DRI-192 for week of 6-7-15: Adding Entrepreneurship to Economics Makes ‘Disruptive’ Innovations Coordinative

An Access Advertising EconBrief:

Adding Entrepreneurship to Economics Makes ‘Disruptive’ Innovations Coordinative

Journalism pretends to be an objective profession. In reality, it is a subjective business. The subjective component derives from the normal limitations nature places on human perception; journalists may aspire to Olympian standards of accuracy and detachment, but they labor under the same biases as everybody else. The need to make a profit causes journalistic enterprises to cater to intellectual fads and fashions just as haute couture does when selling clothes.

The trendy business buzzword these days is “disruptive.” Ever since the Internet began revolutionizing life on the planet, technology has been occupying a bigger part of our lives. Somebody started saying “disruptive” to define new businesses that seemed to usher in noticeable changes in the status quo. When it comes to vocabulary, journalists imitate each other like parrots and chatter like magpies. Now slick magazines, websites and blogs are crawling with articles like “The 10 Most Disruptive Technologies/50 Most Disruptive Firms,” “How to Identify the Next Big Disruptive Technology” and “Which Sector Needs Disrupting the Most?”

It isn’t hard to identify disruptive firms; just picture the firms that have garnered the biggest and most recurring headlines – Apple, Amazon, Uber, Lyft, Airbnb, SpaceX and such. Our job here is to ascertain whether a systematic logic unites the success of these firms and whether the term “disruptive” is economically descriptive – or not. Business writers often associate disruptive technologies with economist Joseph Schumpeter, whose work we examined in last week’s EconBrief.

This association is understandable, but unfortunate. Schumpeter’s linking of entrepreneurial progress and capitalism with technological innovation is not the general case, but only a special case. That is, it is only a small part of the reason why capitalism has been so successful. Schumpeter’s view of the forest was obscured by a few redwoods, figuratively speaking. Even worse, the term “disruptive” – like Schumpeter’s famous phrase “creative destruction” – conveys an utterly misleading impression about the impact of entrepreneurial progress and technological innovation under capitalism.

Journalists and business analysts were right in looking to economics for an understanding of technological innovation. And, as we saw last week, they certainly didn’t get much help from traditional economic theory. But they picked the wrong maverick economist to consult.

A Brief Review 

Our previous EconBrief identified a serious lacuna in economic theory. No, make that multiple lacunae – certain simplifying assumptions that have alienated academic economics from reality. The pervasive use of high-level mathematics and statistical testing encouraged these assumptions because they kept economic theory tractable. Without them, economic models would not have been spare and abstract enough for mathematical and statistical purposes. In effect, the economics profession has chosen theoretical models useful for its own professional advancement but well-nigh useless for the practical benefit of the general public.

Evidence of this is supplied by the traditional indifference to entrepreneurship and innovation shown by mainstream theorists and textbooks. For contrast, we analyzed two striking exceptions to this pattern: the ideas of Joseph Schumpeter and F. A. Hayek. Schumpeter was contemptuous of the mainstream obsession with perfectly competitive equilibrium. He believed that economic development under capitalism was accomplished by a process of “creative destruction.” This did not involve small, incremental increases in output and decreases in price by perfectly competitive firms, each one of which had insignificant shares of its market. Instead, Schumpeter envisioned competition as a life-and-death struggle between large monopoly firms, each producing new products that replaced existing goods and improved consumer welfare by leaps and bounds. “Creative destruction” was a hugely disruptive process, a wholesale overturning of the status quo.

Hayek criticized mainstream theory just as strongly, but from a different angle. Hayek maintained that mainstream, textbook economic theory started out by assuming the things it should be explaining. Where did consumers and producers get the “perfect information” that traditional theory assumed was “given” to them? In effect, Hayek grumbled, it was “given” to them by the economists in their textbooks, not actually given in reality. He had the same complaint about product quality, an issue traditional theory assumed away by treating goods as homogeneous in nature. The trouble is that the vast quantity of information needed by consumers and producers isn’t available in one place; it is dispersed in fragmentary form inside billions of human brains. Only the price system, operating via a functioning free-market system, can collate and transmit this information to all market participants.

Hayek saw the true nature of equilibrium differently than did mainstream economists. The latter took their cue from mathematical economists such as 19th-century pioneer Leon Walras, who formulated equations for supply and demand curves and solved them algebraically to derive an equilibrium at which the quantity demanded and quantity supplied were equal. To Hayek, equilibrium meant that the plans human beings make in the course of living daily life turn out to be compatible, not chaotically inconsistent. That is the true Economic Problem – how to collect and transmit the dispersed information necessary to market functioning among billions of people in order to allow their plans to be mutually compatible.

Entrepreneurship – the Engine of Capitalism

Hayek’s work opened the door to an understanding of capitalism. We had long known that capitalism worked and socialism failed. But we could not supply a nuts-and-bolts, nitty-gritty explanation for why and how this was so. Theory is given little importance by the general public, but it is honored in the breach. The lack of a thoroughgoing theory of capitalist superiority has allowed a myth of socialist superiority to survive and even thrive despite the utter failure of socialism to prosper in practice. A disciple of Hayek and Hayek’s mentor, Ludwig von Mises, utilized the intellectual capital created by his teachers to complete their work.

Israel Kirzner was taught at New York University by Ludwig von Mises. His dissertation became an intermediate textbook on price theory, The Economic Point of View. In 1973, Kirzner synthesized the ideas of Mises and Hayek in a book called Competition and Entrepreneurship. For the first time, we had an explicit justification and explanation of the vital role played by the entrepreneur in economic life.

Heretofore, the entrepreneur had been the mystery figure of economic theory, akin to the Abominable Snowman or Bigfoot. To some, he was simply the organizer of production. To others, he was a salesman or promoter. To Schumpeter, he was an innovator who created new products using the lever of technology. Israel Kirzner took a completely different tack.

The keynote in Kirzner’s view of the entrepreneur is alertness to opportunity within a market framework. As a first approximation, the entrepreneur’s attention is fixed upon the price system. He or she is constantly searching for “value discrepancies;” that is, differences between the price(s) of input(s) and output. For example, he may observe that a, b and c can combine in production to produce D. The price of amounts of a, b and c sufficient to produce one unit of D is $5, while the entrepreneur sees (or envisions) that D will sell for $10. This act of intellectual visualization itself is what constitutes entrepreneurship in Israel Kirzner’s theory. Acting upon entrepreneurial observation requires productive activity.

There is a family resemblance between Kirzner’s concept of entrepreneurship and what is often termed “arbitrage.” But the two are far from identical. Arbitrage is loosely defined as buying and selling in different markets to profit from price differentials. Often, the same good is purchased and sold – simultaneously if possible – to reduce or even eliminate any risk of financial loss. Kirznerian entrepreneurship is far more comprehensive. Different goods may be involved, purchases need not be simultaneous or even close to it; indeed, markets for some of the goods or inputs involved may not even exist at the point of visualization! The entrepreneur may be contemplating the introduction of an entirely new good, a la Schumpeter. At the other extreme, the entrepreneur may be hoping to profit from the smallest price discrepancy in the most homogeneous good, as banks or traders do when they arbitrage away tiny price differences in stocks, bonds or foreign currencies in different exchanges.

In fact, the entrepreneur need not even be a producer or a seller at all. Consumers can and do engage in entrepreneurial activity all the time. Consumers clip and redeem coupons. They scan newspapers and online ads for sales and comparative prices. This activity is analytically indistinguishable from the activity of producers, Kirzner claims, because in both cases there is a net increase in value derived by consumers – and consumption is the end-in-view behind all economic activity.

The Consumer as Entrepreneur – A Case Study

In 1965, Samuel Rubin and a few friends were dismayed by the vanishing interest in, and availability of, silent movies. They held a small film festival for silent-movie enthusiasts and created the Society for Cinephiles. This gathering became the first classic-movie film festival. Fifty years later, Cinecon remains the oldest and most respected of this now-worldwide genre. Three years later, Steven Haynes, John Baker and John Stingley hosted a small gathering for classic-movie lovers in Columbus, Ohio. This year, Mr. Haynes died after planning the 47th meeting of the Cinevent festival, which annually attracts a few hundred dedicated lovers of silent and studio-system-era movies. In 1980, classic-movie fanatic Phil Serling began the Cinefest gathering in Syracuse, New York with a few close friends. 2015 marked the final meeting of this festival, which attracted attendees from around the world. Today the San Francisco Silent Film Festival is a headline-making event featuring the latest newly found and restored rarities.

This genre of classic-movie worship was begun by consumers, not by profit-motivated producers. But these consumers nevertheless were alert to opportunity – the discrepancy in value between the movies currently available for viewing and those of the past. Prior to the digital age, older movies (particularly silent movies) were seldom screened and hard to view. Moreover, they were disintegrating rapidly and dangerous to maintain because of the fire-danger posed by nitrate film stock. Yet thanks to the efforts of these pioneering consumers, today we have multiple television channels exclusively, primarily or secondarily devoted to showing classic films, including silent movies. Turner Classic Movies (TCM) leads the way, while the Fox Channel is close behind. Over twenty thousand people attend the Turner Classic Movies Festival in Hollywood every year and TCM’s annual cruise and other promotions attract thousands more. Film preservation is a major endeavor, with new discoveries of heretofore “lost” movies occurring every year. Classic movies is big business, thanks to the dispersed entrepreneurship efforts of the scattered but determined few decades ago. The small net gains in value experienced by the silent-movie lovers in 1965 multiplied millions-fold into the consumption gains of millions worldwide today on television and in person.

Schumpeter Vs. Hayek/Kirzner: Away from Equilibrium or Towards It?

Contemporary business analysts take an ambivalent attitude toward innovation and entrepreneurship. They give lip service toward its benefits – new products and services, the benefits reaped by consumers. But they imply in no uncertain terms that these benefits carry a terrible price. Terms like “creative destruction,” with heavy emphasis placed on the second word, directly state that there is a tradeoff between consumer gains and destructive loss suffered by workers, owners of businesses driven into insolvency and even members of the general public who lose non-human resources that are somehow vaporized by the awesome power of technology. Instead of stressing the labor-saving properties of technology, commentators are more apt to refer to labor-killing innovations. No wonder, then, that journalists have turned to Schumpeter, whose apocalyptic view of capitalism was that its superior productivity would ultimately prove its undoing. With friends like Schumpeter, capitalism has grown ever more defenseless against its enemies.

Schumpeter believed that entrepreneurial innovation was both creative and destructive – creative because its products were new, destructive because they completely supplanted the replaced competing products, driving their competition from the field. In the technical sense, then, Schumpeter saw entrepreneurs as a dysequilibrating force, spearheading a movement away from one stable equilibrium position to a different one. Schumpeter himself recognized that, in practice and unlike the blackboard transitions that academic economists effect in the blink of an eye, these movements would often be wrenching. But the analysis of Kirzner, using the framework built by Hayek and Mises, leads to different conclusions.

Kirzner acknowledged the validity of Schumpeter’s form of entrepreneurship. But he recognized that it was only the exceptional case. The garden variety, everyday forms of entrepreneurship – practiced by consumers as well as producers – produce movements toward equilibrium, not away from it. This is true for two reasons. First, entrepreneurship does not lead away from equilibrium because the traditional concept of equilibrium is a myth; reality changes far too quickly for actual equilibrium ever to be reached, let alone be maintained. Second, entrepreneurship leads toward equilibrium because it enables human beings to better coordinate their plans by allowing a more efficient exchange of information. Hayek objected to the traditional economic assumption of “perfect information” because he claimed that this assumed the existence of equilibrium at the outset. Kirzner’s theory of entrepreneurship tells us that the so-called “disruptive” businesses of today are pushing us closer and closer to that condition of perfect information – which means we are getting closer and closer to perfectly coordinated equilibrium. Of course, we never reach this blissful state, but capitalism keeps us steadily on the move in the right direction.

What is Google, with its search-engine technology, if not the search for the economist’s informational Shangri-La of perfect information? Wikipedia, a user-created encyclopedia, is the archetype of Hayek’s model of a world in which information exists in dispersed, fragmentary form that is unified by a voluntary, beneficial market. Facebook has become a colossus by making it easy for people to provide information about themselves to others – and in the process become a kind of worldwide clearinghouse for information of all kinds. Pinterest has narrowed this same type of focus to photos, but the key is still information. Newer technology businesses like Crowd Strike, specializing in cyber intelligence and security, and the Chinese company Tencent, with its emphasis on mobile advertising, are also informational in character.

In each of these cases, entrepreneurs were alert to the market opportunities opened by technology and signaled by the low prices ushered in by the digital age. The entrepreneurial character of some of these businesses has baffled the business establishment because it has not emulated the conventional, profit-seeking model. That is usually because the initial entrepreneurs have been consumers striving to create value for their own direct use. Only later have they realized the potential for exporting the value surplus created to the rest of the world. This looks outré to most observers but it is fully consistent with Israel Kirzner’s theory of entrepreneurship.

Another of the unrealistic simplifying assumptions deplored by Hayek was “costless” transactions, particularly entry, exit and determination of product quality. This was another case of economists assuming what they should be proving, or at least investigating; it started out by assuming equilibrium and skipped the market process necessary to produce – or, more realistically, approach – an eventual equilibrium. The technological innovations of the last two decades that weren’t information in character were mostly directed at reducing various costs, either natural or man-made costs.

The Internet itself is a mammoth exercise in reducing the costs of transport and communication. Instead of calling in the telephone, we can now send an e-mail. By inventing smartphones, Apple has one-upped the Internet and desktop computers by making this communication mobile. In between these two inventions, of course, came cell phones – invented decades earlier but made practical when Moore’s Law eventually shrank them to pocket size. The shocking thing is how little economics had to say about any of these revolutionary human innovations – because traditional economic theory had long assumed zero transport and transactions costs. Why concern yourself with an innovation when your theory says there is no need for it in the first place?

The development of cell phones was held back for years by government regulation of telecommunications, which fought tooth and claw to prevent competition between phone companies and innovation by monopoly providers. In formal logic, the effect of government regulation is best envisioned as equivalent to the effect of a mountain range or an ocean on transportation. Alternatively, think of costs as being like taxes. Transport costs are “levied” by nature, while taxes are levied by governments. Transactions costs may be either natural or man-made. And a review of recent “disruptive” businesses shows many designed specifically to overcome either natural or man-made costs.

The entrepreneurs of Uber and Lyft observed the artificially high taxi fares created by local-government regulation in the U.S. and elsewhere in the world. They envisioned lower prices and faster response-times resulting from assembling a voluntary workforce of casual drivers and independent professionals, operating free from the stranglehold of regulation. Airbnb looked at the rental market for habitation and saw the potential for achieving the same kind of economies by enlisting owners as vendors. Jeff Bezos of Amazon envisioned consumers freed from the shackles of traveling to retail stores and a supplier with transport costs lowered by economies of scale. The result has shaken the world of retail sales to its foundations. (We should note that this combines the lowering of natural transport costs and the lowering of artificial man-made sales taxes.) Driverless cars threaten an even bigger revolution in the world of transportation by overcoming the costs of human error and accidents – if they can overcome the “tax” of government regulation to achieve liftoff. Body sensors are a revolutionary innovation triggered by the consumer desire to overcome high medical costs of maintaining good health, which are an artifact of regulation. The new website Open Bazaar dubs itself “a decentralized peer-to-peer marketplace” whose goal “is to give everyone in the world the ability to directly engage in trade with each other.” In other words, it is dedicated to reducing transactions costs to the irreducible minimum.

Once again, these cost-based innovations are entrepreneur-driven. Again, some of them were pioneered by consumers rather than by the corporate or venture-capital establishment. This is exactly what we would expect, given the theory developed by Israel Kirzner.

Monopoly or Competition? 

Schumpeter believed that true progress came from monopoly, not competition. He meant monopoly in the effective, substantial sense, not merely the formalistic sense of a transitory market hegemony enjoyed by the innovator. Events have clearly proven Schumpeter wrong. It is hard to find a case today that would correspond to Schumpeter’s archetype; instead, the initial innovator has been superseded by somebody else. Market leadership has been the result of performance, not entry barriers or patents or government pull. And the innovators themselves have often been “nobodies” rather than monopolists boasting war chests heavy with monopoly profits.

Pattern Prediction

In 1929, Ludwig von Mises predicted a “great crash” and refused to take a position in the Austrian government for fear of association with the economic downturn he anticipated. F.A. Hayek predicted a sharp recession, pursuant to the business-cycle theory he had recently developed. Later, Hayek predicted the failure of Keynesian counter-cyclical fiscal and monetary policies and the high worldwide inflation of the 1970s, coupled with the recession that followed measured taken to break the inflation.

In general, Hayek did not believe that accurate quantitative prediction of economic events was possible. At most, he felt, economic theory could offer “pattern predictions” of a more general nature. His own statements, both in economics and political philosophy, tended to support this approach.

Israel Kirzner did not “predict” the advent of the Internet or the invention of the smartphone. But the technological revolution and the businesses spearheading it conformed to the general pattern of entrepreneurship outlined in Israel Kirzner’s theory. In this sense, while this revolution came as a complete surprise to the mainstream economics profession, it can hardly have surprised Kirzner. The revolution was led by people behaving just as Kirzner hypothesized that entrepreneurs do behave.

Can the Status Quo be “Disruptive?”

Based on our analysis and Israel Kirzner’s theory of entrepreneurship, the business buzzword “disruptive” is misleading when applied to the cutting-edge firms and technologies of today. It is indeed true that these technologies overturn the status quo. But the status quo is hindering human progress and preventing attainment of true economic equilibrium; it is hurting people rather than helping them. If transport costs or transaction costs or taxes or regulation are hurting people – and helping at most only a minority vested interest in the process – then changing the status quo is the indicated action. “Stability” is not always good. After all, Stalin’s Soviet Union was stable. Fortunately, the Soviet Union later collapsed when that stability disintegrated.

As Israel Kirzner himself has always maintained, economics is all about making people better off. When this criterion is placed foremost, discarding the pure formalism of mainstream theory, is becomes clear that Mises, Hayek and Kirzner were right and Schumpeter was wrong. Entrepreneurship is equilibrating because it tends to better coordinate the plans made by individual human beings.

The process by which Nobel Prizes are awarded is highly secretive. The Nobel committee keeps their candidate “cards” close to their vests. Rumors have circulated, however, placing Israel Kirzner’s name on the short list of potential awardees. No man alive has done more than he to redeem the tarnished prestige of economics as a subject worth studying for its practical value to humanity.

DRI-183 for week of 3-1-15: George Orwell, Call Your Office – The FCC Curtails Internet Freedom In Order to Save It

An Access Advertising EconBrief:

George Orwell, Call Your Office – The FCC Curtails Internet Freedom In Order to Save It

February 26, 2015 is a date that will live in regulatory infamy. That assertion is subject to revision by the courts, as is nearly everything undertaken these days by the Obama administration. As this is written, the Supreme Court hears yet another challenge to “ObamaCare,” the Affordable Care Act. President Obama’s initiative to achieve a single-payer system of national health care in the U.S. is rife with Orwellian irony, since it cannot help but make health care unaffordable for everybody by further removing the consumer of health care from every exposure to the price of health care. Similarly, the latest administration initiative is the February 26 approval by the Federal Communications Commission (FCC) of the so-called “Net Neutrality” doctrine in regulatory form. Commission Chairman Tom Wheeler’s summary of his regulatory proposal – consisting of 332 pages that were withheld from the public – has been widely characterized as a proposal to “regulate the Internet like a public utility.”

This episode is riven with a totalitarian irony that only George Orwell could fully savor. The FCC is ostensibly an independent regulatory body, free of political control. In fact, Chairman Wheeler long resisted the “net neutrality” doctrine (hereinafter, shortened to “NN” for convenience). The FCC’s decision was a response to pressure from President Obama, which made a mockery of the agency’s independence. The alleged necessity for NN arises from the “local monopoly” over “high-speed” broadband exerted by Internet service providers (again, hereinafter abbreviated as “ISPs”) – but a “public utility” was, and is, by definition a regulated monopoly. Since the alleged local monopoly held by ISPs is itself fictitious, the FCC is in fact proposing to replace competition with monopoly.

To be sure, the particulars of Chairman Wheeler’s proposal are still open to conjecture. And the enterprise is wildly illogical on its face. The idea of “regulating the Internet like a public utility” treats those two things as equivalent entities. A public utility is a business firm. But the Internet is not a single business firm; indeed, it is not a single entity at all in the concrete sense. In the business sense, “the Internet” is shorthand for an infinite number of existing and potential business firms serving the world’s consumers in countless ways. The clause “regulate the Internet like a public utility” is quite literally meaningless – laughably indefinite, overweening in its hubris, frightening in its totalitarian implications.

It falls to an economist, former FCC Chief Economist Thomas Hazlett of Clemson University, to sculpt this philosophy into its practical form. He defines NN as “a set of rules… regulating the business model of your local ISP.” In short, it is a political proposal that uses economic language to prettify and conceal its real intentions. NN websites are emblazoned with rhetoric about “protecting the Open Internet” – but the Internet has thrived on openness for over 20 years under the benign neglect of government regulators. This proposal would end that era.

There is no way on God’s green earth to equate a regulated Internet with an open Internet; the very word “regulated” is the antithesis of “open.” NN proponents paint scary scenarios about ISPs “blocking or interfering with traffic on the Internet,” but their language is always conditional and hypothetical. They are posing scenarios that might happen in the future, not ones that threaten us today. Why? Because competition and innovation protected consumers up to now and continue to do so. NN will make its proponents’ scary predictions more likely, not less, because it will restrict competition. That is what regulation does in general; that is what public-utility regulation specifically does. For over a century, public-utility regulation has installed a single firm as a regulated monopoly in a particular market and has forcefully suppressed all attempts to compete with that firm.

Of course, that is not what President Obama, Chairman Wheeler and NN proponents want us to envision when we hear the words “regulate the Internet like a public utility.” They want us to envision a lovely, healthy flock of sheep grazing peacefully in a beautiful meadow, supervised by a benevolent, powerful Shepherd with a herd of well-trained, affectionate shepherd dogs at his command. Soothing music is piped down from heaven and love and tranquility reign. At the far edges of the meadow, there is a forest. Hungry wolves dwell within, eyeing the sheep covetously. But they dare not approach, for they fear the power of the Shepherd and his dogs.

In other words, the Obama administration is trying to manipulate the emotions of the electorate by creating an imaginary vision of public-utility regulation. The reality of public-utility regulation was, and is, entirely different.

The Natural-Monopoly Theory of Public-Utility Regulation

The history of public-utility regulation is almost, but not quite, co-synchronous with that of government regulation of business in the United States. Regulation began at the state level with Munn vs. Illinois, which paved the way for state government of the grain business in the 1870s. The Interstate Commerce Commission’s inaugural voyage with railroad regulation followed in the late 1880s. With the commercial introduction of electric lighting and the telephone came business firms tailored to those ends. And in their wake came the theory of natural monopoly.

Both electric power and telephones came to be known as “natural monopoly” industries; that is, industries in which both economic efficiency and commercial viability chose one single firm to serve the entire market. This was the outgrowth of economies of scale in production, owing to decreasing long-run average cost of production. This decidedly unusual state of affairs is a technological anomaly. Engineers recognize it in conjunction with the “two-thirds rule.” There are certain cases in which cost increases as the two-thirds power of output, which implies that cost decreases steadily as output rises. (The thru-put of pipes and cables and the capacity of cargo holds are examples.) In turn, this implies that the firm that grows the fastest will undersell all others while still covering all its costs. The further implication is that consumers will receive the most output at the lowest price if one monopoly firm serves everybody – if, and only if, the firm’s price can be constrained equal to its long-run average cost at the rate of output necessary to meet market demand. An unconstrained monopoly would produce less than this optimal rate of output and charge a higher price, in order to maximize its profit. But the theoretical outcome under regulated monopoly equates price with long-run average cost, which provides the utility with a rate of return equal to what it could get in the best alternative use for its financial capital, given its business risk.

In the U.S. and Canada, this regulated outcome is sought by a public-utility commission via the medium of periodic hearings staged by the public-utility regulatory commission (PUC for short). The utility is privately owned by shareholders. In Europe, utilities are not privately owned. Instead, their prices are (in principle) set equal to long-run marginal cost, which is below the level of average cost and thus constitutes a loss in accounting terms. Taxpayers subsidize this loss – these subsidies are the alternative to the profits earned by regulated public-utility firms in the U.S. and Canada.

These regulatory schemes represent the epitome of what the Nobel laureate Ronald Coase called “blackboard economics” – economists micro-managing reality as if they possessed all the information and control over reality that they do when drawing diagrams on a classroom blackboard. In practice, things did not work out as neatly as the foregoing summary would lead us to believe. Not even remotely close, in fact.

The Myriad Slips Twixt Theoretical Cup and Regulatory Lip

What went wrong with this theoretical set-up, seemingly so pat when viewed in a textbook or on a classroom blackboard? Just about everything, to some degree or other. Today, we assume that the institution of regulated monopoly came in response to market monopolies achieved and abuses perpetrated by electric and telephone companies. What mostly happened, though, was different. There were multiple providers of electricity and telephone service in the early days. In exchange for submitting to rate-of-return regulation, though, one firm was extended a grant of monopoly and other firms were excluded. Only in very rare cases did competition exist for local electric service – and curiously, this rate competition actually produced lower electric rates than did public-utility regulation.

This result was not the anomaly it seemed, since the supposed economies of scale were present only in the distribution of electric power, not in power generation. So the cost superiority of a single firm producing for the whole market turned out to be not the slam-dunk that was advertised. That was just one of many cracks in the façade of public-utility regulation. Over the course of the 20th century, the evolution of public-utility regulation in telecommunications proved to be paradigmatic for the failures and inherent shortcomings of the form.

Throughout the country, the Bell system were handed a monopoly on the provision of local service. Its local service companies – the analogues to today’s ISPs – gradually acquired reputations as the heaviest political hitters in state-government politics. The high rates paid by consumers bought lobbyists and legislators by the gross, and they obediently safeguarded the monopoly franchise and kept the public-utility commissions (PUCs) staffed with tame members. That money also paid the bill for a steady diet of publicity designed to mislead the public about the essence of public-utility regulation.

We were assured by the press that the PUC was a vigilant watchdog whose noble motives kept the greedy utility executives from turning the rate screws on a helpless public. At each rate hearing, self-styled consumer advocacy groups paraded their compassion for consumers by demanding low rates for the poor and high rates on business – as if it were really possible for some non-human entity called “business” to pay rates in the true sense, any more than they could pay taxes. PUCs made a show of ostentatiously requiring the utility to enumerate its costs and pretending to laboriously calculate “just and reasonable” rates – as if a Commission possessed juridical powers denied to the world’s greatest philosophers and moralists.

Behind the scenes, after the press had filed their poker-faced stories on the latest hearings, increasingly jaded and cynical reporters, editors and industry consultants rolled their eyes and snorted at the absurdity of it all. Utilities quickly learned that they wouldn’t be allowed to earn big “profits,” because this would be cosmetically bad for the PUC, the consumer advocates, the politicians and just about everybody involved in this process. So executives, middle-level managers and employees figured out that they had to make their money differently than they would if working for an ordinary business in the private sector. Instead of working efficiently and productively and striving to maximize profit, they would strive to maximize cost instead. Why? Because they could make money from higher costs in the form of higher salaries, higher wages, larger staffs and bigger budgets. What about the shareholders, who would ordinarily be shafted by this sort of behavior? Shareholders couldn’t lose because the PUC was committed to giving them a rate of return sufficient to attract financial capital to the industry. (And the shareholders couldn’t gain from extra diligence and work effort put forward by the company because of the limitation on profits.) That is, the Commission would simply ratchet up rates commensurate with any increase in costs – accompanied by whatever throat-clearing, phony displays of concern for the poor and cost-shifting shell games were necessary to make the numbers work. In the final analysis, the name of the game was inefficiency and consumers always paid for it – because there was nobody else who could pay.

So much for the vaunted institution of public-utility regulation in the public interest. Over fifty years ago, a famous left-wing economist named Gardiner Means proposed subjecting every corporation in the U.S. to rate-of-return regulation by the federal government. This held the record for most preposterous policy program advanced by a mainstream commentator – until Thomas Wheeler announced that henceforth the Internet would be regulated as if it were a public utility. Now every American will get a taste of life as Ivan Denisovich, consigned to the Gulag Archipelago of regulatory bureaucracy.

Of particular significance to us in today’s climate is the effect of this regime on innovation. Outside of totalitarian economies such as the Soviet Union and Communist China, public-utility regulation is the most stultifying climate for innovation ever devised by man. The idea behind innovation is to find ways to produce more goods using the same amount of inputs or (equivalently) the same amount of goods using fewer inputs. Doing this lowers costs – which increases profits. But why do to the trouble if you can’t enjoy the increase in profits? Of course, utilities were willing to spend money on research, provided they could get it in the rate base and earn a rate of return on the investment. But they had no incentive to actually implement any cost-saving innovations. The Bell System was legendary for its unwillingness to lower its costs; the economic literature is replete with jaw-dropping examples of local Bell companies lagging years and even decades behind the private sector in technology adoption – even spurning advances developed in Bell’s own research labs!

Any reader who suspects this writer of exaggeration is invited to peruse the literature of industrial organization and regulation. One nagging question should be dealt with forthwith. If the demerits of public-utility regulation were well recognized by insiders, how were they so well concealed from the public? The answer is not mysterious. All of those insiders had a vested interest in not blowing the whistle on the process because they were making money from ongoing public-utility regulation. Commission employees, consultants, expert witnesses, public-interest lawyers and consumer advocates all testified at rate hearings or helped prepare testimony or research it. They either worked full-time or traveled the country as contractors earning lucrative hourly pay. If any one of them was crazy enough to launch an expose of the public-utility scam, he or she would be blackballed from the business while accomplishing nothing – the institutional inertia in favor of the system was so enormous that it would have taken mass revolt to effect change. So they just shrugged, took the money and grew more cynical by the year.

In retrospect, it seems miraculous that anything did change. In the 1960s, local Bell companies were undercharging for local service to consumers and compensating by soaking business and long-distance customers with high prices. The high long-distance rates eventually attracted the interest of would-be competitors. One government regulator grew so fed up with the inefficiency of the Bell system that he granted the competitive petition of a small company called MCI, which sought to compete only in the area of long-distance telecommunications. MCI was soon joined by other firms. The door to competition had been cracked slightly ajar.

In the 1980s, it was kicked wide open. A federal antitrust lawsuit against AT&T led to the breakup of the firm. At the time, the public was dubious about the idea that competition was possible in telecommunications. The 1990s soon showed that regulators were the only ones standing between the American public and a revolution unlike anything we had seen in a century. After vainly trying to protect the local Bells against competition, regulators finally succumbed to the inevitable – or rather, they were overrun by the competitive hordes. When the public got used to cell phones and the Internet, they ditched good old Ma Bell and land-line phones.

This, then, is public-utility regulation. The only reason we have smart phones and mobile Internet access today is that public-utility regulation in telecommunications was overrun by competition despite regulatory opposition in the 1990s. But public-utility regulation is the wonderful fate to which Barack Obama, Thomas Wheeler and the FCC propose to consign the Internet. What is the justification for their verdict?

The Case for Net Neutrality – Debunked

As we have seen, public-utility regulation was based on a premise that certain industries were “natural monopolies.” But nobody has suggested that the Internet is a natural monopoly – which makes sense, since it isn’t an industry. Nobody has suggested that all or even some of the industries that utilize the Internet are natural monopolies – which makes sense, since they aren’t. So why in God’s name should we subject them to public-utility regulation – especially since public-utility regulation didn’t even work well in the industries for which it was ideally suited? We shouldn’t.

The phrase “net neutrality” is designed to achieve an emotional effect through alliteration and a carefully calculated play on the word “neutral.” In this case, the word is intended to appeal to egalitarian sympathies among hearers. It’s only fair, we are urged to think, that ISPs, the “gatekeepers” of the Internet, are scrupulously fair or “neutral” in letting everybody in on the same terms. And, as with so many other issues in economics, the case for “fairness” becomes just so much sludge upon closer examination.

The use of the term “gatekeepers” suggests that God handed to Moses on Mount Olympus a stone tablet for the operation of the Internet, on which ISPs were assigned the role of “gatekeepers.” Even as hyperbolic metaphor, this bears no relation to reality. Today, cable companies are ISPs. But they began life as monopoly-killers. In the early 1960s, Americans chose between three monopoly VHF-TV networks, broadcast by ABC, NBC and CBS. Gradually, local UHF stations started to season the diet of content-starved viewers. When cable-TV came along, it was like manna from heaven to a public fed up with commercials and ravenous for sports and movies. But government regulators didn’t allow cable-TV to compete with VHF and UHF in the top 100 media markets of the U.S. for over two decades. As usual, regulators were zealously protecting government monopoly, restricting competition and harming consumers.

Eventually, cable companies succeeded in tunneling their way into most local markets. They did it by bribing local government literally and figuratively – the latter by splitting their profits via investment in pet political projects of local politicians as part of their contracts. In return, they were guaranteed various degrees of exclusivity. But this “monopoly” didn’t last because they eventually faced competition from telecommunication firms who wanted to get into their business and whose business the cable companies wanted to invade. And today, the old structural definitions of monopoly simply don’t apply to the interindustry forms of competition that prevail.

Take the Kansas City market. Originally, Time Warner had a monopoly franchise. But eventually a new cable company called Everest invaded the metro area across the state line in Johnson County, KS. Overland Park is contiguous with Kansas City, MO, and consumers were anxious to escape the toils of Time Warner. Eventually, Everest prevailed upon KC, MO to gain entry to the Missouri side. Now even the cable-TV market was competitive. Then Google selected Kansas City, KS as the venue for its new high-speed service. Soon KC, MO was included in that package, too – now there were three local ISPs! (Everest has morphed into two successive incarnations, one of which still serves the area.)

Although this is not typical, it does not exhaust the competitive alternatives. This is only the picture for fixed service. Americans are now turning to mobile forms of access to the Internet, such as smart phones. Smart watches are on the horizon. For mobile access, the ISP is a wireless company like AT&T, Verizon, Sprint or T-Mobile.

The NN websites stridently maintain that “most Americans have only a single ISP.” This is nonsense; a charitable interpretation would be that most of us have only a single cable-TV provider in our local market. But there is no necessary one-to-one correlation between “cable-TV provider” and “ISP.” Besides, the state of affairs today is ephemeral – different from what is was a few years ago and from what it will be a few years from now. It is only under public-utility regulation that technology gets stuck in one place because under public-utility regulation there is no incentive to innovate.

More specifically, the FCC’s own data suggest that 80% of Americans have two or more ISPs offering 10Mbps downstream speeds. 96% have two or more ISPs offering 6Mbps downstream and 1.5 upstream speeds. (Until quite recently, the FCC’s own criterion for “high-speed” Internet was 4Mbps or more.) This simply does not comport with any reasonable structural concept of monopoly.

The current flap over “blocking and interfering with traffic on the Internet” is the residue of disputes between Netflix and ISPs over charges for transmission of the former’s streaming services. In general, there is movement toward higher charges for data transmission than for voice transmission. But the huge volumes of traffic generated by Netflix cause congestion, and the free-market method for handling congestion is a higher price, or the functional equivalent. That is what economists have recommended for dealing with road congestion during rush hours and congested demand for air-conditioning and heating services at peak times of day and during peak seasons. Redirecting demand to the off-peak is not a monopoly response; it is an efficient market response. Competitive bar and restaurant owners do it with their pricing methods; competitive movie theater owners also do it (or used to).

Similar logic applies to other forms of hypothetically objectionable behavior by ISPs. The prioritization of traffic, creation of “fast” and “slow” lanes, blocking of content – these and other behaviors are neither inherently good nor bad. They are subject to the constraints of competition. If they are beneficial on net balance, they will be vindicated by the market. That is why we have markets. If a government had to vet every action by every business for moral worthiness in advance, it would paralyze life as we know it. The only sensible course is to allow free markets and competition to police the activities of competitors.

Just as there is nothing wrong or untoward with price differentials based on usage, there is nothing virtuous about government-enforced pricing equality. Forcing unequals to be treated equally is not meritorious. NN proponents insist that the public has to be “protected” from that kind of treatment. But this is exactly what PUCs did for decades when they subsidized residential consumers inefficiently by soaking business and long-distance users with higher rates. Back then, the regulatory mantra wasn’t “net neutrality,” it was “universal service.” Ironically, regulators never succeeded in achieving rates of household telephone subscription that exceeded the rate of household television service. Consumers actually needed – but didn’t get – protection from the public-utility monopoly imposed upon them. Today, consumers don’t need protection because there is no monopoly, nor is there any prospect of one absent regulatory intervention. The only remaining vestige of monopoly is that remaining from the grants of local cable-TV monopoly given by municipal governments. Compensating for past mistakes by local government is no excuse for making a bigger mistake by granting monopoly power to FCC regulators.

Forbearance? 

The late, great economist Frank Knight once remarked that he had heard do-gooders utter the equivalent words to “I want power to do good” so many times for so long that he automatically filtered out the last three words, leaving only “I want power.” Federal-government regulators want the maximum amount of power with the minimum number of restrictions, leaving them the maximum amount of flexibility in the exercise of their power. To get that, they have learned to write excuses into their mandates. In the case of NN and Internet regulation, the operative excuse is “forbearance.”

Forbearance is the writing on the hand with which they will wave away all the objections raised in this essay. The word appears in the original Title II regulations. It means that regulators aren’t required to enforce the regulations if they don’t want to; they can “forebear.” “Hey, don’t worry – be happy. We won’t do the bad stuff, just the good stuff – you know, the ‘neutrality’ stuff, the ‘equality’ stuff.” Chairman Wheeler is encouraging NN proponents to fill the empty vessel of Internet regulation with their own individual wish-fulfillment fantasies of what they dream a “public-utility” should be, not what the ugly historical reality tells us public-utility regulation actually was. For example, he has implied that forbearance will cut out things like rate-of-return regulation.

This just begs the questions raised by the issue of “regulating the Internet like a public utility.” The very elements that Wheeler proposes to forbear constitute part and parcel of public-utility regulation as we have known it. If these are forborne, we have no basis for knowing what to expect from the concept of Internet public-utility regulation at all. If they are not, after all, forborne – then we are back to square one, with the utterly dismal prospect of replaying 20th-century public-utility regulation in all its cynical inefficiency.

Forbearance is a good idea, all right – so good that we should apply it to the whole concept of Internet regulation by the federal government. We should forbear completely.

DRI-296 for week of 9-7-14: Airlines Fleecing Consumers? No, Columnist Fleecing Readers

An Access Advertising EconBrief:

Airlines Fleecing Consumers? No, Columnist Fleecing Readers

These days Americans fight fiercely for the coveted status of “victim.” In bygone days, we were rebuked for our headlong pursuit of success at any cost. Today, we compete to construct the best excuse for failure.

The favored tactic in the pursuit of victim status is to blame some malign force that has it in for us. Since something large enough to constitute a malign force will usually take on an impersonal character, it is hard to assign a personal motive to its actions. Consequently, it is convenient to claim membership in a class of people similarly afflicted by the force.

Consumers are a leading victim class because they are numerous and because they deal with large, impersonal institutions. Businesses are often nominated as victimizers precisely because their relations with consumers are usually so impersonal.

A recent example turned up in the Washington Post, August 28, 2014, and was entitled: “Are Domestic Airlines Making Money By Fleecing Consumers?” The byline read “By Christopher Elliott, Columnist.” (Hereinafter, he will be referred to as CEC.)

Using the logic of economics, we will discover that CEC’s column stands as an excellent example of consumers being fleeced by a victimizer who exploits their weakness. But the victimizers are not the airlines, as the column contends. CEC himself is the victimizer. And the victims are not airline consumers. They are the readers of CEC’s column.

Columnist Feeds Readers’ Victimization Fantasies by Demonizing Airlines 

CEC begins with this icebreaker: “Why are airlines raking in record profits?” Not pausing to wait for response to this rhetorical question, he responds by speculating. “Maybe they’re monetizing your personal data… without your explicit consent.” Is he about to reveal an investigative scoop? No, he was apparently flinging some mud on the airlines as a cosmetic prep for his next accusation. “Then again, maybe it’s the fees. Airline add-ons, which cover ‘optional’ services for everything from reserving a seat to changing a ticket, used to be included in the cost of almost every fare. But over time, airlines began separating them from base fares. They sometimes neglected to mention that little detail, helping them earn more money but frustrating customers, critics say.”

Decades ago, a journalism school would have used this sort of opening as a primer on how not to write a story. The word “maybe” is a tipoff to the substitution of the reporter’s personal opinion for fact. In this case, the author is a columnist, not a reporter. Does that give him carte blanche to throw his opinions around as though they were nickels rather than hefting them thoughtfully as if they were manhole covers? At the very least, he should offer some supporting evidence for the speculation that the airlines are committing criminal breaches of privacy. Even columnists do not have the privilege of casually libeling their subjects.

CEC then calls upon the favorite weapon of today’s marauding journalist – the supporting anecdote. A man “didn’t know about the change fees when he booked [airline] tickets.” He had to postpone his trip, and complained that “they charged me $300 to change my tickets” while offering him a $142, limited-duration credit instead of a fee refund. His reaction was classic victim-speak: “Airfares are outlandish, fliers are charged for everything and comfort is a thing of the past? How can that be allowed [emphasis added]?”

 

There ought to be a law! Or so says CEC – and a yet-to-be-determined number of U.S. Senators, whose legislative chamber has launched an investigation of “airline fee transparency and passenger privacy.” The investigation will “determine whether current rules go far enough to protect consumers and, if not, whether new laws are needed.” CEC’s phrasing seems unduly circumspect here; if the Senate finds that current rules don’t go far enough, experience tells us that no power on Earth will stop them from passing more laws.

The Senate, led by Sen. John D. Rockefeller (D-W.Va.), “wants to know exactly how much airlines earn from checked baggage, advance seat selection fees, preferred-seat fees and trip insurance” – data that the Department of Transportation (DOT) now doesn’t obtain to this level of disaggregation. In other words, the Senate demands the kind of information publicly disgorged only by public utilities, even though the airlines have been federally deregulated for over 35 years. The Senate also demands to know the airlines’ privacy policies.

CEC predicts that the inquiry will find “that airlines profit from fees and peddling personal data,” which will probably lead to more “consumer-protection” laws. He is not the only prophet quoted in the column. A “data-privacy advocate” also lauds Congress for “expressing interest in…the absence of any federal law protecting air travelers’ privacy.” Where once newspaper stories reported what happened, we now have columns that predict what will and/or should happen.

CEC dutifully quotes a “spokeswoman for …a trade organization for major U.S. airlines.” She insists that “domestic air carriers are committed to ensuring that customers always know the price of their ticket before they buy” and that airlines are “pledged to protect their custom4ers’ privacy.”

“Charging customers for services they value and are willing to pay for – which is common…globally – has also enabled airlines to provide consumers the ultimate choice and control over what they purchase,” she concludes.

CEC contrasts his predicted (!) Senate bill with one passed by the House, the “so-called Airfare Transparency Act,” which “would allow airlines to disclose taxes and fees separately from the fares they quote. If signed into law, critics say, it would give airlines a license to make money by deceiving customers.” But wait – isn’t the whole premise of this column that airlines are already doing just that – “fleecing” their customers through disclosure? Indeed, in the very next paragraph, CEC predicts that the Senate inquiry will produce “a noisy battle between [those] that believe the airline industry should operate free of consumer regulations and those who think that America’s air carriers are shamelessly fleecing passengers.” Then why do airlines need a “license” to do what they are already doing now without one?

So far, we can see that CEC’s column id dedicated to demonizing the airlines by portraying them as victimizers and their customers as victims. CEC’s fact-free libel of the major airlines is bad enough. But the way it plays on the economic ignorance of readers to stoke their victimization fantasies is even more reprehensible. Economics will show that the airlines are not victimizers; that their customers are not victims; that CEC himself is victimizing his readers by exploiting their ignorance of economic logic.

The Economics of Airline Competition

Marxists have traditionally used the phrase “it is no accident that…” to denote the coincidence of events with the Marxian theory of history. In that same vein, we might say that it is no accident that CEC begins his anti-airline diatribe by excoriating airlines for their “record profits.” The current anti-business vogue relies on a pejorative theory of profit as its foundational argument. Since victimization implies that the victimizer gains at the victim’s expense, some highly visible measure of that gain is a handy tool for exponents to wield. In this view, profit is good for business; business is the evil victimizer and consumers are the helpless, passive victims. So, what is good for business must be bad for consumers. Since everybody is a consumer and there are a lot more consumers than business owners, this is a promising line of attack for left-wing journalists.

The modern welfare state is an inflationist environment. Big government cannot exist and thrive without large – and growing – rates of spending. This is the left-wing, welfare-state equivalent of economic growth, the difference being that economic growth is organic, healthy and sustainable while inflationist, welfare-state spending is inherently artificial, unhealthy and time-limited. There are only three ways for government to get money to spend: by taxing it away from citizens, borrowing it from abroad or creating it in one of various ways. Successively higher taxes will eventually spark peaceful or armed revolution; borrowing will eventually exhaust foreign sources; and money creation will destroy the value of money through inflation. (That value includes not merely the purchasing power of money but, even more important, the ability of the price system and interest rates to efficiently allocate the flow of goods and services now and in the future.)

Continuous inflation causes nominal monetary values to rise continuously. This means that profits appear continuously to be increasing even though their true economic value may not have risen. For example, the purchasing power of profits distributed as income to shareholders may not have risen and may even have fallen even though nominal profits have gone up.

But this doesn’t stop the press from solemnly reporting that a particular business or industry has earned “record profits” in this quarter or year. The oil industry is the favorite target, but this tactic is adaptable to any business. In this case, recent news reports celebrated the record quarterly profits earned by American Airlines, United Airlines and Southwest Airlines, thus giving apparent substance to CEC’s lead. Neither those news stories nor CEC’s column bothered to tell the rest of the story behind these “records.”

First, monetary values rise every year, so there is a tendency toward annual record-setting as long as demand is relatively stable. That means that nominal values should be adjusted for inflation using a price index before any records can be detected. If that were to happen, the whole incidence of business record-setting would change dramatically.

Second, the airline industry is a special case. Reading CEC and other left-wing pseudo-journalists would give you the impression that the major airlines are rolling in profits and that you could have become rich by owning their stock. Uh-uh. Ever since airline deregulation got off the ground in 1978, the industry has been a bloody competitive battleground in which survival, not profits, has been the overriding goal of most members. Exhibit A: That “record profit” hauled in by American Airlines last quarter was its first since emerging from bankruptcy recently. American just paid a dividend to shareholders for the first time since 1980. United Airlines is better off, but not by much. And these are the survivors in an airline industry that once included firms like TWA, US Air and Midwest Express. Still want to travel back in time and own airline stocks?

Airlines are among a class of industries, also including railroads and broadcast media, that share the common features of high fixed costs and low marginal costs. In order to produce any output at all, the business must incur heavy costs of initial investment and setup. Once the business is operational, its marginal cost of producing an incremental unit of output – marching one more passenger onboard, loading one more car with coal or sending out the incremental broadcast – is extremely low. That means that such businesses often must incur a high debt load but can remain in business for a long time while just covering incremental costs with prices that fall short of profitable levels. It is a recipe for fierce price competition, low profits and some firms eking out a bare existence.

Prior to deregulation, the major airlines were fat, dumb and happy under federal-government regulation led by the old Civil Aeronautics Board (CAB). The CAB cartelized the industry, setting fares that allowed everybody a nice profit while keeping prices so high that most people viewed air travel as a luxury. Airlines competed by painting their planes different colors and offering competing snacks and beverages – not by lowering their prices.

After deregulation, the CAB was replaced by the Federal Aviation Administration, which ended controls over pricing and entry. Airfares plummeted. The demand for air travel zoomed skyward. Of course, many airlines had a hard time making ends meet even with this increased demand. The price of oil underwent periodic upward spikes and each one claimed a casualty or two from the airline industry, where oil-intensive aviation gas is a key input. The high union wages enjoyed by employees of the old-line firms like TWA, United and American were a heavy chain around the necks of the business, while Southwest Airlines built a consistently profitable business model based on non-union labor, safety, superior service and efficient management.

People like CEC, and most of his online commenters, never tire of bad-mouthing airline deregulation. Yet the years after deregulation provided a laboratory comparison in real time between regulated and deregulated airlines. Deregulation applied specifically to airlines engaged in interstate commerce; e.g., most of them. But many states still supported an intrastate airline industry of planes that flew only routes within that single state. And the fares of those airlines remained sky high. It wasn’t unusual to find regulated intrastate airfares that were much higher than deregulated interstate airfares for routes traveling longer distances and in higher demand.

Of course, anybody who actually believes CEC can always buy airline stocks and sit back, waiting to get rich. When that doesn’t happen, though, the buyer should blame CEC, not this writer.

In the broader sense, CEC and the political Left are barking up the wrong tree in the wrong forest by demonizing profit. During the last 36 years of deregulation, the sole airline to always turn a profit has been Southwest. And the perennial choice among consumers as the most popular airline has also been Southwest. In a free-market system, profit serves at least two indispensable functions: it identifies the sectors where consumers want additional resources to go and it rewards those firms that best serve consumer wants. In these cases, it is consumers that are in the driver’s seat directing the direction and amount of profit and consumers that ultimately benefit from the goods and services that are produced profitably. Nobody can claim that Southwest Airlines was a monopolist or an oligopolist getting fat by sweating money out of the hides of their customers.

The Economics of Bundled Pricing

Economics says that CEC is the opportunist capitalizing on the ignorance of his customers, not the airlines. Review the comments of the dissatisfied customer quoted by CEC: “Airfares are outlandish, fliers are charged for everything and comfort is a thing of the past. How can that be allowed?”

Airfares are not outlandish but cheap compared to the fares prior to deregulation. That refers not only to airline deregulation but also to energy deregulation, which eventually allowed the technological advanced that drove up domestic supplies of oil and drove down oil prices.

The comment that “fliers are charged for everything” is an obvious reference to the fees referenced by CEC. But the comment itself is inane. Of course consumers are charged for everything – how could they not be? Who else is there to pay for the goods and services consumers receive?

Business firms are not charitable institutions. The economic purpose they serve is to produce things more efficiently than we can ourselves. The firms must place a value on all the goods and services they produce because all of them require the use of scarce resources. Only if consumers are willing to pay the costs of all the resources used in production can we conclude that production is efficient. And we can’t draw that conclusion unless all of those costs are reflected in the price consumers pay. Moreover, businesses can’t remain in business unless consumer payments cover all business costs.

Economic logic tells us that CEC’s disgruntled customer is living in a left-wing fool’s paradise, where goods and services are magically provided free. But wait – CEC himself told us the same thing in the second paragraph of his column, when he said “Airline add-ons, which cover ‘optional’ services for everything from reserving a seat to changing a ticket, used to be included in the cost of almost every fare.” Right! And before deregulation, those costs were inflated by everything from union featherbedding and administered wages to government-imposed high fares to frills that consumers cared little about.

So what in the world is all this complaining over fees? Are the complainants really, truly saying “before the fee imposition I paid $X and now I’m paying $X plus the cost of the fee, therefore I’m worse off by the amount of the fee”? But that can scarcely be right, can it? Otherwise, airlines would have the business equivalent of a perpetual motion machine; all they’d have to do is arbitrarily pick something else to charge the customer for in order to inflate the cost of the ticket. (Charge the passenger for putting up the jetway, for taking the boarding pass, for delivering the safety lecture, ad infinitum.) In the fool’s paradise, airlines can arbitrarily charge any price they want when there is no government regulation to protect consumers. But as we now realize, it is competition that protects consumers, not government regulation.

Today’s fee increases are not arbitrary price increases. Instead, airlines are partially unbundling the elements of the airline flight in order to earn more revenue by allowing some customers to pay less by excluding elements that they don’t find desirable. They do the same thing now with beverage service when they offer alcoholic beverages for a price. By serving alcohol only to those few people who want a drink badly enough to pay for it, they allow the rest of us to fly cheaper than would be the case if they had to add on the cost of alcohol to the ticket price. This is not a strategy for raising prices but a strategy for avoiding price increases.

 

Why should the airlines want to avoid price increases? Deregulation has proved that the overwhelming bulk of the American public wants to fly from point A to point B as cheaply as possible – period. But there is a minority of the public that is willing to pay for amenities in the air. Airlines desperate to survive in the Darwinian struggle of the fittest that is today’s airline business are now trying to serve both classes of customers by keeping base fares as low as possible while charging the minority fees for those amenities that can be separately priced.

The political Left may find this competitive desperation unseemly but the one thing airlines shouldn’t be accused of is victimizing their customers. Unfortunately, that is how CEC

and his ilk make their living – by trashing free markets and their practitioners and victimizing readers.

When CEC’s Grumpy Old Man grouses that “comfort is a thing of the past… how can that be allowed?” he is apparently unaware that he is the one allowing it and that calling for government intervention is asking for the government to substitute its arbitrary dictates for his freedom of choice.

The reason “comfort is a thing of the past” is that consumers value comfort less than the cost of providing it. But if CEC or Mr. Grumpy objects, all they have to do is start their own airline and sell it to the public by advertising its comfortable amenities. If there is really a market for a Plush Air or Lavish Skies, lenders will pony up the cash, just as numerous lenders have done over the last 36 years to finance one failed start-up airline after another.

Full Disclosure? 

Is there the hint of a scintilla of a point anywhere in CEC’s disgraceful flight of fancy? Well, his consumer advocate (Sally Greenberg of the National Consumers League) punctuates her own silly diatribe against airline profits with the point that “many of the fees are poorly disclosed.” This is the only shot worth taking against the airlines among all those fired by the hand-held missile launchers of contemporary journalism.

A passenger who wants to change a flight should know in advance that a fee is being charged for the change. “In advance” means at the time of original purchase. Formerly that sort of notification was handled mostly by travel agents. But the same Internet revolution that has lowered the cost of term insurance by decimating the ranks of insurance agents and lowered the brokerage cost of stock transactions by eviscerating the ranks of stockbrokers has also winnowed the ranks of travel agents. And it is not too hard to imagine the relevant notifications falling between the cracks of the system. But a consumer can only fall victim to that kind of informational glitch once before being put on notice. That is not exactly like having your net worth confiscated by an airline.

Free markets are not perfect. But they work vastly better than anything else mankind has yet devised. Eventually the free market will even catch up with people like CEC, whose consumers are really the ones being fleeced.