The telecommunications and airline industries underwent very different paths to deregulation after decades of economic regulation. Airlines were deregulated in essentially cold-turkey fashion, while telecommunications were deregulated in a highly piecemeal manner over many years (and are not entirely deregulated to this day). Despite the divergent deregulatory strategies, some common themes emerged.
In this article, I review the regulatory and deregulatory history of these two industries and examine their industry structure, business strategies, and technological changes with the purpose of comparing the outcomes of the two deregulatory strategies.
Before deregulation, the airline industry was subject to economic regulation of domestic prices and routes by the Civil Aeronautics Board (“CAB”). Airline regulation was thought necessary to avoid “destructive competition.” The theory of destructive competition is that in an industry with high fixed costs, low marginal costs, and economies of scale, competition would drive prices to levels that could not cover the fixed costs and could therefore not sustain ongoing profitability. Under this theory, regulation keeps prices higher than they otherwise would be in order to preserve viability of the regulated entities.
The CAB regulated interstate rates on a route-by-route basis for each carrier. Prices were regulated to achieve profitability goals as well as policy goals including “universal service.” Universal service meant that smaller cities and towns should have some commercial airline service (and in some cases, nonstop service) where such service might not be commercially viable without regulatory intervention.
The CAB also controlled entry into and exit from markets by allocating routes to carriers. CAB regulation was a complex balancing of routes and prices that included cross-subsidization across routes. This was achieved by assigning carriers more profitable routes as well as low-profit or unprofitable routes for universal service reasons.
The telecommunications industry was and is regulated both by the Federal Communications Commission (“FCC”) and by state regulatory commissions. Generally, the FCC regulated rates, entry, and exit for wireline long-distance services, and the state regulatory commissions regulated rates, entry, and exit for wireline local exchange service. Wireless service was regulated at the federal level early in its history but was largely deregulated in 1993.
The purported justification for economic regulation of telecommunications was different from the justification for airlines. Generally, regulators viewed telecommunications as a “natural monopoly” and were concerned about keeping telephone rates below monopoly prices, not keeping prices above “destructive” levels. That is, the general concern was that without regulation, prices would be too high, not too low.
Like airline regulation, telecommunications rates were regulated subject to profitability goals (with the intention of limiting carriers to an acceptable rate of return) and universal service goals that led to complex systems of cross subsidization. In the telecommunications context, the universal service goal was that every household should be connected to the public switched telephone network, whether the household was in an area that was very costly to serve or in a relatively low-cost area.
It was generally understood that, for wireline telecommunications companies, densely populated areas were relatively less costly to serve than less dense areas such as rural locations. It was also generally understood that residential customers were more price-sensitive than business customers. Hence, regulated prices tended to cross-subsidize from urban to rural areas and from business to residential customers by regulating price structures so that urban rates were above their costs, rural rates were below their costs, business customers’ rates were above their costs, and residential customers were (at least in some locations) below their costs.
In addition, universal service goals tended to result in rates for long-distance service that cross-subsidized local service rates, on average, to ensure that all households could afford a basic local connection (which was charged by the local service company, not the long-distance company).
To maintain this complex system of cross subsidies, regulators closely regulated both entry into and exit from markets and services. For example, carriers were generally not permitted to refuse to serve high-cost customers, and there was significant regulatory and industry resistance to allowing entry into business services and long distance (where the profits were).
Companies’ business decisions were responsive to the incentives and restrictions they faced in their industries.
In airlines, because carriers could not compete by reducing prices below regulated levels, they competed by increasing amenities and service frequency. Competition on amenities included offering free meals, free luggage transport, comfortable and roomy seat configurations, in-flight entertainment, and even attendant appearance. Carriers also competed on service frequency by offering more frequent flights—to better comport with travelers’ scheduling desires—at the cost of flying with a higher percentage of empty seats on each flight. More empty seats in turn added to the comfort of the passengers.
These amenities were costly, and the costs of these amenities and empty seats drove down profitability. The dynamic of carriers driving down their profits by ratcheting up their amenities was consistent with the general economic principle that competition tends to drive profits out of a market. In the case of airlines, if they could not compete on price, they competed on quality and thereby eroded their profits in that way.
Economists generally viewed the level of amenities induced by regulatory restrictions on price competition as inefficiently high. Economic theory predicts that amenities valued by customers at least at the level of the cost they caused the airlines would be provided by the airlines with or without regulation. When carriers could not compete for customers by reducing price, however, they had an incentive to offer amenities to attract customers from rivals even if the cost to the carrier of the amenities exceeded the value to consumers. Amenities whose value to travelers was less than the cost to carriers of providing them are a socially inefficient use of resources. In an unregulated market, such amenities would not survive in the marketplace because carriers would offer lower prices instead of the amenities, improving the value proposition to customers.
In telecommunications, the system of cross-subsidization created attractive markets for entry. Potential entrants attempted to capture the profits in the business market by offering alternatives to the local exchange carriers’ access facilities in urban areas and were attracted to profits in the long-distance market by attempting to offer competitive long-distance services.
The domestic airline industry was deregulated by the Airline Deregulation Act of 1978 (“the ’78 Act”). The ’78 Act was truly deregulatory. This Act eliminated price regulation on domestic routes. It also eliminated entry regulation on domestic routes, it eliminated exit regulation on domestic routes, and, most radically, it eliminated the Civil Aeronautics Board itself. The CAB put itself out of business and had closed its doors by January 1985.
In contrast to airline deregulation, telecommunications deregulation has been gradual and ongoing. By the 1980s, AT&T was the single largest provider of telecommunications services in America. AT&T provided both long-distance service nationwide and local exchange service to the majority of American households via vertically integrated Bell operating companies. To settle a landmark antitrust case, AT&T agreed to divest its local exchange companies into seven Regional Bell Operating Companies (“RBOCs”) in 1984. The RBOCs provided local exchange services in their respective geographic areas, while their former parent (AT&T) provided nationwide long-distance service. By the terms of the divestiture, the RBOCs were not permitted to offer long-distance service but effectively had monopolies in their local exchange markets, at least for residential services. In addition, the system of cross subsidy from long-distance to local service was maintained by a structure of intercarrier compensation by which the long-distance company would pay the local exchange companies whenever the local exchange company’s customer made a long-distance call.
Nearly two decades after the Airline Deregulation Act of 1978, Congress passed the Telecommunications Act of 1996 (“the ’96 Act”). This law purported to be deregulatory, with the stated goal of promoting competition and encouraging deployment of new technologies. The ’96 Act opened local exchange markets to competition and allowed RBOCs to enter the long-distance market once they had adequately complied with its market-opening provisions.
Although the ’96 Act purported to be deregulatory, the FCC’s first order implementing the Act was alone over 650 pages long. The ’96 Act did not deregulate retail prices for local telephone service but, rather, permitted regulation of retail prices at the state level. In addition, it imposed new wholesale obligations on the RBOCs—RBOCs were required to “unbundle” their networks and allow new entrants to use the incumbents’ network elements at regulated rates “based on cost.” The Act empowered states to regulate those wholesale prices, which largely resulted in rates that were far below actual costs. The Act also maintained federal and state regulation of intercarrier compensation and universal service objectives.
Certain outcomes of the deregulatory acts in each industry were easily predictable. Because airline regulation was designed to keep prices up to avoid “destructive” competition, it was predictable that deregulation would result in lower prices. As it turned out, prices did decline after deregulation. For example, between 1979 and 2017, domestic round-trip airfares have declined by 43 percent in real (inflation-adjusted) terms.
Figure 1 shows domestic “all-in” airfares by year, which includes base fare plus baggage fees and change fees and excludes government-imposed taxes and fees.
In their 2014 article on reform of airline regulation, Severin Borenstein and Nancy Rose observed that airfares were declining even before deregulation and might have continued to decline had the industry not been deregulated when it was. They analyze the extent to which the declines in airfares after deregulation were likely to have been due to deregulation. They conclude that, while some of the decline would have occurred in any event, deregulation nevertheless appears to have generated substantial consumer gains from reduced prices.
In addition, because maintaining above-competitive prices induced carriers to compete on amenities and flight frequency, it was predictable that deregulation would cause certain amenities (namely, those whose value to consumers was less than the cost to carriers of their supply) would be reduced or discontinued and that load factors (the percent of seats filled)—which were presumably at inefficiently low levels, again as a result of regulatory restrictions on price competition—would rise, as they did (see Figure 2).
All traffic and operations data reflect the total service (scheduled + charter) of U.S. passenger and cargo airlines as reported to the Bureau of Transportation Statistics.
In the telecommunications industry, some of the effects of the ’96 Act were also predictable. First, once the RBOCs were allowed to enter the long-distance market, long-distance prices fell substantially. The first RBOC to win approval to enter the long-distance market was Bell Atlantic in 1999, and the others followed within the next four years.
Figure 3 shows that average revenue per minute for interstate long-distance service fell by a third between 2000 and 2006 (the last year the FCC published long-distance prices).
The decline in long-distance prices was likely due, in part, to the direct competition from the local exchange companies as well as emerging wireless and cable competitors. Also contributing to the rapid decline in long-distance prices, however, were the rapid declines in the regulated access fees that long-distance companies were (and still are, to some extent,) required to pay to local exchange carriers. These access fees fell substantially after the Act was passed, and the declines were substantially passed through to customers in the form of lower rates.
Although long-distance prices fell, the effect of the ’96 Act on local exchange prices was more complex. As noted, local exchange prices, especially residential rates, had been kept artificially low by regulation, the justification for which was to protect consumers against monopoly pricing. Moreover, as also noted, the ’96 Act did not deregulate retail prices for local service, which remained subject to the control of state regulators. The ’96 Act also did not deregulate the ability to exit local exchange markets or local exchange services. Incumbent carriers’ ability to exit areas or services that they did not wish to serve remained under the control of state regulators, many of which continued to enforce “carrier of last resort” obligations that precluded carriers from unilaterally deciding to cease operations in high-cost or other areas. These obligations also precluded some carriers from ceasing to offer stand-alone basic local service.
Over the course of the next decades (and continuing to this day), states individually deregulated certain retail rates in a piecemeal fashion. Deregulation of suppressed retail rates would tend to cause them to rise to more competitively sustainable levels. At the same time, relief from regulation would tend to invite entry into the services that were likely to be sources of cross subsidies in the regulated pricing structure.
As competition for local service has evolved, competitors have tended to focus on bundling local exchange services with other services, including long-distance and, eventually, Internet access and, still later, video. Bundling services allowed competitors to offer prices for the bundles and benefit from the economies of scale associated with offering multiple services on the same local access line. Stand-alone (single-product) pricing for local exchange service was less attractive to competitors, and it was far less common for entrants to offer stand-alone local service in competition with incumbents than it was for them to offer bundles of services only.
The combination of these factors led to a slight increase in the prices for stand-alone local exchange service in urban areas after the passage of the Act (see Figure 4).
Regulation had substantially distorted the industry structure in both industries, and deregulation therefore engendered big changes in the structure of both industries. After their deregulatory acts, both airlines and telecommunications saw a significant degree of consolidation.
In the airline industry, four of the original 16 “trunk” carriers (i.e., national carriers that existed when CAB was formed in 1938), ultimately succumbed to bankruptcy. Insofar as the purported justification for the regulatory scheme in that industry was the possibility that unfettered competition would threaten the sustainability of the carriers, the fact that exit occurred through bankruptcies cannot be said to be a significant surprise, though more discussion on this point will follow shortly.
Of the rest of the original trunk carriers, merger has combined them into the three remaining major domestic carriers: American Airlines, United Airlines, and Delta Airlines (see Figure 5).
The telecommunications industry also saw significant consolidation after its deregulatory act. Four of the RBOCs combined to form SBC; two combined to form Verizon. Horizontal consolation was also accompanied by a return to vertical integration between local and long-distance service. The distinction and structural separation between local and long-distance service were driven by regulation and the AT&T divestiture, rather than by efficiencies. Once the RBOCs were allowed to compete in long distance, there was little business logic behind the separation between the services, and vertical integration was the predictable result. Verizon acquired long-distance company MCI, SBC acquired its former parent AT&T, and the remaining RBOC, originally called U.S. West, was acquired by CenturyLink, which was already a provider of long-distance and local services. Figure 6 shows the consolidation that has occurred among the major telecommunications companies.
Rural companies also experienced substantial consolidation. Rural telephone service was highly fragmented in the 1990s, with many rural areas served by small local phone companies. As it became imperative to roll out broadband services over existing infrastructure—which required upgrades to enable broadband services—the need for a new type of expertise, as well as capital investment, became important. The increased value of new and sophisticated technical expertise was one of the driving factors for the substantial consolidation of rural companies. Of note, however, is that the rural companies were not generally absorbed into the consolidated nonrural incumbents, but, rather, were consolidated amongst themselves into larger and more sophisticated rural-focused companies.
While both the airline and the wireline telecommunications industries experienced structural changes among the incumbent carriers after their respective deregulatory acts, both industries also experienced entry of new providers. In the case of the airline industry, entry has largely come in the form of several low-cost carriers with business models that differ from those of the incumbents. These have included Southwest (which expanded from intrastate Texas service to interstate service); Spirit Airlines (which began its aviation history as a charter carrier and became an “ultra-low-cost-carrier” in the mid-2000s), Virgin America (purchased by Alaska Airlines in 2016), and JetBlue (a de novo entrant in 1999). These carriers’ focus has been on serving price-sensitive customers willing to forgo amenities—the very market that the regulatory structure discouraged incumbent carriers from serving.
Research shows that competitive pressure on prices in the airline industry derives substantially from the presence of these low-cost carriers. In his 2011 working paper, “What Happened to Airline Market Power?,” Severin Borenstein examines the change in average fares for four categories of routes by low-cost carrier (“LCC”) presence: (1) routes on which LCC operated in both 1990 and the observed year; (2) routes on which no LCC operated in 1990 or the observed year; (3) routes with LCC “entry” on which LCC operated in the observed year but not in 1990; and (4) routes with LCC “exit”—routes on which LCC operated in 1990 but not in the observed year. Borenstein finds that routes with LCC entry between 1990 and 2010 experienced the largest airfare decline (about 42 percent); routes on which no LCC operated between 1990 and 2010 also saw substantial decline (32 percent); and, finally, routes with LCC present throughout the period saw a decline of 24 percent, which was smaller than on routes with no LCC presence. He notes, however, that the routes with LCC presence throughout 1990–2010 had much lower fare levels than the routes with no LCC presence throughout that period. A graphical representation of these results can be found in Figure 3 of “What Happened to Airline Market Power.”
Entry in telecommunications has come from directions that were largely unexpected in 1996. At the time the Telecommunications Act was passed, it was expected that entrants, if they materialized, would be newcomers to the industry who would use existing wireline technology. Their entry would be enabled by the requirement of the ’96 Act that incumbents were to offer elements of their networks to potential entrants. It was believed that it would be very unlikely that entry would occur, particularly in the residential market, unless entrants could use the incumbents’ network elements. The logic was that it would not be economically feasible for new entrants to replicate incumbents’ network elements—especially the wireline connection into homes (called the “local loop”), and that those network elements thereby created a barrier to entry.
Hence, the only form of competitive entrant that was generally foreseen was “competitive local exchange carriers” (“CLECs”) who would provide wireline local exchange service relying, perhaps indefinitely, on renting the incumbents’ connections into the home at regulated rates. With that vision in mind, it was no wonder that Congress foresaw “deregulation” of the telecommunications industry as requiring long-term, continued regulation.
In fact, competition in telecommunications did not play out as anticipated. CLECs did not prove to be highly successful in the residential market. Rather, technology developed in two ways that profoundly affected the industry and enabled competition for the incumbent wireline carriers (“ILECs”) through alternative means. One was the development of “voice over Internet protocol” (“VoIP”). VoIP allowed cable companies, which already had a wireline facility into a large percentage of homes in America and therefore did not need to rent the incumbents’ local loops, to offer voice service over their existing facilities. Providing voice telephony over cable facilities required the cable companies to make substantial investments in upgrading their existing infrastructure, but the investment was justified by the ability to offer not only video services but voice via VoIP and high-speed Internet access as well—a “triple play” of services that incumbent telephone companies were unable to fully match for several years.
Figure 7 shows the incursion of VoIP into the wireline marketplace. It demonstrates that although wireline lines were declining overall—due to the ballooning popularity of wireless service as a substitute for wireline—the percentage of wireline lines that were served by carriers using VoIP was growing substantially.
Mandatory reporting by VoIP providers started in 2008. Before 2008, ILECs and CLECs voluntarily included numbers of VoIP subscribers, but the degree of reliability of these numbers is unknown.
The second technological development, as just suggested, was the vast improvement in, and reduced cost of, wireless service. In 1996 the notion that wireless service would materially compete with—let alone largely supplant—wireline telephony was still considered by many to be unrealistic. Today, more households have wireless phones than have wireline phones.
Figure 8 shows the precipitous growth of wireless subscriptions in contrast to the decline in wireline subscriptions.
Figure 9 shows the sea-change in telephony in the United States between 2003 and 2016, during which time wireless service transitioned from a supplement to wireline service to the only service for most households.
Changes in business models of both industries leveraged technological developments and strategic innovations.
Post-deregulatory competition led to a surge of creativity in the airline industry. One dimension of change was that airlines developed a new approach to the design of their route configurations. Instead of the point-to-point structure of airline routes that had dominated the industry during its regulated history, post-deregulation saw the rise of the hub-and-spoke system. Hub-and-spoke route structures were thought to provide cost efficiencies to the carriers that were superior to those of the point-to-point structure.
A visual representation of the Eastern Airlines point-to-point route structure that was effective before deregulation can be found in Figure 2.2 of Severin Borenstein’s and Nancy Rose’s How Airline Markets Work . . . Or Do They?, at https://www.nber.org/chapters/c12570.pdf, which can be contrasted with the representation of United Airlines’ hub-and-spoke route system here: http://www.airlineroutemaps.com/maps/United_Airlines.
Innovation also altered traditional pricing models and marketing channels in the airline industry. One such development was the introduction of loyalty, or “frequent flier,” programs. Loyalty programs are ubiquitous throughout the economy today but were novel when introduced by airlines in the 1980s. One can hardly imagine airline pricing and strategy without them today. In addition, the success of their loyalty programs engendered an incentive for carriers to expand them further, leading to the development of “alliances” of domestic and international carriers. Alliances allow customers of the domestic airline to earn frequent flier miles when travelling abroad on routes otherwise outside the reach of the domestic carrier’s footprint, creating additional loyalty within the allied carrier group.
In telecommunications, the ascendance of wireless telephony and the ability of cable companies to use VoIP to compete in voice using their (upgraded) existing infrastructure induced traditional wireline carriers to invest in their own network upgrades. These upgrades enabled the traditional wireline telephone networks to provide broadband Internet access services and, eventually (in some areas) video services. The increased network capabilities also enabled the wireline telephone companies to offer bundles of services in competition with cable providers to discourage customers from leaving.
Many post-deregulation competitive strategies were largely unanticipated. The Internet, whose business and cultural reach and ubiquity continue to outpace the imagination of most observers, has changed how consumers shop for airline tickets and how airlines price. Fare aggregators and carriers’ own websites have largely replaced travel agents for booking of standard tickets, and consumers’ ability to make price comparisons across carriers in real time has strengthened competition on price.
In telecommunications, technological disruption, low-priced mavericks, and price-innovation mavericks in the wireless sector drive many competitive trends in both wireline and wireless services. These trends have included the transitions to distance-agnostic pricing, no-limit voice service, no-limit broadband service, no contracts, smart devices with app-based services, and “free” services such as streaming music and video included in wireless service plans.
One change in the telecommunications industry was arguably predictable but unintended and had no analog in the airline industry. That was the massive movement of capital and resources associated with regulatory arbitrage after the ’96 Act.
Because the Telecommunications Act of 1996—unlike the Airline Deregulation Act of 1978—preserved much of the regulatory overlay on the industry and introduced additional regulation, many prices (wholesale and retail) continued to be regulated. Arbitrage opportunities abounded. One such distortion was the requirement for several years (until the courts effectively put a stop to it) that incumbents allow competitors to offer local exchange service entirely using the incumbents’ networks at regulated, below-cost rates. This opportunity, known as the “UNE-P” for “unbundled network element platform” was seized upon by both AT&T and MCI, both, at that point, long-distance companies. The UNE-P era proved to be disastrous for both companies because once the D.C. Circuit Court of Appeals ruled in 2004 that the ’96 Act did not require carriers to provide the UNE-P at regulated rates, the strategy of offering local service by purchasing the UNE-P from ILECs and, essentially, reselling it to end-users, was no longer viable for AT&T and MCI. Without a viable strategy for offering local service, MCI and AT&T had no viable stand-alone strategies as long-distance service providers. MCI was acquired by Verizon, and AT&T—which had become a small fraction of its size in its glory days—was acquired by its offspring, SBC.
What lessons can be learned from the deregulatory experience of these two industries? Many of the changes in these industries were predicted by general economic principles. The predictable effects were those on prices, quality, and incentives.
The overall direction of price movements (down for air travel, down for long-distance telephony, up for local wireline service) were the expected result of removal of regulation that had, for airlines and long-distance telephone service, supported inefficiently high prices and, for local exchange service, had suppressed many prices. The overall direction of airline service and amenities—comfort and convenience declined, and load factors increased—was predictable due to that industry’s regulatory propensity to inflate prices above competitive market levels, thereby driving carriers to compete on nonprice service attributes.
Finally, the overhang of ongoing and (after the passage of the ’96 Act) expanding regulatory intervention in the telecommunications industry predictably led to regulatory arbitrage, which has not yet fully ended. As regulation evolves and some arbitrage opportunities evaporate, capital shifts to arbitrage opportunities that remain or are newly created.
Many of the most important changes in the industries were unanticipated. These included the utterly transformative effects of technological change on the telecommunications industry, which circumvented and superseded the entry strategies that Congress had envisioned and facilitated via the wholesale obligations of the ’96 Act. Important but unanticipated developments also included the transformative effects of technology on the way airline services are sold, as well as the appearance of clever new business strategies in both industries.
Clearly, many aspects of the deregulatory strategy in telecommunications—the new wholesale obligations, the regulated prices at which those obligations had to be met, the retention of universal service objectives that were incompatible with the full development of competition, the retention of regulation at the state level—engendered misallocation of resources and misguided business strategies designed to capitalize on arbitrage opportunities. In addition, a body of literature across several industries finds that regulation tends to keep prices high, to the detriment of consumers. State regulators could have deregulated retail prices much more quickly than they did, but they generally expressed concern that immediate deregulation of retail prices would lead to precipitous price increases that would have harmed consumers and might have reversed the success of universal service objectives. Economic principles dictate, however, that allowing prices to rise to market levels would encourage entry, innovation, and investment, as well as efficient allocation of resources, to the benefit of consumers.
These considerations suggest that gradual deregulation in telecommunications was ill-conceived and that an approach closer to the one adopted for airlines would have been superior. But what of the bankruptcies in the airline industry post deregulation? The purported justification for airline regulation in the first instance was to protect the industry against destructive competition, a concern that appears to have been justified by the post-deregulation bankruptcies. The post-deregulation period experienced not only airline bankruptcies but also highly volatile airline profits and periods of sustained losses.
Researchers have argued, however, that it is not clear to what extent the volatility in airline profits and subsequent losses and bankruptcies were caused by deregulation, were harmful from an overall economic viewpoint, or would have been mitigated by gradual deregulation. Bankruptcies are inevitable in markets in which providers’ strategies are exposed to the harsh sunlight of competition. Strategies and carriers that prove less attractive to consumers, are less efficient, or are less nimble do not survive. The sustained periods of losses coincided with the U.S. recession and with the post-911 period, neither of which would have been avoided had the airline industry been deregulated more gradually.
Finally, there is some economic evidence that regulation slows innovation. Available evidence in the railroad and medical device industries, as well as others, suggests that rate regulation retards innovation. In telecommunications, regulatory delay was thought to have postponed the introduction of voicemail services by several years, resulting in over a billion dollars in loss of consumer welfare in 1994 dollars.
There also is evidence, however, that some environmental regulation and standards have had pro-innovation effects. Hence, the literature on the effects of regulation on innovation appear to demonstrate that, while it is tempting to generalize, the effects of regulation depend on the nuances and details of the regulatory structure.
