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SAM PELTZMAN, CAB: Freedom from Competition - Ralph Raico, New Individualist Review [1961]

Edition used:

New Individualist Review, editor-in-chief Ralph Raico, introduction by Milton Friedman (Indianapolis: Liberty Fund, 1981).

About Liberty Fund:

Liberty Fund, Inc. is a private, educational foundation established to encourage the study of the ideal of a society of free and responsible individuals.


CAB: Freedom from Competition

SAM PELTZMAN*

BACK IN THE days when air travel was still considered something of a stunt, the early pioneers of the civil aviation industry begged to be taken seriously. They wanted their industry to be treated just like any other form of transportation, and that meant being regulated and subsidized by a full-fledged federal authority. The federal government had, after all, granted its protection to the railroads, ships, trucks, and busses, and civil aviation remained much the neglected child of the transportation industry. The federal government’s insouciance ended when, in the summer of 1938, Congress passed the Civil Aeronautics Act in which the Civil Aeronautics Authority (now Civil Aeronautics Board) was formed. The industry exulted:

Tension relaxed. The battle had been won. At last civil aviation had come into its own with its own agency. . . .1

The Civil Aeronautics Act is the Magna Charta of aviation. With some defects and some uncertainties, it is nevertheless the finest thing that has happened to aviation since the World War conclusively proved its practicality.2

This “Magna Charta” gives the Civil Aeronautics Board extremely broad powers to regulate the economic aspects of civil aviation,3 the most important of which concern the routes flown by air lines and the fares they charge.

All passenger, cargo, and mail rates, while they are initially set by the airlines, require approval by the CAB. In addition, the CAB may, when it deems these rates not “just and reasonable,” fix maximum or minimum rates or both. Operation of an airline in interstate commerce requires a certificate of “public convenience and necessity” from the CAB, except that the so-called “grandfather carriers” (those airlines in operation at the time the Act was passed) received such certificates automatically. The CAB determines which airline may serve which cities, and it may regulate the number of flights to a city. Additionally, the CAB is empowered to grant subsidies to the airlines and to rule on mergers. These regulatory powers remain essentially the same today as those granted in the 1938 Act. It was thought at that time that, as an “infant industry,” civil aviation required subsidies and protection from competition if it were to develop properly. However, as is the case with many such infants, they never seem to grow old enough for the subsidies and regulation to be discontinued. In fact, while consideration of the “public interest” is supposed to provide the raison d’etre for economic regulation of the airlines, there is much to indicate that the CAB acts in great measure to protect the airlines at the expense of the public interest.

The case of the non-scheduled airlines (today known as “supplemental” airlines) provides perhaps the clearest illustration of this. These are small carriers which do not operate on published schedules or fixed routes, but rather seek to utilize their aircraft as fully as possible by adjusting quickly to changes in air traffic patterns. This results in a considerable cost reduction over the type of service provided by regularly scheduled airlines. After World War II, these airlines, which were exempted from CAB regulation in 1938, began using this cost advantage to undercut the rates of the regularly scheduled airlines.4 They grew in number and some began providing fairly regular service. The regularly scheduled airlines, facing real competition for the first time, retaliated by inaugurating low cost air-coach service. This was nothing more than the normal results of increased competition such as would obtain in any other growing industry—lower prices, more variety of service, etc. However, the regularly scheduled airlines, unlike other industries, had available the full force of federal law, incarnate in the CAB, with which to escape the rigors of competition. In 1947 non-scheduled airlines were required to register with the CAB; in 1949 the blanket exemption from regulation was dropped, and each of the nonskeds (as these airlines were popularly known) was required to file for exemption individually; in 1951 the CAB began limiting nonsked operations. With the aid of an important Supreme Court decision affirming CAB control over the nonskeds,5 this limitation has proceeded more or less systematically. The number of nonskeds dropped from 150 in 1947 to 50 by 1957.6 In 1959 the CAB ordered 12 of those remaining to cease operations; the lines allowed to continue flying received temporary operating certificates for from two to five years. Several of the two-year certificates have recently lapsed without being renewed. Thus, for example, on the New York-Chicago route, most heavily traveled in the country, the number of supplemental flights is now only ten per month as against thirty in 1961. The day may not be far off when the supplemental airlines will be eliminated altogether. This systematic reduction of competition cannot be justified on grounds of public interest. It might possibly be justified on grounds of safety if, as has been charged, the supplemental carriers do not maintain as safe operations as the scheduled airlines. However, the CAB itself dismisses this as a cause for forcing the supplementals out of business:

There is no factual showing that the applicants [for operating certificates] have failed to adhere to required safety standards. . . . Moreover regulatory control for safety purposes is maintained over supplemental carriers as it is over holders of route certificates.7

Rather, the CAB pointed to lack of “going concern status” and lack of “ability to operate” as the major reasons for denying applications.8 At best, these vague criteria are merely lame excuses for restricting competition; at worst, they constitute a blatant interference on the part of a regulatory body with the right of management to take financial risks.9 The CAB’s attitude toward the supplementals was neatly summarized by its chairman at the time of a Congressional inquiry into the supplemental air carrier industry. He told that inquiry:

. . . we have felt it to be our duty under the Civil Aeronautics Act to see to it that the irregular [supplemental] air carriers should do the job which we authorized them to do and . . . not to compete with the certificated air-transport structure of the nation.10

Putting the supplementals out of business has not been the only way in which the CAB has protected the certificated air-transport structure of the nation from the scourge of competition. In an industry which has grown as rapidly as has civil aviation, it is inevitable that many new firms will seek to enter the field. The CAB has in fact received over 150 applications for the establishment of new scheduled airline companies since it was formed. In all the years of its existence, it has not approved a single one of these applications.11 While the CAB insists that it is trying to promote competition in the air transport industry,12 all that it has done in this regard is to shuffle routes among the favored “grandfather carriers.” Further, it is now trying to make the club even more exclusive. The current CAB chairman has issued a call for mergers to reduce “excess competition.”13

EVEN IF THE CAB has stifled competition by limiting and even reducing the number of firms engaging in air transport, the situation might still be mitigated if it encouraged competition among already existing airlines in the fares they charge for their services. However, the CAB’s record does not show that it has acted this way, nor is it clear that the CAB could, given the legal framework under which it operates, have done much to encourage competition. The very fact that all fares must by law be filed with the CAB and receive its approval after a hearing creates a natural tendency away from price competition. When an airline is required to publicize a rate cut before the fact and when it knows that its rivals will likely retaliate before the first CAB hearing, the temporary gains of price cutting, which so often stimulate it in other industries, disappear. There is thus a strong incentive for individual airlines not to initiate rate cuts, and this is endemic to the legal structure. In general, however, the CAB has not been anxious to promote price competition even where it might have been able to do so. The prevailing CAB attitude here is perhaps best seen in its decision in the General Passenger Fare Investigation. This four-year investigation into the fare structure sought to determine what a “fair and reasonable” return on investment would be for the trunk (inter-regional) airlines and to set rate making standards to achieve that return. It found 10.5% to be such a “fair and reasonable” return for the airline industry.14 It is hardly surprising, in view of the CAB’s solicitude for the airlines as shown in its policy toward the nonskeds, that this was a rate considerably in excess of that being earned by the airlines at the time of the investigation.15 The CAB then set forth the rate-making standard which would be applied in attaining this goal:

Where the bulk of the carriers fall within a reasonable range of the rates of return found herein to be proper . . . fare adjustments should normally be based upon the results for the industry as a group.

In effect, the entire domestic trunk-line industry would be regulated so as to produce an over-all rate of return to the industry equal to [10.5] percent.16

This standard, which is to govern future rate making decisions by the CAB, distinctly reduces the possibility of significant price competition. For, suppose an airline were to come up with some method to cut its costs. One way it could capitalize on this would be to cut its fares and win business from its competitors. However, it is possible that, if it did so, the losses of its competitors might exceed the gains to the rate cutting airline, and the rate of return to the industry would fall below the “fair and reasonable” rate. The Board, if it felt this was likely to be the result of the fare cut, would be required, under the standard it has set up, to reject any proposed fare reduction. What seems likely to evolve is something like rate setting by majority vote of the airlines or by that faction which can convince the CAB that its particular rate proposal will bring the 10.5% return to the industry. Clearly, if the industry is to be treated as a group, independent and diverse rate setting policies could not be tolerated. This is hinted at when the Board states:

It is thus clear that the proper fare level must be found at some point between the needs of the most profitable and least profitable carriers. . . .17

If this means anything, it surely means that an efficient airline could not be permitted to institute fare reductions which threatened the existence of inefficient carriers, as this would surely be contrary to the “needs” of the latter. In treating the industry as a corporate entity, the benefits of price competition to the consumer are thus to be made subservient to the “needs” of the carriers. The CAB did not wait long before implementing its announced policy. Even before the General Passenger Fare Investigation report was issued, it made permanent a temporary fare increase and authorized a new increase, the total of the two being 6½% plus $2 per ticket.18 This applied to all trunk airlines, and all of them adopted the new fares immediately. This uniformity, in the face of the great variety of market conditions in an area as large as the United States, is hardly the mark of a vigorously competitive industry.

This absence of reliance on price competition apparently stems from the CAB’s view of the airline industry as a public utility,19 about which the CAB examiner in the fare investigation had this to say:

Unbridled competition tends to be destructive in the case of utilities resulting in widely fluctuating prices, equally fluctuating profits, and bankruptcy for most of the competitors. Thus, bankruptcy eliminates the competition and tends toward monopoly, which without the check of competition has no economic regulator on prices or profits. Consequently, regulation was developed to do the job competition could not do with respect to public utilities.

How this can possibly be taken to apply to the airline industry where it was not “unbridled competition” but deliberate, pertinacious CAB policy which reduced the number of competitors is something beyond the ken of this author. The examiner goes on to say:

. . . the restriction on entry of new carriers into the business and of existing carriers into areas not covered by their certificates renders it impossible to conclude . . . that free-market forces can be depended upon to prevent either too low or too high returns on capital.20

However, if it then follows that free-market forces will be efficient regulators of prices and profits under conditions of free entry, the CAB must explain why it has not permitted first free entry and then free competition.

That the collective pricing judgment of a dominant group will not always be wiser than that of a single aggressive innovator can be seen in a recent case in which the CAB temporarily relented in applying its rate making standards. In 1961, Continental Airlines, eleventh largest of the twelve domestic trunk airlines, attempted to reduce coach fares 20% on its Chicago-Los Angeles route. Its three competitors, United, American, and TWA (first, second, and third, respectively), filed protests with the CAB.21 Consistent with its rate making policy, the CAB ruled against Continental and the fare reduction.22 Recently, however, the CAB has permitted the reduction for a trial period, and Continental’s three competitors have been forced to meet its fares. The results to date: non-stop traffic between Chicago and Los Angeles rose about 30% in the last four months of 1962 (the time in which the new fares were effective), revenues rose 15%. This contrasts with reductions of 7% and 9% in traffic and revenues respectively in the previous months of 1962. Continental’s expenses were cut by $360,000 on an annual basis by eliminating free meals on the coach flights.23 It is still an open question as to how far the CAB will allow this attempt at price competition on an important route to go, but the Continental case illustrates what a gross mistake it is to treat the airline industry as a single public utility. In the airline industry, no less than in any other, it is the experimentation and innovation of independent firms and individuals which can, if it is given free reign, bring about the greatest progress.

While the Continental Chicago-Los Angeles fare reduction is still classed as an “experiment” by the CAB, and its permanence is in doubt, one of the few important routes in the country which has seen extensive and permanent price competition is the San Diego-Los Angeles-San Francisco route. This occurred when Pacific Southwest Airlines purchased new equipment and proceeded to undercut the fares of its bigger competitors. This has been a highly successful policy for Pacific Southwest (and, we may assume, for its customers).24 The “catch” here is that Pacific Southwest operates wholly within the state of California, and, since the CAB’s jurisdiction on fares extends only to firms engaged in interstate commerce, it is free of CAB rate-making policy.

ON THE BASIS of its record over the past 24 years, it is obvious that the CAB has acted as a focal point for the organization of a compulsory cartel in domestic civil aviation. The CAB itself has actively restricted entry into civil aviation by new firms and eliminated old ones, and it has reduced the scope of price competition between airlines. While it may be true that it could do little, given the law, about the lack of price competition, it is interesting to ask why it should have restricted entry to the extent it has. The simplest answer is that it is a deliberately perverse organization beholden to the regularly scheduled airlines. This is not necessarily the correct answer, however. Quite often regulatory agencies, set up in the “public interest,” sincerely identify that interest with the interests of the industry they are supposed to regulate. Looked at from the viewpoint of the regulators, this does not seem unreasonable. To them the “public interest” presents itself as a highly diffuse quantity, in the case of the CAB a traveling public of millions of individuals, with a viewpoint seldom articulated at hearings. The interest of the airlines (always set forth by them as the same as the public interest) is seen in concrete, specific terms and is always pressed insistently before the CAB. The airlines have, after all, a far greater incentive to win the CAB over to their mode of thinking than does any individual purchaser of their services. It is thus natural to expect the airlines to expend more money and effort to convince the CAB that their interest is identical to the general interest. These efforts have not been without success. As one commentator put it:

The present regulatory system for civil aviation with its primary emphasis on protection of the regulatees from competition, was “sold” partly on the basis of the . . . vague identification of the financial welfare of particular carriers with the satisfaction of national need. . . .25

The way in which the CAB confused special interest with the general interest can be seen in the Congressional hearings on the non-scheduled airlines. The regularly scheduled carriers took the position that the nonskeds were “skimming the cream” off their business on major routes, leaving them unremunerative business in small towns. If the regularly scheduled carriers were to continue to provide service to small towns at unremunerative rates, they needed the profits on major routes; hence, the nonskeds had to be restricted, since the “public interest” clearly required extensive air routes all over the country.26 Superficially, it might seem reasonable that the “public interest” indeed required the provision of scheduled air service to small towns at unremunerative rates, and, in fact, the CAB chairman took that stand at the hearings. Yet, even if we accept what is doubtful—that rates to small towns were in fact “unremunerative” in any meaningful sense, the uneconomic utilization of transport facilities this entails (diversion of planes from routes on which their services are more valuable, underutilization of existing rail and highway facilities, etc.) is not in the public interest. At best, it serves the interests of the particular group of people who use scheduled air service to small towns at the expense of those who travel on major routes. Were the subsidies and protection withdrawn, this inefficient rate structure would disappear. So it is with the two other reasons most frequently cited in defense of limiting entry into the airline industry, namely that it is essential to the maintenance of proper safety standards and that it is necessary to the maintenance of regularly scheduled service.27 As to the first of these, we have already seen that the CAB doesn’t really believe it itself; safety regulation and economic regulation are essentially separate matters. As to the second, one authority has concluded that the competitive pressures in the airline industry are such as to work toward greater rather than less regularity of service.28 More to the point, we need ask why regularly scheduled service is in the public interest if it is true that the public doesn’t want it. Undoubtedly, the CAB’s defense, that limiting competition is in the public interest, is completely sincere, though, in this writer’s opinion, it is without a convincing argument in its favor. This is a situation, however, which typically arises when the uncoerced decisions of the market-place are replaced by the arbitrary decisions of an agency of the State.

IT IS INTERESTING to examine the economic situation of the airline industry after 24 years of regulation by the CAB. In addition to limiting entry and discouraging price competition, the CAB has provided outright subsidies to the major airlines; it now provides them indirectly by subsidizing local service carriers which provide much “feeder” traffic to the trunk lines. The industry is further subsidized by federal aid to airport construction under the Federal Airport Act of 1946. Moreover, along with all this assistance to the airlines, the public’s acceptance of air travel has made it one of the fastest growing industries in the United States. From 1947 to 1961, for example, the number of passenger-miles (number of passengers times miles flown per passenger) flown by the airlines has increased from 6.0 billion to 29.5 billion, or about 400%.29 This is a combination of circumstances which, one would have thought, would have been highly profitable for the airlines. However, this has not been the case. In the face of a slowdown in the rate of increase in revenue (revenues still grew absolutely), domestic trunk lines lost 34.6 million dollars in 1961.30 One major trunk line (Capital) averted bankruptcy by merger, another (Northeast) has been temporarily saved from bankruptcy by financial assistance from the Hughes Tool Co. Trans World Airlines, third largest in the nation, suffered a loss of 38.7 million dollars in 1961.31 The largest domestic trunk line, United, had a return on stockholders’ investment of about 2% in the same year as opposed to the roughly 10% which is average in other industries.32 While it would be wrong to say that the domestic airline industry faces a financial crisis, it is apparent that, in spite of all the help it has received, important segments of it are not in the most robust health. Though it may seem paradoxical, this state of ill-health has been induced, to some degree, by an overdose in its adult life of what was the airlines’ sustenance as an infant—CAB regulation and subsidies.

Regulation contributes to the current financial difficulties of the airlines by introducing inflexibility into their operations. Abandonment of a route, to cite one example, requires often lengthy CAB hearings and CAB permission. Thus, except in periods of rapid overall growth in which every route shares to some degree, an airline is liable to find itself flying virtually empty planes on routes experiencing falling traffic for some time, before (and if) it is permitted to abandon them. Similarly, these empty planes cannot readily be shifted to new, more rapidly growing routes before the necessary hearings and certificates of convenience and necessity are obtained. The inefficiencies inherent in such a situation will, if anything, become more troublesome now that the period of most rapid growth for the airlines is apparently ending. Another type of inflexibility induced by regulation finds its source in the rate-making policies fostered by the Civil Aeronautics Act and CAB policy. Airlines, finding it difficult to engage in price competition with each other, compete primarily in the services they offer—e.g., free meals, lavish terminals, faster schedules. Thus, when the jet transport was introduced, each airline felt compelled to introduce them as rapidly as possible to meet its competitors with little regard to the slowdown in traffic growth occurring at the same time. No real attempt was made to create new classes of service (such as those offered by the supplementals) which would have, by lowering the fares on piston planes, utilized them more fully and caused the jets to be introduced at a rate more in keeping with the growth of traffic. Certainly, no new airlines were chartered which might have utilized the piston planes being sold by the airlines converting to jets. All that happened was that piston fares were kept constant while a jet surcharge was introduced. On many routes, the passenger is not even afforded the chance to take advantage of the lower relative cost of piston flights because these routes are currently being served only by jet flights. The net result of an inflexible rate structure in a period of rapid expansion of the jet fleet has been a sharp increase in the number of empty seats on scheduled flights. At $5,000,000 per jet plane, this can be and has been, quite costly. Given a continuation of the present regulatory set-up, however, we will likely witness much the same thing when the supersonic passenger plane is introduced in the 1970’s.

We can conclude that the heavy protection and subsidization of the airlines has been only a mixed blessing even to them. It has, by choking off new sources of competition and discouraging competition among existing airlines, worked against the “public interest” it was created to serve. Quite clearly, it is legitimate to ask what the alternatives to the present regulatory policy are.

In the opinion of this writer, one simple alternative presents itself as the most preferable—abolition of the CAB in all its economic functions. (While I am also in favor of having both the CAB and FAA withdraw from safety regulation, discussion of this is beyond the scope of this article.) If what we mean by “public interest” here is the satisfaction of market demands, in all their variety, at lowest social cost and, as part of this, the quick adaptability to changing market conditions, then our history indicates that this interest is best served by competition free of arbitrary interference by State power. It is not served by reserving civil aviation as the exclusive domain of “grandfather carriers;” it is not served by government supervision of minimum rates; it is not served by compelling the community to pay, in the form of government subsidies, for services provided by and to favored groups. It is true the end of government interference and protection of the airlines will cause some painful readjustments in the air transport industry. Allowing new firms to enter the industry freely and permitting all firms to serve whatever routes they choose to will, judging by the success of the supplementals before their ranks were decimated by the CAB, and the success of Pacific Southwest on the west coast, likely lead to a reduction in the fare level. It will cause a reduction in service on subsidized and poorly patronized routes, increases in service on other routes. With the pressures of competition substituted for bureaucratic controls, airlines would be compelled to adjust services and fares as quickly as possible to changing market conditions. Failure to do so, given the relative ease with which the airline business could be entered into and the great mobility of the basic capital equipment, would result in quick loss of business to new competitors. All of this is surely in the public interest, but it just as surely will force inefficient airlines out of business. However, unless inefficiency is constantly penalized, the airline industry itself will not be healthy for long. We have already seen what has happened to certain parts of the industry in the face of a mere slowdown in the rate of traffic growth. Further protection of inefficiency will only lead to further financial difficulties, more controls and possible ultimate nationalization of the industry. There is no compelling reason for allowing this to happen. Neither is there any reason to believe that the benefits of free competition cannot serve the general interest as well in the air transport industry as it has in other industries. So far, however, we have not given free competition a chance in this industry. We might do worse than to try it.

[* ] Sam Peltzman is Business Manager of New Individualist Review.

[1 ]3 American Aviation No. 23, May 1, 1940, p. 1, cited in Lindsey, John M., The Legislative Development of Civil Aviation, 1938-1958 (Washington: Civil Aeronautics Board, 1962), p. 3n.

[2 ] Logan, “Aeronautical Law Developments, 1939,” 11 Journal of Air Law and Commerce 1 (1940), 16, cited in Lindsey, op. cit., p. 1n.

[3 ] The Civil Aeronautics Board has two major functions in addition to economic regulation; it assists the State Department in negotiating the rights of U. S. international airlines with foreign governments, and it investigates air accidents and makes recommendations on air safety rules to the Federal Aviation Agency. The Federal Aviation Agency, created in the Federal Aviation Act of 1958, administers air safety laws and the air traffic control system. This article will deal only with economic regulation by the CAB of domestic airlines.

[4 ] Cf. Wilcox, Clair, Public Policies Toward Business (Homewood, Ill.: Irwin, 1960), p. 680.

[5 ] North American Airlines v. C.A.B., 353 U.S. 941.

[6 ] Wilcox, op. cit., p. 676.

[7 ] 28 C.A.B. 224 (1959), 238.

[8 ]Loc. cit.

[9 ] Unfortunately criteria such as these are employed constantly at CAB hearings. Thus, to take a recent example, Continental Airlines is denied a certificate for operation between Los Angeles and San Francisco because, among other things: “Continental would be required to install new terminal facilities at San Francisco and Oakland and incur substantial promotional and advertising expenses in establishing itself in the market,” while TWA is favored because it “has the advantage of a long standing identity in this market.” Pacific Southwest Local Service Case, Order E-17950, January 25, 1962 (Washington, D. C.: Civil Aeronautics Board), p. 27 (italics supplied).

[10 ]Future of Irregular Airlines in United States Air Transportation Industry. Hearings before a sub-committee of the Select Committee on Small Business, U. S. Senate (Washington, D. C., 1953), p. 8.

[11 ] Wilcox, op. cit., p. 677.

[12 ] For just one example of this insistence, see discussion at 27 C.A.B. 829.

[13 ]New York Times, Nov. 4, 1961.

[14 ]General Passenger Fare Investigation, Order E-16068, Nov. 25, 1960 (Washington, D. C.: Civil Aeronautics Board), p. 13.

[15 ]Ibid., Appendix A, p. A-1.

[16 ]Ibid., p. 75 (italics supplied); p. 72.

[17 ]Ibid., p. 74.

[18 ] CAB Press Release, June 17, 1960.

[19 ] Cf. General Passenger Fare Investigation, Appendix A, p. 2 ff.

[20 ]Ibid., Appendix A, pp. 3-4.

[21 ] Cf. New York Times, Oct. 31, 1961; Nov. 16, 1961.

[22 ]New York Times, Nov. 23, 1961.

[23 ] Cf. Wall Street Journal, Jan. 22, 1963.

[24 ]Wall Street Journal, Nov. 9, 1959.

[25 ] Keyes, Lucile S., “National Policy Toward Commercial Aviation—Some Basic Problems,” 16 Journal of Air Law and Commerce 280 (1949), 294.

[26 ] See testimony of any certified airline executive in Select Committee on Small Business, op. cit.

[27 ] Kaysen, Carl, and Donald Turner, Antitrust Policy: An Economic and Legal Analysis (Cambridge, Mass.: Harvard University Press, 1959), p. 205.

[28 ] Keyes, Lucile S., “A Reconsideration of Federal Control of Entry into Air Transportation,” 22 Journal of Air Law and Commerce (1955) cited in Kaysen, loc. cit.

[29 ]Moody’s Transportation Manual (1962 edition), p. a69.

[30 ]Ibid., p. a71.

[31 ]Ibid., p. 1298.

[32 ]The Fortune Directory (New York: Time, Inc., 1962), p. 31.