What caused airline deregulation: economists or economics?

• Author: McDonnell, Gary
• Position: Report

A robust economic theory of regulation should be able to explain deregulation (Peltzman 1989). Nevertheless, the idea that economic regulation has interestgroup origins has been less controversial than the origins of deregulation. In The Politics of Deregulation (1985), Martha Derthick and Paul Quirk describe the historical process of deregulation as one where regulatory agencies were captured by industry, but politicians, through congressional oversight and public hearings, called regulators to task for blatant protectionism. (1) Various reformers, aided by the analysis of economists and the appointment of reform-minded individuals (such as Alfred Kahn) to head the Civil Aeronautics Board (CAB) and other regulatory commissions, created de facto deregulation. By demonstrating the efficacy of regulatory reform, reformers eventually drove the creation of legislation to deregulate entry and pricing. A significant share of the credit for this reform is given to economists. Quoting an economist speaking to a gathering of his colleagues, Derthick and Quirk argue that "the fight for deregulation of transportation 'has been the story of a few brave but lonely economists stubbornly attacking the American economy's largest legal cartel'" (1985, 9). However, in Derthick and Quirk's view, economics--capture theory--cannot explain this political change. "We would not have bothered to attempt this analysis were we persuaded that deregulation is explicable mainly by reference to economic events" (1985, 19). (2)

George Stigler's seminal essay "The Theory of Economic Regulation" (1971) postulated that regulated firms succeed in capturing their relevant oversight agency. The agency then supplies regulation beneficial to the industry--limiting entry or regulating higher prices or both--which comes at the expense of relatively unorganized consumers and potential competitors to regulated firms. Narrow interests thus succeed in capturing the regulatory process. Sam Peltzman's (1976) formalization of Stigler's postulation showed that pure profit maximization for the regulated firms is not the typical regulatory outcome. Nevertheless, Derthick and Quirk prefer a "politics of ideas" explanation for deregulation because"[t]he most active and powerful organized interests [the regulated industry] were opposed to the policy change" (1985, 26). They aver that "[b]y the end of the 1970s, capture was nowhere in sight" (91). Their skepticism that capture theory can explain deregulation is warranted. (3) However, skepticism regarding the politics of ideas as a sole explanation for deregulation is also warranted.

Wayne Leighton and Edward Lopez's recent book Madmen, Intellectuals, and Academic Scribblers (2013) seeks to incorporate ideas into an economic framework to better understand political change. In their analysis, ideas are akin to higher-order capital goods that interact with incentives and institutions to affect political outcomes. "In short, political change happens when entrepreneurs notice and exploit those loose spots in the structure of ideas, institutions, and incentives" (134). Economic and "politics of ideas" explanations are not mutually exclusive. Given that all parties to political exchange face constraints, respond to incentives, and have their choice sets shaped by institutions, it can be shown that "political transactions costs and institutions influence the market for regulation," through which "the optimal regulation can shift with exogenous market shocks and endogenous responses to existing regulations" (Lopez 2010, 380).

This essay uses air-passenger deregulation as a case study to illustrate the nexus between ideas, institutions, and incentives in deregulation and to show that in this process both economics and ideas played a role. For example, regulatory agencies will not remain captured when exogenous and/or endogenous shocks upset political equilibrium and impose costs on elected officials (Weingast 1981; Weingast and Moran 1983). Furthermore, political actors face limited and scarce information. It can be shown that political institutions and ideas aid legislators in market-testing new legislation (Weingast 1981; Weingast and Moran 1983). Political institutions also shield them from the perception of opportunistic behavior and allow them to reduce transaction and information costs when dealing with interest groups (Tullock 1989; McChesney 1997). In short, I argue that the ideas of economists and interest-group politics together were responsible for deregulation of interstate air-passenger service. To answer my title question: both economists and economics mattered.

The Agency--Clientele Model

Barry Weingast has modeled the incentives faced by elected officials and bureaucrats: "legislators are simply assumed to rationally calculate the likely effects of various actions (e.g., voting decisions, introduction of legislation, or agenda control) upon their reelection chances." Furthermore, "[congressmen seek reelection and career advancement. This implies that they bend with the wind of public opinion in general, and further the interests of attentive and politically active interest groups in particular. Often this entails that a particular congressmen becomes identified with a specific policy area" (1981, 155, 151; see also Weingast and Moran 1983).

An implication of the agency-clientele model is that elected officials do not merely respond to interest-group demands; they actively pursue their own interests. Weingast notes that administrative agencies (such as the CAB) operate without extensive intervention from Congress "as long as the relevant variables of public opinion, balance of power of interest groups, presidential initiative, and precential legal decisions are stable" (1981, 160). In this model, congressional oversight of regulatory agencies is loose and informal, where "[legislators] judge the success of agency decisions based on constituency reaction, and not through detailed, systematic study and oversight." For this reason "agencies may appear captured by their clientele" (1981, 153). The implication is that agencies will remain "captured" only if regulation is functioning well from the standpoint of constituency benefits and public opinion. When regulation fails to provide sufficient benefits to constituencies and/or imposes costs in the form of low public opinion of government officials, congressional hearings and investigations may be instituted to "police those areas functioning poorly" (Weingast and Moran 1983,769). In this model, the "capture" of regulatory agencies by specified interests is contingent on a stable equilibrium--that is, one where the regulatory agency is serving elected officials' interests. During the period leading up to air-passenger industry deregulation, several factors, including the policies of regulators at the CAB, upset equilibrium.

Protectionist Policies Generate Disequilibrium

By the late 1960s and early 1970s, regulation of the interstate air-passenger industry failed to provide targeted returns to the industry. Nonprice competition (i.e., load factors, amenities, etc.), recession, rising fuel costs, and inflation were factors that reduced rates of return in the industry below the target rate of return (Bailey, Graham, and Kaplan 1985, 19). Interstate airlines were earning a rate of return below manufacturing during this period (Bailey, Graham, and Kaplan 1985, 25). In contrast, nonregulated intrastate carriers were earning higher profits while charging lower fares than their regulated counterparts (Bailey, Graham, and Kaplan 1985, 30). Rent dissipation not only posed problems for the airlines and regulators but were political problems as well. Profits on high-density routes were meant to subsidize losses on low-density routes. The failure of regulation to deliver profits on high-density routes meant that cross-subsidizing further eroded air carriers' profits, threatening their support for this practice, and potentially threatening the constituencies who benefited from this practice (Peltzman 1976). (4) Regulators interpreted their mandate to be one of maintaining this internal cross subsidy. In response to lower industry returns, regulators at the CAB instituted flagrant protectionist policies:

[The CAB] refused to process applications by new companies to enter the interstate airline business. It denied standing in regulatory proceedings to consumer interests. It attempted to organize collusive agreements among airlines to reduce service in competitive markets so that airlines could earn higher profits. And it engaged in an almost comical process of trying to cure by regulation the recurrent outbreaks of competition in service amenities, even to the point of writing regulations that defined the size of a coach-class seat and the amount of meat that could be lawfully served on a sandwich. (Noll and Owen 1983, 156)

This behavior brought the rent-seeking aspects of regulation in plain view of the public and contributed to an already low public opinion of government (due to inflation and war, among other things). As one consumer advocate noted in testimony before Congress, "Economic regulation has become a disease, insidiously destroying the long-term potential of the air transportation industry, the affordability of air travel by a large majority of the population, and the faith of citizens in their government" (qtd. in A. Brown 1987, 37). Referring to the CAB's conduct and its effect on public opinion, Derthick and Quirk note that "[t]he themes that anticompetitive regulation had a pro-business bias and that regulatory agencies were at best incompetent and at worst 'captured' and corrupt had been driven home quite widely by the mid-1970s, even if price and entry deregulation was not, strictly speaking, a mass issue. Anyone with an informed opinion on the subject could hardly have failed to have that opinion" (1985,41).

Derthick and Quirk acknowledge that...