Chairman DeWine, Ranking Member Kohl, and other Members of this distinguished Subcommittee, on behalf of Northwest Airlines’ 50,000 employees worldwide, thank you for the opportunity to testify today. Accompanying my written testimony today is a detailed document we prepared for Subcommittee Members and staff which contains extensive data on competition in the U.S. airline industry since deregulation in 1978. I will refer to that document throughout my testimony as the “Northwest Deck.
”Northwest appreciates the opportunity to discuss the state of domestic competition in the airline industry generally, as well as the Subcommittee’s specific interest in issues relating to hub-and-spoke air service networks and air fares. The concerns being expressed about hub dominance and allegations being made of predatory pricing raise the question whether airline deregulation is off course.
In order to assess whether deregulation is failing to produce the significant consumer benefits envisioned by Congress two decades ago as some suggest, it is critical first to put this debate in context. Specifically, what was Congress’ goal in creating a free market in domestic air service and are consumers of air service better off today than they were 20 years ago? As I will explain, the answer to each of these questions leads to the unmistakable conclusion that airline deregulation is right on course and continues to produce consumer benefits that even its most enthusiastic supporters would not have predicted two decades ago.
Mr. Chairman, we take for granted innovations in air transportation such as discount air fares that have made low air fares readily available to consumers, the hub-and-spoke system that has dramatically increased air service nationwide, and airline alliances offering seamless travel throughout the United States and around the world. Looking at the airline industry today, many consumers cannot recall a time when airlines did not vigorously compete on both the basis of price and service. However, the fact is that 20 years ago, government regulation stifled competition and innovation in the airline industry.
Prior to 1978, the federal government determined what cities an airline could serve, the price it could charge and the type of aircraft that could be used. Mr. Chairman, government regulation was so pervasive there was virtually no aspect of the airline business into which the highly visible hand of government did not reach, and essentially no role for market forces.
Against this backdrop, Congress decided that the marketplace, however imperfect, would produce better and cheaper air service in the United States than could any regulator, however enlightened. As the Senate Committee Report accompanying the Airline Deregulation Act of 1978 succinctly put it, the goal of the legislation was “to encourage, develop, and attain an air transportation system which relies on competitive market forces to determine the quality, variety, and price of air services.”1 The Committee concluded “the lesson of Kitty Hawk is that air transportation will be more likely to expand and prosper if the heavy hand of CAB economic regulation is removed from the creative hand of carrier management.”2
Deregulation lived up to the 95th Congress’ expectation. It released a torrent of innovation that literally has transformed air service in the United States. Today, consumers enjoy more competitive service to more cities offered by more carriers. Equally important, air travel, which once was a luxury service, now is within the economic reach of most Americans.
The consumer benefits of airline deregulation speak for themselves. Since 1978, total domestic traffic has almost doubled to approximately 400 million passengers. (Northwest Deck, page 2) The number of passengers traveling in markets where the leading carrier’s market share is less than 40 percent has increased from 49 million to over 160 million while the average number of competitors has increased in all but the very smallest markets. (Northwest Deck, pages 2-5) As a result of this enhanced competition, as of 1996, overall inflation adjusted fares are over 40 percent lower than prior to deregulation.3 Clearly, consumers of air service are far better off today than prior to 1978.
Nonetheless, some critics of airline deregulation dismiss these facts. By incorrectly making the ideal of a perfectly competitive market the yardstick for measuring the success of deregulation, they rely on market aberrations to proclaim it a failure. However, the 95th Congress never expected there to be perfect competition in air services. Rather, it sought to create a marketplace in which workable competition could flourish. Free markets in any industry are dynamic and therefore are best measured not by their perfection at any point in time, but rather by their ability to self-correct over time. The airline industry has consistently demonstrated this ability since deregulation and, until it ceases to do so, the risks of government intervention into pricing and capacity decisions in my opinion will outweigh the benefits.
Mr. Chairman, let me now turn to the issues I understand are of particular interest to the Subcommittee, airline hub-and-spoke networks and ticket pricing.
The hub-and-spoke system is one of the pro-consumer innovations domestic deregulation made possible. In fact, for consumers residing in cities with hub airports and those relying on one-stop service through hub airports, the system itself, as well as the vigorous competition between hubs that has resulted, is one of the most important developments deregulation made possible. In addition to maximizing consumer choice by making more flight options available, this competition between hubs for connecting passengers has created greatly increased seat capacity in long-haul markets from hubs resulting in lower fares. At the same time, it has proven itself to be a highly efficient operational system for moving millions of passengers every day and has facilitated unprecedented domestic passenger growth.
Prior to 1978, the federal government generally mandated that markets be served by linear, point-to-point routes. As a result, airlines lacked the freedom to efficiently combine traffic flows to the same destination. Instead, they were required to inefficiently serve those passengers with numerous linear routes to the same city. The resulting operating inefficiencies of this system were obvious and very significant. However, airlines were forced by the federal government to operate in this manner, and in fact they were rewarded for doing so by guaranteed profits so long as just 55 percent of their seats were sold. In fact, this highly inefficient system guaranteed airlines a return on capital of around 12 percent while average load factors averaged just over 50 percent. Today, in sharp contrast, load factors are approaching 70 percent while the industry’s return on capital hovers around 5 percent.
Deregulation not only untied the hands of airlines so they could craft a more efficient system, it put them at great commercial peril if they failed to do so. The hub-and-spoke system was the market response. It enabled airlines to more efficiently serve passengers by aggregating at a hub airport local traffic (passengers traveling to or from a hub) with connecting traffic (passengers arriving at the hub for departure to spoke cities). At Northwest’s hub at Detroit Metro Airport, for example, this system enables us to offer consumers a greater level of service. Overall, weekly departures offered at Detroit have risen from 1,781 before deregulation to 4,309 today. The number of non-stop markets served has nearly doubled from 61 to 115.
Despite these benefits, I understand the Subcommittee is concerned about the market share of airlines at some hub airports. Specifically, I understand that concern is whether a large market share by a single carrier at a hub threatens competition because such “hub dominance” enables that airline to control prices. Prior to refuting that concern with data illustrating Northwest’s experience at our hubs in both Detroit and Minneapolis, let me make a general point. Looking solely at the relative share of traffic that a carrier serves at any particular hub overlooks the important fact that competition between hubs disciplines pricing decisions. For instance, Northwest’s pricing decisions at its hubs in Detroit, Minneapolis and Memphis are not based solely on competition from other carriers at those airports, but instead they are largely based on price competition from other hubs.
Turning to Northwest’s experience at our Detroit and Minneapolis hubs, it clearly shows these hubs are highly competitive and the marketplace, not Northwest, is dictating prices. Air fares at Detroit and Minneapolis do not differ meaningfully from fares at comparable hub airports, nor do our passenger yields. (Northwest Deck, pages 11-12). In fact, the vast majority of Northwest’s originating traffic at both hubs use Northwest’s “Every Day Deals” fares, or even lower fares. (Northwest Deck, pages 13-14) These data show that fares at these hubs are affordable and the large majority of passengers in these markets use the most highly discounted fares for sale. In addition, there is virtually no difference between restricted advance purchase fare trends in our hub markets as compared to non-hub markets, nor between trends in unrestricted fares. (Northwest Deck, pages 15-16). Moreover, “walk up” fares at these hubs that frequently are used by business persons are comparable to “walk up” fares from other hubs to the same major destinations. (Northwest Deck, pages 37-38)
The same is true for service to smaller cities. Very reasonable peak “Every Day Deals” advance purchase air fares are widely available at smaller U.S. cities where Northwest has a majority presence. (Northwest Deck, page 18). Even lower fares are available in these same markets with off-peak “Every Day Deals” fares. (Northwest Deck, page 19) These data clearly show that most passengers traveling in these smaller-city markets use our lowest fares.
On a related point, unfounded claims have been made that major network carriers engage in anticompetitive practices to preserve their dominant position at hub airports. These charges are wholly without merit. Detroit, for instance, is a facility constrained airport and all airlines are similarly constrained in their growth, most significantly Northwest. Nonetheless, we sublease gates at Detroit and Minneapolis to numerous of our competitors, including Southwest Airlines and America West and new entrants such as Vanguard and Frontier. (Northwest Deck, page 62) In addition, we provide ground handling services to competitors at Detroit such as Spirit Airlines and Reno Air, as well as maintenance services to other competitors. (Northwest Deck, page 62) Frankly, it is in Northwest’s best economic interest to do so.
Mr. Chairman, let me now turn to the Subcommittee’s interest in issues relating to airline ticket pricing practices. Deregulation introduced vigorous price competition into the marketplace and, the resulting decline in air fares forced airlines to develop a system to maximize revenue on each flight and to fill a greater percentage of seats. Like any business, airlines looked for a system which would enable them to maximize revenue. However, unlike many businesses, the value of our product, an airline seat, is zero if it is empty at the time the plane leaves the gate.
The market-driven response was sophisticated computer programs that allow airlines such as Northwest to better predict the demand for seats, and that in turn enables us to allocate seats more efficiently to passengers based on their purchasing preferences and needs. As a result, these yield management programs are largely responsible for making air travel more affordable for many consumers and ensuring the maximum number of consumers can travel.
Some people find airline ticket pricing to be confusing and as a result have incorrectly concluded that air fares are excessive and irrational. In fact, neither conclusion is correct. Over the past seven years, average fares have barely risen in current dollar terms and, in inflation-adjusted terms, they have declined. (Northwest Deck, pages 7-8) “On demand” fares paid by last minute travelers have risen modestly due to the increase in demand for these seats relative to a very limited supply of them, but this group constitutes only about 5 percent of all travelers. (Northwest Deck, page 9)
Two weeks ago in a hearing before this distinguished Subcommittee, Ranking Member Kohl asked several questions that show precisely how the industry’s often confusing system for pricing tickets can invite the inaccurate conclusion that certain fares are excessive. I would like to respond to those questions today, and in doing so show that pricing decisions in our industry are no different than such decisions in other industries which similarly rely on basic principles of supply and demand.
Senator Kohl, I understand, wondered how to respond to a friend who complained it seemed unfair that he paid $600 while the passenger in the next seat paid around $200 for the same trip. The fact is the price each passenger paid reflected their individual travel preferences and needs. If an airline had sold all of its seats in advance, one would not have been available for Senator Kohl’s friend the day he needed to travel. By pricing some seats at $600, the airline assured some seats would be available for last minute on demand passengers. In effect, airlines use price as a means of rationing their product. The $600 price reflects the cost of keeping the seat available for last minute travelers, the commercial risk it will go unsold.
There is nothing “unfair” or “discriminatory” about pricing air service, or any service or product, in a manner that reflects varying consumer demand for that service or product. As an article in Business Travel News recently explained, “what the purchaser is really looking for is not just the physical representation (the seat or the hotel room) but the opportunity to buy the product at the price under the conditions he wants it. These are factors that differentiate one airline seat from another in the same cabin on the same flight. These are the characteristics that make each airline seat a different product.”4
Senator Kohl also questioned why some air fares between Milwaukee and Minneapolis may be more expensive than some fares between Milwaukee and the West Coast. In the deregulated marketplace, air fares are not mileage based. In fact, since competition between airlines for connecting passengers generates a significant capacity of long-haul seats from hub airports, there is a large pool of such seats available to travelers. At the same time, the cost of providing a seat to a passenger at the margin is quite low. As a result, consumers of long-haul air service benefit when airlines are willing to sell them seats for a low price since the unsold seats will yield no revenue. For instance, as of last Friday, a consumer traveling round-trip between Milwaukee and San Francisco could purchase our lowest round-trip air fare of $276.
It is not necessary to speculate that a mileage based system would be a highly undesirable alternative for consumers. That was precisely the system the government used to set air fares prior to deregulation. In August 1974, the mileage based fare for the lowest priced round-trip ticket between Milwaukee and San Francisco on an inflation adjusted basis was $912, around twice the normal discount fare for such a trip today. While the system of pricing airline tickets that has evolved under deregulation may be confusing and may even result in some short-term aberrations, it has created air fare alternatives that significantly benefit consumers.
Mr. Chairman, I understand the Subcommittee also is interested in airline pricing decisions in response to new entrants in markets. It would be inappropriate for me to comment on particular instances in which Northwest has responded to new entrants because of the pendency of a Department of Justice investigation examining these issues. I can say that Northwest competes vigorously in all markets we serve both on the basis of air fares and service, and we are confident that we are competing in a manner fully consistent with the law.
Congress and the Department of Transportation (DOT) should be very cautious in responding to allegations by unsuccessful new entrant carriers of predatory pricing. Experience has shown that unsuccessful competitors in any industry often seek government solutions when they cannot succeed on their own in the competitive marketplace. Similarly, it teaches that both Congress and DOT should be very reluctant to intervene in pricing and capacity decisions which are responsive to market forces. Once such an interventionist process begins, it is difficult to predict how competition will be skewed, and the extent to which the consumer benefits the dynamic marketplace deregulation created will be put at risk. When a new entrant carrier enters a market, typically one of three outcomes results.
First, price competition may result in two new lower fare alternatives for consumers. This scenario has played out time and time again in hundreds of markets, and currently is at work in the market between Milwaukee and the West Coast to which Senator Kohl has referred.
Second, the incumbent network carrier may be driven out of the market. For instance, when Southwest entered the Baltimore-Washington International Airport market, U S Airways virtually pulled out because it was unable to engaged in sustained price competition with Southwest. However, due to the commercial flexibility offered by the deregulated air service market, U S Airways was able to competitively respond by launching a new low-fare subsidiary, MetroJet, to reenter some of the markets it surrendered at BWI to Southwest. United Airlines similarly responded to competitive challenges in California by starting Shuttle by United, as did Delta when it launched Delta Express in a number of Southeastern markets. Again, consumers have benefited from one, and sometimes two, new low-fare air service options.
Third, there are some instances where the new entrant fails to succeed in the market and withdraws. It is those instances that sometimes give rise to claims of anticompetitive behavior by the incumbent carrier. A handful of critics rely on these incidents to call for legislative action which would put at risk the significant consumer benefits that result from vigorous price competition. However, as an industry analyst recently noted, the explanation may be the market has worked to remove a new entrant carrier that has overextended itself and in doing so lost any competitive advantage the carrier once had.5
Mr. Chairman, if the airline industry is one which is characterized by excessive prices and anticompetitive practices, these facts should be reflected by the industry’s financial performance. The fact is that since deregulation, the airline sector is among the worst financial performers of all U.S. industries. Although the industry finally returned to profitability in 1995 after a cumulative net loss of $13 billion between 1990 and 1994, profit margins remain quite low. (Northwest Deck, pages 66-67). Even in 1996 which was a record year for Northwest, our return on revenues was just 5.4 percent. (Northwest Deck, page 68) Compared to other industries, the U.S. airline industry’s profit margin, return on investment, and return on capital lag significantly. (Northwest Deck, pages 69-70) In large part, this is due to the fact that since 1991, more than $12 billion in new federal taxes and fees have been imposed on U.S. airlines, and the traveling public. (Northwest Deck, pages 71-73)
Let me conclude by saying that Congress’ goal 20 years ago to create a domestic air service marketplace with workable competition continues to be met, and that its expectation of the consumer benefits that would result have been exceeded. When there are aberrations in particular situations, there is no evidence the market is unable to address them as free markets do. Recently, Senator Gorton, the distinguished Chairman of the Senate Aviation Subcommittee, put it best when he cautioned that there is no action Congress can take on issues such as those discussed today which will not result in “the cure being worse than the disease.”