The Fare Skies: Air Transportation and Middle America

When Congress and the Civil Aeronautics Board deregulated the nation's airlines in a series of steps during the late 1970s, policymakers expected travelers' fares to fall, but were apprehensive that small communities would lose airline service as deregulation reshaped the air travel market. Congress was sufficiently concerned that it set up the Essential Air Service Program to provide subsidies to carriers to ensure at least two flights a day for 150 small communities.

Every serious study of airline deregulation in the intervening years has found that travelers have indeed benefited enormously. As we documented in our 1995 Brookings book,

The Evolution of the Airline Industry

, airfares, adjusted for inflation, fell 33 percent between 1976—just before the CAB instigated regulatory reforms—and 1993. Deregulation was directly responsible for at least 60 percent of the decline—responsible, that is, for a 20 percent drop in fares. And travelers have benefited not only from low fares, but from better service, particularly increased flight frequency.

Still, policymakers have kept a vigilant eye on air carriers and registered their concern whenever it appeared that some travelers were being treated unfairly. Today, there is a growing sense, spurred by the anecdotes of many travelers, that America's smaller cities are indeed being shortchanged by deregulation. Flights between smaller cities, it is charged, have higher fares than flights of comparable distances between large cities. Some members of Congress have publicly questioned the fairness and even the wisdom of deregulation. It is a matter that bears looking into.

Fares and Route Classifications

The Federal Aviation Administration categorizes U.S. airports as large hubs, medium hubs, small hubs, and nonhubs (generally speaking, the categories simply suggest the relative size of the cities where the airports are located). We use the FAA's categories to classify airline routes into a hub class based on the airports involved. Thus, a flight between a large hub and a small hub would be classified as a large hub route and a small hub route. An examination of fare and service patterns for all hub types from 1977 (the year before formal deregulation in 1978) through 1996 shows how deregulation has affected different sized cities and airports. (As in previous work, we measure the difference between actual deregulated fares and what fares would have been under regulation; we estimate regulated fares by adjusting the fare formula used by the CAB during the final few years of regulation.) In 1996, travelers paid, on average, 28 percent less for trips than they would have if airlines had remained regulated. The gains are not confined to travelers between large cities. Indeed, travelers on all routes paid lower fares. Deregulated fares were 29 percent lower for trips involving a large hub, 32 percent lower for trips involving a medium hub, and 17 percent lower for trips involving a small hub. Even nonhubs saw a small decline in fares.

Sources of Fare Differences

Although all travelers are now enjoying lower fares, on average, as a result of deregulation, it is clear that travelers at large and medium hub airports have benefited more than those at small and nonhub airports. There are two possible explanations for the difference. One is a lack of competition. The other is costs. Policy options would arise if government policymakers could do something that would either enhance competition or lower airline costs—or both—and therefore increase the benefits from deregulation, especially for travelers at small and nonhub airports.

Before deregulation introduced competition to the airline industry, regulators monitored all routes and seldom authorized entry by would-be competitors. With the advent of deregulation, both incumbent airlines, such as American and United, and the many new airlines, such as People Express and Southwest Airlines, that sprang up in the new competitive market were free to enter all routes. Not surprisingly, competition—as measured by the number of equal-sized competitors—has increased on routes of all hub classifications. Today large hub and medium hub routes are about equally competitive. Small hub and nonhub routes, however, have fewer competitors because their markets are smaller.

Although the number of equal-sized competitors is an important indicator of competition on a route, the identity of the carriers is also important. Two routes may have the same number of competitors and be comparable in other ways, but one may enjoy lower fares because it is served by a low-cost (low-fare) carrier and the other route is not. Indeed, the growth of new low-cost carriers, such as Southwest Airlines, has been one of the most important consequences of airline deregulation. New entrants are serving all routes. They are providing the greatest share of service at medium hub airports and about equal shares to small hubs and large hubs.

In short, competition does vary by hub classification, but large hub routes are not the only ones on which competition has increased significantly since deregulation. Medium hub routes appear more competitive than large hub routes, and small hub routes are clearly attracting competition from new airlines.

What about cost differences? There are at least two important sources of air transportation economies. The first is larger aircraft. As one would expect, the cost per seat is lower on large planes than on small planes because the fixed costs of aircraft operations are averaged over more seats. The second is larger load factors. For an aircraft of any given size, costs per passenger fall as more seats are filled.

Airlines trade off those economies with flight frequency. Although carriers can fly big planes on routes with few passengers, they would have to cut flight frequency to fill enough seats to cover costs and earn a profit. Because travelers value frequent service, carriers and travelers on low-density routes find it mutually beneficial to have, for example, a small plane provide service twice a day, rather than have a large plane provide service once a day. Indeed, if nonhub and large hub routes had the same aircraft sizes and load factors, nonhub routes would have 62 percent fewer flights than they now have.

Thus, the more passengers a route has, the greater economies it can achieve. Naturally, the larger the hub route, the greater the traffic—and the larger the aircraft serving it and the higher the load factor on it. Because airlines are able to realize the greatest economies on large hub routes, they will have the lowest costs on these routes, other things equal.

How much of the variation in fares among hub routes is explained by differences in competition and costs? According to our estimates, differences in load factor account for about half of the observed differences in fares for small and nonhub routes relative to large hub routes. Differences in aircraft size account for about 40 percent of the difference. The relative lack of competition at small and nonhub airports accounts for only about 10 percent of the cost differences. Medium and large hubs are nearly equally competitive. But lower load factors and smaller aircraft at medium hubs should make their fares about 5 percent higher than fares at large hubs. In fact, their fares are 4 percent lower than fares at large hubs because of the strong presence of new entrants on their routes. (We note for the benefit of readers interested in our methodology that the estimates rely on a competition "elasticity" of -0.1, indicating that if the number of competitors on a route increases by 1 percent, fares fall 0.1 percent. They also incorporate an aircraft seat-mile cost elasticity of -0.2, indicating that costs per seat mile fall by 0.2 percent when aircraft size, measured in seats, increases by 1 percent.)

Differences in Service

Certainly deregulation has affected fares, but what about service—particularly flight departures and cities served? According to data from the U.S. Department of Transportation, since the airline industry was deregulated, daily departures have increased considerably at large and medium hub airports, moderately at small hub airports, and slightly even at nonhub airports. An indicator such as daily departures, however, does not include connecting flights and thus substantially understates travelers' feasible flight alternatives. For example, because of the existence of connections, an additional aircraft departure from a nonhub to a large hub increases the number of flight alternatives on many connecting routes. The accelerated development of hub-and-spoke operations since deregulation has led to an increase in connections, especially on small and nonhub routes. In our 1986 Brookings book, The Economic Effects of Airline Deregulation, we estimated that feasible flight alternatives had increased as much as 20-30 percent on small hub and nonhub routes. Of course one way that airlines were able to increase the number of daily departures was by sacrificing economies of aircraft size and load factor in favor of greater flight frequency—a development that kept fares higher than they otherwise would have been.

Deregulation has also sharply increased the number of cities served nonstop at all airports. The accelerated development of hub-and-spoke operations has also increased the number of cities served with a connection at small and nonhub airports.

Slot-Controlled Airports

The volume of complaints about the perceived failures of deregulation in small cities has been so loud that it seems to have deafened policymakers to a few voices (ours among them) pointing to a relatively small but real glitch in deregulation at four airports in three of the nation's largest cities. Since the late 1960s regulatory limits have been imposed on the number of arriving and departing planes at Chicago O'Hare, New York La Guardia, New York Kennedy, and Washington National in an effort to decrease congestion. These regulatory limits, which survived airline industry deregulation, decrease both departure frequencies and competition. According to our estimates, last year carriers charged one-way fares that averaged from $17 to $22 higher (11-15 percent) on routes involving O'Hare, La Guardia, and Washington National than they charged for flights of similar distance that did not involve these "slot-controlled" airports. Fares at Kennedy Airport were not higher than those on comparable routes.

As we have argued elsewhere, the inefficiencies due to the slot system could be eliminated if the system—whose very purpose, as noted, is to reduce congestion—were replaced by congestion pricing—charging aircraft for their takeoffs and landings according to the cost of the delay that each aircraft imposes on other aircraft. During peak travel times, when one plane can delay many others, the cost would be high. At other times, it would be low, perhaps nothing. Current airport fees are based on aircraft weight, so that fees for large passenger planes are high while those for general aviation and commuter planes are low. The fees have nothing to do with the costs of delay, which can be caused almost equally by large and small planes. Congestion charges would reduce delays from congestion by encouraging planes, especially general aviation and commuter planes, to use congested airports during off-peak periods or to switch to less congested airports.

The Department of Transportation has recently signaled an interest in promoting competition at slot-controlled airports by making more slots available and encouraging low-cost carriers in particular to apply for the new ones. The implicit concern is that slots are preventing low-cost carriers from competing at these airports. But the evidence does not bear this out. According to our calculations, new entrant carriers provide 8 percent of passenger miles at slot-controlled airports and 20 percent at airports that were not subject to slot controls. When Southwest Airlines, which has an explicit and well-known strategy of avoiding congested airports, is excluded, the share of passenger miles provided by new entrants at airports that are not slot-controlled falls to 10 percent, which is roughly comparable to their share at slot-controlled airports. Slot controls, then, do not appear to be a serious barrier to competition from new entrants in particular, though they do impede competition in general. Policymakers at the Department of Transportation could improve efficiency at congested airports far more readily by supporting a move to abolish the slot system altogether and replace it with efficient congestion pricing. Regulatory watchdogs on Capitol Hill should also take note that fares for travelers to these metropolitan airports—which sometimes include travelers from small cities around the nation—could well fall if congestion pricing is adopted.

It Ain't Broke, So Don't Fix It

Anecdotes about high fares and infrequent service in some markets are sure to continue to attract lawmakers' attention and to raise questions about whether action should be taken to improve the fairness of deregulated air fares and service. Certainly problems persist at slot-controlled airports, where congestion pricing would enable the market to work efficiently. But differences in fares at different sized airports are not arbitrary. The vast majority of those differences reflect underlying cost differences, rather than anticompetitive effects, and we see no reason for government involvement. The market, while by no means perfect, is proving a strong protector of fairness to air travelers.