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Contrived competition: airline regulation and deregulation, 1925-1988.

Contrived Competition: Airline Regulation and Deregulation, 1925-1988

Airline regulation and deregulation, taken together, provide a uniquely interesting laboratory for testing basic concepts of political economy. During the forty years of federal regulation (from 1938 to 1978), a number of economists studied airlines to understand how federal intervention affected key aspects of market structure--especially entry, price, and supply and demand. (1) Political scientists and historians also cited this experience to illustrate theories of regulatory origin or capture. (2) Students of business administration focused on the regulate airlines' marketing, logistics, and competitive strategy. (3)

More recently, scholars have been fascinated by the unanticipated consequence of deregulation. The business conduct and market performance of deregulated airlines have challenged even the most sophisticated ideas about contestability, information and transaction costs, economies of scale, and the public and private interest theories of government. (4) For the theorists of regulation, deregulation has proven hard to explain.

Despite the richness of this scholarly output, economic and political explanations remain relatively unintegrated: the economic studies tend to be cross-sectional, seldom focusing on the dynamic process of an evolving market structure; the policy explanations strive unsuccessfully for monocausality. With some exceptions (for example, the work of John Meyer and Michael Levine), neither the economic nor the policy explanations take into account the strategic conduct of the firm or its effects on market structure. By examining the history of regulation that is grounded in a dynamic view of market structure, political interests, and the strategic behavior of firms.

The article is organized in five parts: 1) an analysis of the origins of airline regulation, 1925-38; 2) its effects on market structure, 1938-69; 3) a discussion of the causes of deregulation, 1969-78; 4) a description of American Airlines' strategic adjustment to deregulation; and 5) an overview of deregulation's impact on market structure and performance, 1978-88.

Origins of Airline Regulation, 1925-1938

The airline business in America started out as a dangerous, heavily subsidized, mail delivery service. Government virtually created the market, long before the technology could sustain nationwide passenger service. During the First World War, Congress funded the development and large-scale production of military aircraft. As the war ended, the Post Office inaugurated scheduled airmail service, with operations provided by army pilots. For several years, the industry limped along with a short supply of skilled pilots, few control systems, rudimentary airports, and an uncoordinated route structure. Recognizing these weaknesses, the industry itself sought government help, asking for regulation of the airways and subsidies for commercial airmail. (5) Congress tried to meet these needs with the Kelly Airmail Act of 1925, which provided for competitive bidding and subsidies for contract airmail service, and the Air Commerce Act of 1926, which authorized the Department of Commerce to regulate air navigation and safety. (6).

The subsidies, amounting to $7 million a year by 1930, stimulated demand for airmail service and intense competition among suppliers. Route mileage increased tenfold, with more than a dozen carriers organized to provide regular service. But competitive bidding for subsidies severely limited profits and prevented the development of any significant passenger service. Frustrated by the industry's slow development, Walter F. Brown, Herbert Hoover's postmaster general, proposed legislation to give himself wide-ranging authority over routes, mail rates, and discretionary contract awards. Congress granted Brown his request, save for the waiver of competitive bidding, in the McNary-Watres Act of 1930. (7)

Brown immediately called a meeting of the principal airmail carriers, none of whom were breaking even on passenger service at the time, and asked them to "agree among themselves as to the territory in which they shall have the paramount interest.'" (8) After several days of discussions and some arm-twisting by Brown, three transcontinental routes were designated and awarded: a southern route to American Airways, a central route to Trans Continental and Western Air (TWA; after 1950, Trans World Airlines), and a northern route to United Airways. Six other carriers received the remaining contracts. "There was no sense," as Brown later explained, "in taking the government's money and dishing it out to every little fellow that was flying around. . . ." Administrative integration and consolidation, he believed, would "make the industry self-sustaining." (9)

With this government-sponsored cartel in place, the airline business made some rapid advances. Improvements in aircraft technology, together with noncompetitive mail contracts, stimulated the growth of passenger service. The principal carriers grew by merger as well as by extension. TWA was acquired by General Motors (along with Eastern, Western, and Douglas Aviation); United formed a holding company with National Air Transport, Pratt & Whitney, Boeing, and Sikorsky; and American was acquired by Aviation Corporation (along with Texas Air, Continental Air, Robertson Aircraft ["the Lindbergh Line"], and several others). (10)

In 1934, when Brown's "spoils conference" came to light in a full-blown political scandal, the cartel and holding-company pyramids came crashing down. President Franklin Roosevelt, responding to allegations of conspiracy, canceled all existing airmail contracts and ordered the army to deliver the airmail. (11) Congress hastily revised the Air Mail Act (with the Black-McKellar Act of 1934), curtailing the postmaster general's authority, reimposing strict competitive bidding, and giving the Interstate Commerce Commission control of entry through a certification process. The act's most distinctive feature was its punitive thruwt: it prohibited existing carriers from bidding on contracts, banned interlocking directorates, and restricted airlines with mail contracts from "engag[ing] in any other phase of the aviation industry." These measures destroyed the aviation trusts. (12)

The 1934 act restructured the airline industry, creating the horizontal oligopoly that would last until 1978. with new executive officers, new names, and new incorporation papers, eleven carriers emerged from the conglomerates. The "Big Four" --American Airlines, United Airlines, TWA, and Eastern Airlines--held about 80 percent of market share (in revenue-passenger miles). Seven others--Northwest, Pennsylvania Central, Braniff, Western Air Express, Chicago & Western, Mid-Continent, and National--shared the remaining 20 percent. The act also imposed a competitive bidding system, which, as the only feasible means of entry, resulted in absurdly low bids.

The industry as a whole operated at a loss for the next few years, giving the impression that "excess competition" was a sort of market failure. A blue-ribbon panel, appointed by Congress to evaluate long-term aviation policy, concluded that air transport was "not a natural monopoly," but that it did suffer from the wrong sort of competition. The panel recommended that Congress appoint an independent commission to regulate entry and to set minimum standards of service: "There must be enough competition to serve as a spur to the eager search for progressw, but there must not be so much as to raise costs materially through the duplication of facilities. There must be no arbitrary denial of the right of entry of newcomers. . . ." (13)

The airline industry lobbied hard for regulation. Half the total investment in aviation hae allegedly been lost, complained Edgar Gorrell, president of the Air Transport Association. Without regulation, "there is nothing to prevent the entire air carrier system from crashing to earth under the impact of cut-throat and destructive practices." (14) Congress (and eventually the Roosevelt administration) agreed, and, in 1938, passed the Civil Aeronautics Act. (15) The act created a Civil Aeronautics Authority (later renamed Board) with broad authority to control entry and exit by certification, approve or amend tariffs, set mail rates, control mergers, authorize interfirm agreements, and control methods of competition. (16) These extraordinary powers were based on two criteria: "the promotion of adequate, economical, and efficient service . . . at reasonable charges," and the promotion of "competition to the extent necessary to assure the sound development of an air-transportation system. . . ." (17)

The act represented neither the "public interest" concept that had evolved from Munn v. Illinois nor the simple "capture" of policy by industry. (18) Rather, the Civil Aeronautics Act was a muddled attempt to guide competition toward a socially optimal mix of service, innovation, and economic growth. This approach, of course, was perfectly consistent with the prevailing economic wisdom in the context of the Great Depression. Congress had already responded in a similar manner to depressed conditions in other industries, with the Emergency Railroad Transportation Act of 1933, the Banking Act of 1933, and the Motor Carrier Act (for trucking) of 1935. In 1938, interstate pipelines were placed under similarly tight federal controls in the Natural Gas Act.

Regulation-Defined Airline Markets, 1938-1968

During its first thirty years, the Civil Aeronautics Board (CAB) tried several tactics, depending on its makeup (particularly its chairman) and on airline market conditions. Prior to 1955, the board fostered rapid growth through route extensions, tight control over mergers and new entrants, and "route strengthening" for the smaller trunk carriers. Since the act had grandfathered the routes of the major carriers, the Big Four started out from a dominant position. As the CAB added 56,000 miles of new routes in the late 1940s (doubling the prewar network), it favored the growth of the smaller trunk carriers (for example, Northeastern, Northwestern, Braniff, Continental, Delta, National, Wewtern, Mid-Continent, and Southern) (see Tqble 1). (19) The board also promoted growth by certifying and nurturing non-competing "feeder lines," which by 1954 had grown into thirteen relatively stable local carriers with 22,000 miles of routes and $54 million in revenues (see Table 2).

Control of entry was a difficult issue for the Civil Aeronautics Board. Because airmail subsidies artifically stimulated entry, and because low natural entry barriers encouraged cream-skimming, entry restrictions appeared warranted, even necessary. But with the glut of aircraft and pilots after the Second World War, hundreds of "irregular" carriers commenced service, exempt from certification. For a time, these irregulars showed extraordinary imagination and flexibility in skirting each new CAB rule. At its peak in 1951, market share of the irregular carriers reached 7.5 percent of revenue-passenger miles and 21 percent of cargo. It took the board nearly a decade to close every loophole, alienating quite a few members of congress in the process. (20)

On the major trunk routes, the board had no real decision-rule for dealing with requests for competitive entry or with service rivalries. Case-by-case decision making reflected a balancing act, slightly tilted toward a "presumption in favor of competition on any route which offered sufficient traffic to support competing services without unreasonable increase of total operating costs." (21) Too much service rivalry, without pricing flexibility, clearly threatened to raise costs, add excess capacity, and dilute traffic. (22) The board's case-by-case development of service authority produced a linear, point-to-point route structure that merely extended the early mail routes. Discussions of more comprehensive plans nevr surmounted the apparent limits to the board's authority--or to its vision. (23) Regulation was bounded on the end by a lack of faith in real competition, and on the other end by a fear of centralized administration. This was perhaps the essential dilemma of American-style regulation and a critical element in subsequent regulatory failures.

While the CAB fumbled to regulate competition, technological change and the business cycle periodically rocked airline markets. In 1947, the industry plunged into a second re-equipment cycle (the first had been the prewar shift to DC-3s), converting to larger, faster four-engine aircraft capable of seating forty to sixty people. As the carriers incurred new debt to expand capacity, recession struck (in 1948), load factor (the proportion of available seats filled--that is, capacity utilization) plummeted, and operating margins turned sharply negative. (24)

The CAB responded to this crisis by urging all major carriers to raise rates by 10 percent and to offer promotional fares to fill empty seats. (25) Accused by the incumbent airlines of encouraging "competition for competition's sake," the board substantially curtailed its encouragement of city-pair rivalry--competition among carriers for the same city-pair market--and shut the door to new entry. (26) Eventually, it approved most of the mergers precipitated by recession; by 1954, the sixteen trunk carriers were reduced to thirteen, and the twenty-three locals to thirteen.

Shortly after the Korean War, this policy of structural stability was completely reversed. In April 1955, President Dwight Eisenhower appointed Ross Rizley, previously a congressman from Oklahoma, to chair the Civil Aeronautics Board. With prosperity helping to fill seats and to sustain record high airline earnings, Rizley concluded that more competition would best serve the public interest. (27) In a series of fourteen decisions over the next eighteen months, the CAB reduced the number of noncompetitive city pairs--cities served by only one carrier--in the top 100 markets from forty to sixteen. In all, competition was introduced or strengthened in 559 city-pair markets. (28)

At this moment of intensified rivalry, the jet age commenced. First turbo-props, developed in England, and then jets were introduced into commercial aviation. Pan American ordered the first Boeing 707s and McDonnell-Douglas DC-8s in October 1955. The other carriers followed suit, and within a year, the industry had committed $1.4 billion to new equipment--about $200 million more than its total previous net investment. (29)

Once again, this re-equipment cycle added capacity and debt and undermined return on investment. An investigation of passenger fares opened in 1956 evolved into a collective rate case that brought fare increases of 10 percent in 1958 and 5 percent in 1960. The board justified these increases by an array of utility-like rate-making standards, with a rate of return pegged at 10.25 percent. (30)

The crux of this rule-making was a target load factor of 63 percent. Airline passengers, the board proclaimed, should not be burdened with the cost of excess capacity. Rather, "airline management [was] both responsible and capable of exercising control of load factors over reasonably extended periods by tailoring capacity to the requirements of traffic." (31)

Nowhere was the hubris of regulated competition more evident. The CAB's view that capacity utilization was a managerial prerogative, independent of price and entry regulation, was myopic. It separated the economic links between the firm and the market--between price, capacity investment, market share, and earnings.

Excess capacity was just the most perverse consequence of a hybrid regulation that prevented price competition, but not service rivalry (see Figure 1). Carriers could maintain market share only by adding capacity (more frequent departures) and service. These costs drove up prices, which in turn weakened demand and resulted in lower capacity utilization. The utility-type rate making that tried fares to the weaker performers among diverse corporations also discouraged cost effectiveness. Pricing under regulation tended to bundle a variety of services into one or two simple packages that hid the real costs and left travelers with little choice about the number and level of services they could purchase.

The effects of regulation on route structure and aircraft fleet were among the most important. By allocating routes piecemeal through individual certification proceedings, CAB regulation produced fragmented, politically stylized, point-to-point route systems. Although they provided convenient nonstop service, often to locations where maintaining that level of service made no economic sense, such route structures afforded air carriers none of the economies of scale or scope that would have been possible with a more integrated, centralized structure.

Rivalry restricted to service had a positive effect on the technological development of the aircraft fleet. Modernity, speed, and comfort were critical aspects of service rivalry. No major carrier could afford to fall behind in new aircraft acquisition--hence, the repetition of frantic re-equipment cycles. Development of the DC-3, for example, and later of the DC-10, were the direct results of American Airlines' efforts to be more competitive. Similarly, Pan American played a major role in Boeing's development of the 747. The immense investment in re-equipping, moreover, was made possible by the economic security (and protection from competitive entry) that regulation afforded. (32)

Regulatory Failure and Reform, 1969-1978

Prior to 1969, healthy economic growth (with low inflation) and productivity gains from technological innovation had more than compensated for the inefficiencies caused by regulation. But the macroeconomy began to change at the end of the decade. Slower economic growth, rising inflation, and higher interest rates staggered airline markets. Demand, which had been growing at an annual rate of 18 percent from 1965 through 1969, slowed to 4 percent between 1969 and 1975. Fuel supply shocks in the early 1970s, combined with the ratcheting upward of wage costs, sparked an explosion of airline operating costs. Between 1969 and 1978, the price of jet fuel increased 222 percent, amounting to nearly one-fifth of operating costs; and labor costs, which accounted for 45 percent of airline expenses, increased 135 percent (to $22,422 per employee). (33)

New technology and a fourth re-equipment cycle coincided with a downturn in the business cycle. Pan American, as before, acted first, buying twenty-five wide-bodied Boeing 747s (with 350 to 450 seats). Domestic carriers followed suit, ordering McDonnell-Douglas DC-10s and Lockheed L-1011s as well as 747s. By 1975, trunk carriers were operating 282 wide-bodied aircraft. At $22 to $25 million a plane, this capacity cost more than $6 billion--nearly four times cumulative operating profits. (34)

Together, these dramatic changes in demand for service--downward--and in supply of available seats--upward--amounted to a reversal of the airline industry's economic structure. Since the conversion to jet aircraft began in the late 1950s, the industry had enjoyed declining unit costs of capacity (with productivity growth outstripping inflation). (35) In effect, technological gains had been masking the inefficiencies of airline regulation. But in 1969, real capacity costs stopped declining, and they remained at their 1970 levels for the next seven years. Meanwhile, nominal unit costs, driven by wage gains and fuel prices, shot up 77 percent over the next seven years (see Figure 2). And since capacity utilization was so low, nominal costs per revenue-passenger mile rose even more sharply. Dramatic price increases were necessary, forcing the CAB to open an industry-wide rate case that threw the political spotlight on its own regulatory failings.

It was excess capacity that actually triggered the regulatory crisis. Customers, especially business travelers, desired convenience and choice in frequency of departure and nonstop service. In the absence of pricing flexibility, the addition of capacity by one competitor in a city-pair market was likely to take market share from the others. In fact, market share appeared historically to vary disproportionately to capacity share--an empirical relationship called the "S Curve." A city-pair rival with a minority share of capacity was likely to have a lower load factor than competitors--that is, airlines that had fewer seats were likely to fill a lower percentage of them than were competitors with greater capacity. And since overall load factors were often near the break-even point, it was difficult for a minority-share competitor to make a profit. This condition created a perverse incentive to increase capacity, even though capacity utilization would fall if a company's rival(s) followed suit. For carriers serving the same city-pair, this phenomenon posed a kind of prisoners' dilemma. (36)

Load factor, falling since 1965, hit a record low of 48 percent in 1971. Rapid growth in the number of flights, meanwhile, had already caused severe air traffic congestion, especially in the largest urban markets--Chicago, Los Angeles, New York, and Washington. On those routes, where price-insensitive business customers sought maximum convenience, excess capacity was rampant. Load factor on domestic 747 flights fell to 33 percent in 1971-72.

Between 1971 and 1974, the CAB approved a series of capacity agreements among the major carriers that reduced the number of weekly round-trip flights by 10 percent (on the Washington-Los Angeles route) to 38 percent (on the New York-San Francisco route. (37) Secor Browne, the CAB chairman from 1969 to 1973, also imposed a near-moratorium on new route authorizations. In the five years beginning in July 1969, only two applications were granted. (38)

With capacity and route expansion foreclosed as outlets for product differentiation, the trunk carriers devised new means of service competition. "Capacity wars" gave way to "lounge wars." On wide-bodied aircraft, lounges were introduced in first class, then in coach. When American installed piano bars, TWA countered with electronic draw-poker machines. Live entertainment proliferated, with musicians, magicians, wine-tasters, and Playboy bunnies. (39) This heightened service rivalry, meanwhile, spilled over into other city-pair markets, where some of the grounded aircraft were put to use. When smaller carriers complained, the industry's consensus on behalf of regulation began to waiver.

The Domestic Passenger Fare Investigation was the CAB's most constructive response to this crisis in capacity utilization. This proceeding, begun in January 1970 and concluded five years later, yielded fare increases totaling 38 percent. Although the fare investigation produced several regulatory innovations, its impact on economic efficiency was debatable. (40) Mileage-based pricing prevented fare flexibility and marginal-cost pricing, and the industry-averaging of costs protected the least efficient carrier. By 1975, the CAB's efforts had done little to improve airline performance; gross overcapacity, high prices, and weak earnings prevailed.

The policy debate on airline regulation came unraveled with great speed. The political process, especially in view of its active support by regulators, confounded the conventional wisdom of the policy literature. What could have broken the symmetry of the "iron triangle"--the regulated industry, congressional interests, and regulators--to which theory had attributed such immutable power? How, indeed, could a "captured" agency cross its captors to advocate its own demise? (41) No single explanation can suffice. Changes in basic economic factors, technological innovation, and regulatory failure were necessary, but not sufficient, preconditions. New ideas about government regulation and a degree of "policy entrepreneurship" also contributed.

Academic professionals, especially economists, played an unusual role in the process of airline deregulation. The work of John Meyer, Richard Caves, and Michael Levine had earlier established a scholarly thread of criticism. Now, as the industry's performance worsened, other critical voices joined in. (42) In the early 1970s, their critique of regulation was disseminated widely through the economic policy literature familiar to Washington insiders. (43) And the criticism was magnified by the broader loss of faith in the federal government that stemmed from problems in the macroeconomy and, especially, from the political disasters of the Vietnam War and Watergate. This regulatory critique, which extended to trucking, railroads, natural gas, and electric power, began to diffuse through a dozen agencies and executive departments in Washington. In the second half of 1974, with the presidency weakened and the polity very much confused by the first oil crisis, the time for reform, and for political entrepreneurship, was ripe.

Stephen Breyer and Senator Edward Kennedy were the first to seize this political opportunity. Kennedy hired Breyer, from the Harvard Law School faculty, to revitalize the Subcommittee on Administrative Practice, which Kennedy chaired. Together, they close regulatory reform as a strategic issue. [44] Breyer shrewdly suggested that they start with the airline industry, for several reasons: 1) its visibility and glamour; 2) the weak theoretical reed (excess competition) by which airline regulation was justified; 3) the industry's failing performance; 4) its relatively simple political-interest structure (only firms and unions, neither of which had much political clout); and 5) the existence of unregulated intrastate airlaines whose performance compared favorably with that of CAB-regulated trunk carriers.

Senator Kennedy;s subcommittee held hearings on airline regulation in the spring of 1975. Orchestrated by Breyer to present a "story" and to maximize attention in the press, these hearings were immensely successful. The central theme was that CAB regulation had caused airline fares to be higher than necessary. Witnesses from the airlines and from the CAB found it impossible to rebut the critical logic of Senator Kennedy and his well-prepared staff. [45]

What had been an academic debate now became a political issue, into which a wider arraya of interest groups were drawn. Gerald Ford's administration proposed legislation to reform airline regulation in 1975, and a coalition of consumer activists, together with a number of airport authorities and municipalities, lent support to the administration's initiative. [46] CAB chairman Richard O'Melia appointed a special staff to review the board's performance, and in July 1975, the special staff issued a lengthy critique that recommended deregulation. (47) During the next two years, congressional committees held hearings on various legislative proposals to liberalize restrictions on entry and fares. The idiea of complete deregulation and shutdown of the CAB was not seriously advocatoed by anyone, including Alfred Kahn, until the final stages of legislative debate.

Organized labor was uniformly and adamantly opposed to deregulation. Pilots, machinists, clerks, flight attendants, engineers, teamsters, and transport workers realized the implications of increased competition for wages, work rules, and job security. [48] The airlines themselves started out in unanimous opposition to any significant reform, let along general deregulation. Eventually, a few of the carriers broke ranks and supported regulatory reform. Some of the regionals saw an opportunity for growth; Pan American hoped for domestic routes; and United realized that its market dominance might be a competitive advantage.

Still, most carriers remained vehemently opposed. Although a self-styled "great believer in market forces," Frank Lorenzo, the chairman of Texas International, anticipated some structural problems from unfettered competition:

[If] the Aviation Act of 1975 goes into effect, we will, over a period of years, end up with a couple of very large airlines. There will be many small airlines that will start up here and there, but they will never amount to a very significant amount of the transportation market. . . . The operating and financial advantages will go to the large carriers with substantial resources, and to very small carriers that temporarily have lower labor costs, primarily because they are non-unionized.

When asked by Senator Howard Cannon if regulatory liberalization "would be an attack on the labor movement," Lorenzo answered, flatly, "yes." [49]

Executives at American Airlines opposed deregulation as adamantly as anyone. Albert Casey, American's chairman, was so intransigent that Senator Cannon (once he had come around to the idea himself) facetiously nominated him for "dinosaur-of-the-mouth." Likewise, Robert Crandall, who eventually because president of American, warned that deregulation needlessly risked degradation of service, safety, and the integrated air-transport network. [50]

While Congress deliberated, the CAB experimented. John Robson, whom Ford appointed chairman in 1975, liberalized charters, expanded competitive route authority, and experimented with fare competition--the off-peak "peanut fare" by Texas International and American's broad rejoinder, the "Super Saver." In 1977, President Jimmy Carter appointed Alfred Kahn to chair the CAB. This quintessential policy entrepreneur took charge at the perfect time. With a powerful intellect, a dedication to microeconomic efficiency, and a quick and infectious humor, Kahn set about reorganizing the CAB. [51] Under Kahn, the Board decided several landmark cases, testing open entry and unrestricted price competition. [52]

Early in 1978, both houses of Congress passed bills to liberalize regulation (not to eliminate it). But as the policy options narrowed, airline executives, such as American's Crandall, faced with the prospect of a policy "that would leave the airlines half free and half fettered," now shifted gears and called for the total elimination of economic regulation. [53] By then, too, Alfred Kahn and his staff economists at the CAB had lelarned the limitations to partial, piecemeal deregulation: "The reason I concluded finally that the CAB should be abolished was my conviction that no government administrator was competent to determine the proper structure of the airline industry." [54] In October 1978, Congress passed the Airline Deregulation Act, which placed "maximum reliance on competitive market forces." The Civil Aeronautics Board would automatically certify entry, unless doing so damaged the public interest. Fares would be flexible within a wide zone of reasonableness, and mergers would be readily approved. If all went well, the Civil Aeronautics Board would cease to exist by 1985. (55)

American Airlines and the Strategic Adjustment

to Deregulation

The first year of airline deregulation "was one of the most difficult and tumultuous years of our history," commented Bob Crandall. "As an industry, we seemed bent on giving away the store." [56] And 1980 proved worse still. All but two of the major carriers lost money, with American Airlines' first-half losses of $120 million the worst in the industry. Passenger traffic slumped because of the recession, and the price of jet fuel doubled as a result of the second oil shock. [57] Intense competition for key routes, with wild discounting of fares, caught the industry and its regulators by surprise. The coincidence of deregulation and severe macroeconomic shocks probably telescoped, and certainly aggravated, the process of structural adjustment.

The major carriers were totally unprepared. Although the Deregulation Act had proposed an orderly phase-out of regulation, reallocation of routes and fare competition swept past the board's half-hearted attempts at stabilization. A sort of reverse tarbaby effect set in, as competitive rivalry spread throughout the market. (58) By the spring of 1980, carriers were virtually free to determine the routes they served and the prices they charged. (59)

New entry by low-cost , no frills, point-to-point carriers contributed to the shock. Former intrastates, charters, commuters, and start-ups sensed tremendous opportunities to make money on low-density, ill-served routes as well as on high-density, overpriced ones. With low overhead, nonunion labor, depreciated aircraft, leased facilities, and few extraneous services, these companies--PSA, Air Cal, Southwest, Capital and World, and eventually Midway, New York Air, and People Express--put intense competitive pressure on the established carriers. (60)

When World Airways offered a transcontinental fare (New York--Los Angeles) of $108, the major carriers followed. Eastern tried to enter the market with a $99 fare, and fares soon plummeted to $88. Pricing madness next spread to the "peripheral transcon" markets of Boston, Washington, and Philadelphia. (61) Hastily, the major airlines began dropping unprofitable routes and entering the potentially profitable markets of their competitors. Braniff, for example, challenged American in the southwest, and Delta attacked American's market in Dallas from the east. Such unrestricted competition forced a dilution of yields (effective revenue per passenger mile), pushing break-even load factors higher. Of all the major carriers, American's was the highest. (62)

Accelerated "hubbing" was the first clear strategic response by the major carriers. The practice of concentrating connecting flights at a particular airport had been used to a limited extent since the 1960s. Both Delta and Eastern had developed a hub at Atlanta, United at Chicago, American at Dallas, and Allegheny (now US AIR) at Pittsburgh. But hitherto regulation had severely limited the use of a hub-and-spoke route structure as an operating strategy. (63) Only after receiving route flexibility could the majors contemplate the potential economies of scale and scope that the hub-and-spoke system had to offer. (64)

But fleet composition, at least in the short run, was a major constraint on route restructuring. As Crandall explained in 1980, "the established carriers bought their airplanes years ago expecting to operate them over a stable and franchised route system. . . . Critical decisions about which airplanes to buy, and in what numbers, were based on marketing assumptions that seemed reasonable at the time. They could not--and did not--anticipate the free-for-all we have today." (65) Thus, the four-engine Boeing 707s, designed for transcontinental service in the mid-1950s when oil was cheap and load factors high, had become uneconomical by 1980. On most domestic routes, so had the 747s and even the older model 727s. Although a new generation of aircraft (Boeing 767s and 757s) was nearing the start of production, few of the major carriers could afford the price, nearly $25 million a plane.

Here, then, was the most fundamental market-structuring impact of regulation. Four decades of CAB control had penetrated to the operational core of the regulated firms. Fleet composition and route structure, the essential plant and operating method of the airline business, had become artifacts of public policy. Moreover, most other aspects of the business--work rules and crew assignments, terminal and gate investments, organization of maintenance, and all critical marketing activities--were shaped to fit the routes and fleet. Managers who realized this, and who could implement effective changes quickly, had an immense competitive advantage. But few did.

In terms of strategy, organization structure, and performance, American Airlines, starting as the second largest but least efficient of incumbent domestic carriers, made the most thoroughgoing and successful adjustment to deregulation. Its reaction provides an especially clear contrast for examining the effects of regulatory change on business practice. Conversely, its size and revealed market power show how effective strategy, like regulation, can shape market structure to create sustainable profits.

American Airlines was not prepared for deregulation. Its break-even load factor was the industry's highest. Its labor costs were higher than the industry average and its productivity growth lower. Its fleet was the least fuel efficient, and its route structure the industry's most fragmented. (66) During the period in which regulation broke down (1968-74), American's management had made several serious errors: over-expansion into hotel properties, acquisition of too many wide-bodied aircraft, cutbacks in the development of computerized reservation systems, a failed merger attempt, and illegal campaign contributions. When chairman George Spater resigned in 1974, he left behind serious organizational problems and ruined morale. (67)

For the job of restoration, American's board chose Albert Casey, president of the Times Mirror Company. Casey, a rough-and-tumble, gregarious Boston Irishman with a self-depreciating sense of humor, specialized in finance but knew nothing about airlines. He found a top-heavy organization with inadequate management systems. Cost controls, planning, marketing, and the piece-parts of operations were thoroughly fragmented. The budgetary system, Casey recalled, "was a disaster." The new chairman quickly discovered that "Bob [Crandall] knew more about the company than anybody else," even though he'd only been there one year. Crandall, who had held finance positions at Eastman Kodak and Hallmark Cards, was also experienced in managing information systems. Together, Casey and Crandall "got down and ripped the airline apart," creating cost controls and a centralized budgeting system. (68)

Both executives also encouraged the modernization and expansion of SABRE--American's computerized reservation system. This huge, real-time computer network, first developed in the mid-1960s to keep track of the growing volume of reservations, had become a vital component of American's operations even before deregulation. (69) Several of the major carriers had developed similar systems, and at least two of them--United's and TWA's--were comparable to American's. Then in 1975, American started committing resources to develop new features for SABRE and test marketing its terminals in travel agencies--the industry's fastest growing distributon channel. In 1976, as United prepared to expand its system (APOLLO), American scooped the market with a large-scale program to sign up travel agents for SABRE. Now, recognizing SABRE as a strategic (rather than an operational) component of competitive advantage, American invested heavily. (70)

Between 1975 and 1979, Casey eliminated some managerial deadwood, sold the American Hotel chain, centralized maintenance, training, and computer operations, and moved American's corporate headquarters out of New York City to the Dallas--Fort Worth Airport. Still, in June 1980, when he appointed Crandall president and chief operating officer, the company was staggering under the brunt of competition.

Crandall moved quickly to staunch American's losses. In a matter of weeks, his management team developed a five-part plan to restructure American Airlines, creating a smaller, but more efficient company with a long-term goal of remaining a full-service national airline. (71) The plan was implemented immediately.

First, they grounded the fifty-three 707s. These aircraft--about one-fifth of American's capacity--were losing money every time they took off. This decision--to shrink the airline--was a drastic step that threatened an irretrievable loss of market share. Other difficult decisions were to cancel its order for 757s, which American could not afford, and to convert its underutilized 747s to freighters.

With fewer aircraft, American could eliminate a large number of direct, point-to-point, nonstop flights that were losing money without necessarily reducing the number of city-pairs served. Route flexibility provided a unique opportunity for American to restructure routes in a hub-and-spoke pattern, optimizing aircraft utilization, cost reduction, and market retention. American's planners assessed city availability, airport gates, weather conditions, traffic patterns, demographic trends, and competitors' systems. Above all, they studied the economies of scale and scope.

American had already concentrated 142 daily departures (29 percent of its system total) at the huge Dallas--Fort Worth Airport. These flights were grouped in a series of connecting "complexes" (the nearly simultaneous arrival and departure of multiple aircraft), the largest of which used nineteen gates. A similar, but smaller, hub operation had developed at Chicago's O'Hare Airport. The scale advantages in these arrangements derived from the concentration of labor resources and costly ground equipment (for example, aircraft pushers, baggage haulers, service vehicles, and maintenance equipment) at a single point, increasing their utilization and spreading those costs across more arrivals and departures (and passengers). Economies of scope were even greater. By using the hub to serve two groups of city markets on either side of it, an airline could provide service to many more city pairs and could offer more frequent service with fewer aircraft and flight crews. Thus, a hub connecting twenty cities to the east and twenty more to the west could provide one-stop service to 440 city pairs. At that level, an increment of one flight added forty-three more markets. (72)

On the revenue side, effective "complexing" was a critical part of this operating strategy. By scheduling large complexes, with one-hour stopovers, airlines could gather traffic from diffuse sources, substitute one-stop for nonstop service, retain customers end-to-end, and increase load factor on previously thin routes. Delta, with its regional hub at Atlanta, provided a model. Figure 3, which reflects American's initial analysis of hubs, illustrates both the cost and revenue advantages of large hubs and large complexes. The left side of the chart shows that for a relatively small increase in personnel, a huge number of additional city-pair markets could be served (through the geometric impact of hubbing one additional flight); similarly, the right side shows the disproportionate gain in revenue (by adding connections to prevent loss of customers to connecting carriers) to expense.

Once these economics were clear, the other issues easily fell into place. American would focus 50 percent of its traffic at the Dallas--Fort Worth (DFW) "Superplex." The number of transcontinental nonstop flights was reduced; dozens of miscellaneous routes, Northeast business routes, and routes to Mexico were discontinued. But through DFW, twenty-two new destinations would be served within a year, increasing city-pair combinations from 655 to 1,519 and daily departures to 213. (73) By 1984 the number of daily departures would reach 300 in eleven daily connecting complexels, of which the largest used thirty-five gates (see Figures 4 and 5). This level of concentration was nearly matched at O'Hare, with 224 daily departures serving sixty-five cities. (74)

With a smaller fleet and a more efficient route structure, American needed fewer employees. Crandall announced layoffs and early retirements, reducing personnel from 41,000 to 35,500 by the end of 1981. Labor productivity in every job classification was reviewed and improved to the extent allowed by labor contracts. Miscellaneous costs, especially for fuel, were attacked on every front. New flying procedures were adopted; aircraft were modified and even repainted to reduce drag. Seating density was increased everywhere and weight reduced.

Despite these efforts, American could not hope to compete on cost alone. differentiation, with a full range of services targeted toward business travelers, was American's only prior competitive advantage. Thus, the last part of the plan was a marketing strategy that applied American's traditional strengths to its emerging hub-and-spoke network. Service, traffic control, and distribution were its critical components. (75)

Service, relatively unscathed by cost-cutting, would be maintained at existing levels for reservations, ticketing, baggage handling, in-flight amenities, and, above all, on-time departures. To hold business travelers on the system, the hub connections had to work efficiently, with little more than an hour between flights.

Pricing to maximize revenue yield and to fill seats would be implemented through SABRE. Peak-load and promotional pricing would need sufficient restrictions to prevent business travelers from crossing over from premium fares to discount categories, and enough flexibility to avoid selling too many discount seats and thus preempting premium customers. (76) Before long, American's reservation system could manage this more complex fare structure, allocating seats on each flight to five different classes of fares and shifting allocations daily.

sABRE also gave American an advantage, perhaps even an unfair advantage, in distribution channels. The great complexity of route and pricing options made travel agencies an appealing channel for perplexed travelers; it also made computerized reservation systems a necessity for travel agents. Crandall saw this, and he pushed SABRE to expand as fast as possible; the system had captured 27 percent of the tra travel agency market by 1983. Competitors complained that United's and American's reservation systems were programmed with a bias toward the owners' flights. (77) By the time the bias was removed in 1983, American's SABRE had become the industry's biggest and most profitable distribution system, as well as an awesome source of market and strategic data.

To cap the marketing plan, American devised a scheme to create brand loyalty and to bond its frequent flyers to the hub. With SABRE delivering the necessary automated record-keeping, American rolled out its AAdvantage program in the spring of 1981. AAdvantage gave passengers mileage credits for flying American, which could be accumulated and exchanged for free seats. By inventing the frequent flyer program, American seized a first-mover advantage, capturing 6.3 million subscribers, whose loyalty, given the cumulative nature of awards, strengthened over time.

With this short-run plan under way and showing results by the end of 1981, Crandall's management team turned to the longer-term issues of competing in an unregulated environment: labor productivity and costs, fleet modernization, and expansion.

Top management undertook a massive, three-year program of employee education on the impact and implications of competition. (78) Then, in 1983, it negotiated new contracts with American's unions that substantially relaxed work rules (especially for temporary workers and job cross-overs) and inaugurated a drastically lower "B" wage scale for newly hired employees. (79) In return, the company guaranteed job security and profit sharing. (80)

With this "two-tier" wage system in place, American was ready to expand. In spring 1984, American ordered sixty-seven MD Super 80s, with an option to buy one hundred more at the same price. This stretch version of an older McDonnell-Douglas design, with two fuel-efficient engines and a two-pilot cockpit, could deliver 32 percent lower operating costs. With 142 seats (compared to 115 seats in a 727-100), it was the right size for most of American's hub-and-spoke routes. (81) McDonnell-Douglas, moreover, agreed to very favorable financing terms.

Now in a position to compete effectively, and with earnings of $500 million (exceeding those of all other carriers), American moved to complete its expansion. In 1985 Crandall announced American's re-entry into the East with two new hubs--at Nashville and at Raleigh-Durham. Both cities were growing rapidly and would provide American with a north-south route structure that straddled the hubs of two major competitors--Delta and Piedmont. (82) Eventually, American planned to use these hubs as its gateways into Europe. (83)

Market Structure and Industry Performance, 1978-1988

Four strategic patterns, or competitive types, were evident in the deregulated environment. None, however, was as successful as American's.

Building on their prior advantages, three other carriers besides American--United, Delta, and TWA--eventually developed full-service, price-differentiated, hub-and-spoke trunk systems. United tried unsuccessfully to integrate into travel-related businesses before refocusing on airline operations to take advantage of its dominant size. Both Delta and TWA decided to acquire regionals (Western and Ozark) to gain the scale and hub strengthening deemed necessary to compete with American and United.

A second pattern, of full-price, hub-and-spoke regionals, proved transitory. Four large regional carries--Western at Salt Lake City, Republic at Detroit and Minneapolis, US AIR at Pittsburgh, and Piedmont at Charlotte--strengthened their hubs to preempt competitive entry. (84) But when the national carriers eventually expanded and brought to bear their scope advantages, this "fortress" strategy proved to be transitional; all four regionals subsequently merged with nationals. (85)

A low-cost, limited service, low-fare strategy was pursued by several new entrants, by two failing trunks, and by one previously intrastate carrier. People Express was the most important, but eventually unsuccessful, new entrant using this strategy. Continental and Braniff were major carriers, which, after bankruptcy, rebuilt their operations as low-cost, discount carriers. Continental, a subsidiary of Texas Air, pursued a distinctive strategy of voiding labor contracts and benefit obligations through bankruptcy. By 1989, Texas Air had acquired People Express, Frontier, and Eastern, and was trying to rationalize operations and service a debt of about $6.5 billion. (86) Only Southwest, with long experience with no-frills, low-cost service, had remained profitable, and even grown, by making this strategic choice.

A fourth competitive strategy was adopted by commuter airlines hustling to survive in smaller, low-density markets. Initially this was a viable business, with appropriate aircraft, sensible schedules, and low-cost labor. But the major airlines needed to control and integrate traffic fed from smaller communities into their hub operations. The commuters, meanwhile, needed gate space and services where they connected at the major airports. Joint marketing tie-ins between the major carriers and commuters therefore seemed to serve both interests. Eventually, these evolved into "code-sharing" arrangements (co-listing flights on computerized reservation systems), shared aircraft colors, capital infusions, and new names. By 1988, tie-ins had given the eight largest carriers effective control of forty-eight of the fifty largest commuters. (87) Foreclosure of entry was one of the consequences.

All of these strategic responses to deregulation, and the structural adjustments that accompanied them, had an obvious impact on overall industry structure. Figure 6 shows the wave of mergers that occurred between 1981 and 1988. The eight largest surviving carriers were among those certified by the CAB in 1938. Rationalization of industry structure did raise Big Four concentration to 61 percent--higher than in 1978, but less than in 1934. (88) Concentration levels were especially high at the major hubs and may have begun creating uncompetitive pricing. But for travelers flying between non-hub cities, concentration was less important, since airlines competed through different hubs.

The effects of deregulation on market structure and performance were also dramatic, although not so clearcut. Several exogenous events, including the second oil shock, the air traff controllers' (PATCO) strike in 1981, and the 1982-83 recession, also shaped the patterns of adjustment. Yet with this qualifiction in mind, we can observe significant changes in important market characteristics: 1) entry and exit conditions; 2) price level and pricing mechanisms; 3) segmentation; 4) distribution channels; 5) cost structure; 6) operations; 7) demand; 8) service levels (and safety); and 9) industry profitability.

Entry into the industry and into individual city-pair markets clearly opened up as soon as the CAB lowered its barriers. As Table 3 indicates several start-ups entered the business during the first few years of deregulation. Relatively low minimum efficient scale, small capital costs, and nonunion wages made this possible. Initially, economists, especially those associated with the new "contestability theory," thought that the airline industry without regulation would be a model contestable market. By this, they meant that entry (and exit) would be relatively easy and without cost, since there were few sunk costs (especially for entry into an individual city-pair market). If so, then the very threat of entry would hold fares down near marginal costs, even in a markets that were not structurally competitive in a traditional sense but that were "contestable." (89)

As Table 3 also shows, however, few of these entrants survived to 1988. The market did not prove to be frictionaless, because incumbent firms derived competitive advantages from their specialized assets (such as loyal employees, route planners and marketers, training facilities, and reservation systems), and from their strategic choices. By building economies of scale and scope to lower unit costs, by segmenting markets with strategic pricing, and by developing control of distribution channels, the incumbent firms created competitive advantages and eventually foreclosed entry. (90) "For a while it was easy," an American executive commented in 1983, "to blow United and American out of the market based on cost. But it isn't that easy any more." (91)

Deregulation allowed an immediate reduction of prices and a continuing fragmentation of pricing structure. Here too, the early pricing responses seemed to support the logic of contestability. Even monopolists lowered their fares. (92) Eventually, though, prices stabilized in the least competitive markets, and then increased. Price structure, meanwhile, fragmented into a wide range of special packages, discounts, and incentive deals. The proportion of passengers using discount fares had risen from 37 percent 1977 to 91 percent in 1987. (93) Yield management became the sine qua non of airline marketing. This development should not have been surprising, in view of airline economics (lumpy bundles of seats with diverse marginal costs) and a history of similar, albeit constrained, pricing practices. (94)

Among the most striking outcomes of airlines deregulation was the development and new strategic importance of distribution channels (methods of selling tickets). Under regulation, distribution channels were unimportant and unsophisticated. But with the transition to competition, customer access and control suddenly became critical for sellers, while the fluidity of adjusting markets caused extreme informational problems for buyers. Computerized reservation systems, with the ability to add a travel agency at a relatively small incremental cost and huge economies of scale (and scope), quickly became a competitive bottleneck, of which first movers took tremendous advantage. By 1988, American (SABRE) and United (APOLLO) controlled 70 percent of the travel agency channel, leaving competing systems (TWA, Delta, and Eastern) with too small a base and other carriers in abject dependency. (95)

Cost reduction was a more predictable result of deregulation. The most dramatic and politicized aspect of this process was the decreasing of labor costs. Elimination of work rules, increases in "hard" hours for flight crews, and wage givebacks all contributed to lower costs. (96) Like American, every major carrier eventually moved to reduce costs across the entire range of operations--fuel, overhead, fleet, and route structure--as well as labor. One estimate put the overall cost reduction at 30 percent (from 4.5 to 3.3 cents per passenger mile) between 1981 and 1987. (97)

Perhaps the most important change in market structure was the fundamental redesign of operations. The hub-and-spoke route structure, combined with "complexing," was a major innovation over the predominantly point-to-point, nonstop operations encouraged by regulation. Besides the economies of scale and scope previously discussed, the full development of hub operations, combined with feeder tie-ins, created powerful barriers to entry by potential competitors. (98) Complexing also aggravated air-traffic congestion and placed a tremendous premium on gates and landing "slots." These scarce commodities, according to economists, had become bottleneck facilities that interfered with competition. (99)

Degradation of service quality could arguably be attributed to deregulation's success, since total demand for air transportation had doubled since 1978. (100) The higher traffic volume, without a concomitant improvement in air-traffic control systems or airport capacity, caused all sorts of operating problems, especially delays, although safety, according to several studies, had not suffered. (101) Yet some service degradation did reflect the deregulated carriers' freedom of strategic choice. One major change was the sharp reduction of nonstop, point-to-point service. Frequency of flights, on the other hand, improved 14 percent overall between 1977 and 1984, and 20 to 30 percent in major cities. (102) Consumer complaints about lost baggage, crowding in reservation and ticketing services, overbooking and bumping, and inflight services increased dramatically for all airlines, but with a sizable differential across companies.

Overall measures of industry performance changed dramatically. Load factor, a basic measure of capacity utilization and the industry's perennial problem under regulation, had risen significantly since the early 1970s (see Figure 7). Labor productivity, in terms of available seat miles, had also improved by 3.8 percent annually since 1978. (103) On the other hand, financial results were dismal. Several major carriers experienced persistent losses, and four (Continental, Braniff, Frontier, and People) failed altogether. A few firms were reasonably profitable--most notably American and US AIR--but the average was very low. Total net income for the major carriers over the nine years since deregulation was about $750 million, on sales of $313 billion. Return on equity, which had averaged 1.3 percent from 1970 to 1977, fell to 0.1 percent. (104)

Contrived Competition

The evolution of domestic airline regulation, and then deregulation, can best be understood as a market-structuring process. It was initiated to prevent price competition from limiting the growth of large systems. Between the 1930s and the late 1970s, it shaped most of the market's important characteristics--entry, exit, pricing, distribution, route structure, and fleet. In this sense, the market became an artifact of policy that bore little resemblance of any natural economic or technological factors. This process, moreover, did not stop at the boundary of the firm. Regulation shaped the organizational resources of each airline, down to its operational core. This is clear in the case of American Airlines and is true, I think, for most companies in other regulated industries. Once regulation began to fail, or was perceived to fail, interest groups coalesced to provide the political pressure necessary for regulatory reform. Finally, deregulation allowed competition to reshape airline markets in dramatic new patterns.

By examining airline regulation from start to finish, in historical perspective, we can see these developments as a kind of dialectic between decentralized competitive forces and centralized administrative control. To understand and generalize on the causes and consequences of changing regulatory policy in the American context--to explain broad patterns of origination, effect, failure, and reform--we need to examine multiple factors and to accept complex relationships. The whole history of airline regulation, as well as that in other regulated industries, discredits monocausal theories from any individual academic discipline.

To explain the onset of economic regulation for airlines, and its subsequent removal, we need to look at five factors, or change drivers, that were evident in this history and that also apply to other regulated sectors: 1) changes in basic economic and political conditions; 2) technological developments; 3) new ideas about regulation's appropriateness and regulatory methods; 4) political entrepreneurship; and 5) regulatory failure.

The Great Depression was a sudden, seemingly inexplicable change in basic economic conditions that prompted a change in underlying political values and attitudes toward the role of government. Deflation and stagnation threatened to destroy the incipient passenger-airline business just as technological innovation (the DC-3 and other long-range, large-bodied aircraft) made passenger travel possible. Postal subsidies, meanwhile, and the existing form of federal regulation were inducing an unsustainable industry structure in which excess competition and below-cost entry were encouraged. Industry leaders, bureaucrats, and some legislators consequently came to believe that price and entry regulation by government was necessary to foster stable economic growth. And finally, Edgar Gorrell of the Air Transport Association mobilized the necessary political coalition to bring about the regulatory legislation.

Beginning in the late 1960s, the same factors were again at work. Basic macroeconomic conditions changed, from high real growth and low inflation to low growth and high inflation. Political values that traditionally supported regulation were eroded by the weak economic (and regulatory) performance and by extraordinary events in which government management appeared to fail. Technology contributed wide-bodied jets just when additional capacity was least needed. Regulators failed to address the accumulating problems effectively, resorting to irrational rate-of-return proceedings, capacity cartels, and a freeze on new route authorizations. Academic commentators had developed a regulatory critique, which gradually permeated the political establishment. And finally, in the mid-1970s, political entrepreneurs (Kennedy, Breyer, and Kahn) seized on the issue, helped crystallize an interest-group coalition that sought regulatory reform, and precipitated legislative change.

These same generic change drivers, though in different proportions, can account for the imposition and reform of economic regulation in most other areas of the American economy--in surface transportation, financial services, fossil fuels, and power generation. In all of these sectors, industry economics and technology underwent significant change in the early 1930s and the late 1960s. In both periods, existing forms of government intervention proved inadequate, and political coalitions emerged to bring about change. (105)

Historians and politicalscientists have focused on the causes of policy change, but they have often ignored the consequences of regulation for market structure, industry organization, and the behavior of the firm. In this article, I have tried to show how regulation shaped the airline industry according to government's evolving definition of the public interest, the methods and procedures of CAB regulation, and the continuing interaction of regulators and the firms in the industry. Thus, between 1938 and the late 1960s, the airline business developed as a network of point-to-point, nonstop routes (with aircraft fleets to match), with restricted entry and limited service competition, undifferentiated pricing, limited channels of distribution, and an inflated cost structure.

It is important and useful to see regulation in this light--as a market-shaping force--for several reasons. The responses of the firms and the market are, after all, the consequences of government intervention. If they seem to benefit the public interest, then they justify the regulation. If, however, they serve only a narrow, self-interested group--such as the regulated carriers or organized labor in this case--or if they impose significant inefficiencies or costs on the broader society, or if they create overwhelming asymmetries within the market, they will not remain economically or politically sustainable. Policy reform by legislators, adjustment by regulators, and effective management of the regulated firms all require a careful understanding of how regulation is shaping the market over time, and how those effects interact with technological developments and with the broader marcroeconomic context.

The final aspect of regulation that this analysis of airlines tries to illuminate is its relationship to the internal workings of the business firms that constitute the supply side of the market. A firm, as Oliver Williamson has suggested, is a set of transactions, or (potential) market relationships, collected together within an organization. Thus, the boundary between firm and market is, at most, semitransparent. (106) As regulation shapes markets, it shapes the inner workings of firms--their investment decisions and asset mix, the operating systems (route structure, in this case), pricing and distribution, and managerial and professional skills. At the onset of deregulation, American Airlines' route structure, marketing system, fleet, and costs were the product of regulation.

But of course, business organizations like American Airlines are much more than a set of transactions. They are human institutions, composed, as William Lazonick puts it, of "organizational resources." (107) These are not merely the specialized assets that economists think of, but primarily the collective skills of managers, professionals, and workers, together with operating and competitive knowledge imbedded throughout the organization--for example, in institutional arrangements, software, training programs, labor relationships, and traditions. In the airline industry, these resources were shaped by regulation, and they were initially ill-suited to unrestricted competition. Robert Crandall saw this; he understood the industry's underlying economics, recognized american's strengths and its weaknesses, and hastened to adapt his firm to the new circumstances. The history of American Airlines' response to deregulation shows how these organizational resources could be used to build a competitive advantage before other firms responded, and then used to redefine airline markets into oligopolistic patterns that economists had not anticipated. (108)

Taken as a whole, then, the airlines' regulatory experience--and I believe that of other regulated industries as well--provides a historical model of hos public policy changes, of how it affects markets, and of how business firms respond strategically, also shaping market outcomes. In the airlines, however, we can see the interaction of regulation with competition more clearly than in regulated industries like electric power or telecommunications, where natural monopolies prevailed. We might conclude from this history that regulated competition, at least in the american political and legal context, was a flawed concept. The idea that certain market characteristics could be shaped by government without affecting management's other prerogatives or inducing a distorted strategic response reflected a kind of hubris. Unlimited consequences abounded, eventually forcing structural adjustments, changes in policy, or both.

More than a decade after it began, airline deregulation is less than a total success. There are competitive bottlenecks (with gates, landing slots, and reservation systems), oligopolistic patterns of competition (for example, rising prices at dominant hubs), traffic congestion, and service problems. But costs are also lower and route structures more efficient; newer, safer aircraft are being financed with earned profits, and passengers generally have widespread choices of carriers and of pricing and service packages. Economies of scale and scope are better realized.

Competition scarcely appears more "perfect" in the airline industry than regulation; the problems are just different.

(1) Among the best studies by economists are Richard E. Caves, Air Transport and its Regulators: An Industry Study (Cambridge, Mass., 1962); Samuel B. Richmond, Regulation and Competition in air Transportation (New York, 1961); and William A. Jordan, Airline Regulation in America: Effects and Imperfections (Baltimore, Md., 1970); Alfred E. Kahn, The Economics of Regulation (New York, 1971), 2: 209-20.

(2) Samuel P. Huntington, "Clientalism: A Study in Administrative Politics" (Ph.D. diss., Harvard University, 1951); Marver H. Bernstein, Regulating Business by Independent Commission (Princeton, N. J., 1955); Emmette S. Redford, The Regulatory Process: With Illustrations from Commercial Aviation (Austin, Texas, 1969); Robert C. Fraser, Alan D. Donheiser, and Thomas G. Miller, Jr., Civil Aviation Development: A Policy and Operations Analysis (New York, 1972); David D. Lee, "Herbert Hoover and the Development of Commercial Aviation, 1921-1926," Business History Review 58 (Spring 1984): 78-84: Ellis Hawley, "Three Facets of Hooverian Associationalism: Lumber, Aviation, and Movies, 1921-1930," in Regulation in Perspective: Historical Essays, ed. Thomas K. McCraw (Boston, Mass., 1981), 95-123.

(3) Paul W. Cherington, Airline Price Policy: A Study of Domestic Airline Passenger Fares (Boston, Mass., 1958); Stanley C. Hollander, Passenger Transportation, Readings Selected from a Marketing Viewpoint (East Lansing, Mich., 1968); William Fruhan, The Fight for Competitive Advantage (Boston, Mass., 1972).

(4) Among the economic studies of deregulation are John Meyer, et al., Airline Deregulation: The Early Experience (Boston, Mass., 1981); John Meyer and Clinton Oster, Deregulation and the New Airline Entrepreneurs (Cambridge, Mass., 1984), and Deregulation and the Future of Intercity Passenger Travel (Cambridge, Mass., 1987); Elizabeth E. Bailey, David R, Graham, and Daniel P. Kaplan, Deregulating the Airlines (Cambridge, Mass., 1985); Elizabeth E. Bailey and Jeffrey R. Wiliams, "Sources of Rent in the Deregulated Airline Industry," Journal of Law and Economics 31 (April 1988): 173-202; Steve Morrison and Clifford Winston, The Economic Effects of Airline Deregulation (Washington, D.C., 1986); Robert J. Andriuliatis, et al., Deregulation and Airline Employment: Myth Versus Fact (Vancouver, B.C., 1987); and Michael E. Levine, "Airline Competition in Deregulated Markets: Theory, Firm Strategy, and Public Policy," Yale Journal of Regulation 4 (Spring 1987): 393-494. On the politics of deregulation, see Bradley Behrman, "Civil Aeronautics Board," in The Politics of Regulation, ed. James Q. Wilson (New York, 1980), 75-120; Stephen Breyer, Regulation and Its Reform (Cambridge, Mass., 1982); Thomas K. McCraw, Prophets of Regulation (Cambridge, Mass., 1984); Martha Derthick and Paul J. Quirk, The Politics of Deregulation (Washington, D.C., 1985); and Anthony E. Brown, The Politics of Airline Deregulation (Knoxville, Tenn., 1987).

(5) Lee, "Herbert Hoover and the Development of Commercial Aviation," 78-84.

(6) Paul T. David, The Economics of Air Mail Transportation (Washington, D.C., 1934); Francis A. Spencer, Air Mail Payment and the Government (Washington, D.C., 1941), 29-39; and Charles C. Rohlfing, National Regulation of Aeronautics (Philadelphia, Pa., 1931).

(7) J. Howard Hamstra, "Two Decades--Federal Regulation in Perspective," Journal of Air Law and Commerce 12 (April 1941): 108-14.

(8) Irving Glover, Second Assistant Postmaster, "Memorandum to the Postmaster General," 20 May 1930, reprinted in U.S. Congress, House, Committee on Post Office and Post Roads, Air Mail Hearings, 73d Cong., 2d sess., Feb.-March 1934, 227.

(9) Quoted in Robert J. Serling, Eagle: The Story of American Airlines (New York, 1985), 65.

(10) U.S. Congress, Senate, Committee on Post Office and Post Roads, Revisions of Air Mail Laws, 73d Cong., 2d sess., March 1934, 76-86.

(11) Franklin D. Roosevelt, Executive Order No. 6591, 9 Feb. 1934; also, U.S. Congress, Senate, Special Committee, Investigation of Air Mail and Ocean Mail Contracts, 73d Cong., 2d sess., parts 1-9, 1934.

(12) Public Law 308, 48 Stat. 933, 39 U.S.C. 463 (1034); Charles Rhyne, The Civil Aeronautics Act Annotated (Washington, D.C., 1939), 29-31.

(13) Federal Aviation Commission, "Report of the Federal Aviation Commission," Senate Document No. 15, 74th Cong., 1st sess., Jan. 1935, 52-53.

(14) U.S. Congress, House, Committee on Interstate and Foreign Commerce, To Create a Civil Aeronautics Authority, 75th Cong., 3d sess., March 1938, 38; and Edgar S. Gorrell, "Rationalization of Air Transport," An Address Presented at the Seventh Annual Convention of the National Association of Aviation Officials, 1-3 Dec. 1937, reprinted in Journal of Air Law 9 (1938): 43.

(15) The Roosevent administration preferred that all regulatory responsibilities for transportation be consolidated in a single agency--either the ICC or a new cabinet department. See Franklin D. Roosevelt, "Message of Transmittal," 31 Jan. 1935, in Federal Aviation Commission, Report, iii-iv; and, U.S. Congress, Senate, Subcommittee on S. 3659, Committee on Interstate Commerce, Civil Aviation and Air Transport, 75th Cong., 3d sess., April 1938, 1-2.

(16) The original (1938) act actually combined regulatory and developmental (air traffic control and safety) functions under the same administrative roof. But after just two years, Congress amended the act, restoring air traffic control and safety to the Commerce Department (and changing the name of the Civil Aeronautics Authority to the Civil Aeronautics Board); see Reorganization Act of 1940, 54 Stat. 735; also, U.S. Congress, House, House Report No. 2505, 76th cong., 3d sess., 1940.

(17) Civil Aeronautics Act of 1938, 52 Stat. 973; also, Rhyne, Civil Aeronautics Act Annotated.

(18) The board itself drew this distinction in Civil Aeronautics Board, "Acquisition of Marquette by TWA--Supplemental Opinion," 2 CAB 409 (1940), 411-13.

(19) Civil Aeronautics Board, Annual Reports, 1946-1949 (Washington, D.C.).

(20) Investigation of Nonscheduled Air Service, 6 CAB (1946), 1049; Large Irregular Carriers, Exemption, 11 CAB (1950), 609; U.S. Congress, Select Committee on Small Business, Future of Irregular Airlines in United States Air Transportation Industry, 83d Cong., 1st sess., 1953, and U.S. Congress, House Judiciary Committee, Report Pursuant to H. Res. 107 on Airlines, 85th Cong., 1st sess., 5 April 1957.

(21) Transcontinental and Western Air North-South California, 4 CAB 373 (1943), and Colonial Air et al., Atlantic Seaboard Op., 4 CAB 552, 555 (1943).

(22) In a 1947 case, for example, this ambivalance toward city-pair competition (among trunk carriers) was clear, as the examiner sought to distinguish "between the cut-throat, disruptive type of competition where the existing carrier is fighting for financial survival and the constructive kind of competitive service imposed to stimulate traffic, reduce costs, encourage better service, and otherwise promote the development of the industry"; see Civil Aeronautics Board, Docket No. 679, Detroit Washington Service Case, "Report of Examiner," 17 March 1947, 84.

(23) See for example, the President's Air Policy Commission, Survival in the Air Age (Washington, D.C., 1948); U.S. Congress, Congressional Aviation Policy Board, National Aviation Policy, 80th Cong., 2d sess.; and, James M. Landis, "Air Routes under the Civil Aeronautics Act," Journal of Air Law and Commerce 15 (Summer 1948): 299.

(24) Load factor dropped from 79 to 60 percent in two years; Civil Aeronautics Board, Annual Report, 1948, 3.

(25) Cherington, Airline Price Policy, 186-289.

(26) Civil Aeronautics Board, Docket No. 1102, Southern Service to the West, "Report of the Hearing Examiner," 21 June 1959, 99, and 12 CAB 518 (1951), 534.

(27) Ross Rizley, "Some Personal Reflections after Eight Months as Chairman of the Civil Aeronautics Board," An Address to the Enid Chamber of Commerce, Enid, Okla., 13 Nov. 1955, in Journal of Air Law and Commerce 22 (Autumn 1955): 445-52.

(28) Richmond, Regulation and Competition, 112-90.

(29) Caves, Air Transport, 307-13. Net investment, as of 1955, was reported as $1,239,305,000, in U.S. Congress, Antitrust Subcommittee, Report on Airlines, 18.

(30) Jordan, Airline Regulation in America, 62-65.

(31) Emmette S. Redford, The General Passenger Fare Investigation, Inter-University Case Program No. 56 (University, Ala., 1960), 43-44.

(32) This rapid turnover of aircraft, however, may not have been an unmixed benefit. Richard Caves pointed long ago to the fact that excessive equipment competition may have precluded some desirable utilization of older aircraft for lower fare service; see Caves, Air Transport and its Regulators, 241, and Kahn, Economics of Regulation, 2:213-14. On the re-equipment cycle, see Louis J. Hector, "Problems in Economic Regulation of Civil Aviation in the United States," an Address before the New York Society of Security Analysts, 28 Nov. 1958, in Journal of Air Law and Commerce 25 (1958): 101-7.

(33) Civil Aeronautics Board, Handblook of Airline Statistics, 1972, 464; 1978, 136.

(34) Civil aeronautics Board, Handbook of Airline Statistics, 1974, 134-35.

(35) Fruhan, The Fight for Competitive Advantage, 24.

(36) Ibid., 126-39.

(37) In these markets, load factor improved considerably, to the point where travelers actually complained of difficulties getting tickets. William A. Jordan, "Airline Capacity Agreements Correcting a Regulatory Imperfection," Journal of Air Law and Commerce 39 (1973): 184-86; U.S. Congress, Senate, Judiciary Committee, Subcommittee on Administrative Practices and Procedure, Civil Aeronautics Board Practices and Procedures--A Report, 94th Cong., 1st sess., Committee Print (Washington, D.C., 1975), 145-46. These capacity agreements were ruled unlawful in Civil Aeronautics Board, Docket No. 22908, Capacity Reduction Agreements Case, "Report of the Examiner," 18 Nov. 1974.

(38) Commissioner G. Joseph Minetti, quoted in U.S. Senate, CAB Practices and Procedure, 84-86.

(39) Jordan, "Airline Capacity Agreements," 203.

(40) The CAB's procedure and methodology had been subject to criticism since the late 1950s, when commissioner Louis Hector resigned and sent an open letter to President Eisenhower, criticizing the board's lack of rational criteria, policy flip-flopping through case-by-case, oral decisions, justified after the fact by written opinions; Louis J. Hector, "Problems of the CAB and the Independent Regulatory Agencies," A Memorandum to the President, 10 Sept. 1959. In the DPFI, the board adopted an elaborate new set of standards, including 1) determination of an industry-wide average cost; 2) a target load factor of 55 percent; 3) a 12 percent rate of return; 4) a rate structure based on mileage; 5) an assumed price elasticity of demand of -0.7 percent; and 6) an automatic quarterly process for reporting costs and calculating fare adjustments. See U.S. Congress, Senate, CAB Practices and Procedure, 109-13.

(41) For a detailed analysis of the theoretical literature that pertains to airline deregulation, see Jonathan L. Katz, "The Politics of Deregulation: The Case of the Civil Aeronautics Board" (Ph.D. Diss., Columbia University, 1985), chaps. 2 and 3.

(42) In addition to those previously cited, see John R. Meyer, et al., The Economics of Competition in the Transportation Industries (Cambridge, Mass., 1959); Michael E. Levine, "Is Regulation Necessary? California Air Transportation and National Regulatory Policy," in Yale Law Journal 74 (1965): 1416-47; Theodore E. Keeler, "Airline Regulation and Market Performance," Bell Journal of Economics and Management Science 3 (Autumn 1972): 399, George W. Douglas and James C. Miller III, Economic Regulation of Domestic Air Transport: Theory and Policy (Washington, D.C., 1974), and Paul MacAvoy and John W. Snow, Regulation of Passenger Fares and Competition among the Airlines (Washington, D.C., 1977).

(43) Derthick and Quirk, The Politics of Deregulation, 29-39.

(44) K. Harrigan and D. Kasper, Senator Kennedy and the CAB (Boston: Harvard Business School, Case No. 9-378-055, 1977).

(45) Breyer, Regulation and Its Reform, 321-22.

(46) Economic Report of the President, February 1975 (Washington, D.C., 1975), chap. 3.

(47) CAB Special Staff, Regulatory Reform: Report of the CAB Special Staff (Washington, D.C., 1975); also, 284-91.

(48) See U.S. Congress, Senate, Commerce Committee, Subcommittee on Aviation, Regulatory Reform in Air Transport, 94th Cong., 2d sess., April-June 1976, 827; and, U.S. Congress, Senate, Committee on Commerce, Science, and Transport, Subcommittee on Aviation, Regulatory Reform in Air Transportation, 95th Cong., 1st sess., March-April 1977.

(49) Regulatory Reform in Air Transportation, March-April 1977, 510.

(50) Rush Loving, Jr., "The Pros and Cons of Airline Deregulation," Fortune, Aug. 1977, 212; Robert Crandall, "Speech in Detroit," 28 May 1975, in Robert Crandall Papers at American Airlines, Dallas, Texas.

(51) McCraw, Prophets of Regulation, chap. 7.

(52) See especially, Civil Aeronautics Board, Docket 30277, Chicago-Midway Low Fare Route Proceeding, 12 July 1978; and CAB Order No. 38-7-40, 74.

(53) Robert Crandall, "Airline Regulation: Sense and Nonsense," Remarks before the Rotary Club of Tulsa, 12 July 1978; also, Alfred Kahn, "A Funny Thing Happened on the Way to Cincinnati," before the American Association of Airport Executives, Cincinnati, Ohio, 22 May 1978.

(54) Alfred Kahn, "The Uneasy Marriage of Regulation and Competition," Telematics 5 (Sept. 1984): 16. At the time, however, few advocates of deregulation had recognized the need for stricter antitrust enforcement. By the time of this aritcle, though, Kahn would warn that "the prevention of unfair competition is the proper job of the antitrust laws, not economic regulatory commissions."

(55) Certain regulatory functions involving customer services (baggage complains, bumping, and smoking), interline ticketing, and joint fares would devolve upon the Department of Transportation. U.S. Congress, House, Committee on Public Works, Legislative History of the Airline Deregulation Act of 1978, 96th Cong., 1st sess., 1978.

(56) Robert L. Crandall, "Opening Remarks, System Marketing Management Meeting," 2 April 1980, quoted in Richard Vietor, American Airlines (A) (Boston: HBS Case Services, Case No. 9-385-182, 1985), 1.

(57) Again, difficult macroeconomic conditions coincided with important changes within the industry. The second oil shock drove jet fuel prices from 40 to 90 cents a gallon--or to about 25 percent of operating costs. With inflation at 10.1 percent, wages per employee reached $26,691. As GNP growth turned negative (0.7 percent), airline traffic fell 4 percent. (American's traffic dropped 15 percent from a 1979 level inflated by United's strike.)

(58) The economist James McKie used the "tarbaby" metaphor to describe the spread of economic regulation across market segments and functions; James McKie, "Regulation and the Free Market: The Problems of Boundaries," Bell Journal of Economics 1 (1970): 6-26.

(59) Office of Economic Analysis, Civil Aeronautics Board, Competition and the Airlines: An Evaluation of Deregulation (Washington, D.C., 1982), 22.

(60) Ibid., 108.

(61) Thomas Plaskett (vice-president of marketing, American Airlines), "Address to American Airlines Marketing Meeting," Spring 1981, 31.

(62) Salomon Brothers, Industry Analysis, 31 May 1983, 6.

(63) Morrison and Winston, Economic Effects of Airline Deregulation, 7; and Levine, "Airline Competition in Deregulated Markets," 413.

(64) CAB, Office of Economic Analysis< Competition and the Airlines, 49.

(65) Robert L> Crandall, "Remarks Before the 33rd Annual Conference of Airport Operators Council International," Mexico City, 30 Sept. 1980, 8.

(66) American Airlines, "Market Activity Report, 1980"; and Merrill Lynch, Airline Industry Annual Financial Statistics, December 1982.

(67) Serling, Eagle: The Story of American Airlines.

(68) Albert Casey, retired CEO, American Airlines, interview with author, 1 April 1987.

(69) Duncan Copeland, "Information Technology for First-Mover Advantage: he U.S. Airline Experience" (D.B.A. diss., Harvard Business School, 1990).

(70) Duncan Copeland, "Evolution of Airline Reservation Systems: 1945-1985," working paper, Harvard Business School, Boston, Mass., 1988).

(71) American Airlines, "Profit Improvement Plan" (a slide presentation), 1980.

(72) Wesley G. Kaldahl, "Address to a Lenders Meeting," 4 May 1982.

(73) American Airlines, "The Dallas/Ft. Worth Connecting Complex," 20 Jan. 1982.

(74) Wesley G. Kaldahl, "Presentation to Airline Analysts," 2 July 1985, 7.

(75) Thomas G. Plaskett, vice-president, marketing, American Airlines, interview with the author, Aug. 1984; and Plaskett, "American Airlines Marketing Meeting," 24.

(76) Discount pricing across broad categories of passengers, which was sometimes forced by the "no-frills" discount carriers, was devastating to the profitability of high-cost carriers like American. In the spring of 1982, before American's strategy was fully implemented, Braniff suddenly shifted strategies after its rapid expansion as a full-service carrier proved unsustainable. Howard Putnam, who had been the president of Southwest Airlines, tried to save Braniff with a low-fare strategy--especially on routes in the Southwest and Midwest where it competed with American. In a moment of poor judgment, Robert Crandall allegedly telephoned Putnam and urged him to end the price war by raising prices 30 percent. Putnam made a tape recording of the conversation and gave it to the Justice Department. Crandall eventually settled the resulting suit by a consent decree, in which he agreed not to discuss pricing with other airline executives; Business Week, 5 Aug. 1985, 92.

(77) United Airlines v. Civil Aeronautics Board, 766 F.2d 1107, 1109 (7th Cir. 1985).

(78) Robert L. Crandall, interview with the author, August 1984; and interview with Judith Leff, September 1987; also, C. A Pasciuto, vice-president of employee relations, American Airlines, "Remarks Before Western Railroad Association," 28 April 1983.

(79) The "two-tier pay scale," as American takes pains to explain, is not a phrase coined by the company. Indeed, management did not initially see the "B" rate as a separate wage system. Rather, it was a front-end adjustment to lower costs of new employees. The same applied to flight attendants; it was a temporary measure, scheduled to reconvenge with the "A" scale after several years, and disappear altogether after nine years. With the pilots, American made a commitment to recall more than 500 already on furlough, but at 15 percent less than they were making before, the five years. American's management hoped that these temporary differentials would make American more competitive until its operating costs came down and its low-cost competitors accrued their own seniority and overhead costs. From the union's perspective, this temporary concession was the least unattractive means of protecting oldtimers from the cutbacks and benefit losses that deregulation made ineviatable.

(80) American Airlines, "The Plan for Achieving Union Productivity Improvements," early 1982; and, "A Blueprint for the Future . . .," American Airlines' Proposal to the Transport Workers Union, 1982.

(81) American Airlines, "Fleet and Route Planning Issues," mid-1984.

(82) American Airlines, "American's Planned North/South Hubs," Presentation to the Board of Directors, 17 July 1985.

(83) American did enter Europe in 1987, and it continued to expand as rapidly as it could acquire routes. But the new small hubs did not prove to be useful as gateways; Bridget O'Brian, "American Air Expands into Three Continents, Flexing Its U.S. Muscle," Wall Street Journal, 8 June 1990, 1, A4.

(84) Bailey and Williams, "Sources of Rent in the Deregulated Airlined Industry," 173-202.

(85) US AIR and Piedmont combined, and then acquired Pacific Southwest Air, to form a new national carrier by 1989. Half a dozen other small regional carriers did remain independent, serving small geographic niches in which the national carriers were not interested. These include Air Wisconsin, Alaska Air, Aloha, American West, Jet America, and Midway.

(86) M. Weinberg, Continental Airlines (A) (Boston: HBS Case Services No. 9-385-006, 1984); and, "House of Mirrors," Wall Street Journal, 7 April 1988, 1.

(87) Clinton V. Oster, Jr., and Don H. Pickrell, "Marketing Alliances and Competitive Strategy in the Airline Industry," Logistics and Transportation Review 22 (1986): 371-87; also, "Major U.S. airlines Rapidly Gain Control Over Regional Lines," Wall Street Journal, 17 Feb. 1988.

(88) "Texas Air's Hard Bargainer," New York Times, 16 Sept. 1986.

(89) Elizabeth E. Bailey and John C. Panzar, "The Contestability of Airline Markets during the Transition to Deregulation," Law and Contemporary Problems 44 (Winter 1981): 809-22; and William J. Baumol, John C. Panzar, and Robert D. Willig, Contestable Markets and the Theory of Industry Structure (New York, 1982).

(90) Bailey, Graham, and Kaplan, Deregulating the Airlines: also, for a good review of the revisionist literature, see Dipendra Sinha, "The Theory of Contestable Markets and U.S. Airline Deregulation: A Survey," Logistics and Transportation Review 22 (1987): 405-19.

(91) Don Carty, quoted in "A pact that will help American become a low-cost airline," Business Week, 28 Nov. 1983, 41.

(92) Meyer and Oster, Jr., Deregulation and the Future of Intercity Passenger Travel, 110.

(93) "Assessing the Effects of Airline Deregulation," New York Times, 20 March 1988.

(94) See Cherington, Airline Price Policy, 186-289.

(95) By 1985, travel agents accounted for 57 percent of all airline tickets sold; United Airlines v. Aeronautics Board, 766 F.2d 1107, 1109 (7th Cir. 1985); also, Civil Aeronautics Board, Investigation into the Competitive Marketing of Air Transportation, Order 82-12-85 (Washington, D.C., 1984), and U.S. Congress, Senate, Committee on Commerce, Subcommittee on Aviation, Computer Reservation Systems, 99th Cong., 1st sess., 19 March 1985.

(96) James Blumestock and Evelyn Thomchick, "Deregulation and Airline Labor Relations," Logistics and Transportation Review 22 (1986): 389-403; also, Meyer and Oster, Deregulation and the Future of Intercity Passenger Travel, 83-107. However, a study by Canadian economists indicates that "since deregulation, the growth rate of compensation in the U.S. airline industry exceeds that of the transport/utility sector of the economy and nearly matches that of the U.S. business sector"; Andriuliatis, et al., Deregulation and Airline Employment, 27, 31-32.

(97) New York Times, 20 March 1988.

(98) Bailey and Williams, "Sources of Rent," and David K. Massey, "Hub Strategies," Airline Executive, June 1987, 37-41. In commenting on this point, however, Meyer suggested that the prospect of point-to-point hub overflights with appropriate new aircraft, like 757s, 767s, and 737-300s, may partially undermine hub dominance.

(99) Prosposed solutions, such as sale or auction of slots, were second-best, since dominant firms had the deepest pockets. Not surprisingly, Robert Crandall was a vocal advocate of a market for peak-hour slots. Lawrence T. Phillips, "Structural Change in the Airline Industry: Carrier Concentration at Large Hub Airports and its Implications for Competitive Behavior," Transportation Journal 25 (Winter 1985): 18-28; and Robert Crandall, interivew, March 1987.

(100) Revenue-passenger miles grew 7.6 percent annually between 1968 and 1978, and 8.7 percent from 1978 to 1987; Merrill Lynch, Airline Industry, Nov. 1985, and Department of Transportation, Air Carrier Monthly Traffic Statistics, June 1987.

(101) In 1986, the number of federal controllers was down to 22,000, from 27,000 before the PATCO strike in 1981. By 1987, the number of departures handled per controller had risen by 52 percent. While the incidence of near-collisions had increased, most other safety measures had improved because of continuing advances in avionics; see, Federal Trade Commission, Bureau of Economics, The Deregulated Airline Industry: A Review of the Evidence (Washington, D.C., Jan. 1988), 76-77.

(102) FTC, The Deregulated Airline Industry, 61-83; also, Morrison and Winston, The Economics of Airline Deregulation, 25-47.

(103) Congressional Budget Office, Policies for the Deregulated Airline Industry (Washington, D.C., 1988), 4.

(104) Alfred Kahn, "Airline Deregulation-A Mixed Bag, But a Clear Success Nevertheless," Transportation Law Journal 16 (1988): 248-49 and footnote 58.

(105) For a comparison across several industries, see Richard Vietor, "Regulation and Competition in America, 1920s-1980s," in Governments, Industries and Markets, ed. Martin Chick (London, 1990), 10-35.

(106) Oliver E. Williamson, The Economic Institutions of Capitalism (New York, 1985).

(107) William Lazonick, Competitive Advantage on the Shop Floor (Cambridge, Mass., 1990), and Business Organization and the Myth of the Market Economy (forthcoming).

(108) This point is acknowledged, and throughtfully discussed, in Michael Levine, "Airline Competition," 393-417.

RICHARD H. K. VIETOR is professor of business administration at the Harvard Business School.
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