Deregulation and Strategic Behavior in the Airline Industry – Essay

Prior to the 1978 deregulation of the airline industry, the ruling decisions of the Civil Aeronautics Board (CAB) had allowed the existence of only two distinct tiers of operation. Namely that applying to the long distance (or trunk) carriers, and that applying to the smaller, regional airlines, each of which operated in their own, predefined geographical area.

Consequently, during the regulated period the civil aviation industry existed in a market consisting of mixed monopolies and oligopolies. Being geographically confined and prohibited from actively competing on the price of airfares, the airlines were only able to seek increased rates of economic rent through the use of strategies based around performance and quality of service.

Thus the opportunities for increases in economic rent afforded by the change to industry wide economic deregulation were plentiful, as were the variety of competing market strategies.
In the case study “Deregulation and Strategic Behavior in the Airline Industry” (McCarthy, Patrick S. (2001) Transportation Economics, (First Edition, pp 308-319. Blackwell Publishers) Patrick McCarthy posits three particular hypotheses concerning the varying strategies for increasing economic rents that may have been applied by airlines following this deregulation of the American aviation industry.

 One:

“…[R]egional carriers will be more concerned about competition from other regional carriers than from larger trunk carriers. Conversely larger trunk carriers identify their strategic competitors to be trunk carriers rather than regional carriers.”

 Two:

“…Since trunk airlines have large-scale operations, this implies that the trunk-line carriers will seek to expand the scale or volume of their operations… Local carriers, on the other hand, whose economic rents derive specifically from location monopolies, are not expected to engage in scale enhancing activities but, rather, to focus their resources on increasing regional concentrations.

Three:

“Competitive firms in a multi-product industry can balance cost differences associated with alternative levels of product differentiation in such a way that, regardless of strategy, all firms make normal profits…If, on the other hand, these multi-product firms are imperfectly competitive, then choice of strategy will enable them to make above or below normal returns on investment.”

I note with interest that Mr McCarthy offers little to support the theory set forth in hypothesis one, preferring instead to concentrate his findings, gained from a variety of statistical reports based upon performance of the airline industry from 1978 to 1984 on hypotheses two and three.

Having viewed the data within his case study, I would have to agree with his observation that the statistics strongly support a mixture of both hypotheses two and three, although leaning more toward the third.

This is especially true when the case study is approached from a standpoint specifically concerned with economic rents.

Although immediately following deregulation, the incumbent airlines had the added bonus of brand recognition and an already trusting local customer base, I would fully expect an initial decline in each firm’s economic rent due to the introduction of strategies built around competitive airfares, the use of which is often successful in squeezing out smaller competitors who are unable to swallow the costs of such a strategy as well as the larger firms, leading eventually to a much larger return in both economic rent and market share for the larger carriers.

Subsequent mergers between these larger and smaller firms gradually eases out further competition, leading to a return to a more oligopolistic, even monopolistic arena whereby prices may now begin to stabilise and be set in favor of the carriers, rather than the consumer, so leading to a higher level of economic rent, as suggested by Mr McCarthy in both hypothesis two and three.

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