A small number of intercontinental carriers recaptured control of industry oversight in Washington and Brussels to convert the world’s most important markets from robust competition to a permanent oligopoly of Too Big To Fail airlines. Part 2 of a series of 4.
As discussed in Part One of this series, there is serious doubt as to whether a stable, efficient and competitive private sector airline industry could possibly emerge from the staggering post-coronavirus demand collapse.
Starting in 2004, a small number of intercontinental carriers led a carefully orchestrated program to recapture control of industry oversight in Washington and Brussels, reversed thirty years of successful pro-consumer and pro-competitive aviation policies, and converted the world’s most important markets from robust competition to a permanent oligopoly/cartel of Too Big To Fail airlines.
That consolidation movement undermined many of the mechanisms that had allowed the industry to restructure after past crises, and it is difficult to see how those mechanisms could rapidly be restored in order to help cope with today’s much larger crisis.
The 1930s-1980s regulatory capture
In the 1930s, strict economic regulatory controls over airlines were established because airline technology and economics were extremely immature. Decades of regulatory protections were clearly needed to nurture an industry whose huge economic potential was still far into the future. The Civil Aeronautics Board (CAB) began managing US airline competition in 1933.
The CAB segregated markets between those served by large trunk carriers (e.g. United, Eastern), the Local Service carriers using DC-3s to feed smaller cities to the trunk carriers, and international “flag carriers.” The trunk carriers were viewed as having the greatest potential to someday become standalone commercial enterprises, but the system required elaborate cross-subsidies to ensure the politically required national network coverage.
While historically, the overwhelming majority of US airline service was domestic, outside the U.S., it was international. Governments worked hand-in-hand with their designated “flag carrier” (e.g. BOAC, Air France and Alitalia) who was usually state owned and the long-term nurturing of aviation was primarily seen as a means of advancing national trade and development policy, and not in terms of developing a future private sector industry.
The 1947 Chicago Convention established a system whereby every international market depended on bilateral treaties where the most protective government could dictate limits on competition.
The focus of the very different US and non-US systems both morphed from nurturing industry technology/economic development to cartel management, focusing more on the near-term interests of the largest, most politically organized incumbents than on longer-term industry or consumer interests. There was no mechanism that could override the interests of carriers benefiting from protections in order to force the overall industry efficiency improvements that would permit increased service and lower prices.
A prominent regulatory history summarized the US shift to incumbent protection:
“Clearly, in passing the Civil Aeronautics Act [of 1938], Congress intended to bring stability to airlines. What is not clear is whether the legislature intended to cartelize the industry. Yet this did happen. During the [next] forty years ….the overall effect of board policies tended to freeze the industry more or less in its configuration of 1938. One policy, for example, forbade price competition. […]Charged by Congress with the duty of ascertaining whether or not ‘the public interest, convenience, and necessity’ mandated that new carriers should receive a certificate to operate, the board often ruled simply that no applicant met these tests. In fact, over the entire history of the CAB, no new trunkline carrier had been permitted to join the sixteen that existed in 1938. And those sixteen, later reduced to ten by a series of mergers, still dominated the industry in the 1970s. All these companies… developed into large companies under the protective wing of the CAB. None wanted deregulation.”
The primary beneficiaries in the US were the large trunk carriers whose “government affairs” investments (backroom negotiations with CAB staff, Congressional lobbying) had given them exclusive access to the most lucrative routes, blocked the efforts of Local Service carriers to establish more efficient networks, and prevented charter carriers from selling low price tickets to individual travelers.
CAB authorized price and capacity levels were designed to ensure that even the most mediocre airline could survive and the CAB engineered mergers to salvage airlines that failed to achieve mediocrity. Much of the early economic literature on “regulatory capture” used the CAB as a prime example of how regulators could become more responsive to larger, politically adept incumbents than to their obligations to the general public interest.
1970Ss US deregulation/liberalization
1970s academic critiques of New Deal-era regulatory regimes only gained political traction in the field of transportation. Simple examples existed, for both airlines and other modes, of how the economic logic behind the original legislation had become obsolete, how regulators were no longer attentive to the broader public interest, and how regulatory actions were directly harming economic welfare.
Critiques of the CAB noted that regulatory approaches established in the DC-3 and DC-6 eras were still being used well after the second generation of jets (e.g. 737s and 747s) had dramatically improved efficiency, and created a true mass market for air travel. Why was the CAB hurting consumers by demanding that United and Western charge $35 for Los Angeles-San Francisco tickets, when PSA could profitably operate with $19 fares?
The US airline deregulation legislation of the late 70s that emerged after extensive Congressional review was designed to directly address the regulatory capture problem. The objective of government oversight shifted from protecting the short-term financial interests of incumbent carriers to protecting the public’s longer-term interest in dynamic, level-playing-field competition.
Level-playing field competition was seen as critical to driving ongoing innovations that would in turn increase overall industry efficiency and consumer welfare.
Antitrust rules were still seen as critical to protecting competition. “In enacting the Airline Deregulation Act, Congress directed that control of the air transportation system be returned to the marketplace. We have consistently held that a part of the return to market control is exposure of participants to the antitrust laws, as that exposure exists in unregulated industries” 
The CAB’s artificial rules limiting the use of integrated commuter airline feed and preventing “Local Service” carriers from developing hubs or operating longhaul routes that had been reserved for “Trunk” carriers quickly broke down,  and the two categories melded into what became known as the “Legacy US hub” business model.
Meanwhile in Europe
In Europe, there was growing recognition that flag carriers’ regulatory capture of each country’s industry oversight contradicted the principles that became embodied in the Single European Act of 1986. But neither Brussels nor national governments did anything to change the political position of these highly visible “national champions.”
Similar to the US convergence around the “Legacy US hub” model, these flag carriers converged around the “intercontinental hub” model; every flag carrier hub in Europe (Amsterdam, Zurich, Rome, Brussels, Vienna, etc.) became a smaller version of the industry leader (Lufthansa’s hub in Frankfurt).
While over half the passengers at these hubs were taking intercontinental trips, they also served a variety of regional and domestic markets. The EU recognized the consumer benefits created by US deregulation but the increased pricing and market entry freedoms it introduced were limited to shorthaul, intra-European markets.
“Deregulation” was always a misnomer, and the EU’s approach was correctly labeled “liberalization”. Governments were not abandoning industry oversight. A government policy that its industry oversight should try to maximize long-run competition and consumer welfare instead of short-term incumbent profitability is still a government policy. In addition to antitrust, regulations regarding safety (pilot training, maintenance, aircraft licensing) financial integrity and reporting, and consumer and labor protections remained fully in place. New entry was allowed, but entrants had to meet those stringent safety and financial standards. It was only after the economic and popular success of U.S. airline “deregulation” reforms that the term was repurposed as a branding for much more radical reductions in government oversight of the financial industry.
A full accounting of 1970s/80s US/EU airline “deregulation”/liberalization is not possible here. While there were numerous shortcomings, I would argue that it achieved the vast majority of its primary objectives and was one of the most successful 20th Century U.S. public policy initiatives focused on improving the efficiency of a major industry. It was implemented after an exhaustive and transparent public debate, based on detailed analysis of industry economics, involving all important stakeholders, and support from a wide variety of political interests.
Congress passed public laws codifying its major objectives and rules. It led to major improvements in industry efficiency and profitability, and many of these benefits were passed on to consumers (increased service at lower prices) and workers (increased employment). Carriers certainly pursued a lot of ideas that hindsight demonstrated to be foolish and uneconomical. But because there was robust competition among a large set of competitors the worse-run airlines could not hide behind regulatory or other artificial protections.
I would also argue the biggest impact of deregulation/liberalization was that the industry didn’t just achieve a one-time service/efficiency boost from eliminating regulatory distortions but became much more dynamic over time. The industry became capable of faster growth, and demonstrated it could better withstand fuel shocks and cyclical downturns.
Prior to the 1970s/80s, most airline productivity gains originated outside the airlines, primarily from improved aircraft/engine technology, but also public investment in airport and air traffic control infrastructure. Increased competition forced airlines to become much more innovative. After deregulation, carriers aggressively restructured in order to fully exploit hub network efficiencies. Hubs established before deregulation (Atlanta, Chicago, Dallas-Ft. Worth) became much bigger and more efficient. New marketing freedoms led to the development of extremely sophisticated pricing and revenue management systems and customer loyalty (frequent flyer) programs.
An even bigger post-deregulation innovation was the development of the “low-cost-carrier” model. This had been originally pioneered by PSA and Southwest on intrastate routes exempt from CAB restrictions, but was finally able to demonstrate its value nationwide in the 80s. The new LCC model drove major industry growth by offering very low fares in high-volume point-to-point markets using simplified, better utilized fleets and avoiding high cost hubs. In Europe, a different type of “low-cost-carrier” sector emerged combining new startups such as Ryanair (founded 1984), and airlines that had originated (due to previous regulatory limits) as tour-package charter operators.
A two-tier industry
The separate 1930s-1970s American and European regulatory regimes had inadvertently dictated that all Legacy carriers follow a “one-size-fits all” business model. Both models were clearly the most efficient way to serve the majority of traffic, especially in smaller markets which needed hubs and complex fleets. But they were not an efficient way to serve high-volume point-to-point markets. With the historic regulatory straitjacket removed, the industry structure in both America and Europe quickly bifurcated into a mixture of point-to-point low-cost carriers (LCC) and traditional Legacy (pre-deregulation) hub airlines.
As Exhibit 2 illustrates, the widespread perception that “deregulation”/liberalization had unleashed a torrent of new competition is highly misleading. Essentially all of the new competition in the industry after 1980 came from shorthaul/narrowbody airlines. The success of Southwest and Ryanair and the vastly reduced entry barriers in shorthaul markets unleashed a wave of new startups in America and Europe. Other variations of the non-hub, point-to-point “LCC” model were introduced in rapidly growing markets around the world.
Government favoritism towards their “national champions,” entry barriers and protective bilaterals ensured that the number of intercontinental competitors remained absolutely flat. These markets remained competitive stagnant even though these markets enjoyed much stronger underlying demand growth (from increasing and global trade, labor movements and tourism) and efficiency gains (from newer longhaul aircraft including 330s, 777s, 787s).
The Open-Skies Treaties
Two-tier airline competition (shorthaul dynamic, intercontinental stagnant) remained in place despite Washington’s desire to extend domestic level-playing field competition to international markets The first major breakthrough did not occur until 1993, using the combination of the first collusive alliance (Northwest-KLM) and the original US-Netherlands “Open Skies” treaty.
The 1990s collusive alliances were an innovative solution to the problem of poor service and high fares in small secondary North Atlantic markets that neither a US airline nor a European airline could economically serve with its own aircraft.
European carriers could feed markets across Europe through their hubs to large US cities, and the smaller carriers could only economically serve the very largest cities (New York, Chicago, Los Angeles). US carriers could feed passengers from across America, but were similarly limited to flights to London, Paris and Frankfurt.
With antitrust immunity, Northwest and KLM could offer superior schedules and a full range of discount fares to passengers not previously served by any single carrier’s online service.
These were largely double connect markets (e.g. St. Louis to Stuttgart via Detroit and Amsterdam) where the only available services were interline connections with long layovers and higher fares. The markets that had lacked single-carrier service were individually small, but accounted for over 30% of the total US-Europe market.
The success of the KLM-Northwest efforts led a number of other European countries to abandon protective bilaterals and sign “Open Skies” agreements. In 1995, Delta established a similar collusive alliance with Swissair and Sabena and in 1997 United joined forces with Lufthansa and SAS.
The full consumer and industry benefits of collusive alliances had been fully realized by the end of the 90s when previously interline trips had completely shifted to superior single carrier and alliance alternatives. None of these airlines attempted to introduce this type of collusive alliance in the 1990s to transpacific or other international markets, because the problem they fixed were only found on the North Atlantic.
The original “Open Skies” treaties laid out strictly defined requirements that applicants for antitrust immunity had to meet. These including case-specific evidence that the immunity grant not only met Clayton Act tests showing that markets were fully contestable and that market power would not increase but was “required by the public interest” in order “to achieve important public benefits” that could not be created otherwise and would outweigh the risks of reduced competition.
In the case of the original 90s collusive alliances those tests were clearly met.  As noted, antitrust immunity grants reduce competition just as a full merger would have, but the original three collusive alliances had only minor impacts on market concentration, grew on the basis of verifiable service/efficiency improvements, and (as Exhibit 3 illustrates) succeeded in an environment that remained robustly competitive. Combined, these three alliances only operated 42% of North Atlantic capacity and reduced average North Atlantic fares by 8% while capacity increased 54% (4.4% per year).
Non-alliance carriers continued to focus on very large local markets (British Airways at London, Air France at Paris, Continental in New York) while the alliance carriers exploited their advantages in connecting markets.
|Concentration of US-Continental Europe||top 3||41%||55%||67%||97%|
|market (40 million annual pax)||top 5||59%||69%||80%||99%|
|Concentration of total North Atlantic||top 3||42%||48%||54%||96%|
|market (55 million annual pax)||top 5||56%||66%||73%||99%|
|Collusive Alliance Share||0%||42%||48%||96%|
|North Atlantic competitors with||>4%||10||8||8||3|
|capacity share of at least||>2%||15||10||9||3|
As Exhibit 3 also illustrates, the competitive impact of the DOT’s later (post-2004) antitrust immunity grants would be dramatically different. After the turn of the century, the successful policies focused on preventing regulatory capture and protecting level-playing field competition and maximizing consumer welfare were completely reversed.
This radical consolidation destroyed the resilience the industry needed to cope with challenges much smaller than coronavirus. The effective recapture of government oversight by the powerful oligopoly carriers and the elimination of policies designed to protect competition and consumer welfare created a huge obstacle to establishing a post-coronavirus industry that can efficiently serve the overall public interest.