Should airlines be regulated like a public utility?

Yesterday, several outlets reported on former American Airlines CEO Robert Crandall’s speech at the Wings Club (full text here). Crandall, who ran AA during the process of deregulation and made it an industry leader in the post-deregulation era, opposed deregulation in the late 1970s, and his opinions haven’t changed: “We have failed to confront the reality that unfettered competition just doesn’t work very well in certain industries, as aptly demonstrated by our airline experience and by the adverse outcomes associated with various state efforts to deregulate electricity rates. It’s time to acknowledge that airlines look and are more like utilities than ordinary businesses.”

Because Crandall is such a legend in the airline world, I’d like to go through his remarks seriously and respectfully. The key question: should airlines be operated like public utilities? Public utilities arise from natural monopolies, in which it is most efficient for a single firm than multiple, competitive firms to provide a service. Natural monopolies usually result in infrastructure- and capital-intensive industries. Classic examples include electricity transmission or public transportation: it’s too costly for competing firms to maintain multiple networks of power lines or subway tunnels. A utility is often created because it is the only way to ensure crucial infrastructure investments are made; if multiple firms are competing, they may not be able to afford to upgrade their systems over time. Economists have been doing important work exploring whether such utilities are really natural monopolies. Back in the 1970s, a consensus was reached that airlines did not constitute such a monopoly.

Indeed, certain elements of the infrastructure of the airline industry may be natural monopolies. Would it be more efficient to have multiple air traffic control firms competing? Not likely. And communities in which there is one major airport may find that a natural monopoly. (But regions with multiple, competitive airports, like London or New York, have great potential for airline competition. BAA, the owner/operator of London’s three largest airports, was set up as a sort of private utility with so much market power because only such a structure was thought to allow sufficient investment in infrastructure. As it turns out, BAA’s common ownership in a competitive environment has retarded investment.)

But airlines themselves are no longer thought of as a utility. Why were they ever? They were regulated as one, with strict limitations on fares and routes. Deviations from scheduled fares and routes were rarely if ever granted. Competition was thus limited, and slim profit margins for conservatively managed airlines were ensured. But what investment were the airlines supposed to be making? The largest capital investment airlines make is in aircraft, and the track record of investment in the regulation era is not great. Today, U.S. airlines may have relatively old fleets, but managements under regulation often made foolish or risky decisions about capital investment. Howard Hughes of TWA refused to buy jets, setting his airline back several years technologically and perhaps dooming it when deregulation occurred. On the other hand, Pan Am’s Juan Trippe and his successor, Najeeb Halaby, aggressively pursued the Boeing 747, an investment that paid off but nearly bankrupted the airline — not an example of the prudent investment meant to characterize a utility.

In addition to making investments, airlines instead used their protected positions to offer exceptional benefits to their employees — contractual obligations that put them at a disadvantage to new competitors in a deregulated market. That’s the key reason so many airlines suffered financially in the 1980s and ’90s, but it’s not a reason to treat airlines as utilities. Monopoly protection is not afforded to protect wages but to promote investment and efficiency.

So then, let’s look at Crandall’s argument. (Forgive the all caps; that’s the way it’s published on the Wings Club website and I don’t have the time to retype it all.)

CONSUMERS CLEARLY BENEFIT FROM THE EXISTENCE OF MULTIPLE AIRLINES; THE ABSENCE OF ALTERNATIVES DOES NOT ENCOURAGE GOOD CUSTOMER SERVICE. THUS, OUR GOAL SHOULD BE TO HARNESS COMPETITION AND REGULATION TO CREATE A SYSTEM RESPONSIVE TO BOTH THE IMPERATIVE OF EFFICIENCY AND THE DESIRABILITY OF DECENT SERVICE.

One reason for deregulation was to improve efficiency, and economic research shows it has. Indeed, regulation promotes “fairness,” not market efficiency. “Deregulation has shown that the well-intentioned and orderly views of the regulators caused enormous distortions in productivity and service,” write Elizabeth E. Bailey (a former Civil Aeronautics Board member), David R. Graham, and Daniel P. Kaplan. The results of deregulation — rationalization of routes, drops in fares, variable pricing based on loads and demand — have produced a different, more efficient equilibrium between fares and service.

THE INDUSTRY’S PROBLEMS REFLECT SEVERAL SHORTCOMINGS:
• FIRST AND FOREMOST, WE HAVE FAILED TO CONFRONT THE REALITY THAT UNFETTERED COMPETITION JUST DOESN’T WORK VERY WELL IN CERTAIN INDUSTRIES, AS AMPLY DEMONSTRATED BY OUR AIRLINE EXPERIENCE AND BY THE ADVERSE OUTCOMES ASSOCIATED WITH VARIOUS STATE EFFORTS TO DEREGULATE ELECTRICITY RATES. IN MY VIEW, IT IS TIME TO ACKNOWLEDGE THAT AIRLINES LOOK AND ARE MORE LIKE UTILITIES THAN ORDINARY BUSINESSES.
• SECOND, OUR GOVERNMENT HAS FAILED TO DEVELOP A NATIONAL TRANSPORTATION PLAN OF ANY KIND AND HAS THUS BEEN INDIFFERENT TO THE CONTINUING DECLINE OF OUR HIGHWAYS, OUR RAILROADS AND OUR AIRLINES.
• AND THIRD, THE GOVERNMENT HAS FAILED TO INVEST IN THE CAPABILITIES AND RESOURCES WHICH ONLY IT CAN PROVIDE, MOST NOTABLY BY FAILING TO IMPLEMENT THE NEW AIR TRAFFIC CONTROL SYSTEM THAT EVERYONE AGREES WE DESPERATELY NEED.

As I’ve discussed above, airlines do not resemble traditional utilities. But Crandall is right: our public-sector infrastructure agencies have not made investments to keep up with the growth unleashed by deregulation. Economist and deregulator Alfred Kahn warned about this in 1978:

There is no guarantee that freer competition on the airline side of the equation—that is the part that creates the demand for airports [and air traffic control]—alone will solve these problems. On the contrary, it will stimulate more air travel. . . . [M]y moral is simply this to the FAA: If you are going to follow economically irrational policies, don’t ask the CAB to bail you out by doing the same thing.

The business side of the airline industry was reformed to promote efficiency, but the government side wasn’t, and although it has expanded and developed, it has not kept pace — a key factor in today’s congestion and delays that Crandall rightly complains about.

I FEEL LITTLE NEED TO ARGUE THAT DEREGULATION HAS WORKED POORLY IN THE AIRLINE INDUSTRY. THREE DECADES OF DEREGULATION HAVE DEMONSTRATED THAT AIRLINES HAVE SPECIAL CHARACTERISTICS INCOMPATIBLE WITH A COMPLETELY UNREGULATED ENVIRONMENT. TO PUT THINGS BLUNTLY, EXPERIENCE HAS ESTABLISHED THAT MARKET FORCES ALONE CANNOT AND WILL NOT PRODUCE A SATISFACTORY AIRLINE INDUSTRY, WHICH CLEARLY NEEDS SOME HELP TO SOLVE ITS PRICING, COST AND OPERATING PROBLEMS.

Crandall himself pioneered yield management software that enabled airlines to sell some seats cheaply and some for higher prices. As for costs, airlines accumulated those costs up in a regulated, protected environment because they were sheltered from competition — not because airlines “can’t” make it. Earlier in his speech, Crandall says that high oil prices are just one of the airlines’ problems. But airlines have already become so lean that many of them would be profitable today had oil not gone up nearly 200 percent over a few years.

THE MOST AGGRESSIVE FAVOR GOVERNMENT SUPERVISED PRICING DISCUSSIONS WHOSE GOAL WOULD BE TO ESTABLISH MINIMUM FARES SUFFICIENT TO COVER FULL COSTS AND PRODUCE A REASONABLE RETURN. WHILE I WOULD FULLY SUPPORT SUCH AN APPROACH, THE IDEA IS DEEPLY OFFENSIVE TO THOSE WHO CLING TO THE BELIEF THAT THE MARKETS CAN SOLVE EVERYTHING.

Markets can’t solve everything, but they can price airfares efficiently.

SUPPOSE FOR A MOMENT THAT IN A WORLD WHERE EVERY AIRLINE SET ITS OWN PRICES, A REGULATORY AGENCY REQUIRED THAT ANY PASSENGER TRAVELING BETWEEN TWO POINTS VIA A CONNECTING POINT PAY THE SUM OF THE LOCAL FARES ON HIS OR HER ITINERARY. AS WE HAVE ALL KNOWN FOR MANY YEARS, THE CHEAPEST WAY TO CARRY A PASSENGER FROM POINT A TO POINT B IS NON STOP, AND THE MOST EFFICIENT WAY TO DO IT IS BY USING THE LARGEST AIRPLANE COMPATIBLE WITH DEMAND.

I addressed this issue in a recent post, but I think airlines ought to be free to set fares that fit the market. Crandall seems to want to break down the hub-and-spoke system (again, something he developed for American during his time there). But the system produces efficiencies that allow relatively lower fares. There’s no reason to impose a Ryanair-style pay-by-the-leg fare system if most airlines prefer not to operate that way.

But perhaps there’s a reason to begin undoing the efficiencies of the hub-and-spoke system:

TIMES ARE VERY DIFFERENT NOW THAN THEY WERE WHEN THE HUB AND SPOKE SYSTEM WAS GROWING RAPIDLY. IN THOSE DAYS, THE UNITED STATES GAVE LITTLE THOUGHT TO EITHER GLOBAL WARMING OR ENERGY INDEPENDENCE; TODAY, THE U. S. SPENDS $600 BILLION PER YEAR ON PETROLEUM , PINES FOR ENERGY INDEPENDENCE AND WATCHES THE ICE CAPS WITH INCREASING TREPIDATION.

But to incentivize reduced emissions and fuel use, carbon taxes or other market-based mechanisms like cap-and-trade are more likely to set the most efficient prices with the stipulated environmental conditions than regulatory fiat.

THE CARRIERS ALSO NEED HELP IN CURBING LABOR COSTS. AS EVERYONE HERE KNOWS, AIRLINE EFFORTS TO CONTROL LABOR COSTS HAVE BEEN BLUNTED – SINCE THE DEMISE OF THE MUTUAL AID PACT IN 1978 — BY THE DRAMATIC IMBALANCE BETWEEN THE NEGOTIATING STRENGTH OF ORGANIZED LABOR AND THAT OF THE AIRLINES. . . . AS A PRACTICAL MATTER, NO AIRLINE CAN ENDURE A STRIKE AND WILL INVARIABLY YIELD TO LABOR’S DEMANDS BEFORE A STRIKE IS ACTUALLY CALLED. . . . SINCE STRIKES AGAINST TRANSPORTATION UTILITIES ARE ILLEGAL IN MANY JURISDICTIONS AROUND THE WORLD AND ARE CLEARLY CONTRARY TO THE PUBLIC INTEREST, I DO NOT SEE WHY THE RAILWAY LABOR ACT SHOULD NOT BE AMENDED TO REQUIRE BINDING ARBITRATION.

But these labor costs have only to do with legacy airlines’ ability to make a profit, not with whether they’re utilities. The Big Three U.S. automakers are also having trouble meeting their pension obligations and face hostile unions. Can they be regulated as utilities? Clearly not — and the same holds for airlines.

WE WOULD ALSO BE WELL ADVISED TO REVISE OUR BANKRUPTCY LAWS TO DEPRIVE FAILED CARRIERS OF THE RIGHT TO USE LOWER COSTS TO UNDERCUT THE FARES OFFERED BY THEIR MORE PRUDENT RIVALS. FORCING BOTH MANAGEMENT AND LABOR TO FACE THE TWIN SPECTRES OF LIQUIDATION AND UNEMPLOYMENT WOULD LIKELY BE ANOTHER STEP TOWARDS LESS CONFRONTATION AND MORE COOPERATION.

Agreed.

IT IS ALSO CLEAR THAT DECISIVE GOVERNMENT ACTION IS NEEDED TO RELIEVE THE EXTREME CONGESTION NOW BEING EXPERIENCED AT OUR BUSIEST AIRPORTS. . . . THE ONLY SOLUTION IS A REGULATORY MANDATE THAT LIMITS THE NUMBER OF FLIGHTS SCHEDULED TO WHAT THE RUNWAYS, TERMINALS AND AIR TRAFFIC CONTROL FACILITIES AT A GIVEN AIRPORT CAN HANDLE. TO GET THERE, PRESENT SCHEDULES SHOULD BE REDUCED PROPORTIONALLY TO EACH CARRIER’S PRESENT FREQUENCY SHARE. DOING SO WOULD CREATE PRESSURE TO USE THE LARGEST FEASIBLE AIRCRAFT IN EACH SLOT.

This is nothing more than incumbent protection. Congestion pricing is a rational, efficient way to allocate space for its most productive uses. The final claim is unsubstantiated; instead, congestion pricing would give airlines financial incentives to use their spaces as efficiently as possible.

WE SHOULD ASK OURSELVES WHETHER USING OUR ANTI-TRUST LAWS TO PREVENT AIRLINES FROM COLLABORATING TO ACHIEVE MORE INTENSIVE ASSET UTILIZATION AND MORE EFFICIENT OPERATIONS REALLY MAKES SENSE.

This is what Holman Jenkins has suggested.

BUT REGULATION ALONE IS NOT ENOUGH. WE ALSO NEED A NATIONAL TRANSPORTATION PLAN, INCLUDING A CLEARLY ARTICULATED, WIDELY UNDERSTOOD STATEMENT OF OUR AVIATION GOALS. IN MY VIEW, OUR OBJECTIVES SHOULD BE:
• FIRST, TO STRENGTHEN OUR NATIONAL ECONOMY BY ENCOURAGING THE CREATION OF A COST EFFECTIVE, ENERGY SENSITIVE TRANSPORTATION NETWORK WHICH WILL PERMIT PEOPLE TO MOVE EASILY FROM ONE PLACE TO ANOTHER
• SECOND, TO ASSURE SAFE, COURTEOUS AND ON TIME SERVICE FOR CONSUMERS
• AND FINALLY, TO IMPROVE THE FINANCIAL PERFORMANCE AND INTERNATIONAL COMPETETIVENESS OF AMERICA’S AIRLINES.

The second would be a fantastic expectation for airlines, but government regulation of courtesy strikes me as a bit of an overreach. Furthermore, what if I wanted to fly a rude airline that charged lower fares (i.e, Ryanair)? Would Crandall give me that option? Apparently, no:

UNHAPPILY, SUCH A PLAN DOES NOT EXIST. FOR MANY YEARS, THE ONLY APPARENT GOAL OF U. S. AVIATION POLICY HAS BEEN TO SECURE LOWER FARES FOR CONSUMERS BY ENCOURAGING COMPETITION OF ANY STRIPE IN EVERY MARKET, WITHOUT REGARD TO ANY OTHER CONSEQUENCES, INCLUDING THE INDUSTRY’S VIABILITY.

Crandall claims that his proposals would not constitute full-scale reregulation. But it would reduce efficiency in the financial interests of airlines. He is clearly looking out for airlines’ bottom lines. But if airlines aren’t profitable, that doesn’t mean they have natural monopolies and should be regulated that way. It’s clear that they don’t have these monopolies. I don’t dispute Crandall’s knowledge of the industry, but I do dispute his disdain for rational economic analysis of aviation. As he said to a congressional staffer during the deregulation debates of the 1970s, “You f***ing academic eggheads! You don’t know s***. You can’t deregulate this industry. You’re going to wreck it. You don’t know a g****m thing!”

A little economic analysis never hurt anyone.

Photo credits: Flickr user OiMax through a Creative Commons license; Washington Speakers Bureau.