If you’ve followed the problems that bad weather created for US airlines over the recent holiday season, you know that one airline, Southwest, has been responsible for a hugely disproportionate share of flight cancellations. On December 25 and 26, for example, Southwest canceled more than 5,500 flights. To put that in perspective, Delta Air Lines, which had the second-most cancellations of any airline, canceled 311 flights. It turns out that this was not just a weather issue. If it had been, the Southwest cancellations would not have been eighteen times the number of Delta cancellations. Although Southwest is generally known for its innovations that have created strong competition in the industry, it is behind the curve on one particular technology: its method of assigning flight crews. When very bad weather calls for changes in assigning crews, the Southwest technology is just not up to snuff.
In response to the Southwest “meltdown,” Transportation Secretary Pete Buttigieg has called for Southwest to be “accountable.” What does accountability mean for an airline or for any for-profit business? Also, because Buttigieg is a government employee, it’s worth asking what accountability means for government employees. A crucial question is whether for-profit companies are more or less accountable than government agencies. I’ll save you the suspense. For-profit companies are far more accountable. And the reason has to do with the presence or absence of what economists call a residual claimant.
What Matters to the Residual Claimant
Often economists come up with potentially awkward terms for important concepts. One such term, the residual claimant, means someone who has a claim on, an ownership of, of the residual. The residual, for any enterprise, is what’s left over from revenue after all expenses have been paid. Those expenses include wages, rent, materials, etc.
Why does it matter to have a residual claimant? Because that claimant has great incentives. For a given expense, the higher the revenue, the higher the residual. For a given revenue, the lower the expenses, the higher the residual. So the residual claimant cares a lot about both revenues and expenses.
To see why having a residual claimant creates good incentives, start with a small case that I experienced with a dry cleaner some decades ago. I went to pick up a dress shirt at the cleaner that I had done regular business with for a few years. The shirt was missing. I told the young employee I was dealing with that I had worn the shirt only a few times and had paid top dollar for it. I was looking to be compensated for about 80 percent of the price of a new shirt. The employee compensated me 100 percent and took my word for it about what I had paid.
But what would I have done if the employee had refused reasonable compensation? I would have asked to see the manager. Why? Because the manager must answer to the owner and, therefore, has a longer-range viewpoint than the typical employee. If the manager hadn’t given me satisfaction, I would have asked to see the owner. Of course, in the small mom-and-pop dry cleaning establishments I deal with, the manager typically is the owner.
Think about how the owner sees the issue. If he refuses to give satisfaction, he will lose my business. Not only that, but also I’ll spread the word, telling others that the owner treats customers badly. That loss of business hurts his revenue: his residual is less. Until about the late 1990s, the ways we could spread the word were orally and with letters to the editors of local newspapers. But now we have so many ways to do so: Facebook, Yelp, and Nextdoor, to name three.
We consumers are ruthless. Businesses know that and, unless they’re bailed out by governments, they need to take that into account.
Accountability at Southwest Airlines
Now let’s consider Southwest Airlines. The principle is the same as with the mom-and-pop laundry. The managers are accountable to the owners, also known as the stockholders. If they mess up, the company’s profit—its residual—falls.
Moreover, we don’t even need Facebook, Yelp, or Nextdoor to spread the word about their mistakes. Various major newspapers and news channels trumpet the facts. So the companies have to adjust, and adjust fairly quickly.
In short, the managers at Southwest Airlines are accountable. They’re accountable to the stockholders, and the stockholders’ concern with profitability causes them to be concerned about losing customers.
For that reason, I’m willing to make a prediction: by the end of 2023, and probably much sooner, Southwest will have a much better crew-scheduling system. Their profitable existence depends on it.
Buttigieg’s Idea of Accountability
In an interview with Judy Woodruff on PBS, Buttigieg stated:
I spoke to the CEO of Southwest Airlines. I reminded him of the stepped-up commitments that the airline made to our department over the summer. And we got those commitments in writing about how they take care of customers, passengers when there are issues like this.
We’re going to be holding them accountable to those commitments and expect them to go above and beyond the letter of the law in terms of how they treat passengers, making sure that they are paying for things like hotels, ground travel expenses, meals, and, of course, the refunds for passengers whose flights are canceled.
Notice two interesting things in Buttigieg’s statement. First, he got Southwest to make a commitment to his department, the Department of Transportation. For some reason, he must have thought he could step in and speak for Southwest passengers. But how would he know what they wanted?
Second, notice his expectation that Southwest go “above and beyond the letter of law.” The things he wants Southwest to do for passengers do seem reasonable. But neither he nor I knows what is reasonable. An airline that promises to pay for hotels, ground travel, and refunds will need to factor those expenses into future air fares. If it were a one-time thing, it wouldn’t: the expenses would be sunk costs. But paying passengers for all these things would set up an expectation that Southwest will do the same thing when there are future problems. One of the distinguishing features of Southwest historically has been its low air fares. I’m sure that virtually every passenger put at great inconvenience by the Southwest meltdown would want to be made whole, but future passengers might think differently: many would probably rather take the risk and, in return, get lower air fares. Buttigieg has no idea what future passengers would want, yet he is dictating arrangements between the airline and the passengers.
The biggest economic issue regarding virtually every policy topic is whether we should have more government or less government. Should we have more government control and even outright government ownership, or should we have less government and more private enterprise?
Advocates of more government often bias the debate from the get-go by pointing out ways in which private enterprise, the free market, has failed and then simply assuming that if government control were substituted, it would not fail. The late Harold Demsetz, one of my economics mentors when I was in graduate school at UCLA in the early 1970s, referred to this as the “Nirvana approach.” It consists of comparing real markets with ideal and imaginary government. Surprise, surprise, government often wins.
Demsetz advocated instead what he called a “comparative institutions” approach. He argued that we should compare actual markets with actual government.
Because the specific issue here is accountability, let’s look at how accountable government is. The first thing to note is that in government, there is no residual claimant. If a government official makes a particularly good decision that creates huge value, he might get promoted and might get a slight salary bump. But that’s about it. If he makes a bad decision that creates huge losses, he probably won’t get fired and his pay won’t be cut at all. The result is that government officials have very little incentive to make good decisions.
We can see that in transportation or in pretty much any other area of government involvement. Take, for example, the so-called “high speed” railroad (HSR) being built in California. (If it is ever completed—a big if—it’s more likely to be medium-speed.)
When California voters approved the HSR in 2008, they were told that it would be ready in 2020 and would cost $34 billion. As Hoover economist Lee Ohanian has pointed out, “the cost has escalated to $105 billion” and it’s still not ready and not even close. Have major government officials who made these promises been fired? Not that I know of. So here’s a project that is two years overdue and is not even close to being done, and yet no one is accountable.
In a nutshell, the problem with government accountability is that it’s almost nonexistent.
How About Real Improvements?
Is there anything Buttigieg could do to improve the airline business? There is, and economists have talked about it for years: allow foreign airlines to compete in the domestic market.
Deregulation of airlines in the late 1970s and early 1980s was a tremendous success. Before deregulation, airlines had to give notice to the Civil Aeronautics Board (CAB) in advance of fare reductions, and other airlines could intervene to contest the cuts. They often did. Also, an airline that wanted to add a route between any two cities had to first get permission from the CAB. Other airlines that already flew that route could contest that also. But when economist Alfred E. Kahn took over as CAB chair under President Carter, he did everything he could within the law to allow airlines to change fares and to add routes. At the same time, a Harvard law professor named Stephen Breyer worked closely with Democratic Senator Edward Kennedy to pass an airline deregulation bill that ended CAB regulation of fares and routes. (Breyer later became a US Supreme Court justice from 1994 to 2022.) A cozy airline cartel that had existed since 1938 was ended.
The results were noticeable almost immediately. Before deregulation, airlines had charged high fares and competed on meals and frequency (a famous airline jingle in the early 1970s was “Delta is ready when you are”). After deregulation, they competed on price and ultimately dropped almost all meals. Consumers were quite happy to save on fares and buy their own meals in the airport. Between 1978 and 2000, inflation-adjusted airline fares fell by 44.9 percent. Economists Clifford Winston and Steven Morrison estimated that half of this fall was due to deregulation.
In short, competition worked, and works. So let’s have more of it. Allowing foreign airlines to fly domestic routes would create more competition, more options, and lower fares. Even radical leftist Mexican President Andrés Manuel López Obrador sees the benefit of allowing that to happen in Mexico. If even a socialist can see the benefits of competition, then maybe Buttigieg can too. Of course, he would need the permission of his boss, President Biden, to start pushing for it, and Biden would need Congress. Maybe it’s a long shot, but in the mid-1970s, airline deregulation was a long shot. By December 31, 1984, the Civil Aeronautics Board had been abolished.