Benjamin Limmer

History of Aviation

Executive Summary

The airline industry has been over time one of the staples of America. It is one of the most successful and globally visual industries in the United States today. We arguably have more air traffic in and out of Hartsfield International in Atlanta (our nation's busiest airport) than any other entire nation in the world. This industry has grown to unprecedented numbers, with our airline carriers creating a growing presence overseas as well. The vitality of this industry was rocked on September 11, 2001, when four commercial airliners were highjacked and used for suicide bombings. This apparently disrupted the entire industry and threatened to shake the entire industry and domestic economy to levels unheard of during this entire generation. The government took action eleven days after the terrorist attacks with an extensive airline aid package. This extensive package, although at the surface seemed essential, may not have had any effect on the industry or the economy.

In this analysis, I will take an in-depth look at the airline industry since deregulation during the late 1970's and through the terrorist attacks of 9/11. I will analyze system data, as well as financial data of the industry, to attempt to describe the situation of the industry both before and after the attacks. An in-depth look into the fundamental microeconomic framework of the industry will also be discussed in detail.

Overall, I believe anyone will agree that the airlines were justified support of some magnitude. To what magnitude is another question? What was the industry's effect on the entire economy and would either or neither of them had been affected without the attacks? Was the aid package politically, economically, or politically-economically motivated? These are all fundamentally important questions that I will attempt to answer. In the end, one will see the realities of what happened to the industry and the overall economy on September 11, 2001, and what should have or should not have been done to the airline industry specifically. Regardless of what happens in the future, no one will argue that American social, political, and economic forces changed with the blink of an eye on that particular day.

Deregulation

Up to 1978, the airline industry resembled a public utility being governed by two separate government agencies. The private industry had essentially no control over their own fate for that matter. It wasn't the market driven industry as it is today. What happened and how did it become this way? On October 24, 1978, Jimmy Carter signed the Airline Deregulation Act which would affect the industry more than any other piece of legislation. It was brought about for several years and for several reasons. Advancements had been made increasing the size of passenger airlines, the Middle Eastern oil embargo, inflation, and the overall economic downturn. All of this was brought about primarily though due to the incredible inefficiency, unreliability, and overall cost of the industry.

Deregulation began in 1977 with the deregulation of air cargo, which was the first step in proving it would also work for passengers. This caused a major push in the traffic of express package delivery. This was incredibly popular with businesses and the express package delivery industry was an incredibly beneficiary of airline deregulation. A year later, passenger deregulation came to fruition with the abolishment of any governmental interference in setting routes and rates. This obviously caused the CAB to vanish.

Before dissecting what occurred when the airlines were deregulated, some things did remain regulated. International flights were still regulated mainly due to the agreements that the two nations would have to make just to have international service in the first place. Before 1978, the CAB could grant mergers and exempt those involved from anti-trust issues. This was still in tact for the international flights, but not domestic. Essential air service was also another function not to die. It forced the airlines to serve small and medium sized markets through incentives and subsidies. The last function not to be deregulated was safety. The government, especially since September 11th, is highly responsible for the safety of the industry.

Deregulation had several major effects to the airline industry. It first and foremost completely changed the routes traveled and the hierarchy of the airline network. The "hub and spoke" system was an immediate result of deregulation. The "hubs" were major transfer points for the airline and passengers, strategically located for a spatial monopoly. This caused individual airlines to take hold on individual "hubs" so they could capitalize on the new movement. Today, we see hubs such as Delta in Atlanta, American in Dallas, United in Chicago, Continental in Houston, and U.S. Airways in Pittsburgh. The "spokes" were the smaller airports nearest to the "hub" airports and thus, allowing the most efficient airline travel in history.

The main reason for the establishment of the "hub and spoke" network is so the airlines can accommodate a wider geographic area more efficiently than before. It also allowed the airlines to compete by attempting to carry passengers from beginning to final destination on the same airline and thus, eliminating the need to transfer to another airline. Most importantly, it aided the airlines in achieving higher load factors. Take a city such as Des Moines, Iowa. This is traditionally a medium or small sized market, but with a "hub and spoke" system, several passengers can begin in Des Moines and take a "spoke" route to Minneapolis-St. Paul and then each passenger can break off to their final destinations. This allows the most efficient service to and from smaller markets and at lower fares.

Airline deregulation also caused some spin-offs and, essentially a chain reaction of benefits, due to the "hub and spoke" network. Reshuffling among the major carriers was highly apparent immediately following deregulation, but new airline carriers sprouted up as well. In 1978, there were just over 40 airline carriers. Today, there are nearly 100. This number has fluctuated over the course of time, according to market conditions, but has surged lately due to the Air Trans of the world offering low-cost, direct, hassle-free service to certain locations. These types of airlines would reuse pilots, aircrafts, mechanics, and other resources to operate more efficiently than the large carriers. This also for obvious reasons caused a major increase in overall competition with the emergence of these new carriers with the large carriers, and the emergence of new airline markets (i.e. Moline, Illinois or Northwest Arkansas Regional). At the present time, 85% of passengers have a choice between at least 2 airline carriers for a trip compared with 60% around the time of deregulation. This has caused the airlines to fiercely compete with each other in all sized markets, with the most intense competition occurring in the small and medium sized markets once again. On top of this, discounted fares were widespread to aid in beating the competition. This is the most obvious benefit to the general public of airline deregulation, leaving their pockets still jingling after ticket purchases. In 1999, the Brookings Institution estimated that the American public had saved over $20 billion in real dollars since airline deregulation. These savings arrived from the combination of discount fares and increased service. Nearly all the flights of today are discounted in some way shape or form. This unprecedented amount of discounted fares has then caused a rapid increase in air travel as a whole. It has been estimated that over 85% of the general adult public has flown during the course of their lives. During 1977, the airlines carried nearly ¼ million passengers and by today, that number is approaching 700 million. This enormous growth in air travel has caused the airlines to fight for the repeat customer as well. This can be accomplished through the advent of frequent flyer programs. These programs essentially allow the passenger to accumulate miles to receive free airline travel and other benefits. This was a marketing innovation that worked beyond anyone's wildest dreams. These programs not only exist with widespread success, but several tie-ins and partnerships have come about such as those with credit card companies, rental cars, restaurants, hotels, and even 1800FLOWERS.com.

9/11: Air Transportation Safety & Stabilization Act

On September 11, 2001, the lives of New Yorkers, Americans, the World, and the airline industry would forever change. At around 9am, terrorists had hi-jacked four planes and had run two of them into each of the World Trade Centers, one into the Pentagon, and the other crashed in Pennsylvania. This even caused 3,000 deaths, brought reality to an American generation who had been spoiled with peace, and worst of all, generated a major problem for the airline industry and the economy as a whole. The terrorist attacks caused a full two day shutdown of all airline traffic in the United States, but would ultimately cause a longer term reduction in air travel. In the 11 days after the terrorist attacks, the airline industry cut their schedules by over 20% and reduced the number of employees by over 80,000. Overall, the airlines predicted layoffs totaling over 100,000 employees, over $11 billion in total losses, continued losses in flight capacity and revenue, and added cost due to new security due to the attacks.

The event of 9/11 would cause government to intervene in the airline industry in a way it was not accustomed to. On September 22, 2001, President Bush signed the Air Transportation System and Stabilization Act, or Public Law 107-42, which brought assistance in many forms to virtually all facets of the airline industry. Bush said the Act "will provide urgently needed tools to assure the safety and immediate stability of our nation's commercial airline system. This important legislation also establishes a process for compensating victims of the terrorist attacks." This Act also created the Air Transportation Stabilization Board, which was responsible for administering the $10 billion in loan guarantees and the $5 billion in cash payments to the airlines. The Act as a whole established the following aid package for the airlines:

Ø $5 billion in cash payments to the airlines ($4.5 billion to passenger airlines, $500 million to cargo carriers)
Ø $10 billion in loan guarantees to airlines with airline stocks and options serving as collateral for the loans
Ø The airlines liability for the events of 9/11 be limited to the extent of their insurance coverage that they carried at the time of the attacks
Ø The airline executive that earned over $300K receive no pay increases for two full years
Ø Established a victim compensation fund and available to victims only if they renounced their right to sue the airlines in court
Ø The airlines continue to provide adequate and essential service, the service program that was doubled at the beginning of the fiscal year before the attacks

The politically fragile Act passed the House by a 356-54 margin, and passed the Senate by a 96-1 margin. The primary reason for those who opposed the legislation was that it did not cover supporting industries and the airline industry employees who lost their jobs due to the terrorist attacks and the consequent financial constraints of the airlines themselves. This bill demonstrated the widespread and bipartisan support, probably for political reasons, but mostly to ensure the overall support of all those involved in the terrorist attacks such as the victims, communities, the industry, and the economy as a whole.

As mentioned above, the Act created the Air Transportation Stabilization Board to administer the loan guarantees. The mission statement of the newly created board is "On September 22, 2001, President Bush signed into law the Air Transportation Safety and System Stabilization Act. The Act establishes the Air Transportation Stabilization Board. The Board may issue up to $10 billion in Federal credit instruments, e.g. (loan guarantees)." The commercial airlines will get three rounds of loan guarantees, but:

Ø The obligor is an air carrier for which credit is not reasonably available at the time of transaction
Ø The intended obligation is prudently incurred
Ø Such agreement is necessary part of maintaining a safe, efficient and viable commercial aviation system

Who got what?

The cash payments, and more importantly, the loan guarantees were intended to stabilize the industry and to prevent financial hardship as a result of the terrorist attacks. Dorothy Robyn, a former economic policy advisor to Clinton said critics of the federal government's bailout should consider the alternative. "I think some help is appropriate. The trick is to figure out how much and in what form, so we don't end up bailing out companies that were in financial trouble even before September 11th." This was a legitimate concern indeed as I will outline later in the paper when analyzing the financials of the industry as a whole. Indeed, it has always been the nature of the industry since deregulation for bankruptcies, mergers, alliances, and other business activities to occur between the airlines to remain on the edge and competitive.

Vanguard Airlines of Kansas City, Missouri, received the first installment of government loan guarantees when on October 1, 2001; they took their initial installment of $4.5 million through the Air Transportation System and Stabilization Act. This was only the beginning of what was to come. Small, medium, and large airline companies were all eligible for loan guarantees. As mentioned earlier, so were the cargo carriers, a group that is easily forgotten about in light of what has happened to passenger airlines. The largest loan guarantees were for the 7 largest airlines naturally, with the payment totals to date listed below along with the share of all loans granted up to December 10, 2002:

Ø United (Chicago) = $774.2M/16.93%
Ø American (Dallas) = $639.9M/15.18%
Ø Delta (Atlanta) = $635.7M/13.90%
Ø Northwest (Minneapolis) = $405.5M/8.87%
Ø Continental (Houston) = $361.4M/7.91%
Ø US Airways (Arlington, VA) = $306.9M/6.71%
Ø Southwest (Phoenix) = $282.8M/6.19%

Remember, these are the payments already received. Each airline does get three rounds of loan guarantees. Many other large airline packages are currently pending, or have very recently been realized. Many of the following recent requests are pending and will not be granted until at least October 2003, with the most notable of recent history, United Airlines declaring bankruptcy in December 2002:

Ø United Airlines = $1.8B/filed Chapter 11 bankruptcy on 12/8/2002
Ø US Airways = $900M/pending
Ø America West = $379.5M/pending
Ø Spirit Air = $165M/pending
Ø National Airlines = $50.5M/pending
Ø Vanguard Airlines = $15M/denied due to the questionable ability for the company to repay the loan guarantee
Ø Frontier Flying Service = $7.2M/denied

The loan guarantees to airlines have been for large commercial airliners, cargo carriers, and private airliners. The distribution of aid is broad and complex. For instance, some of the carriers who were granted the largest guarantees include Federal Express, UPS, and Atlas Air, all cargo carriers. In addition, a total of 419 airliners have been granted loan guarantees but most of them the general public has never heard of and the industry doesn't necessarily depend on these small airliners for their general financial well being. A complete list of the up-to-date loan guarantees granted is listed at the end of the report in Appendix I. The industry and its airlines predict that even additional aid will be needed in order to save the industry, but many feel that the industry should just sort itself out as it has in the past.

Was this a good law?

Since the industry is so competitive, mostly as a result of deregulation as mentioned earlier, it seems reasonable to use the old microeconomic model of competition within industries to analyze the effects of September 11. Profits within the airline industry during the years since deregulation have been growing at reasonable rates over the years, especially during the late 1980's and early 1990's. During the time prior to September 11th, was the industry in the long-run equilibrium. That would be safe to assume since the industry had all the characteristics of a traditional capitalist industry. The September 11 terrorism caused demand to fall to levels not experienced in memory. Most industry experts predict that the industry will never reach the levels it had prior to September 11th. They claim the industry is damaged forever.

Figure 1 below shows the airline industry on September 10, 2001 in long-run equilibrium. At the market clearing price, P*, each firm earns zero economic profit. Industry output is Q*, and each firm produces q*.

Figure 2 shows the industry after September 11, 2001. Industry demand has shifted leftward, the market-clearing industry price has dropped from P* to P**. Industry output falls to Q**, and each firm produces q**. Firms in the industry will lose money at P** equal to the teal-shaded area (SAC - P**)q**.

Figure 3 below shows the restoration of long run equilibrium that would occur in the absence of government aid. In a competitive industry, price must equal minimum average cost in the long run. However, the post-September 11th long-run equilibrium likely would occur at a slightly lower industry price than P*. This is due to airline costs dropping as industry demand contracted below Q*: laid-off pilots, mechanics and flight attendants might accept lower compensation to secure jobs at other airlines, surplus aircraft might become available at lower costs than new aircraft, and airlines would cease serving their highest-cost locales. These decreases in costs would cause the firm's costs in Figure 3 to drop from LAC, SAC, and SMC to LAC', SAC', and SMC'. The post-September 11 long run equilibrium would occur at P' rather than at P*. In practice, Figure 3 shows what happens to the large airlines such as United as opposed to smaller airlines such as Air Tran and how the two companies interact in the competitive marketplace. These basic economic graphs are intended that government should have let the industry work out their wrinkles.

The airline industry is at long-run equilibrium at P' by firms exiting the industry. As long as consumers demand of airline travel is falling, as reflected by demand being D' rather than D, long run equilibrium requires provision of less airline service than Q*. Exit of firms in the industry shifts industry supply to S', and long run equilibrium is restored when price is P', industry output is Q', and each firm produces q'.

During transition from September 11th, until long-run equilibrium is restored at P', Q', economic theory predicts that airlines will lose money and continue to lose money with no end in sight. The losses cause the exiting of firms which is needed to restore the new long-run equilibrium at P',Q'. Exit also causes hardship on airline employees as the airlines lay off workers to reduce output and as airlines exit the industry and lay off workers when they cease operating. All in all, the overall effect of the aid is that the government aid doesn't change the shift of demand from D to D'. Government aid merely helps airline shareholders by transferring some of their losses to taxpayers.

The tables shown above portray a traditional competitive industry, with typical firms, in a competitive environment. Several assumptions are made within these figures such as the assumption that all firms have identical costs. We all know that some airlines operate more efficiently and others operate less efficiently. Most familiar to most travelers is the case of Southwest Airlines and how they are generally considered the best managed airline, while Northwest Airlines has been criticized as an inefficient company. Should Government aid help poorly managed airline companies? If Government aid were the difference between survival and failure for all airlines, should the Government impose its judgment, rather than market judgment, to decide which airlines are managed well enough to warrant aid and warrant surviving? This is at the core of the problem between government aid and the airline industry. The industry will become healthier for all if the airlines work competitively. We all know from experience that a high level of governmental interference when not warranted can wreck, or at least harm powerful industries.

Financial Outlook: Pre-9/11 vs. Post-9/11

The airline industry today as mentioned earlier has nearly 100 commercial airline carriers, many more than the deregulation days. Despite this, the industry is "top heavy". There are 7 incredibly large airlines, and soon to be fewer than that. It is not unrealistic to think that we will someday have only 2 or 3 major airlines, with several subsidiaries. This has occurred in all phases in the development of the transportation infrastructure, from the waterways, to the railroads, to the Interstate highways. Downsizing is the nature of any deman oriented industry, and no industry reacts to demand quite like the transportation industry. Look what happened to the railroad industry after the advent of the automobile.

These incredibly large air carriers are associated with airports as I mentioned earlier in the "hub and spoke" discussion. They are also associated with routes, whether small or large airlines (i.e. Air Tran, Akron/Canton to Atlanta or Northwest, Detroit to Amsterdam). Other geographic patterns emerge with these large airlines. Analyze a service map of Southwest Airlines, one of the most successful, you will find heavy service out West and "selective" and "strategic" service to the Midwest and Eastern Seaboard. These patterns among the airlines and the industry as a whole constitutes constant shifting and reorganizing of the aforementioned variables in order to maximize profit and minimize cost. Senator Chuck Grassley (R-IA) once said to President Bush, "The airline industry is a marginal industry, just like farming. And just like farming, it depends upon a constant and consistent flow of cash."

It is now time to analyze the industry as a whole prior to September 11th vs. after the terrorist attacks. I will incorporate a series of financial graphs obtained from the Bureau of Transportation Statistics in order to give a visual representation of what has been occurring over the past 5 fiscal years, encompassing 20 quarters.

Before I discuss the financial situation of the entire airline industry, analyze the Figure 4 above. As one can see from the graph, prior to September 11th (the red indicates the quarter of attacks in all of the following charts), the number of departures fell through the floor after the attacks (see Appendix II). Who is to say that the airlines had too many departures given the demand prior to September 11th? This may become very apparent in the following figures.

Figure 5 above outlines the total operating expenses for the industry as a whole over the past 5 years. As one can see, the industry had declining operating revenues for two straight quarters prior to September 11th. This revenue graph is including passenger and freight revenues, the decline in just passenger revenues is much more evident. Figure 6 is the total operating expenses over the past 5 years. As one can see, the expenses had been steadily rising, indicating an incredibly dynamic industry with a large amount of competition. The revenues were falling along with the expenses increasing. This didn't paint a pretty picture and may have been blurred by the terrorist attacks. For a comprehensive financial report of the airline industry, see Appendix III at the end of the report.

Recall Mr. Grassley's commentary about the airline industry. He stressed the word "marginal". Well, look at the total operating profit margin as a percent portrayed in Figure 7 above. The operating profit margins had been falling through the floor prior to September 11th. Now, take a quick glance at the total net income margin of the industry (the peak is the Winter Olympic Games of 1996, in Lake Tahoe, California). As one can see, the net income margin had been declining for nearly 3 years, another indication of a healthy industry suffering from a large amount of competition. A quick look at either of these graphics by Congress and we may have had a slightly different result in legislation.

Implications for Burke

The before and after September 11th trends outlined above indicate that the international, national, and local airline industry was beginning to see a drastic decrease in cash flows even prior to the terrorist attacks. Many of the smaller airports were hit the hardest by such cash strapped situations, especially general aviation airports such as Burke according the Bureau of Transportation Statistics, 2002. The economies of scale in the realm of commercial airports put Cleveland Hopkins (as well as the smaller brother Burke) at an extreme disadvantage when coupled with tough economic times. Hopkins role in the regional aviation market (Detroit Metro, Toledo, Columbus, Akron/Canton, and Pittsburgh) is incredibly limited, especially with Hopkins heavily reliant upon one commercial carrier such as Continental. Any decline in Continental's customer base could ultimately prove drastic for Hopkins and the Cleveland market. If Hopkins is to face such tough economic times while "supporting" such money pits as Burke, it must strategically play its role in the regional market to perfection. Hopkins will always be behind a Pittsburgh and Detroit, but it can manage its assets to a higher degree. Whether this means getting rid of Burke or improving conditions at Burke, which is yet to be determined. Hopkins must decide which way it wants to go.

According to the Reuter's Business Journal, the private corporate jet market, along with corporate "time-share" jet market is on a drastic decline since 9/11. This is contrary to popular belief since the general public believed many would shy away from commercial airliners in light of what occurred on that dreadful day. The fact of the matter is that the underlying economic cycle within the airline industry was taking over and people's preferences do in fact have a financial roof. Given the current conditions at Hopkins and at Burke, each must play their current role in the market to perfection and not plan on making any drastic moves anytime soon (i.e. commercial services at Burke or catering to terminal construction at Hopkins). All in all, 9/11 changed the airline industry locally, but similar changes were most likely on their way even without the attacks. As a matter of fact, under the newly developed Air Transportation and Stabilization Act no tenant of Burke, nor any user of Burke, received any federal aid to help recover from 9/11. One interpretation of this is that no operation at Burke is qualifies to receive federal grant money, even though it is the 125th busiest airport in the world. On the otherhand, federal subsidies granted to operations at Hopkins would undoubtedly have a trickle down effect to Burke.

Conclusions

Over the past year plus, the overall result of the Act is yet to be realized. It is becoming apparent to many that the airline industry was in trouble prior to the terrorist attacks, and thus, aid may not help the industry recover due to the underlying economic forces that were transpiring long before September 11, 2001. According to Tom Friedman of Rutgers University, the tension between aiding the industry and allowing competition to work is evident in the attempt to implement the law. He asked the following:

Ø The Air Transportation Stabilization Board requires that airlines demonstrate the ability to repay the loan without the guarantee being used. Should the loan only help companies that are solvent? If so, why is aid needed?
Ø As of August 2002, United Airlines had requested loan guarantees but hadn't tried to raise money in the capital market. Should the government be the lender of last resort or a low-cost alternative to private financing? If private companies aren't willing to loan airline money, can the airline meet the Board's requirement that the airline demonstrate the ability to repay the loan?
Ø How can the Board aid an airline without giving it an unfair competitive advantage? If the Board aids one airline, must it then aid all airlines for competitive equality?

He asked legitimate questions, and some that at this point in time, may be too complex too address. The airlines industry and the airlines individually have been granted loan guarantees only if they are able to repay the loans. I believe that the government knew that only the "strong will survive" so they knew what they were doing. Any company that couldn't under any circumstances survive without the loan is a responsibility the government does not want any part of, and for good reason. I believe United could have pulled out if proactive measure would have been taken over a year ago. The fact that they continued to operate at levels that were beyond their reach helped them achieve Chapter 11 two days ago. When addressing the last question, the Board made it clear they will only aid the airlines that show the capability of paying the loans back. The government should give loans to the airlines that are most like to maximize their financial situations with the loan monies. Even though this paradigm is present, the government has simply thrown money at the problem if you will, which is evident by looking the Appendix I at the end of the text. It seems like every airline in the United States has received some sort of government assistance.

So what is the real reason for the large amount of government aid if the industry was failing to begin with? Why was this a big deal if they were going to fail anyhow? Some possible answers to this question according to Friedman are:

Ø Send a political message to those who instigated the attack: Was that a necessary supplement to attacking al Quada in Afghanistan?
Ø Prevent general economic collapse: Was a general economic collapse likely? Was Government action needed to prevent a collapse?
Ø Prevent massive unemployment that would have resulted from a string of airline bankruptcies? The bankruptcy law includes at least two types of bankruptcies: Chapter 7 and Chapter 11. Chapter 11 is more common than Chapter 7. Under Chapter 7, firms liquidate and cease conducting operations. Under the more common Chapter 11, firms may curtail operations but remain in business. The airlines' 20% cutback in flights between September 11th and September 22nd may have accomplished much of the curtailment that Chapter 11 filings would have accomplished. Hence, it isn't clear that government aid preserved many jobs.
Ø Assist politically powerful airline companies and their shareholders: Most observers would say this is not a laudable public policy objective and that it calls for campaign finance reform, this may be the primary reason the government aided the airlines.

I believe in light of what occurred on September 11th, which sending a political message to those who aided in carrying out the terrorist attack is definitely true, although I believe it had little to nothing to do with the airline bailout. The airline industry was absorbing a tremendous amount of political sympathy from both parties for political reasons, and that is the extent of the political message. A general economic collapse was likely also. In fact, many economists have stressed the economy prior to 9/11 and how the attacks just accelerated what was going to occur anyhow. The next argument is the most valid one, which has been driven home by the recent filing of Chapter 11 bankruptcy by United Airlines. United Airlines will not be the last of the Chapter 11's, although this will be the largest airline to file bankruptcy. It should be apparent that a major merger is likely to occur to prevent more bankruptcies. The last argument is legitimate a believable, but the government can help major airlines and its stakeholders only to a certain extent. The government is not in business to run the economy and the government into the ground.

Benjamin Limmer is a planner for University Circle, Inc. He lives in Cleveland.