Deregulation of the U.S. Airline Industry

Date October 24, 1978

Although deregulation of their industry gave the airlines more flexibility to develop business strategies, the shakeout that followed passage of the Airline Deregulation Act underscored the need for businesses to avoid poorly planned rapid expansion.

Also known as Airline Deregulation Act; U.S. Statutes at Large 92 Stat. 1705; Public Law 95-504; U.S. Code 49 § 334

Locale Washington, D.C.

Key Figures

• Jimmy Carter (b. 1924), president of the United States, 1977-1981
• David C. Garrett (b. 1922), president and chief executive officer of Delta Air Lines at the time of deregulation
• Alfred Kahn (1917-2009), chairman of the Civil Aeronautics Board in the late 1970’s
• Harding Lawrence (b. 1920), chief executive officer and chairman of the board of Braniff International Airways at the time of deregulation

Summary of Event

Prior to the Airline Deregulation Act, the Civil Aeronautics Board (CAB) strictly regulated airline routes, fares, and mergers. For example, before a trunk carrier (an airline that primarily served large cities and high-density routes) could provide service on a new route, it had to petition the CAB for approval. Approval was contingent on the CAB’s judgment regarding three issues: need for additional service on the route, which airline should be awarded the route, and whether the route tied into an airline’s existing network. Incumbent airlines usually contended that the petitioned route could not support any additional service, so proceedings often dragged on for years.

The CAB also regulated airfares by establishing maximums, minimums, or both maximums and minimums. Each carrier was required to obtain permission before introducing a new fare. The CAB ruled on these fare changes to determine whether they were reasonable. Although the CAB designed the fare limits to provide a rate of return on investment equal to 12 percent, this target was rarely reached.

Mergers were a third area in which the CAB exercised control. The airlines used mergers to acquire the route networks and aircraft capacity of other carriers. This strategy was often more expedient than petitioning the CAB for individual routes because the acquiring carrier could receive many new routes simultaneously. The CAB generally approved a merger, however, only if it prevented a carrier from going bankrupt, with the result that a particular geographic area would lose air service.

The CAB regulations effectively prevented trunk carriers from competing on the basis of fares and routes. Although the airlines could offer different in-flight amenities, each aircraft had approximately the same level of comfort. Because their product was undifferentiated, airline managers realized that customers were more concerned with scheduling the most convenient flight than with maintaining brand loyalty. As a result, frequency of service became the most important determinant of market share. The CAB did not regulate flight frequency except to prevent de facto abandonment of routes.

Proponents of deregulation argued that the CAB regulations were responsible for increasing the cost of air transportation. Their argument was based on the premise that as the airlines scheduled more flights to increase market exposure, each flight carried fewer passengers. Costs, and thus fares, rose because the fixed cost of each flight was spread among fewer passengers. They argued that deregulation would permit the airlines to differentiate their product and provide a wider range of fares and services. One anticipated outcome was lower prices.

Advocates of deregulation also argued that the legislation would result in greater efficiency and flexibility. First, by increasing a carrier’s flexibility to improve route structures and flight schedules, deregulation would permit better aircraft utilization. Second, assets would not be wasted simply to seek future route awards. Under regulations, some carriers had used artificially low fares to strengthen their bargaining position when seeking future routes. Third, carriers would have more leverage when dealing with labor unions because the U.S. government would not be obligated to aid an ailing airline.

With the exception of United Air Lines, the trunk carriers either vehemently or tacitly opposed deregulation. They argued that the absence of entry restrictions on the more profitable routes would result in duplication and overcapacity. Because more planes would fly these routes, higher rather than lower fares would result. If increased competition resulted in excess capacity, then profitability would decline because each flight would carry more empty seats. In addition, they argued that deregulation would diminish stable and reliable air service. In a deregulated environment, an airline could enter a market on weekends or holidays and carry full flights by offering reduced fares. During periods of reduced traffic demand, however, the carrier could suspend its service. Finally, critics feared that rate wars would develop as airlines offered cut-rate fares to establish themselves in new markets. As incumbent airlines lowered their fares to remain competitive, profits would be reduced. As a result, carriers would have difficulty replacing their fleets.

Opponents of deregulation also argued that smaller cities would suffer reduced or suspended service because the trunk carriers would concentrate their equipment capacity on the lucrative long-haul routes between high-density population centers. This argument was similar to a cross-subsidy issue: The trunk airlines claimed that they used profits from their long-haul routes to negate losses on their shorter, less profitable routes. If deregulation eliminated these profits, then carriers would not be able to offset the losses from their shorter routes and might have to abandon them.

Flights over shorter distances are relatively more expensive in terms of cost per mile because fixed costs, such as passenger and luggage processing, are spread over fewer miles. In addition, slower average aircraft speeds cause higher labor costs per seat mile. Finally, fuel costs per seat mile are proportionately higher because the rate of fuel consumption is greater during takeoff and landing than it is during flight. Because other forms of transportation, such as the automobile, are relatively attractive at shorter distances, demand is highly elastic; that is, customers are very likely to choose a substitute form of transportation if prices go up. As a result, the higher costs of shorter flights cannot be offset by fares that reflect those costs and allow as much profit as earned on longer flights.

Significance

The Airline Deregulation Act of 1978 ended the government’s regulation of the airlines and eliminated the CAB by the end of 1984. Airlines now were subject to market competition to “regulate” price, routes, and qualities of air travel. The effect was to reduce airfares significantly over the first decade of the law’s existence.

The aftermath of airline deregulation underscored the need for managers to evaluate corporate strategy accurately. For many years, the airlines preferred to pay the costs of CAB regulation rather than face the uncertain environment that would exist without controls. Once the industry was deregulated, however, many carriers were lured by the freedom to expand and increase market share. The result was that many airlines overexpanded, faced overcapacity, and therefore had to sell their product at low prices, suffering declining profits as a result.

Prior to deregulation, managers were enamored of the concept of flight frequency. Because CAB regulations severely limited the trunk carriers’ ability to compete on the basis of fares and routes, flight frequency became the most important determinant of market share. This led to the widespread practice of using long-term debt to finance large aircraft fleets that could provide frequent service. As a result, trunk carriers were highly leveraged, faced large interest charges, and were adversely affected by the 1980-1981 recession that reduced air traffic demand.

A brief description of the corporate strategies implemented by Delta Air Lines and Braniff International Airways following deregulation illustrates these points. Delta and Braniff implemented strategies that resulted in good and poor performance, respectively. Both companies used a hub-and-spoke route network prior to deregulation, and both carriers flew the less popular routes to small and midsized cities. These flights were then aggregated at a hub city and efficiently scheduled to connect with the carrier’s more profitable long-distance flights. This system minimized passenger inconvenience resulting from layovers and made the airlines less dependent on other carriers for their feeder traffic.

A major advantage of this type of network was that each airline was generally a monopoly carrier on its short-haul routes. Consequently, older planes could be used without worrying about flight frequency, competition, or price wars. As a result, these carriers entered the deregulated era in better financial shape than did the larger carriers. Delta had one of the industry’s lowest debt ratios, whereas Braniff’s leverage was commensurate with the industry average. These two carriers also tended to be more profitable than the larger carriers.

Following deregulation, Braniff changed its strategy and placed more emphasis on adding long-haul routes. In 1979, for example, Braniff added new routes to Europe and the Far East, even though it lacked marketing exposure in these areas. Braniff hoped that the new domestic and international routes would feed each other and increase traffic flow through its domestic hub cities. It also expected that new traffic patterns would help smooth demand over the entire system. This rapid expansion strategy was not compatible with the environment. Braniff tried to expand its operations during a period of rising interest, fuel, and operating costs, but it had to lower prices to remain competitive on existing routes and offer promotional fares to increase its market exposure on the new routes. Braniff ignored the importance of flight frequency and its relationship to market share. In many cases, Braniff initiated only one flight on its new routes, sometimes with an inconvenient arrival or departure time. As a result, Braniff was not able to schedule its system as efficiently as it initially hoped. Braniff also shifted capacity from markets in which it previously held a prominent position, with the result that competitors entered these cities and gained market share.

In contrast to Braniff, Delta maintained its position as one of the trunk industry’s most profitable carriers. It did not deplete its resources in price wars on the more popular routes, and it added routes only when it perceived a need for additional service. Delta also added routes that could be profitable in the short term. As a result, it initiated service to fast-growing regions in the Pacific Northwest, California, and Texas. Delta did not sacrifice flight frequency in its traditional markets to provide service on these new routes. When Eastern Airlines increased flight frequency to Atlanta, Delta’s major hub, Delta countered by simultaneously adding more flights. To combat the tendency toward providing excess capacity, Delta introduced flight complexes at its Atlanta hub. Thirty or forty planes would converge on Atlanta at two-hour intervals, exchange passengers, and fly to different spoke cities. The strategy kept a greater percentage of passengers within the feeder and connector system. Passenger layover was minimized through efficient scheduling, which, in turn, reduced the chance that passengers would defect to another airline. Delta became one of the dominant U.S. carriers, and Braniff filed for bankruptcy in 1982.

Along with lower fares, therefore, the hub-and-spoke strategy was one of the major outcomes of deregulation. Passengers now needed to travel from major hub to major hub, using connecting flights or ground travel to reach the hubs, as fewer direct flights were available. Other changes that passengers noticed were a broader variation in the quality of service and amenities such as meals (no-frills trips now could be offered to passengers wanting to minimize the cost of their tickets). The increase in competition—with the choice with the number of certified large-aircraft carriers doubling over the following three decades—provided passengers with more options in airlines and allowed them to benefit from discount pricing, frequent flyer programs, and cross-industry credit card promotions. Increasingly, however, passengers also saw overbooking, delayed schedules and missed connections, and longer overall travel times. Older passengers complained that the civility and graceful amenities of their earlier flying experience had been replaced with coach travel that resembled a bus trip.

Nevertheless, in 1999, the Brookings Institution estimated that deregulation had saved travelers more than $20 billion per year, and the increase in travelers seemed in line with that estimate: According to the Air Transport Association of America, in 1999 some 640 million passengers flew on U.S. airlines, more than two and one-half times the number of passengers who traveled in 1977.

Bibliography

Dempsey, Paul Stephen, and Andrew R. Goetz. Airline Deregulation and Laissez-Faire Mythology. Westport, Conn.: Quorum Books, 1992. Presents a good retrospective critique of the outcomes of deregulation. Contends that several key assumptions made by free market economists were erroneous and advocates some regulatory reforms.

Fruhan, William E., Jr. The Fight for Competitive Advantage: A Study of the United States Trunk Air Carriers. Boston: Division of Research, Graduate School of Business Administration, Harvard University, 1972. Good resource analyzes the competitive environment in the trunk airline industry under the auspices of the Civil Aeronautics Board.

Kahn, Alfred E. Lessons from Deregulation: Telecommunications and Airlines After the Crunch. Washington, D.C.: Brookings Institution, 2004. Examines the deregulation of two industries and argues that deregulation was the proper course in both cases.

Lewis, W. Davis, and Wesley P. Newton. Delta: The History of an Airline. Athens: University of Georgia Press, 1979. Presents a comprehensive review of the history of Delta Air Lines from 1929 to 1979 in an easy-to-read narrative.

MacAvoy, Paul W., and John W. Snow, eds. Regulation of Passenger Fares and Competition Among the Airlines. Washington, D.C.: American Enterprise Institute for Public Policy Research, 1977. Collection presents the findings of studies conducted by the U.S. Department of Transportation and other public and private agencies regarding the likely impacts of deregulation on airline costs and service.

Petzinger, Thomas, Jr. Hard Landing: The Epic Contest for Power and Profits That Plunged the Airlines into Chaos. New York: Three Rivers Press, 1995. Examines the airline industry in the United States from the 1930’s to the mid-1990’s. Includes discussion of the impacts of deregulation.

Saunders, Martha Dunagin. Eastern’s Armageddon: Labor Conflict and the Destruction of Eastern Airlines. Westport, Conn.: Greenwood Press, 1992. Interesting case study examines the demise of Eastern from both historical and organizational behavior perspectives. Analyzes the conflict between Eastern’s labor unions and Texas Air’s management after Eastern was acquired by Texas Air in 1986.