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Federal Document Clearing House
Congressional Testimony
June 14, 2000, Wednesday
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 5147 words
HEADLINE:
TESTIMONY June 14, 2000 ALFRED E. KAHN PROFESSOR OF POLITICAL ECONOMY CORNELL
UNIVERSITY HOUSE JUDICIARY AIRLINE HUBS; UNITED US AIR MERGER
BODY:
Statement of Alfred E. Kahn on The State of
Competition in the Airline Industry June 14, 2000 My name is Alfred E. Kahn. I
am the Robert Julius Thorne Professor of Political Economy, Emeritus, Cornell
University, and also Special Consultant with National Economic Research
Associates, Inc. Most directly pertinent to my appearance here, I was Chairman
of the Civil Aeronautics Board during the 16 month period ending with
deregulation of the airlines, in October of 1978. In compliance with your rules,
I attach a brief curriculum vitae and attest that I have not received any
federal grant, contract or subcontract associated with my studies of the airline
industry. I am honored by your invitation to appear before you today, to offer
you my opinions about the state of competition in the industry. I can state my
first and most general opinion very briefly: deregulation has been a great
success, precisely because it unleashed the forces of competition in the
industry. This means that on the whole I regard the industry as highly
effectively competitive. I will leave to others-most notably Dr. Clifford
Winston, of the Brookings Institution, and Professor Steven Morrison, of
Northeastern University, who have studied the subject in much greater detail
than I-the documentation of the proposition that competition has produced annual
savings for travelers in excess of $15 billion dollars a year. Last year, in
large measure because of the pressures of competition, more than 93 percent of
all air travel was at discount fares, with the discounts averaging some 69
percent below full fares. There are, I think, two things to be said about the
fact that all this discounting has been accompanied by a marked increase in
discomfort and congestion. First, it was precisely the failure of regulation to
offer travelers a low-cost/lower-quality product that was its greatest failure:
more crowded planes are the means by which deregulation has brought air travel
within the means of families with modest incomes. Second, this deterioration in
the quality of the air travel experience is a consequence, in important measure,
of the failure of government to provide the optimal infrastructure-specifically,
air traffic control and airport capacity-and to price it in recognition of the
fact that the true costs of these services are far higher when and where
congestion is severe than when and where capacity is ample. I take it as a
truism, which requires no explanation to this Committee, that the withdrawal of
direct regulation shifts the responsibility for protecting consumers to
competition, and responsibility for preserving that competition to increased
vigilance in enforcing the antitrust laws, including the statutory prohibition
of unfair methods of competition. In these remarks, I propose to concentrate on
the two aspects of antitrust policy, as applied to this industry, that have
inspired the greatest amount of controversy and concern in the last several
years. The first is the question of what constitutes or should constitute
unfairly exclusionary practices, such as the Department of Transportation is
charged with preventing. The second, and more immediate, is raised by the
proposed merger of United Airlines and US Airways, and the
possibility that it might set off imitative or defensive
mergers among the other four major domestic carriers, which
would threaten to produce a very substantial increase in industry concentration
at the national level. Along with the reform of the arrangements for providing
and pricing access to infrastructure and our long-continuing efforts to lift the
governmentally imposed barriers to competition at the international level, I can
think of no other aspect of government policy with greater significance for the
preservation and expansion of the benefits of deregulation. Predatory or
Exclusionary Pricing The basis for the heightened concern in recent years about
such assertedly exclusionary tactics-which the Department of Transportation is
charged with preventing-as predatory pricing, interference with new entrants
obtaining fair access to airport facilities, refusals to interline or exchange
luggage, and the offer of special override commissions to travel agents targeted
at markets subjected to new competitive entry is by now entirely familiar. 1
While I have not been in a position to make any direct assessment, on the basis
of historical experience, of the importance of such practices-and am not at all
clear how it might be conducted-I have at least the strong impression that the
intense controversies engendered by DOT s promulgation of proposed rules in
fulfillment of that responsibility, in April of 1998, does properly reflect
their importance. Consistently with that opinion, I strongly endorse the
proposition that DOT both has and should have that responsibility: it is the
precise counterpart of the statutory responsibility of the Federal Trade
Commission to prevent unfair methods of competition-from which airlines were
exempted because of their historical subjection instead to direct regulation.
While average yields, per mile, have declined on the order of 40 percent in real
terms- i.e., adjusted for changes in the Consumer Price Index-since
deregulation, full fares, paid on only some 6 percent of total mileage, have
apparently increased on the order of 70 percent. That sharply increased spread
has surely been in large-indeed, I offer the impression, major-measure
beneficial to all travelers, for two reasons. In part, it reflects wide
differences in real costs as between long and short, dense and thin routes and
by hour of the day and day of the week, as well as of holding seats open for
last-minute availability. Moreover, to the extent that the fare differentials
are discriminatory, they make it possible to use larger, more efficient planes
and offer more convenient scheduling on a greater number of routes than would
have been possible if all fares had to be uniform. Within limits-of incremental
costs at the bottom and stand-alone costs at the top-the offer of heavily
discounted tickets to discretionary and/or leisure travelers, in order to fill
seats that would otherwise go empty, while charging higher fares to
demand-inelastic travelers, is beneficial to both of them. At the same time,
this increased discrimination has raised legitimate concerns about the
likelihood that those full fares reflect also monopoly exploitation of travelers
who cannot make their reservations weeks in advance or stay over a weekend-the
most familiar devices by which the airlines discriminate between demand-elastic
or discretionary travelers, on the one side, and demand-inelastic, exploitable
ones, on the other. There are, effectively, only two ways of preventing
exploitation of the demand-inelastic travelers. One would be a resumption of
regulation; since no economist I know advocates this, it would be superfluous to
expatiate on my reasons for not recommending it. The only alternative
protection, and the one completely consistent with deregulation, is competition.
One important function of free competitive entry is to ensure that no group of
travelers is ever charged more than the costs of serving it alone. This process
was apparently exemplified by the increasing challenge by new, low-cost,
low-fare entrants in the middle 90s to the sharp increases in full fares
-documented by the Department of Transportation, along with an estimate that
they saved travelers some $6 billion in 1996. This is precisely the way in which
a deregulated, competitive industry is supposed to protect not merely consumers
generally but any smaller subgroup of them. As I put it in my testimony on April
22, 1998, The theoretically correct basis for. . .charges to subgroups of
customers. . .is stand-alone costs-the hypothetical cost of serving any partial
grouping of customers alone. That is the ceiling that would prevail if there
were perfectly free entry:. . .. Clearly, the best way of ensuring that such a
ceiling will prevail is free entry itself; and it was indeed on freedom of
competitive entry that we relied for the protection of travelers when we
deregulated the airlines. But what seems to have occurred time and again in
recent years has been: unrestricted fares are jacked up and up; that induces
entry of low-cost, more or less uniformly low-fare rivals, emulating Southwest,
who can profitably serve those customers at much lower fares; the incumbents
then cut their fares deeply and sharply increase the number of low-fare seats
they offer on the routes-and only on the routes-on which they have been
challenged; the new entrant departs; and fares immediately go right back up,
with no further challenge. That is the kind of scenario that the Department of
Transportation says it has seen played out many times in the last few years and
that it sees as crying out for remedy. I should point out, at the same time,
that the pattern I have just described is by no means uniform and invariable.
While the TRB Committee, of which I was a member, that reported on Entry and
Competition in the U.S. Airline Industry last summer, 2 found some of the
responses of incumbents to competitive entry "difficult to reconcile with fair
and efficient competition" (p. 6), it could find no uniform pattern in the
instances of possibly exclusionary conduct presented to it by the Department of
Transportation: while incumbent airlines typically reduced their fares sharply
in response to such entry, sometimes increasing capacity, sometimes not, there
is no clear and consistent relationship between those responses and either the
disappearance of the challengers or the restoration of fares to their previous
level. On the other hand, there has just come across my desk a monograph by
Professors Fred Allvine, of the Georgia Institute of Technology, and Ashutosh
Dixit, of the University of Georgia, which appears to document at length and in
great detail exactly the kind of scenario that I have just described, showing a
pattern of great consistency; it clearly deserves your careful attention and
that of the Department of Transportation. Market entry by low-cost, more or less
uniformly low-fare- charging carriers has made a grossly disproportionally great
contribution to the benefits of price competition in the industry, according to
the definitive studies of Drs. Winston and Morrison. 3 The airline industry is
especially susceptible to predation, because of the mobility of aircraft and the
consequent relatively small proportion of sunk costs in undertaking to serve and
responding to competitive entry into individual markets: the incumbents need
incur virtually no additional sunk costs when they increase capacity on
challenged routes and entrants can be readily induced to depart, because of
their ability correspondingly to move their equipment out. The sophistication of
the major airlines in practicing yield management, rationing the availability of
deeply discounted tickets, makes it easy for them sharply to increase the
availability of such fares on individual routes in response to competitive
challenge and to withdraw them when the challenge disappears. This character of
the industry and of its costs makes it extremely difficult to apply the test of
predation that has been most widely adopted by the courts-namely, pricing by the
incumbent below its short-term marginal or average variable production costs. In
the circumstances that I have just described, the principal component of those
average variable costs are not production costs but opportunity costs-the
revenue foregone elsewhere by transferring capacity to the contested route
and/or the revenue from undiscounted or only modestly discounted ticket sales
sacrificed by the suddenly increased availability of deeply discounted ones.
This is the essence of the condition incorporated in all three indicators of
"unfair exclusionary practices" proposed by the Department of Transportation:
that "the ensuing self-diversion of revenue results in lower local revenue than
would a reasonable alternative response." 4 (in Transportation Research Board,
p. 166) There is nothing wrong in principle with this proposed criterion of
predation or unfairly exclusionary practices proposed by DOT. A carrier that
adopts a less profitable response to the entry of a competitor than others
available to it may reasonably be presumed to have made that sacrifice only in
the expectation that it would succeed in driving the competitor out of the
market and permit restoration of the previous more profitable fares. The
problem, recognized by both supporters and opponents of the DOT initiative, lies
in the feasibility of administering such a standard: one can readily envision
the judicial morass that would be involved in a government agency attempting to
determine whether there were indeed other more profitable alternative responses
available to the carrier. Moreover, there is the difficulty, in proceeding
against these vigorous competitive responses, in predicting which of them will
ultimately succeed in destroying competition and which will not, and in which
markets, therefore, competition is likely to be destroyed, in which instead it
is likely to persist, to the lasting benefit of consumers. My own proposed
resolution of this dilemma would be to leave the determination of what would be
the least unprofitable response to competitive entry, absent a predatory intent,
to the incumbent carriers themselves, by a simple requirement that if their
response does indeed succeed in driving out the challenger, they be required to
maintain the levels of capacity and of fares that they adopted after entry for
some substantial period of time-say, two years. This would tend to ensure that
an incumbent carrier would not lightly undertake a predatory, profit-sacrificing
response in the expectation of being able to withdraw it if it succeeds in
driving out the challenger; and, at the same time, give travelers the continuing
benefit of the newly introduced competition for some substantial period of time,
rather than permitting its quick withdrawal. I must emphasize, in fairness, that
the overall profitability of the airline industry seems hardly reflective of
what one would expect from a monopolist: overall, it apparently has, on average
over the years, fallen well below the average of American industries generally.
This consideration does not, however, exclude the possibility of purchasers of
unrestricted tickets having a legitimate complaint; and it by no means follows
that if unrestricted fares were to come down, discount fares would inevitably go
up. The industry is far from perfectly competitive; there is therefore a wide
range within which its rates of return can vary, not only from year to year, but
also in the long run, if only because its costs are not exogenously fixed by
perfectly competitive input markets but are themselves instead responsive in
important measure to the intensity of competition in airline markets. If
competitive entry were freer than it is today of predatory responses, the
intensified competition that it could bring could clearly be associated with
lower costs, the latter because of both intensified downward pressures of
competition on the costs of incumbents and the increase in the proportion of the
traffic carried by the low-cost carriers. There is always a danger, in
proceeding more vigorously against what appear to be predatory pricing
responses, of weakening competition itself. The concern is a legitimate one-that
a more vigorous attack on responses by incumbent airlines to competitive entry
may outweigh the benefits, by labeling as predatory what is really healthy and
consumer-benefiting competition. On the other hand, some of the criticisms of
the Department of Transportation s initiative, to the effect that it would
suppress more competition than it would protect, generally ignore the fact that
the only possible circumstances under which the DOT policy would discourage such
price reductions would be when the incumbents were not offering such low fares
in such profusion until they were challenged, then offered them only in direct
response to competitive entry and only on the particular routes affected, and-
in those instances in which the competitor had been driven out-promptly withdrew
them. The Proposed United Airlines/US Airways Merger I must
begin by pointing out that I do not as yet have a settled opinion about whether
the proposed merger of United Airlines and US Airways should be
approved. I do urge your Committee-and, of course, even more, the antitrust
agencies-however, to give careful consideration to its possible anticompetitive
effects. It seems to me they are of three kinds. The first is the possibility
that it will suppress preexisting direct competition between the two carriers. I
do not know whether there are indeed any substantial number of particular routes
on which United and US Airways are already direct competitors.
In the case of the proposed merger of Continental and
Northwest, the Antitrust Division identified several very important routes
between their respective hubs (for example, Houston/Minneapolis-St. Paul,
Houston/Detroit, Cleveland/Minneapolis-St. Paul, Cleveland/Memphis, Newark/Twin
Cities) on which it appeared those airlines were the two main if not only
competitors, and their merger would simply eliminate that
competition. I do not know to what extent there are similar overlaps between
US Airways and United. Second, however, in deregulating the
airlines we relied very heavily on the threat of potential as well as actual
competition to prevent exploitation of consumers: an important part of the
rationale of deregulation was the contestability of airline markets. It seems to
me highly likely that there are many routes in which either United or US
Airways is a potential competitor of the other. And it is my
recollection that while studies of the behavior of airline fares after
deregulation (notably one by Winston and Morrison and another by Gloria Hurdle,
Andrew Joskow and others) demonstrated that one actual competitor in a market is
worth two or three potential contesters in the bush, they nevertheless also
found that the presence of a potential contester-identified as a carrier already
present at one or the other end of a route-did constrain the fares of
incumbents. The likelihood that a United/US Airways merger
would indeed result in suppression of such potential competition would seem to
be enhanced by what I take it would be United s explanation and
justification-namely, its need for a strong hub in the Northeast (commented on
widely in the literature, along with attributions of a similar need to American
Airlines). But if United really does feel the need for a big hub in the
Northeast, this suggests that it is indeed an important potential competitor of
US Airways, and that, denied the ability to acquire the hub in
the easiest, noncompetitive fashion, by acquisition of that company s Pittsburgh
and Charlotte hubs, might instead feel impelled to construct a hub of its own in
direct competition with it. And while I have the impression that the suppression
of potential competition has not played a major role in most
merger litigation, it might properly be definitive in this
case, if only because, either explicitly or implicitly, United is in effect
conceding the potentiality of that competition in its rationalizations of the
merger itself. The stronger its argument that it does indeed
require a big hub in the Northeast, the more that signifies that the
alternative, if it were denied the opportunity to acquire US
Airways, would be to construct a major competitive hub of its own.
Finally, if indeed United s acquisition of a competitive advantage by this
acquisition-giving it the first claim on traffic feed from US
Airways extensive network-does increase the pressure on other carriers,
particularly American, to merge similarly, then it seems to me that is a
possible competitive consequence of this particular merger that
should additionally be taken into account in deciding whether it should be
permitted. A consolidation of the big six into an even bigger three would
certainly raise most serious questions about its compatibility with the
continuing competition that has brought such benefits to the traveling
public-all the more so because of the legal prohibitions of foreign-owned
carriers operating in the U.S. market. I do hope your Committee will press the
antitrust agencies (and if their resources are strained, help them obtain
resources sufficient) to undertake this important inquiry: we may be confronting
a very radical consolidation of the industry that would threaten to reverse the
great benefits of deregulation.
LOAD-DATE: June 19,
2000, Monday 
