Monopoly in Alaskan Skies

The Case of Alaska Airlines

William S. Brown, Ph. D.
University of Alaska-Southeast

Air transportation is more important to Alaska than any other state. Many Alaskan communities are not served by the road system and even for those that are, the distance that must be traveled is often so far that air transportation is the only practical means to travel. Transportation problems are particularly acute in the Southeast and Bush communities. Not only is it impossible to drive between many communities, but air travel is served by only a single monopoly carrier, Alaskan Airlines. As this paper will show, the monopoly in the airline industry has serious adverse consequences for all Alaskans, including higher prices, inferior service and less innovation conditions that harm Alaskans who need to travel and Alaskan businesses which benefit from travel to, from, and within our state.

It is time to examine whether something can and should be done about the monopoly power of Alaska Airlines. This paper will begin with a simple economics lesson by defining monopoly and explaining why economists are so concerned about its existence. Next, we'll briefly review the Airline Deregulation Act of 1978 and trace how it has affected air transportation in the United States. We'll then return to economic theory to examine the conditions where it is appropriate and inappropriate for the government to be involved in the affairs of private business. This will provide us with the information necessary to consider the questions at hand:

Does Alaska Airlines have a monopoly in parts of Alaska? What, if anything, should be done about it if it does? Does Alaska Airlines Have Monopoly Power in Alaska? Economists define monopoly as an industry dominated by a single firm producing a good or service for which there are no good substitutes available. A classic example of monopoly is the local electric company: There is only one company, and there are few good substitutes for electricity. In some communities, the electric company is publicly owned; in others, it is privately owned. But in all cases, electric utility companies are tightly regulated as to how they do business what prices they can charge, and so on. There is a simple reason for this: If the utility company were not regulated, it could (and probably would) charge exorbitant prices. Customers would obviously complain, but if there were not good substitutes for electricity, they would be forced to pay or do without.

Economists as far back as Adam Smith in 18th century Scotland have recognized capitalism works best when there is vibrant competition: When competition prevails, the market process automatically generates the best of all possible worlds goods that customers want are sold at "fair" prices close to the actual cost of production. In the absence of competition monopoly fewer goods are offered and prices are higher.

Contemporary economists have elaborated on the problems associated with monopoly in some significant ways. First, market competition provides an incentive to innovate new products and improve production methods. For example, extreme competition in the personal computer industry has resulted in a steady flow of new and better computers selling at lower and lower prices. Most economists worry that these incentives are weak or even absent under monopoly. The Austrian economist Ludwig von Mises may have expressed it best when he argued that the profits earned by monopolists are not the result of entrepreneurial activities, but the result of mere ownership of a monopolized factor of production.

A second problem associated with monopoly has been called DUP for directly un-productive activities. That is, a firm with monopoly status will typically engage in activities designed to maintain its monopoly status and monopoly profits activities that, in themselves, do not produce any tangible goods for society. In the past, for example, steel producers have lobbied Congress to keep out imported steel. Such lobbying would be considered DUP activities: It is costly to domestic steel producers and produces nothing for customers but may preserve jobs and profits in the domestic steel industry because inefficient producers are not faced with foreign competition.

Pricing strategies under monopoly. Just because a firm has a measure of monopoly power does not mean that will charge the highest possible price. If it charges a price too high, there are two likely consequences: First, consumers will look for substitutes. For example, if we were charged $150 instead of $15 per month for local telephone service, letter writing would suddenly become much more popular! Second, high prices may attract entry into the industry and erode the incumbent firm's monopoly status. Economists have developed a large literature on optimal pricing strategies under monopoly: some monopoly firms set prices to deter entry; others engage in "predatory pricing" meaning that they lower prices to drive competitors out of business; and some monopolies behave exactly as if they were facing severe competition from a number of other firms they set prices just high enough to earn a "fair" return on a "fair" valuation of capital.

But whether monopolies set "high" or "low" prices is not really what distinguishes monopoly pricing from pricing in competitive markets. The key is that monopolies have the ability to set their prices; they do not have to accept the market price. For example, when wheat farmers take their crops to the market, they can only hope for a good price; they cannot set the price and look for buyers. Monopolies are different: they can offer their products on the market and any one of many prices. Clearly the price they set will have an influence over how much they sell, but it is up to the monopolist's discretion as to whether it wants to sell a large quantity at a low price or a small quantity at a high price. Many factors go into the pricing decision most of which are under the monopoly firm's control but just what prices are charged depends on the goals of the monopolist.

When a monopoly is not a monopoly: the theory of contestable markets. Even a cursory examination of air transportation in Alaska is enough to suggest that Alaska Airlines is a monopoly in many Alaskan markets. However, before we should accept this conclusion, we need to examine one more economic theory, the theory of contestable markets. In a nutshell, this theory says that a monopoly firm will act as if it is a competitive firm (i.e., charge prices close to cost, and make only "normal" profits) if it fears the potential entry of a competing firm. When John Kelly, President and CEO of Alaska Airlines writes that he, " approaches every markets as if we had a competitor," he seems to be echoing contestable markets theory. However, a closer inspection suggests that few air transportation markets in Alaska fit the definition of contestable markets.

Economists argue that four conditions must hold for a market to be classified as contestable. First, the potential entrant(s) must be able to serve the same market demand as the existing firms in the industry. Second, the same production techniques used by existing firms must be available to the potential entrants. Third, potential entrants firms must incur zero sunk costs. Sunk costs are costs which cannot be recovered even if a firm exits an industry. Finally, the potential entrants must estimate profits based on existing industry prices; that is, their entry into the industry cannot depress prices and eliminate profits. The first two conditions are easy to satisfy, and the third often holds approximately.

It is the fourth condition that negates the assumption of contestable markets: When Mark Air entered the Juneau-Seattle market, Alaska Airlines dropped prices (below cost, I suspect), and with its larger pockets, was able to sustain losses much longer that Mark Air. As is well-known, Mark Air soon went out of business, but that is not the important issue. What is important is that history of the Mark Air price war represents a real threat to any future entrants Alaska Air will use predatory pricing even if it requires sustaining substantial short term losses to drive any future entrant out of the market. This seems contrary to the quote from the President of Alaska Airlines cited above: If Alaska Airlines always acts as if there is a competitor in the market, then they should be lowering prices dramatically all the time!

Deregulating the Airline Industry

In many ways, the roots to the problem date back to the Airline Deregulation Act of 1978. In general, this Act was, and remains, quite popular among economists a view may have been best expressed by Alfred Kahn, President Carter's chair of the Civil Aeronautics Board, who said, "I have more faith in greed than in regulation." Proponents of airline deregulation believed that deregulation would bring down prices in many markets, generate market efficiency, and make airline markets contestable. At first glance, it appears that the proponents were right: Between 1980 and 1989, average air fares fell 20 percent, and the number of passenger miles flown doubled between the 1970s and 1990s. There were, of course, a few casualties along the way: average airline profits fell, and several carriers exited the industry, but most economists believed this was merely the forces of "creative destruction" working themselves out, not something to be concerned about.

But the popular pro-deregulation view was not the only one heard when the bill was being debated in Congress. Many people but especially the major airlines and unions expressed two main fears. First, they feared that deregulation would make airlines unsafe. This fear appears to have been unjustified given the continuing safety in airline transportation today. It is the second fear that is most important for this paper: Opponents of deregulation were concerned that small communities would be hurt by deregulation with higher prices and less service. Once the airlines were deregulated, it was argued, there was little reason for the airlines to serve small communities if they could make higher profits flying between large communities, and there was no reason to serve these communities if they incurred losses in the process. And if the number of carriers serving these communities fell, there would be less competition and thus higher prices.

The deregulators recognized this problem, so to prevent deterioration of service to smaller communities, the Essential Air Service Program was passed. This program established a 10-year transition to the new, deregulated system to ease the adjustment costs. The cost of this program was $71 million in its first year of operation, with the bulk of this money spent to subsidize air fares to and from 202 communities in the continental United States. By 1987, this cost had fallen to $21 million. The Act was extended for another 10 years in 1987, though with lower levels of funding. Alaska and Hawaii were granted special status because of the unique role played by air transportation in those states. Today, Alaska Airlines receives substantial subsidies on several of its routes in Alaska (which ones and why)

Recognizing that there may be a problem with air service to small communities, the General Accounting Office and Federal Aviation Administration conducted a series of studies in 1996. These studies reached several important conclusions:

  1. average air fares, adjusted for inflation, have decreased;
  2. the number of departures and seats have increased;
  3. the accident rate has been lower.

However, as encouraging as these results might seem, it should be stressed that they are averages, because not all air fares declined and the number of departures and seats did not increase in all communities. In fact, GAO officials discovered that air fares increased rather sharply in several small and medium-sized communities.

Why did fares rise and service decline in some small and medium-sized communities? The main reason was the existence of barriers to entry which prevented the entry of new carriers and subsequent price competition. These barriers included federal limits on takeoff and landing slots in major cities and long term, exclusive-use gates leases. Another important barrier was the competitive strategies of some existing carriers which made entry by new carriers risky. These strategies include paying bonus commissions to travel agents, frequent flier plans, and code-sharing partnerships with commuter carriers.

These studies contain a wealth of information for anyone curious about air fares in the era of deregulation, but they have a serious flaw for Alaskans: They were confined to the contiguous 48 states! One can only infer how much they relate to the very special problems of air travel in Alaska. It could well be that Alaska's problems are so special that a different methodology would be necessary to understand the Alaskan airline industry; Alaska certainly does not face the same sort of federal limits on takeoff and landing slots that apply to New York's LaGuardia airport. The same cannot be said for the implicit barriers of frequent flier plans and code-sharing partnerships; these may be even more important in Alaska than the contiguous 48 state. The fact is, we don't know and we can't know until a serious study is conducted.

But Should the Government Be Involved?

Suggesting that free market forces may be working against the best interest of the Alaskan public, or (heavens!) that the GOVERNMENT should consider re-regulation the airlines is anathema to most economists, and, I would suspect, the vast majority of Alaskans. However, economists recognize that even the most ardent laissez faire advocates admit that markets fail on occasion, and thus do not generate the best social outcome. That's why we have speed limits and stop signs! Without the intrusive intervention of the government, we would be free to drive as fast as we wanted, and zip through intersections as we pleased but few would argue that we would be better off if all speed limits and all stop signs were eliminated. It is appropriate for the government to be involved in the economy. The question is how much involvement is appropriate, and how to make that involvement as unobtrusive as possible.

The extent of government involvement in the economy will always be a contentions issue for a simple reason: The power to regulate is the power to coerce and there is no easy way to measure the benefits of government involvement. We can often calculate the costs what we pay for traffic officers, wasted gasoline as we start and stop at stop signs, etc. but measuring the value of the lives saved is simply impossible. What this means is that before we are ready to allow government to interfere with the private economy, we need to be sure that any such involvement rests of logical, scientific economic theory.

There are more than a few jokes about disagreement among economists, but when it comes to monopoly, there is general though not unanimous agreement that most monopolies do more harm than good and must be broken up. This attitude has been part of federal antitrust law for almost a century. The first major piece of antitrust legislation in the United States, the Sherman Act (1890), was passed to prevent the sort of behavior practiced by Standard Oil which had been using predatory pricing to drive competitors out of business, and then once it had a local monopoly, raising prices to what were considered exorbitant levels. Unfortunately, the Sherman Act and the companion Clayton Act (1914) were a bit vague in their wording. As a consequence, the enforcement of antitrust statutes was left to the interpretation of judges.

The philosophies of antitrust enforcement. The courts have used two main philosophical rules in the application of antitrust legislation, the rule of reason and the per se rule. The rule of reason gave considerable latitude in enforcement: Suppose that two firms in different industries decide to merge into a conglomerate. Such a merger would not necessarily be harmful, so the courts would have to look into the "evident purpose" or reason for the merger to decide whether it should be allowed. The rule of reason dominated antitrust rulings until about 1940 when it was replaced with the per se rule. The per se rule works like this: Certain practices say price fixing by a cartel can have only harmful effects, so price fixing by the cartel is considered a "per se" offense or an offense "in itself" and must be outlawed. As you might guess, per se rule antitrust cases tend to be much shorter than cases based on rule of reason arguments.

Does any of this apply to Alaska Airlines? That could be determined only with an in-depth study by the justice department, but there is certainly the suggestion that an investigation may be appropriate: Alaska Airlines' pricing strategy changed markedly when faced with competition by Mark Air. Is this predatory pricing of the same variety used by Standard Oil in the 1890's? Only an investigation could know for sure. Does Alaska Airlines pay bonus commissions to travel agents that prevent entry? Are there code-sharing agreements with air taxis and other carriers that make it difficult for entry to occur? These actions could be classified as per se offenses but, again, only a careful study could make this determination.

Conclusions and Suggestions

Do we even have a monopoly problem? Are Alaskan air travelers being hurt? Anecdotal evidence from the xxx who have signed petitions gives an emphatic Yes! But that is far from scientific. We need a dispassionate study, perhaps the sort of study that the GAO did in the lower 48. If nothing else it is a matter of state pride: With air travel so important to all Alaskans to travelers, to consumers, to tourists, to business we should feel insulted that the federal government chose to study the air transportation problems faced by small and medium sized communities and ignored our state. We need to conduct that study. Alaskans deserve nothing less. It could be that such a study would show that the anecdotal evidence of high fares and shoddy service by Alaska Airlines is just that, anecdotal, and nothing needs to be done. But if it is shown that Alaskan Airlines does have a monopoly and that air travelers are being hurt with poor service, poor scheduling, and high prices, then what to do? There are three possible scenarios that must be considered:

  1. It could be that the market is too thin to support more than one carrier in some parts of the state but that more than one carrier could operate profitably in other parts. In those areas where the market can support only one carrier, then a case should be made for consumer protection and/or airline subsidies so that ticket prices and service will approximate what would be achieved under a competitive system. Ticket prices do appear to be substantially higher in Alaska than in the lower 48 (Ketchikan to Seattle, 678 miles: $344; Seattle to San Francisco, 672 miles, $61). Are these prices justified by costs? Only a careful study can tell.
  2. If the market is broad enough to support more than one carrier as it certainly seems to be in much of Southeast then measures should be taken to attract entry into this market. Unfortunately, we should not expect entry without some sort of incentives given Alaska Airlines very credible threat to engage in predatory pricing to deter entry. This means that we will need some sort of creative incentives to attract entry. Perhaps a solution can be suggested by the classic 1945 antitrust case, United States vs. Aluminum Company of America. ALCOA had long had a monopoly on aluminum production in the United States. Circuit Judge Lerned Hand ruled that ALCOA was guilty of illegal monopolization because of its size alone. Said Judge Hand: "ALCOA did not have to seize every opportunity " to be guilty of monopoly behavior. It is important to note that ALCOA had not used any of the aggressive or predatory practices that had been the basis for antitrust litigation in the past. In fact, ALCOA practiced limit pricing, the strategy of keeping prices low to deter entry. Judge Hand noted that ALCOA's sales plus its own internal use of aluminum constituted fully 90 percent of the total production plus imports, enough to constitute a monopoly. Interestingly, the solution was not to dissolve ALCOA. Instead, the federal government subsidized the entry of Reynolds and Kaiser Aluminum into the aluminum industry by selling them war plants at bargain prices. Other subsidies were later given to three more entrants into the aluminum industry.

Does Alaska Airlines have a monopoly in the skies of Alaska? It appears that it does but without a careful study, we have only anecdotal evidence. We need that study. Alaskans deserve that study. And if it is determined that Alaska Airlines holds monopoly power, then measures should be enacted to attract additional carriers. All Alaskans will benefit.