IN A DRAMATIC BREAK with past policy, the U.S. commercial air transportation system was deregulated in 1978. Although deregulation was initially popular, primarily because it led to lowerfares, public uneasiness has recently set in.1 Airport congestion and flight delays, increased concerns with safety, and rising fares in less competitive markets have all been attributed to the change in the regulatory environment. But, as illustrated in figure 1, deregulation is only one among many influences on the air transportation system. Equally influential are technological change, macroeconomic performance, and public policies besides those having to do with economic regulation. Because all these influences are interdependent, each must operate in accord with the others or the system can become disrupted. This paper focuses on improving the air system by aligning public policy regarding mergers, airport pricing and investment, and safety with the traffic volumes and patterns that exist under deregulation. We We are grateful to Robert Hahn, Richard Johnson, Joan Winston, and the conference participants for their comments and to Leslie Siddeley and Carol Evans for research assistance. 1. The overall decrease in fares is documented in John R. Meyer and Clinton V. Oster, Jr., eds., Airline Deregulation: The Early Experience (Boston: Auburn House, 1981); Elizabeth E. Bailey, David R. Graham, and Daniel P. Kaplan, Deregulating the Airlines (MIT Press, 1985); and Steven Morrison and Clifford Winston, The Economic Effects of Airline Deregulation (Brookings, 1986). 61 2. Air passenger round-trips are from the U.S. Civil Aeronautics Board, Ticket Dollar Value Origin and Destination Data Bank (third quarter, 1983). The final sample consisted of 3,593 round-trips covering the following five randomly selected markets: Allentown

We study alternate approaches to implement congestion pricing at US airports. Conventional formulations toll all aircraft without determining whether a plane operated by a given airline delays other planes that it operates or planes operated by other airlines. Recent work points out optimal pricing calls for carriers to be charged only for the delay they impose on other airlines. We find a small difference between the net benefits generated by the two congestion-pricing policies because the bulk of airport delays are not internalized and because the efficiency loss from pricing internalized congestion is small. (JEL L11, L93, R41)

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The airline business is the closest thing there is to legalized warfare. Robert L. Crandall Chief Executive Officer, American Airlines SINCE THE AIRLINE industry was deregulated, its financial performance has continued to be extremely volatile. ' During its most recent downturn, which lasted from 1990 to 1993, industry losses totaled nearly $13 billion, prompting worried policymakers to create the National Commission to Ensure a Strong Competitive Airline Industry in 1993.2 Although the primary recommendation of that commission-to establish another commission to provide financial advice to the industryhas been ignored, it nevertheless raised the possibility of some form of government intervention in the airline industry if performance did not improve. Although the airlines rallied nicely after the losses of the early 1990s, even the near-record profits made during 1995 only partially offset those losses. We acknowledge helpful comments from , and from conference participants at Brookings and seminar participants at Chicago, Harvard, Northwestern, U.S. Department of Justice, Virginia, and Washington. 1. During the last nineteen years of full regulation (1958-76), the standard deviation and coefficient of variation of the industry's gross profit margin were 3.9 percent and 0.67; during the first nineteen years of administrative and full deregulation (1977-95), the standard deviation fell to 3.0 percent, but the coefficient of variation rose to 1.67. 2. Morrison and Winston (1995) caution that this figure overestimates the underlying plight of the industry because of accounting changes and the large losses incurred by a few firms in bankruptcy, but we still conclude that airlines did sustain considerable losses. 85 86 Brookings Papers: Microeconomics 1996 The large fluctuations in industry earnings may be an inevitable result of the business cycle and the high income elasticity of demand for air travel. But they may also be attributable to the fare wars that have marked the industry since deregulation-to the delight of travelers and the dismay of industry shareholders.3The airline industry is not the only U.S. industry to engage in price wars. The popular press routinely contains stories about price wars in supermarkets, consumer electronics, and service industries, wars that break out when a firm attempts to "steal" market share.4 But the price wars in the airline industry are of particular interest. First, they are part of the airline industry's turbulent and ongoing adjustment to deregulation, a fact that warrants policymakers' attention at a time when other major industries such as communications and electricity are embarking on substantial deregulation. Second, the industry's technology and investment behavior, unpredictable demand, and complex patterns of network competition invite competing theories about why airlines engage in fare wars, and they provide a rich laboratory in which to test those theories. Finally, industry executives, some of whom are eager to believe that fare wars are a temporary rather tha...