Professor Dr. Christopher Brown

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“Old regime” economic regulation of the airline industry
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Airline deregulation: Assessing the outcome
“Old regime” economic regulation of electric utilities.
 Electric utility deregulation: Assessing the outcome

•High fixed cost
•Low (negligible) marginal cost of serving passengers
•“Load factors” are critical
•Long-haul economies
•Powerful unions of pilots and machinists
•Sophisticated systems of price discrimination or “yield management”
•Control of gates and take-off and landing rights at airports by large carriers blockades entry of new carriers at major airports (LAX, Chicago, Atlanta, for example).

Passenger Miles (PMs) = Passengers

Miles Traveled
$/PM
Cost per passenger mile
Flight profitability partly depends on:
•Number of passengers (load factor)
•Distance of flight
0
PMs

1938 Civil Aeronautics Act
The Civil Aeronautics Board (CAB) created to: (1) promote airline safety; (2) to insure the industry operates in an economically sound fashion; and (3) to allow for the adaptation of the airline system to the commercial, postal, and defense needs of the country.

The CAB determined that its primary objective should be to insure that “economical” air service would be widely available.

 Fares set by a formula developed by the CAB that raised fares substantially above costs on medium and long haul trips and below costs for short haul trips.
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Carriers could not enter or exit specific routes.
High profits earned on “prime” routes subsidized losses sustained on undesirable routes.

High load factor, long distance
Low load factor, short distance
Fargo
Omaha
Chicago
Dallas

The 1971-96 is called the "era of deregulation" because of the major deregulatory initiatives passed— e.g., the abolition of fixed brokerage fees by the SEC in
1975, the Motor Carrier Reform
Act of 1980, and the
Telecommunications Act of 1996.
For an overview see Clifford Winston, "Economic Deregulation: Days of
Reckoning for Microeconomists," Journal of Economic Literature , September
1993:1263-1289.

•Professor Stigler’s “capture theory” of regulation
•Professor Peltzman’s “political theory” of regulation
•The Averch-Johnson effect

•Since 1982 entry has been granted on all interstate routes to carriers that are "fit, willing, and able."
•All restrictions on fares lifted in 1983.
• The CAB is defunct.

Laramie
Col.
Springs
Denver
OK City
Hub and
Spoke system
Lubbock
Dallas

•Cheap fares on flights between hub airports (Dallas to
Denver, Atlanta to Chicago, New York to LA).
•Expensive fares for service between (non-hub) cities linked to different hub airports.
•“Window of opportunity” for the “no frills” discount carriers such as Southwest Airlines, AirTran, and US
West.

Assessing Airline Deregulation
Criterion
Overall fares
Dispersion of fares (price discrimination)
Travel time
Service frequency
Load factors
Safety
Service quality
Travel restrictions
Working conditions
Very good
Bad
Mixed results
Good
Good
No difference
Bad
Bad
Bad

Morrison and
Winston estimate benefits (lower fares) from airline deregulation exceed
$20 billion per year.
Peltzman, S. and Winston, C., editors. Deregulation of
Network Industries: What’s Next?
(AEI-Brookings Joint
Center for Regulatory Studies, 2000), p. 2

Consider United Airlines Flight
815 from Chicago to LA on October
31, 1997
1
•There were 27 different one-way fares, ranging from
$1,248 for a first class ticket purchased the day of the flight to $87 for an advance purchase coach ticket.
•Some travelers cashed in frequent flier miles.
•Some qualified for senior citizen discounts.
•Some passengers traveled on restricted tickets that required Saturday stayovers.
1 ”So, How much did you pay for your ticket,” New York Times, April 12,
1998

•American Airlines
•United Airlines
•U.S. Air
•National Airlines
•Midway Airlines
•Pan American Airlines
•Trans World Airlines
•People’s Express
•Eastern Airlines

Generation
Transmission Distribution

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Vertically-integrated power companies enjoy regional monopolies but are subject to regulation by state commissions.
State commissions use the “revenue requirement” model to establish electricity rates.
Regulated utilities subject to minimum capacity requirements.

Revenue Requirement Model
RR

( RB
 r )

E
RR is the “revenue requirement”
RB is the rate base —an estimate of the value of owners’ investment in the regulated firm.
r is the “allowed rate of return” to owners’ investment.
E is expenses (fuel, wages, etc.)

Electric deregulation is really about the vertical separation of the three stages of production —or the creation of a multi-market industry .

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Formerly integrated utility giants (Cal. Edison, Pacific Gas &
Electric) retain distribution monopoly but required to sell off generating and transmission assets.
Utility companies get $28 billion in “stranded costs” financed by a “competitive transition fee.”
Distribution monopolists subject to rate regulation by California
Public Service Commission
Distribution companies must purchase power “spot” on the
“power exchange”— no forward contracts allowed .
Independent system operator (ISO) created to manage transmission.
Generation transformed into a competitive industry

•Operates the transmission grid
•Power generators have access to the grid on equal terms.
•Subject to regulation by California Public
Service Commission and FERC

Average Retail Electricity Prices in California
(cents per kilowatt hour)
1994 10.23
1995 9.94
1996 9.98
1997 10.06
1998 10.09
1999 10.11
2000 10.42
2001 13.30
2002 13.41
2003 13.92
First year under new regime
Source: California Energy Commission

Important aspects of electricity
Energy “speculators”
(several employed by
Enron) took advantage of these unique aspects of electricity and
“rigged” the wholesale market.
•Inelastic demand
•Non-storable
•Capacity limits on transmission