, the airlines have figured out that adding fees for previously complimentary amenities such as baggage or food can boost their bottom line. While passengers have reacted negatively, they are slowly getting used to this new normal. Finally, barriers to entry have increased as lenders have begun to realize that a new airline is not a great investment. For years this obvious fact was overlooked in part due to the glamour and prestige involved in owning an airline. But the bottom line appears to have caught up with investors and the number of new entrants has slowed dramatically.

This period of relative stability has been positive for the industry, but what about its customers? Customers love to complain about the airlines, especially their new fees for baggage and better seats, but the fact is that the commercial aviation system in this country remains incredibly effective and affordable. Congestion is down because airports aren’t flooded with capacity by carriers looking to capture market share. More flights are full, which may be uncomfortable for passengers but is also a sign of a more stable industry. Sure, people would always prefer to have lower fares and empty planes, but that dream—along with free lunches, sunshine, and lollipops—may be unrealistic.

Conclusions

The DOJ may have good reason to suspect that the American Airlines – US Airways merger will result in higher fares for consumers. But the problem is that DOJ is a legal entity that is interceding on what is actually a transportation and economic issue. We should not be determining our national transportation policies through legal means – that should be a last resort.

Unfortunately, when we eliminated the CAB, we did not create an effective mechanism within the U.S. Department of Transportation (USDOT) to deal with potential competitiveness issues. The high fixed costs and potential for aggressive competition that plagued the industry prior to deregulation still plagues it today, and consumers could face monopolistic pricing if barriers to entry become high and consolidation continues. The only things keeping the industry in check are the airlines themselves, DOJ, and to a large extent Congress, which will hold hearings anytime the industry does anything suspect. None of these entities are likely to be effective regulators of a transportation issue that impacts the economy at large and the traveling public. If the federal government believes that the current regulatory arrangement may result in harm to consumers, the appropriate action is to institute a thoughtful policy, ideally initiated by Congress and executed by USDOT, to change that. Perhaps some careful and limited forms of regulation might be necessary to prevent monopolistic pricing. But blocking mergers on an ad-hoc basis in an industry that remains only marginally profitable is not a sustainable solution.

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of The Eno Center for Transportation.

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