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

Professor Dr. Christopher Brown

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

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).

Passenger Miles (PMs) = Passengers Miles Traveled

$/PM

PMs0

Cost per passenger mile

Flight profitability partly depends on:

•Number of passengers (load factor)

•Distance of flight

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.

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

available.

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.

Chicago

Dallas

Omaha

Fargo

High load factor, long distance

Low load factor, short distance

Deregulation

For an overview see Clifford Winston, "Economic Deregulation: Days of Reckoning for Microeconomists," Journal of Economic Literature, September 1993:1263-1289.

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.

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

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.

DallasLubbock

OK City

DenverCol. Springs

Laramie

Hub and Spoke system

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.

Assessing Airline DeregulationCriterion

Overall fares Very good

Dispersion of fares (price discrimination)

Bad

Travel time Mixed results

Service frequency Good

Load factors Good

Safety No difference

Service quality Bad

Travel restrictions Bad

Working conditions 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

Airline ticket pricingConsider 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

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

Structure of the Electric Utility Industry

GenerationDistributionTransmission

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.

Revenue Requirement Model

ErRBRR )(

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.

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

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

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

Average Retail Electricity Prices in California (cents per kilowatt hour)

Source: California Energy Commission

                                                                                                           

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