Deregulation Countdown Pt1

Together, the three articles will combine to give an exhaustive and authoritative account of the vital and exciting airline industry. Australian Aviation is proud to present this series as government, airlines, consumers, unions and entrepreneurs alike gear up for deregulation from October of 1990.

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The US industry was regulated by three means: restrictions on new airlines, fare setting and immunity from fair trading laws. These factors led to an industry which competed with service instead of price. Inefficiencies developed because costs could be passed on to consumers while innovation was generally discouraged.

This environment favoured business travellers who didn’t have to personally foot the bill. This led to ‘excessive’ profits and eventually deregulation was introduced to make airlines more competitive.

The US industry has now had a decade of deregulation. The adjustment in the industry has gone beyond the previous areas of regulation and significant changes to route structure. The provision of small community services, labour relations and the infrastructure of airways systems and airports were also affected. A shift in power to the travel agents also occurred along with

a rise in consumer complaints. Now the increasing mergers and takeovers of 1986/87 in the US industry is causing concern and this combined with union pressure has led to some limited calls for re-regulation!

Meanwhile, the Australian industry during this period was in a state of flux. Political moods were changing and consumer

pressure was mounting for the introduction of services and fare structures being experienced overseas. Therefore the government announced in October 1987 that the domestic airline industry would be deregulated as of October 1990. The aim being to allow market forces to ensure a better industry through increased competition.

So, how can Australia learn from the US experience? Firstly, the structure of regulation in Australia is almost identical to the previous US system. However, the unique feature of the government owned airlines is a complicating factor along with the agreement commonly known as the Two Airline Policy.

We now have the advantage of being able to learn from the lessons of deregulation in the USA. We can now reap the profits of their mistakes. Indeed, we’d be errant not to at least avoid the

obvious pitfalls. However, the real benefit of using the United States’ industry as a model will be to avoid some of the unintended problems of their deregulated airline industry.

However, there are several uncertainties in the Australian situation. Further, there are severe limitations in infrastructure, market size and a less flexible industrial relations system. Even so, the opportunities are available for new and existing airlines to service the burgeoning leisure travel market as well as increase existing markets with innovative marketing and improved frequency.

Regulation in the USA

Like Australia, regulation started in the 1930s to foster the infant aviation industry. It was supposed to allow economies of scale, decrease the prevalent rate of bankruptcies and curtail monopolies. Further, regulation was deemed politically necessary to ensure adequate service to the public, especially the smaller cities that were neglected in favour of the large centres.

This coddling continued until deregulation in 1978 and covered all aspects of the industry except intrastate carriers and operators of small aircraft carrying less than 30 passengers. The existing carriers in 1938 favoured the legislation because it granted them financial stability. Indeed, the enabling act established their airlines under the ‘grandfather clause’ which effectively operated until 1975 to grant a monopoly on the trunk route industry.

The original sixteen grandfather companies had merged into ten by the mid 1970s. Only one new trunk carrier was allowed to enter the industry before it too was merged into a grandfather company. The advantage these companies enjoyed meant they accounted for 66% of industry revenues totalling $US14. 4bn in 1974. The next tier of the industry was the regional operators who fed hubs from small and medium sized cities and made up 31% of revenues. These qualified for subsidies in weak markets or were granted access to some larger cities in compensation. Finally, the third tier of commuters who served the small communities were immune from federal regulation but only accounted for 2. 9% of revenues. Thus the industry was highly concentrated; just five of the forty three certified air carriers accounted for 65% of revenue ton miles in 1975 Labour accounted for over 40% of costs and airline employees and crew were among the highest paid employees of any US industry. In fact, a government study in 1975 described organised labour as having a ‘stranglehold’ on the industry. This regulated industry was maintained by the following three means:

Market Entry – The criteria for market entry was ‘public convenience and necessity’. In addition the rules stipulated an applicant must show that it had ample experience in the proposed operation and that it had financial responsibility. These conditions were extremely difficult to satisfy before the fact! Further, the authorities had to consider that no harm should be done to the established operator by the introduction of a new carrier. Thus they were reluctant to grant new routes. Fare. Setting – The government established rates which would cover the industry for depreciation, taxes and costs. The airlines were also guaranteed a 12% return on total investment. The· formula used was also designed to remove crosssubsidisation. Fares were principally determined by distance with no allowance for density, seasonal influences or special geographical factors. So, by insisting that equal fares were charged for equal distances, a carrier was prevented from cutting fares on a particular route because other similar routes would then be affected.

The government chose a low load factor of 55% in working out its fare structure. Actual load factors were closer to 75%. Therefore, because fares are inversely related to load factors, breakeven occurred at lower real load factors which further increased profits. Thus a basic flaw of the system of setting fares was that they calculated the price on the number of seats flying, instead of the average number of paying passengers.

Further, the government used industry averages in its calculations which offered no incentive to any of the airlines to improve their efficiency. Thus fare competition was virtuafly eliminated from the industry. In the early seventies this reached the stage where the authorities ruled that most discount fares

were unjustly discriminatory and banned them! Immunity From Trading Laws – The US airlines were protected from laws which normally applied to mergers or agreements. For

example, they were able to formulate an agreement which stipulated that when a signatory airline was struck against, its competitors would compensate it for lost revenue!

A further example occurred in 1971 when airlines serving two dozen primary cities agreed to reduce capacity in an attempt to cut costs. However, there was no flow on to lower fares. Service Rather Than Bargains – The overall result was an industry which competed on service with flight frequency, meals, glamorous hostesses and gimmicks being the marketing tools.

Further, the regulated environment rewarded pack behaviour: collective mistakes were remedied by fare increases while risk taking was penalised when competition was equally allowed onto successful new routes. This vital point is also a major characteristic of our own Two Airline Policy.

One example was the early 1970s introduction of wide bodied aircraft at a time of low market growth. The resultant over capacity lowered productivity, wasted resources and greatly increased the fuel burned per revenue passenger mile. Because the trend was universal, fares were quickly raised to compensate all carriers.

However, the major oversight of regulation in the USA was the prevention of low cost, vacation oriented, widely available and price attractive travel. The US industry was therefore accused of ‘creative inaction’. This is suspiciously like Australia today.

What Really Happened After Deregulation?

The Airline Deregulation Act (ADA) was signed into law on 24th October, 1978. It used wording such as “maximum reliance on competitive market forces” to stress that competition would now drive the industry, although reforms were staggered over several years to allow effective planning by both the airlines and government.

Mergers had meanwhile become a means of quickly obtaining an enlarged fleet with crucial ground facilities. These would no longer be allowed unless there was no alternative and even then the anti-competitive effects had to be outweighed by the public transportation benefits. The Act also banned any agreement which imposed capacity restrictions or rate fixing. Agreements between the airlines could only be approved by the Justice Department if the benefits were greater than possible with competition. This meant that airlines had to operate like any other business.

The Impact On Market Entry

The ADA decreed that a carrier “fit, willing and able to properly perform air transportation” would be allowed access to a market. Market entry and exit was now wholly subject to market forces.

Since then the average number of carriers per market has increased by an additional half a carrier although many new entrants arrived on the scene in the profitable markets. These carriers enjoyed a productivity gap with freshly negotiated labour contracts or no labour union at all. Initially, they had low market share, but high leverage by lowering prices. Thus existing carriers suffered a profit loss in the short term and had to find ways to bring their cost structure into line with the new competitors. The mortality rate for new entrants has been high which led to a shakedown in the number of airlines. However, market power is limited by the convenience of alternative carriers in long haul markets and the option of surface competition in short haul markets.

The impact on the stability of the industry is clouded by contradictory assessments. Some reports claim that the industry has endured ‘most unfavourable’ financial results and the outlook is not good. Alternatively, others calculate that the airlines have enjoyed at least a $US2. 5bn (in 1977 dollars) annual increase in industry profit. It is this sort of ambiguity which made the Australian decision· to deregulate that much more difficult.

The Impact On Fares

Ticket prices were now a marketing decision within the airline. Because the second oil crisis coincided with deregulation, short flights were difficult to operate profitably because they use proportionally more fuel. This prompted carriers to concentrate on long haul markets and led to considerable price anomalies. For instance, in 1984 a direct flight from Houston to Cincinnati was double the price of going via New York, which is over twice the distance of the direct flight! Thus long haul high density markets achieved lower fares while short haul low density markets suffered price rises.

Airlines could also now use discounts to fill up the empty seats on their flights; the then President of American Airlines called this “wacko pricing” but traffic was stimulated while average fares dropped. One study calculates that travellers have saved $US6bn per annum in 1977 dollars. The market became segmented into full fare business passengers and vacation travellers. Marketing strategies aimed to capture the business traveller as the core of a service. Thus mileage bonus plans have proliferated in an attempt to buy brand loyalty. (Refer p. 56 July 88 AA) This favours larger airlines with more attractive ‘prize’ flights to offer and is perhaps the worst distorting factor to evolve from deregulation-except of course if you are a much travelled executive.

However, both segments gained because the discretionary passenger achieved greater flexibility while the time sensitive passenger paying full fare gets more frequent and a generally better timed service. The airline is also using its equipment more economically.

The trunk operators’ profitability though took a nosedive into the negative from 1979. The regionals’ rate of return on stockholder’s equity plummeted to levels well below manufacturing shares. The trunk carriers could not even keep their return posit- Ive! The parlous financial health of the industry shows that this is not a viable situation now that the transition period is over.

Consumers are the winners with fares lower than would have existed without deregulation. The average fare over all routes increased less than warranted by cost increases over the first six years of deregulation. Today, “prices are moving closer to costs in all markets”. This can seem anomalous especially to small communities where longer ranging vacation trips are cheaper than short business flights. Fares have also experienced wide swings from season to season and year to year depending on the business cycle.

The Impact On Route Structure

Because non stop services could not be sustained between many city pairs, the hub and spoke network has become the dominant pattern since deregulation. Operators can tailor their aircraft to traffic flows and a greater share of connecting trips are kept within the airline. This arrangement also allows ‘economy of scope’ by increasing the use of facilities.

The hub and spoke system has been a major and unexpected shift from the lineal systems engineered by regulation. It also meant that fleets have tended towards smaller planes running a shuttle service.

Because of limited capacity at most airports the hub and spoke system means certain markets are restricted to one or maybe two companies who have bought up the unused gate rights at the terminals to exclude other carriers. However, this new route structure has meant about a 7% improvement in service convenience to the smaller hub cities.

Overall, the most beneficial aspect of deregulation has been in schedule convenience for the traveller and the loss of through plane services is more than offset by the increased number and varieties of connections offered.

Another impact of deregulation has been that commuter operators have taken over from regional airlines-in smaller communities. There has been a stepping up process through the sectors of the industry with a consequent increase in efficiency at the commuter level.

The changes to route structure have indeed been more radical than anticipated. Few routes have escaped adjustment to the nature of the service. However, there is still overcapacity in the industry because schedule rivalry continues to be a major form of competition despite the intention that prices would be the dominant factor.

The Impact On Small Communities

The ADA provided for ‘Essential Air Services’. Thus any community listed on the certificates of carriers when the ADA commenced would be guaranteed service for ten years. This was backed up by a subsidy programme which is based on carrier need but is then open to the lowest tender.

These guarantees freed up the commuter industry while providing a safety net for small towns. The aim was obviously political but the result has been a more vibrant sector. By 1983 there had been a 92. 9% increase since 1978 in commuter passenger traffic. The number of points served increased 22% until 1981 while the number of airlines increased from 117 at the end of 1976 to 162 at the end of 1983. These figures disguise the ebb and flow in the sector because over the period 1976 to 1983, 257 new commuter airlines commenced while 240 ceased trad- ing. This led to service instability in some communities.

Overall, commuter airlines have been “major beneficiaries of deregulation with their above average passenger growth and consequent increased share of the total US passengers”. However, by 1982 the financial posture of the commuter sector was weak. Their debt to equity position was extremely poor while losses were common.

Before deregulation, 400 communities received subsidised air services. Now the more efficient commuters only require assistance in 150 communities. Over ten years, the payments declined from $US78m to $US21m in 1986. In 1988 Congress voted to extend the Essential Air Services subsidy for an additional de- cade but limited the communities to those isolated from larger nearby airports.

The irony of the commuter sector is that its relative efficiency has allowed it to grow despite declining subsidies. However, the financial strain of establishing operations has placed it in Jeopardy without the subsidies!

The Impact On Labour

Some people believe that the unions enjoyed ‘extraordinary benefits’ and ‘featherbedding’ under regulation and adjustment was necessary. For example, People Express operated with 14,000 non union employees averaging just over $US20,000 per annum in 1984 which was half the average at unionised airlines. Therefore, many airlines declared bankruptcy as a means of reneging on labour contracts. Staff numbers could be reduced and remaining crew must then take a substantial pay cut to retain their job. US airlines reduced staffing by 329,000 between 1980 and 1984 despite the large increase in business. Symptomatic of this adjustment was the move to aircraft with only two pilots. The perspective of the unions is obviously quite different. The famous Air Traffic Controllers’ strike came within three years of deregulation. The surge in traffic and the unpreparedness of the system had combined to lower morale. That 11,500 people lost their jobs indicates the general anti union sentiment at the time. Today, the unions are fighting hard even to the extent of half page advertisements in the Wall Street Journal urging travellers to protest to the Government over the problems in the industry. The unions have even offered to buy ailing Eastern Airlines to avoid any additional deterioration in wages and conditions. Meanwhile pilots are testifying against their companies at a Senate Commerce Committee Hearing which is considering re-regulation of the industry. Concurrently there is a bill before Congress to reintroduce some consumer protection such as was established for ensuring on time performance reporting and penalties for lost baggage.

The airline unions, led by the Airline Pilots Association, have been waging a “holy war’ against deregulation and this bill will encourage their efforts. For buried in the bill is a Labor Protective Provision. This uses the concept of ‘fair treatment’ to extract extraordinary new merger, relocation or dismissal benefits from the airlines.

The Impact On The Infrastructure

The increase in traffic ensuing from deregulation has placed airport facilities at a premium. One recent survey of airports showed that two thirds of airports had no space for new airlines. This is despite the 1982 Airport and Airway Improvement Act which states that airports will be made available for public use on fair and reasonable terms’.

The airways system also suffers from the trend to smaller aircraft with an increased number of flights compounding the massive growth since deregulation.

Thus in 1986 the FAA introduced its ‘Buy-Sell Slot Rule’ where established users at congested airports were grandfathered and were then able to trade their arrival and departure slots as company assets. However, any slots not used at least 65% of the time are lost. The problem is that the Slot Rule gives access to the airport but not necessarily the terminals! These economic controls amount to the equivalent of an operating certificate. Only now the competing airlines control them instead of the government. Deregulation has given way to self regulation.

So Who Won And Who Lost?

Both advocates and opponents of deregulation claim to find support for their positions in the experiences since deregulation. Complications such as rising oil prices and initially difficult economic conditions also obscure the effects of deregulation. Add to these the technological advances of the decade along with rapid growth of the industry and it becomes difficult to realistically assess the consequences of deregulation. The market has been forced to experiment to find the most efficient way to operate in a deregulated environment. Because the industry relies on marginal cost calculations to decide both capacity and price, the fear is that competition may be destructive rather than constructive. For instance, the Wall Street Journal describes the industry as “deeply troubled”.

Both the airports and the Air Traffic Control system are suffering from increased congestion. (Refer p. 86 July 88 AA) Indeed, the lack of capacity to cope with expansion will be the limiting factor for the next decade. The huge cost of airport development requires federal assistance which will be subject to fiscal restraints.

In 1987 the number of near collision reports had risen by 50% over the previous year although the FAA Administrator claimed the figures were not meaningful because actual collisions were still rare! Although safety is of increasing concern, the fears expressed before 1978 have not materialised. Regardless, the popular press points to deregulation as “the villain in this erosion of confidence in the system”. Again, truth is the victim.

Three independent consumer groups now specialise in complaints against the airline industry. The newest opened in 1987 because the system was ‘such a mess’. Echoing this sentiment the WHEAL club even formed – We Hate Eastern Air Lines. Meanwhile, the Department of Transportation had had to install a 24 hour toll free consumer hotline to cope with public dissatisfac- tion.

As far back as 1985, academics were calling for the reintroduction of some regulations such as entry controls, rationed airport slots and controlled departure frequencies. As the public clamour for solutions continues, at least some action by Congress and the States appears likely.

The outcome has been the rekindled interest of Congress in the industry. Airlines must now report on time performance (previously they lied about flight times to secure passengers) overbooking and baggage problems. Congress also proposes to finally release some of the $US5. 6bn which was built up from aviation fuel and ticket taxes. Belatedly, this will go to solve some of the airport and airways problems.

Ironically, the threat of re-regulation has prompted the airlines to improve their service. However, under the increasing oligopoly of deregulation, the airlines have little need to differentiate themselves.

This is indeed reminiscent of the industry under regulation. So far this series has examined the United States airline industry after forty years of regulation and then how it changed after deregulation.

In the March edition of Australian Aviation, the scene moves to Australia where the airline industry is still regulated. Australia is now going through the debate over deregulation which the US encountered in the seventies. Thus this continuing feature will draw from the US experience to assess the prospects of deregulation in Australia.