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

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

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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).

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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
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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.

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

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High load factor, long distance
Low load factor, short distance
Fargo
Chicago
Omaha
Dallas
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Deregulation
The 1971-96 is called the "era of deregulation"
because of the major deregulatory initiatives
passede.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 19931263-1289.
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If economic regulation can improve social
welfare, why deregulate?

• Professor Stiglers capture theory of
  regulation
• Professor Peltzmans political theory of
  regulation
• The Averch-Johnson effect

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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.

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

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Assessing Airline Deregulation
Criterion
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
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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 Whats Next?
(AEI-Brookings Joint Center for Regulatory
Studies, 2000), p. 2
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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.

1So, How much did you pay for your ticket, New
York Times, April 12, 1998
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Airline Bankruptcies(partial list)

• American Airlines
• United Airlines
• U.S. Air
• National Airlines
• Midway Airlines
• Pan American Airlines
• Trans World Airlines
• Peoples Express
• Eastern Airlines

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Structure of the Electric Utility Industry
Generation
Distribution
Transmission
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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.

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Revenue Requirement Model
RR is the revenue requirement RB is the rate
basean 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.)
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Electric deregulation is really about the
vertical separation of the three stages of
productionor the creation of a multi-market
industry.
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(No Transcript)
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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 exchangeno forward contracts
  allowed.
• Independent system operator (ISO) created to
  manage transmission.
• Generation transformed into a competitive
  industry

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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

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