Economic Regulation and Deregulation in the U.S.A.: Airlines, Electric Utilities

1. Economic Regulation and Deregulation in the U.S.A.: Airlines, Electric Utilities Professor Dr. Christopher Brown

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

3. Economics of the Airline Industry • 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).

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

5. Civil Aeronautics Board (CAB) 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.

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

7. Airline Regulation under the CAB • 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. • Carriers could not enter or exit specific routes. • High profits earned on “prime” routes subsidized losses sustained on undesirable routes.

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

9. Deregulation 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.

10. If economic regulation can improve social welfare, why deregulate? • Professor Stigler’s “capture theory” of regulation • Professor Peltzman’s “political theory” of regulation • The Averch-Johnson effect

11. The Airline Deregulation Act of 1978 • 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.

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

13. Effects of the Hub and Spoke System • 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.

14. Assessing Airline Deregulation

15. 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

16. Airline ticket pricing • Consider United Airlines Flight 815 from Chicago to LA on October 31, 19971 • 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

17. Airline Bankruptcies(partial list) • American Airlines • United Airlines • U.S. Air • National Airlines • Midway Airlines • Pan American Airlines • Trans World Airlines • People’s Express • Eastern Airlines

18. Structure of the Electric Utility Industry Generation Distribution Transmission

19. Features of “Old Style” Utility Regulation • 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.

20. Revenue Requirement Model 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.)

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

23. Deregulation California Style • 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

24. Independent System Operator (ISO) • Operates the transmission grid • Power generators have access to the grid on equal terms. • Subject to regulation by California Public Service Commission and FERC

25. Average Retail Electricity Prices in California (cents per kilowatt hour) First year under new regime Source: California Energy Commission

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