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14 December 2011
Economics 333
Market Contestability, Deregulation and Evolution in the Airline Industry
In 1978 with the passage of the Airline Deregulation Act, the industry was to undergo
revolution: it had developed over fifty years with governmental regulations in place to prevent
destructive competition. Too often, though, any competition was defined as destructive. In the
lead up to the deregulation, authors in academia speculated that potential competition could
help discipline the market. Following deregulation theorists led by William Baumol published
widely a theory of market contestability which formalized the role of potential competitors had
on monopolist pricing. Looking forward, a brief history of the airline industry under regulation
will be presented as well as the factors leading to deregulation. After appreciating the broad
strokes of history, market contestability will be presented and then compared to empirical results
which sought to test it. In the final section, the airline industrys evolution since deregulation will
be analyzed; notable among the features to evolve are hub-spoke systems of traffic routing,
customer loyalty programs and novel ways to price discriminate.
History
The history of airlines in the United States presents a crucial perspective on why
deregulators thought that market contestability would be realized in the new market. While the
history of the commercial airline industry goes back to the 1920s, viewing the twenty years
leading up to deregulation serves as a practical guide to the state of the industry. Following
deregulation, new airlines entered into service, regional airlines expanded into national carriers
and previously established firms consolidated into fewer companies.

The Civil Aeronautics Board (CAB) began in 1940 charged with several functions,
though the most important was its economic regulation of commercial aviation. In the coming
years the CAB would exercise its authority by setting prices and granting licenses to airlines for
routes between cities. The Board worked to ensure that unfettered competition did not halt the
development of the nascent airline industry, but increasingly into the jet age, competition would
have resulted in better outcomes, not worse. CAB policy on competition waxed and waned
through its years. The 1950s were good for competition in the airline industry when the Board
allowed more airlines to enter certain CPRs while the early 1970s worse.
The airline industry responded to economic regulation by purchasing aircraft constrained
by two components of operations. The primary constraint carriers optimized against was the
route structure they controlled given to them by the CAB. Major carriers purchased large jets
suitable for longer transnational routes which were generally profitable, but total route structure
was firmly controlled by the CAB through its regulation of CPR entries and exits. An egregious
example of the rigidity of these routes occurred between 1969 and 1974 when the CAB approved
only two new CPRs for the major carriers. Large carriers were required to continue service to
unprofitable CPRs in order to maintain a franchise on a profitable one. This form of crosssubsidy did not efficiently serve society by refusing to let firms exit a route if they were
sustaining an irrecoverable loss.
Secondly, low fuel prices incented the major airlines to purchase jets that were less fuel
efficient than they could have been. If oil prices ever increased, airplanes which had been
profitable at the time of purchase would lose money.
In academia, economists began studying the airline industry. Beginning in the early
1960s academics began publishing papers and books arguing that regulation in the airline

industry no longer served CABs original goal of ensuring long-term development of the
industry. Notably, Caves (1962) argued airlines would keep prices low in markets in which they
had a monopoly potential competition to discourage market entrants. Market contestability
theory would formalize the extent to which potential competition impeded the ability of
monopolist to freely set prices. Levine (1965) compared the structure of Californias intrastate
carriers to the regulated interstate airlines and concluded that deregulation would be the next
logical step of the industry. Towards the end he, too, cites the hypothetical effect of potential
competition on keeping monopolies from forming. Fortunately, academic papers are not only
read by other academics.
Policy-wonks in Washington policy circles took notice of what academias
recommendations. During the 1970s, Senator Ted Kennedy of Massachusetts and Stephen
Breyer, future Supreme Court Justice, worked together to bring reform and deregulation to
several industries. Their joint decision to target CAB and the airline industry was chiefly a
political one, though economics did inform the decision. Breyer had identified the airline
industry as being an attractive target for five reasons. These included the visibility the airlines
enjoyed in public consciousness, but also how regulators no longer received theoretic support
from the academy. The airline industrys lack of strong political interests meant that it could not
effectively oppose calls for deregulation. Practically, Kennedy and Breyer could point to
intrastate airlines in California which performed better than national carriers when able to set
both prices and routes. Vietor (1990) goes on to note that if the duo were unsuccessful in getting
the airline industry deregulated then similar proposals in the trucking and natural gas industry
were doomed to failure. This statement reflects the belief that the airline industry was ripe for
deregulation.

The initial set of hearings began in the spring of 1975 when Senator Kennedy questioned
CAB officials and representatives from the airline industry. The result of these hearings would be
a report critical of the CAB and a recommendation to deregulate the industry. Notably, this early
form did not call for CABs dissolution. Airline industry officials and representatives from the
industrys unions were not in favor of deregulation at this early stage. Towards the end of the
legislative process, the management of Pan-Am and United Airlines would come out in support
of the bill hoping to be able to expand and profit in a deregulated business climate. Pan American
Airways had hoped to enter more domestic routes while United Airlines thought that its market
dominance would help it expand.
The Airline Deregulation Act of 1978 was passed in October and called for gradual
reductions in CABs powers until the Boards dissolution in 1985. Under the Acts timeline,
airlines would have complete control over route-setting decisions by early 1982 with fare-setting
authority to follow in 1983. (Bailey, 1986) Airlines began planning future operations to meet the
new business climate of the time.
The early years of deregulation saw eighteen new market entrants; however, of the
original entrants between 1978 and 1988, none survived to present day. (Vietor 1990) These
entrants tried to compete by offering cheap point-to-point routes, but failed. Failed entrants either
merged with existing airlines, as in the case of People Express, or were liquidated, as was the
fate of Midway Airlines. Carriers which had originally operated as intrastate or regional carriers
expanded outward. The most notable of these intrastate was Southwest Airlines that achieved
continued success in the deregulated market through fuel hedging and low-cost service. In the
late 1980s, several of these former regional airlines had been absorbed into larger transnational
carriers. Of the eight largest airlines (by revenue passenger miles) in 2010, the top six all existed

prior to deregulation. Both the four-firm and eight-firm concentration ratios have fallen below
1977 levels.
Market Contestability Hypothesis
The market contestability hypothesis seeks to model how potential competition in a
market affects a firms decision to price goods. Martins (2000) and Shepherds (1984) versions
of the axioms combine to reach a powerful conclusion influential in the early deregulation of the
passenger airline industry. Shepherds critical perspective is considered which sharply attacks the
reality of the assumptions made. A distinction is then drawn between the stronger claims of
market contestability and weaker versions of the theory which are less formal. Finally, the
literature is reviewed for evidence of either strong market contestability or weak market
contestability. Unfortunately, only weak evidence supports the weaker version of the theory.
The axioms needed to reach market contestability theorys conclusions involve how
potential competition chooses to enter into an industry, how an incumbent firm can react and
how firms exit the market. Entry into the market must be without barriers, because potential
competitors must be free to decide on entrance based solely on expected revenue. Second, an
incumbent firm viz. a previously established firm in the market and a new firm must be
indistinguishable to the consumer. There should be no first-mover advantage; consumers will
decide which firm to purchase from strictly on cost. Finally, exiting the market is also without
cost. This is to say that there are no sunk costs in entering.
Martin (2000) makes a number of assumptions which flesh out the way in which an
incumbent firm views potential competitors. The most important additional component makes a
claim about the capacity of the potential competitor. He states that the incumbent firm must
believe that an entrant can capture the entire market with a small price decrease. Shepherds

assumptions when viewed with Martins differ from the model of perfect competition by only
one axiom: many sellers exist to satisfy demand. This is assumption is jettisoned to investigate
the role potential competition has in driving a firms decision to set a price.
An unexpected conclusion follows from the preceding assumption: the incumbent firm
will price the good at marginal cost to capture the entire market. Pricing at marginal cost has a
very desirable property in welfare analysis insofar that it is associated with the outcome of
perfect competition. Showing how a small number of firms could get to a perfectly competitive
outcome is the result of deduction. If an incumbent firm fears that an entrant could enter and
steal the entire market, then the firm will price it as low as it can without suffering economic
losses which means equal to marginal cost. The implied consequences are drastic. Firms could be
long term monopolists in an industry, but only because they set prices low. Moreover, it would
counsel all public policy to reduce barriers to entry to allow freer entry of competitors.
Proponents of contestability theory hoped empirical investigation would validate their
claims within the recently deregulated airline industry. Airlines existed by servicing a collection
of city-pair routes (CPRs) that could each be thought of as a market. After the removal of the
majority of regulations by 1980, airlines could take on new CPRs based purely on profitability.
In the early scramble of this period, airlines entered the previously profitable CPRs of
competitors thus spreading around passengers and reducing profitability (Vietor 1990). These
early shifts could easily be explained by previous theories on realized competition. More
interesting, however, would be the long term development of an equilibrium characterized by
marginal cost pricing and potential competition among the airlines.
Thorough criticisms have been presented to contestability theory by Shepherd (1984)
and (1995). Shepherd (1984) provides a sharp critique of contestability theory arguing that it

should be renamed ultra-free entry. This criticism is primarily semantic; contestable implies
that two firms struggle for dominance, but the hypothesis predicts that only one firm captures the
entire market. Other criticisms are more substantive. He moves to show that the assumptions of
market contestability are mutually inconsistent. Specifically, he challenges the claim that
potential entrants can be both ultra-free and total in capturing the entire market. Shepherd
claims that proposing completely unfettered entrants and supposing an entrant could capture the
market away from an incumbent before the incumbent could respond are inconsistent. Yet Martin
(2000) does not make claims about what the potential competitor is going to do, only what the
incumbent firm believes a potential competitor could do. The first axiom rests on a deeper
principle of the incumbents beliefs: the incumbent does not view the entry of a new firm as a
threat. But the incumbent must also hold that the entrant can completely seize the market.
Shepherd (1995) solidifies his highly critical position by reviewing publications from Baumol et
al. since 1984 only to find no response to criticisms. The 1995 paper also contains a list of the
points the Baumol group has conceded or remained silent on during the time since his first
publication against the theory in 1984.
Outside the Baumol group, the theory developed to include imperfectly contestable
markets. These markets are characterized by lower barriers to entry, though not complete absence
of them. To investigate claims that a CPR is imperfectly contestable, researchers look at
correlations between fare-price on the route and subsequent entries into the market.
Bailey and Panzar (1981) researched market contestability during the transitory period.
They found two conclusions: for routes less than 400 miles actual competition drove pricing
policies, but for routes greater than 400 miles potential competition provided the limit. They

concede that their dataset has weaknesses from it lack of reach. Finally, since it was a transitory
period it does not reflect the long-run equilibrium.
Graham, Kaplan, and Sibley (1983) challenge one of the central presuppositions of
contestability theory when they write that incumbent firms enjoy favorable mindshare in the
flying public. Moreover, by regressing fares on Herfindahl index numbers they found a
statistically significant, positive effect. This result is inconsistent with the conclusion of the basic
formulation of the theory.
Bailey (1986) dropped the rhetoric of contestability theory for a nuanced position saying
that, Significant technological, productivity, and competitive developments have occurred in the
transportation and communication industries since deregulation.
Strassman (1990) investigated the effect of current prices on market entry, a theoretical
result of contestability theory. If market entry could be correlated to prices then a basic tenet of
contestability theory would be proven false. For, market entry signals expectations of profit for
the entering firm, but theory predicts that competitive prices would dissuade rivals from entering.
Strassman concluded that there was only a correlation between past prices and future entry.
However, she also found strong evidence of barriers to entry which would also strike at
contestability theorys fundamental axiom.
But Bailey and Liu (1995) concede that considerable evidence has mounted since
deregulation that neither market contestability nor intrastate carrier models predicted what would
happen after deregulation. The rise of hub and spoke systems presented considerable sunk costs
necessary to enter the entire market; hub systems also replaced point-to-point carriers. Bailey and
Liu (1995) present a case in which fewer firms could still enhance consumer welfare by
improving flight frequency.

The preponderance of evidence critical of market contestability leads one conclude that
potential competition was not the cause of lower fares realized since deregulation.
Evolutionary Developments
Among the vast array of business decisions to be made in the deregulated industry was
how to change route structure and fleet composition. Airlines quickly moved to enter CPRs
where their competitors had been profiting and exited CPRs that were hemorrhaging money.
The most important evolution in the deregulatory period was the development of hub and
spoke operations. By using a central hub to reroute long distance flights through, airlines were
able to decrease the proportion of transnational flights in its scheduling. Moreover, hubs could
serve to increase economies of scope and density. Economies of scope were achieved by using
gate attendants, ground crew, baggage handlers into one airport; under the new system they
received less breaks than before, but they also became more productive. Economies of density
are achieved when one increases the number of passengers at the hub. By bringing in travelers
from all over the network to a central location, airlines increase the likelihood that at least some
of those passengers will want to go some other spoke. American Airlines pursued an aggressive
hub strategy at the Dallas-Fort Worth International Airport (DFW) after deregulation when they
routed over 50% of their traffic through it. Since Delta first implemented its Atlanta hub, all
major carriers have established hub operations, except for Southwest.
In the long run all aspects of business are endogenous. This proved true when the airlines
had to reconcile their prior fleet compositions to the new route structure it was planning. In the
short run, no carrier had the fleet that suited the needs of the market. American Airlines had a
fleet in which twenty percent of their capacity was the antiquated Boeing 707. In the regulated
era the 707 served the transnational CPRs, but in the deregulated era they lost money whenever

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they left the ground. The oil shock of 1979 did not enhance the 707s ability to compete. They
were grounded permanently at American which instead sought the more fuel efficient DC-9.
Fleet composition remains an important strategic decision; upstream manufacturers have
responded by designing more efficient planes in response to fuel forecasts. Boeing and Airbus
have both designed passenger airliners with enhanced fuel economy achieved through the use of
composite materials. (See Boeing 787 and Airbus 350)
The airline industry had developed computer reservations systems (CRSs) to help keep
track of sales before deregulation. However, during deregulation CRSs took on an increasing
importance as several new strategies emerged in the industry. American Airlines captured the
first mover advantage when it introduced incentives for travel-agents to book flights through its
computer reservation system. Travel agents could also use the system to display all competing
prices on screen to compare prices to make decisions for clients. Airlines also introduced
customer loyalty programs in the form of frequent-flyer miles for passengers who consistently
booked through a single carrier. Of the two features, travel agents were the more valuable target
as they made eighty percent of reservations by 1990.
Following the development of CRSs, a wealth of customer data became available for
analysts to determine optimal pricing strategies. During the CAB days intentional overbooking
was anathema. Rothstein (1985) relates his personal experience in the industry as a systems
analyst. When overbooking occurred, a procedure went into effect which generated the list of
passengers who would be denied boarding. Famously, when Ralph Nader was denied boarding in
1972 he brought suit against Allegheny Airlines and won. Until deregulation overbooking was a
thorny issue, openly practiced, but only tacitly acknowledged as the CAB thought it to be unfair
to consumers. Through various metrics, airlines have created fare-tranches wherein a class of

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travelers is targeted. For instance, business travelers separate themselves from leisure travelers
by an aversion to traveling on the weekend; the CRS then prices round-trips without a weekend
overnight stay higher than a comparable trip that included one. Computer reservation systems
took on an increasing role when they could be programmed to automatically respond to
competitors price changes.
Unsurprisingly, during deregulation several business ideas and strategies did not work
and subsequently failed. Regional and commuter airlines performed ably, but could not compete
with national carriers; they exited the market through mergers and bankruptcy. Regional airlines
existed under the CAB regulation servicing one region of the country, but following
deregulation, the regional airlines were able to expand into new markets. These airlines included
Allegheny Airlines and Southwest, both of which survive to this day.
A special class of carrier existed following deregulation called the commuter airline.
These independent airlines were documented by Crandall (1983.) It was initially thought before
deregulation that there would be loss of service to smaller, local airports; to an extent this was
true. The large national carriers lost money in small markets and reduced jet service there, but
smaller corporations saw an opportunity to profit. By using smaller jets, even turbo-props, a
small commuter airline could profit by serving these communities at reasonable fares. The entire
industry though would soon see a shift towards hubs so the purpose of this type of small airline
changed: they would operate CPRs to and fro the hub of a major carrier. In the next five years
major airlines would begin code-sharing arrangements with commuters. Borenstein (1992) noted
that these arrangements were a type of vertical integration. By acquiring the commuters, larger
carriers could increase the density of passengers at its hub.

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The history of the airline industry under regulation provides relevant context to the
deregulation period by illustrating the structural inefficiencies which were built into the system.
Before deregulation occurred academics speculated that potential competition would prevent
poor social outcomes. Reviewing the relevant literature one can only conclude that market
contestabilitys potential competition was not the cause of social gains realized from deregulation
of the passenger airline industry. Gains were realized primarily through competitive forces
within the industry and along city-pair routes (CPRs). Industry competition resulted with
innovations in the operational structure of firms while competition along CPRs resulted in lower
fares and comparatively better route service.

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